Essays: Corporations Flashcards
Corporate Liability for Preincorporation Contract
As a general rule, a corproation is a legal entity separate and apart from its shareholders. As a consequence, corpoations are not liable for contracts entered into before incorporation. Generally, only the promoters (i.e., the people who undertake to form the corporation) are liable for preincorporation contracts. Corporations may become liable for preincorporation contracts only if it adopts the contract. However, even if the corporatoin adopts the contract, this does not relieve the promoter from being personally liable for the contract as well. The promoter’s liability ends only when there is a novation (i.e., the other party and the corporation agree that the promoter is not liable and that the corporation is liable for the contract instead) or a release (i.e., the party with whom the corporation has a contract releases the promoter form liability).
Adoption can either be an express adoption (e.g., by resolution of the board of directors) or impliedly (i.e., the knowing acceptance and retention of benefits of the preincorporation contract.
Promoter Liability
A promoter is a person who undertakes to procure commitments for a corporation before it is formed. A promoter who enters into a contract knowing that there has been no valid incorporation is personally liable on the contract.
A promoter is liable on a pre-incorporation contract unless: (1) the contracts expressly indicates that the promoter is not to be bound (in which case the contract is construed as a revocable offer to the proposed corporation); or (2) all parties have agreed to a novation (i.e., an agreement among the parties releasing the promoter and substituting the corporation.)
Shareholder Liability – Piercing the Corporate Veil
As a general rule, shareholders in a properly formed corproation are not personally liable for the obligations of the corporation. This is another consequence of the corporation being a legal entity separate and apart from the shareholders.
However, a court will ignore this separateness–and pierce the corporate veil to hold the shareholders personally liable for the corporation’s obligations–if the privilege of conducting business as a corporation has been abused. The corporate veil will usually not be pierced unless one of the following is present: (1) Corporate formalities have been ignored and injustice has resulted; (2) The corporation was inadequately capitalized at the time of formation; or (3) The corporate form is being used to perpetrate a fraud.
Shareholder-Creditors and Equitable Subordination
Another consequence of a corporation being a legal entity separate and apart from its shareholders is that the shareholders may become creditors of the corporation by lending money to the corporation.
As a general rule, shareholders who are unsecured creditors are not subordinate to other, outside unsecured creditors. However, a court might subordinate the unsecured shareholder-creditor claims if any kind of wrongdoing is attributable to them. This is known as the Deep Rock doctrine or equitable subordination.
Shareholder Derivative Suits
Shareholders may bring both direct and derivative actions. Direct actions seek to redress injuries to the personal rights of the plaintiff. Derivative actions seek to redress injuries to the corporation. Generally, remedies in a direct action inure to the shareholder directly whereas remedies in a derivative action inure to the benefit of the corporation.
PREREQUISITES FOR BRINGING A DERIVATIVE CLAIM (SAD)
If a shareholder believes that the corporation has been harmed, but the corporation does nothing to vindicate the harm, the shareholder may try to bring a derivative action if the following prerequisites are met: (1) the shareholder bringing the action was a shareholder at the time of the act or omission complained of (or obtained his shares by operation of law from one who was); (2) The shareholder makes written demand on the board to take suitable actions; (3) The shareholder remains a shareholder throughout the pendency of the action; and (4) The shareholder can fairly and adequately represent the interests of the corporation.
A derivative proceeding may not be brought until 90 days after the demand is made unless the shareholder is notified earlier that the corporation will not take action or irreparable injury will occur. Moreover, if a majority of directors (but at least two) who do not have a personal interest in the transaction find in good faith after reasonable inquiry that the suit is not in the corporation’s best interest, a derivative action cannot be brought. In some states, demand will be excused if it is futile (such as where the shareholder is seeking damages from the entire board). However, the Revised Model Business Corporation Act does not provide for such a demand-exception in cases of futility.
Fundamental Corporate Changes
Fundamental corporate changes include dissolution, amendment of the articles, merger, and selling substantially all assets of the corporation not in the ordinary course of business. Approval of a fundamental corporate change requires approval by the board and then by an absolute majority of shares entitled to vote.
Alter Ego
Where shareholders treat the corporation as their alter ego, such as where they take corporate funds for personal use (commingling of assets for personal and corporate use) and the corporation does not have sufficient funds to pay its creditors as a result, or where a corporation fails to follow corporate formalities or fails to keep proper accounting, the courts will often pierce the corporate veil.
Fiduciary Duties
Directors are fiduciaries of the corporation and owe the corporation a duty of care and a duty of loyalty. The duty of care requires the directors to act in good faith and in the best interests of the corporation, using the care that would be exercised by an ordinarily prudent person in a like position. Under the business judgment rule, directors who meet this standard are protected against lawsuits challenging their decisions. Moreover, in making decisions, directors are entitled to rely on the opinions and reports of other directors, corporate officers, corporate employees, and outside experts if their reports are within their expertise.
The duty of loyalty prohibits directors from competing with their corporation and from usurping a corporate opportunity for personal benefit. When a director usurp a corporate opportunity, the corporation may sue the director to recover the director’s profits.
