Two Wrongs Don't Make A Right – Ratifying Defective Corporate Actions
As part of incorporating and conducting your business, Nebraska statutes generally provide that certain formalities be followed — whether you’re appointing a board of directors, authorizing and issuing shares to shareholders, or obtaining director or shareholder approval for certain actions. Performing these formalities incorrectly (or not at all) can create questions as to their validity. If a director’s appointment or a shareholder’s shares are invalid, it can discredit subsequent transactions (such as declaring dividends, borrowing funds, buying assets, etc.).
If continuing business-as-usual won’t cure the problem, and two (or more) corporate wrongs won’t make a right, then how can corporations validate past mistakes?
The Nebraska Legislature has provided a solution by adopting Sections 21-218.01 to 21-218.08 to the Nebraska Model Business Corporation Act (the “Act”). These sections provide mechanisms for corporations to ratify defective actions or seek judicial declaration to determine the validity of such actions. These provisions go into effect on July 1, 2021.
Defective Corporate Action
A defective corporate act is any act or transaction that would have been within the power of the corporation at the time taken but which is “void or voidable” due to a failure of authorization. Examples of defective corporate actions include the failure to validly appoint directors, actions taken without the appropriate board resolutions, failure to obtain required shareholder approval, or any other action within the corporation’s powers that was not properly authorized in accordance with the Act or the corporation’s organizational documents. A defective corporate act also includes any issuance of corporate stock in excess of amounts or of a different class than those authorized by the articles of incorporation (known as “putative stock”). No defective corporate act will be deemed void or voidable if it is ratified or validated in accordance with the new provisions of the Act.
So is a defective corporate act a big deal? The potential consequences can be significant if a corporation is looking to do a deal or raise capital because it is bound to be discovered during a buyer’s or lender’s due diligence process. Having a clear, effective mechanism to fix issues and obtain validation of corporate acts provides certainty and stability and clears a hurdle that could otherwise stand in the way of a transaction.
Generally, to ratify a defective corporate action the board of directors must follow the same quorum and voting requirements that were originally required to approve such action. In voting on ratifying the action, the directors must state (i) the defective corporate action to be ratified, (ii) the date of such defective action, (iii) the nature of the failure of authorization, and (iv) that the board of directors approves the ratification of the defective action. If shareholder approval would have been required for the defective action when it was taken, then such approval is also required for its ratification with the same quorum and voting requirements as would have been originally required. With respect to a defective corporate act related to the election of the initial board of directors, the persons who are exercising the powers of directors must state (i) the name of the person(s) who first took action as the initial board of directors of the corporation, (ii) the date such persons were purported to have been elected as the initial board of directors, and (iii) that the ratification of the election of such person(s) as the initial board of directors is approved.
Once the defective corporate action is ratified, it is retroactively considered valid as of the date the action was purportedly taken. Further, any subsequent corporate actions taken in reliance on the defective action having been valid, shall also be ratified as of the time they were taken. With respect to putative shares, such shares shall be valid shares effective as of the date they were originally purported to be issued.
If a defective corporate action would have required a filing under the Act, then the corporation must file articles of validation to amend or substitute such other filings with respect to the action. The articles of validation must include as an exhibit the original filing (if no correction to a previous filing is required), corrected filing (if correction to a previous filing is required) or a new filing (if no previous filing was made).
In addition to ratifying defective actions internally, the corporation, any director, any shareholder or any other person claiming to be substantially and adversely affected by ratification may seek judicial proceedings to (i) determine the validity and effectiveness of a defective corporate action, or (ii) modify or waive the procedures required to ratify a defective corporate action. Any action asserting that ratification of a defective corporate action should not be effective (or should only be effective on certain conditions) must be brought within 120 days of the validation effective time, which is the later of (a) the time the action was ratified by the shareholders, or, if shareholder approval isn’t required, the time the shareholders were notified of such ratification, and (b) when the articles of validation become effective.
Two wrongs don’t make a right, but the new sections of the Nebraska Model Business Corporation Act provide a framework on how make it right. Reach out to a member of McGrath North’s Business Corporate team for assistance with forming new, or restructuring existing, entities and implementing proper corporate governance procedures to avoid your corporate actions being found as defective.