Chancery Court Holds Under-Manned Board’s Acts Were Invalid but Potentially Susceptible to Validation under DGCL §205

By: Scott E. Waxman and Michael C. Payant

In Applied Energetics, Inc. v. George Farley, et al., C.A. No. 2018-0489-JTL (Del. Ch., Aug. 3, 2020), the Delaware Court of Chancery (the “Court”) considered a motion for partial summary judgment by Applied Energetics, Inc. (the “Company”) relating to actions by George Farley (“Farley”) as sole member of the Company’s board of directors (the “Board”) and compensation committee (the “Committee”). The Court granted summary judgment for the Company that certain actions taken by Farley were invalid for failure of authorization but denied the Company’s motion for summary judgment on other claims, holding (a) that the actions could potentially be validated under §205 of the Delaware General Corporation Law (“DGCL”); and (b) Farley could potentially recover damages for an allegedly-agreed salary or under an unjust enrichment theory.

Founded in the early 2000s, the Company marketed, developed and manufactured defense and security products. Farley was one of six directors as federal funding and innovative IP carried the Company to a market capitalization of nearly $1 billion in 2006. Two years later, the Company’s share price had fallen by 98%. One director resigned without replacement in 2009, and in 2012, the Board was reduced to three directors and the Committee’s operations were suspended to cut costs. In 2015, one of three directors resigned and Farley was named principal executive officer and principal financial officer. Early in 2016, the other remaining director resigned, leaving Farley as the lone director and Committee member. In the absence of a bylaws amendment or Board action, the Board remained at three and the Committee remained suspended.

Farley, as sole director and sole Committee member, took several actions ostensibly geared to reactivate the then-dormant Company. In February 2016, Farley executed a Board consent (the “Board Consent”) resolving to issue 33 million shares of nominal value to compensate legal counsel and several third party advisors. The Board Consent also purportedly approved issuance of 20 million shares to Farley for prior services as a director and officer. The Committee remained suspended and the stock plan’s terms did not permit a sole Committee member to administer the Company’s stock plan. Nevertheless, Farley purported to execute a written consent as sole Committee member (the “Committee Consent”), in which he resolved to issue another 5 million shares to himself under the stock plan (together with the 20 million shares issued under the Board Consent, the “Issuances”). According to public filings, Farley also directed the Company to accrue $150,000 annually as compensation to him (the “Salary Agreement”), though this arrangement was not captured in any formal Board action. Soon thereafter, Farley transferred 20 million of his shares as a gift (the “Transfer Shares”) to AnneMarieCo, LLC, an entity owned by Farley’s wife and children (“AMC”).

The Company brought a number of claims against Farley and AMC for damages and equitable relief based on Farley’s purported action as the sole Board and Committee member. Farley brought counterclaims seeking damages and a judicial validation of his actions under DGCL §205. In the present action, the Company moved for partial summary judgment that (i) Farley’s approvals of the Issuances and the Salary Agreement (collectively the “Challenged Acts”) were invalid; (ii) the Court could not validate the Challenged Acts under DGCL §205; and (iii) Farley could not recover damages under the Salary Agreement or an unjust enrichment theory.

The Court first determined the Challenged Acts were invalid due to failure of authorization. At the relevant time, the Company’s bylaws required three directors on the Board, and a quorum required a majority of such directors. Without a quorum, the Board could not act, other than to fill director vacancies. Accordingly, Farley as sole director could not make a quorum to approve the Challenged Acts in a Board meeting, nor could he evade the quorum requirement by acting through a written consent. Likewise, Farley as sole member of the suspended Committee lacked authority to enact the Committee Consent. As such, the actions purportedly approved by him in either capacity – including the Challenged Acts – were invalid due to a failure of authorization. Likewise, the Committee Consent was invalid for deficient authorization. Due to the failure of authorization, the Challenged Acts were invalid, and the Court granted summary judgment to the Company on this point.

The Court further explained that the Transfer Shares were likewise invalid, even in the hands of AMC. Under Delaware law, invalid shares in the hands of innocent third parties remain invalid – absent ratification or validation – unless the transferee is a bona fide purchaser for value. Because AMC received the Transfer Shares as a gift, they were not purchased for value and remained invalid. The Company was therefore entitled to summary judgment on the continuing invalidity of the Transfer Shares.

The Court next addressed the Company’s request for summary judgment that the Challenged Acts could not be ratified, concluding that the Challenged Acts could be judicially validated under DGCL §205. The statute provides that certain parties may petition the Court to validate an act that was within the power of a corporation, but which act was invalid due to a failure of authorization. As both a stockholder and a director, Farley was among the class of persons with standing to seek validation under DGCL §205. The Court extensively parsed out the distinction between (i) acts not within the power of a corporation, and (ii) acts otherwise within a corporation’s power, rendered void or voidable due to a failure of authorization. “Power” refers to a corporation’s ability to engage in a given act. “Authorization” deals with “whether the proper intra-corporate actors or combination of actors, such as the corporation’s officers, directors, or stockholders, have taken the steps necessary to cause the corporation to take the given act.” The Court explained that the power to issue shares and the power to compensate officers and directors were each among the numerous powers enumerated in the DGCL. As such, the Challenged Acts failed not for a lack of corporate power, but due to the failure of authorization described above. As the Challenged Acts were within the Company’s power and invalid only due to a failure of authorization, they were subject to validation under DGCL §205. Accordingly, the Court denied the Company’s motion for summary judgment on this issue.

Next, the Court addressed Farley’s counterclaim for non-payment of funds he claimed were due to him under the alleged Salary Agreement. The Company sought summary judgment on the basis that Farley, as sole director, could not have validly caused the Company to agree to pay him $150,000. As discussed above, the Salary Agreement was subject to potential validation by the Court under DGCL §205, which would permit Farley to continue pursuit of his claim for non-payment. Accordingly, the Court also denied the Company’s motion for summary judgment on this point.

Finally, the Court declined to grant summary judgment to the Company on Farley’s counterclaim seeking payment for his services as an officer and director under an unjust enrichment theory. The Court briefly outlined the requirements for an unjust enrichment claim: “(1) an enrichment, (2) an impoverishment, (3) a relation between the enrichment and impoverishment, (4) the absence of justification, and (5) the absence of a remedy provided by law.” The Company contended Farley agreed to serve as a director without pay and was not entitled to recovery for benefits he provided the Company, but the Court found the evidence gave rise to disputes of material fact on this question. Viewing the evidence in the light most favorable to Farley, the Court denied summary judgment as to Farley’s unjust enrichment claim.

Applied Energetics, Inc. v. George Farley, et al., C.A. No. 2018-0489-JTL (Del. Ch., Aug. 3, 2020)