Joined: 31 Jan 2005
|Posted: Wed Mar 18, 2015 10:33 am Post subject: New Lecture Outline Postings
|As promised in class, I am posting the lecture notes from De Facto and Estoppel "corporations." I am also posting a new post regarding Promoters of Corporations which will be included in my lecture of tomorrow, 3/19.
RECOGNITION OF CORPORATIONS WHEN CORPORATION IS DEFECTIVE
One main reason to incorporate: Avoid personal liability for business obligations. This veil of protection generally available when Dejure corporation is formed (i.e., when all the steps required by statute for incorporation have been followed).
Veil of protection may also be available in some circumstances even when all of the steps necessary under the incorporation statute have not been followed—under the de facto corporation or corporation by estoppel doctrines.
1. De Facto Corporation:
A. Retains all rights and powers of a de jure corporation at common law, but remains subject to direct attack by the state.
(1) Common Law Requirements Traditionally, the requirements for establishing a de facto corporation are: a) Statute for Valid Incorporation available, i.e.: There must be a corporate law under which the organization could have been legally incorporated b) Colorable Compliance and Good Faith attempt at Incorporation under the state’s laws must have been made. c) Exercise of Corporate Privileges: e.g.: the “corporation” must act like a corporation, i.e., conduct the business in its corporate name and exercise corporate privileges.
B. Limitation on De Facto Doctrine. Persons who purport to act as or on behalf of a corporation knowing that there was no incorporation are liable for all liabilities created in so acting. It follows persons who do not know that there was no incorporation will not be liable (i.e., the de facto corporation doctrine probably is available for such persons). Examples: 1) Andrea and Bart agree to form AbbeyCorp. They properly draw up the necessary papers and Bart tells Andrea that he will file them the next day. Bart forgets to file the papers and forgets to tell Andrea of his failure. The following week, Andrea enters into a contract with a supplier on behalf of AbbeyCorp. Andrea probably can avoid personal liability on the contract under the de facto corporation doctrine. 2) Same facts as above, but the day after Andrea and Bart draw up the articles, Bart mails them to the secretary of state, and a few days after Andrea entered into the contract with the supplier, Andrea and Bart receive a letter from the secretary of state indicating that the articles were not filed because they were missing the incorporators' signatures. Andrea probably can avoid personal liability on the contract under the de facto corporation doctrine once again.
Corporation by Estoppel.
A business might also be treated as a corporation despite the lack of de jure status under the corporation by estoppel doctrine. Under the doctrine, persons who treat an entity as a corporation will be estopped from later claiming that the entity was not a corporation. The doctrine can be applied either to an outsider seeking to avoid liability on a contract with the purported corporation, or to a purported corporation seeking to avoid liability on a contract with an outsider.
Examples: 1) Suppose X, an outsider, deals with the entity, Z, as though it were a valid corporation. Upon discovering a defect in formation, X seeks to hold the shareholders personally liable. A shareholder without prior knowledge of the defect may successfully assert that X is estopped to deny the corporation's existence, since X always treated the corporation as though it were properly formed.
(2) Z tries to use estoppel with X because they can purchase goods elsewhere, Z would be treated legally by X as a corporation by estoppel.
PROMOTERS PROCURE CAPITAL AND OTHER COMMITMENTS
The first step in forming a corporation is the procurement of commitments for capital and other instrumentalities that will be used by the corporation after formation. This is done by promoters. Generally, promoters enter into contracts with third parties who are interested in becoming shareholders of the corporation once it is formed (i.e., "stock subscriptions"). Promoters might also enter into contracts with others for goods or services to be provided to the corporation once it is formed. Usually, the promoters will go on to serve as incorporators, but this is not necessary
I. PROMOTERS' RELATIONSHIP WITH EACH OTHER
Absent an agreement indicating a contrary relationship, promoters are considered to be joint-venturers, and they occupy a fiduciary relationship to each other. As fiduciaries, promoters are prohibited from secretly pursuing personal gain at the expense of their fellow promoters or the corporation to be formed. Example: Amie and Barb have agreed to form a corporation to engage in a real estate business. Amie tells Barb that he can acquire a piece of land suitable for subdividing for $100,000. Amie acquires the land for $70,000 and pockets the difference. Amie is liable to Barb for breach of a fiduciary duty, since the promotion began when Amie and Barb agreed to form the corporation.
PROMOTERS' RELATIONSHIP WITH CORPORATION Upon incorporation, the promoters owe fiduciary duties to the corporation, and to those persons investing in it. The promoters' duty in this respect is one of fair disclosure and good faith. Promoters are not permitted to retain a secret profit resulting from transactions with, or on behalf of the corporation. Promoters' liabilities will arise under one of three theories:
(i) breach of fiduciary duty;
(ii) fraud or misrepresentation; or
(iii) obtaining unpaid stock.
A. BREACH OF FIDUCIARY DUTY
Arising from Sale to Corporation. A promoter who profits on the sale of property to the corporation may be liable to the corporation for the profit, or may be forced to rescind the sale, unless:
a. the promoter has disclosed all of the material facts of the transaction to an Independent Board of Directors If the transaction is disclosed to an independent board of directors (not under the control of the promoter) and approved, there is no breach of a fiduciary duty.
b. Disclosure to Subscribers or Shareholders If the board of directors is not completely independent, the promoter's transaction must be approved by the shareholders or subscribers to the stock of the corporation. The promoter is insulated from a breach of fiduciary duty if the subscribers knew of the transaction at the time they subscribed or, after full disclosure, unanimously ratified the transaction. Disclosure must be to all shareholders, not merely to the controlling shareholders. In addition, disclosure must include those persons contemplated as part of the initial financing scheme. [Old Dominion Copper Mining & Smelting Co. v. Bigelow, 203 Mass. 159 (1909)] Example: Alex, Becky, and Chloe decide to form a corporation with 200,000 shares of authorized common stock. They plan to sell 50,000 shares to the public. Prior to formation they obtain subscriptions to 20,000 per share Alex, Becky, and Chloe contribute property in exchange for 150,000 shares and they "profit" on the transaction. They obtain approval of the transaction from the subscribers for the 20,000 shares. The remaining 30,000 shares are sold within three weeks after formation of the corporation, but the promoters do not disclose their profit to the new shareholders. Under the Bigelow rule, the promoters are liable to the corporation because the transaction was not approved by all shareholders who were contemplated as part of the original promotion plan
Situation where Promoters' purchase all the stock
If the promoters purchase all the stock of the corporation themselves, with no intention | to resell the stock to outsiders, but subsequently do sell their individual shares to outsiders, they cannot be liable for breach of a fiduciary duty with respect to then-promoter transactions, since at the time they purchased the stock there was no one from whom the profit was kept secret.
Promoters may always be held liable if plaintiffs can show that they were defrauded by the promoters' fraudulent misrepresentations or fraudulent failure to disclose all material facts. The basis of this liability can be either common law fraud or the state and federal securities acts.
C. FEDERAL SECURITIES LAWS
Failure to disclose material facts or any material misrepresentations of a fact in cobination with the purchase or sale of securities may violate rule l0b-5 of the Securities Exchange Act. (TBD later)
II. PROMOTERS' RELATIONSHIP WITH THIRD PARTIES—PREINCORPORATION AGREEMENTS
1. Promoter's Liability
If a person(s) act(s) on behalf of a corporation, knowing that there "has been no incorporation” he/she/they is (are) jointly and severally liable for any obligations incurred. Thus, as a general rule, if a promoter enters into an agreement with a third party to benefit a planned, but as of yet, unformed corporation, the promoter is personally liable on the agreement.
Example: Fred and Bamey agree to pool their money to form a corporation ("Dyno, Inc.") to run a rock quarry. Fred approaches Mr. Slate, explains his plans, and enters into a contract to purchase a small quarry from Slate for $100,000—$50,000 to be paid at closing and an additional $50,000 to be paid six months later. The contract provides that the closing will not be held for 45 days so that Fred and Barney will have time to incorporate Dyno, Inc. Before the closing. Fred signs the contract, "Fred, on behalf of Dyno Inc." Subsequently, Fred and Barney have a falling out, and Dyno, Inc. is never formed. Fred probably will be found to be personally liable on the contract with Mr. Slate since he entered the contract knowing that Dyno, Inc. had not yet been formed. (Depending on if Barney still involved he might be liable as well, we must use the reasonable person standard: What a reasonable person would believe looking at all the surrounding circumstances.)
Liability Continues After Formation Absent a Novation
A promoter's liability on pre-incorporation agreements continues after the corporation formed, even if the corporation adopts the contract and benefits from it. The promoter's liability can be extinguished only if there is a novation—an agreement among the parties releasing the promoter and substituting the corporation. To clearly establish a novation, the third party should expressly release the promoter after the corporation has adopted the contract, although some cases have implied a novation from the conduct of the third party and the corporation would therefore be liable.
Example: Same facts as in the example above, but Fred and Bamey do not have a falling out, Dyno, Inc. is formed, and a few days later the parties close on the quarry. At the closing, title to the quarry is transferred to Dyno, Inc. Despite Dyno, Inc.'s adoption of the purchase contract, Fred remains personally liable for the remainder of the purchase price unless the parties agreed to a novation at the closing.
Agreement Expressly Relieves Promoter of Liability If the agreement between the parties expressly indicates that the promoter is not to be bound, there is no contract. Such an arrangement may be construed as a revocable offer to the proposed corporation. The promoter has no rights or liabilities.
When a promoter is liable on a pre-incorporation contract and the corporation thereafter adopts the contract but no novation is agreed upon, the promoter may have the right of indemnification from the corporation if he is subsequently held liable on the contract.
a. General Rule—No Liability Prior to Incorporation Since the corporate entity does not exist prior to incorporation, it is not bound on contracts entered into by the promoter in the corporate name. A promoter cannot act an agent of the corporation prior to incorporation, since an agent cannot bind a nonexistent principal.
b. Adoption The corporation may become bound on promoter contracts by adopting them. The effect of an adoption is to make the corporation a party to the contract at the time it adopts, although adoption of the contract by the corporation does not of itself relieve the promoter of his liability. The liability of the corporation runs from the date of adoption, not from the making of the original contract. Adoption may be express (e.g. by board of directors' resolution) or implied (e.g., by acquiescence or conduct normally constituting estoppel).