Recent Opinion Highlights Strategy for Shareholders Opposing Corporate Action: Invalidity

In a recent opinion, the Delaware Court of Chancery considered a summary judgment motion in an action by Applied Energetics, Inc. against George Farley, who at the time of the challenged actions was the sole member of the company’s board of directors and compensation committee as well as an officer. The suit sought to undo certain actions taken by Farley on behalf of Applied and recover certain amounts the company paid him. The company sought a declaration that Farley’s actions on behalf of Applied were invalid for lack of authorization. The Court granted the company summary judgment on the issue of whether Farley’s actions were invalid for a lack of authorization but denied summary judgment on the other claims, including on the issue of whether Farley’s actions could potentially be validated under §205 of the Delaware General Corporation Law and that Farley could potentially recover damages from Applied for allegedly unpaid compensation.

Applied was founded in 2002 in response to the terrorist attacks on 9/11. The company markets, develops, and manufactures products for the defense and security industry. At its peak in 2006, the company achieved a market capitalization of nearly $1 billion. However, things went downhill for the company after that and just two years later, the company’s share price had fallen by nearly 98%. The company continued its decline over the next decade shedding employees and directors until five of the company’s six directors had resigned, leaving Farley as Applied’s only remaining director.

Alone at the helm of the company which had ceased all operations by that time, Farley attempted to revive Applied with the help of Steven McCahon, one of the company’s founders who had previously served as its chief technology officer. McCahon had left Applied to form his own company. Farley and McCahon decided that Applied would contract with McCahon’s new company to assemble a scientific team and develop new technologies based on Applied’s patent portfolio. To pay McCahon, Farley and McCahon agreed that Applied would issue shares of common stock to McCahon and accrue cash compensation for him at a rate of $150,000 per year, payable once the company had sufficient funds to make the payments.

Farley decided to issue additional shares in order to pay other individuals providing services to Applied. These other individuals included Applied’s patent attorney, outside general counsel, and accountant along with a long-time associate of Farley who was an expert in company valuation and was well-connected in the private equity and hedge fund arena. Farley also decided to issue shares to himself and pay himself an annual salary of $150,000 per year retroactively and prospectively. In total, Farley issued 63,000,000 new shares, including 25,000,000 of which he granted to himself.

Several existing shareholders took issue with this stock issuance as it had the effect of diluting their interest in the company. These shareholders approached Farley and offered a financing package to Applied that was contingent upon Farley resigning and allowing the company to repurchase his shares. Farley refused and the disgruntled shareholders mounted a successful proxy contest to have Farley removed from the board and replaced with three new directors. Following his removal from the board, Farley resigned as Applied’s principal executive officer as well.

After removing Farley from the board and his subsequent resignation from the company, Applied filed suit against Farley alleging breaches of the fiduciary duties of loyalty and care and seeking a declaration by the Court that “all of the actions Farley took in his capacity as the Company’s sole director from February 10, 2016, through his removal on March 9, 2018, were invalid, including Farley’s issuance of twenty-five million shares to himself and his compensation of $150,000 per year.” Farley filed counterclaims alleging that Applied still owed him compensation for his services under a contract or quantum meruit theory. After extensive discovery, both parties filed for partial summary judgment.

The Court began its analysis by examining whether Farley’s actions were invalid for lack of authority. The Court examined Applied’s articles of incorporation and bylaws  as well as the Delaware General Corporation Law (Illinois has its own version of these laws in the Business Corporation Act of 1983, 805 ILCS 5/1 et seq.).

Based on its examination, the Court determined that the challenged actions of Farley were invalid because they lacked authorization. The company’s bylaws required three directors, and a majority of the directors for a quorum. Without a quorum, the board could not act, other than to fill director vacancies as permitted by Delaware law. As such, a single director could not form a quorum to approve the share issuances or compensation packages. Likewise, the bylaws required a minimum of two directors to sit on the compensation committee, meaning Farley alone could not take action on behalf of the committee. Because the actions Farley took as a sole director lacked authorization, they were invalid, and the Court granted summary judgment to the company on this point.

The company’s victory was not plenary, however, as the Court denied the company’s request to declare that the invalid actions could not be validated by the Court. As the Court explained, Delaware’s corporate law permits the Court to validate otherwise invalid actions. The Court could only decide whether to validate the invalid actions after trial. The Court also found that Farley could maintain his claims for unpaid compensation for his services as an officer and director.

The Court’s full opinion can be found online here.

Our Chicago breach of fiduciary duty and business litigation attorneys have defended and prosecuted minority shareholder oppression, business divorce, stolen corporate opportunity and breach of fiduciary duty lawsuits for more than three decades.

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