By Paula Valencia-Galbraith

Has your corporation sold stock before having a sufficient number of shares authorized under its Certificate of Incorporation?  The DGCL requires that the authorized capital be increased before the sale is consummated because the Corporation needs to create the stock it is going to sell.  Without the stock’s creation there is nothing to sell to the investors and failure to increase the authorized capital could deem the sale and issuance void or voidable due to the Corporation’s failure to comply with the technicalities of the DGCL. Before 2014 there was no mechanism that could retroactively fix issuing equity with an insufficient number of authorized capital or any other type of transaction that required certain technical requirements by the DGCL.  These types of mistakes led to potentially embarrassing conversations with a corporation’s investors but in 2014 this all changed.

In 2014 Section 204 was added to the DGCL to provide companies with a mechanism to ratify defective corporate acts retroactively.  The ratification process as it relates to the issuance of equity with an insufficient number of authorized shares will be the focus of this article but Section 204 can be used to ratify many other defective corporate acts such as the election of directors without the correct stockholder vote or the authorization of certain transactions as outlined by the DGCL.  The ratification process is not an easy process but once completed retroactively fixes the mistake.

What does a Corporation need to do to ratify a defective corporate act such as issuing equity without a sufficient number of authorized capital under Section 204?

In order for a Corporation to ratify an issuance of equity where there was an insufficient number of shares authorized the Corporation must first seek Board of Director approval.  The Board needs to clearly identify the defective corporate act, the date of such act, approve and confirm the ratification of such defective issuance by filing a Certificate of Validation with the State of Delaware and recommend such ratification to the stockholders of the corporation.

Once Board of Director approval is obtained the Corporation must seek the approval of its stockholders.  In the event that at the time of the consummation of the defective corporate act a certain group of stockholders held rights that required their consent, then the consent of such stockholders must be obtained even if they no longer have such rights.  For example, if the Series A Preferred holders of a corporation were needed to consent for the amendment of the certificate of incorporation that should have been filed at the time of the defective corporate act, then such approval must be obtained for the ratification of the defective corporate act in addition to any other consent requirements currently in effect.

Upon the receipt of both the consent of the Board of Directors and the requisite stockholders the Corporation must then file a Certificate of Validation that outlines the defective corporate act, confirms the approval of the corporation’s board and stockholders, includes as an exhibit the certificate of incorporation or amendment to such certificate that provides for the correct number of shares to cover the defective issuance of equity and provides for the date the certificate of incorporation or amendment should be deemed effective.   The State of Delaware filing fee for the Certificate of Validation is at least $2,579 but could be higher depending on the corporation’s authorized capital.  The fee does not include legal fees or any other third party fees, so fixing a defective corporate act is not inexpensive.  The Certificate of Validation acceptance is also not a quick process because it could take two to four weeks to be accepted by the Secretary of State of Delaware and there is no expedited option.

Corporations must also send a notice in hard copy (not solely by e-mail) to all its non-consenting stockholders, as well as any former stockholders who held shares as of any of the defective corporate acts ratified.   The notice should include a statement alerting the stockholders that any claims that the stock issuances are void or voidable due to the failure of authorization, or any claim that the Court of Chancery of the State of Delaware should declare in its discretion that the ratification not be effective or be effective only on certain conditions, must be brought within 120 days from the date of the notice.  Once the time period has lapsed the Corporation has completed the process and the defective issuance of equity is deemed ratified as of the date of the sale of equity.

Section 204 of the DGCL is a useful tool when corporations find themselves in a situation that may call into question the validity of their transactions; however, it is a long and expensive process that should only be used if absolutely necessary.