Bad Corporate Practice Leads to Bad Result

I recently had a practice note published in the February 2019 eNews from the Business Law Section of the California Lawyers Association. What follows is the text that was submitted for publication.

The Delaware Court of Chancery found that a stockholder consent signed without the stockholder having been provided the exhibits referred to in the consent made the consent invalid under the Delaware General Corporation Law (“DGCL”). This case could be of interest to California practitioners because the section of the DGCL in question is functionally identical to the corresponding section of the California Corporations Code.

In Carsanaro v. Bloodhound Technologies, Inc., 65 A.3d 618 (2013), the plaintiffs were five software developers (referred to as the “Founding Team”) who all held common stock. They claimed that after the company raised its initial rounds of venture capital financing, the venture capitalists obtained control of the company’s board of directors. From that point on, the plaintiffs alleged, the venture capitalists financed the company through self-interested and highly dilutive stock issuances. The plaintiffs said they did not learn of the issuances or their consequences until the company was sold for $82.5 million. At the time of the sale, the plaintiffs discovered that the common stockholders’ overall equity ownership had been diluted to under 1%. After members of management received transaction bonuses of $15 million and the preferred stockholders received nearly $60 million in liquidation preferences, the plaintiffs were collectively left with less than $36,000.

The plaintiffs challenged the dilutive transactions, the allocation of $15 million in merger proceeds to management, and the fairness of the merger. The defendants moved to dismiss on a wide range of theories. With limited exceptions, the motions to dismiss were denied. This practice note focuses on one narrow aspect of the case, and for the ease of reading, a number of facts are omitted.

Stockholder Consent to Corporate Transactions

In addition to challenging the fairness of the issuance of a series E preferred stock, the plaintiff alleged that the approval of the 10-for-1 reverse stock split (as well as the amendment to the certificate of incorporation for the series E preferred stock) violated DGCL § 228. The reverse stock split required approval by a majority of the common stockholders voting separately as a class. To get a majority vote of the common stockholders, the consent of at least one member of the Founding Team was needed. In this case, the consent of Samir Abed, a Founding Team member, was obtained.

Less than four hours before filing the amendment giving effect to the reverse stock split, the company’s CFO emailed Abed a written consent for the first time. The consent approved an amendment to the certificate of incorporation to effect the reverse stock split. The amendment (and another exhibit) was supposed to be attached to the consent as an exhibit, but the CFO did not provide the attachment. Abed replied to the CFO’s email, asking to see the exhibits. Abed then recalled the CFO telling him earlier in the week that executing the written consent was essential and an urgent matter for the company. Fearing that his delay might jeopardize the financing and that could cause the company to take a harder line in its negotiations with him on the terms of his departure from the company, Abed signed and emailed back to the CFO the written consent without receiving the exhibits.

If Abed’s consent was valid, then the reverse stock split received the necessary vote. The plaintiffs argued that the written consent Abed executed failed to comply with § 228 because it did not adequately describe the actions taken. DGCL § 228 states:

Unless otherwise provided in the certificate of incorporation, any action required by this chapter to be taken at any annual or special meeting of stockholders of a corporation, or any action which may be taken at any annual or special meeting of such stockholders, may be taken without a meeting, without prior notice and without a vote, if a consent or consents in writing, setting forth the action so taken, shall be signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present…. [emphasis added]

The form of consent provided to Abed incorporated by reference exhibits to the consent, including the certificate of amendment effecting a reverse stock split. But the exhibits were not attached or otherwise provided to Abed.

The defendants argued that when stockholders are asked to vote on an amendment to the certificate of incorporation at a meeting, the notice can provide the text of the amendment “in full” or “a brief summary of the changes to be effected thereby.” 8 Del. C. § 242(b)(1). They argued that the consent summarized the actions taken.

But the court responded that the language of § 242(b)(1) is premised on action being taken at a meeting. Section 228(a) establishes a different requirement: the consent must “[set] forth the action so taken.”

The court held that when a stockholder consent specifically refers to exhibits and incorporates their terms, the plain language of § 228(a) requires that a stockholder have the exhibits in hand to execute a valid consent.

Relevance to California Corporations Code

Section 603(a) of the California General Corporation Law corresponds to DGCL § 228(a). Though there are some slight differences in wording, the two sections are functionally identical.

California Corporations Code § 603(a) provides:

Unless otherwise provided in the articles, any action that may be taken at any annual or special meeting of shareholders may be taken without a meeting and without prior notice, if a consent in writing, as specified in Section 195, setting forth the action so taken, shall be provided by the holders of outstanding shares having not less than the minimum number of votes that would be necessary to authorize or take that action at a meeting at which all shares entitled to vote thereon were present and voted. [emphasis added]

A California court could well come to the same conclusion as the Delaware court and could hold a shareholder consent invalid on the ground that the consent did not “[set] forth the action so taken” if the consent referred to exhibits but the exhibits were not attached to the consent or otherwise provided to the signatory.

Discussion

In a major corporate transaction, particularly those involving financing or a merger, it is not unusual for there to be time pressures. Often, the operative instruments, such as an amendment to the articles of incorporation or a merger agreement, will be approved by the board and the shareholders only after the finishing touches have been put on the underlying documents, which may be at the last minute. Carsanaro makes it clear that bad practices in getting board and shareholder approval can have bad consequences.

Take this hypothetical example. Drafts of operative documents are being circulated by email to various corporate decision-makers (board members or shareholders). Time is running out, and in the interest of efficiency, the corporate decision-makers sign bare consents. These consents refer to and incorporate by reference as exhibits the operative documents, but the operative documents do not yet exist in final form. Once the lawyers for the various parties agree on the final form of the operative documents, someone attaches to the pre-signed consents the operative documents as exhibits.

In light of the Carsanaro case, this procedure cannot be recommended. An argument could be made that the consents in this hypothetical example, when signed, did not “[set] forth the action so taken” and therefore are invalid. A counter-argument could be made that the consents were not effective until delivered, that whoever attached the operative documents as exhibits was authorized to do so by the persons signing the consents, and that delivery was authorized to be made only after the exhibits were properly attached to the consents. But the counter-argument raises a number of legal and factual issues. Why have these issues?

Even where the consents are circulated to decision-makers only after all the operative documents are in final form, it is not unknown for attachments to be inadvertently omitted from emails. A director who has been apprised of the negotiations might not object upon receiving an email that has omitted an exhibit to a consent (or the director might not realize that an exhibit was omitted). That director might sign the consent not realizing that a legal question could arise for lack of having all the exhibits in hand prior to signing the consent.

Practice Suggestion

One way to avoid this problem would be to create a consent that has the exhibits included as part of the document containing the consent. This is possible with the Word word-processing program, but incorporating different documents into one Word document can create a number of formatting issues. A more efficient way to transmit the consent and all the exhibits as one document would be to create the consent as a document in PDF format with all the exhibits included as part of the PDF document. That way, the formatting of one constituent document will not affect the formatting of other constituent documents. More important, there will be no issue whether the corporate decision-makers had in front of them (and as part of the consent) the exhibits that are referred to in the consent and that constitute part of “the action so taken.”

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