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Prizm Group, Inc. v. Anderson - Court of Chancery Holds that Unsecured Promissory Note Not Valid Consideration for Issuance of Stock of a Delaware Corporation Under Pre-August 2004 DGCL

August 3, 2010

In Prizm Group, Inc. v. Anderson, C.A. No. 4060-VCP (Del. Ch. May 10, 2010), Prizm Group, Inc., a Delaware corporation (“Prizm”), sought a declaration that Mark E. Anderson (“Anderson”), who was issued common stock of Prizm in exchange for an unsecured promissory note, had failed to provide valid consideration for the shares and that the shares were void ab initio or voidable at the election of Prizm. The Court of Chancery held that under Delaware law in effect prior to August 1, 2004, an unsecured promissory note did not constitute valid consideration for the issuance of stock of a Delaware corporation. The Court therefore issued a declaratory judgment that Anderson no longer owned the shares of Prizm, but it declined to determine whether the shares were void ab initio or voidable at the election of Prizm.

In May 2004, Anderson and two other investors purchased Prizm and elected themselves directors. Each agreed to make an initial equity contribution of $7000 and to provide a $100,000 loan to Prizm. The other two investors each made their respective contribution and loan, but Anderson could not contribute cash or property and instead executed an unsecured $107,000 promissory note. Prizm then issued to each investor 333 shares of common stock. Shortly thereafter, Prizm’s financial situation worsened, and Prizm sent Anderson a formal demand for payment of the promissory note. After Anderson failed to pay the note, the board of directors of Prizm held a meeting and voted to cancel Anderson’s shares for failure to pay any consideration. Approximately two years later, Protective Life Corporation (“Protective Life”) offered to purchase Prizm for $15 million. However, Protective Life delayed the transaction because Anderson emerged, claiming to be a stockholder of Prizm and demanding to be a part of the negotiations. Eventually, Prizm was sold to Protective Life, but the value of the transaction declined significantly because of the delays caused by Protective Life’s concerns regarding Anderson.

The Court considered whether an unsecured promissory note constituted valid consideration for the issuance of stock of a Delaware corporation. At the time of the issuance of the shares by Prizm, Article 9, Section 3 of the Delaware Constitution provided that “[n]o corporation shall issue stock, except for money paid, labor done, or personal property, or real estate or leases thereof actually acquired by such corporation.” Similarly, 8 Del. C. § 152 (“Section 152”) then required that consideration for newly issued shares be paid in “the form of cash, services rendered, personal property, real property, leases of real property or a combination thereof.” According to the Court, the provisions of the Delaware Constitution and Section 152 required that consideration for newly issued shares be in the form of (i) money paid, (ii) labor performed or (iii) property actually acquired, or some combination thereof, and that these were each forms of current, rather than future, consideration. The Court held that the unsecured promissory note did not constitute valid consideration for the issuance of stock, as an unsecured promissory note is merely a promise to pay in the future, which was not intended by the framers of the Delaware Constitution to constitute the capital of a Delaware corporation.

The Delaware Constitution and Section 152 were amended in relevant part effective August 1, 2004. Under the amended Section 152, newly issued stock may be obtained for “cash, any tangible or intangible property or any benefit to the corporation, or any combination thereof.” The Court did not address what result it might have reached under the amended provisions.

After finding that the unsecured promissory note did not constitute valid consideration, the Court declined to determine whether Anderson’s shares were void ab initio or voidable. The Court noted that shares of stock issued in exchange for improper consideration are typically void ab initio, absent certain equitable considerations. Where such equitable considerations do exist, shares purchased with invalid consideration are generally deemed voidable at the election of the corporation. Even if Anderson’s shares were merely voidable by action of the board of directors—the best-case scenario for Anderson—the board had properly voided the shares.