Chapter 3 Pre- incorporation Transaction by
Promoters
• Who is a “promoter”?
• A “promoter” is a person who takes initiative in founding
and organizing a business or enterprise. (SEC Rule 405)
—arranging for the necessary capital;
—acquiring any needed assets or personnel;
—arranging for the actual incorporation of the business.
The Regulation in China
• Article 80 The initiators or (promoters) of a
stock company shall undertake the
preparatory work of the company. They
shall conclude an agreement of initiators
to clarify their respective rights and
obligations during the course of
establishing the company.
Issues Concerned
• 1. Under what circumstances does the promoter become
personally liable for transactions he undertake on
behalf of the corporation?
• 2. Under what circumstances does the corporation,
once it is formed, become liable based on the promoter’s
pre-incorporation transactions? And
• 3. What, if any, are the promoter’s fiduciary obligations
to the not-yet-formed corporation?
The Liabilities of Promoters
 To outside creditors:
Promoters have significant responsibilities in the
formation of business and can become liable to outside
creditors for:
—pre-incorporation contracts they sign before the
business is incorporated
—contracts they sign for a corporation that was not
properly incorporated.
 To corporations and other investors:
—fiduciary duties of avoiding unfair self-dealings with
corporations.
—providing full disclosure to other investors during the
capital-raising process.
The Liabilities of Promoters
• If the corporation has already been formed, and
a promoter makes the contract in the
corporation’s name——
• If the promoter purports to make a contract on
behalf of a not-yet-formed corporation, the
situation is much fuzzier ——
• (To be continued next page)
The Liabilities of Promoters
• Traditional Theories of Contracts
• newly formed corporation could not ratify preincorporation contracts since no corporation existed
when the contract was entered into.
• The Restatement (Second) of Agency
• a purported agent acting for a nonexistent principal
becomes a party to the contract.
• The default rule
• The promoter is personally liable on a preincorporation contract absent a contrary intent.
The Liabilities of Promoters
• 1. Corporation not named
in promoter’s own name, without referring to the not-yetformed corporation
• 2. Contract in corporation’s name
• The contract does not on its face disclose the fact that
the corporation has not been formed as of the contract
date.
• A. Promoter knows: personally liable
• B. Later formation of corporation and adoption of
contract:
The Liabilities of Promoters
• 3. Promoter unaware that corporation hasn’t
been formed: court is more sympathetic to the promoter,
tending to find a way to relieve him of personal liability.
• 4. Contract states that corporation is to be formed:
• — most often, the promoter would have signed the
contract “for a corporation to be formed”, but it is not
conclusive, two more elements must be considered:
• 1. look to negotiating assumptions for intent
• 2. look at corporation’s action (adopt the contracts)
• (to be continued next page)
The Liabilities of Promoters
• a. Corporation never formed:
the promoter is personally liable.
b. Corporation formed, but no adoption:
the situation is the same as above.
c. Adoption by corporation:
If the corporation is eventually formed and then
manifests its intent to take over the contract.
Liability of corporation for promoter
contract
• Interests Conflicts between outside
creditors and the new shareholders.
Outside creditors: hold corporation liable
on pre- incorporation contracts.
New shareholders: would not take
“surprise” corporate liabilities.
Liability of corporation for promoter
contract
• Suppose the corporation did come into existence
afterwards.
• 1. No adoption, no liability:
The corporation does not become automatically
liable merely by coming into existence.
2. Adoption by corporation:
The corporation does manifest its assent to be
bound by the contract previously signed in its name.
(what constitutes adoption?——to be continued
next page)
Liability of corporation for promoter
contract
• What constitutes adoption?
• A. Express adoption:
• B. Implied adoption:
• Effective date:
• When adoption occurs, it is usually held not to be
retroactive to the date of the original contract.
Promoter’s fiduciary obligation to
corporation and shareholders
• During a corporation’s start-up process, promoters have absolute
control of the corporate governance machinery.
• Duties of Fiduciary and Disclosure
• Case
A and B
purchased 1million Ⅰ
Mining rights & Property
FormedⅡ Sold Assets
sold shares Ⅳ
3.25 million in note Ⅲ
One Company
claimed to rescind the notesⅤ
New Investors
Promoter’s fiduciary obligation to
corporation and shareholders
• self-dealing in a corporation is governed by a set of
fiduciary duties that directors, officers, and controlling
shareholders owe the corporation.
• Questions: To whom do promoters owe duties when they
enter into a transaction with the corporation before there
are other shareholders or creditors?
• Can the following two theories be used to infer promoters’
duties?
A and B have violated—
Fiduciary duties to the corporation, and
disclosure duties to subsequent investors and creditor
Promoter’s fiduciary obligation to
corporation and shareholders
• Not really:
• The problem with the first theory is at the time
of transaction, the promoters’ interest was
known by the corporate decision maker.
• To overcome the above, the outside
shareholders might argue that the approval
and disclosure of the transaction must await
their arrival and that the promoters stand in a
fiduciary position as to shareholders who are
expected to be brought in after the transaction.
Promoter’s fiduciary obligation to
corporation and shareholders
• The true problem is the prompters failed to
disclose the prior self-dealing when they
sold the shareholding to new investors.
Defective Incorporation and Its
Consequences
• How defects can occur?
• A. technical reasons:
• B. deceit intents:
Defective Incorporation and Its
Consequences
• The Main Point: Limited Liability or Personal Liability should be imputed
• Previously, two theories as follows dominate the judicial process:
• The first one is De facto corporation:
This doctrine requires (1) some colorable good-faith attempt to
incorporate and (2) actual use of the corporate form, such as carrying
business in the corporate name.
As to the outsiders, a de facto corporation has all the attributes of a de
jure corporation, including limited liability.
State can challenge the existence of a de facto corporation, but outside
parties cannot.
Defective Incorporation and Its
Consequences
 The second one is Corporation by estoppel.
 The theory arises when the parties have dealt with each
other on the assumption a corporation existed, even
though there has been no colorable attempt to
incorporate.
 Outsiders who rely on the representations or
appearances that a corporation exists and act
accordingly are estopped from denying corporate
existence or limited liability.
•
Defective Incorporation and Its
Consequences
• Whether a modern court uses one of these common
law doctrines to impute a non-recourse relationship
depends on two factors:
• First, does the state corporate statute permit judicial
imputation of limited liability even without
incorporation?
• Second, if so, under what circumstances will a court
impute limited liability?
Defective Incorporation and Its
Consequences
 The Trend: Modern Abolition of the de Facto and
Estoppel Doctrines
 Reason: Incorporation under modern corporate statutes
is so easy, forgiving an insider’s failure to incorporate
may be too protective.
 Statutory Liabilities MBCA §2.04 states:
All persons purporting to act as or on behalf a corporation,
knowing there was no incorporation …are jointly and
severally liable for all liabilities.
Defective Incorporation and Its
Consequences
• The Interpretation on Statutory Liabilities MBCA §2.04
• One the one hand, it’s clear that there is defective
incorporation liability when insiders deceive outsiders
about corporate status.
• One the other hand, it implies that there is no liability if
the insider purporting to act in her corporate capacity
does not know of the incorporation defect.
• Notice that MBCA’s apparent focus’s on insider’s
knowledge differs from the judicial focus on the
outsider’s understandings.
Liability for Defective Incorporation
• Actually, a comprehensive, statistical
study of the defective incorporation
cases suggests that the insider’s attempt
to incorporate and the outsider’s belief of
incorporation are critical in actual judicial
decision-making.
Liabilities During Incorporation Process for LLC:
Process of capital delivery
deposit full amount of currency
• make full payments
non-monetary properties
• checked by capital verification institution
• application made by the representative designated by all
shareholders or the agent entrusted by shareholders
• prepare a register (list) of shareholders
Liabilities During Incorporation Process for LLC
 Contractual liabilities
 The Shareholders shall make the capital
contribution:
 in accordance with the amounts and terms specified
by the articles; and
 Deposit the currency into the account of the
company; or
 Transfer the non-currency properties to the company.
Liabilities During Incorporation Process for LLC
 Q1: When a shareholder fails to make his/its
capital contribution, what liabilities should he
take?
 Example: One company has three investors: A,
B and C. Investor A promised to contribute
RMB10,000 in 2006, but he only has paid off
RMB5,000 in the end.
Liabilities During Incorporation Process for LLC
• Article 28 (Section Two) Shareholders who fail to
make capital contribution in accordance with the said
provisions shall, in addition to making the capital
contribution in full, bear liability of breach of contracts
towards other shareholders who have made their
capital contributions in full in accordance with the
schedule.
• Q2: What are the liabilities for breach of the contract of
capital contribution?
Liabilities During Incorporation Process for LLC
 Q3: What if the actual value of the capital contributions
in non-monetary properties is significantly lower than
that provided for in the articles of association of the
company?
 Example: Shareholder A provided one computer to
an IT company as capital contribution, which was
assessed as RMB 10,000 during the incorporation
process, while after the establishment of this company,
the computer was found worth 1,000RMB only.
Liabilities During Incorporation Process for LLC
• Remedies:
• The initial shareholder shall supplement
the margin, and
• Other shareholders shall bear the joint
liabilities
Liabilities During Incorporation Process for LLC
• Fiduciary duties to the companies and outside investors
•
Article 31 After the establishment of a limited liability company, if the
actual value of the capital contributions in non-monetary properties is found
to be significantly lower than that provided for in the articles of association
of the company, the balance shall be supplemented by the shareholder who
has offered them, and the other shareholders of the company who have
established the company shall bear joint liabilities.
•
Q4: What if the currency contributions are found to be significantly lower
than that provided for in the articles?
Should other shareholders bear joint liabilities?
Liabilities During Incorporation Process for LLC
• Q5：What liability should CPA undertake when the
fraud on verification of capital contribution are proved?
• Example: A company with actual registered capital at 1
million but verified by CPA as 2 million failed in the end,
and was in debt to creditors at 3 million. The creditors
claimed the CPA should be liable for 3 million jointly with
the company.
Liabilities During Incorporation Process for LLC
• Article 208 (Section 3)
• Where the creditors of the company suffer damages due
to an inaccurate valuation or capital verification issued
by an asset valuation organization or a capital
verification organization, the valuation organization or
capital verification organization shall bear compensation
liability within the scope of the inaccurate valuation or
verification unless it is able to prove that the fault does
not lie with the organization.
Related Question
 Q6: Suppose shareholder A sells his shares to B for 10
RMB/share, but does not make any modification in the
register of the company.
Then A sells the same shares to C for 20 RMB/share
and make the modification in the register of company
accordingly.
 Who shall be recognized as shareholder,
B or C?
 Answer: Article 33
Related Question
• Article 33(Section 2) The shareholders recorded in the register
of shareholders may, in light of the register of shareholders,
claim to and exercise the shareholder's rights.
• Companies shall register the names of their shareholders and
their respective amount of capital contribution with the company
registration authorities. Where there is a change in the
registration details, change of registration formalities shall be
completed. Where the registration or change of registration
formalities are not completed, no defense against third party
claims shall be made.
Liabilities During Incorporation Process for
Companies Limited by Shares
Contractual liabilities
Article 80
The promoters shall enter into a promoter’ agreement to
specify their respective rights and obligations in the
process of establishment of a company.
Fiduciary duties
Article 94
Promoters of a company limited by shares who fail to
make full capital contribution in accordance with the
provisions of the articles of association of the company
shall make up for the payment; other promoters shall
bear joint liability.
Liabilities During Incorporation Process for
Companies Limited by Shares
• Where it is discovered after the incorporation of a
company limited by shares that the actual value of noncash assets used for capital contribution for the
incorporation is significantly lower than the amount
stated in the articles of association of the company, the
promoter who made the capital contribution shall make
up for the difference; other promoters shall bear joint
liability.
Liabilities During Incorporation Process for
Companies Limited by Shares
• Fiduciary duties to the companies and outside
investors
• The promoters of companies limited by
shares shall:
• (1) bear the debts and expenses incurred for the
incorporation in the event that the incorporation is
unsuccessful; and
• (2) bear joint liability for refund of the payments made by
the subscribers and bank deposit interest for the same
period in the event that the incorporation is
unsuccessful;
• (3) compensate the company for damages incurred by
the company in the course of incorporation due to the
fault of the promoters.
Liabilities During Incorporation Process for
Companies Limited by Shares
•
A
2 Million
IP
B
C
1 Million
cash
D
3 Million
land use right
E
2 Million
cash
2 Million
cash
Daqing Stationery Product Company Limited by shares
1.
2.
3.
4.
D only paid off 1 million
Actually, C’s land use right is valued at 2 million after the incorporati
The company had raised 4 million from outside investors, and the
costs of incorporation is 100 thousand, but unfortunately, the compa
cannot be incorporated in the end.
The company was incorporated in the end, but the promoters
purchased the computers in price much higher than the market valu
Liabilities During Incorporation Process for
Companies Limited by Shares
• Comments
• Much more stricter than those in US
• Combine the liabilities of breach of
contracts and fiduciary duties.
•