In a rare decision pertaining to Section 205 of the DGCL handed down today by the Delaware Court of Chancery, Applied Energetics, Inc. v. Farley, et al., C.A. No. 2018-0489-JTL (Del. Ch. Aug. 3, 2020), Vice Chancellor Laster granted summary judgment in favor of a plaintiff who challenged a defective board action, as result of failing to meet the quorum requirement under the corporation’s bylaws.  However, the Court also ruled that such defective act could be remedied under Section 205 of the Delaware General Corporation Law (“DGCL”).  This decision is an important read for any party seeking to validate an otherwise defective corporate act for failure of authorization.

In Applied Energetics, Plaintiff Applied Energetics, Inc. (the “Company”) sued George Farley, its former director and principal executive officer, and AnneMarieCo, LLC, an entity owned by Farley’s wife and children. The Company asserted claims based on actions Farley took to issue himself twenty-five million shares of common stock and grant himself an annual salary of $150,000 per year. Among other things, Farley brought a counterclaim to validate his actions under Section 205 of the Delaware General Corporation Law (the “DGCL”), 8 Del. C. § 205, among other claims.

The Company moved for partial summary judgment, contending that Farley lacked authority to issue himself twenty-five million shares and grant himself an annual salary of $150,000 per year. At the time Farley took those actions, he was the Company’s sole remaining director. However, the board had three seats.

The Court found that, consistent with the default rule under Section 141(b) of the DGCL, 8 Del. C. § 141(b), the bylaws of the Company mandated that a majority of the total number of directors be present at a meeting to constitute a quorum.

However, the Court 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. The decision notes that the “substantive purpose of [Sections 204 and 205] was “to overrule the existing precedents requiring that defective stock and acts be found void.” Slip op. at 45.

In rejecting the Company’s position that the Court could not rectify the act, Vice Chancellor Laster drew a distinction between the absence of corporation power and a failure of authorization, stating:

[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.

Slip op. at 2.

The Court noted that the Company had the corporate power to issue shares and compensate its officers and directors. Farley’s attempts to cause the corporation to take those actions failed because of defects in authorization, not the absence of corporate powers.  Accordingly, the Court found that his acts could be validated under Section 205.

The Court further noted that Section 204(a) of the DGCL, which Vice Chancellor Laster noted refers to as a “keystone” provisions, states that “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.” 8 Del. C. § 204(a). This provision “legislatively overturns” precedents which held “that stock issued or acts taken in contravention of the DGCL are void and not voidable and thus not susceptible to ratification or validation on equitable grounds or otherwise.” Slip op. at 45 (citations omitted).

This decision is an important read given the dearth of decisions interpreting Sections 204 and 205 of the DGCL.  The 75 page memorandum opinion also provides a helpful guide to the inner workings and legislative history such statutes.

Carl D. Neff is a partner with the law firm of Pierson Ferdinand LLP, and practices in Delaware. You can reach Carl at (302) 482-4244 or at carl.neff@pierferd.com.