This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.
In a recent ruling that clarified the scope of Delaware’s power to validate defective corporate actions, the Chancery Court denied Applied Energetics Inc.’s summary judgment motions on three of four claims in a dispute with a former officer and director it accused of overreaching for power and compensation in Applied Energetics Inc. v. Farley, et al., No. 2018-0409 JTL, opinion issued (Del. Ch. Aug. 11, 2020).
Vice Chancellor J. Travis Laster’s Aug. 11 opinion granted the struggling company summary judgment on its claim that as the sole remaining member of a three-director board, George Farley clearly lacked board authority to issue himself twenty-five million shares and grant himself a $150,000 yearly salary.
But the vice chancellor declined Applied Energetics’ bid to dismiss Farley’s counterclaims that:
(1) under Section 205 of the Delaware General Corporation Law, the court has the power to validate defective corporate acts that were within the power of the corporation to take,
(2) the court could theoretically validate a decision to grant Farley a salary, and
(3) Farley is entitled to compensation under an unjust enrichment theory (i.e., that the company profited by getting his services for too little), because when the record is construed in Farley’s favor, there is evidence to support an award under a theory of quantum meruit.
Applied Energetics Inc., a Delaware-chartered company headquartered in Tucson, Ariz., began engineering and marketing products for the defense and securities industries in 2002 after the 9/11 attacks, but after enjoying some initial success, went into a steep decline in 2006, according to the court.
Farley was the sixth director when he joined the board, but by 2015 he was one of two remaining directors when he and the other director agreed that he should be the principal officer, who would be the official face of the firm, which had a share value of $0.0002 and had been delisted from NASDAQ.
After a group of insurgent shareholders mustered the support of 58 percent of the investors in March 2018 to remove Farley and fill the three director vacancies, Farley resigned his principal officer position, claiming that during his watch, the company’s share price rose 844% to $0.076 per share and that he received only $69,500 out of approximately $300,000 in salary he believes he was owed.
The company filed this suit in July 2018 against Farley and AnneMarieCo. LLC, a stock repository for his children, asserting claims for breach of fiduciary duty, aiding and abetting breaches of fiduciary duty, conversion, and fraudulent transfer and seeking cancellation of the defendants’ shares. It claimed that while Farley said he was trying to re-launch and/or sell the foundering company, he misused his status as the sole officer and director to gain power and revenue he was not entitled to have.
Applied Energetics won a January 23, 2019, preliminary injunction from Justice Tamika Montgomery-Reeves, then a Vice Chancellor, to preclude what the company said was the threat that Farley would abscond with its dwindling resources. Applied Energetics Inc. v. Farley et al., No. 2018-0409 TMR, injunction decision issued (Del. Ch. Jan. 23, 2019).
The summary judgment ruling
The company then revised its complaint and sought summary judgement on its claim that none of the actions Farley took while principle executive and sole director, from February 10, 2016, until March 9, 2018 – including the $150,000 salary and stock grants – were valid. It also sought summary judgment on the four counter-claims Farley filed in response to the amended complaint.
In his Aug. 11 opinion, Vice Chancellor Laster said the actions Farley took on behalf of the three-member board while it was without a quorum were invalid and could not be validated under Section 205 because Section 141 of the DGCL requires a majority of the board for any vote or written consent and a single director cannot remedy that defect by decree.
“Because Farley lacked authority as the sole remaining director to amend the bylaws, the stockholders were the only intra-corporate actor with the power to amend the bylaws between February 10, 2016, until March 9, 2018,” the vice chancellor said. “The precedents on implicit bylaw amendments consistently apply the doctrine to favor stockholder rights, not to favor incumbent director rights.”
He said the shares Farley purportedly transferred to AnneMarieCo. are invalid because, “under Delaware law, invalid shares in the hands of innocent third parties remain invalid.”
As to Farley’s counterclaim that the court has the power under Section 205 to validate his grant of shares or salary to himself, the vice chancellor said only after a trial can the court determine whether it can or will do that, so that motion must be denied at this juncture.
He explained that the Delaware General Assembly enacted Sections 204 and 205 of the DGCL to create the ability “to overrule the existing precedents requiring that defective stock and acts be found void.” He said the “keystone” provision is Section 204(a) which 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.”
The section hinges on the distinction between “power” and “authorization,” he said. “Properly understood, the concept of corporate power refers to whether the entity has been granted the ability to engage in a given act,” but “the concept of authorization refers to whether the proper intra-corporate actors or combination of actors, such as the corporation’s officers, directors, or stockholders, have taken the steps necessary to cause the corporation to take the given act.”
Applied Energetics had the power to take the challenged actions, the vice chancellor said; the question was whether Farley was authorized to employ that power, and the court has to decide whether he could have properly obtained that authorization.
Farley’s inability to satisfy those authorization requirements was just that—a “failure of authorization that can be validated under Section 205, not an absence of corporate power that cannot,” he said in denying summary judgment on Farley’s counterclaims other than the unjust enrichment claim.
The vice chancellor denied the company summary judgment on that claim because Farley had no contract and, “in the absence of a valid contract, principles of quantum meruit come into play and can support a recovery under a theory of unjust enrichment.”