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How Delaware's new Section 204 lets corporations fix past corporate approval mistakes.

Byline: Emily V. Burton

The actions of a Delaware corporation must be consistent with the corporation's certificate of incorporation and often require either board of director or stockholder approval to be valid. These requirements apply to all Delaware corporations from the Fortune 100 to small family corporations. But, unfortunately and perhaps unsurprisingly, corporate action is sometimes not validly approved. When a Delaware corporation acts inconsistently with its certificate or does not obtain necessary approvals in the correct order, the resulting corporate action is invalid.

For example, a small start-up company may need to raise additional equity. So, the company's founders, who are also its directors and stockholders, negotiate the terms of a new preferred stock issuance with a group of new investors. Then, the company purports to issue the preferred stock to the investor.

The process of the start-up company issuing stock may seem simple to the people involved, but it is often not simple at all. For the preferred stock issuance to be valid, the company's certificate of incorporation must authorize the issuance. If the company's certificate does not already authorize the issuance, first, the certificate must be amended before the stock is issued. This amendment must be approved by the founders acting first in their capacities as directors and then acting in their capacities as stockholders. Then, the corporation must file an amended certificate with the Delaware Secretary of State. Once the company's certificate of incorporation authorizes the issuance of this preferred stock, the company's founders must formally authorize the issuance in their capacities as directors before they hand the stock certificate over to the investor.

Not only must each of these steps be taken by the correct people in the correct capacities, but they must also be taken in the correct order and form. For example, the directors can only validly act at a board meeting or unanimously by written consent. And, the founders must approve any amendment to the certificate in their capacities as directors before they approve the amendment in their capacities as stockholders.

Often, the people involved do not realize that a corporate action was defective when the corporation purported to take the action. In our example above, the founders (or their counsel) may not realize all of the steps needed to issue the preferred stock. In many cases, years pass before anyone realizes that a particular corporate action was not valid.

In an unfortunate number of cases due diligence in connection with a corporation's IPO or a major financing uncovers one or more past defective corporate actions. These defects generally need to be corrected before the IPO or investment can proceed because defective corporate acts, particularly stock issuances, create uncertainty as to the corporation's capital structure. Few issuers or new investors are willing to proceed while such uncertainty exists.

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Section 204 of the Delaware General Corporations Law permits corporations to retroactively fix corporate actions that were not validly approved or were inconsistent with the corporation's certificate of incorporation. When a corporation uses Section 204 to correct a defective corporate action, the defect is cured retroactively. This means that any later corporate actions that are defective by reason of the first defective corporate action are also cured.

Section 204 is the first statute of its kind in the country. Delaware is the first state to provide a statutory path for corporations to fix prior mistakes in the authorization of corporate acts.

The specific requirements of Section 204 may be complicated or unachievable in some scenarios. As a general matter, to ratify a defective corporate act using Section 204, first the corporation's board must approve the ratification. Then, the corporation's stockholders must be notified of the ratification. If the corporate action is one requiring stockholder approval, the corporation's stockholders must then approve the ratification. And finally, if the corporate action would generally require a filing with the Delaware Secretary of State, the corporation must file a certificate of correction with the Delaware Secretary of State before the ratification becomes effective.

People affected by a corporation's use of Section 204 have standing to challenge the corporation's purported ratification under Section 205 of the Delaware General Corporations Law. Where the corporation has fully complied with the requirements of Section 204, any challenge to the ratification under Section 205 must generally be brought within 120 days.

Where a corporation cannot satisfy the requirements of Section 204 the corporation can bring a petition in the Delaware Court of Chancery under Section 205 to ask the court to modify the requirements of Section 204, to declare the corporate act valid, or to provide other similar relief.
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Publication:Inside Counsel Breaking News
Geographic Code:1U5DE
Date:Jan 20, 2015
Words:788
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