BA III 2

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Business AssociationsSection III.2: Limited Liability: 

Business Associations Section III.2: Limited Liability Prof. Amitai Aviram Aviram@law.uiuc.edu College of Law University of Illinois Copyright © Amitai Aviram. All Rights Reserved S07

Limited LiabilityMBCA §6.22(b): 

Limited Liability MBCA §6.22(b) MBCA §6.22(b): 'Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct.' '…not personally liable…': Liability extends to what shareholder invested in the corporation (i.e., the shareholder’s portion of the corporation’s assets).

Limited LiabilityMBCA §6.22(b): 

Limited Liability MBCA §6.22(b) MBCA §6.22(b): 'Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct.' Distinguish between: Direct liability: SH’s actions create a legal cause of action against the shareholder, not just against the corporation. 'Piercing the [corporate] veil': SH’s actions cause limited liability to be ignored, so SH becomes liable for the corporation’s obligations.

Limiting Liability: 

Limiting Liability Hypo: Abe is a very planned person. He keeps portions of his savings in separate accounts to fund unexpected financial liabilities. For example, he keeps $20,000 in an account, to cover damages he might cause to his neighbor Bob’s apartment if his convector leaks.

Limiting Liability: 

Limiting Liability Unfortunately, Abe’s convector does leak. Even more unfortunately, the leak completely destroys Bob’s antique furniture, causing $100,000 in damages. Bob sues Abe for $100,000 and wins. Abe says he is really sorry for the damage he caused, but asks that he pay no more than $20,000, because this is the amount he allotted (in good faith) for such contingencies. Will Bob recover $100,000, or $20,000?

Limiting Liability: 

Limiting Liability Suppose that an expert civil engineer testified that $20,000 are usually more than enough to cover damage caused by a leaking convector and that only 1% of leaks cause damage higher than $20,000. Would Bob recover $100,000, or $20,000? Suppose that the apartment belonged not to Abe, but to his wholly owned corporation, AbeCo. AbeCo’s net worth was $20,000. Would Bob recover $100,000, or $20,000?

Justifying Limited Liability: 

Justifying Limited Liability What are the benefits of limited liability? Diversification: Facilitating small andamp; more risk-averse equity investments Liquidity: Facilitating transferability of equity interests

Benefits of Limited LiabilityDiversification: 

Benefits of Limited Liability Diversification Iris has $1,000 available for investment. Barbara offers that Iris will invest this money in return for a 1% interest in Barbara’s restaurant business (which is a general partnership). Iris expresses concern about the risk of losing more than her investment if the business fails. Barbara agrees to add a clause in the partnership agreement stating that Iris’ share of the losses is zero. What is the largest loss Iris is exposed to? Would Kovacik protect Iris from having to bear the losses? Iris’ problem with unlimited liability is due to her inability to diversify her small investment

Benefits of Limited LiabilityLiquidity: 

Benefits of Limited Liability Liquidity Igor saved $10,000, with which he plans to pay for law school, where he will enroll next year. Meanwhile, he wants to invest the money and reap some returns. Bob offers Igor to invest in his produce supply business (a general partnership). Igor likes the idea, but wants to make sure he can cash out easily next year. Can he do so? Igor’s problem with unlimited liability is due to it’s constraint on liquidity.

But what about the harms fromlimited liability?: 

But what about the harms from limited liability? Do creditors unfairly carry the burden of limited liability? Voluntary creditors Involuntary creditors

Are Voluntary Creditors Harmed byLimited Liability?: 

Are Voluntary Creditors Harmed by Limited Liability? Laura has $1,000 available for investment. She wants to lend the money rather than make an equity investment. Ben offers her to lend to his general partnership, while Betty offers her to lend to her corporation. Assume both firms are in the same business andamp; expect similar profits Which investment is better? If both firms have the same net assets, which firm offers access to more assets to satisfy the debt? If Betty’s corporation is highly solvent, does Laura care about not having Betty personally liable?

Are Voluntary Creditors Harmed byLimited Liability?: 

Are Voluntary Creditors Harmed by Limited Liability? But what if it is not certain that the corporation will be able to repay its debts? Assume that Laura has $500,000, diversified into 500 investments of $1,000 each. She checks the solvency of Betty’s corporation, and anticipates that there is a 90% chance that the corporation will be able to repay the loan (plus interest), and a 10% chance that the corporation will default. Suppose that the current yield for risk-free investments (e.g., a U.S. treasury bond) is 5%. Will Laura agree to lend money to Betty’s corporation at 5%? Can Betty offer Laura an interest rate that will make Laura interested in investing?

Are Voluntary Creditors Harmed byLimited Liability?: 

Are Voluntary Creditors Harmed by Limited Liability? Laura might agree to lend the money to Betty’s corporation for 16⅔ % 90% x [1+x%] + 10% x 0 = [1+5%] 0.9 + 0.9x = 1.05 0.9 x = 0.15 x = 0.1667 x = 16⅔ % Why does it matter that Laura is diversified? Can Laura contractually protect herself from default (e.g., by charging a higher interest rate) if Betty 'cooked the books' of the firm?

Are Involuntary Creditors Harmed byLimited Liability?: 

Are Involuntary Creditors Harmed by Limited Liability?

Are Involuntary Creditors Harmed byLimited Liability?: 

Are Involuntary Creditors Harmed by Limited Liability? Hypo: Concerned about the rising cost of air travel, Congress forms a commission to investigate ways to make air fares cheaper. The airlines tell Congress that liability for accidents is a major cost of air travel. Congress responds by enacting a law that eliminates airlines’ tort liability. What will this law’s effect be: On airline’s cost of providing service? On ticket prices and the number of flights offered? On the number of accidents occurring? On overall social welfare?

Externalizing Costs ofDoing Business: 

Externalizing Costs of Doing Business An externality is the characteristic that your actions affect someone else, negatively or positively. Positive externality: Maintaining an attractive front yard Negative externality: Keeping a Lion in your back yard Angela is a lion tamer. Her house is located on an isolated island. She wants to keep a lion at home so that she can work from home. There’s a 5% chance that the lion would attack her. Will Angela take this risk into account in deciding whether to keep a lion at home? Is there an externality?

Externalizing Costs ofDoing Business: 

Externalizing Costs of Doing Business Now suppose that Angela lives in a suburb. There’s a 5% chance that the lion would attack her, and a 1% chance that the lion would escape and attack a neighbor. Is there an externality? Negative or positive? Suppose that the law only holds the lion (and not its owner) liable for attacking neighbors. Would Angela take the risk to the neighbors into account in deciding whether to keep a lion at home? Now suppose that the law holds a lion’s owner liable for attacking neighbors. Would Angela take the risk to the neighbors into account in deciding whether to keep a lion at home? A law that imposes liability on Angela for harm caused by the lion internalizes the negative externality she imposed on neighbors.

Externalizing Costs ofDoing Business: 

Externalizing Costs of Doing Business Back to the airline hypo: The law in the hypo allowed airlines to externalize a cost of doing business: Causing accidents is a cost of providing air transportation, but the cost is externalized on passengers. Law in the hypo does not internalize the cost back to the airlines. Since the airlines decide on the amount of service provided and they don’t bear that cost, they will offer an excessive amount of air travel at insufficient levels of care. Moving on to Walkovszky: Are accidents a cost of running a taxi service? Does Carlton externalize this cost in Walkovszky? How and on whom? Does Walkovszky indicate a way in which law attempts to make taxi owners internalize the cost of accidents?

Walkovszky v. Carlton: 

Walkovszky v. Carlton Carlton and others had a taxicab business. They owned ten corporations, each of which owned two taxi cabs. Each cab was heavily mortgaged, and each corporation carried only the legally mandated minimum liability insurance. SHs regularly drained the corporations of assets. All cabs operated out of a single garage (held by yet another corporation). One of the cabs, owned by Seon Cab Corp., injured Walkovszky, who sued all ten corporations and Carlton. Carlton moves to dismiss. The majority opinion makes a distinction between liability based on fraud and liability based on agency. Finds no fraud, and agency cause of action was not pleaded. Why is there no fraud?

Walkovszky v. Carlton: 

Walkovszky v. Carlton Liability based on agency (Respondeat Superior) Seon Corp. acted on behalf of Carlton and subject to his control of Seon’s conduct. Therefore, Seon was Carlton’s agent. Carlton controlled Seon’s physical conduct. Therefore, Seon was Carlton’s employee. Seon’s tort was within the scope of Seon’s 'employment'. Therefore, Carlton (principal), is liable for Seon’s tort. Liability based on fraud Piercing the corporate veil: Carlton disregarded the separate existence of Seon, and it would promote injustice to require W to respect that separation. Enterprise liability: The sister companies acted as divisions of the same enterprise disregarding their separate existence, and it would promote injustice to require W to respect that separation.

Liability Based on Agency: 

Liability Based on Agency To be liable as a principal to the corporation’s torts, the corporation must first be an agent of SHs: The corporation was under SHs’ control The corporation acted on SHs’ behalf

Liability Based on Agency: 

Liability Based on Agency Corporation under SHs’ control SHs sometimes actively manage the company (by appointing themselves as directors) If SHs appoint others to be directors, the fact that SHs can replace directors suggests that the directors are subject to SHs’ control, so SHs indirectly control the company Result: Corporation is almost always under SHs’ control

Liability Based on Agency: 

Liability Based on Agency Corporation acted on SHs’ behalf Suppose that if Seon operated another cab, it would increase its profits by $10,000/year. Is that good for Seon, or good for Seon’s SHs? In other words, if Seon buys another cab, does it do it on its behalf or on behalf of its SHs? Result: Corporations almost always act on SHs’ behalf. Conclusion: If corporations are (almost) always under SHs’ control andamp; acting on SHs’ behalf, they are (almost) always the SHs’ agent. I.e., SHs are (almost) always liable for corp’s actions.

Liability Based on Agency: 

Liability Based on Agency Good bye limited liability… But this is an incorrect analysis: SHs are owners of rights in Corp, not principals. Managers are agents of Corp, not of SHs. Cause of confusion: Business entities are unusual in having a legal entity yet being owned.

Liability Based on “Fraud”: 

Liability Based on 'Fraud' SH Corp. Piercing the Corporate Veil Directors Corp. Director Liability SH Corp. Reverse Piercing Technically: Direct liability Substantively: Directors breach their duties

Liability Based on “Fraud”: 

Liability Based on 'Fraud' SH Corp. Piercing the Corporate Veil Directors Corp. Director Liability SH Corp. Reverse Piercing Technically: Vicarious liability + loss of liability shield Substantively: SHs treat Corp. as extension of their personal activities

Liability Based on “Fraud”: 

Liability Based on 'Fraud' SH Corp. Piercing the Corporate Veil Directors Corp. Director Liability SH Corp. Reverse Piercing Technically: Tracing the true ownership of corporate assets Substantively: SHs hide assets in the corporation

Liability Based on “Fraud”: 

Liability Based on 'Fraud' SH Corp. A Enterprise Liability Corp. C Corp. B Technically: PCV to SHs + Reverse piercing to sister corporations Substantively: Separate corporations act as if they are divisions in a single enterprise

Piercing the Corporate Veil: 

Piercing the Corporate Veil Conditions required to pierce the corporate veil: 'Such unity of interest and ownership that the separate personalities of the corporation and the individual [or other corporation] no longer exist' Undercapitalization Failure to maintain adequate corporate records or to comply with corporate formalities Commingling of funds and assets SH uses the assets of the corporation as his own

Piercing the Corporate Veil: 

Piercing the Corporate Veil Conditions required to pierce the corporate veil : '[C]ircumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice.' Court: prospect of unsatisfied judgment does not satisfy this prong of the test But court endorses Kreisman, in which 'unjust enrichment' satisfied the 2nd prong. Kreisman: SH defaulted on debt for purchasing equipment, and used this equipment for several years Court suggests that 2nd prong will be satisfied if SH used corp. to avoid responsibilities to creditors, or if one of the corporations will be 'unjustly enriched' unless liability is shared by all corporations.

Piercing the Corporate Veil The Injustice Prong of the Test: 

Piercing the Corporate Veil The Injustice Prong of the Test What constitutes 'unjust enrichment'? Ann buys fire insurance coverage for her house. Consider the difference between – Ann sets fire to her house andamp; Ann’s house burns (through no fault of hers)

Enterprise Liability: 

Enterprise Liability Enterprise liability occurs when: There is such a high degree of unity of interest between two (or more) entities, that their separate existence had de facto ceased; and Treating the entities as separate would sanction fraud or promote injustice.

Enterprise Liability: 

Enterprise Liability In Olympic Financial Ltd. v. Consumer Credit Corp. (S.D. Tex.), the court examined whether the corporations had: Common employees; Common record keeping; Centralized accounting; Payment of wages by one corp. to another corp.’s employees; A common business name; Services rendered by the employees of one corporation on behalf of another; Undocumented transfers between corporations; Unclear allocation of profits and losses between the corporations; The same officers; The same shareholders; The same telephone number.

Sea-Land Services, Inc.v. Pepper Source (CA7, 1991): 

Sea-Land Services, Inc. v. Pepper Source (CA7, 1991) Pepper Source shipped sweet peppers with Sea-Land and reneged on the freight bill. Sea-Land sued and won a default judgment, but Pepper Source had no assets. Sea-Land sues Marchese, the owner of Pepper Source, and some other entities. Should Marchese be liable under a PCV theory? Unity of interest and ownership? Failing to PCV will sanction fraud or promote injustice? Who else does Sea-Land sue? What’s the alleged cause of action against these defendants?

Reverse PiercingSea-Land Services, Inc. v. Pepper Source: 

Reverse Piercing Sea-Land Services, Inc. v. Pepper Source Jamar, Caribe Crown, Sales-caster (Wholly-owned by Marchese) Sea-Land is asking for 'reverse piercing'. Suppose that a bank gave Jamar a loan. The bank carefully checked what assets Jamar had, and found that Jamar had sufficient assets. The bank then lends Jamar the money, under the condition that Jamar will not take other loans until it repays the bank. What priority in liquidation did the bank bargain for? What priority does the bank have if Jamar is 'reverse pierced'?

Reverse PiercingSea-Land Services, Inc. v. Pepper Source: 

Reverse Piercing Sea-Land Services, Inc. v. Pepper Source Jamar, Caribe Crown, Sales-caster (Wholly-owned by Marchese) Solution: Pepper Source creditors can PCV Marchese and get his shares in Jamar. They would be subordinate to Jamar’s creditors, yet have the residual ownership of the money Marchese misappropriated to Jamar.

Reverse PiercingSea-Land Services, Inc. v. Pepper Source: 

Reverse Piercing Sea-Land Services, Inc. v. Pepper Source Tie-Net The company is owned 50% by George Andre and 50% by Marchese. Does Tie-Net have a unity of interest and ownership with Pepper Source? Will respecting Tie-Net’s independent existence sanction fraud or promote injustice? Let’s ask the reverse: Will PCV-ing Tie-Net promote injustice?

Suggested Criteria for PCV: 

Suggested Criteria for PCV Contract (voluntary) creditors To mitigate the risk of corporation defaulting, a contractual creditor can: Investigate corporation’s credit-worthiness; Require personal guarantees; Require higher interest to compensate for higher risk. Can a contract creditor protect herself contractually from being harmed by undercapitalization? By failure to abide by formalities? By moving assets between the firm andamp; other firms/SH? By fraud?

Suggested Criteria for PCV: 

Suggested Criteria for PCV Tort (involuntary) creditors Does a tort creditor care about SH’s respect for corporate formalities? Does a tort creditor care about corporation’s undercapitalization?

Suggested Criteria for PCV: 

Suggested Criteria for PCV PCV for a contract creditor: if SH failed to observe formalities andamp; siphoned assets between corporation and other corporations/SH, but only if creditor can’t acquire/enforce contractual protection PCV for a tort creditor: if corporation was undercapitalized Walkovszky? Creditor: Tort or Contract? Lack of formalities? Undercapitalization? No (majority opinion) Expected result? Actual result?

Comparing Our Suggested Criteria with the Case Law: 

Comparing Our Suggested Criteria with the Case Law Walkovszky Sea-Land Services? Creditor: Tort or Contract? Undercapitalization? Lack of formalities? Is contractual protection possible? Expected result? Actual result?

Comparing Our Suggested Criteria with the Case Law: 

Comparing Our Suggested Criteria with the Case Law Walkovszky Sea-Land Services

Comparing Our Suggested Criteria with the Case Law: 

Comparing Our Suggested Criteria with the Case Law Kinney Shoe Corporation v. Polan (CA4, 1991): Polan owned 100% of Industrial Realty Company ('IRC'). Certificate of incorporation was issued No organizational meeting was held; no officers elected No stock was issued; no money was paid to IRC Polan negotiated on behalf of IRC to lease a building from Kinney. IRC then leased part of the building to another corporation owned by Polan. Polan paid from his own pocket the first rental payment. Kinney did not receive any further payments. Kinney successfully sued IRC, but IRC has no assets. Court: Lack of formalities + undercapitalization → Kinney can PCV and collect from Polan.

Comparing Our Suggested Criteria with the Case Law: 

Comparing Our Suggested Criteria with the Case Law Walkovszky Sea-Land Services Kinney? Creditor: Tort or Contract? Undercapitalization? Lack of formalities? Is contractual protection possible? Expected result? Actual result?

Comparing Our Suggested Criteria with the Case Law: 

Comparing Our Suggested Criteria with the Case Law Walkovszky Sea-Land Services Kinney One yes, one maybe, one no. The criteria are not perfect predictors… No bright-line rule in PCV. Policy arguments help, but it is important to argue based on two-prong test (or equivalent in the relevant state), study similar case law andamp; analogize/distinguish

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