Don’t Have Enough Authorized Shares? There’s a Fix for That.
October 19, 2016 | By Kevin Vela
Last September, the Texas legislature ratified Subchapter R, giving Texas for-profit corporations a statutory device for ratifying what were once considered void or voidable corporate acts or issuances of company shares. The new legislation applies to well-established and newly formed corporations alike, but can be particularly helpful for startups who may have accidentally issued more shares than were initially authorized.
What is Subchapter R?
Subchapter R is an amendment to Chapter 21 of the Texas Business Organizations Code (“TBOC”) and is modeled after a recent addition, Section 204, to the Delaware General Corporation Law (“DGCL”). In both states, the new laws simplify the complex process of authorizing corporate acts and protect actions that were not properly authorized but made in good faith.
According to Subchapter R, a defective corporate act or over-issuance of shares is not void or voidable solely because it wasn’t formally authorized in accordance with law or governing documents. Before the amendment, corporations either had to follow the steps of authorization to a t, or risk being subject to a domino effect of problems if the act was later determined to be void. For example, if a company issued unauthorized shares, the relevant shareholder’s votes would be meaningless and the actions on behalf of the votes could be found to be meaningless as well.
The new law safeguards against the consequences that could follow in the above scenario. Subchapter R lays out a simple means of ratification for otherwise void or voidable defective corporate acts or putative shares.
Subchapter R and Startups
Despite the negative connotation attached to the idea of acting without authorization, there are many situations in which unauthorized action is accidental, mostly harmless, and done with the best interests of a corporation in mind.
Before startups are profitable, they often compensate founders and raise capital by issuing company shares. If the startup doesn’t have counsel, or perhaps inadvertently filed an initial certificate without the appropriate number of shares, future share issuance activities could be severely impaired.
We regularly see companies whose original Certificate of Incorporation (in Delaware) or Certificate of Formation (in Texas) authorized 100 or 1,000 shares (with an inappropriate par value, which leads to a host of other problems), or some other small number. While it is true that the actual number of shares is irrelevant, and voting percentage is the key factor regarding ownership; most startups work off of 10,000,000 shares. It’s simply industry standard, and subsequent corporate transactions flow from this. With all of the cheap and easy do it yourself entity formation websites out there—the problem comes up more than you’d think. Amending the original documents has always been possible, but before Subchapter R’s ratification process it required strict adherence to intricate corporate formalities.
Our clients are happy because the three step ratification process means founders have a quick and simple way of amending corporate documents, protecting ownership interests, and raising capital without the headache and stall of corporate formalities or a looming risk of void or voidable action.
What is the Ratification Process of Subchapter R?
Step 1: The Resolution
Under Subchapter R, ratification requires that the corporation’s board of directors adopt a resolution containing information set out in TBOC 21.903. Resolutions must include: the defective corporate act to be ratified; the time of the defective corporate act; the nature of the failure of authorization with respect to the defective corporate act to be ratified; that the board of directors approves the ratification of the defective corporate act; and if the defective corporate act involved the issuance of putative shares, the number and type of putative shares issued and the date or dates on which the putative shares were purportedly issued.
Step 2: Shareholder Submission and Approval (if Applicable)
The resolution must be approved by shareholders in accordance with Sections 21.905-907 of the TBOC, but only if shareholder approval of the defective corporate act to be ratified was required at the time of the act or at the time of the resolution. The resolution may also state that the board of directors may at any time before the effective time abandon the resolution without further shareholder action.
Step 3: Certificate of Validation with the Secretary of State
Additionally, Section 21.908 requires that a Certificate of Validation be filed with the Secretary of State if the act initially required a filing. This means that rather than filing the original required document, a corporation ratifying an act or issuance only needs to file the Certificate of Validation. The filing includes: a copy of the resolution, the date of adoption of the resolution by the board of directors and, if applicable, the date of adoption by the shareholders, and a statement that the resolution was adopted in accordance with this subchapter; the title and date of filing of the prior filing instrument or document and any articles or certificate of correction to the filing instrument if a filing instrument or document was previously filed with a TX SOS; and required provisions under the TBOC that otherwise would have been required to be filed with respect to the defective corporate act.
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While governing documents and authorization procedures typically provide an effective check on corporate governance, there are many circumstances in which the hassle of corporate formalities are accidentally overlooked or sacrificed in the interest of more gratifying activities (like building a product or generating revenues). This is especially true in the context of quickly changing startups. Whether the action to be taken contradicts governing documents because the founders didn’t anticipate growth, or because they weren’t properly advised in the process of entity formation—Subchapter R makes facilitating growth and raising capital a much smoother process for corporations across Texas.