Applied Energetics, Inc. v. Farley
Not Reported in F.Supp.3d, 2020 WL 4496791 (Del. Ch. Aug. 3, 2020) (2020)
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Rule of Law:
Under Delaware law, a sole remaining director on a multi-seat board cannot satisfy a quorum requirement to take corporate action, making such actions invalid due to a "failure of authorization" rather than a lack of "corporate power," and these acts may be subject to judicial validation under DGCL Section 205.
Facts:
- Applied Energetics, Inc. (the "Company") was a Delaware corporation in the defense and security industry, which went public through a reverse merger in 2004.
- George Farley joined the Company's board as the sixth director in 2004, having approximately forty years’ experience as a certified public accountant and expertise in complex financial transactions.
- Over several years, the Company's business declined, leading to cuts in government funding, delisting from Nasdaq, and a board resolution in July 2012 to reduce the number of directorships from six to three.
- By March 2015, all other directors except George Farley and John Levy had resigned, and Farley was appointed principal executive officer and principal financial officer.
- In January 2016, George Farley discussed a plan to reactivate the Company's business and issue shares, which John Levy opposed, leading to Levy's resignation on February 10, 2016.
- After Levy's resignation, George Farley became the sole remaining director on a board with three seats and purported to take actions to reactivate the Company.
- Between February 2016 and March 2018, George Farley, acting as the sole director, caused the Company to issue himself 25 million shares of common stock, grant himself an annual salary of $150,000, and transfer 20 million shares to AnneMarieCo, LLC, an entity owned by his wife and children.
- To execute these actions, Farley signed "Written Consent of Board of Directors" and "Unanimous Consent of the Compensation Committee" and caused the Company to file an amendment to its certificate of incorporation to increase authorized shares.
Procedural Posture:
- On July 3, 2018, Applied Energetics, Inc. filed an action against George Farley and AnneMarieCo, LLC in the Delaware Court of Chancery, asserting claims for breach of fiduciary duty, aiding and abetting breaches of fiduciary duty, conversion, and fraudulent transfer.
- Applied Energetics sought a preliminary injunction prohibiting Farley and AnneMarieCo from transferring their shares.
- On January 23, 2019, the Court of Chancery (Justice Montgomery-Reeves) granted the preliminary injunction, finding a reasonable probability of success on claims that Farley lacked authority, breached fiduciary duties, and fraudulently transferred shares.
- After the issuance of the Injunction Decision, Applied Energetics filed the currently operative complaint, which included Count V asserting that all actions Farley took as the Company's sole director from February 10, 2016, through March 9, 2018, were invalid.
- On July 19, 2019, Farley and AnneMarieCo answered the Complaint and asserted counterclaims, including Count IV, which sought the court's exercise of authority under Section 205 of the DGCL to validate Farley's actions.
- Applied Energetics moved for partial summary judgment on Count V of its complaint and on Counts I-IV of Farley's counterclaims.
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Issue:
Does a sole remaining director on a multi-seat board have the authority to take corporate actions, such as issuing stock or setting compensation, that require a quorum, or are such actions invalid due to a failure of authorization but potentially subject to judicial validation under DGCL Section 205?
Opinions:
Majority - Laster, V.C.
Yes, a sole remaining director on a multi-seat board cannot satisfy a quorum requirement for corporate action, making such actions invalid due to a failure of authorization; however, these acts are potentially subject to judicial validation under DGCL Section 205, as the corporation possessed the underlying corporate power to undertake them. The court found that George Farley’s actions as the sole remaining director between February 10, 2016, and March 9, 2018, were invalid as a matter of law. Under DGCL Section 141(b), a majority of the "total number of directors" (referring to directorships, not directors actually in office) is required for a quorum. With a three-seat board, a quorum required two directors, which Farley, as the sole director, could not meet. This inability to meet the quorum also precluded valid action by unanimous written consent under Section 141(f), which implicitly requires a quorum to be present. Therefore, Farley’s self-issuance of twenty-five million shares and approval of his $150,000 annual salary were statutorily invalid. However, the court determined that these invalid acts are potentially subject to judicial validation under DGCL Section 205. The court distinguished between a corporation’s fundamental "power" to act (e.g., to issue shares or compensate officers/directors, granted by Subchapter II of the DGCL) and a "failure of authorization" (a procedural defect in how that power was exercised, such as failing to meet quorum requirements). Farley’s actions represented a failure of authorization, not an absence of corporate power, making them candidates for Section 205 validation. The court clarified that the Nguyen v. View, Inc. decisions, which concerned an explicit rejection of a corporate act by a required intra-corporate actor, are distinguishable from Farley’s situation, which involved a procedural failure of authorization rather than an active veto after he became the sole director. Furthermore, the 2018 amendment to DGCL Section 204(h)(1) specifically aimed to clarify that the nature of the authorization failure does not negate the corporation's underlying power. Farley's deliberate efforts, including executing written consents and securing legal opinions, constituted bona fide "corporate acts" sufficient to satisfy a prerequisite for Section 205 validation. The Company's argument that its decision not to challenge other share issuances implied ratification of Farley's acts was rejected, as were arguments against the survival of Farley's unjust enrichment and breach of contract counterclaims; these claims can proceed to trial, contingent on potential validation under Section 205.
Analysis:
This case significantly clarifies the distinction between a corporation's fundamental "power" to act and the "authorization" required for valid action under the DGCL, particularly in the context of single-director boards and the scope of Section 205 validation. It confirms that even actions taken by a sole director who lacks quorum-satisfying authority can be subject to judicial validation if the corporation possessed the underlying power to take such actions, emphasizing the statute's role in stabilizing potentially void corporate acts. The opinion also reinforces the high bar for proving implied bylaw amendments through conduct and meticulously distinguishes an affirmative rejection of an act from a mere failure of authorization.
