Chapter 3 Pre- incorporation Transaction by Promoters

1. Chapter 3 Pre- incorporation Transaction by Promoters • Who is a “promoter”? • A “promoter” is a person who takes initiative in founding and organizing a business or enterprise. (SEC Rule 405) —arranging for the necessary capital; —acquiring any needed assets or personnel; —arranging for the actual incorporation of the business.

2. The Regulation in China • Article 80 The initiators or (promoters) of a stock company shall undertake the preparatory work of the company. They shall conclude an agreement of initiators to clarify their respective rights and obligations during the course of establishing the company.

3. Issues Concerned • 1. Under what circumstances does the promoter become personally liable for transactions he undertake on behalf of the corporation? • 2. Under what circumstances does the corporation, once it is formed, become liable based on the promoter’s pre-incorporation transactions? And • 3. What, if any, are the promoter’s fiduciary obligations to the not-yet-formed corporation?

4. The Liabilities of Promoters • To outside creditors: Promoters have significant responsibilities in the formation of business and can become liable to outside creditors for: —pre-incorporation contracts they sign before the business is incorporated —contracts they sign for a corporation that was not properly incorporated. • To corporations and other investors: —fiduciary duties of avoiding unfair self-dealings with corporations. —providing full disclosure to other investors during the capital-raising process.

5. The Liabilities of Promoters • If the corporation has already been formed, and a promoter makes the contract in the corporation’s name—— • If the promoter purports to make a contract on behalf of a not-yet-formed corporation, the situation is much fuzzier —— • (To be continued next page)

6. The Liabilities of Promoters • Traditional Theories of Contracts • newly formed corporation could not ratify pre-incorporation contracts since no corporation existed when the contract was entered into. • The Restatement (Second) of Agency • a purported agent acting for a nonexistent principal becomes a party to the contract. • The default rule • The promoter is personally liable on a pre-incorporation contract absent a contrary intent.

7. The Liabilities of Promoters • 1. Corporation not named in promoter’s own name, without referring to the not-yet-formed corporation • 2. Contract in corporation’s name • The contract does not on its face disclose the fact that the corporation has not been formed as of the contract date. • A. Promoter knows: personally liable • B. Later formation of corporation and adoption of contract:

8. The Liabilities of Promoters • 3. Promoter unaware that corporation hasn’t been formed: court is more sympathetic to the promoter, tending to find a way to relieve him of personal liability. • 4. Contract states that corporation is to be formed: • — most often, the promoter would have signed the contract “for a corporation to be formed”, but it is not conclusive, two more elements must be considered: • 1. look to negotiating assumptions for intent • 2. look at corporation’s action (adopt the contracts) • (to be continued next page)

9. The Liabilities of Promoters • a. Corporation never formed: the promoter is personally liable. b. Corporation formed, but no adoption: the situation is the same as above. c. Adoption by corporation: If the corporation is eventually formed and then manifests its intent to take over the contract.

10. Liability of corporation for promoter contract • Interests Conflicts between outside creditors and the new shareholders. Outside creditors: hold corporation liable on pre- incorporation contracts. New shareholders: would not take “surprise” corporate liabilities.

11. Liability of corporation for promoter contract • Suppose the corporation did come into existence afterwards. • 1. No adoption, no liability: The corporation does not become automatically liable merely by coming into existence. 2. Adoption by corporation: The corporation does manifest its assent to be bound by the contract previously signed in its name. (what constitutes adoption?——to be continued next page)

12. Liability of corporation for promoter contract • What constitutes adoption? • A. Express adoption: • B. Implied adoption: • Effective date: • When adoption occurs, it is usually held not to be retroactive to the date of the original contract.

13. Promoter’s fiduciary obligation to corporation and shareholders • During a corporation’s start-up process, promoters have absolute control of the corporate governance machinery. • Duties of Fiduciary and Disclosure • Case A and Bpurchased 1million Ⅰ Mining rights & Property FormedⅡ Sold Assets sold shares Ⅳ 3.25 million in note Ⅲ One Company claimed to rescind the notesⅤNew Investors

14. Promoter’s fiduciary obligation to corporation and shareholders • self-dealing in a corporation is governed by a set of fiduciary duties that directors, officers, and controlling shareholders owe the corporation. • Questions: To whom do promoters owe duties when they enter into a transaction with the corporation before there are other shareholders or creditors? • Can the following two theories be used to infer promoters’ duties? A and B have violated— Fiduciary duties to the corporation, and disclosure duties to subsequent investors and creditor

15. Promoter’s fiduciary obligation to corporation and shareholders • Not really: • The problem with the first theory is at the time of transaction, the promoters’ interest was known by the corporate decision maker. • To overcome the above, the outside shareholders might argue that the approval and disclosure of the transaction must await their arrival and that the promoters stand in a fiduciary position as to shareholders who are expected to be brought in after the transaction.

16. Promoter’s fiduciary obligation to corporation and shareholders • The true problem is the prompters failed to disclose the prior self-dealing when they sold the shareholding to new investors.

17. Defective Incorporation and Its Consequences • How defects can occur? • A. technical reasons: • B. deceit intents:

18. Defective Incorporation and Its Consequences • The Main Point: Limited Liability or Personal Liability should be imputed? • Previously, two theories as follows dominate the judicial process: • The first one is De facto corporation: This doctrine requires (1) some colorable good-faith attempt to incorporate and (2) actual use of the corporate form, such as carrying business in the corporate name. As to the outsiders, a de facto corporation has all the attributes of a de jure corporation, including limited liability. State can challenge the existence of a de facto corporation, but outside parties cannot.

19. Defective Incorporation and Its Consequences • The second one is Corporation by estoppel. • The theory arises when the parties have dealt with each other on the assumption a corporation existed, even though there has been no colorable attempt to incorporate. • Outsiders who rely on the representations or appearances that a corporation exists and act accordingly are estopped from denying corporate existence or limited liability.

20. Defective Incorporation and Its Consequences • Whether a modern court uses one of these common law doctrines to impute a non-recourse relationship depends on two factors: • First, does the state corporate statute permit judicial imputation of limited liability even without incorporation? • Second, if so, under what circumstances will a court impute limited liability?

21. Defective Incorporation and Its Consequences • The Trend: Modern Abolition of the de Facto and Estoppel Doctrines • Reason: Incorporation under modern corporate statutes is so easy, forgiving an insider’s failure to incorporate may be too protective. • Statutory Liabilities MBCA §2.04 states: All persons purporting to act as or on behalf a corporation, knowing there was no incorporation …are jointly and severally liable for all liabilities.

22. Defective Incorporation and Its Consequences • The Interpretation on Statutory Liabilities MBCA §2.04 • One the one hand, it’s clear that there is defective incorporation liability when insiders deceive outsiders about corporate status. • One the other hand, it implies that there is no liability if the insider purporting to act in her corporate capacity does not know of the incorporation defect. • Notice that MBCA’s apparent focus’s on insider’s knowledge differs from the judicial focus on the outsider’s understandings.

23. Liability for Defective Incorporation • Actually, a comprehensive, statistical study of the defective incorporation cases suggests that the insider’s attempt to incorporate and the outsider’s belief of incorporation are critical in actual judicial decision-making.

24. Liabilities During Incorporation Process for LLC: Process of capital delivery deposit full amount of currency • make full payments non-monetary properties • checked by capital verification institution • application made by the representative designated by all shareholders or the agent entrusted by shareholders • prepare a register (list) of shareholders

25. Liabilities During Incorporation Process for LLC • Contractual liabilities • The Shareholders shall make the capital contribution: • in accordance with the amounts and terms specified by the articles; and • Deposit the currency into the account of the company; or • Transfer the non-currency properties to the company.

26. Liabilities During Incorporation Process for LLC • Q1: When a shareholder fails to make his/its capital contribution, what liabilities should he take? • Example: One company has three investors: A, B and C. Investor A promised to contribute RMB10,000 in 2006, but he only has paid off RMB5,000 in the end.

27. Liabilities During Incorporation Process for LLC • Article 28 (Section Two) Shareholders who fail to make capital contribution in accordance with the said provisions shall, in addition to making the capital contribution in full, bear liability of breach of contracts towards other shareholders who have made their capital contributions in full in accordance with the schedule. • Q2: What are the liabilities for breach of the contract of capital contribution?

28. Liabilities During Incorporation Process for LLC • Q3: What if the actual value of the capital contributions in non-monetary properties is significantly lower than that provided for in the articles of association of the company? • Example: Shareholder A provided one computer to an IT company as capital contribution, which was assessed as RMB10,000 during the incorporation process, while after the establishment of this company, the computer was found worth 1,000RMB only.

29. Liabilities During Incorporation Process for LLC • Remedies: • The initial shareholder shall supplement the margin, and • Other shareholders shall bear the joint liabilities

30. Liabilities During Incorporation Process for LLC • Fiduciary duties to the companies and outside investors • Article 31 After the establishment of a limited liability company, if the actual value of the capital contributions in non-monetary properties is found to be significantly lower than that provided for in the articles of association of the company, the balance shall be supplemented by the shareholder who has offered them, and the other shareholders of the company who have established the company shall bear joint liabilities. • Q4:What if the currency contributions are found to be significantly lower than that provided for in the articles? Should other shareholders bear joint liabilities?

31. Liabilities During Incorporation Process for LLC • Q5：What liability should CPA undertake when the fraud on verification of capital contribution are proved? • Example: A company with actual registered capital at 1 million but verified by CPA as 2 million failed in the end, and was in debt to creditors at 3 million. The creditors claimed the CPA should be liable for 3 million jointly with the company.

32. Liabilities During Incorporation Process for LLC • Article 208 (Section 3) • Where the creditors of the company suffer damages due to an inaccurate valuation or capital verification issued by an asset valuation organization or a capital verification organization, the valuation organization or capital verification organization shall bear compensation liability within the scope of the inaccurate valuation or verification unless it is able to prove that the fault does not lie with the organization.

33. Related Question • Q6: Suppose shareholder A sells his shares to B for 10 RMB/share, but does not make any modification in the register of the company. Then A sells the same shares to C for 20 RMB/share and make the modification in the register of company accordingly. • Who shall be recognized as shareholder, B or C? • Answer:Article 33

34. Related Question • Article 33(Section 2) The shareholders recorded in the register of shareholders may, in light of the register of shareholders, claim to and exercise the shareholder's rights. • Companies shall register the names of their shareholders and their respective amount of capital contribution with the company registration authorities. Where there is a change in the registration details, change of registration formalities shall be completed. Where the registration or change of registration formalities are not completed, no defense against third party claims shall be made.

35. Liabilities During Incorporation Process for Companies Limited by Shares Contractual liabilities Article 80 The promoters shall enter into a promoter’ agreement to specify their respective rights and obligations in the process of establishment of a company. Fiduciary duties Article 94 Promoters of a company limited by shares who fail to make full capital contribution in accordance with the provisions of the articles of association of the company shall make up for the payment; other promoters shall bear joint liability.

36. Liabilities During Incorporation Process for Companies Limited by Shares • Where it is discovered after the incorporation of a company limited by shares that the actual value of non-cash assets used for capital contribution for the incorporation is significantly lower than the amount stated in the articles of association of the company, the promoter who made the capital contribution shall make up for the difference; other promoters shall bear joint liability.

37. Liabilities During Incorporation Process for Companies Limited by Shares • Fiduciary duties to the companies and outside investors • The promoters of companies limited by shares shall: • (1) bear the debts and expenses incurred for the incorporation in the event that the incorporation is unsuccessful; and • (2) bear joint liability for refundof the payments made by the subscribers and bank deposit interest for the same period in the event that the incorporation is unsuccessful; • (3) compensate the company for damages incurred by the company in the course of incorporation due to the fault of the promoters.

38. Liabilities During Incorporation Process for Companies Limited by Shares • A B C D E 2 Million 1 Million 3 Million 2 Million 2 Million IP cash land use right cash cash Daqing Stationery Product Company Limited by shares • D only paid off 1 million • Actually, C’s land use right is valued at 2 million after the incorporation • The company had raised 4 million from outside investors, and the costs of incorporation is 100 thousand, but unfortunately, the company cannot be incorporated in the end. • The company was incorporated in the end, but the promoters purchased the computers in price much higher than the market value.

39. Liabilities During Incorporation Process for Companies Limited by Shares • Comments • Much more stricter than those in US • Combine the liabilities of breach of contracts and fiduciary duties.