Fellow BLPB editor, Stefan Padfield, raised some insightful questions on the continued reach and impact of defacto corporation doctrines and corporation by estoppel in an earlier, offline conversation. [Stefan uses my Business Organizations casebook offered on the electronic platform ChartaCourse and was graciously providing me some feedback]. The conversation raised two related groups of questions. First what is the continued import and application of defacto corporation doctrine in a world of standardized incorporation processes. Long gone are the days of lost mail (lost Email maybe) and corrections can be made nearly instanteously and will relatively little cost in the event of typos or other defects. To what extent does the de facto doctrine, long a staple of the survey law school course on corporations, still play a relevant role in practice. I understand all of the doctrinal reasons law professors may want to continue to teach it because it tests the outer limits of the substance over form debate in corporations and the begs the questions how fragile or strong is the legal fiction of separately incorporated entities. It is nearly as fun as piercing the corporate veil! But in [insert finger quotes here] "real life" or "practice" how relevant is this doctrine?
The MBCA Section 2.04 Liability for Preincorporation Transactions states "All persons purporting to act as or on behalf of a corporation, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting." Despite earlier attempts to eliminate the doctrine of de facto corporations ("Therefore a de facto corporation cannot exist under the Model Act. Comments to section 56 in 1969 Model Act), the current version makes clear that the de facto doctrine lives on. "A number of situations have arisen, however, in which the protection of limited liability arguable should be recognized even though the simple incorporation process established by modern statutes has not been completed."
The MBCA, as a uniform statute, is a guide, but not operative law under individual state corporate charters. An initial count finds 27 jurisdictions with statutory language expressly acknowledging a knowledge-based standard for de facto corporations similar to that established in the MBCA. Many other states recognize de facto doctrine solely through case law. A few jurisdictions, such as Alaska and Idaho explicitly abolish de facto corporations via statutory text. Idaho recently changed the statute to state: "All persons purporting to act as or on behalf of a corporation, when there was no incorporation under this chapter, are jointly and severally liable for all liabilities created while so acting." Idaho Code Ann. § 30-29-204 (West)The highlighted word "when" replaced "knowing".
Academic interest in de facto corporation doctrines, a hot topic in the early 1900's (see, e.g. Edward H. Warren, Collateral Attack on Incorporation A. De Facto Corporations, 20 Harv. L. Rev. 456, 479-80 (1907)), has waned. One exception is the 2009 article The Doctrine of Defective Incorporation and its Tenuous Coexistence with the Model Business Corporation Act, by Timothy Wyatt,
This paper revisits the earlier studies and demonstrates that the apparently inconsistent findings were the result of analytical flaws. The paper then presents a new extensive study of post-MBCA defective incorporation cases, and demonstrates by statistical regression that the courts have continued to apply the defective incorporation doctrine (the MBCA notwithstanding) and that the courts have applied the doctrine in a way that is highly predictable: Where the defendant is active in the management of a business entity that is not validly incorporated, he will not be held personally liable for his actions on behalf of the corporation so long as he believed the corporation was valid at the time of the actions.
I conclude that, for the situation where the shareholders of a defective corporation seek limited liability, the concepts of “de facto corporation” and “corporation by estoppel” are largely indistinguishable and are really two different ways of stating the unitary common-law doctrine of defective incorporation. The outcomes of these cases are highly predictable if one considers whether the shareholder of the defectively incorporated entity is acting in good faith—a factor that has been neglected by previous commentators. I also conclude that, while the attempted abolition of the defective-incorporation doctrine by the MBCA injected some uncertainty into the outcomes of cases, the courts largely ignored the MBCA on this point. In fact, the judicial backlash against attempts to legislate defective incorporation out of existence may actually have strengthened the doctrine.
My initial reading of this is that attempts to eliminate the doctrine have failed. De facto corporations remains intact and a relevant legal theory. Justifications for removing de facto incorporation persist even though the process of incorporation has changed. The bottom line is that human error may still necessitate the doctrine. At a minimum, a variety of jurisdictions agree as evidenced by statute or common law.
Related to the inquiry on de facto corporations is the extension of any changes or continued relevance to the uncorporate entities space. Those issues will be tackled in a separate post.
-Anne Tucker