The Doctrine of Defective Incorporation and its Tenuous Coexistence with the Model Business Corporation Act

Abstract

At common law, where an entity had failed to incorporate, its shareholders could still obtain limited liability if the courts elected to apply one of two equitable concepts – “de facto corporation” or “corporation by estoppel.” In the 1950s, an influential empirical study of cases involving these “defective incorporation” concepts concluded that courts applied them inconsistently, and that the doctrine should be abandoned. At the same time, many states were adopting the 1950 Model Business Corporation Act (MBCA), which purported to abolish the doctrine.

A subsequent regression analysis of the pre-MBCA defective incorporation cases concluded that, contrary to the earlier study, the cases were highly predictable. Another empirical study of post-MBCA defective incorporation cases concluded that courts continued to apply the defective incorporation doctrine to grant limited liability to unincorporated entities despite the MBCA’s attempt to abolish the doctrine, making cases more unpredictable than before.

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.

Keywords: corporate law, de facto corporation, corporation by estoppel, defective incorporation, limited liability, regression

JEL Classification: K22, C25