Corporate Governance Tales From (Virtual) Open Door Encounters – Part 2
Richard Leisner’s article was published on October 15, 2020 by The D&O Diary. You can view the guest post here.
By: Richard Leisner
Inspired by remembering and missing the benefits of personal interaction lost to the Covid-19 pandemic, this is a second installment of “hypothetical” fact situations illustrating the multiple legal disciplines that comprise corporate governance and the benefits of “thinking it through” before embarking on a solution. As in the first group of hypos, these in Part 2 are based upon “open door” encounters in my practice and expert witness work. Again, names and facts have been changed to protect client confidentiality and to clarify practice pointers. Part 1 is available here.
How Many Directors Does it Take?
Facts: Our client, Big Dog Entertainment, Inc. has been sued by its former CEO Gary Greed for severance benefits under Greed’s employment agreement. The agreement featured extremely generous benefits for any “not-for-cause” termination. Foreclosing any chance to argue what termination constituted “not for cause,” the agreement provided that any termination other than “for cause” would be “not for cause.” Greed’s agreement defined “for cause” termination narrowly: being criminally convicted of misappropriating company assets or otherwise defrauding the company and, in each case, the exhaustion or abandonment of all appeals. Greed was never charged with or convicted of any crime that would satisfy the definition of “for cause.” Nevertheless, the Board fired Greed and refused to pay any post-termination benefits. Greed’s suit followed.
Greed negotiated his contract after winning a fight for control of Big Dog. Before the fight, Greed and his affiliate Sam Sidekick were two members of Big Dog’s six-member Board. Greed and Sidekick were at odds with the other four directors. Greed and Sidekick and their friends accumulated proxies for 51% of Big Dog’s voting stock. Using the proxies, Greed and Sidekick executed a shareholders’ written consent removing the four unfriendly directors, leaving Greed and Sidekick as the only directors. Acting as the Board of Directors, Greed and Sidekick approved and executed Greed’s sweetheart employment agreement.
Control of Big Dog by Greed and Sidekick was short-lived. In a few months, the four ousted directors lined up sufficient proxies to first re-elect themselves to the Board and then remove both Greed and Sidekick from the Board. The remaining four directors unanimously voted to fire Greed and refused to make any severance payments.
Issue: The firm’s litigation department is defending Big Dog and quickly identifies Greed’s employment agreement as a conflict-of-interest transaction, subject to strict scrutiny about the “fairness” of the agreement’s terms. Attorney Robert Star, a recent hire in the firm’s litigation practice group, visits me asking about an expert witness to testify that the severance benefits were so far “out of market” as to be unfair to Big Dog – and therefore should not be enforced.
Solution: While considering names of a few executive compensation experts, a more direct defense to Greed’s litigation came to mind: I told Star that Greed’s employment agreement is invalid and unenforceable because it was never properly approved by the Big Dog Board.
Attorney Star shakes his head in disagreement and asks: “What’s the problem? There were six directors; four were removed, leaving two. All the serving directors approved Greed’s agreement.”
Let’s review the facts and applicable law: At the time Greed’s agreement was considered, Big Dog had a six-member Board; a Board quorum required a majority of the directors (four of the six members) in order for the Board to take valid action; at that time, only two directors, Greed and Sidekick, were serving;. two directors is not a quorum for a six-member Board; therefore, the acts of two directors approving Greed’s employment agreement were not valid actions of the Big Dog Board. Without valid Board approval, Greed’s employment agreement was not enforceable against Big Dog (especially when the extravagant severance terms were “out of market” and paying severance was opposed by current the Big Dog Board).
The size of the Board does not “shrink” from six to two members with the removal of four directors. The language of both the corporate statute and Big Dog’s governing documents require formal Board action to fix or change the number of directors that comprise the Board.
Greed and Sidekick had sufficient proxies to change the size of the Board in the written consent that removed the four unfriendly directors. They failed to take that action. The language in the written consent says nothing about changing the size of the Board. After the four directors were removed, as the only two serving directors left, Greed and Sidekick could have then elected new directors to fill the four vacant seats. By statute, filling vacancies of the board does not require a board quorum. Greed and Sidekick had it within their power to elect sufficient replacement directors to validly approve Greed’s agreement. They did not.
Greed may argue that because he and Sidekick “could have” changed the sized of the Board, the law should recognize an “assumed” or “virtual” change of the Board’s size from six members to two. Such arguments appear foolish when you see them in print, but Greed’s lawyers may advance them. They should prove unsuccessful. In these circumstances, the failure to obtain valid Board approval of Greed’s agreement should prove fatal to the claimed validity of his employment agreement and enforcement of its lavish severance terms. The conflict-of-interest and “fairness” issues are available as backup.
Lessons: In evaluating corporate actions, careful attention to the details avoids the embarrassment (and possible malpractice exposure) of invalid corporate actions. Well intentioned clients may tell their lawyers about the underlying corporate governance facts, for example, that the company has a five-member board. You cannot be sure until you review the primary source materials. For lawyers practicing in corporate transactions, the following list functions similarly to the preflight checklists used by even the most experienced pilots.
- What is the size of the Board? Check articles of incorporation, bylaws, meeting minutes and written consents to see how Board size was set and possibly changed over the life of the corporation.
- What was the board quorum requirement for the subject action and was it met? Review materials noted above. Usually, a majority of the Board is required for a quorum.
- What was the required vote/written consent for the matter that was approved and was it obtained? Most Board and shareholder matters will usually be approved by a majority vote of a quorum present and acting. A few matters or special provisions in the articles of incorporation or bylaws may require an absolute or super-majority of all shareholders or directors.
- Who is currently serving on the Board? Check shareholder and Board meeting minutes and written consents to see if each current director was properly elected, for example making sure there was an “open” seat at the time of election.
- What do you know about the currently serving directors? Are some/all of the directors personally known to you? If not, can you seek assistance from at your firm or a trustworthy employee at the client who can advise you? In evaluating written consents and waivers, are you familiar with the directors’ signatures?
- Have directors resigned or been removed and replaced properly? Again, review shareholder and Board minutes and written consents. Resignations usually do not require Board or shareholder action, but removals do. Resignations should be documented in the corporate minute book.
- Were written consents valid? In Florida, director written consents must be signed by all directors; shareholder written consents must be signed by the same number of shareholders as would be required to approve the matter at a meeting attended by all shareholders.
- For Board and shareholder meetings, was appropriate advance notice given or were waivers of notice from non-attending directors or shareholders obtained? Generally, waivers of notice may be given after the meeting. Double-check that days have been “counted” as required in the governing documents or by applicable statutes.
- Are there documentary errors and omissions that can be ratified? Some matters that are discovered after review to have been invalidly adopted by the Board may be “fixed” by ratifying actions that include the same level of specificity as would have been required in the first instance.
A Zoom Meeting by any Other Name
Facts: Widgets Corp. is a venture capital backed fast growing Florida corporation. Widgets’ Orlando headquarters are adjacent to the Disney parks, the principal customer for the company’s widgets software. Widgets has a six-person Board of Directors, including one Disney executive and two partners in the venture capital investor. Walter Widget, the company’s founder, CEO and principal stockholder, has an opportunity to sign a major contract with the Lego Theme Park to use some of the same software services Widgets provides to the Disney parks. Walter worries that he will lose out to a competitor if he cannot get Board approval today.
Under procedures previously adopted by the Widgets Board, formal approval by the Board was required for contracts as large and important to the company as that proposed for the Lego Theme Park. Walter sets up an afternoon Zoom meeting for all the directors to consider approving the contract. When the meeting convenes, all directors are present and are able to see, hear and speak with each other simultaneously. There is a vigorous discussion about the pros and cons of working with Lego Parks; three of the directors, including both the VC and Disney directors, are ambivalent about approving the arrangement. Walter tells the directors that after the end of discussions they may vote using the Zoom Comments feature. With the discussions not yet completed, an afternoon thunderstorm knocks out the power and internet connection for the VC and Disney directors. Before adjourning, the three present directors all cast favorable votes via Zoom Comments. Walter says he will follow up with the three absent directors. After the meeting, Walter gets oral approval votes from the VC directors, confirmed via text messages. The Disney director says he wanted to talk further with his fellow directors about the reasons not to approve the Lego Park agreement; if he has to “vote,” right away, the Disney director says he votes “no.”
Issue: Walter immediately contacts attorney Sally Smart at our firm, and she adds me to a three-person Zoom call. Walter explains events and asks: “Has my Board approved the Lego Park contract?” Five of our six directors wanted to do the deal. If there hadn’t been a thunderstorm, that’s what the Board would have approved in our Zoom meeting. And, Walter continues, even if you say we didn’t complete the formal meeting, we had “written consent” from a majority of our directors – three directors “signed” their approval using Zoom Comments and the two VC directors signed with text messages.
Solution: We advise Walter to convene another Zoom Board meeting. Modern statutory and bylaw provisions endorse as valid meetings where all directors are not physically present at the meeting site but are able to participate in all proceedings, meaning that each director must be able to hear and speak to all the other directors (and vice-versa) on a continuous real-time basis. When the VC and Disney directors were disconnected, the meeting had only three of six directors present and acting, not enough for a quorum to validly transact business after the power outage. Also, remember, the Disney director wanted to talk further with the other directors.
It might be suggested that combining Zoom meeting consent/votes with the post-meeting text messages would be sufficient. Director written consents must be signed by all directors. The amalgamation of Zoom and text message “written consents” would work only if the Disney director agreed to vote with a text message and voted “yes.” Neither the interrupted Zoom meeting partial vote nor the post-meeting “written consents” are sufficient for the Board to have taken valid formal action to approve the Lego deal.
It’s a close call, but we suggest Walter reconvene his Zoom meeting. We also suggest Walter allow the VC and Disney directors to share their views before taking a vote.
Lessons: Stick to the rules, especially when there may be directors who are unhappy with the particular decision at hand. Most corporate governing documents and statutes require directors be given notice before meetings; waivers of notice may be collected before or after the meeting. An absent director who will not waive notice could result in an invalid meeting. An unhappy director may be unwilling to sign a post-meeting waiver of notice or written consent. In these circumstances there may be no substitute for giving the formal notice required by the governing documents and re-convening a formal meeting.
Get the Facts – All the Facts
Facts: Peter, Paul and Mary, inseparable college friends, founded a nutritional snack products company shortly after graduation to market a low calorie, high-fiber snack bar Mary invented. They agreed each of them would own one-third of the business. In 2017 the business was incorporated in Florida as “Bountiful Snacks, Inc.” Peter filled in the necessary information by handwriting in the blanks on a state-supplied pre-printed form Articles of Incorporation. Peter purchased a loose-leaf notebook corporate minute book kit with fill-in-blanks minutes, bylaws, stock certificates and a corporate seal. The kit’s forms remained blank and no stock certificates were ever issued.
Mary’s snack bar, branded as “Mary’s Bountiful Snack Bar,” was very successful, making Peter Paul and Mary wealthy. Mary invented more nutritional products and several new Florida corporations were created to house the new products. The three owners contributed equal amounts of cash to fund each new company. Peter purchased corporate minute book kits for each new company. These kits also remained unused. None of the stock certificates in the other corporate kits were filled in or issued. None of the new companies or products were as successful as Mary’s Bountiful Snack Bar.
In late 2018, Paul and Mary unveiled plans for a new mineral-based cosmetics line called “Complexion Perfection, Inc.” Peter incorporated a new Florida corporation under the new name, and otherwise followed his past practices for new corporations. Peter, Paul and Mary each contributed $500,000 cash to the new venture. For more than a year, things moved ahead with the development and production of Complexion Perfection products, contracts for dealer relationships, planned advertising, etc. Just when the plans for an extravagant product line launch were coming to fruition, a developing schism between the three founders threatened to interrupt the Complexion Perfection launch. Paul and Mary were on one side and Peter was by himself on the other. Peter voiced strong opposition to the new line. In heated telephone calls, Paul and Mary “out voted” Peter. Plans for the launch proceeded.
Peter wanted to stop the development of Complexion Perfection and get his money out of the new company. Paul and Mary refused. In 2020, Peter visited with attorney Sally Smart, an associate in the firm’s transactions practice group. After Peter told Sally his objectives he asks, given his minority position vis-à-vis Paul and Mary, if he can do anything to stop the launch and get the return of what’s left of his investment.
After research, Smart tells Peter that as sole incorporator, Peter has the power to dissolve Complexion Perfection, provided that (i) the corporation has no directors, (ii) no stock has been issued and (iii) there are no unpaid debts.
Peter provided the following facts: Peter is the sole incorporator of Complexion Perfection and that there are no formal written corporate records electing directors, approving bylaws or approving the issuance of common stock. No stock certificates have been issued and the stock books are blank. There are no Board or shareholder meeting minutes or written consents. In addition, Peter has check-signing authority to pay off the small amount of outstanding debts.
Sally tells Peter that it looks like he may be able to dissolve the new company but that she wants to check first with one of her more experienced colleagues.
Issue: Attorney Smart knocks on my door and tells me about the back story of Peter, Paul and Mary (see above). These facts, Smart says, satisfy the requirements of Section 607.1401 for dissolution by Peter as the sole incorporator.
“So, can we give Peter the OK?” she asks.
No. Not so fast.
Attorney Smart did not ask, and Peter did not tell her, other important facts in the several years’ history of the businesses owned by Peter, Paul and Mary, including Complexion Perfection: In the pre-printed fill-in-the-blanks Articles of Incorporation Peter had written in Peter, Paul and Mary as directors. While there were no written Board or shareholder meeting minutes or written consents for Bountiful Snacks or any of the other companies, the three met in person or by phone frequently to discuss business results and make business decisions, usually by consensus (albeit informally and without formal written corporate minutes). The Complexion Perfection annual report filed with the Department of State identified Peter, Paul and Mary as directors (and officers). The IRS Form 2553 electing S-Corporation status identified each of Peter, Paul and Mary as the owner of one-third of the company’s stock. Banking documents stated that they had been approved by the company’s Board of Directors. An office lease and various vendor agreements were signed by Peter as “President” of Complexion Perfection. The company’s financial statements showed the $1.5 million cash contributed by the founders as paid in capital (not loans from shareholders). All of the corporations owned by Peter, Paul and Mary had been “in business” for several years, each conducting their affairs informally in a manner similar to Bountiful Snacks and Complexion Perfection.
In Florida, depending on the facts, the failure to comply strictly with corporate formalities (including director meetings, minutes, physical stock certificates, etc.) has not proved fatal to the recognition of the validity of certain corporate acts, including the existence of stock ownership.
Attorney Smart and I conclude that the better view of the facts is that (i) Peter, Paul and Mary are directors of Complexion Perfection and (ii) the corporation has outstanding common stock. Therefore, Peter as sole incorporator lacks the power to dissolve Complexion Perfection. Dissolution would have to be approved by the Board of Directors and Sally says she will advise Peter against attempting to dissolve Complexion Perfection as sole incorporator without Board approval. In addition, Sally will advise Peter if he decides to move ahead with the planned dissolution as sole incorporator, he would need to engage other counsel to represent him.
Lessons: Even the most honest and ethical client may unintentionally omit key facts in presenting matters to counsel. Clients seeking legal advice to support their predetermined business plans may hold back material information deliberately. Every deal has a history that pre-dated the client’s arrival in your office. Gathering all of the material facts is crucial to providing quality legal advice.
Effective fact gathering requires polite but persistent efforts to collect candid factual answers to open-ended questions (i.e., avoiding questions that can be answered “yes” or “no”). Sally allowed Peter to provide “his version” of the facts. Sally should have asked such open-ended questions as would have led her to learn the informality in the way the parties carried on their businesses and what governmental filings had been made (e.g., IRS Form 2553). Sally should have asked to see the financial statements for Complexion Perfection. Next, Sally should have checked the records-searching pages of the Florida Department of State website here for the Articles of Incorporation and annual report filed with the Department of State. The information gathered from proper questioning and from these publicly available filings would have given Sally great pause about advising Peter that he had sole authority to dissolve Complexion Perfection.
The case of Peter, Paul and Mary was not Sally’s best performance. However, after considering more material facts, Sally recovered gracefully by making it clear to Peter that the firm would not act as his counsel if he persisted in asserting his legal power as sole incorporator to dissolve the corporation.
To be continued in Corporate Governance Tales From (Virtual) Open Door Encounters – Part 3.
 As in Part 1, unless noted to the contrary, all references to Chapter 607, Florida Statutes, are to provisions of Florida’s corporation law as currently in effect.
 Applicable statutes may impact the content of notices, the means of transmission and when and whether notices are deemed to have been sent or received. The several pages of details in Section 607.0141 of the current Florida corporation law may impact established practices and governing documents that were adopted before the current law.
 These are the requirements of Section 607.1401 as currently in effect. The previous version of the statute had an additional precondition for dissolution by the incorporator, that the corporation had not “commenced operations.” This article does not address whether pre-2020 requirements would be imposed by a court today considering a challenged dissolution by the sole incorporator.
 Under most corporate statutes and most bylaws, officers are elected by directors; therefore, there would have to be corporate directors to elect officers. The officers could not spring into existence out of thin air.