Still do it right the first time: Delaware’s new mulligan for botched issuances of securities

An essential part of the due diligence on an offering of securities through Section 4(a)(6) crowdfunding or Rule 506(c) is ensuring that any previous issuances of securities (such as offerings to friends and family) are not defective.  For instance, if the securities were not authorized by the company’s certificate of incorporation, or properly approved by the Board or existing shareholders, that issuance might be defective.  If an earlier offering of securities was botched, that might wreck a planned crowdfunding round, requiring an expensive and time consuming unwinding of transactions and company decisions.  CrowdCheck addressed this issue in an earlier blog post, Do it right the first time.

No investor wants to see their investment go to the legal fees necessary for corporate housekeeping after the company has been sloppy with its corporate governance.  In fact, investors would likely have the right to get their entire investment returned, plus interest.

Delaware has recently created a legal process that will allow companies to cure defective issuances of securities.  Previously, defective issuances in some circumstances were “void” — automatically cancelled, return investor money, do not pass go, do not collect $200.  Effective April 1, Delaware amended its General Corporation Law to allow companies to fix botched corporate actions, including defective issuances.  This amendment is now Section 204 of the Delaware General Corporation Law.  In essence, defective issuances of securities are no longer void by law, but they must be “ratified” (essentially a re-do of the approvals they should have got first time round) according to the procedure set out in the new law, or through a court proceeding.  As you can guess, this will take time and lawyers and will be expensive to do properly.

What does this mean for small or early-stage companies?  Likely not too much unless the company has enough money to handle the legal expenses of ratifying defective actions and has investors that won’t jump at the opportunity to take their money back at the first sign of trouble.  Prior to ratification, the investment is voidable at the request of the investor, which means they have the right to rescind the entire investment just as they did prior to the new law.

What about for companies not organized in Delaware, or organized as limited liability companies?  Again, this change does not mean much.  Most states have not amended their corporation laws in the way that Delaware has to create a definite means to cure defective issuances of securities.  As such, securities issued by companies organized outside of Delaware that were not duly authorized or validly issued may be void rather than just voidable at the investor’s discretion.

For limited liability companies, the new rules do not create a method to cure defective issuances of LLC membership interests.  For instance, LLCs can only sell the classes of membership interests that are specifically authorized by the individual LLC’s operating agreement.  If the company tries to sell securities that isn’t authorized to offer, the complete transaction might be void, or the membership interests that weren’t properly authorized may end up giving the investors more rights than the company intended.

The moral of the story is that, while the change to Delaware law is important because it provides for a procedure to fix defective stock issuances, there is no change to any company’s obligation to sell securities that are properly authorized in the first place.  Failure to do so will result in diverting time and resources to fixing the mistake, and may grant investors the right to rescind the transaction.

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