Ruling

The court held that Farley lacked the authority under the Company’s bylaws and Delaware law to issue himself the shares of common stock and the annual salary.¹⁰ Delaware law provides two ways for a board of directors to take action: (1) through a resolution adopted at a meeting, or (2) through unanimous written consent without a meeting.¹¹ The court held that Farley’s actions were invalid under both methods for effecting corporate action and granted the Company’s motion for summary judgment as to this claim.¹²

First, the court held that Farley, as the sole remaining director, could not meet the quorum requirement and could not take action at a meeting.¹³  Although Farley was the sole remaining director at the time he issued the stock and approved his own compensation, the Company’s board of directors had three seats.¹⁴ The Company’s bylaws, consistent with Section 141(b) of the DGCL, required that a majority of the total number of directors be present at a meeting to constitute a quorum.¹⁵ For a board with three seats, a quorum required two directors to approve the corporate actions, and Farley alone could not meet it.¹⁶

Second, the court held that Farley could not bypass the quorum requirement by acting by unanimous written consent without a meeting.¹⁷ Delaware law requires the number of directors acting unanimously by written consent be sufficient to constitute a quorum if the actions were taken at a meeting.¹⁸ Accordingly, the court held that the actions Farley took, as the sole remaining director, were invalid as a matter of law.¹⁹ 

The court, however, denied the Company’s motion for summary judgment as to Farley’s counterclaim seeking the court’s validation of the act under Section 205 of the DGCL and deferred on the question of whether it would exercise its authority under Section 205 to validate the acts until after trial.²⁰ 

The court noted that the Delaware General Assembly enacted Sections 204 and 205 of the DGCL to create the ability “to overrule the existing precedents requiring that defective stock and acts be found void.”²¹  And, equally important, Sections 204 and 205 authorize the curing of defects which, if incurable, might destabilize a company’s capital structure.²²  The court further explained that Section 204(a), which the court referred to as a “keystone” provision of the DGCL, states “no defective corporate act or putative stock shall be void or voidable solely as a result of a failure of authorization if ratified as provided in this section or validated by the Court of Chancery in a proceeding brought under § 205 of this title.”²³  Notably, the court explained that Sections 204 and 205 “may not be used to authorize retroactively an act that was never taken but the corporation now wishes had occurred, or to ‘backdate’ an act that did occur but that the corporation wishes had occurred as of an earlier date.”²⁴

The court rejected the Company’s position that because Farley was the sole director on a board with three seats, the corporation lacked the power to take the actions in question.²⁵  The Company’s position conflated corporate power (whether the entity had been granted the ability to engage in a given act) with authorization (whether the proper intra-corporate actors took the necessary steps to exercise that power):

[T]he Company contends that because Farley was the sole director on a board with three seats, the corporation lacked the power to take the actions in question. This contention misunderstands the distinction between the absence of corporate power and a failure of authorization. The question of corporate power refers to the ability of the corporation as an entity to engage in a particular act, regardless of what steps may be necessary to properly authorize that act. The question of authorization refers to whether the appropriate combination of intra-corporate actors – viz., the officers, board of directors, or stockholders – took the proper steps to authorize the entity to exercise corporate power in compliance with the requirements of the DGCL and the corporation’s constitutive documents.²⁶

The court explained that the Company had the “raw corporate power” to issue shares and compensate its officers and directors.²⁷ Farley’s attempts to cause the corporation to take those actions failed because of defects in authorization, not because of the absence of such “raw corporate powers.”²⁸  Accordingly, the court found Farley’s acts could be validated (but declined to do so until after trial) because they fell “squarely within the grant of authority provided by Section 205(a)(3).”²⁹

Takeaways

• A corporate action that is clearly at odds with the DGCL may be later validated by the Court of Chancery if the corporate action was within a corporation’s power but not properly authorized.
• Understanding Sections 204 and 205 of the DGCL, as well as their legislative history, can be an important tool for any party seeking to validate an otherwise defective corporate act for failure of authorization (opposed to lack of corporate power).
• The key distinction between the power of the corporation and a failure of authorization is that corporate power refers to whether the entity has been granted the ability to engage in a given act, but authorization refers to whether the corporation’s officers, directors, or stockholders have taken the steps necessary to cause the corporation to take the given act.
• Whether the Court of Chancery will validate a defective corporate act is a determination that will likely be made after trial.

1. See Applied Energetics, 2020 WL 4432271, at *2.
2. Id. at *2-3.
3. Id. at *5.
4. Id. *10.
5. Id.
6. Id. The Company initially brought suit seeking a preliminary injunction against Farley and AnneMarieCo, LLC. In 2019, the court issued a preliminary injunction barring Farley from transferring his shares pending the final disposition of the litigation. See Applied Energetics, Inc. v. Farley (Injunction Decision), 2019 WL 334426 (Del. Ch. Jan. 23, 2019, revised Jan. 24, 2019).
7. See Applied Energetics, 2020 WL 4432271, at *1, *12.
8. Id. *12.
9. Applied Energetics, 2020 WL 4432271, at *1, *11; see also Del. C. Section 205 (providing the Court of Chancery the authority to determine the validity of defective corporate acts, including to “[d]etermine the validity and effectiveness of any defective corporate act not ratified or not ratified effectively pursuant to § 204 of this title”).
10. See Applied Energetics, 2020 WL 4432271, at *1, *12 (granting the Company summary judgment as to the issue of whether Farley’s acts were invalid).
11. See 8 Del. C. Section 141(a)-(b), (f).
12. See Applied Energetics, 2020 WL 4432271, at *1, *12.
13. Id. at *16.
14. Id. at *12.
15. Id. at *1, *12; see also Del. C. Section 141(b).
16. See Applied Energetics, 2020 WL 4432271, at *16.
17. Id.
18. Id. at *15-16 (“Section 141(f) is not a vehicle for directors to avoid the requirements of a meeting. It is a vehicle for directors to use when they could satisfy the requirements for action at a meeting but the consensus is unanimous and thus a meeting is unnecessary.”).
19. Id. at *12.
20. Id. at *21-23.
21. Id. at *22.
22. Id. at *24 (noting that a “domino effect” can result from a defective corporate act, such as issuing stock, that infects subsequent acts).
23. Id. at *22.
24. Id. at *23.
25. Id. at *1, *25 (“According to the Company, because the board lacked a sufficient number of directors to supply a quorum, the Company lacked the “raw corporate power” to take any acts. This argument misunderstands the distinction between the power of the corporation and a failure of authorization.”).
26. Id. at *1.
27. Id. at *28-29.
28. Id. (“The absence of a quorum is not a question of corporate power. It is a failure to comply with ‘a provision of…[Section 141(b) of the DGCL] and the Company’s charter and bylaws. It is therefore a failure of authorization within the meaning of Section 204(h)(2).’”).
29. 2020 WL 4432271, at *29 (“This court has the authority to validate Farley’s issuance of shares and his approval of his compensation because those acts are within the power of the corporation but are void or voidable due to a failure of authorization.”).

Client Alert 2020-502