Delaware Corporate Law Update

Updates on Delaware Corporate Law by Evan O. Williford, Esq., Delaware Corporate Litigation Attorney.

Registered Agents

Every business entity formed in Delaware – whether a corporation, LLC, or some other form – is required to have a “registered agent”.  A registered agent is a person or business physically located in Delaware that can receive documents and forward them on as necessary.

Why have a registered agent when someone can just send mail to business headquarters?  Because Delaware business entities and their managers can be sued in Delaware courts, someone must be present in Delaware to receive “service of process” (that is, typically the complaint along with a summons ordering the defendant to respond).  This reduces the risk that a business will intentionally avoid being served and thus having to defend itself in court.

There are many registered agents to choose from; they can be found quickly online and are often very inexpensive.  Some registered agents serve hundreds or thousands of businesses.

Once a registered agent has been hired, the business must designate that registered agent on a filing with the Delaware Division of Corporations.  A business can change its registered agent anytime by making a filing with the Delaware Division of Corporations noting the change.  You can find any Delaware business entity’s registered agent on the Delaware Division of Corporations’ website.

If a business entity fails to maintain a registered agent, then the Delaware Division of Corporations will serve as a fallback registered agent.  Eventually the entity’s certificate of incorporation or formation may be canceled, however, making it difficult or impossible for the entity to function legally.

Filed under: Basic Law of Corporations

Forming a Delaware Entity

So how does someone actually form a Delaware entity?  As it turns out, the actual tasks required to form one are not that expensive, nor do they take a lot of time.   But it is important to understand in advance why you want to form such an entity, as that will affect various choices you make along the way.  And, of course, it is always a good idea to get the advice of a qualified lawyer.

First, you must decide what kind of entity you want.  For example, do you want to form a corporation or a limited liability corporation (“LLC”)?  There are a number of other forms, though the ones specifically mentioned are among the most common.  We have discussed these common entity forms and their characteristics in a previous post – keep those in mind when selecting an entity form, do your own research and thinking, and seek qualified legal advice.

You will also need to choose a name for the entity.  That name will have to follow certain rules that you can find out from the Delaware Division of Corporations.  For example, obviously, it cannot be the same as an existing business.  There are other rules, such as that a corporation must including a word like “incorporated” or “corporation” (or an abbreviation like “inc.” or “corp.”).

If the entity will not have an office in Delaware, you will need to hire a “registered agent” and put their contact information on the forms you file with the Division of Corporations.  A registered agent is a person or company whose job it is to accept service of process if your entity is sued in a lawsuit in Delaware.  Hopefully that will never happen!  But the good news is that registered agents are relatively cheap.  A number of companies provide that service for a relatively low yearly price; information regarding them is available online.

It is a very good idea – and sometimes necessary – to put together certain organizational documents.  We have briefly discussed in a previous post what organizational documents are and how they create rules for that entity.  An attorney can help you do that, or you can look online for various resources, such as sample documents, to help you do that yourself.  If you are doing that yourself, be very careful to make sure that all the rules make sense for the entity you are forming.  Many lawsuits are caused or made worse when an entity has rules that apply not because they made sense for that entity, but because someone just adopted them without thinking about it!

Next, go to the Division of Corporations’ website and find out what they need from you to form your entity.  They will charge a filing fee, depending on what type of entity you want to form and whether you are in a hurry.  They will also tell you whether you need to file the entity’s organizational documents, and if so which ones.  When your paperwork is ready, mail or fax it to the Division of Corporations.

Now you have formed your own Delaware entity!  A Delaware entity has certain things it must do every so often in Delaware to maintain its good standing.  For example, corporations must file an annual report and pay a franchise tax; other entities similarly have to pay an annual tax.  Keep in mind there are a number of other things you may want or have to do that are outside the scope of this post, such as (1) getting an “Employer Identification Number” from the U.S. Internal Revenue Service; and (2) registering to do business in the State of Delaware, or another state.

Filed under: Basic Law of Corporations

Types of Delaware Business Entities and Limited Liability

The most well-known business entity, of course, is the corporation.  There are many others, however, such as limited liability companies (“LLCs”).  Each one has its own characteristics.  Which should a business owner choose?  That depends on their circumstances.

The corporation has a well-defined structure that most people dealing with it will be familiar with.  Its day-to-day business is run by certain key people called “officers.”  The officers themselves are hired, fired, and supervised by “directors,” who sit on what is known as a “board of directors.”  And the corporation itself is owned by “stockholders,” who can in turn elect the directors.

Another popular entity form is the LLC.  One of the big advantages of the LLC over a corporation is that it is possible to greatly customize how that LLC is structured, far beyond what is possible with a corporation.  With great freedom comes great responsibility, however.  Those forming an LLC should make sure that its structure, typically specified in detail in a document called an “LLC Agreement,” matches what is needed for the business.

Another consideration for those forming a business entity is taxation.  Some entities may elect with the U.S. Internal Revenue Service to pass income through to their owners, such as “S Corporations,” while others are taxed twice, once at the entity level and again at the owner level.  Those considering this issue should consult their accountants as to which tax treatment is best for them and what business forms qualify.

A key feature of many business forms is “limited liability.”  That means business owners are not generally liable for the business’s debts.  Thus their “liability” has been “limited”.  This was an important historical reason behind the rise in popularity of the corporation.  Investors wanted the ability to take risks by investing their money into a business without the possibility that if the business failed its creditors might go after them.

To form a Delaware business entity like a corporation or LLC, one needs to file the appropriate forms with the Delaware Division of Corporations, as will be discussed in another post.  But what happens if a business is run without creating a legal business entity?  The answer depends upon the state the business is operating in, but one possible result is the formation of a “sole proprietorship” or “general partnership”.  Such entities typically do not have limited liability.  That is one of many reasons it is important to properly form a business entity with a state like Delaware.

Filed under: Basic Law of Corporations

Governing Documents

While the state of Delaware creates rules that Delaware entities have to follow, all Delaware entities have some flexibility to create rules for themselves (though some, like LLCs, have more than others, like corporations).  They create those rules in “governing documents.”  What those are depends on what kind of entity it is.

Let’s start with the classic business entity, the corporation.  It typically has two core governing documents: (1) a “certificate of incorporation” (also called a “charter”); and (2) a “bylaws”.

The certificate of incorporation must be filed with the Delaware Division of Corporations (so it is “public” in the sense that anyone who wants to pay for a copy can get one).  This is a short document that must contain certain basic information or rules about the corporation, including certain details about the corporation’s stock and the name of the person forming the corporation.  It can also contain other rules, like eliminating directors’ liability to pay money for breaches of the fiduciary duty of care (we’ll talk about fiduciary duties in another post) or requiring the corporation to pay directors’ legal fees if they get sued.

The corporation can also have bylaws.  This is typically a longer document that contains more detailed rules, such as the procedures for its annual stockholder meetings and its board meetings, how stock is issued and transferred, and the duties of its officers.  If there is a conflict between the bylaws and the charter, the charter wins.

An LLC does not really have anything like a charter.  Rather, it is only required to file a “certificate of formation” with the Division of Corporations, which only needs to include its name and registered agent.  LLCs are sometimes preferred because of this additional privacy.

The primary governing document for an LLC is an “operating agreement” or “LLC agreement,” which basically serves as the LLC’s charter and bylaws all rolled up in one.  It is even more important because an LLC has much greater flexibility than a corporation to create its own rules.

There are many sample charters, bylaws, and LLC agreements on the internet.  But beware!  It can be very complicated to create business rules that work with existing law and to anticipate and provide for potential emergencies or disagreements.  If you are going to use a form, think very carefully about how you want the business to function and carefully edit the form accordingly.  But usually it is far better to hire a lawyer with business governance experience to draft the documents.  Once a lawsuit is filed it is too late to make rules that would have prevented it.  As Benjamin Franklin once said, “an Ounce of Prevention is worth a Pound of Cure.”

Filed under: Basic Law of Corporations

Why Delaware?

You may have noticed that many large U.S. and international businesses are incorporated in the U.S. state of Delaware.  (For that matter, the authors are Delaware lawyers.)  Why is that?  After all, Delaware is a small state and very few large businesses are headquartered there.

The United States of America has a federal system of government:  national law governs some subjects while state law governs others.  Business formation and governance (the way the business is structured and controlled) is one subject typically governed by state law.  Thus, each state has its own laws governing businesses formed in that state.

Delaware has a long history of laws allowing businesses to form the entities most appropriate for their needs.  Those laws are designed, and amended typically every year, to allow a flexible response to any business conditions that might be encountered while also protecting the rights of investors.

Delaware also has a separate court, the Court of Chancery, which over the years has evolved into a court that specializes in resolving many business disputes.  Cases involving Delaware entities, particularly regarding their formation and governance, will often be brought or transferred to that court.  Its five judges specialize in resolving those cases fairly and predictably under Delaware laws and the court’s past decisions interpreting those laws.  Therefore, a business has some assurance that if it forms in Delaware a lawsuit brought in that state of formation will proceed predictably.

For these reasons and more, businesses that are large or seek investment will often form in, or move to, Delaware.  Small U.S. businesses, particularly those that anticipate doing business only in one state, might consider forming in that state instead.

Filed under: Basic Law of Corporations, Uncategorized

Supreme Court Reverses Denial of Contractual Fee-Shifting

In Washington v. Preferred Communication Systems, Inc., (opinion available here), decided February 27, the Delaware Supreme Court reversed the Court of Chancery and awarded attorneys’ fees pursuant to a promissory note fee-shifting provision.

In 2006, appellants bought promissory notes issued by appellee Preferred Communication Systems, Inc. (“PCSI”). When the notes came due in 2007, PCSI was unable to pay. PCSI agreed in an offer letter to provide noteholders with stock warrants as compensation for delay until it could pay.

In 2013, after PCSI received a significant cash payment, noteholders sued PCSI in Texas. The parties ultimately settled the noteholders’ claims for outstanding principal and interest but agreed to litigate their claims for warrants in Delaware. The Court of Chancery granted summary judgment in favor of the noteholders, holding, “The contract at issue consists of the Notes as modified by the Offer Letter” and that PCSI had breached the contract by not issuing the warrants.

The successful noteholders then sought attorneys’ fees pursuant to a fee-shifting provision in the promissory notes. The provision shifted fees if “any indebtedness” evidenced by the notes was collected in a court proceeding; or if the notes were “placed in the hands of attorneys for collection after default”. The Court of Chancery denied the motion, holding that “fee-shifting rights extend only to collection efforts.”

On appeal, the noteholders argued that “indebtedness” was a broad term that included warrants as well as principal and interest; and that PCSI had defaulted by not issuing the warrants. The Supreme Court agreed with the noteholders that the plain language of the notes shifted fees, emphasizing the Court of Chancery’s summary judgment ruling that the offer letter had modified the notes (which contained the fee-shifting provision) to promise warrants. The Supreme Court also held that even if the promissory notes had been ambiguous, they would have been construed against drafter PCSI under the contra proferentem doctrine. Thus, the Court reversed and remanded to the Court of Chancery to award attorneys’ fees.

The Williford Firm LLC served as Delaware counsel for appellants-noteholders in this action.

Filed under: Attorneys' Fees, Delaware Supreme Court

No Standing For Stockholder Squeezed Out Before Books and Records Suit

On February 27, the Court of Chancery in Weingarten v. Monster Worldwide, Inc. held as a matter of first impression that a stockholder cashed out in a merger lacked standing when he served a books and records demand under 8 Del. C. § 220, but did not sue, before the merger closed.

The Court sidestepped policy arguments by applying the “unambiguous language” of the statute, which requires a stockholder to “first establish” that “[s]uch stockholder is a stockholder”.  The Court held that the statute thus “made clear that only those who are stockholders at the time of filing have standing to invoke this Court’s assistance under Section 220.”

The Court distinguished two other Court of Chancery cases where plaintiffs had been squeezed out after – not before – filing their Section 220 complaints.

For lawyers representing aggrieved holders of stock in a company soon to merge, the lesson of Weingarten is clear.  Serve the demand and file suit before the merger closes – or risk dismissal for lack of standing.

Filed under: Court of Chancery, Section 220 Books and Records, Standing

Close Board Ties And A Shared Airplane Eliminate Independence

Earlier this month Chief Justice Strine authored an opinion (Sandys v. Pincus) holding that close ties among certain board members, including co-owning an airplane, caused key directors to be non-independent.  Therefore, the Delaware Supreme Court reversed Chancery’s grant of a motion to dismiss derivative claims for plaintiff not having demanded that the board bring them.

Plaintiff alleged that top managers and directors of Zynga Inc. breached their fiduciary duties by selling stock while in possession of non-public information which, when it became public later, caused Zynga’s stock price to drop some 74%.  After quickly concluding three of Zynga’s nine directors were interested or non-independent, Sandys primarily concerns three additional directors:  Ellen Siminoff, William Gordon, and John Doerr.

Plaintiff alleged that Siminoff and her husband co-owned an airplane with interested director Pincus (Zynga’s Chairman, controlling stockholder, and former CEO) and that she was a “close family friend” of that director.  The Court criticized plaintiff for not getting more information about the relationship, either in a books and records lawsuit plaintiff had previously filed against Zynga or simply from a search engine such as “the tool provided by the company whose name has become a verb”.  Nevertheless, the Court held Siminoff lacked independence because joint plane ownership was “suggestive of the type of very close personal relationship that, like family ties, one would expect to heavily influence a human’s ability to exercise impartial judgment.”

Plaintiff alleged a number of facts about Gordon and Doerr including that (1) both are partners in Kleiner Perkins, a venture capital firm that controls 9.2% of Zynga’s stock; (2) Kleiner Perkins invested in a company co-founded by Pincus’ wife; and (3) Kleiner Perkins had invested in and obtained board seats at another company with another interested director.  Moreover, the board had determined Gordon and Doerr non-independent for purposes of rules promulgated by the NASDAQ stock exchange.  The Court again criticized plaintiffs for not seeking additional information including the reasons for the NASDAQ determination.  Nevertheless, it ruled Gordon and Doerr non-independent where alleged facts suggest directors belong to “networks [that] arise of repeat players who cut each other into beneficial roles in various situations” and where the board itself has determined them non-independent.  Conversely, it held that plaintiffs need not plead a “detailed calendar of social interactions”.

Justice Valihura authored a (uncommon though certainly not unheard of) dissent.  As to Gordon and Doerr, Valihura cited the lack of pled facts on the size or materiality of the ties or the relevant reasons for the NASDAQ determination.  As to Siminoff, Valihura pointed to plaintiff’s own description of the shared airplane as evidencing a “business” relationship as insufficient to result in non-independence.

Key take-aways:

  • The Court did not announce a new standard on when close business or personal ties result in non-independence. Nevertheless, Sandys could lead to Delaware courts being more willing to hold directors non-independent in close cases involving specific pleaded facts that reasonably suggest possible bias.
  • It behooves all lawyers to use search engines in light of the massive amount of information available online, including before filing complaints. The Court cautions lawyers to use them to find information of a “reliable” nature such as “articles in reputable newspapers and journals, postings on official company websites, and information on university websites”.
  • The appeal concerned a motion to dismiss ruling using a somewhat plaintiff-friendly standard. Delaware courts will be more skeptical as to whether – after trial – a plaintiff has proven a director non-independent for purposes of invoking the stringent entire fairness standard.
  • Plaintiffs seeking pre-lawsuit books and records should consider asking for information about director independence if that issue is potentially relevant.

Filed under: Delaware Supreme Court, Demand Futility, Derivative Actions, Director Independence, Fiduciary Duties, Section 220 Books and Records

Chancery Court Denies “Litigation Financier” Attorneys’ Fees

In Judy v. Preferred Communication Systems, Inc., (opinion available here), decided September 20, the Court rejected a motion by intervenor Preferred Spectrum Investments, LLC (“PSI”) for attorneys’ fees.  Judy rules that litigation financiers do not have standing to seek attorneys’ fees for corporate benefits created by the funded lawsuit.  It is also a useful review of many of the reasons a fee petition might be rejected.

Preferred Communication Systems, Inc. (“PCSI”) was formed by individuals with criminal records, including Pendleton Waugh, to buy licenses issued by the Federal Communications Commission (the “FCC”) and solicit money from investors.  Later Waugh was ousted from control of PCS; then he along with new ally Carole Downs formed PSI as a vehicle to regain control of PCSI and to solicit additional investor funds.  They told investors they would use those funds to loan money to PCSI in return for equity.  When PCSI refused to agree to this, Downs and Waugh instead used PSI money to fund another associate, Michael Judy, to litigate a series of lawsuits in the Delaware Court of Chancery (as consolidated, the “Judy Action”).  Ultimately the Court in the Judy Action temporarily appointed a court receiver, made changes to PCSI’s capitalization, and ordered an annual meeting.

At a January 2013 annual meeting, a PSI-backed slate of directors including Downs and Judy (Waugh having passed away) was elected.  In June 2014, a transaction closed in which (in essence) PCSI sold many of its licenses to Sprint for $60M.  Later Judy and Downs had a falling out and persons closely associated with PSI including Downs were removed as PCSI directors.

PSI then intervened in the Judy Action to seek attorneys’ fees, albeit without the cooperation of plaintiff and former ally Judy.  PSI claimed that the Judy Action had saved PCSI and its licenses, sold and unsold.  It claimed tens of millions of dollars as its appropriate share of the value of those licenses under a corporate or common benefit theory.  Alternatively, PSI sought recovery of over $8M in alleged charges associated with the Judy Action under a quantum meruit theory.

The Preferred Investors Association (the “PIA”), an association of PCSI stockholders, took the lead in opposing the petition.  The Court wholly rejected the petition.

PSI lacked standing because it was not plaintiff, only “a source of financing”.  The Court followed past precedent which has refused to broaden the common benefit doctrine into a “generalized mechanism for achieving redistributive justice.”  The Court noted that PSI could have formed a contract with Judy to be repaid by a court-ordered fee award but chose not to.  Therefore, the Court rejected PSI’s argument: “Litigation financiers do not need the common benefit doctrine to give them an incentive to finance litigation.”

The Court also rejected the petition on the basis of precedent that the Court will not award fees if the litigation was filed in support of a takeover effort.

The Court also rejected PSI’s request for a percentage award upon concluding that PSI did not cause the benefit.  Even under PSI’s version of events, the Judy Action was only one of many reasons the licenses were monetized.  This led the Court to liken PSI’s argument to the story about the “horseshoe nail that lost the kingdom”.  In fact, the Court found, PSI had affirmatively jeopardized the licenses.

Finally, the Court separately rejected PSI’s quantum meruit theory for a number of reasons.  PSI had made previous representations to PCSI stockholders that they would not bear expenses associated with the Judy Action.  The Court also found a host of factual issues with the various claimed costs (for example, some were not associated with the litigation, while others paid for arguments not in PCSI’s interests).

The Williford Firm LLC served as counsel for the PIA in this action.

Filed under: Attorneys' Fees, Court of Chancery

Good Things (Sometimes) Come To Those Who Wait: Two Recent Cases Show Pros And Cons To Seeking Books and Records Before Suing

When considering stockholder litigation in Chancery, one of the decisions plaintiffs face is whether to (1) sue immediately or (2) seek books and records under 8 Del. C. § 220 hoping for documents to help survive a motion to dismiss.  This summer, two cases where plaintiffs took the latter route had very different outcomes.

In August, the Court in In re Investors Bancorp, Inc. Stockholder Litigation considered cross motions to appoint lead plaintiffs in a case attacking director compensation as self-interested.  One plaintiff served a books and records request, obtained documents, and filed a complaint twice as long as the other.  While the Court complimented all counsel as “highly competent,” it placed decisive weight on the significant additional information the former uncovered.  For instance, in arguing that the compensation was a self-interested quid pro quo scheme, the latter solely used temporal proximity while the former cited board minutes.  The Court found that the information added by the former counsel was “not fluff;” rather, the former used documents “including board and compensation committee meeting minutes, to provide meaningful, additional factual support for their allegations.”

In June, however, the Court held a complaint filed after litigating a Section 220 action was precluded by the dismissal of another similar complaint two years earlier (Bensoussan).  The Court responded to plaintiff’s argument that the original plaintiff was an inadequate representative by ruling it was reluctant to judge “inadequacy based on the contents of documents obtained in response to a Section 220 demand because that approach ‘encourages hindsight review of conduct’”.  (A plaintiff in such a situation may also contend, whether or not based upon additional books and records, that the claims in the later suit are substantively different from the ones in the prior suit.)  The Court cited two other Delaware cases with similar outcomes.

Thus, as one of the “tools at hand” a books and records demand is a double-edged sword: it may lead to a superior complaint or a precluded one.  In determining whether to make such a demand plaintiffs’ counsel should carefully consider and monitor, among other things: (1) the likelihood of other similar complaints being filed; (2) the likelihood of uncovering evidence that could make the difference on a motion to dismiss (a surviving plaintiff can of course seek merits discovery); and (3) the speed with which the demand will procure helpful documents.  (As the Court in Investors Bancorp noted, a plaintiff faced with a slow demand response can always decide to abandon it and file a merits suit anyway.)

Filed under: Court of Chancery, Derivative Actions, Preclusion, Section 220 Books and Records

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Disclaimer

Delaware Corporate Law Update solely reflect the views of Evan Williford of The Williford Firm, LLP. Its purpose is to provide general information concerning Delaware law; no representation is made about the accuracy of any information contained herein, and it may or may not be updated to reflect subsequent relevant events. This website is not intended to provide legal advice. It does not form any attorney-client relationship and it is not a substitute for one.