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North Carolina Now Offers Tool to Mend Corporate Actions Taken Without Proper Authorization

By David Clement and Justin Truesdale
08.22.2018

The North Carolina General Assembly recently approved a number of significant changes to the North Carolina Business Corporation Act (“NCBCA”), which the governor signed into law and which will take effect on October 1, 2018 (the “Act”).[1] The NCBCA, codified in Chapter 55 of the North Carolina General Statutes, is based upon the Model Business Corporation Act (“Model Act”), and the 2018 amendments are intended to update the NCBCA based on changes made to the Model Act as well as selected changes in state laws in other jurisdictions. This Client Alert describes certain changes to the NCBCA made by the Act that add a statutory procedure to remedy defective corporate actions. 

Permitting Statutory Ratification of Defective Corporate Actions 

A “defective corporate action” is an action that is within the power of a corporation, but is void or voidable because the action was taken without proper authorization. Directors, officers, incorporators, committees, subcommittees, agents and shareholders all take corporate actions that must comply with articles of incorporation, bylaws, corporate resolutions, third-party agreements, board authorizations and shareholder authorizations then in effect (collectively “Governing Documents”) to the extent those authorities are applicable to the particular action being taken. Failure to observe these corporate formalities can have negative implications that are difficult to remediate. For example, if shares that were issued without proper authorization are voted in a board of directors election, it casts doubt on all subsequent decisions by that board of directors. A nonexclusive listing of additional examples of defective corporate actions are below:[2]

  • failure of incorporator to validly appoint an initial board of directors,
  • corporate action taken in the absence of board resolution authorizing the action,
  • failure to obtain requisite shareholder approval of a corporate action,
  • issuance of shares without evidence that the corporation received consideration,
  • failure to comply with appraisal rights, and
  • issuance of shares without complying with preemptive rights.

In 2013, the Delaware General Corporation Law was amended to add §§ 204-05, which allows corporations to cure defective corporate actions through ratification and certificates of validation. In 2016, the Model Act was updated to add provisions for a similar purpose. Now the North Carolina General Assembly has amended the NCBCA, based upon the Model Act, to create a nonexclusive statutory procedure to remedy defective corporate actions.[3] These amendments are found in Sections 1 and 3 of Session Law 2018-45.

Section 1 merely establishes a new filing fee, whereas Section 3 adds an entirely new Part to Article 1 of Chapter 55 of the N.C. General Statutes. The heart of Section 3 is codified in § 55-1-61(a): “A defective corporate action is not void or voidable if ratified in accordance with G.S. 55-1-62 or validated in accordance with G.S. 55-1-67.”

Ratification Procedure
In ratifying a defective corporate action, N.C. Gen. Stat. § 55-1-62 requires the board of directors to adopt resolutions that contain the following information:

  • the defective corporate action that is to be ratified,
  • the date of the defective corporate action,
  • the nature of the failure of authorization with respect to the defective corporate action, and
  • the board of directors approval of the ratification of the defective corporate action.

Following approval by the board of directors, the corporation must notify shareholders of the ratification. N.C. Gen. Stat. § 55-1-64(a) requires that notification be given to holders of both valid and putative shares in each case as of both the date of ratification and the date of the defective corporate action. Putative shares are corporate shares or interests (e.g., stock options or warrants) that could have been validly issued, but there was a failure of authorization or proper authorization cannot be proven. Notice is not required for shareholders whose identities and addresses cannot be determined from the records of the corporation. The notification must state the information listed above from the board resolutions, and must alert such persons that they have 120 days from the “validation effective time” to challenge the ratification. The validation effective time is the later of: (1) when the shareholders approve the ratification; (2) if shareholder approval is not required, when the shareholders are notified of the ratification; or (3) when the articles of validation are filed, if such a filing is necessary.

Ratification of a defective corporate action requires shareholder authorization only if the corporate action in question would require shareholder authorization according to the then current Governing Documents at the time of ratification. The Governing Documents in effect as of the date of the defective corporate action do not control whether a shareholder vote is required for ratification. If the ratification is to be authorized at a shareholder meeting, the corporation must notify all shareholders of the meeting. This includes voting and nonvoting shareholders both as of the record date of notice of the meeting and as of the date of the defective corporate action. Although holders of putative shares must be notified of a meeting considering a ratification proposal, holders of putative shares are neither entitled to vote nor counted for the purposes of quorum. The meeting notification must state that ratification is one of the purposes of the meeting, and must include a copy of the board resolutions described above regarding ratification. Furthermore, the notification must inform shareholders of the 120-day window to challenge the ratification. Notice of the shareholder meeting is not required for holders of valid and putative shares whose identities or addresses for notice cannot be determined.

Upon the validation effective time, N.C. Gen. Stat. § 55-1-65 states that the defective corporate action is no longer void or voidable. Furthermore, corporate actions that directly or indirectly resulted from the defective corporate action are also not void or voidable.

Quorum and Voting Requirements
The quorum and voting requirements for ratification by the board of directors are the same requirements needed for board action at the time of ratification, not such requirements as based on the Governing Documents as of the time of defective corporate action. Similarly, the quorum and voting requirements for shareholder approval are the shareholder authorization requirements at the time of ratification. In the case of ratifying a defective corporate action that purported to change the voting requirements themselves, N.C. Gen. Stat. § 55-7-27 states that the voting requirements may not be amended by a vote that is less than what is prescribed in the bylaws or articles of incorporation. For example, a defective corporate action that purported to reduce voting requirements from two-thirds to a majority would require a two-thirds vote to approve its ratification. Lastly, in ratifying an election of a particular director, similar to plurality voting requirements for regular director elections, shareholder votes in favor of ratification must exceed shareholder votes against ratification.

Filing Required in Certain Cases
Many corporate actions require a filing with the Secretary of State; a list of such filings can be found at N.C. Gen. Stat. § 55-1-22(a). If one of these actions is defective, the ratification procedures require filing of “articles of validation” in accordance with N.C. Gen. Stat. § 55-1-66. The articles of validation should describe: (1) the defective corporate action; (2) the date of the defective corporate action; (3) the nature of the defect; (4) that the defective corporate action was properly ratified, including the dates of board approval and shareholder approval as applicable; and (5) information on the original filing that may or may not need to be corrected or, if a required filing was never made, the articles of validation should include all of the information that should have been filed with respect to the defective corporate action and the date and time such filing is deemed effective. There is a $150 filing fee for articles of validation.

Judicial Proceedings
Ratifications can be challenged in the Superior Court of the county where the corporation’s principal office is located, or in the Business Court if the action is designated a mandatory complex business case. N.C. Gen. Stat. § 55-1-67(a) grants those courts the authority to determine the validity and effectiveness of: (1) corporate actions and defective corporate actions, (2) statutory ratifications, and (3) putative shares. Additionally, those courts can make any findings or orders and take into account any factors or circumstances that they deem proper under the circumstances. Challengers are not limited to formal stakeholders such as directors and shareholders. N.C. Gen. Stat. § 55-1-67(a) makes judicial proceedings available to any “person claiming to be substantially and adversely affected by a ratification.”

Ratification Examples 

1.) Issuance of Putative Shares

One common defective corporate action with respect to shares is the issuance of putative shares. When ratifying putative shares, the board’s description of the defective corporate actions must include both the number of putative shares issued and the date of issuance. If the shares are not authorized under the articles of incorporation, ratification must be accompanied by the necessary amendments to the articles of incorporation to create the class or series of stock, or to increase the number of authorized shares of an existing class or series of stock, as needed to include the putative shares. Following the validation effective time, the putative shares are deemed valid as of the date of their original issuance. Below is an example:

Company X has authorized 100 shares of common stock and 100 shares of Class A preferred stock in its articles of incorporation. The articles of incorporation provide that an amendment to the articles of incorporation requires authorization from a majority of shares held by common shareholders and Class A preferred shareholders voting together as well as a separate vote of the holders of Class A preferred shares. At a time that Company X has issued and outstanding 90 shares of common stock and all 100 shares of Class A preferred stock, the company then makes a restricted stock grant of 20 common shares to Employee Y. Next Company X repurchases and retires all of the Class A preferred stock. Sometime later after the restricted stock would have been fully vested, Employee Y tries to sell her common stock and learns that 10 of her shares were never properly authorized. After October 1, 2018, the following steps should be taken: 

Step 1: The current board should adopt resolutions to recommend to the shareholders that the company’s articles of incorporation be amended to include at least 110 authorized shares of common stock and to ratify the original restricted stock grant to Employee Y.

Step 2: The company would call a shareholder meeting (or prepare a shareholder written consent) to approve the recommendation to amend the articles of incorporation and to ratify the restrictive stock grant in respect of the 10 putative shares. Pursuant to N.C. Gen. Stat. § 55-1-63(b), the company would notify holders of valid and putative stock as of both the date of the restrictive stock grant and the record date of notice of the meeting. At the shareholder meeting, the articles of incorporation can be amended by common shareholders acting alone, even though authorization from the Class A preferred shareholders would have been required under the articles of incorporation as in effect at the time of the restrictive stock grant. Employee Y’s 10 putative shares may not be counted for quorum or voted at the shareholder meeting.

Step 3: Following shareholder approval, the company would file articles of validation with the Secretary of State to amend the articles of incorporation consistent with the shareholder approval. The articles of validation should contain all of the information required by N.C. Gen. Stat. § 55-1-66(b)-(c).

Step 4: As a result of the above steps, the restricted stock grant is valid retroactive to the date of its original grant, and Employee Y can now sell her common shares.

2.) Failure to Formally Elect Initial Board of Directors

If the defective corporate action relates to the election of the initial board of directors, there may be no duly elected board to ratify the action. N.C. Gen. Stat. § 55-1-62(b) addresses this situation. The defective election of the initial board of directors can be ratified by a majority of the individuals who are exercising power as directors at the time of the ratification. In ratifying the initial election, the acting board must adopt resolutions that include: (a) the name or names of the persons who first took action as the initial board of directors, (b) the earlier date of either when such individuals were purportedly elected as the initial board of directors or when they took their first board action, and (c) that the ratification is approved by the acting board. According to N.C. Gen. Stat. § 55-1-65(3), ratifying the initial board of directors will cure subsequent actions taken by that board. Below is an example:

Company X is organized by Incorporator Y as its incorporator. Incorporator Y issues herself shares in the company without ever formally appointing herself as the initial board of directors. Incorporator Y then uses her shares to elect a new board of directors. After October 1, 2018, the following steps should be taken: 

Step 1: The current board of directors should adopt resolutions ratifying Incorporator Y’s position as the initial board of directors.

Step 2: The company should send shareholders a notice of ratification in accordance with N.C. Gen. Stat. § 55-1-64.

Step 3: The initial board of directors is now ratified, which cures subsequent corporate actions dependent on the validity of Incorporator Y’s service as the initial board of directors. This includes the issuance of shares to Incorporator Y and Incorporator Y’s voting of those shares in the election of the current board of directors.

CONCLUSION
As is outlined above, the Act makes significant changes to provide a non-exclusive ratification procedure to remedy defective corporate actions of a North Carolina corporation. While the Act does not take effect until October 1, 2018, we recommend that North Carolina corporations and their directors, officers and shareholders understand its impact as it provides a useful tool to cure defective corporate actions. Corporations that are aware of existing defective corporate actions can prepare now to carry out a statutory ratification promptly after October 1, 2018. Further information regarding these and other provisions in the Act can be found here

Special thanks to contributing writer Nicolas Eason, current student at the University of North Carolina School of Law. 

If you have questions about the recent changes in the Act or questions about the information in this Client Alert, please contact Dave Clement, Justin Truesdale, or the Smith Anderson lawyer with whom you normally work. 


[1] Senate Bill 622 (Session Law 2018-45), https://www.ncleg.net/Sessions/2017/Bills/Senate/PDF/S622v5.pdf.

[2] Model Act § 1.46, official comment (2016).

[3] N.C. Gen. Stat § 55-1-61(b) preserves the effectiveness of existing common law ratifications, despite the introduction of statutory ratifications.

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Jamie Greene
jgreene@smithlaw.com
T: 919.838.2045

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