Unilateral Issuance of Shares Rejected
A recent decision from the Delaware Court of Chancery involved the question of whether shares constituting, on a fully diluted basis, a 25% ownership in the corporation had been validly issued. In this instance, the board was comprised of one person, and he approved the issuance of the shares to himself. Even without the fundamentally flawed appraisal utilized, the court was able to strike the transaction on the basis that the one individual did not constitute a legitimate Board of Directors. Applied Energetic, Inc. v. Farley, C.A. No. 2018-0489-TMR, 2019 WL 334426 (Del. Ch. Jan. 23, 2019, rev’d Jan. 24, 2019).
Applied Energetics was a publicly traded company that was essentially dormant after the demand for its technology ceased. At the time of going dormant, the company had a board of three members. Two of those directors, Lister and Levy, would resign from the board before the events here at issue, leaving Farley as the sole director. As the sole director, Farley executed a written consent pursuant to which the corporation would issue to him 25 million shares at the price of $0.001 per share. While Farley retained Rahne to value the shares, Farley proceeded with the transaction before the valuation was delivered. Farley and Rahne went back and forth as to the appraised value, Farley finely advising Rahne “I need the value to be $0.001 or lower.” As recounted by the court, “Within three hours” Rahen sent a valuation report at the requested $0.001 price.
Responding here to a motion for a preliminary injunction following a complaint alleging a variety of claims against Farley, including breach of the duty of loyalty, that relief was granted. The court had little problem finding that the plaintiff would likely prevail on the merits with respect to the challenge of the share issuance if only for the reason that the majority of a three person board did not approve the issuance.
The Company argues that Farley caused the Company to invalidly issue twenty-five million shares to himself because Farley acted without proper board authorization. “The Delaware General Corporation Law requires that the board of directors of a company approve any issuance of stock by the corporation.” Applied Energetics’ bylaws require “a majority of the total number of directors” to be present to constitute a quorum for the transaction of business at a board meeting. The board members may also take action without a meeting if all members of the board sign a written consent. In 2012, the Company’s board reduced the number of directors from five to three. The size of the board remained three members through February and March 2016. The parties have not identified any board resolution or other action that reduces the size of the board to less than three members; nor do the parties identify anything that purports to reduce the threshold for a quorum to less than a majority of the directors.
It is reasonably probable that Farley could not cause the board to validly issue stock acting as the only board member of the Company’s three-member board. Stated differently, it is reasonably probable that any board action to validly issue stock, whether at a board meeting or through written consent, required the affirmative vote of at least two members of the Company’s board. Only Farley signed the written consents dated February 15, 2016, and March 25, 2016, authorizing the issuance of twenty million and five million shares, respectively. It is reasonably probable, therefore, that the twenty-five million share issuance is invalid. 2019 WL 334426, *6 (footnote omitted).