Potential Problems Thinking Through Some Issues 1

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 2

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

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. 4

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 5

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 6

Structuring Solutions in Entities So Many Choices! 7

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. 8

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

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) 10

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. 11

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. 12

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. 13

Delegated management + board Centralization of management. Notifies 3 rd 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. 14

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. 15