CORPORATONS - ICE/DI Flashcards
Predictably, there are situations where a corporation is defectively formed; there’s a problem withthe content of the articles of incorporation, incorporation fees aren’t paid, incorporatior’s signatures aren’t notarized, the organization’s lawyer neglects to file the articles, etc. When does this typically become an issue?
When creditors seek payment from the corporation and it’s insolvent, such that they’ll want to seek payment from sharholders instead. However, it’s generally not possible to get to the shareholders personally if either of the folowing is true:
1. The shareholders in question believed in good faith that the corporation was properly formed (e.g., the problem is that the articles contained an innocent mistake or omission or the shareholder relied on someone else, typicaly a lawyer, to file the articles and that person dropped the ball); or
2. The shareholders in question were passive investors in the business; that is, their involvment is limited to a monetary investment, and they weren’t actively involved in its operation.
NOTE: A corporation’s existence officially begins when he state’s Secretary of State accepts and records the corporation’s articles.
RELATED ISSUE: A court allowing creditors of a properly formed company to go after the shareholders personally is called “piercing the corporate veil” (topic:PCB). Here, we’re only discussing defects in incorporation as grounds for holding shareholders personally liable for corporate debts.
When creditors seek payment of “corporate” debts directly from shareholders on grounds of defective incorporation, there are three possible defenses shareholders can use – two at common law and one modern one. What are they?
the two common law defenses are:
1. De facto corporation (the corporation made a colorable attempt, in good faith, to organize for an authorized purpose under a valid statute, and it’s exercised corporate powers, but some defect in incorporation prevents it from being a proper, “de jure” corporation).
2. Corporation by estoppel (prevents people who’ve dealt withthe corporation believing it’s a corporation from thereafter tyring to deny the corporation exists in order to hold officers or sharholders personally liable on contracts. Even if the third party dealt with the corporation a a corporation, thi defense isn’t available to shareholders who knew about the defect in incorporationg; thus, it’s generally available to shareholders who relied on a third party; like a promoter or lawyer, to hadle the incorporation).
The modern defense is:
3. The RMBCA approach. Under RMBCA Sec. 2.04, anyone who acts as a corporation without knowing of the defect can’t be liable personally for corporate obligations (and vice versa). The RMBcA view abolishes the de facto corporation doctrine and doesn’t recognize corporation by estoppel, but the result is frequently the same as at common law (since the RMBCA exonerates anyone acting as a corporation believing in good faith that the corporation exists).
N.B.: The “good faith belief in incorporation” requirement of these three defenses is only relevant to active shareholders; that is, those involved in operating the company. that’s because courts typically exonerate passive investors from personal liability even if they knew about the defect. Timberline Equipment v. Davenport (OR 1973). (Passive investors’ only involvement in the corporation is their investment.)
When a corporation’s formation substantially complies with the state’s corporation statute – that is, its articles of incorporation are duly executed and filed. and they’re accepted and recorded by the state’s Secretary of State – what’s the corporation’s status?
It’s a “de jure” corporaton.
SIGNIFICANCE: A “de jure” corporation’s corporate status can’t be attacked by anyone – not even the state. HA Sec 139.
NOTE: Substantial compliance is all that’s necessary, not perfect compliance. thus, a monor error – e.g., a typo in the corporation’s address in its artilces – won’t erase its de jure status. (“Minor” errors require case-by-case analysis, looking at the nature of the compliance and the extent to which compliance was attempted.) People v. Montecio Water (CA 1893).
What is a “de facto” corporation?
It is a common law defense shareholders can raise when creditors try and seek payment from them directly for corporate debts. A “de facto” corporaton is one tht has:
1. made a colorable attempt (i.e, an effort by promotrs to prepare and secure filing of articles, but there’ a hitch – e.g., the artilces have something missing or mistaken or the promotrs’ lawyer doesn’t file them),
2. in good faith, to organize for an authorized purpose under a valid satute, (i.e., shareholder can’t be awar of defect when they operate the corporation), and
3. exercised corporate powers, (i.e., conducting business as a corporation, including issuing stock, electing directors, appointing officers), but
4. some defect in connection with its incorporation prevents it from being a de jure corporation.
SIGNIFICANCE: Creditors of a de fcto corporaton can’t seek payment from shareholders or officers on grounds of defective formation. The only exception to this is guilty shareholders – that is, shareholders who knew the formation was defective but carried on business as a corporation anyway. Even guilty shareholders can be liable only if they were actively involved in the management of the corporatin; passive investors can’t be liable, even if they were “guilty.”
NOTE: The state itself can attack a de facto corporation in a “quo waranto” action.
NOTE: De facto corporation is a common law defense; most modern statutes follow the RMBCA, which officially abolishes de facto corporation; however, it has the same effect, because it holds that anyone who acts as a corporation without knowing of a defect in incorporation can’t be held liable for corporate debts. RMBCA Sec. 2.04
The common law defenses “de facto corporation” and “corporation by estoppel” both shield shareholders from liability due to defects in forming the corporation. What’s the most important difference between the two?
who they can be used against.
The de facto corporation defense protects shareholders from liability to *all *parties. Corporation by estoppel only defends shareholders against those third parties who’ve dealt with the corporation believing it to be a proper (de jure) corporation. It can’t be used, for instance, aginst anone witha tort claim against the corporation, or involuntary creditors, neither of whom dealt with the business as a corporation.
EXAMPLE: the You-Bet-YOur_Asp Pet shop INce. is a defectively formed corporation. Cleopatra extends credit to You-Bet-Your-Asp on the sale of some snakes, relying on the company’s credit rating. Mark Antony is run over by a You-Bet Your-Asp delivery van. If the company becomes insolvent, Cleo is estopped from getting to the shareholders, because she relied on the corporation’s credit status; Mark Antony can’t be estopped, because he didn’t rely on the corporation’s credit (although he may be barred by de facto corporation status, which applies to all parties).
