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In re Genelux Corporation and In re Baxter International Inc.: Court of Chancery Provides Guidance Regarding the Scope of Section 205 of the DGCL

February 25, 2016

Two recent decisions by the Delaware Court of Chancery have helped to define the contours of the Court’s authority in proceedings under Section 205 (“Section 205”) of the General Corporation Law of the State of Delaware (the “DGCL”). In In re Genelux Corporation, 126 A.3d 644 (Del. Ch. 2015), the Court of Chancery held that a corporation cannot use Section 205 to invalidate prior corporate acts, and in In re Baxter International Inc., C.A. No. 11609-CB (Del. Ch. Jan. 15, 2016) (TRANSCRIPT), the Court of Chancery held that a corporation cannot use Section 205 as a means to ensure the validity of future corporate acts.

Section 205, which became effective April 1, 2014, and was amended effective August 1, 2015, confers jurisdiction on the Court of Chancery to determine the validity of defective corporate acts and stock issuances. Since Section 205 was enacted in 2014, the Court of Chancery has used its powers under Section 205 to resolve issues relating to a corporation’s valid existence, including confirming the identity of the members of the corporation’s board of directors (see In re Trupanion, C.A. No. 9496-VCP (Del. Ch. Apr. 28, 2014) (ORDER)), and to validate defective stock issuances (see In re Numoda Corporation Shareholders Litigation, C.A. No. 9163-VCN (Del. Ch. Jan. 30, 2015) and In re CertiSign Holding, Inc., C.A. No. 9989-VCN (Del. Ch. Aug. 31, 2015)). However, both Genelux and Baxter involved unique petitions that had the potential to expand the scope of the Court of Chancery’s authority under Section 205 beyond the validation of past defective corporate acts.

In Genelux, Genelux Corporation (“Genelux”) petitioned the Court of Chancery to invalidate 1.5 million shares of Genelux’s Series A Preferred shares (the “Disputed Shares”) that Genelux purportedly issued to Aladar Szalay, one of Genelux’s founders (“Szalay”), under Section 205 and to declare the elections of two directors invalid under Section 225 of the DGCL as a result of the invalid issuance of the Disputed Shares. Genelux claimed that the Disputed Shares were invalid because, among other things, (i) the Disputed Shares were allegedly issued in exchange for shares of Genelux common stock that were invalid; (ii) Szalay released his claim to the Disputed Shares in a settlement of litigation with a third party; (iii) the issuance of the Disputed Shares was not supported by valid consideration; and (iv) Genelux was fraudulently induced by Szalay to issue the Disputed Shares.

Before reaching the merits of Genelux’s claims with respect to the validity of the Disputed Shares, the Court of Chancery addressed the threshold issue of whether Section 205 can be used to invalidate purportedly defective corporate acts. Genelux argued that because Section 205(a)(4) authorizes the Court of Chancery to determine the validity of any stock (and not just putative or defective stock), the Court of Chancery should have the ability to determine that the stock subject to the petition is invalid. Szalay argued that Section 205, when read as a whole, only granted the Court of Chancery the power to validate defective stock issuances, not stock issuances that have been treated by the corporation as valid as evidenced by, in this case, the issuance of stock certificates, entries in the corporate stock ledger and board resolutions. The Court of Chancery found that the plain language of Section 205 was ambiguous as to whether the Court of Chancery is permitted to invalidate corporate acts. Accordingly, the Court looked to extrinsic evidence—including the legislative synopsis of House Bill 127 (which became Section 205 and Section 204 of the DGCL), the other provisions of Section 204 and Section 205, and commentary in Delaware law treatises concerning Section 205—to resolve the ambiguity.

After reviewing these materials, the Court of Chancery concluded that Section 205 is a “remedial statute” that was only designed to “cure otherwise incurable defective corporate acts, not a statute to be used to launch a challenge to stock issuances on grounds already available through the assertion of plenary-type claims based on alleged fiduciary duty or common law fraud or a Section 225 action, if the stock had been voted.” Thus, the Court of Chancery dismissed for failure to state a claim Genelux’s petition under Section 205 seeking a declaration that the Disputed Shares were invalid. The Court of Chancery also dismissed Genelux’s Section 225 claims, concluding that (i) Genelux had failed to prove by a preponderance of the evidence that it did not approve the issuance of the shares of common stock for which the Disputed Shares were exchanged; (ii) the settlement did not include a general release of claims that Szalay may have against Genelux; (iii) the exchange of the shares of common stock and Szalay’s release of his claims to additional shares of Genelux constituted valid consideration for the issuance of the Disputed Shares; and (iv) Szalay’s conduct in pressing Genelux to issue the Disputed Shares in connection with an unrelated third-party financing did not rise to the level of fraud.

In Baxter, the certificate of incorporation of Baxter International Inc. (“Baxter”) contained a provision that stated that Article SIXTH of the certificate of incorporation could not be amended without the vote of at least “two-thirds of the holders of all the securities of [Baxter] then entitled to vote on such change” (the “voting provision”). Baxter planned to seek an amendment of Article SIXTH at its upcoming annual meeting, and its board of directors adopted a resolution (the “voting resolution”) stating that the board had determined to count votes on the amendment on a “per share basis, rather than on a per capita basis,” even though the voting provision, on its face, seemed to call for a per capita vote and previous public disclosures indicated that Baxter had counted votes subject to the provision on a per capita basis in the past. Baxter filed a petition with the Court of Chancery under Section 205 requesting that the Court validate the voting resolution as well as the voting standard set forth in the voting resolution. In effect, Baxter requested the Court to declare that the voting resolution properly provided that the upcoming vote on the amendment to the certificate should be determined on a per share basis, rather than a per capita basis. Although Baxter’s Section 205 petition was initially unopposed, the Court of Chancery appointed Richards, Layton & Finger, P.A. as special counsel to file an opposition brief if no stockholder came forward to oppose the petition after notice was given.

The Court of Chancery, issuing its ruling from the bench after oral argument, distinguished between determining the validity of the voting resolution itself and determining the proper voting standard for the proposed certificate amendment. The Court of Chancery indicated that it could address under Section 205 the validity of the voting resolution if there had been some defect in its adoption (for example, if it was not adopted by a sufficient number of directors), but that Section 205 did not permit the Court to provide an opinion on the underlying contents of the voting resolution.

Moreover, the Court of Chancery determined that Section 205 did not empower the Court to validate future corporate acts. While Baxter argued that a corporate act had already occurred because the board had adopted the voting resolution, the Court of Chancery pointed out that the annual meeting where the vote on the amendment was to occur had not been held and might never occur. The Court of Chancery likened Baxter’s Section 205 petition to a request for an advisory opinion on an unripe issue and dismissed the case. However, the Court of Chancery acknowledged that Section 205 is a flexible statute “intended to promote equitable outcomes and to provide certainty to stockholders,” and that relief under Section 205 may be possible under appropriate circumstances. The Court of Chancery noted that if Baxter held its annual meeting, received sufficient votes counted on a per-share basis to amend, and actually amended its certificate of incorporation on that basis, Baxter would have a stronger argument that the Court should validate the amendment under Section 205 because a corporate act would have actually occurred.