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Liability of the Corporation

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Derivative Suit:
A derivative suit (or derivative action) is a lawsuit brought by a shareholder to reclaim funds, value or property that were lost to the corporation as a result of negligent action by the corporation’s directors or officers. The suit, if won, will result in liability for the directors or officers and a return of the lost amount to the company. The individual who brought the suit will not receive any particular damage award (except, perhaps, legal fees) but will benefit by the return to the value of the company.

Pre-Incorporation Contract:
A pre-incorporation contract is a contract that was entered into prior to the firm being formally registered with the state. In general, such contracts will eventually become the obligation of the corporation, by the company's agreeing to accept the contract and by releasing the pre-incorporation parties (promoters) through novation. However, if the company fails to ever reach formal incorporation, the individual(s) who entered the contract on the defunct company’s behalf, the promoters, will be personally liable for the contract.

A promoter is an individual who engages in acts on behalf of a corporation that has yet to complete formal incorporation. Promoters generally perform logistical tasks for the company, such as entering into leases or contracts for services or property, or soliciting business for the company. Ultimately, if the company fails to complete registration or otherwise refuses to accept the contract and its benefits, the promoter may be personally liable for the contracts by virtue of the pre-incorporation contract doctrine discussed above.

Introduction to Liability

So far in this chapter we have spoken generally of liability as it applies to the corporation. However, up till now, we have been speaking in generally relative terms. How is it that an organization can be liable? Is it not the case that an organization is nothing more than the sum of its individual parts? Should the directors and officers of the corporation be liable for all acts of the corporation? After all, that is the group of people who make all of the decisions. Why not the shareholders? They are the ones who reap the ultimate rewards of the company.

Ultimately, we find that shareholders, directors, officers and the corporation itself are each subject to some specific liabilities. In certain instances, we are prepared to limit the liability of each of these groups in order to ensure that it is able to carry on its business without the constant threat of a legal suit. However, as each of these groups is also liable to the others, we must have some mechanism that allows for liability to attach to certain acts.

Liability of the Corporation

Historically, it was thought that the corporation itself had a very limited set of liabilities, and in most cases, it was thought that those liabilities could only be civil in nature. However, recent events, specifically the Enron debacle and the resulting fall and criminal liability of the accounting firm of Arthur Andersen, have shown this not to be the case.

Corporations have always been liable for the contracts and obligations that directors, officers, and employees enter into on their behalf. Absent a severe abuse of this power to contract by an individual employee or director, any contract in which the company receives a benefit will attach to the company. It is worth noting that contracts entered into prior to the actual moment of a company’s incorporation may also be the responsibility of the company. Such “pre-incorporation” contracts entered into by the company’s promoters or those people who eventually come to run or own the company, become the obligation of the company the moment they are either adopted by the corporation or that the corporation accepts the benefits attached to the contract. See McArthur v. Times Printing Co., 51 N.W. 216 (Minn. 1892).

EXAMPLE: Jasmine, in setting up her new corporation for the sale of high-fashion hairclips, rented an office and warehouse location and hired several people to operate her machines. However, Jasmine had not yet finished incorporating the company. Ultimately, a corporate charter was denied to the company because of Jasmine’s track record of embezzling funds from companies that she had previously worked for and the fact that she also had failed to pay taxes on companies she had previously run. Jasmine is now personally liable for the rental and employment contracts, even though the company does not exist.

In addition, the promoter who entered into the contract on behalf of the yet-to-be formed corporation will generally be personally liable for any contracts entered into on behalf of the future corporation. However, if the   parties to the contract agreed to look only to the corporation, and not to the incorporator, for such liability, then that can absolve the incorporator from personal liability. See Quaker Hill, Inc. v. Parr, 364 P.2d 1056 (Co. 1961)

As far as torts are concerned, generally, a company has some degree of liability for the torts committed by its directors and/or employees during the course of their employment, depending on the nature and effect of the tort. The general rule as to a company’s tort liability is that it will typically avoid liability for intentional torts on the part of its directors/employees, but may be liable for unintentional torts committed by an employee. However, if the intentional tort was foreseeable to the corporate directors or if the corporation accepted the benefits of the commission of the tort, the corporation will generally be liable even for a tort committed intentionally by an employee. See Greenfield v. Colonial Stores, Inc., 110 Ga. App. 572 (Ga. Ct of App. 1964).

EXAMPLE: Todd acted negligently in hiring Arthur, a known criminal, to act as the bouncer at Club Happiness Inc. Club Happiness, though its board knew of Arthur’s background, decided not to fire him immediately because he was a very effective bouncer. One night, Arthur injured a patron of the club, who sued for his injury. Because of its actions, Club Happiness, as well as Todd, are liable for Arthur’s acts as the Club knowingly accepted the benefits and dangers of Arthur’s employment.

However, a corporation will generally not be liable for punitive damages based on a tort committed by the employee unless the tort was authorized by the corporation. See Kline v. Multi-Media Cablevision, Inc., 233 Kan. 988 (Kan. 1983).

Finally, as to criminal liability, it was believed, prior to the unwinding of Arthur Andersen, that a company itself could not be held criminally liable. In essence, the problem was: how can a company be put in jail? While this question remains partially unresolved, the latest indications are that under some circumstances, a corporation can be held criminally liable, with a finding that can result in either dissolution of the company or derivative criminal liability for the company’s directors, officers, or employees.

Liability of the Directors and Officers to the Shareholders

Operating a business entails risks. The people who have to choose among these various risks to identify the company’s best course of action are its directors and officers. Typically, when something goes wrong, those who have suffered from the risk – shareholders in the case of a corporation – want to place blame, and just as frequently, want to sue to recover some of the loss. The problem with the corporation holding the directors liable in a lawsuit is that it is generally the directors who make the decision as to whether the corporation files a lawsuit. Directors are obviously not going to sue themselves. Therefore, the law has developed a mechanism by which the shareholders can sue the officers or directors of a corporation on behalf of the corporation. Because the shareholders are representing the corporation in such a lawsuit, their suits are known as “shareholder derivative actions.” See NY CLS Bus Corp § 626; Cal Corp Code § 800

Given this potential liability of a corporate director or officer and the fact that many companies will fail simply because of choosing the wrong risk, who would want to become a director or officer, if accepting such a position entailed accepting a degree of risk to one’s personal wealth or position every time a decision was made? As such, corporate law has evolved to create a system where the liability of directors and officers is limited as to the extent of their liability so that corporate America may still retain a healthy body of executives to administer its corporations. 

The general rule, as described above, has evolved to create a legal doctrine known as the “business judgment rule.” In effect, the Business Judgment Rule says that the law and the courts will not allow shareholders, employees, and the public at large to question the business judgment of a company’s directors and officers. The Rule is based on the recognition of the fact that risk is an inherent aspect of business, and managers must be allowed latitude in selecting the course they deem best for their company. The ultimate outcome of the rule is that liability – both civil and criminal – will not attach to an individual director or officer so long as that person (or group in the context of the board) acted without intent to commit fraud or deceive the company and based her decision on sound business reasoning and adequate investigation. See Nebenzahl v. Miller, 1996 Del. Ch. LEXIS 113 (1996). We will discuss the business judgment rule to a greater extent in later chapters, but for now, keep this rule in mind when considering the actions of corporate managers.

EXAMPLE: Tim and Johnny are the President and VP of New World Games, Inc. The two managers, thinking they are the brightest people in corporate America, choose to go outside their knowledge base in board games, and instead, to have the company start building racing yachts. They thoroughly research the racing yacht industry, determine a business model and plan, and develop a sound strategy for the company. Given their lack of knowledge in the yacht business, the company, so to speak, sinks. Subsequently, the shareholders sue for the loss of the company’s value. Assuming that a court finds that Tim and Johnny acted with due diligence and deliberation and the shareholders went along with the change of business, then the shareholders will lose their suit.

One item of note as to the above should be discussed regarding an extreme case of management’s missteps. In cases where the evidence suggests that management, or an individual director or employee, has acted to defraud the company and its shareholders, liability will attach. In addition, gross negligence by a director can sometimes eliminate the protection of the business judgment rule. See Winters Run Condo v. McCarthy, 1996 Conn. Super. LEXIS 2164 (Conn. Sup. Ct. 1996). However, the liability – potentially both civil and criminal – resides only with the manager, and not with the company, unless the company knew or should have known of the individual’s actions. In such a situation, the corporation’s shareholders might institute a derivative suit, intended to reclaim the lost value to the company resulting from the liable act.

Liability of the Shareholders

Similar to the situation of officers and directors is the case of shareholders. Companies seeking to raise capital would find themselves speaking to empty conference rooms if potential investors came to every investment knowing that they could face personal liability solely on the basis of their investment. 

Liability as to shareholders is even more limited than that of directors and officers. This is the natural outcome of the relationship between shareholders and directors whereby shareholders have elected the managers as their agents to augment, or at least protect, their investment. Generally speaking, shareholders owe no fiduciary duty to the corporation or the shareholders. Because shareholders hold very little influence in the actual decision making processes of the corporation, they are faced with very little in the way of liability.

This commentary should not be read to mean that shareholders are totally immune from liability. On the contrary, there are certain, identifiable categories of actions that the courts have addressed in attaching personal liability to shareholders. Among these situations is a case when a shareholder knowingly pays less than the full value of the shares sold to her during a share issuance. Similarly, a shareholder who knowingly receives an illegal dividend (such as a dividend that results in the company being insolvent) will be personally liable for the amount of the dividend. 

EXAMPLE: Horace, a big investor in Tuddle’s Tuba Co., learns from one of the company’s directors that the firm is in big trouble and only has one month left of solvent operation before going bankrupt. To try and salvage some of his investment, Horace convinces the board to make a quick distribution to shareholders in an amount greater than what the company has as reserve before entering insolvency. If Horace accepts this distribution, he may be liable for that amount as he has knowingly accepted an illegal dividend. 

While other cases exist, these two examples are the instances that a legal professional is most likely to encounter in practice. The thread running through all these situations, however, should be obvious. What the courts are looking for is intent on the part of the shareholder to commit an act that is blatantly against the interest of the corporation; an act bordering on or constituting fraud. Later on in the course, we will further discuss manners in which shareholders can be liable for corporate debts.