Court of Chancery Applies New DGCL § 205 to Determine Validity of Defective Corporate Acts
By Eric Freedman and Sophia Lee Shin
In In Re Numoda Corporation Shareholders Litigation, the Court of Chancery exercised its new powers under Delaware General Corporation Law (“DGCL”) § 205, which became effective as of April 1, 2014, to resolve various disputes regarding the capital structures of two related corporations that consistently failed to follow corporate formalities.
In In Re Numoda Corporation Shareholders Litigation, C.A. No. 9163-VCN (Del. Ch. January 30, 2015) (Noble, V.C.) (the “Numoda Shareholders Litigation Decision”), the Delaware Court of Chancery addressed a dispute concerning the capital structures of two corporations, Numoda Corporation (“Numoda Corp.”) and Numoda Technologies, Inc. (“Numoda Tech.”). The Numoda Shareholders Litigation Decision came on the heels of a decision of the Court of Chancery in a prior related action, Bons v. Schaheen, 2013 WL 6331287 (Del. Ch. Dec. 2, 2013) (the “225 Action”), in which the Court of Chancery refused to recognize several purported stock issuances due to a failure to comply with corporate formalities. Because DGCL § 204 (Ratification of defective corporate acts and stock) and DGCL § 205 (Proceedings regarding validity of defective corporate acts and stock) became effective on April 1, 2014, after the decision in the 225 Action, the Court in the Numoda Shareholders Litigation Decision used its new statutory powers to untangle the capital structures that had been the subject of the 225 Action.
DGCL § 204 provides that no defective corporate act or putative stock will be void or voidable solely because of a failure of the act to be properly authorized, so long as the act is ratified or validated thereafter. DGCL § 205 states that the Court of Chancery may “[d]etermine the validity of any corporate act or transaction and any stock, rights or options to acquire stock”. The Court in the Numoda Shareholders Litigation Decision opined that, while DGCL § 205 provides the Court with the flexibility to resolve a variety of defective corporate acts, the Court must not rely upon the statute to extend its powers far beyond remedying failures of the mechanics of corporate governance. Instead, in exercising its powers under DGCL § 205, the Court must look for evidence of a bona fide effort that would constitute a corporate act but for a defect rendering the act void or voidable.
Ann S. Boris (“Ann”), John A. Boris (“John”), and Mary S. Schaheen (“Mary”) were the initial directors of Numoda Corp. and Numoda Tech., which was formed as a subsidiary of Numoda Corp. John W. Houriet, Jr. (“Houriet”) was the Chief Technology Officer of Numoda Corp. and had served as president and a director of Numoda Tech. since January, 2014. Patrick J. Keenan (“Keenan”) performed legal work for both corporations and served as chief counsel and a director of Numoda Capital Innovations LLC. The Numoda Shareholders Litigation Decision refers to Ann, John, and Numoda Corp. collectively as “the Numoda Corp. Parties”, and to Mary, Houriet, Keenan, and Numoda Tech. collectively as the “Numoda Tech. Parties”.
The parties disputed the validity of the following actions relating to the two corporations’ capital structures: (1) whether Keenan was granted 30,000 shares of Numoda Corp. voting stock in 2002; (2) whether the Numoda Corp. board agreed to issue stock to Ann, John, Mary, and Keenan in April, 2004 (the “2004 Exchange Stock”); (3) whether Mary was granted 400,000 shares of Numoda Corp. voting stock before the spin-off of Numoda Tech.; (4) whether the board issued 5,100,000 shares of of Numoda Corp. voting stock to Houriet; (5) whether Ann returned 2,000,000 of her own Numoda Corp. voting stock to Numoda Corp.; (6) whether Mary was granted 5,725,000 shares of Numoda Corp. voting stock; and (7) whether changes to Numoda Tech.’s capital structure mirrored changes to Numoda Corp.’s structure after Numoda Tech.’s purported spin-off in January, 2005.
In an attempt to reduce the scope of litigation, the Numoda Corp. board on January 31, 2014 ratified the issuance of 30,000 shares of Numoda Corp. voting stock to Keenan (#1 above), the issuance of the 2004 Exchange Stock (#2 above), and the issuance of 5,100,000 shares of Numoda Corp. non-voting stock to Houriet (#4 above, but with the difference that the board ratified the issuance of non-voting rather than voting shares) (the “January Ratification”). The Court held that, although the DGCL as of April, 2014 allowed a board to ratify both void and voidable acts, the January Ratification failed to resolve the validity any of the share issuances disputed by the Numoda Tech. Parties, because it had occurred prior to the effectiveness of DGCL §§ 204 and 205.
The Court then proceeded to address each of the disputed capital structures in turn. First, it held that the issuance of 30,000 shares of Numoda Corp. stock to Keenan (#1 above) and the 2004 Exchange Stock (#2 above) were valid. The Court found that the January Ratification, among other evidence, provided sufficient proof that these attempted issuances were corporate acts, albeit defective. In determining the validity of the issuances, the Court analyzed the factors specified in DGCL § 205(d): (1) whether the defective corporate act was originally approved or effectuated under the belief that it was compliant with the requirements of the DGCL or the corporation’s certificate of incorporation or bylaws; (2) whether the corporation and the board treated the defective corporate act as valid and whether anyone has acted in reliance on the public record of the validity of such defective corporate act; (3) whether anyone was or will be harmed by the validation of the defective corporate act (without consideration of any harm that would have resulted if the defective corporate act had been valid when approved or effectuated); (4) whether anyone will be harmed by the failure to validate the defective corporate act; and (5) any other factors that the Court deems just and equitable. The Court validated the issuance of 30,000 shares to Keenan in large part because (a) all the parties had operated for years assuming the issuances had been made and had represented the capital structures as such to third parties; (b) Keenan could lose a significant voting interest if the issuance were not validated; (c) the Numoda Corp. board attempted to take official action to ratify the issuances; and (4) the issuances were no longer disputed, given the January Ratification.
The Court did not validate the issuance of 400,000 shares to Mary (#3 above) because she was unable to provide evidence of a corporate act for the Court to validate. Thus, this claim failed the DGCL § 205 analysis. As an alternative, Mary requested relief for breach of contract, unjust enrichment, promissory estoppel, intentional misrepresentation, and negligent misrepresentation. The Court concluded that Mary was not entitled to relief under any of these theories either, and stated that a claim that fails the DGCL § 205 analysis is unlikely to succeed on other equitable theories.
The Court validated the issuance of 5,100,000 Numoda Corp. voting shares to Houriet (#4 above). The most important question at stake was whether the shares issued to Houriet were voting or non-voting shares. The evidence reflected that during the negotiation for these shares, Houriet believed that his interest would be qualitatively similar to that of the other directors holding voting stock. Keenan, who prepared Houriet’s certificate, stated that although the certificate for these shares indicated that they were non-voting shares, Keenan believed he had prepared a certificate for voting stock, and the indication of non-voting stock was in error. Also, an informal stock ledger dated December 11, 2007 suggested that these shares had been approved by at least that date, and Numoda Corp. had been authorized to issue only voting stock until a charter amendment was filed on December 27, 2007. The Court also analyzed the five factors under DGCL § 205(d), and held that these factors favored validating the issuance because (a) the board of Numoda Corp. acted as if the issuance were valid and (b) Houriet would lose a substantial benefit if his shares were invalidated. The Court stated that the discrepancy between voting and non-voting status appeared to be attributable merely to a clerical error, and thus validated the issuance as voting shares.
The Court held that Ann had indeed returned 2,000,000 shares to Numoda Corp. (#5 above). All the parties conducted their business for years under the assumption that Ann had returned these shares, and made representations regarding the capital structure as such to third parties. There was additional support for the return in the issuance of a certificate for 5,100,000 shares of Numoda Corp. stock to Houriet, which issuance would have been facilitated by Ann’s return of the 2,000,000 shares. Also, Keenan stated that he had relied on the representation that Ann had returned 2,000,000 shares when he pledged his personal assets for the benefit of Numoda Corp.
The Court validated the issuance of 5,725,000 shares of Numoda Corp. stock to Mary (#6 above). The Court analyzed the five factors of DGCL § 205(d) and found support for the issuance because (a) until the litigation, the Numoda Corp. Parties had made representations accepting the issuance of these shares, (b) Mary and Keenan relied on these representations, and (c) Mary would be significantly injured if the Court failed to validate the grant.
Rather than validating the grants of Numoda Tech.’s shares to individual shareholders, the Court held that Numoda Tech.’s shares were under the control of Numoda Corp. (#7 above). The Court held that the evidence showed that Numoda Corp. was the parent of Numoda Tech., the former intended a spin-off of Numoda Tech., and Numoda Tech. believed that related share issuances had been made. However, while there was some evidence of corporate acts surrounding the spin-off and related issuances, the Court ultimately held that the uncertainty surrounding Numoda Tech.’s board meetings and the absence of any completed stock certificates suggested only that the two boards vaguely agreed that issuances would be made at some future time. The Court held that these were merely bare-minimum corporate acts, and the five factors of DGCL § 205(d) failed to persuade the Court to validate the issuance of Numoda Tech.’s stock to Numoda Corp. or the latter’s shareholders. The Court noted that its finding that Numoda Tech. was wholly controlled by Numoda Corp. did not significantly harm anyone, and given the above considerations, the evidence was insufficient for the Court to exercise its powers under the DGCL.
Lastly, the Court addressed whether the theory of unclean hands precluded the Numoda Tech. Parties from recovering entirely in a court of equity. The Court held that, while all of the parties acted poorly in failing to follow basic corporate formalities, there was no indication that the parties acted with improper intent that outweighed the benefit of resolving the issues on the merits, and thus denied the defense of unclean hands.