Tips for Using New Statutory Ratification Procedure to Cure Defects in Authorizations of Share Issuances and Other Corporate Actions
As described in an earlier ncbarblog post, among the 2018 changes to the North Carolina Business Corporation Act, Chapter 55 of the General Statutes (the “NCBCA”) , which took effect Oct. 1, 2018 was the addition of a new Part 6 to Article 1 (N.C. Gen. Stat. §§55-1-60 through 55-1-67) based on changes to the Model Business Corporation Act providing that defects in authorizations of share issuances and other corporate actions shall not be void or voidable solely as a result of a failure of authorization if a prescribed statutory ratification process is followed.
When you discover only one defective corporate act, determining the requirements under the statute for ratification (e.g., board approval, shareholder approval, and/or filing of articles of validation) is perhaps relatively straight-forward. But what should you do when you discover multiple defects, perhaps occurring over a number of years?
A Hypothetical Startup
Jake Jones is the founder of Ratification Case Study, Inc. (the “Company”). Jake as incorporator files Articles of Incorporation (the “Articles”) with the North Carolina Secretary of State on June 30, 2016 that provides for 1,000,000 shares of authorized common stock. Immediately after filing the Articles of Incorporation and without ever electing an initial board of directors of the Company, on July 1, 2016, Jake issues 50,000 shares of Common Stock to himself. On August 1, 2016, Jake executes a joint written consent of sole director and as the sole shareholder of the Company approving an Amendment and Restatement of the Articles of Incorporation creating 100,000 shares of Class A Preferred Stock, which he then files with the Secretary of State. On September 1, 2016, Jake ostensibly acting as the sole director of the Company issues 50,000 shares of Class A Preferred Stock to angel investor Linda Smith, and 25,000 shares of Class A Preferred Stock to angel investor Susan Brown. On October 1, 2016, Jake appoints Linda Smith to the board of directors even though the Company’s then-current bylaws state that the board of directors shall consist of a single director. Thereafter, Jake and Linda act as the Company’s board of directors. The Company is successful and has investment interest from a venture capital fund, which during its due diligence investigation expresses concern that Jake has not followed proper corporate formalities. On April 1, 2019, Jake calls you. Where do you start?
First Identify All of the Defective Corporate Actions
NCBCA §55-1-60(3) defines a defective corporate action as “any corporate action purportedly taken that is, and at the time the corporate action was purportedly taken would have been, within the power of corporation, but is void or voidable due to a failure of authorization. This term includes an overissue.” Under NCBCA §55-1-60(5)b., an “overissue” includes the purported issuance of “shares of any class that is not then authorized for issuance by the articles of incorporation.” The defective corporate actions reflected in this case study include:
Defect #1. Because Jake failed to complete the organization of the Company as required by N.C. Gen. Stat. §55-5-05(a), initial directors for the Company were never elected.
Defect #2. Issuance of shares is a board prerogative. Jake’s issuance of 50,000 shares of Common Stock to himself did not have proper board authorization.
Defect #3. The August 1, 2016 adoption of the Amendment and Restatement of the Articles of Incorporation purportedly creating the Class A Preferred Stock was defective because under NCBCA §55-10-03 a charter amendment requires that the board of directors approve the amendment and recommend its approval to the shareholders and that the shareholders thereafter approve the amendment. Because Jake was not a properly elected director and because his common shares had not been properly issued, a charter amendment could not be properly adopted.
Defect #4. Jake’s issuance of shares of Class A Preferred Stock was defective because Jake was not a proper director of the Company. In addition, the charter amendment was not properly adopted so the purported issuance of the Class A Preferred Stock resulted in an overissue in respect of each of Linda Smith and Susan Brown.
Defect #5. Jake’s appointment of Linda Smith to the board of directors was defective because it conflicted with the bylaws of the Company that then specified a single director.
Next Identify the Required Approvals for Ratification
For Defect #1, NCBCA §55-1-62(b) provides that if a defective corporate action to be ratified relates to the election of the initial board of directors of the corporation, a majority of the persons who, at the time of the ratification, are exercising the powers of directors may take an action ratifying the election of the person or persons who first took action in the name of the corporation as the initial board of directors of the corporation. Since Jake and Linda are currently acting as the Company’s directors (notwithstanding their defective election), Jake and Linda can ratify the election of Jake as the initial director of the Company, which has a retroactive effective date to the time when he first took action. No shareholder approval or filing of Articles of Validation is required.
For Defect #2, under NCBCA §55-1-62(a), the board of directors can adopt resolutions that identify the issuance of Jake’s shares without board approval as the defective corporate action to be ratified and, if the defective corporate action involved the issuance of putative shares, the number and type of putative shares purportedly issued. Jake’s shares are “putative shares” under NCBCA §55-1-60(6)a. because they are shares that were created or issued as a result of a defective corporate action, and that would constitute valid shares but for any failure of authorization. Shareholder approval of the board’s ratification action is not required under NCBCA §55-1-62(c) because none of the NCBCA, Company’s Articles of Incorporation or bylaws, any corporate resolution, or any plan or agreement to which the Company is a party in effect at the time of ratification require shareholder approval to issue authorized shares.
For Defect #3, ratification of the Amendment and Restatement of the Articles of Incorporation that purported to create the Series A Preferred Stock requires (i) board approval under NCBCA §55-1-62(a) ratifying the Amendment and Restatement of the Articles of Incorporation, (ii) shareholder approval under NCBCA §55-1-62(c) (because charter amendments require shareholder approval under NCBCA §55-10-03), and (iii) the filing of Articles of Validation under NCBCA §55-1-66(a) (because the defective corporate action being ratified is a charter amendment, which would have required a filing with the Secretary of State in accordance with the NCBCA).
For Defect #4, ratification of the overissues can be accomplished by the board only but the authorization of the Class A Preferred Stock (i.e., Defect #3) must first be cured.
For Defect #5, ratification of the increase in the size of the board of directors (a de facto amendment to the bylaws of the Company) and appointment of Linda Smith to fill the vacancy created by that increase in board size requires board approval under NCBCA §55-1-62(a). Shareholder approval under NCBCA §55-1-62(c) is not required because the Company’s bylaws can be amended by the board of directors and the directors then in office can fill vacancies on the board of directors without shareholder approval.
Always Start with Defects in Corporate Authorization that Affect the Legitimacy of Your Board
In every case, ratification requires at the very least that the board adopt resolutions meeting the requirements of N.C. Gen. Stat. 55-1-62. If your current board is not validly constituted, then you lack a basic prerequisite for most statutory ratification actions. The only exception is correction of a defect in an initial board of directors. For Defect #1, Jake Jones and Linda Smith as the persons currently acting as the board of directors of the Company are able to ratify Jake’s election as the initial board of directors of the Company. Once Defect #1 is ratified, Jake as the duly elected board of directors can ratify the issuance of shares to himself (Defect #2). Jake could also ratify the amendment to the bylaws increasing the size of the board of directors to two and the appointment of Linda Smith to fill the vacancy created thereby (Defect #5). Once Linda’s defective appointment is cured, which would be retroactively effective to the date of her original appointment, then thereafter she could vote on subsequent ratification actions.
Once the issuance of Jake’s shares have been cured, you now have a shareholder with valid shares who is able to vote to approve the board’s ratification of the Amendment and Restatement of the Articles of Incorporation (Defect #3). Even though Linda Smith and Susan Brown hold shares of Class A Preferred Stock, such shares are putative shares for purposes of the shareholder vote to cure Defect #3 and are not eligible to vote nor to be counted for purposes of quorum per NCBCA §55-1-63(e). Following filing of Articles of Validation, then the board of directors could ratify the issuance of shares of the Class A Preferred Stock by Jake at a time when he was not a properly elected director (Defect #4).
As demonstrated by the preceding discussion, the sequence of board resolutions, shareholder resolutions, and Articles of Validation filings is important because certain ratification actions may be dependent on the effectiveness of a preceding ratification of another defective corporate action. In this case study, for example, the ratification of Amendment and Restatement of the Articles of Incorporation required that there be at least one shareholder with valid shares to provide the necessary shareholder approval. Thus, the issuance of Jake’s shares (Defect #2) had to be ratified before Defect #3 could be ratified. Because different directors/shareholders may hold valid offices/shares at different points in time (including following the effectiveness of a ratification), it is recommended that you consider having separate ratification resolutions and separate Articles of Validation for each defective corporate action you seek to cure rather than trying to combine them into a single omnibus ratification document and that you provide for sequential effective dates and times so that the order of your ratification steps is clear. This also makes it easier to keep track of who is allowed a vote on a particular ratification resolution. For example, until Linda’s defective appointment as a director was cured, she would not be able to vote on any of the board resolutions providing for ratification.
Track Closely the NCBCA Requirements for Ratification Approvals, Shareholder Notices, and Articles of Validation
The items that must be included for board ratifications are detailed in NCBCA §55-1-62(b) for a defective corporate action related to the election of the initial board of directors and in NCBCA §55-1-62(a) for all other defective corporate actions. If shareholder approval is required, the shareholders will be provided either a copy of the board of directors ratification action or a copy of the information required by subdivisions (1) through (4) of NCBCA §55-1-62(a). Requirements for notices to each holder of valid and putative shares, as of the date of the action by the board of directors (if shareholder approval is not required), as of the record date for notice of the meeting (if shareholder approval is required) and as of the date of the occurrence of the defective corporate action (in any case), are set forth in NCBCA §55-1-63(c) and §55-1-64(b). The items that must be included in Articles of Validation are set forth in NCBCA §55-1-66(b) and (c) and the North Carolina Secretary of State provides Form B-15 as a sample form for this purpose.
Although the statutory ratification procedure is a new tool in North Carolina, Delaware has authorized statutory ratifications under Delaware General Corporation Law Sections 204 and 205 since April 1, 2014. Although there are differences between Delaware’s statute and our Model Act-based statute, there are many similarities and Delaware local counsel may be a useful resource if you have any thorny issues in drafting ratification resolutions, shareholder notices, or Articles of Validation based on your particular facts.
Filing Process for Articles of Validation with the Secretary of State
If Articles of Validation are required in connection with a ratification, NCBCA §55-1-66(b)(1) requires that in the case of a defective corporate action involving the issuance of putative shares that the filing include the number and type of putative shares issued and the date or dates that the putative shares were purportedly issued. Note that the names of the holders of the putative shares are not required to be included in the Articles of Validation and it is not recommended that you include them. However, in order to have a clear record for posterity, although not required by NCBCA §55-1-62(a)(1), you should consider including names in the board resolutions approving ratification each of the issuances being ratified. It may be convenient to present the information in table form, including holder name, number of shares, class or series, and date of issuance. Although not required by NCBCA §55-1-63(b) or NCBCA §55-1-64(b), you should also consider including the holder name in your shareholder resolutions or notice to shareholders in the interest of providing disclosure of material facts to shareholders.
As compared to Delaware where there is no option to expedite filing of Certificates of Validation, the North Carolina Secretary of State provides better service, offering the same expedited filing options (i.e., 24-hour or same day) it offers for other filings. The Articles of Validation can be submitted online. The filing fee is $150 and you need to ensure all required attachments are uploaded with the Articles of Validation if you choose to submit it online. The North Carolina Secretary of State also offers preclearance review of Articles of Validation for $200, the same fee charged for preclearance review of any filing with that office. You might choose a preclearance review where, for example, you wanted to make sure that all defects in share issuances had been cured before effecting a merger.
 Senate Bill 622 (Session Law 2018-45), https://www.ncleg.net/Sessions/2017/Bills/Senate/PDF/S622v5.pdf
The above article was originally published on the NCBA Business Law Section Blog on August 5, 2019, and has been republished here with the consent of the North Carolina Bar Association.