Late last year, Vice Chancellor John Noble of the Delaware Court of Chancery issued a decision in Boris v. Schaheen1 that highlights the importance of following formalities when issuing stock. The decision found an array of purported stock issuances to be invalid and held that the invalid issuances could not be "ratified"—i.e., retroactively validated. In the decision, Vice Chancellor Noble made broad statements about defects relating to the issuance of stock and when and whether such defects can be ratified, which could be viewed as limiting the ability of corporations to ratify certain defects under the Delaware case law, at least in the stock issuance context. Importantly, if attempted stock issuances are void because a corporation did not follow the proper formalities and those issuances are not properly ratified or cannot be ratified, a person thought to own the related stock is not actually a stockholder. The principles from this case could apply as well to the grant of stock options and other similar awards.
The decision also underscores the potential utility of new Sections 204 and 205 of the Delaware General Corporation Law (DGCL), which go into effect on April 1, 2014. Sections 204 and 205 are intended to provide a path by which corporations, using statutory procedures, can ratify defective corporate acts, including stock issuances, that may otherwise be incapable of ratification under the case law.
Delaware law requires that corporations follow certain procedures when issuing stock. Generally, Delaware law views stock issuances as "within the exclusive control" of the board of directors2 and imposes the following requirements:
The board of directors must approve stock issuances in a written instrument, either by resolution at a properly held meeting or by unanimous written consent.
The company must receive sufficient consideration in return for stock.
The company should generally maintain a proper stock ledger.
The board of directors must also approve the grant of stock options and stock rights, as well as the terms of such awards and the instruments evidencing them. The board of directors can delegate to officers the authority to grant stock options and other rights to acquire stock to employees if the board of directors and the company follow certain requirements specified in the DGCL.
Under current Delaware case law, certain defective corporate acts are "void," whereas others are "voidable." The distinction between "void" and "voidable" corporate acts has long been a concern of practitioners because acts that are merely "voidable" may be ratified, whereas those that are "void" may not. The Delaware case law provides that, at least in some instances where companies fail to follow proper procedures in undertaking corporate acts, including with respect to stock and other equity issuances, those acts can potentially be ratified—for example, by an informed vote of the board of directors to validate the defective acts retroactively. Historically, the question of whether a defective act is one that is "voidable" and can be ratified—versus simply being "void" from the outset—has been governed by an array of cases that often do not lead to a clear answer.
Unfortunately, questions concerning the validity of a corporation's stock often arise in pivotal moments—for example, when a battle over control emerges along with a dispute over who actually owns stock and can remove and elect directors (as in Boris v. Schaheen), or when a company embarks on a major transaction such as an IPO or sale and requires a legal opinion about its prior corporate acts. Although Boris v. Schaheen arose in the context of a small, private company that informally conducted its internal affairs and had extensive problems surrounding its attempted stock issuances, in our experience, companies of all kinds and sizes encounter issues concerning the propriety of their stock issuances and grants of stock options, restricted stock, and similar awards.
The New Boris v. Schaheen Decision
Boris v. Schaheen arose in the context of a dispute over control of a small, private company and a related company (originally intended to be a subsidiary). Two purported stockholders attempted to replace each company's board of directors, which in turn led to a dispute over who validly held stock and could remove and appoint directors. Delving into the companies' stock issuance history, the Court of Chancery noted that the companies informally conducted board meetings, never providing proper notice of the meetings, maintaining minutes, or keeping any records of formal votes taken by the directors. Significantly, in what became a principal focus of the case, the purported board approvals of the companies' stock issuances were not reflected in any written instrument—i.e., board resolutions or a unanimous written consent of the board of directors. Instead, the directors informally approved issuances loosely based on the intended "percentage ownership" of the companies. The companies originally designated official stock ledgers, but the companies did not maintain those ledgers and instead used electronic spreadsheets—the accuracy of which was in dispute and which the directors never formally adopted as the replacement stock ledgers of the companies. In addition, the governance, board meetings, and records of the two companies were generally commingled. In one case, one of the companies issued a stock certificate to an employee signed by the directors, but the issuance was not formally approved and the stock certificate listed an erroneous class of stock. At another point, the directors attempted to ratify their prior acts in general terms but did not specifically approve any of the attempted stock issuances. However, with respect to most of the purported stock issuances, contemporaneous documentation indicated that the directors had intended to issue many shares of each company's stock.
The court noted that the DGCL contemplates "a formal approach to corporate governance, particularly for changes to the corporation's capital structure" and that "[s]tock is not validly issued unless the board of directors exercises its power [to issue stock] in conformity with statutory requirements."3 The court focused on the statutory requirement of a written instrument adopted by the board of directors to evidence the issuance under Section 151(a) and other provisions of the DGCL, either by board resolutions or by written consent. The court noted that this requirement should be enforced in a "strict" manner because this "formality maintains the integrity of the stockholder franchise under Delaware corporate law," "facilitates investment in stock," which is the "critical component" of wealth creation, and discourages "a repeat of situations . . . in which uncertainty is heaped on uncertainty, with the result being a jumbled corporate mess."4 The failure to comply with such a requirement, as in this case, rendered the stock "void,"a nullity such that "it cannot be remedied by equity."5 Further, the court found that although the board of directors might have informally decided to issue stock and the directors and stockholders might have acted as though stock had been issued, "even a shared understanding of what was intended is insufficient to satisfy the DGCL's strict requirement of a written instrument."6
The court concluded that only one of the companies had ever validly issued stock—in its initial "founder" issuances, which the parties had stipulated were valid. The court determined that the other company had no valid stock or stockholders at all. Importantly, the court further concluded that flaws of the kind before it could not be ratified and that the court could not apply the remedy of estoppel to recognize the issuances.
Boris v. Schaheen is a significant case addressing a basic corporate law matter—the implications of flawed common stock issuances—that has been infrequently addressed in modern Delaware case law, and thus, the case is an important new point of reference for Delaware corporations and their advisors. In our experience, some of the questions that commonly arise relating to whether a corporation has properly issued stock or granted stock options and similar awards include the following:
Did the board of directors and corporation follow proper procedures, including receipt of required approvals?
Did the corporation receive adequate consideration in return for the issuance or grant?
In the case of stock options and other awards by board committees or officers, did the committee or officers have proper authority to grant the awards (i.e., was the delegation done properly and did the committee or officers have authority to grant the types of awards in question)?
When stock is issued following an amendment to a certificate of incorporation implementing a new class of stock or a stock split occurs, did the corporation follow the proper procedures for adopting the amendment, including obtaining proper approvals?
Historically, where a defect arose in one of these areas, whether the defect could be ratified and validated in reliance on Delaware case law would depend on the various facts and circumstances of the defects in question. Corporations seeking to ratify defective acts in reliance on the Delaware case law now must also carefully consider Boris v. Schaheen.
DGCL Sections 204 and 205
Last summer, the Delaware legislature adopted, and the governor signed into law, two new provisions of the DGCL that are intended to provide a clearer path to ratifying "defective corporate acts"7 and issuances in most circumstances—including where the case law previously did not permit ratification or was ambiguous about whether ratification would be permissible. These provisions go into effect on April 1, 2014. Section 204 will allow a corporation to ratify various applicable defective corporate acts, including stock issuances, if the corporation follows particular procedures, including, among other things, approval by the board of directors, notice to stockholders, and, in certain cases, approval by stockholders. Section 204 imposes many procedures that will need to be carefully followed and, notably, is a new, untested provision. However, it will provide corporations with a potentially more certain path for resolving difficult problems and clarifying uncertainties.
Section 205 will give the Delaware Court of Chancery equitable jurisdiction and authority to validate and adjudicate defective corporate acts and to determine whether defects were properly ratified.
Conclusion: Corporate Formalities Matter and the Impact of DGCL Sections 204 and 205 Remains to Be Seen
The Boris v. Schaheen decision makes it clear that corporate formalities remain extremely important under Delaware law, particularly in the context of issuing stock and equity awards. Failure to follow corporate formalities may result in material, negative consequences, including concerns about the most fundamental issues relating to a corporation's existence. Corporations should regularly consult with their advisors to ensure that their practices relating to stock matters are in compliance with applicable law. Where defects are identified and ratification is the desired path for fixing those defects, Delaware corporations will need to weigh carefully with their advisors whether the defects can be remedied by the use of basic common law ratification—i.e., after-the-fact proper approval by directors and/or stockholders—or, beginning in April, whether the statutory ratification procedures set forth in Sections 204 and 205 are more appropriate.