Blades v. Wisehart: Court of Chancery Confirms that Strict Adherence to Corporate Formalities Required in Implementing a Stock Split

February 1, 2011

Publication| Corporate Transactions| Corporate & Chancery Litigation

In Blades v. Wisehart, 2010 Del. Ch. LEXIS 227 (Del. Ch. Nov. 17, 2010), the Court of Chancery held that a corporation had not validly effectuated a stock split because it had not complied with the requisite corporate formalities, notwithstanding that the corporation’s board and stockholders all had the subjective intent to effectuate the split.

Blades involved a dispute under 8 Del. C. § 225 over the proper composition of the board of directors of Global Launch, Incorporated (“Global Launch”). Global Launch was the brainchild of plaintiff Rusty Blades, and was dedicated to pursuing Blades’ idea of taking the concept of layaway purchasing to the internet.

When Global Launch was formed, Blades received roughly two-thirds of its 10 million shares of authorized stock. The remaining one-third interest went to The Ohio Company, in exchange for its agreement to provide Global Launch with $500,000 in capital.

Shortly after Global Launch was formed, Blades and The Ohio Company agreed to amend Global Launch’s certificate of incorporation by increasing the authorized stock from 10 million to 50 million shares, and to engage in a 1 for 5 forward stock split. The additional stock was intended to be sold to other investors to raise capital, and a portion was intended (by Blades) to become gifts to certain Global Launch employees. Defendant Richard Wetzel, an Ohio attorney who had assisted with Global Launch’s formation and who was familiar with Blades and a number of people interested in investing in Global Launch, was tasked with effectuating these transactions. While Wetzel prepared (and the board, Blades and The Ohio Company approved) resolutions authorizing the increase in capital stock and amending Global Launch’s certificate of incorporation to reflect this increase, he never prepared a resolution or amended Global Launch’s charter to reflect the stock split.

Notwithstanding this failure, all interested parties acted as if the split had taken place. Accordingly, for the next several months, The Ohio Company identified a number of potential investors and the Global Launch board of directors proceeded with plans to issue stock to interested investors. Wetzel was tasked with making investor presentations and materials, and with documenting the transactions once they were completed.

In late 2008, Blades resigned from the Global Launch board and from his position as President of the company due to legal troubles. Shortly thereafter, Wetzel and certain members of the Global Launch board “stepped up a series of purported transfers of Global Launch stock” with little or no notice to Blades. Some transfers went to individuals identified by The Ohio Company; others went to employees Blades had previously identified, but in all instances, Wetzel’s cursory attempts to document the transfers “did not accurately or reliably reflect the substance of these transactions.”

For the next year, and while these purported transfers were ongoing, Blades claimed that he was “increasingly frozen out” from Global Launch business. Accordingly, in November 2009 Blades convinced an ally on the company’s board to notice an annual meeting. At that meeting, the stockholders elected seven new directors for a one-year term. Wetzel briefly attended the meeting, informed the stockholders of his belief that the meeting had been improperly called and would not result in valid stockholder action, and was then escorted out. After the meeting, the new board (among other things) purported to adopt new bylaws, remove all of the current officers, install Blades back in his position as President, and terminate Wetzel’s representation of the Company.

Concerned that the annual stockholders meeting had not been properly called, on March 8, 2010 Blades and The Ohio Company executed a unanimous written consent ratifying the actions from the annual meeting. Blades then initiated this action to confirm the actions taken through the consent.

As all of the purported transfers of stock had relied on the stock split and were intended to be comprised of post-split shares, the Court of Chancery’s decision hinged on whether the stock split had validly been effectuated. If the split was invalid, the transfers of post-split shares would be void, and Blades and The Ohio Company would be the only two stockholders of Global Launch.

Blades argued that the split had not validly been effectuated because of the failure to comply with three requirements set forth in the Delaware General Corporation Law to split stock — (i) passage of a board resolution setting forth an amendment to the certificate of incorporation effectuating the split, declaring the advisability of the amendment, and calling for a stockholder vote; (ii) proper notice of the proposed amendment and stockholder meeting; and (iii) if the vote is approved, a certificate of amendment being filed. Defendants argued that the split should be recognized because Blades and The Ohio Company admitted that they supported the concept, and evidence existed suggesting that the board also supported the concept.

The Court of Chancery held that Global Launch (and Wetzel’s) attempts to effectuate the split were ultimate failures. Analogizing to the Delaware Supreme Court’s decisions in Waggoner v. Laster and STAAR Surgical Company v. Waggoner (which involved issuances of stock), the Court held that “the same policy reasons recognized in those cases for requiring scrupulous adherence to corporate formalities are germane to a board’s adoption of a stock split because both board actions involve a change in the corporation’s capital structure.” Thus, notwithstanding that the Court found it “clear from the record” that both the Global Launch board and the two pre-split stockholders subjectively wished to adopt a stock split, the failure to adhere to the requirements of the DGCL in adopting that split was fatal.

Because all of the purported transfers were with post-split shares, those transfers were declared void. Global Launch’s only two stockholders — Blades and The Ohio Company — had therefore validly taken action to replace the company’s board through the March 8, 2010 written consent.

The Court’s opinion concluded with a warning that plaintiffs’ victory “may not be the cause for celebration they may have anticipated at the outset of this litigation.” Global Launch — a struggling company — and its newly elected board now have to address various claims brought by investors, employees and certain of the defendants regarding the stock transfers that had been declared invalid.1

 1While Blades makes clear that failure to follow requisite corporate formalities can be fatal to a corporation’s efforts to implement a stock split, an even more recent Court of Chancery decision suggests that stock splits are also subject to equitable attack. More specifically, in Reis v. Hazelett Strip-Casting Corp., C.A. No. 3552-VCL (Del. Ch. Jan. 21, 2011), the Court of Chancery held that a reverse stock split implemented at the behest of a controlling stockholder was susceptible to a claim for a breach of the duty of loyalty, that, therefore, the controlling stockholder bore the burden of demonstrating the entire fairness of the reverse stock split that cashed out minority stockholders and ultimately awarded plaintiffs monetary damages based on the Court’s appraisal-like going-concern analysis of the fair price of the relevant shares.
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