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Potential Problems

Thinking Through Some Issues

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• General rule: no personal liability• Limits– ONLY limits liability of owners– Sometimes can reach beyond to owners’ assets

(e.g. fraud)• Exception: direct liability of shareholders

under contract or tort law if shareholder (a) assumes liability by contract or (b) commits a tort in the conduct of corporation’s business

Limited liability

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• Exception: “Piercing the corporate veil”• Equitable remedy• “Piercing sees to happen freakishly. Like

lightning it is rare, severe and unprincipled.”• Frank Easterbrook & William Fischel

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• Example: Dewitt Truck Brokers, Inc. v. Fleming Fruit Co., 540 F.2d 681 (4th Cir. 1976).

• Fleming Fruit Company, a close corporation controlled by a single individual.

• Sells fruit for growers on commission.

• Defaults on shipping contract with DeWitt Truck.

• Pres. of Fleming assures DeWitt he will pay if company does not.

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• Key factors:– Gross “undercapitalization” and “insolvency

of the corporation”– Failure to observe adequate corporate

formalities– Nonpayment of dividends– Control / domination by Fleming– Siphoning of corporate funds by Fleming– Nonparticipation by officers, directors,

shareholders other than Fleming in affairs of corporation

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• Defective incorporation cases– De facto corporation - partially formed, serves as

shield• Colorable compliance• Good faith• Use of corporate power (e.g. issued stock, held

meetings)– Corporation by estoppel• 3rd party who dealt with entity as a corporation without

expectation that shareholders will be liable is estopped• Good faith by party asserting defense

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Structuring Solutions in Entities

So Many Choices!

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Common Structure of Entity Law

• What is “corporate law” / “business organizations law”?

• Businesses face a fundamentally similar set of problems which legal systems solve with a fundamentally similar set of legal rules and standards.

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“Corporation”

• Legal personality

• Limited liability

• Transferable shares

• Delegated management under a board structure

• Investor ownership

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Why?

• Purpose of these 5 characteristics is to constrain value-reducing forms of opportunism among the constituencies of the corporate enterprise.

• 3 generic conflicts– Managers & shareholders– Shareholders & shareholders– Shareholders & other constituencies (employees,

creditors)

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Legal Personality

• Ability of the firm to own assets distinct from property of other persons.– Civil law: “separate patrimony”– “Affirmative asset partitioning”: shields assets of

firm from owners’ creditors– “liquidation protection”: protect going concern

value of firm against individual shareholders and creditors of shareholders.

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Limited Liability

• Default term in firm’s contract with creditors that limit creditors’ claims.– “defensive asset partitioning”

• Limited liability + legal personality reduce overall cost of capital by facilitating monitoring of assets.

• Allows isolation of lines of business for obtaining credit.

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Transferable shares

• Permits firm to conduct business uninterruptedly as identity of owners changes.

• Connected to liquidation protection: value of firm stays constant because of limited liability, legal personality, and transferable shares.

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Delegated management + board

• Centralization of management.

• Notifies 3rd parties who have authority to bind the firm.

• Formal separation of board and managers checks opportunism by managers.

• Means of access to credible information for minority shareholders & other interests.

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Investor ownership

• Right to receive net earnings.

• Investors are hardest to protect contractually; corporate law solves problem.

• Investors have (are induced to have) homogenous interests.