Why Do We Still Encounter Issues of Promoter Liability? Menard, Inc. v. Dial-Columbus, LLC

The normal treatment where a promoter purports to enter into a contract on behalf of a corporation that has not yet been formed is that the promoter is personally liable. Here is a summary of the normal treatment:

  • The promoter is personally liable for pre-incorporation contracts.
  • The corporation becomes liable not merely upon formation but upon adoption. This is sometimes referenced as “ratification”. A somewhat tedious observation is that one formally cannot ratify a contract where the person purporting to ratify the contract was not in existence as of the time of the contract. Hence, avoiding tedious distraction is facilitated by referencing this as an “adoption”.
  • Acceptance of benefits constitutes adoption.
  • The promoter is not discharged upon corporation becoming bound, unless creditor assents to substitution (novation).
  • A novation exists where the newly-formed entity accept benefits “if performance is made with the understanding that a complete novation is proposed”.

More after the break …

One can see all this in, for example, Jacobson v. Stern, 605 P.2d 198 (Nevada 1980). Note the court states, at 201:

“However, liability of the corporation by adoption does not, absent a novation, end the liability of the promoter to the third party.”

To be clear, this liability attaches to a promoter even if, at the time the contract was formed, the obligee thought it was dealing with an entity and intended at that time for only the entity to be bound.

One supposes the need for an express novation in order to eliminate the promoter’s liability derives from considerations of options. Allowing the promoter to eliminate liability by forming the entity and then having it partially perform creates an option. The costs of forming an entity are minor. If that were all that was required to eliminate the promoter’s liability, the promoter would have an ongoing ability to terminate personal liability by a ministerial act of forming an entity, and potentially substituting a judgment-proof obligor having trivial assets, and have it do something trivial amounting to an adoption.

A primary circumstance in which the corporate form should not be respected is where one running a firm causes the appearance of assets subject to claims by obligees that are not, in fact, subject to those claims. Shuffling of assets would be one manifestation. But treating mere formation and adoption of the contract as sufficient to terminate promoter’s liability would be a similar circumstance.

Are LLC’s Different?

Menard, Inc. v. Dial-Columbus, LLC, 2014 WL 3586091 (8th Cir. 2014), addresses the same issue, in the context of an LLC. Should the answer be different? No. The same principles are at-work, whether the entity to be formed is a corporation or an LLC. It is expected that, as a default, when parties purport to contract on behalf of entities, they intend to give rise to a current obligation. If the putative principal does not exist, the putative agent, contracting behalf of the putative principal, would need to be liable personally as of that time. If not, the contract would be ineffectual for lacking two parties.

This imposition of personal liability upon a promoter when the promoter has entered into an agreement on behalf of the proposed corporation is based upon the principle that one who acts on behalf of a nonexistent corporation is himself personally liable on the contract unless there is an agreement to the contrary.

In re Rothman, 204 B.R. 143, 151 (E.D. Pa. 1996). The nature of the entity for these purposes is not relevant.

Menard v. Dial-Columbus

Into this challenging context is a claim one signing on behalf of a non-existent LLC should not be liable for the obligation, where the LLC was thereafter formed.

As noted above, to effect a novation, releasing the promoter, there would need to be an intent, as of the time the putative novation happens, to release the promoter and substitute the newly-formed entity. Mere reference to the intent as of the time the contract was formed is not sufficient. Only reference to an intent to effectuate a novation at that time eliminates the option value of speculation that is at the heart of circumstances in which the forms giving rise to limited liability are not respected.

It is very easy to form an LLC. There is rarely a persuasive excuse for not having properly formed one.

Repealed Statutory Provision

The plaintiff’s response brief notes a repealed section Neb. Rev. Stat. 21-2635 provided “All persons who assume to act as a limited liability company without authority to do so shall be jointly and severally liable for all debts and liabilities of the company.”

The old MBCA includes this kind of provision. Robertson v. Levy, 197 A.2d 443, 447 (D.C. Ct. App. 1964) indicates this statutory language eliminates principles of corporation by estoppel and de facto corporation:

We hold, therefore, that the impact of these sections, when considered together, is to eliminate the concepts of estoppel and de facto corporateness under the Business Corporation Act of the District of Columbia.

As it is so easy to form a corporation, the principle being, there no longer is a justification for allowing the shield of limited liability to extend to those who do not perform the trivial acts to form the entity.

Now, some jurisdictions have equivocated when it comes to extending liability to persons who did not actively participate in the business. However, regardless of whether one would extend the liability to passive investors, the liability would clearly attach to a primary participant.

The corresponding provision in an LLC statute provides no comfort to one who signs an agreement on behalf of an unformed LLC.