Potential Problems

1. Potential Problems Thinking Through Some Issues

2. Limited liability • 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

3. Exception: “Piercing the corporate veil” • Equitable remedy • “Piercing sees to happen freakishly. Like lightning it is rare, severe and unprincipled.” • Frank Easterbrook & William Fischel

4. 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.

5. 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

6. 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

7. Structuring Solutions in Entities So Many Choices!

8. 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.

9. “Corporation” • Legal personality • Limited liability • Transferable shares • Delegated management under a board structure • Investor ownership

10. 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)

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.