Delaware Court of Chancery Addresses Technical Defects in Equity Issuances, Ratification of Defective Acts, and Related Fiduciary Duty Issues
June 20, 2018
The Delaware Court of Chancery issued a post-trial decision determining that a director who refused to cooperate in remediating flaws in the company’s capital structure breached his fiduciary duty of loyalty and owed damages to the corporation. The opinion is particularly important because of that holding. However, the opinion is equally important because of the court’s emphasis on the importance of complying with technical rules under Delaware law when issuing equity and the need to document the board’s decision to issue equity. Finally, the case highlights the ongoing use of provisions of the Delaware corporate statute that allow for the ratification and validation of defective corporate acts—and the reality that some of the most fraught uses of those provisions can occur in the context of disputes among founders and board members.
In this case, CertiSign Holding, Inc. v. Kulikovsky,1 CertiSign Holding (CertiSign) was in the process of exploring a potential sale of the company or a subsidiary business in 2012 when it discovered during diligence that previous corporate actions had been improperly approved. The root of the defective corporate acts was an invalid authorization of stock that occurred in 2005 when CertiSign filed an amended and restated certificate of incorporation with the State of Delaware before the certificate had been approved by the board and stockholders. Following the issuance of that invalid stock, the stockholders elected directors and approved corporate actions, but those elections and approvals, as well as actions approved by those directors, were likewise defective.
In 2012, prior to the time that the ratification procedures under Sections 204 and 205 of the Delaware General Corporation Law (DGCL) were adopted, CertiSign’s counsel proposed a process for correcting the defective corporate acts by, among other things, exchanging invalid shares for valid shares (the “self-help”). CertiSign determined that the defendant, a founder and former CEO and director, was one of only two validly elected sitting directors, and therefore his approval as a director was required for approval of the self-help. Unfortunately, the former director’s relationship with other founders and company insiders had soured, and from that time until 2014, the former director withheld his consent unless CertiSign agreed to certain personal demands. CertiSign rejected the former director’s offer, and the former director was removed from the company’s board.
In 2014, CertiSign petitioned the Court of Chancery for a judicial order ratifying the defective corporate acts related to the issuance of the invalid stock under Section 205 of the DGCL. In 2014, at the time CertiSign petitioned the Court of Chancery, the former director also offered to sign his consent approving the self-help. The former director filed a counterclaim to CertiSign’s petition, seeking ratification of certain alleged option grants and other matters. In 2015, the Court of Chancery granted CertiSign’s petition and thereby ratified the defective corporate acts related to the issuance of the defective stock. After a trial in 2017 on the remaining issues between the parties, the Court of Chancery addressed CertiSign’s claim that the former director had breached his fiduciary duties by obstructing the self-help and the matters in the former director’s counterclaim.
After trial, Vice Chancellor Joseph R. Slights III found that the former director had refused to give his consent, that he had been aware that his refusal perpetuated the corporate defects, and that his refusal was motivated by personal interests. Vice Chancellor Slights also found that the sole impediment to remedying the corporate foundation was the former director’s refusal to give his consent. The court concluded that the former director “single-handedly and knowingly jeopardized CertiSign’s existence and operations in order to obtain leverage to advance his personal interests. This is the quintessential breach of the duty of loyalty.” Addressing the former director’s argument that his personal demands were actually aligned with the interests of other stockholders, Vice Chancellor Slights stated, “A control dispute . . . cannot justify [the former director’s] decision, as a CertiSign fiduciary, to hold hostage the entire capital and board structure of CertiSign at the expense of that company’s stockholders. . . . Every stockholder holding defective stock had an interest in remedying the situation immediately.” Finally, the Vice Chancellor rejected the former director’s defenses that either he had cured any breaches of fiduciary duty by consenting to the self-help, or he had never refused to consent but only “declined to do so at that moment.” The court rejected these arguments because the former director had already been removed from the board when he ostensibly agreed to sign a director consent (“too little too late”) and because the former director’s refusal was not “momentary” but rather extended for approximately 18 months. As a result, the Vice Chancellor held that the former director had breached his fiduciary duty of loyalty to the company and awarded CertiSign damages in the amount of $390,455.20, equal to the legal fees and expenses that the company incurred in remediating the flaws in its capital structure without the former director’s help, including the prosecution of its Section 205 action in the Court of Chancery, plus pre-judgment and post-judgment interest.
Finally, the court rejected separate counterclaims by the founder in which the former director asked the court to validate under Section 205 of the DGCL the alleged grant of stock options by CertiSign, including to the former director, over time. The court determined that CertiSign had not validly granted the alleged options, noting that Section 157 of the DGCL requires (1) proper board action at a meeting or by written consent to approve the material terms of options and (2) a written instrument evidencing options, and concluding that no such actions had occurred in this case. Although Section 205 permits a court to validate technically flawed corporate acts, the court refused to use its discretion to do so in this case. On that front, it was critical to the court that the post-trial record did not reflect an adequate “meeting of the minds” on the part of CertiSign’s board of directors as to the quantities, terms, dates, and recipients of the alleged option grants. Instead, the court found that the board had only preliminarily discussed the grant of the alleged options in question and had not taken the steps required under Section 157.
The facts found by the court in CertiSign provide an important context for the post-trial rulings, but the opinion offers important insights regarding the application of Sections 204 and 205 of the DGCL, the requirements to effectively issue equity, and the nature of a board member’s fiduciary duties to a company’s stockholders. The opinion generally counsels against fiduciaries using their position as fiduciaries to act opportunistically when a company resorts to self-help to remedy corporate defects. This guidance may be particularly applicable to the self-help, out-of-court ratification procedure available to companies under Section 204 of the DGCL (as well as judicial ratification under Section 205 of the DGCL), which can often provide the type of certainty that broadly serves the interests of the company and its stockholders when a defective corporate act needs to be cured and which therefore directors would be expected to facilitate. The opinion also counsels in favor of careful and deliberate documentation of any issuances of capital stock and equity awards and grants, as later attempts to ratify defective issuances and grants can prove to be costly, distracting, and uncertain, and arise in sensitive moments in a corporation’s life after compounding over time.
For more information about the CertiSign decision or any related matter, please contact Amy Simmerman, Julia Reigel, John Aguirre, or any member of the corporate governance or employee benefits and compensation practices at Wilson Sonsini Goodrich & Rosati.