Delaware Law Pitfalls in IPOs

About the Authors:

Jeffrey R. Wolters is a partner at Morris, Nichols, Arsht & Tunnell LLP in Wilmington, Delaware.

The number of initial public offerings in 2013 is up sharply over that of 2012. Approximately 85 percent of U.S. IPOs in 2013 involved Delaware corporations. Some of these IPO companies were originally incorporated outside of Delaware, but reincorporated into Delaware in anticipation of their IPO. 

Given the predominance of Delaware as the jurisdiction of incorporation for IPO companies, Delaware law plays a significant role in IPOs, as it does in M&A transactions. However, the relevant Delaware issues are somewhat different. In M&A transactions, the focus is typically on the terms of the merger agreement and the fiduciary duties of directors. In IPOs, the focus is more likely to be the company’s historic capital structure and the terms of its charter and bylaws. There are several issues to watch out for. 

Problems with Pre-IPO Capital Structure Can Infect the IPO 

A key aspect of IPO diligence is reviewing the company’s pre-IPO capital structure. This requires scrutiny of the board and stockholder actions approving such matters as prior stock issuances and option grants, and the filings made in Delaware to effectuate them (e.g., charter amendments or certificates of designation creating preferred stock for a financing round). It will also often require checking that the company’s directors had been properly elected. 

Problems may arise for two main reasons. First, such diligence requires looking back to the earlier stages of a private company’s life, when attention to corporate formalities and record keeping may not have been as careful as during the build-up to an IPO. Second, the rules of Delaware law that apply to such early-stage actions are quite strict. In fact, Delaware cases have made clear that failure to adhere to such rules may render the actions in question void or voidable. Cases have applied this reasoning to actions such as issuing stock when the board resolutions approving the issuance were not properly adopted (for example, because a written consent was not returned by all directors, or because the board had not been properly elected); effectuating a stock split without proper language in the charter or board resolutions; failing to follow the statutory sequence for charter amendments and mergers, which requires that the stockholder consents approving such matters be obtained only after the board has approved the matter; and failing to ensure that stockholder consents were signed, dated, and returned in accordance with the exact requirements of the Delaware consent statute. 

The implications of such problems are not merely hypothetical. In a recent case involving Vitacost.com, Inc., the board discovered problems with the company’s pre-IPO stock issuances more than a year after the company went public. Kloss v. Kerker et al., C.A. No. 018594XXXXMB (Fla. 15th Dis. 2011). The problems stretched back to the company’s original incorporation 14 years ago, and included defects in the election of the company’s initial board of directors, as well as in the approval of certain prior stock issuances and stock splits. After an investigation by its audit committee, the company restated financials and faced delisting from Nasdaq. It also faced stockholder derivative suits, which it ultimately settled. Such suits are often preceded by a stockholder demand to inspect the corporate records of prior transactions under Section 220 of the Delaware General Corporation Law (DGCL), which provides stockholders with a tool to discover prior problems. The company ultimately brought suit against its corporate counsel, which had rendered an unqualified legal opinion that the company’s shares were duly authorized and validly issued. 

Fortunately, while it is the strictness of certain Delaware rules that can lead to such dire consequences, Delaware law also offers several fixes. For example, Delaware law generally recognizes a broad application of the doctrine of ratification, which may enable a board to ratify and effectively cure prior stock issuances or option grants that did not previously receive proper approval. The Delaware correction statute (Section 103(f) of the DGCL) also gives a corporation the ability to correct prior corporate filings – for example, a charter amendment creating stock or effectuating a stock split – if there were errors in such filings. If these fixes are not available under a given set of facts, the corporation may be able to effectively reissue improperly issued stock if certain steps are taken before the IPO. 

In addition, partly in recognition of the threat that Delaware’s strict rules can pose to a successful IPO, the DGCL was amended this summer to adopt two new sections allowing corporations to validate prior acts, such as stock issuances, that might otherwise be invalid under Delaware case law. New Section 204 of the DGCL allows a corporation to cure prior defects without going to court. New Section 205 allows a corporation to seek judicial validation of prior defective acts. Both sections effectively require a “redo” of the act in question by the board or stockholders, as applicable, as well as notice to stockholders. Generally, if no stockholder objects within 120 days, then the act in question is no longer subject to invalidation based on prior defects in authorizing the act. Importantly, however, while Sections 204 and 205 were adopted this year, they do not actually take effect until August 1, 2014. 

Charter and Bylaw Issues 

In connection with going public, most companies amend their charter and bylaws to adopt various provisions that are more typical for public companies than for private companies. In addition, typically, the company’s pre-IPO preferred stock would be converted to common stock, and going forward the company would have only common stock outstanding (although it might have preferred stock authorized in its charter, most likely pursuant to a “blank check” provision allowing the board to fix the terms of such stock). 

Interestingly, while most existing public companies have had to back off of their anti-takeover provisions in recent years – for example, by eliminating classified board structures (under which directors serve three-year terms and are only removable for cause) and implementing majority voting for directors (instead of traditional plurality voting) – new IPO companies are much more likely to retain these and other anti-takeover features. Thus, counsel will need to assess the desirability of various charter provisions that are available under Delaware law – including a classified board, elimination of the stockholders’ right to act by written consent, blank check preferred stock, supermajority vote requirements in the charter and bylaws, advance notice bylaws, voting standards in director elections, and the applicability of Section 203 of the DGCL (Delaware’s anti-takeover statute). 

Companies will also have to decide whether to adopt certain “state of the art” bylaw provisions, including: 

Exclusive Forum Provisions 

These generally provide that any stockholder lawsuit relating to director fiduciary duties or compliance with Delaware corporate law must be brought only in Delaware. Such bylaws were upheld in a much-noted decision this summer involving Chevron and FedEx. Boilermakers Local 154 Ret. Fund v. Chevron Corp., C.A. No. 7220-CS (Del. Ch. June 25, 2013); see also Edgen Grp. Inc. v. Genoud, C.A. No. 9055-VCL (Del. Ch. Nov. 5, 2013)(Trans.). Many public companies and companies doing IPOs responded by adopting such bylaws. However, that response has been far from universal, in part due to uncertainty concerning the reaction of proxy advisory firms such as ISS and Glass Lewis. The decision of any particular company on this issue may depend in part on the presence or absence of certain other features in its charter or bylaws. For example, if a company is not subject to majority voting for directors, then a “vote no” campaign against reelection of a board would be less of a threat than for an established public company that was subject to majority voting. 

Indemnification 

Most public Delaware corporations provide some degree of indemnification coverage in their charter or, more typically, bylaws. However, some companies have begun to rethink boilerplate forms that require full indemnification and advancement of defense costs in all cases. For example, Goldman Sachs recently was required to pay the defense costs of a computer programmer of one of its subsidiaries who was prosecuted for stealing Goldman’s computer code. Aleynikov v. Goldman Sachs Group, Inc., 2013 WL 5739137 (D.N.J. Oct. 22, 2013). The reason was a broad, boilerplate bylaw requiring full indemnification and advancement of expenses for “any officer” of the firm or its subsidiaries. Largely because the programmer had the title of “vice president,” the court ruled that he was entitled to coverage (notwithstanding Goldman’s argument that “vice president” was a widely used “courtesy title” and that the person in question did not exercise any typical managerial or officer functions, which was not disputed). Goldman also was required to pay the litigation costs incurred in suing Goldman to enforce the bylaw. One takeaway for companies contemplating an IPO is to assess the scope of boilerplate indemnification grants, and in particular which officers and employees will fall within the coverage (both at the parent company and subsidiary level). 

Director Qualification Bylaw 

IPO companies may also consider whether to adopt a new bylaw designed to disqualify director candidates who receive compensation from insurgent stockholders, such as candidates who agree to serve on a hedge fund’s proxy contest slate. There have been a few high profile adoptions of this bylaw by established public companies, such as Marathon Oil and Halliburton (modified version). However, the Delaware courts have not ruled on the validity of such a bylaw. 

Finally, companies that choose to reincorporate into Delaware prior to an IPO will often want their new Delaware charter to carry forward the rights of stockholders that existed under the pre-Delaware charter, including accrued dividends (which often add on to a preferred stock’s liquidation preference) and conversion adjustments. This may require careful drafting to preserve such rights rather than simply duplicating all the terms of the prior charter.

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