Flyover 5 - Formation Veil Piercing

Now we're going to turn to corporations and LLCs. My goal here is not to teach you every possible thing about corporate law but to give you core concepts you can apply on the MEE. We're going to start with formation, pre-organization transactions, and veil piercing.

Formation

Both corporations and limited liability companies, LLCs, are formed by filing some paperwork with a state government. Let's run through each in turn.

Corporations

Corporations are formed when a person, often dubbed the incorporator, files articles of incorporation with the state. Often this document will be called a corporate charter. The corporate charter will normally include the corporation's name, for-profit or nonprofit status, the corporation's registered agent for service of process, the number of shares authorized, and anything else the incorporator decides to put in. The incorporator may adopt initial bylaws and appoint the initial board of directors.

Corporate charters may also include special provisions. They can specify special rights for certain kinds of shares. The rights any share will have must be set out in the charter. Common shares are the default. The share of common stock comes with one vote per share and the right to the shareholders' pro rata portion of anything left over if the corporation goes bankrupt. Corporate charters may also limit how much liability directors may face for causing harm to the corporation.

Corporations are limited liability entities, and shareholders do not have personal liability for the corporation simply because they are shareholders. Corporations are more formal and hierarchical entities. The bylaws may not contradict anything within the corporate charter. Amending the bylaws may be done by whatever method is set out in the bylaws or by a shareholder vote at the annual meeting if there is nothing in the bylaws about how to amend the bylaws.

Limited Liability Corporations

Limited liability companies differ from corporations in significant ways. These are more informal entities. An LLC may be formed by going to the state and filing articles of organization or a certificate of formation. This document will contain the LLC's name and the name of the LLC's registered agent. An LLC will ordinarily have an operating agreement, which specifies everything else about how the LLC will run.

Unlike the corporate context, the operating agreement will control in the event of any conflict with the articles of organization. The one exception to this rule is that the articles of organization may control if some third party without access to the operating agreement relies on it.

An operating agreement is a flexible document, and members of an LLC may contract through it for however they want to operate their LLC. The holders of equity interest in an LLC are members of the LLC. An LLC may be managed by its members, or it may employ a manager to manage the LLC on behalf of the members.

Pre-Organization Transactions

Persons promoting and forming LLCs and corporations will have personal liability if they start signing contracts or incurring liability in the name of the entity before it is formed. Once the entity is formed and operating, the promoter will still have liability for anything they did before formation.

Sometimes promoters will want to sign deals before formally forming the corporation. One way to manage this risk is for the contract to specifically disclose that the entity has not yet been formed and for the counterparty to contractually agree to look only to the entity for recovery once the entity has been formed.

Promoters owe fiduciary duties to the corporation's future shareholders and may be liable for any breach of the duty after the corporation is formed. This means that a promoter may be liable for any profit they make from breaching their fiduciary duties. A promoter will also have a disclosure duty to reveal any way she makes profit off the corporation. Subscribers may consent to the promoter taking some profit, but the promoter should not be making secret profits by hiding important information.

Corporate promoters may also have investors sign subscription agreements before incorporation. When investors sign a subscription agreement, they agreed to buy a certain number of shares at a particular price per share. Later, when the corporation is formed, the directors will issue stock to subscribers.

Veil-Piercing

Both corporations and LLCs grant equity holders limited liability, meaning that their personal assets are not ordinarily at risk on account of the entity's actions. This has been described as the veil of limited liability. Veil piercing occurs when courts look through the entity and make either the shareholder of the corporation or the member of the LLC personally liable for the entity's liability.

Veil piercing remains an equitable doctrine, and courts do not always reach the same conclusions on similar facts. Most consider two factors in evaluating a veil piercing request: (1) whether the owner of the entity used it as an alter ego, and (2) whether some inequity or injustice would result from upholding limited liability.

The test may be applied somewhat differently with corporations and LLCs. As corporations are more formal entities, a failure to observe corporate formalities may make it more likely that courts will pierce the veil. In the LLC context, LLCs are largely informal entities and thus the failure to keep formal records should not be as significant.

In evaluating injustice, courts require more than that the liability will not be paid if the court upholds limited liability. For example, courts may be likely to pierce the veil if the owner of an entity has siphoned assets off after knowing that some liability might arise. Courts are more likely to pierce the veil when limited liability has been abused to leave creditors without recovery.

Summary

Here are some key takeaways. Corporations are more formal and hierarchical entities than LLCs. A corporate charter must describe the amount of stock its board may issue and the characteristics of any share. LLCs are informal entities and will generally have an operating agreement containing the rules for how the LLC will operate.

Promoters may face personal liability for actions taken before forming an entity. Promoters also owe fiduciary duties to deal fairly with persons who subscribed for shares. Courts may pierce the veil and impose personal liability in some circumstances. Courts usually consider whether the entity has been used as someone's alter ego and if upholding limited liability would be unjust.