Applied Energetics, Inc. v. George Farley, et al., C.A. No. 2018-0489-TMR (Del. Ch. Jan. 24, 2019) (Montgomery-Reeves, V.C.).
The Court of Chancery recently granted a preliminary injunction preventing the sale of 25 million shares of stock that defendant George Farley previously issued to himself at a discounted price. Under the well-established preliminary injunction framework, the Court of Chancery found that the plaintiff was likely to prevail on its claims. This decision is a helpful reminder of a simple—yet easy-to-overlook and consequential—Delaware corporate law principle that requires strict compliance with statutory and bylaw provisions for valid corporate action.
Applied Energetics (“Applied Energetics”) is a technology development company that reduced its operations and entered into “shell” status in March 2014. By February 2016, Farley was Applied Energetics’ sole officer and appointed director when he executed a written consent issuing 25 million shares of stock to himself at a discounted price per share of $0.001.
In March 2018, after the company shed its shell status, stockholders removed Farley as a director for cause and appointed three new directors. Applied Energetics sued, asserting that Farley’s stock issuance was invalid under the corporation’s governing documents because it was approved by fewer directors than required. Applied Energetics also asserted breach of fiduciary duty, conversion, and fraudulent transfer claims against Farley, as well as aiding and abetting breach of fiduciary duty and fraudulent transfer claims against AnneMarieCo., LLC (“AnneMarieCo”), an entity owned by Farley’s wife and children.
Chancery Court Decision
A company’s board of directors must approve any issuance of stock. The court found that since 2012, and despite its subsequent shell operational status, Applied Energetics’ board comprised three directors, and that no resolution or written consent ever decreased the number of members on the board. Looking to Applied Energetics’ bylaws for the requirements of official corporate action, the court found that a majority of the total number of directors was necessary to establish a quorum or, alternatively, action by written consent was permissible if all directors signed the consent. Strictly construing these provisions, the court held that the plaintiff was likely to show that Farley, while acting as a single member of a three-person board, could not cause the board to validly issue stock, thus invalidating the 25-million share issuance.
In addition, the court found it likely that Farley breached his fiduciary duty of loyalty by awarding himself stock through an unfair process and at an unfair price, and that Farley made a fraudulent transfer of 20 million stock shares to AnneMarieCo. The court also found that, absent an injunction, Farley’s and AnneMarieCo’s stated intent to sell the 25 million shares could cause serious irreparable harm to Applied Energetics’ restart of operations, including an inability to raise capital, or worse, a potential bankruptcy filing. To balance the potential harm to Farley and AnneMarieCo in not being able to dispose of the shares, the court required Applied Energetics to post an injunction bond tied to the trading price of Applied Energetics’ stock.
The Court of Chancery’s Applied Energetics decision is a valuable reminder for corporate practitioners to consult an entity’s governing documents to ensure that a quorum of directors is present before corporate action is taken. If action is to be taken by written consent, a sufficient number of directors must be available to execute the consent.
Further, where director resignations create board vacancies, careful consideration should be given to the company’s prospective business strategy before determining whether to nominate replacement directors or adopt a bylaw provision reducing the size of the board to ensure valid corporate action. In either circumstance and in others, it is always appropriate to perform conflict of interest analyses to reduce the risk of potential challenges to board-approved corporate actions.