CHAPTER 39
CORPORATE FORMATION
AND FINANCING
ANSWERS TO QUESTIONS
AT THE ENDS OF THE CASES
CASE 39.1—QUESTION (PAGE 758)
THE ETHICAL DIMENSION
Was it acceptable for the Williams’ to demand $125,000 each for their shares? Why or why not? In this
CASE 39.2—QUESTIONS (PAGE 765)
THE LEGAL ENVIRONMENT DIMENSION
Did Alabama MBA exist as a de jure corporation when it entered into the contract with W.P. Media?
Why or why not? No. A de jure corporation is a firm that has substantially complied with all applicable
laws—particularly by filing of articles of incorporation—and has been recognized as a corporation.
Alabama MBA was not a de jure corporation at the time the operating agreement was executed because
its articles had not yet been filed.
WHAT IF THE FACTS WERE DIFFERENT?
Would the result in this case have been different if the parties’ contract to build and operate a wireless
network had been negotiated and agreed to entirely online? Discuss. No. The method by which the
CASE 39.3—QUESTIONS (PAGE 768)
1A. Schultz argued that even if the corporate veil should be pierced, the $450,000 judgment against
him was too much and should be reduced. How might the court have responded to this argument? The
court refused to give much credence to Schultz’s argument. The court stressed that once the corporate
veil had been pierced, Schultz could have been liable for the full amount owed by Intra-Med to GE. The
court pointed out that at the initiation of this lawsuit, Intra-Med still owed GE approximately $4 million.
GE could have sought to recover the entire amount from Schultz but instead settled for $1,150,000—
and then later for $450,000. Thus, stated the court, the $450,000 judgment was not excessive.
2A. Suppose that Schultz had turned over the proceeds from the sale of his properties to his
corporation, Intra-Med, and used them to pay part or all of GE’s judgment. In this situation, if the funds
were insufficient to cover the debt, would the court have pierced the corporate veil to obtain the
balance from Schultz personally? Explain. It is hard to say with certainty what the outcome of the case
would have been in this situation. The court listed the three elements that must be established to
pierce the corporate veil under the “instrumentality theory”—the corporation must be a mere
instrumentality of the shareholder; the shareholder must exercise control over the corporation in such a
way as to defraud or to harm the plaintiff; and a refusal to disregard the corporate entity must subject
ANSWERS TO QUESTIONS IN THE REVIEWING FEATURE
AT THE END OF THE CHAPTER
CHAPTER 39: CORPORATE FORMATION AND FINANCING 345
1A. Theory
The court would be likely to pierce the veil of the corporation and hold Sharp personally liable. Because
he commingled personal funds with corporate funds and generally treated the business as his alter ego,
as one would treat a proprietorship, the limited liability that accompanies corporate status could be lost.
2A. Articles
Sharp is likely to be personally liable based on piercing the corporate veil due to ignoring the corporate
form. Technical details in the articles of incorporation alone would not be likely to result in liability being
imposed; the fact that the entire operation ignored the corporate status matters more in losing the
liability shield.
4A. Classification
The corporation was formed and operated in Georgia, so it is a domestic corporation. It is owned by one
person, so it is private; its stock is not traded, so it is also a close corporation.
ANSWER TO DEBATE THIS QUESTION IN THE REVIEWING FEATURE AT THE
END OF THE CHAPTER
The sole shareholder of an S corporation should never be able to avoid liability for the torts of
her or his employees. Perhaps it makes sense to allow individuals to use business organization forms
that allow them to pass through profits to their personal tax returns, but it makes little sense to allow
them to escape liability with such structures when their employees or agents commit torts. Normally,
employees do not have liability insurance or even assets that could pay for tort judgments against them.
Those who suffer from these torts would therefore end up with nothing, even if they win at trial.
ANSWERS TO QUESTIONS AND CASE PROBLEMS
346 UNIT EIGHT: BUSINESS ORGANIZATIONS
AT THE END OF THE CHAPTER
39-1A. Incorporation
(Chapter 39—Pages 753–754)
By incorporating, the partnership will create a separate legal entity, the corporation. The corporation is
owned by shareholders (in this case the former partners), who elect the board of directors. The board
39-2A. QUESTION WITH SAMPLE ANSWER: Preincorporation
(a) As a general rule, a promoter is personally liable for all pre-incorporation contracts made
(1) The promoter’s contract with a third party can stipulate that the third party will look only
to the new corporation, not to the promoter, for performance and liability.
(2) The third party can release the promoter from liability.
(3) After formation, the corporation can assume the contractual obligations and liability by
and (3) Peterson’s contract with Babcock did not limit Babcock to holding only the corporation liable.
(Peterson’s liability was conditioned only on the corporation’s formation, which did occur.)
39-3A. Ultra vires doctrine
(Chapter 39—Page 766)
39-4A. Corporate powers
(Chapter 39—Page 766)
The court issued a summary judgment in InterBel’s favor, concluding that its Internet service was not
ultra vires. Weber appealed to a state intermediate appellate court, which affirmed the lower court’s
39-5A. Torts and criminal acts
(Chapter 39—Pages 754–755)
The court found that Allen personally participated in, directed, or authorized all of the violations of Allen
Construction’s duty to perform in a workmanlike manner. The court decided, however, that Allen was
39-6A. CASE PROBLEM WITH SAMPLE ANSWER: Torts and criminal acts
A corporation can be liable under the doctrine of respondeat superior for the torts of its agents or
39-7A. Improper incorporation
(Chapter 39—Pages 764–765)
The plaintiffs in this case asserted the theory of corporation by estoppel to support their claim for
wrongful interference with a contractual relationship. Under that theory, if an association that is not an
39–8A. Piercing the corporate veil
(Chapter 39—Page 766)
The appellate reversed the trial court’s opinion as it relates to the piercing of the corporate veil. The
appellate court pointed out that genuine issues of material fact existed as to whether Smith’s
39-9A. A QUESTION OF ETHICS: Improper incorporation
(a) The sign indicated—at least to Weimar—that an impartial trial could not be had. A judge
or a juror asked to make a finding or render a conclusion in this dispute might perceive the sign as an
endorsement of Lyons or his corporation—or so Weimar likely contended. Because the sign was on the
courthouse lawn, so Weimar’s argument might have run, it could be interpreted as implying that the
court favored Lyons. The court denied the motion for a change of venue, apparently because it did not
accept Weimar’s assertion of certain partiality in the existence of the sign.
(b) The court applied the doctrine of corporation by estoppel and denied Weimar’s motion to
dismiss the counterclaim. Weimar argued that the doctrine’s application in this case “makes no sense
because a dissolved corporation does not exist and could not receive payment on any judgment
awarded in its favor.” The court ultimately ruled in the defendants’ favor. Weimar appealed to the
Montana Supreme Court, which upheld the lower court’s ruling. The state supreme court explained that
under the doctrine of corporation by estoppel if “a business held itself out as a corporation, and . . . a
third party dealing with it assumed it to be a corporation, both the corporation and the third party are
estopped from raising the issue as to whether or not the corporation is validly incorporated. In short, the
fact that an entity is not a corporation should not, in and of itself, be a defense to an otherwise valid
obligation.” The court noted that these principles cover an entity “whose certificate has been revoked by
the state.” The doctrine of corporation by estoppel “prevents a party from denying a party-corporation’s
status. The doctrine may apply to the corporation itself, or to the corporation’s opponent.”
(c) The court concluded, and on appeal the Montana Supreme Court upheld, that the parties’
written contract was a “fixed price” transaction, but that the oral agreements were on a time-and-
materials basis. The court found that the written contract was for identified work at a price of $19,810,
followed by “a series of binding oral agreements” for additional work. Lyons had completed the work he
had agreed to, but some of the work had not been done in a workmanlike manner.
350 UNIT EIGHT: BUSINESS ORGANIZATIONS
With respect to the deficiencies, Weimar had waived some of them by accepting them or by
causing them when he insisted on hasty performance or had his own employees perform improper
preparation (form) work. In a rush to complete the project, Weimar “repeatedly advised his
subcontractors to disregard [Lyons’] potential defects.” The court entered a judgment in Lyons’s favor
for $16,763, plus interest, costs, and attorney’s fees. For the deficiencies attributable to Lyons’s work,
the court credited Weimar with $8,967.19 for their repair.
ANSWER TO VIDEO QUESTION NO. 39–10
Corporation or LLC: Which Is Better?
(a) Compare the liability that Anna and Caleb would be exposed to as
shareholders/owners of a corporation versus as members of an LLC. In a corporation, Anna and
Caleb, as shareholders/owners, would not be held personally liable for paying the corporation’s
debts. Anna and Caleb would also enjoy limited liability in a LLC. Members in an LLC can be held
(b) How does the taxation of corporations and LLCs differ? Corporations pay income tax
on net profits, with no deduction for dividends, and then the shareholders pay income tax on the
dividends they receive. In other words, corporations are subject to double taxation. The LLC is
not (necessarily) taxed as an entity, but its members are taxed personally on profits “passed
through” the LLC. If the LLC has more than one member, however, the members can choose to
be taxed as a corporation or as a partnership. Although there can be significant differences in
the way the two business forms are taxed, it may not, in reality, mean that Anna and Caleb
realize more profit by forming a LLC. The only thing that can be said for sure is that Anna and
Caleb would, by forming an LLC, would have greater flexibility in choosing how the business is
taxed (as a partnership or corporation).
can you think of any drawbacks to forming an LLC? There are two possible drawbacks to becom–
While a corporation is considered to be a citizen of the state where it is incorporated, LLCs are
frequently deemed by the courts to be citizens of every state in which their members are citi–
zens. Thus, if Anna and Caleb live in different states or if Wizard Internet has members in other
CHAPTER 39: CORPORATE FORMATION AND FINANCING 351
states, the LLC may be deemed a citizen of all of those states. This would be a problem in the
event that the company is sued and wants to claim that a federal court has diversity jurisdiction,
and the plaintiff lives in the same state as one of the LLC members. The second potential
disadvantage is that state LLC statutes are not yet uniform. This can cause some uncertainty of
how liability issues will be resolved. Anna and Caleb would need to check to make sure that the
rules in other states in which the firm does business recognize their limited liability status.
Although most states will now apply the law of the state in which the LLC was formed, some may
not. Also, Internet businesses may conduct business outside the United States in places that do
not recognize LLCs, which would complicate matters for Anna and Caleb in the event of a lawsuit
brought against them by a foreign entity.
(d) If you were in Anna and Caleb’s position, would you choose to create a corporation or
LLC? Why? The answer to this question will vary, of course, because individuals will see the
matter differently. The object of the question is to have students analyze and assess the
differences between the two business forms in terms of the factors listed in the text and those
brought up in the video (such as a corporation’s ability to raise capital).