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INSIGHT: How to Use a Delaware Law to Clean Up a Corporate Mess

May 15, 2020, 8:01 AM

In today’s environment where startups are managed leanly with minimal cash and founders increasingly handle their own legal, accounting, and fundraising efforts, it is not surprising that shortcuts are taken and corporate formalities are not followed, with potentially unpleasant legal, accounting and financial consequences.

Not to fear, however, as the State of Delaware enacted Section 204 of the General Corporation Law, and other states have adopted analogous provisions, to enable corporations to rectify defective corporate acts. Section 204 of the DGCL is especially handy before a round of financing, or upon a sale of a company, when a due diligence investigation turns up the errors.

The statute provides direct instructions for how a company’s board of directors and shareholders can ratify otherwise voidable or void actions purported to have been taken without proper corporate authorization.

For example, if a company issued simple agreement for future equity to investors without prior approval from the board of directors, the board can retroactively ratify that issuance. In addition, Section 204 can ratify the appointment of a CEO or a director who had not been duly appointed and can ratify all prior actions taken that unauthorized officers and directors had made.

Limitations to Section 204

There are some limitations, however, in Section 204, insofar as it is not a time machine that can be used to change history. For example, if shares were not issued, the board ratification will not be deemed to have caused the issuance at a prior date in time.

By the same token, if a board reviewed a proposed action and rejected it, a later board action can not deem that it had been approved at the prior meeting.

Following are the guidelines for using Section 204 of the DGCL to cleanup a corporate mess:

  1. The currently presiding board of directors must affirm by unanimous written consent or adopt resolutions at a duly convened meeting resolutions that itemize the prior defective corporate act, including all relevant information, such as the reason for the need for reliance on Section 204.
  2. If shareholder authorization would have been required at the time of the purported corporate action, then the company’s current stockholders must adopt resolutions approving and ratifying the prior purported defective action, and then issue notices to both the prior shareholders as well as the other current shareholders, whether or not the holders were holding validly issued stock or putative stock (e.g., stock that was intended to be issued but not properly issued).
  3. If the prior defective corporate act would have required a filing with the State of Delaware, then the company will need to file a certificate of validation upon ratification pursuant to Section 204.

While a corporate mess can often be cleaned up by compliance with Delaware Section 204, the cost and timeline should not be ignored. There is a not insignificant filing fee for a certificate of validation, the timeline is not easily expedited, and obtaining the consent of the directors and shareholders can be time consuming and potentially involve some negotiation.

Section 204 of the Delaware General Corporation Law is a great tool to clean up corporate messes, but should not be a reason to delay implementation until a financing or liquidity event, as it could cause unnecessary delays, costs and compromises that you might not otherwise need to make.

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

Author Information

Louis Lehot is the founder of L2 Counsel P.C. He is a corporate, securities, and M&A lawyer, and helps his clients, whether they be public or private companies, financial sponsors, venture capitalists, investors or investment banks, in forming, financing, governing, buying and selling companies. He is formerly the co-managing partner of DLA Piper’s Silicon Valley office and co-chair of its leading venture capital and emerging growth company team.

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