Corporations Law - June 7

Question 1

What is a corporation (as defined by most states)? (Epstein)

Answer 1

“(i) a corporation is a separate legal entity and (ii) its owners, usually called shareholders (or stockholders), are generally not personally liable for the debts of the corporation.” (152)

Question 2

What is the concept of limited liability? (Epstein)

Answer 2

“While there is no statutory limit on how much money an owner of a corporation can make from her investment in a corporation, the most that she risks is the amount she paid for the shares of stock. That is the limit of her liability.” (152)

Question 3

What are the four primary sources of “corporate law”? (Epstein)

Answer 3

“(1) state statutes, (2) articles of incorporation, bylaws and other agreements, (3) case law, and (4) federal statutes.” (155)

Question 4

How does a corporation usually come into existence? (Epstein)

Answer 4

“A corporation comes into existence when the appropriate state agency (usually the Secretary of State) accepts for filing a document known generally as the “articles of incorporation.” (156)

Question 5

What do corporations need to do after the secretary of state files the articles of formation? (Epstein)

Answer 5

“To “complete the organization of the corporation.” That process consists of two steps: appointing the initial officers and adopting the initial bylaws of the corporation. These tasks are undertaken at the “organizational meeting” (or can be done by written consent).” (161)

Question 6

If there is a conflict between the articles of formation and a corporation’s bylaws, which document will prevail? (Epstein)

Answer 6

The articles because they form the corporation. The bylaws are an internal document. (162-63)

Question 7

What is a promoter? (Epstein)

Answer 7

A promoter is someone acting on behalf of a corporation not yet formed. (163)

Question 8

How can a corporation adopt a document? (Epstein)

Answer 8

“First, the corporation itself might expressly adopt the contract. As we will see later in this book, a corporation generally acts through its board of directors. So if the board of directors of Todos, Inc. passes a resolution formally adopting the lease, the corporation will be liable on the lease from that moment. Second, the corporation might impliedly adopt the lease. Suppose, for instance, the board of directors does not take such a formal action, but a corporate official causes the corporation to use the premises that are subject to the lease. By using the premises, the corporation has adopted the lease, and is liable from that point.” (164)

Question 9

What is a novation? (Q)

Answer 9

The substitution of a new contract, obligation, or party for an old one, thereby extinguishing the old contract or obligation or excusing the old party from liability.

Question 10

What are shares of stock? (Epstein)

Answer 10

Shares of stock are the units of ownership in a corporation. (167)

Question 11

Can a corporation sell it’s own stock? (Epstein)

Answer 11

Yes. (167)

Question 12

What is an issuance? (Epstein)

Answer 12

When a corporation elects to sell shares of its own stock. (167)

Question 13

What are “authorized shares”? (Epstein)

Answer 13

The number of shares a corporation may issue, as defined in its articles of incorporation. (167)

Question 14

Is a corporation required to issue all of its authorized shares? (Epstein)

Answer 14

No. (167)

Question 15

What are “issued shares”? (Epstein)

Answer 15

Shares that a corporation actually does issue. (167)

Question 16

What are “outstanding shares”? (Epstein)

Answer 16

““Outstanding shares” consist of issued shares that the corporation has not reacquired (the corporation can buy stock back from shareholders, and those shares that have been issued and not reacquired are “outstanding”). (167)

Question 17

Can a corporation have more than one type (“class or series”) of stock? (Epstein)

Answer 17

Yes. (167)

Question 18

What is preferred stock? (Epstein)

Answer 18

Stocks that are outlined in the articles of incorporation to be treated more favorably than the other class of stock. (168)

Question 19

What is common stock? (Epstein)

Answer 19

The other class of stock that does not enjoy special treatment. (168)

Question 20

What is dividend preference? (Epstein)

Answer 20

When one class of stock has the preference of dividends over another. (168)

Question 21

What is a dividend? (Q)

Answer 21

A corporation’s distribution of earnings to its shareholders.

Question 22

What is a liquidation preference? (Epstein)

Answer 22

“The preference is designed as a form of “downside protection” so that if the company is ultimately sold for a relatively low value, the VCs will get all their money back (assuming there are sufficient proceeds) before the founders (and other holders of common stock) get any proceeds at all.” (168)

Question 23

What is par value? (Epstein)

Answer 23

Par value is the minimum price for which a corporation can issue its shares. (169)

Question 24

What kind of stock does par value effect? (Epstein)

Answer 24

Par value only affects the issuance price. (170)

Question 25

What role does a promoter play in the formation of the corporation? (Q)

Answer 25

A promoter is an agent who actively participates in the formation of a corporation. A promoter can facilitate the formation of a corporation by acting on its behalf before the legal entity is formed, as well as conducting business on behalf of a newly formed corporation while the corporation is still getting off the ground.

Question 26

May a promoter be held personally liable for actions taken on behalf of a business before the corporation is legally formed? (Q)

Answer 26

Yes. A promoter be held personally liable for actions taken on behalf of a business before a corporation is legally formed. Specifically, if a promoter enters into a pre-incorporation transaction on behalf of a business, the promoter may be held jointly and severally liable for any obligation created during the pre-incorporation transaction. To avoid personal liability, promoters can incorporate the business and receive authority to act on the corporation’s behalf before entering any transactions as the business’s agent. However, if a promoter has already engaged in a pre-incorporation transaction, the promoter may avoid personal liability for that pre-incorporation contract only if the corporation later adopts the contract and takes the promoter’s spot using a novation.

Question 27

If a promoter enters into a contract before a corporation is formed and the corporation later adopts that contract, does the adoption insulate the promoter from personal liability for that contract? (Q)

Answer 27

No. If a promoter enters into a contract before a corporation is formed and the corporation later adopts that contract, that adoption of a pre-incorporation contract does not insulate the promoter from personal liability for that contract. Adoption of a pre-incorporation contract means that the now-formed corporation is accepting the benefits and agreeing to fulfill the obligations of that contract. Adoption can occur through explicit conduct (e.g. a board vote officially adopts the contract at issue) or implicit conduct (e.g. the corporation accepts the benefits of the contract or otherwise begins to perform pursuant to the contract’s terms). However, the corporation’s adoption does not relieve the promoter of liability under the contract. Adoption merely makes the corporation and the promoter co-obligors.

Question 28

If a promoter enters into a contract before a corporation is formed, what action, if any, may a corporation take after being formed to relieve the promoter of personal liability for that pre-incorporation contract? (Q)

Answer 28

If a promoter enters into a contract before a corporation is formed, once formed, the corporation may effect a novation to relieve the promoter of personal liability for that pre-incorporation contract. A novation replaces the promoter with the corporation as the party liable on the contract. The counterparty to the contract must approve the novation for it to be effective.

However, the replacement is only effective from the date the novation is approved, and, thus, protects the promoter from only prospective or future personal liability under the contract. The promoter is still liable for any damages that arise from conduct occurring during the period after the contract was executed but before the novation became effective.

Question 29

If a promoter enters into a contract on behalf of a newly formed corporation without the corporation’s authorization, can corporation do anything to insulate the promoter from personal liability for that contract? (Q)

Answer 29

Yes. If a promoter enters into a contract on behalf of a newly formed corporation without the corporation’s authorization, the corporation can insulate the promoter from personal liability by ratifying the contract. Ratification means the corporation is approving or authorizing its agent’s earlier, unauthorized conduct and making the conduct its own. A corporation’s ratification can be either express or implied. By ratifying a contract, the corporation takes the place of the promoter as the party liable on the contract, as of the time the contract was executed. That means, once the contract is ratified, the corporation has all liability under the contract, even for events that occurred prior to the ratification.

Question 30

If a corporation was not incorporated at the time its promoter entered into a contract, after the corporation is incorporated, can it then ratify that contract and insulate the promoter from personal liability? (Q)

Answer 30

No. If a corporation was not incorporated at the time its promoter entered into a contract, after the corporation is incorporated, it cannot then ratify that contract and insulate the promoter from personal liability. Although ratification occurs retroactively, it applies only if the the corporation existed at the time the contract was executed. Even though ratification cannot be used to insulate a promoter from liability for a pre-incorporation transaction, other potential methods are available (e.g., a novation).

Question 31

Do promoters owe fiduciary duties to the future or actual corporation for whose benefit they are acting? (Q)

Answer 31

Yes. Promoters owe fiduciary duties to the future or actual corporation for whose benefit they are acting. Typically, promoters owe:

a duty of care,

a duty of disclosure,

a duty of loyalty, and

the duty to act in good faith.

However, promoters do not necessarily have all of the duties of corporate directors and officers. This is because the promoter’s actions occur during the early stages of corporation formation, often before the corporation is even formed. Thus, the corporation generally does not yet have shareholders to whom other duties would be owed.

Question 32

A promoter had not yet incorporated or opened her restaurant business. The promoter was planning to offer complimentary bread to all patrons and talked to a bread supplier. The supplier offered the promoter a good discount if she signed a contract immediately, and the promoter signed the contract. However, a few days later, the promoter decided that her restaurant would not provide complimentary bread to patrons. The promoter then told the bread supplier that she wouldn’t make any payments under the contract. The next month, the promoter filed the necessary paperwork to incorporate her restaurant business. The promoter then learned that the bread supplier was suing her for breaching the supply contract.

Can the promoter’s restaurant corporation ratify the contract with the bread supplier to insulate her from personal liability for the breach-of-contract claim? (Q)

Answer 32

No. The corporation cannot ratify the bread-supply contract to insulate the promoter from personal liability for the claim. If a promoter takes an action on a corporation’s behalf without the corporation’s authorization, the promoter is personally liable for the action. However, if the corporation later ratifies or authorizes that action, the corporation replaces the promoter as the party liable for that action, relieving the promoter of any personal liability for the act. A corporation may ratify acts only if the the corporation existed when the act occurred. Thus, a corporation may not ratify pre-incorporation actions.

Here, the restaurant was not incorporated when the contract was executed. Thus, the restaurant may not ratify the contract with the bread supplier to insulate the promoter from personal liability for her breach.

Question 33

A promoter entered into a pre-incorporation contract with a marketing firm. The firm agreed to provide promotional support for the promoter’s business for $50,000. The promoter signed the contract. Later, the promoter filed the necessary paperwork to incorporate her business. At the corporation’s first board meeting, the corporation’s directors voted to adopt the marketing contract. The corporation made a $5,000 payment to the marketing firm. The business failed and the corporation was forced to dissolve. The marketing firm was still owed $45,000 under the contract.

Does the promoter have any personal liability to the firm for the breach of the marketing contract?

Answer 33

Yes. The promoter still has personal liability to the firm for the breach of the marketing contract. A promoter who enters into a pre-incorporation contract is personally liable for that contract. After the corporation is formed, it may adopt a pre-incorporation contract, thereby accepting the benefits and agreeing to fulfill the obligations of that contract. However, the corporation’s adoption does not relieve the promoter of liability under the contract. Adoption merely makes the corporation and the promoter co-obligors.

Here, the promoter signed the contract before the business was incorporated, taking on personal liability for it. The corporation’s later adoption of the contract did not relieve the promoter of her personal liability; it merely made the corporation and promoter co-obligors. Thus, the promoter is still personally liable to the marketing firm for the remaining $45,000.

Question 34

A promoter entered into two pre-incorporation contracts on behalf of his business venture. The first contract was with a software company; the second contract was with a software developer. The promoter and the software company had a dispute, and the promoter refused to perform a contractual obligation, breaching the first contract. The next month, the promoter’s business incorporated. At its first board meeting, the corporation’s directors voted to adopt and effectuate a novation of both pre-incorporation contracts. The software company and the software developer both agreed to the novation. The corporation later breached the second contract with the developer.

Does the promoter have any personal liability for either of these contractual breaches? (Q)

Answer 34

Yes. The promoter is personally liable for the breach of the first contract but not the second. A promoter who enters into a pre-incorporation contract is personally liable for it. After the corporation is formed, it may effect a novation to replace the promoter as the party liable on a pre-incorporation contract. However, a novation is effective only from the date it is approved. The promoter is still liable for any breach that occurred after the contract was executed but before the novation.

Here, initially, the promoter was liable for both pre-incorporation contracts. Through the novation, the corporation became fully responsible for the contracts going forward. The second contract was breached after the novation, and only the corporation is liable for it. However, the first contract was breached before the novation. Thus, the promoter is personally liable for the pre-novation breach.

Question 35

May a prospective corporation issue shares of stock? (Q)

Answer 35

Yes, a prospective corporation may issue shares of stock through subscriptions (i.e., contractual agreements to purchase securities that are newly issued as soon as the corporation is formed). Typically, a subscription entered into before incorporation is irrevocable for six months, unless provided otherwise by agreement or subsequently revoked by all subscribers. By contrast, a subscription entered into after incorporation is treated as a typical contract.