Throughout the life cycle of a company, and especially during the leaner early start-up stages, corporate actions that are defective due to failures to obtain the correct board or shareholder votes, errors in the approval process, or failures to make filings with the applicable Secretary of State are not uncommon. These defects, while detrimental on their own, can also call into question the validity of some or all other board and shareholder approvals, and thus substantive corporate transactions down the line. For example, if the holders of invalidly issued stock of a company later participate in the approval of a sale of the company, that later sale transaction may also be invalid because it was not approved by the requisite vote of valid shareholders. To compound this, common law ratification (e.g., approval of challenged or defective board or shareholder action by a later vote of the board and/or shareholders) is not always available for such defective actions, and even when it is available, it is not clear that the ratification can “relate back” to the date of the initial defective act so that acts subsequent to the arguably now remedied act would themselves no longer be defective.
A situation of this nature was faced by Vitacost.com, Inc. (Vitacost) in 2010,1 after the company uncovered several corporate irregularities that called into question the validity of its equity capitalization.2 Vitacost had attempted to take some remedial actions, but they were not effective to remediate the defects. Vitacost considered numerous ways to try to remedy these defects further, including measures as extreme as filing for bankruptcy. Ultimately, a Circuit Court in Florida issued an order quieting title to the shares and options at issue.3 The untenable position that Vitacost (and many other companies) found themselves in due to technical defects led the Delaware state legislature to create a corporate ratification statute, and new Sections 204 and 205 of the Delaware General Corporation Law (DGCL) were adopted into law in 2014. Multiple states have since followed suit including Nevada and most recently, California.
On August 8, 2022, the California legislature approved Senate Bill 218, which amends the California Corporations Code (CCC) to adopt provisions to enable corporate ratifications and judicial validation of past defective corporate acts. Governor Gavin Newsom signed Senate Bill 218 on August 29, 2022. Senate Bill 218 adopts features of both the Nevada ratification statute (Nevada Revised Statutes 78.0296) and DGCL Sections 204 and 205. The new California provisions, contained in Section 119 of the CCC, will go into effect on January 1, 2023.
CCC Section 119
Section 119 allows California corporations to ratify or validate any otherwise legal corporate action (e.g., stock issuances, the initial election of directors, technically invalid filings, etc.) that may not have been effected in compliance with either the CCC or a company’s corporate governing documents. Importantly, any corporate act ratified or validated under Section 119 may be made retroactively effective. Section 119 has several limitations—it is not available to dissolved corporations or foreign corporations, and it does not permit corporations to cure defects due to fraud, breaches of fiduciary duty, interested party transactions unless permitted under the then-existing corporate law, impermissible distributions or dividends, or distributions and dividends that would cause the corporation to be unable to meet its obligations. (Section 119, however, expressly does not limit any other avenues of relief that may be available to a company.)
Section 119 provides for both a self-help ratification process and judicial validation. The self-help process to ratify a defective corporate act (other than the initial appointment of directors) requires approval by the current board and, if the act would require shareholder approval at the time of ratification, by the shareholders. Generally, the shareholder approval required is the approval that would have been required to take the corporate action at the time of ratification (not the time the act was actually taken), unless at the time the act was taken, the company’s governing documents required a higher approval standard, in which case, the ratification must be approved in accordance with such higher voting standard. Section 119 also provides a process by which those currently purportedly serving as a company’s directors may ratify the initial appointment of the company’s board. Once the ratification process is complete, notice of the ratification must be promptly sent to all shareholders as of the date of the ratification only, which may be accomplished through a mailing to the shareholders, a notice to shareholders by electronic transmission, or a public securities filing, but not by a press release or website posting. If the defective corporate act would have required that an instrument be filed with the California Secretary of State, or if the ratification would cause any instrument filed prior to the ratification to be inaccurate, a certificate of ratification must be filed containing specific details about the ratification. Helpfully, multiple instruments may be ratified through the same certificate of ratification.
Section 119(e) allows for the judicial validation of potentially defective acts by the California superior courts and also gives such courts the jurisdiction to determine the validity of a corporate act that has been subject to ratification, both upon a petition by an authorized person. The statute defines an authorized person to include “the corporation, any successor entity to the corporation, any director, any shareholder or holder of shares purportedly issued, any shareholder or holder of shares purportedly issued as of the time of a corporate action ratified pursuant to this section, or any other person, so long as the other person claims to be substantially and adversely affected by the ratification of a corporate action pursuant to this section.” When reviewing a petition under Section 119(e), the court is not limited in the evidence it considers or the remedies it may grant to provide relief. If the court ultimately validates a corporate act that would have required the filing of an instrument with the California Secretary of State, or if the court’s validation would cause any previously filed instrument to be inaccurate, the company must file a certificate of validation containing the information required by Section 119(f).
There are several important timing considerations that clients and practitioners should be aware of. The California Secretary of State undertakes merit review of all filings, and Section 119 provides that both certificates of ratification and certificates of validation may be rejected by the California Secretary of State if accepting the certificate would make any existing filing of the company “inaccurate, ambiguous or unintelligible.” In addition, the California Secretary of State’s office has not yet released sample forms for certificates of ratification or validation. As such, these filings could take months or more to be effective and may be more frequently returned with comments than similar certificates in other states. The California Secretary of State, like the Delaware Secretary of State, is not expected to provide expedited service for certificates of ratification or validation. The inability to obtain a stamped certificate of ratification or validation prior to closing a transaction may result in legal opinion negotiations, including whether an opinion could be given or whether assumptions should be made or exceptions should be taken from the opinion.
Section 119 provides that challenges to a statutory ratification must be filed within 180 days after the notice of ratification is given, but there is no express deadline for an action asserting that a ratification was not accomplished in accordance with Section 119. Further, any person who was entitled to notification of a ratification under the statute but did not receive it is similarly not bound by this 180-day window. This lack of certainty could also have implications for how Section 119 ratifications are treated for the purposes of opinions.
Section 119(j) provides that notice of a Section 119(e) petition must be filed with any other court then-considering litigation in which the validity of the act subject to the petition is challenged, or which validation could result in the dismissal of such other litigation in whole or in part. However, it is unclear whether the superior court hearing the petition, or the other court has priority in hearing the case before them. Uncertainty may therefore arise about the priority of the cases and the impact of validation.
Key Differences from Delaware Sections 204 and 205
Unlike DGCL Sections 204 and 205, CCC Section 119 provides a single section that includes both a self-help remedy and a judicial remedy. CCC Section 119 is more consistent with the Nevada ratification statute (Nevada Revised Statutes 78.0296) in this regard, which is less detailed in its specification of the process and requirements for ratification and validation.
Although the Delaware Secretary of State’s office also reviews every certificate of validation filed with it, CCC Section 119 goes further, explicitly providing that the California Secretary of State’s office can reject a certificate of ratification or validation in the event that the impact of such certificate of ratification or validation would cause other filings made by a company to be inaccurate, ambiguous, or unintelligible. The California Secretary of State’s office conducts merit review of every filing by a corporation, so it is likely that the California Secretary of State’s office will substantively review every certificate of ratification and validation with a view to determining whether the certificate of ratification or validation would cause any of the filings made by the company after the defective filing that is being ratified or validated not to be in compliance with the CCC. In addition to making the timeline for acceptance of filings unpredictable, companies may be in the position of having to ratify or validate these subsequent filings, if the California Secretary of State’s office determines that the initial certificate of ratification or validation would cause such later filings to be inaccurate, ambiguous, or unintelligible. Unless the California Secretary of State’s office reinstates its preclearance process, companies and practitioners should be prepared for subsequent needs to ratify or validate matters after the initial filing.
CCC Section 119 provides companies and practitioners with the ability to have ratification or validation be effective as of a different time than that of the original act, which is in contrast to DGCL Section 204. Although DGCL Section 204 permits changing the effective time of a filing, it also provides that the effectiveness of the ratification is retroactive to the time of the defective corporate act. For example, if a company did not file an amendment to its Articles of Incorporation until after it had issued shares first authorized in that amendment, the company and counsel may determine that the ratification under CCC Section 119 should include a change to the effective time of the amendment such that it is after the company originally obtained shareholder approval but before the issuance of the shares authorized in such amendment, or they could decide to change the date that the issuance itself would be effective. CCC Section 119 is also more expansive with respect to the number of actions that may be ratified or validated in a single certificate of ratification or validation than DGCL Section 204, which limits the scope of items that can be ratified or validated in a single certificate of validation.
Although both DGCL Section 204 and CCC Section 119 require shareholder approval of the ratification of any action that would have required shareholder approval initially, CCC Section 119 does not require the notice of ratification to go to those persons who were shareholders at the time of the defective action. This difference may make it more feasible for companies to exercise self-help when there has been a recapitalization, tender offer, or other corporate event because the company will not need to locate and send notice to persons who are no longer shareholders (though DGCL Section 204 excuses notice to holders whose identities or addresses cannot be determined from the records of the corporation).
Unlike DGCL Section 204, CCC Section 119 is explicit in those items which cannot be ratified, including breaches of fiduciary duty, self-dealing transactions with directors, distributions, and dividends made in violation of the CCC, and fraud. CCC Section 119 is also explicit that it does not provide a remedy to foreign corporations (i.e., corporations that are incorporated in other states) or to corporations that have previously dissolved.
Examples of Defective Actions for Which CCC Section 119 May Provide a Remedy
There are a broad range of items for which CCC Section 119 may provide a remedy to companies and their shareholders. For example, CCC Section 119 may be used to fix an incorrect implementation of a stock split, as Wine.com did through a petition pursuant to DGCL Section 205.4 In the Wine.com example, the company completed a reverse stock split, but the split was implemented for a different ratio than what was contained in the certificate of amendment to Wine.com’s Certificate of Incorporation.
The provisions of CCC Section 119 may also be used to appoint a valid board of directors in the event that the incorporator of the company failed to document the appointment of an initial board of directors. Another issue faced by Vitacost in the example at the top of this article was that there was uncertainty as to whether the initial board of directors of the company was properly appointed. As a result, it was unclear whether the directors of the company were properly appointed and whether actions they took to issue shares were also invalid. If a company has failed to have a valid board of directors from the time of its formation, all actions subsequently taken by a putative board of directors may also be invalid, and, since shares issued by an invalid board are also invalid, merely obtaining shareholder approval to appoint a valid board is insufficient to cure the defect. CCC Section 119(b)(2) provides a remedy for this, whereby the putative board of directors can act to ratify the appointment of those persons who took action as the initial board of directors. Once that occurs, the initial board is deemed validly appointed from the time of appointment, the issuance of shares by that initial board is ratified as of the time those shares were issued, and subsequent actions by the initial board of directors and the shareholders are no longer defective.
A company can also utilize CCC Section 119 to cure defects caused by the issuance of shares in excess of the authorized number of shares (an “overissuance”). Overissuances can result from a timing problem—the company issues shares prior to filing a certificate of amendment to its Articles of Incorporation to authorize those shares—or can result from a simple failure to authorize a sufficient number of shares. If the issuance suffers from a timing problem, CCC Section 119 permits using a certificate of ratification to change the effective time of the certificate of amendment to prior to the time the overissuance occurred. If the overissuance was caused by a failure to authorize a sufficient number of shares, CCC Section 119 permits using a certificate of ratification to file a certificate of amendment that was effective prior to the overissuance to authorize a sufficient number of shares.
Statutory ratification could also have been used to remedy the issues faced by Vitacost, discussed above, if the statute was available at the time that company was searching for a solution. Under the applicable corporate law, effecting a stock split required amendment of the Certificate of Incorporation, which itself required certain steps be taken (e.g., board and shareholder approval of the exact text of the amendment, filing of a certificate of amendment with the Secretary of State for each amendment, etc.) in a specific sequence. Vitacost’s corporate records indicated, however, that the statutory amendment process had not been strictly followed, meaning the amendments setting forth the stock splits, and shares issued pursuant to such stock splits, were not valid.5 If a California company were to face a similar issue now, CCC Section 119 would provide a way for the company to ratify the amendments to the Articles of Incorporation, the stock splits, and the related stock issuances. Further, even though there were two separate defective filings at issue in the Vitacost situation, CCC Section 119 would allow both defective certificates to be fixed through one certificate of ratification.
These examples of how CCC Section 119 could be used are not exclusive, and the provisions of CCC Section 119 are intended to be expansive to enable companies to have significant abilities to cure defects through ratification or validation.
Conclusion
CCC Section 119 will provide a remedy for defective corporate acts to California corporations similar to one that is already available in other states. We anticipate that CCC Section 119 will assist companies to resolve many defective acts to enable those companies to raise capital, acquire corporations, and conduct their operations. However, the provisions of CCC Section 119 are not identical to statutory provisions in other states, and companies and practitioners should exercise caution in using CCC Section 119, at least initially. Because of the timing and substantive uncertainties in the processing of certificates of ratification and validation by the California Secretary of State, we anticipate that CCC Section 119 may not immediately remedy the uncertainties in giving legal opinions that may touch on defective corporate acts to the same extent that those uncertainties have been alleviated in other states. In other states, however, we expect as companies and practitioners gain more experience with the California Secretary of State’s processes, these uncertainties may be reduced.
For more information about CCC Section 119, please contact Wilson Sonsini attorneys Julia Reigel and Angela Flaherty.
[3] Kloss v. Kerker et al., No. 502010CAXXXXMB (Fla. Cir. Ct. May 27, 2011) (ORDER).
