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INSIGHT: Your Corporate Client Made a Big Mistake—Delaware Law to the Rescue

Jan. 17, 2020, 9:01 AM

No matter how minor, innocent, or accidental it may be, courts can nullify an entire transaction if a single “technical defect” relating to a corporate law, bylaw, charter provision, or agreement occurs In a state such as Delaware, where most U.S. corporations are incorporated, this has long been standard practice.

Of course, this puts a lot of pressure on corporate lawyers to cross every “t” and dot every “i.” However, even the best lawyers make mistakes, and there is always the risk that an innocent error no one is aware of today can surface out-of-the-blue tomorrow, rendering material corporate transactions and stock as void.

This risk, often hidden in plain sight, potentially poses existential consequences to corporations and can wipe out shareholder value in an instant. Not to mention that if such a situation unfolds, the corporation’s lawyers will likely be blamed first.

Whether they know it or not, all Delaware corporations and their shareholders, as well as their counsel, constantly and inevitably bear this risk.

Enter Sections 204 and 205 of the Delaware General Corporate Law

In 2014, Delaware’s General Assembly passed two sister statutes that would allow Delaware corporations to fix bungled transactions: Delaware General Corporate Law Sections 204 and 205. Even though these statutes provide procedures for a Delaware corporation to immediately fix a technical defect without causing disruption or harm to the corporation or its shareholders, too often corporate leadership, shareholders, and their counsel are unaware that they even exist.

In short, Section 204 is a “self-help” provision that enables the board of directors of a Delaware corporation to retroactively amend a company transaction or agreement, including stock issued pursuant to the defective corporate act which might otherwise be void due to a technical defect.

To do this, the board must first adopt a special resolution (ratification resolution”), effective the day it’s filed or as of a prior chosen date, identifying, among other things:

  1. the nature of the technical defect;
  2. the act or omission that caused the technical defect;
  3. the action the corporation is taking to correct it; and
  4. the effective date of the corrective action.

If the ratified act is one that originally required the corporation to make a filing with the Delaware secretary of state, then the corporation must also file a “certificate of validation” with the secretary of state describing the act being ratified and containing a copy of the ratification resolution.

The board must also provide notice of the ratification resolution to the corporation’s shareholders of record as of the effective date of the ratification resolution. Additionally, if the corporate act being ratified would have originally required a shareholder vote, the corporation must hold a shareholder vote (among its current shareholders) on the ratification resolution.

Section 205 is a legal proceeding that may be brought exclusively in Delaware’s Chancery Court under at least two circumstances.

First, Section 205 empowers shareholders and non-shareholders who claim they are adversely affected by a ratification resolution to challenge the effectiveness of any such resolution by bringing a legal proceeding in Delaware’s Chancery Court in which the court will decide if the ratification should stand.

Second, Section 205 enables a Delaware corporation to entirely bypass the ratification resolution process, and instead go straight to the Chancery Court by commencing a Section 205 proceeding seeking a court order declaring as valid a bungled corporate transaction marred by defects and “fixing” any such errors.

For example, if as of January 2010, a Delaware corporation’s board decides to issue new stock but mistakenly fails to codify that decision in a writing such as a board resolution, the stock issuance and all shares issued pursuant to it are void under Delaware law.

Suppose, however, that years later in a transformative transaction (e.g., a sale or a merger), the board’s mistake is discovered for the first time. To remedy this, the board can pass a ratification resolution, under Section 204, to ratify the stock issuance and the shares issued pursuant to it.

The corporation would then have to provide notice of the ratification resolution to holders of record as of January 2010, who would then have 120 days to commence a Section 205 proceeding in Delaware’s Chancery Court should they wish to challenge it. Should they fail to timely do so, the ratification resolution indelibly stands.

Statutory Ratification Outlook for 2020 and Beyond

Connecticut, Delaware, Idaho, Kansas, Nevada, North Carolina, Oklahoma, Texas, and Washington have adopted statutory ratification statutes similar to DGCL Sections 204/205, all of which became effective in 2019.

Additionally, many other states have adopted similar legislation which become or will become effective in 2020, including: Alabama (effective Jan. 1), Colorado (effective July 1), Montana (effective June 1), Oregon (effective Jan. 1), and Virginia (effective July 1).

As we look to 2020 and beyond, the trend in state adoption of statutory ratification statues is only expected to continue. Statutory ratification is here to stay, and corporate practitioners are well advised to master these statutes.

Conclusion

If there is any doubt, no matter how small, that a corporate transaction involving a Delaware corporation may not have been executed properly, counsel should consider using Sections 204/205 to ratify the transaction.

This can make all the difference between gaining immediate comfort that the corporation and its stock is legally sound versus having any misgivings that the slightest potential mistake that no one is focused on or knows about will someday surface and pose a threat down the road.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

About the Author

Scott Watnik is a litigation partner at Wilk Auslander LLP in New York City. His practice emphasizes all aspects of commercial litigation, and he has the distinction of being the only lawyer to date in the nation who has represented a shareholder, from case inception through appeal, in the only Section 204/205 case that was tried in Delaware’s Chancery Court and subsequently heard on appeal before Delaware’s Supreme Court.

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