In re Numoda: Delaware Court of Chancery Describes Ratification of Defective Corporate Acts under New DGCL Section 205

Practical Law Legal Update 9-599-0505 (Approx. 8 pages)

In re Numoda: Delaware Court of Chancery Describes Ratification of Defective Corporate Acts under New DGCL Section 205

by Practical Law Corporate & Securities

Background

At issue in Numoda were a series of stock issuances by two related corporations that were not properly documented and which resulted in a dispute over the corporations' capital structures. Three siblings, Ann Boris, John Boris and Mary Schaheen, served as the initial directors of Numoda Corporation and Numoda Technologies, formed in June 2000 and December 2000, respectively. At its formation, Numoda Corp. validly issued 5,100,000 shares of voting stock to Ann, 1,266,667 shares to John and 3,333,333 shares to Mary. Numoda Tech. was intended to be a subsidiary of Numoda Corp. All three siblings were initially appointed as directors of both corporations. Subsequently, John and Ann resigned as directors of Numoda Tech.

As of December 2008, the parties believed that Numoda Corp. had the following capital structure:

John, with 3,045,561 voting shares (10.6%).
Ann, with 7,745,500 voting shares (26.9%).
Mary, with 10,839,053 voting shares (37.7%).
Patrick Keenan, with 1,035,000 voting shares (3.6%).
John Houriet, with 5,100,000 voting shares (17.7%).
PIDC Penn Venture Fund, with 1,018,950 voting shares (3.5%).

The parties also believed that in January 2005, Numoda Tech. had been spun off to the stockholders of Numoda Corp. and that Numoda Tech. had the same capital structure as Numoda Corp., despite there being no entries in Numoda Tech.'s stock ledger and no evidence that stock certificates had been issued.

In December 2012, John and Ann filed a lawsuit in the Delaware Court of Chancery to determine the validity of their stockholder written consents that removed Mary from, and elected themselves to, the boards of both Numoda Corp. and Numoda Tech. (Boris v. Schaheen, C.A. No. 8160–VCN, (Del. Ch. Dec. 2, 2013)). The litigation, whose resolution depended on whether the past issuances of stock had followed the necessary procedures under the DGCL, brought to light the defectiveness of the various stock issuances.

Following trial, the Boris Court found that both corporations' boards had not issued stock certificates as a default policy, had used informal processes without sending prior notice before board meetings and had failed to document their meetings with minutes. Due to the invalidity of several stock issuances resulting from the defective corporate acts, the Court held in 2013 that:

John and Ann owned a majority of the validly issued stock of Numoda Corp. and therefore had validly removed Mary from its board and elected themselves as the new directors.
John and Ann did not own a majority of the validly issued stock of Numoda Tech. and therefore had not validly removed Mary from its board or elected themselves to the board.

The Court added that because of its ruling that all of Numoda Tech.'s and some of Numoda Corp.'s stock issuances were void, a purported stockholder of either corporation could assert claims against the relevant issuers.

Numoda Corp. soon sued Numoda Tech., seeking to compel Numoda Tech. to issue its shares to Numoda Corp. in order to effect the spin-off as originally intended. Mary, Houriet and Keenan filed a complaint seeking stock consistent with their understanding of the two corporations' capital structures, and later amended their complaint seeking relief under the new Section 205 of the DGCL. Mary also appealed the Boris decision to the Delaware Supreme Court, which stayed the action pending the decision in Numoda. Meanwhile, on January 31, 2014, Nomuda Corp.'s board unanimously ratified some of its earlier defective corporate acts, including its issuance of:

30,000 shares of Nomuda Corp. voting stock to Keenan.
5,100,000 shares of Nomuda Corp. non-voting stock to Houriet.
Shares of stock to Ann, John, Mary and Keenan in exchange for certain obligations in order to improve its balance sheet and obtain a credit facility (the 2004 Exchange).

The parties in the present action asked the Numoda Court to rule on the validity of the acts taken in the January ratification. The parties also disputed:

A grant of 400,000 shares to Mary before the spin-off of Numoda Tech.
A grant to Mary of 5,725,000 voting shares of Numoda Corp.
Whether Houriet was issued voting or non-voting shares when the board approved a grant of a 15% interest in Numoda Corp. to him.
Whether Numoda Tech's capital structure mirrored that of Numoda Corp.'s after the spin-off.

Outcome

The Court ratified certain of the disputed stock issuances and not others, based on its interpretation of the types of defective corporate acts that it has the authority to ratify under Section 205.

Scope of Court's Authority under New Section 205

The new Section 204 permits boards to remedy otherwise void or voidable acts and stock. When judicial intervention is necessary, such as when the status of the board itself is in question, Section 205 allows the corporation, any director, any stockholder or any putative stockholder to bring an action to the Court of Chancery to retroactively validate the defective corporate act as of the date of the act. Under Section 204(h), a defective act includes any act or transaction that a corporation may take but is void or voidable due to a failure of authorization.

Section 205(d) provides a list of factors that the Court may consider in deciding whether to exercise its equitable authority under Section 205. In addition to a catch-all consideration of any factors that the Court deems just and equitable, the Court may consider whether:

The defective corporate act was approved with the belief that the approval was in compliance with the DGCL or the corporation's certificate of incorporation or by-laws.
The defective corporate act was treated as valid by the corporation and the board of directors, and if any person acted in reliance on the public record that the act was valid.
Any person will be harmed if the defective corporate act is ratified or validated by the court.
Any person will be harmed if the defective corporate act is not ratified or validated by the court.

The Numoda Court noted that by its wording, Section 205 grants the Court substantial discretion with no "rigid outer boundary," but cautioned that it should still exercise that discretion with caution and an eye towards the legislative intent. To that end, the Court reviewed Section 204's legislative synopsis, which plainly states that Section 204 is intended to overturn holdings in which a corporate act has been found void due to noncompliance with the DGCL or the corporation's organizational documents and which could not be ratified or validated on equitable grounds. The legislative synopsis called out in particular the decisions in STAAR Surgical Co. v. Waggoner, 588 A.2d 1130 (Del. 1991) and Blades v. Wisehart, (Del. Ch. Nov. 17, 2010). In STAAR Surgical, shares of preferred stock were deemed invalidly issued because the board failed to formally adopt the necessary documents in violation of Section 151 of the DGCL. In Blades, a stock split was deemed invalid because the board violated Section 242 of the DGCL by not:

Adopting a resolution proposing the split.
Obtaining shareholder approval.
Filing a certificate of amendment specifically about the split.

As the Numoda Court explained, the legislation's specific intent to overturn these two decisions reflects a desire to allow for an equitable remedy, even in situations where "corporate formalities are barely recognizable."

However, the Court cautioned that it does not read the legislation as giving it a "license to cure just any defect." In particular, the Court should only attempt to cure technical defects without either:

Retroactively authorizing defective corporate acts that the corporation never took but that it now wishes it had taken.
Changing the date that a valid act was taken.

The Court concluded that before addressing the equitable factors in Section 205(d) for ratifying a defective act, it must first find that there was an underlying act at all. The Court drew a distinction between defective corporate acts and informal intentions or discussions, finding that there must be a bona fide effort that resembles a corporate act that would have been valid but for a defect in the process. Significantly, the Court also found that parties bringing a claim under Section 205 no longer need to plead general equitable theories, as the legislation itself now provides the steps and requirements for ratification and validation of defective corporate acts.

Application of Section 205 to Contested Acts

The January Ratification Acts

The Court first turned to the Nomuda Corp. board's ratification of several of its defective stock issuances. The Court determined that the issuances ratified in the January 31 board meeting were corporate acts because:

The record contained stock certificates for Keenan and Houriet, even if Houriet's stock certificate may have been defective.
The record contained unsigned minutes of a board meeting regarding the 2004 Exchange.
The January ratification itself was proof that the Nomuda Corp.'s board intended for those issuances to have occurred.

Having satisfied itself that the issuances were corporate acts, the Court next turned to the issue of whether it should validate the corporate acts under Section 205. The Court determined that:

The parties treated the defective corporate acts as valid, having operated for years under the assumption that the capital structure was as they believed it to be as of December 2008 and having made consistent representations to the public based on this belief.
Keenan would be harmed if the Court failed to validate the issuance of his stock because he would otherwise lose a significant voting interest in Nomuda Corp.
The official action taken by the Nomuda Corp. board in the January ratification meant that the stock involved was no longer disputed and judicial intervention would therefore not cause material harm. Rather, judicial intervention would put the stockholders in the same position they thought they had been in before learning that the corporate acts were not valid during the Boris litigation.

Considering the above factors, the Court found the acts in the January ratification to be retroactively valid.

Mary's Disputed Issuances

The Court next turned to Mary's requested validation of two separate issuances of Numoda Corp. stock:

400,000 shares before the spin-off of Numoda Tech.
5,725,000 shares related to uncompensated work and Houriet's stock grant.

The Court found that Mary failed to establish that there had been any board meeting or determination regarding the issuance of the 400,000 shares. Because there was no corporate act, the Court denied validation of those shares.

The Court did find evidence of a corporate act for the issuance of the 5,725,000 shares even though Mary and Ann, the approving directors, did not hold formal meetings, take minutes or issue certificates. The Court was sufficiently convinced that the meeting took place and that the intent was to discuss board business, including the stock issuance to Houriet and its dilutive effect on Mary's ownership.

Having found there to be a defective corporate act, the Court turned to the analysis in equity and determined that:

The directors acted under the belief that the shares had been issued. Additionally, Keenan made a loan to the corporation after relying on the purported issuance of the shares.
The other stockholders will not be harmed if the issuance is validated because they will be in the same position that they previously thought they were in.
Mary would be significantly harmed if the issuance was not validated because her ownership would otherwise be diluted in contrast to her expectations and the parties' understanding.

Therefore, the Court found that the factors weighed in favor of validating the issuance of 5,725,000 shares.

Houriet's Disputed Issuance

The Court found that Houriet's share issuance was clearly a corporate act, evidenced by the stock certificates he had received and the January ratification by the Nomuda Corp. board. At issue was that the stock certificates erroneously indicated non-voting stock, even as the intent and belief was that Houriet would be issued voting stock. Among the evidence identified by the Court in support of the intent to grant Houriet voting stock was:

Houriet's negotiation for an ownership interest that did not envision different interests from that of the other directors.
Keenan, who prepared the stock certificates, credibly testifying that he was unaware that he had prepared a non-voting stock certificate, and did not realize the mistake until the Boris litigation.
An informal stock ledger that indicated that the stock grant was approved by at least December 11, 2007, even though Nomuda Corp. was not permitted to issue non-voting stock until it filed an amendment to its certificate of incorporation on December 27, 2007.

In applying the Section 205(d) factors, the Court determined that:

The parties believed that they had properly effectuated the stock grant when the stock certificate was prepared. The Court notes that it is within its power to fix "ministerial errors," including erroneous preparation of an incorrect form, when substantial evidence exists as to the true intent of the parties.
All of the parties acted for years under the assumption that the stock grant had been completed correctly to give Houriet voting stock.
None of the parties would be harmed if the court corrected the stock-type error because each party would be in the same position they previously thought they had been in.
Houriet would be harmed if the type of stock was not corrected because he would lose the benefit of his bargain.

Stock Grant to Reflect Spin-off

The Court was next asked to validate grants of Numoda Tech. stock to its individual stockholders and to Numoda Corp. as allegedly approved by the boards of Numoda Corp. and Numoda Tech. The Court acknowledged that it was clear that the Numoda Corp. board intended to spin off Numoda Tech., but found that the vague evidence only showed that the Numoda Tech. board intended to issue Numoda Tech. stock at some point following the spin-off. The Court found that the purported agreements about Numoda Tech.'s stock issuance were bare-minimum corporate acts because there was substantial uncertainty surrounding the meetings and there were no completed stock certificates.

The Court then analyzed the act under the Section 205(d) factors and determined that it would not validate the Numoda Tech. stock grants on equitable grounds. Specifically, the Court based its decision on:

The lack of clear evidence that Numoda Tech. had two classes of stock.
The uncertain evidence about the timing of the purported Numoda Tech. stock issuances.
The lack of harm to any party if the Court were to rule that Numoda Tech.'s stock is controlled by Numoda Corp. itself.

Therefore, the Court refused to ratify the grants of Numoda Tech. stock. However, the Court footnoted that Numoda Corp.'s board must act in good faith to distribute Numoda Tech.'s stock in the manner that it had represented to outsiders.

Practical Implications

The Numoda decision is critical for corporate practitioners because it provides the Delaware Court of Chancery's first analysis of DGCL Sections 204 and 205. Although the Court's definition of the boundaries of its new authority may change and be refined as more cases are brought under these new sections, the decision is notable for the Court's fairly expansive and lenient approach to ratifying defective corporate acts. Even in circumstances where the parties have ignored almost every basic corporate formality, the Court seems willing to rely heavily on the parties' understanding of the effect of the act to determine whether an act was taken. That analysis, in turn, seems to heavily influence the ensuing equitable review, which turns in large part on maintenance of the parties' perceived status quo.

However, one theme that recurs throughout the decision in Numoda is that the parties had operated for years under their incorrect understanding of the validity of the defective corporate acts. It is conceivable that the Court would have weighed the equitable factors of Section 205(d) differently if the defective corporate acts had occurred more recently. Other factors that may come to distinguish Numoda from future cases includes the parties' relatively uniform understanding of surrounding events and the fact that a record has already been established in a related action.

In re Numoda: Delaware Court of Chancery Describes Ratification of Defective Corporate Acts under New DGCL Section 205 | Practical Law