Chancery Court Grants Preliminary Injunction Restraining Former Director from Selling Shares Allegedly Invalidly Issued to Himself

By: Annette Becker and Michael Payant

In Applied Energetics, Inc. v. George Farley and AnneMarieCo., LLC (C.A. No. 2018-0489-TMR), the stockholders of Applied Energetics, Inc. (“AE” or “Plaintiff”) sued defendants George Farley (“Farley”) and his family owned-holding company AnneMarieCo., LLC (“AMC”) for issuing stock to himself and transferring such shares to AMC in a self-interested transaction.  Plaintiff sought a preliminary injunction to restrain defendants from selling AE shares during the pendency of the stockholder litigation. The Delaware Court of Chancery (the “Court”) granted the preliminary injunction holding that AE established reasonable probability of success on the merits for its claims.

In 2011 demand for AE’s defense technology ceased, and by 2014 its board of directors (“Board”) placed it in shell status. At the time, AE had a three-person board of directors.  After a resignation in early 2015, the only two remaining directors were Farley, also AE’s sole officer, and John Levy. Farley and Levy did not agree as to the direction of AE’s business.  Levy resigned, effective February 10, 2016, after Farley expressed an intent to issue himself and Levy shares in lieu of unpaid compensation.

Five days later, Farley executed a written consent as sole director issuing himself 25 million shares (representing 25% of AE’s outstanding stock) at $0.001 par value, despite a market price of $0.004 per share. Farley reached out to a long-time associate for a valuation of the stock but did not wait for the valuation before issuing the shares. When the valuation came back higher, Farley pressured his associate to lower it. Farley also used $0.001 as the price for shares issued to third parties for services and an additional five million shares for himself under AE’s incentive plan.

AE disclosed these issuances in its March 30, 2016 annual report, and multiple stockholders contacted Farley to complain. Shortly thereafter, Farley transferred 20 million shares to AMC, a limited liability company owned by his wife and six children. AE did not disclose the relationship between Farley and AMC until six months later, after multiple SEC letters and the filing of amended registration statements, and even then certain facts were omitted. In spring 2017, AE announced plans to restart its business.  AE also shed its shell status at this time. In early 2018, Farley made efforts to remove restrictive legends from the shares held by AMC to make them freely tradeable. AE stockholders removed Farley from the Board for cause in March 2018.  One of the reasons enumerated was the issuance of 25 million AE shares to himself.

On these facts, the Court granted a preliminary injunction restraining Farley and AMC from selling AE shares. To support a preliminary injunction, the Court was obligated to find (1) reasonable probability of success on the merits; (2) an imminent threat of irreparable injury; and (3) a balance of equities favoring a preliminary injunction. The Court first found reasonable probability of success on three grounds.

Initially, the Court considered whether Farley acted without proper Board authorization in issuing the shares to himself. Under Delaware law, the Board was obligated to approve any issuance of shares. During the relevant time, AE’s bylaws required three directors on the Board and a quorum of at least a Board majority (two of the three directors) to approve the issuance. Because only Farley signed the consent, there was no independent director approval and no stockholder approval the Court found it reasonably probable the issuance was invalid.

The Court considered whether Farley breached his fiduciary duty as a director by issuing the shares to himself. In a self-interested transaction without stockholder approval, a director must establish entire fairness of the transaction to the corporation. At the preliminary injunction stage, the burden is on the plaintiff to show a “reasonable likelihood” that the defendants will be unable to prove fairness at trial. Plaintiff presented evidence neither AE’s shell status nor the low daily trading volume justified departure from the $0.004 trading price because Farley planned to resume operations and remove restrictive legends. Plaintiff argued there was no legitimate third-party opinion supporting the below-market price because Farley initially acted without an expert’s opinion and later pressured his associate to issue a low valuation. Furthermore, Farley failed to factor in material non-public information concerning AE’s plans to resume operations. As to whether Farley was owed past compensation, he was obligated to issue the shares at a fair price in any event. Collectively, the Court found this evidence established a reasonable probability of success on the merits.

The Court considered whether Farley and AMC violated Delaware’s Uniform Fraudulent Transfer Act (the “Act”). The Act prohibits transfers by debtors with the intent to “hinder, delay or defraud any creditor of the debtor.” Farley did not dispute that he is a debtor of AE because of AE’s claims against him. He instead argued he lacked the requisite intent because the transfer was made for estate planning purposes consistent with past practice. The Court disagreed. Evidence showed Farley had already been confronted by several stockholders at the time of the transfer and was aware of the threat of litigation. The Court also found evidence Farley retained effective control of AMC-held shares, including emails to his son with instructions on selling shares. In addition the Court found repeated failure to disclose the relationship between AMC and Farley indicative of an intent to conceal. Taken together, the Court determined that there was a reasonable probability of Plaintiff’s success on this issue.

The Court found the other two requisites for a preliminary injunction were present. A sufficient threat of irreparable harm existed because if Farley was permitted to flood the market with his shares and those held by AMC, it could hinder AE’s ability to raise sufficient capital in planned future issuances. Combined with lost business opportunities for AE, this could lead to bankruptcy. Additionally, the balance of equities weighed in favor of the preliminary injunction because any loss of profit by Farley could be remedied through AE posting a bond, whereas the potential harms to AE could not be remedied. Finding all three elements present, the Court granted the preliminary injunction.

Applied Energetics, Inc. v. George Farley and AnneMarieCo., LLC, C.A. No. 2018-0489-TMR (Del. Ch. Jan. 23, 2019)

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