Recent DGCL Sections Facilitate Ratification, Validation of Defective Corporate Acts; Minimal Reported Court Activity To Date But More Expected

It’s been more than a year since the Delaware General Corporation Law added sections 204 and 205, allowing boards of directors to ratify, or the Court of Chancery to validate, defective corporate acts, including the issuance of stock that did not fully comply with corporate formalities. The Delaware General Assembly’s unanimous adoption of sections 204 and 205 elevated substance over form by giving effect to corporate action that at all times was treated as validly authorized, even if the action was technically deficient.

Sections 204 and 205 have potentially far-reaching consequences and rolled back longstanding judicial precedent. Yet they appear to have been the subject of very few decisions to date. In the most prominent and first reported decision, In re Numoda Corp. Shareholders Litigation, the Court of Chancery invoked sections 204 and 205 to validate issuances of stock in a closely-held corporation that were evidenced by “a bona fide effort bearing resemblance to a corporate act but for some defect that made [them] void or voidable.” Specifically, the Court found sufficient evidence of Board action in stock certificates (albeit with defects), unsigned meeting minutes, and the purported ratification of certain acts to satisfy itself that the company intended to do that which the Court was being asked to validate. In other instances where no such evidence existed, the Court declined to find a corporate act upon which to validate the shares.

The holdings in Numoda resulted from the Court’s exercise of what it deemed to be the “substantial discretion” conferred by sections 204 and 205, which direct courts to balance the following factors: (1) whether the defective corporate act was believed to have been compliant when effectuated; (2) whether the corporation treated the defective corporate act as valid and others relied on it as being valid; (3) whether harm would result from validation of the defective corporate act; (4) whether harm would result from the failure to validate the defective corporate act; and (5) any other factors the court deems just and equitable.

As the Numoda Court observed, sections 204 and 205 “create a flexible standard that the Court can use to fix a range of defective corporate acts” and, thus, “do[ ] not set a rigid outer boundary on the Court’s power to validate” such acts. It is easy to imagine future litigation over just how “flexible” and how far that “outer boundary” extends. Numoda, however, makes clear that technical non-compliance with corporate formalities will not necessarily render a corporate act unenforceable, as it used to be under Delaware law. That reality, embodied by sections 204 and 205, is not likely to change, and no doubt other courts will be asked to apply it going forward.

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