Blades v. Wisehart, C.A. No. 5317-VCS (Del. Ch. Nov. 17, 2010), read 34-page opinion here.
In this action pursuant to DGCL Section 225, the Court of Chancery addressed whether unanimous written consents validly removed the defendant directors from the board and whether the same written consents validly elected new directors for a company called Global Launch, Inc. In connection with making its decision on the validly elected directors, the Court also needed to decide who the valid shareholders were.
Practice Note: This opinion should be required reading for any lawyer responsible for creating the formation documents of a corporation, or for ensuring proper authorization for the issuance of an increased number of shares. It is also instructive for those who seek to avoid the pitfalls and litigation mess suffered by the corporate counsel and parties involved in this matter.
The business plan of Global Launch was based on an idea of the plaintiff, Blades, an ousted co-founder, to bring to the internet the concept of layaway purchasing.
The Court describes Global Launch as a Delaware corporation that was formed by an Ohio lawyer without the benefit of Delaware counsel. The formation was based on a merger with an Ohio corporation into an empty shell Delaware corporation. In its description of the documentation that set up the company, the Court eviscerates the Ohio lawyer who did a less than stellar job in documenting the corporate transactions that form the basis for many of the issues in the lawsuit. An example of the Court’s factual description of the messy state of affairs includes the following: “Without exaggeration, it is fair to say that a thousand hours could be spent trying to fathom the implications of the various actions [the attorney] took, often unilaterally it seems, as Global Launch’s counsel and one would still be left with serious questions, so pervasive were the departures from expected norms in the execution of important corporate transactions.” However, the Court also noted that some of the errors were so fundamental that they obviated the need to address other issues presented in the case. [Editor’s Note: In order to avoid mentioning the name of the attorney who was pilloried in this opinion, only indirect reference is made to him, even though the directness or active voice of this summary may be otherwise sacrificed.]
The initial shareholders of Global Launch were only two: a company called The Ohio Company, an Ohio corporation, and the plaintiff, Rusty Blades, the latter owning two-thirds of the authorized stock. Based on two separate shareholders’ agreements, the parties consented to an initial board or four people.
Lack of Proper Corporate Formalities and Inadequate Documentation of Stock Split
In order to raise funds, the parties appeared to have intended to increase the authorized shares from $10 million to $50 million “and then to engage in a stock split in which the shares held by Blades and The Ohio Company would be split one for five.” The problem, however, was that the only validly authorized amendment to the Certificate of Incorporation, if any, was to increase the number of authorized shares from $10 million to $50 million. That is, no proper documentation was ever completed in order to consummate a stock split.
Nonetheless, shares were purportedly issued to many shareholders based on the faulty assumption that the stock split had been effectuated. Among those shares issued without the number of authorized shares being properly increased, were shares to the law firm (to be held in escrow) of the lawyer who was roundly criticized by the Court for botching the corporate documentation that is at the heart of this case.
Despite the lack of proper authorization for the stock split and despite the lack of clear authorization for the increased shares that were issued, a private placement memorandum was distributed to potential investors and investor presentations were made and created by the same hapless lawyer who is at the center of this imbroglio.
In November 2008, matters took a turn for the worse. Blades was arrested amid embarrassing publicity which led to his resignation as president and a director. After the departure of Blades from the board, the attorney at the heart of this case made purported transfers of shares that did not comply with the provisions of a March 2008 agreement which granted Blades a right to notice and a right of first refusal. Nor did the transfers comply with the provisions of that same agreement that prohibited any transfer of Global Launch stock within two years of acquisition “except from an opinion of counsel to the company.” Footnote 33 refers to trial testimony of the attorney at the heart of this case from whom the referenced opinion was required. The Court describes that opinion contemplated by the agreement, as not being satisfied because the beleaguered attorney testified that the opinion that he was required to give to the company was addressed as follows by him: “He orally gave undated and unspecified opinions to this effect to himself.”
In sum, the original two shareholders were Blades and The Ohio Company. Because the stock split that was intended to increase the number of shares available was never validly consummated, those new shareholders were never validly in receipt of shares. Despite the lack of compliance with the formalities of the DGCL, the defendants argued that as a matter of equity, because the original two shareholders supported the concept of a split (even though they acknowledged the necessary formalities were not met), the Court should treat the shares as being validly issued. The Court rejected these arguments for the reasons explained in the legal analysis that follows.
Notably, among the individual defendants was the lawyer for the company who was responsible for the documentation regarding the authorization of increased shares, its capital structure, its formation and for other documentation that is at issue in this case. That same attorney was also a director whose directorship was contested in this case.
In explaining why the stock split was invalid, the Court provides a primer on the required Delaware statutory corporate formalities that must be adhered to in order to implement a stock split. The Court explained that the term "stock split" is never specifically used in the DGCL, but it is a means by which a corporation changes the number of outstanding shares either by increasing them or reducing the number. A reverse stock split involves dividing the existing number of outstanding shares by a specific number. A forward stock split multiplies the existing number of outstanding shares by a specific multiplier. Section 242(a)(3) of the DGCL provides that a corporation may amend its certificate to change the number of outstanding shares.
Statutory Requirements for Stock Split or Increasing Number of Authorized Shares
Thus, in order to properly implement either a forward or a reverse stock split, the corporation must follow the prescribed corporate formalities to amend its Certificate of Incorporation. Specifically, Section 242(b)(1) of the DGCL governs amendments to the Certificate of Incorporation and requires that the board do three things. (1) The board must duly adopt the resolution setting forth the amendment proposed, declaring its advisability, and either calling a special meeting of the stockholders entitled to vote or directing that the amendment proposed be considered at the next annual meeting of stockholders. Alternatively, the proposed amendment may be submitted to the stockholders entitled to vote thereon for their adoption by written consent. (2) The board must give the stockholders proper notice of the proposed amendment and a stockholder meeting before asking the stockholders to vote on it. (3) If the stockholders vote to approve the amendment, in order to give effect to the amendment, “a certificate setting forth the amendment and certifying that such amendment has been duly adopted in accordance with Section 242 shall be executed, acknowledged and filed . . . [with the Delaware Secretary of State].” The Court explained that the temporal sequence of the order of the above three requirements is essential and must be followed precisely.
The Court concluded that there was insufficient evidence presented at trial to demonstrate that these three prerequisites were satisfied.
Strict Compliance with Statutory Requirements and Requisite Formalities of Capital Structure of a Corporation will be Enforced–"Law Trumps Equity"
The Court made it clear that “law trumps equity” in this area of corporate decision-making involving the capital structure and ownership of a corporation in terms of the number of shares authorized. See cases cited at footnotes 81 and 82. The cases relied on by the Court made it clear that the otherwise broad remedial capacity of a court of equity was unavailable in this context because the Delaware Supreme Court has made it clear that the statutory prerequisites regarding the issuance of new stock, like a stock split, require strict adherence to the statutory formalities. See STAAR Surgical Co. v. Waggoner, 588 A.2d 1130, 1136 (Del. 1991). See generally footnote 84 (quoting from the STAAR case with a description of the Certificate of Incorporation as a contract between the corporation and its shareholders, the corporation and the state, and among the shareholders themselves. Moreover, the Court explained that the DGCL is a part of the Certificate of Incorporation of every Delaware company.)
Despite the plea of the parties that they “intended to properly authorize the additional issuance of shares", the Court explained in detail why there was simply not enough evidence to support the position that the statutory prerequisites and formalities had been satisfied. Moreover, the Court said even if, hypothetically, it were able to weigh the equities, even then, the Court was not convinced that the equities favored the defendants, especially “given the primary role [that the beleaguered attorney] played in creating pervasive uncertainty about Global Launch’s ownership.”
Based on the Court’s conclusion that there were only two valid shareholders, the shares that were purportedly issued to other shareholders–in light of the lack of a properly authorized stock split, were “void and a nullity.”
Thus, the only valid written consent was the written consent by the original two shareholders which was sufficient to remove all the members of the board and to elect a new board. That conclusion, the Court emphasized, does not mean that a new board was insulated from any challenges. For example, the Court observed that there were “nearly 50 minority shareholders” who hold invalid share certificates that the company will need to address. The Court cited in footnote 100 to the classic text entitled: “Plutarch’s Lives” for a description of the victory at battle of Pyrrhus from which our expression "Pyrrhic victory" comes. See also footnote 101 citing the Delaware Supreme Court decision of Liebermann v. Frangiosa, 844 A.2d 992, 1009 (Del. Ch. 2002), which involved a similar situation of a board needing to deal with the multiple claims that would likely arise from invalidly issued stock, or put differently, from stock that was not properly authorized and not properly issued. The Court indicated that the shares that were invalidly transferred would undoubtedly lead to claims being made by those who received those purported shares, and the board would need to deal with those issues.
In conclusion, the Court held that the written consents of the two original shareholders were effective to remove the insurgent slate of directors, and that the directors appointed by the two original shareholders by written consent were properly seated. The written consent of the two shareholders was also a valid ratification of the actions taken at a meeting that they sought to ratify.