Your Tenant Is in Default, But the Entity Does Not Exist

A promoter is a person who takes an active part in inducing the formation of a company whether he afterwards becomes connected with the company or not. (Ex-Mission Land and Water Co. v Flash, 97 Cal. 610; Marsh California Corporation Law, Fourth Edition, Section 11.01.) Promoter liability is an equitable remedy providing that those dealing with promoters of an entity that is yet-to-be-formed should be left with the double security of the promoter and the company when one is formed, unless it clearly appears that the liability of the promoter was not intended, or that it was intended to be released when the liability of the corporation began. (Brisacher v. Baier, supra 67 Cal. App. at 101.)

In Brisacher, an attorney drafted an option contract for the defendants who were forming a corporation. Once it was completed, one of the defendants, Baier, signed the option agreement. The attorney was then instructed by the defendants to draft organizational documents for the formation of the corporation. As a result of the inability of the defendants to sell its stock, the corporation was never operational. The attorney sued the defendants for unpaid services, and the defendants argued that since the services were rendered on behalf of the corporation, they should not be liable as individuals. The court held that the defendants were liable as joint venturers and joint promoters because they had expressed at meetings with the attorney that they were working together on the deal; they were all present at the signing of the option agreement; and they each paid $2,000 toward the first payment owed under the option agreement. The court held that “Promoters of a corporation are personally liable for the contracts made by them, or by agents authorized by them, preliminary to its organization.” (Id.) Since the corporation was formed for the benefit of the defendants and the corporation never functioned, the court found that the defendants, as the promoters, were personally obligated to pay for the attorney's services.

Even though the promoter may assume to act as an agent on behalf of a projected corporation, the promoter is personally liable because he or she cannot be deemed an agent of an entity that does not exist. (Shell Oil Co. v. Hanchett (1936) 18 Cal. App. 2d 240, 243.) In Shell, the defendant was organizing a new taxicab business. An oral contract was entered into between the defendant and Shell pursuant to which Shell agreed to sell gas to the defendant at a certain price. Deliveries began to be made under this contract, and the products were billed to the defendant personally. The new corporation was later formed and the defendant insisted that thereafter the billings should be charged against the corporation and not himself as an individual. Shell complied with the defendant's request. At some time after this arrangement began, a gas war broke out and since gas could be bought at retail from dealers at a price less than the defendant was paying under his contract, he demanded to enter into a written contract between Shell and himself as an individual, so that he could take advantage of the lower gas prices. The defendant's business later went into bankruptcy. When Shell demanded payment from the defendant for the gas provided to him under the contract, he argued that the only reason for the written contract was to prevent any later disputes over the price he was to pay for gasoline, and that the parties' earlier oral agreement and understanding (as evidenced by the plaintiff modifying its practice from billing the defendant to billing the corporation) was that the corporation, not the plaintiff, was liable for the payment of the gas. Shell argued that even if the oral contract controlled over the written contract, the defendant would still be liable because he entered into such agreement before his corporation came into existence and without any express agreement that Shell was to look only to the corporation for payment. The court held in favor of Shell, stating that, even though the defendant may have assumed to be acting on behalf of the soon-to-be-formed entity, he could not have entered into a contract as an agent for the corporation since it had not yet been formed.

Instances Where Promoter Liability May Fail

However, there are circumstances that would prevent a party from holding the signatory liable as a promoter. If there is evidence sufficient to support a claim that the parties intended the contract to be made in the name of, and solely on the credit of, the future corporation, and the defendant did not represent that the corporation was then in existence, the signatory would not be liable as a promoter of an entity not-yet-formed. (MacDonald v. Arrowhead Hot Springs Co. (1931), 114 Cal. App. 496, 501.) Whether a contract is incurred on the credit of the corporation to be formed, as opposed to the individual, can be a question of fact or law, depending on the circumstances. (Id.)

Plaintiffs have argued that if the entity existed but was suspended at the time of entering into a contract, the individual signatory should be liable under the contract. However, courts have held that the suspension of a corporation's powers, rights and privileges does not cause the corporation to cease to exist. Consequently, the actions that would have been considered those of the corporation before the suspension continue to be viewed as the actions of the corporation during the suspension. (United States v. Standard Beauty Supply Stores, Inc. (9th Circuit, 1977), 561 F.2d 774, 777.) In Standard Beauty, the sole shareholder of the company, Hal Linden, purchased the shares of Standard Beauty, unaware that the company was delinquent in the payment of its California franchise taxes. Linden, in his capacity as president of the company, then entered into a contract on behalf of Standard Beauty for the purchase of assets owned by O'Henri's, Inc. The purchase of the assets was subject to any then-existing indebtedness, including a loan guaranteed by the Small Business Association (SBA). Due to the delinquent payment of the franchise taxes, at the time of its purchase of the O'Henri's, Inc. assets, Standard Beauty's corporate powers, rights and privileges were suspended pursuant to California Revenue & Taxation Code Section 23301. The plaintiff, SBA, argued that since the company's rights were suspended at the time of Linden's execution of the contract, Linden was individually liable under the loan. The court held that although California Revenue & Taxation Code Section 23304 provides that any contract made by an entity during a period of suspension is voidable by any other party to the contract, the code does not support holding the individual signatory liable. The court rejected the plaintiff's argument that Linden was personally liable, and held that the corporation, not the individual signatory, is liable under its contracts even if such contracts are entered into during a period of suspension. (U.S. v. Standard Beauty Supply, supra, 561 F.2d at 777.)

How Can a Landlord Avoid This Situation?

There are some simple things that every landlord can do to avoid falling into this situation. First, the landlord should confirm that the entity it is entering into a lease which does, in fact, exist at the time of entering into the contract. This usually can easily be accomplished by a quick and free search on the secretary of state's website. The landlord can require, as a condition to the lease, that the tenant provide copies of its corporate filings and a corporate resolution approving entering into the lease. The lease should also include a representation and warranty by tenant that the entity is lawfully organized, is in good standing, and is authorized to operate business in the state in which the premises is located. Taking these steps will help ensure that the landlord knows with whom it is doing business and can be reasonably assured that it will know against whom its recourse lays in the event of a tenant default.

How Can a Promoter Avoid This Situation?

A promoter, even more so, ought to be careful to avoid this situation. Typically, tenant-entities will be single-purpose entities formed to shield the principals from personal liability. If the principals and promoters are careless, they may be exposing themselves to the liability that they inended to avoid by forming a separate tenant-entity. The best answer is not to enter into any agreements as an authorized signatory for the entity until it is, in fact, lawfully formed. However, if for any reason the entity is not lawfully formed at the time of entering into the lease, the promoter must disclose to the landlord that the entity is not yet formed, and obtain the landlord's written agreement that once the entity is formed, it will only look to the entity for performance under the agreement. Once the entity is formed, the promoter should also have the entity ratify the contract.

Conclusion

Discovering upon an event of default that the tenant-entity did not exist when it entered into the lease may seem like an unfortunate event but it may actually be a boon. Under promoter liability law, the landlord quite possibly could be in a better position than it would be if the entity had been formed at the time of execution of the lease. Since the tenant is likely in default because of financial failure, seeking a judgment against the tenant-entity could be a pointless endeavor. However, under the right circumstances, promoter liability law might provide the landlord with recourse that it would otherwise not have.

Kevin Montee is a Partner at the firm of Horner & Singer, LLP, Walnut Creek, CA. His practice focuses on business and commercial real estate litigation, primarily in the areas of commercial landlord representation including commercial unlawful detainers, breach of lease actions, the enforcement of judgments and tenant bankruptcies. Monica Sloboda is an Associate at the firm.

More often than you might think, landlords enter into leases with tenant-entities only to find later, when the tenant defaults under the lease, that the tenant-entity was never lawfully formed or did not exist at the time of entering into the lease. The tenant might be anxious to finalize the lease and is in the process of forming a single-purpose entity, but has not completed that process for one reason or another. The parties might be hasty and not as diligent as they should be with regard to the formalities of the transaction and the signatory executes the lease on behalf of an entity that does not yet exist. Does this mean that the landlord has no remedy? Not necessarily. In fact, under promoter liability law, such a situation may provide a better potential for recovery than if the entity did exist!

Promoter Liability Law

Under promoter liability law, if the signatory is determined to be a promoter for the tenant-entity, the landlord who finds that such entity does not exist may have personal recourse against the signatory. “As a general rule, when a promoter makes a contract for the benefit of, or in the name of, a prospective corporation, he is personally liable on the contract in the absence of an agreement with the contracting party that the promoter is not liable.” (18 Am. Jur. 2nd Corporations ' 137.) Further, under California case law, if the tenant-entity was formed subsequent to the promoter's execution of the lease, the landlord may be able to recover from the entity as well as the individual promoter. (Brisacher v. Baier (1924), 67 Cal. App .96,1401, holding that “Those dealing with promoters should be left with the double security of the promoter and the company when one is formed, unless it clearly appears that liability of the promoter was not intended or was intended to be released when the liability of the corporation began.”)

A promoter is a person who takes an active part in inducing the formation of a company whether he afterwards becomes connected with the company or not. (Ex-Mission Land and Water Co. v Flash, 97 Cal. 610; Marsh California Corporation Law, Fourth Edition, Section 11.01.) Promoter liability is an equitable remedy providing that those dealing with promoters of an entity that is yet-to-be-formed should be left with the double security of the promoter and the company when one is formed, unless it clearly appears that the liability of the promoter was not intended, or that it was intended to be released when the liability of the corporation began. (Brisacher v. Baier, supra 67 Cal. App. at 101.)

In Brisacher, an attorney drafted an option contract for the defendants who were forming a corporation. Once it was completed, one of the defendants, Baier, signed the option agreement. The attorney was then instructed by the defendants to draft organizational documents for the formation of the corporation. As a result of the inability of the defendants to sell its stock, the corporation was never operational. The attorney sued the defendants for unpaid services, and the defendants argued that since the services were rendered on behalf of the corporation, they should not be liable as individuals. The court held that the defendants were liable as joint venturers and joint promoters because they had expressed at meetings with the attorney that they were working together on the deal; they were all present at the signing of the option agreement; and they each paid $2,000 toward the first payment owed under the option agreement. The court held that “Promoters of a corporation are personally liable for the contracts made by them, or by agents authorized by them, preliminary to its organization.” (Id.) Since the corporation was formed for the benefit of the defendants and the corporation never functioned, the court found that the defendants, as the promoters, were personally obligated to pay for the attorney's services.

Even though the promoter may assume to act as an agent on behalf of a projected corporation, the promoter is personally liable because he or she cannot be deemed an agent of an entity that does not exist. (Shell Oil Co. v. Hanchett (1936) 18 Cal. App. 2d 240, 243.) In Shell, the defendant was organizing a new taxicab business. An oral contract was entered into between the defendant and Shell pursuant to which Shell agreed to sell gas to the defendant at a certain price. Deliveries began to be made under this contract, and the products were billed to the defendant personally. The new corporation was later formed and the defendant insisted that thereafter the billings should be charged against the corporation and not himself as an individual. Shell complied with the defendant's request. At some time after this arrangement began, a gas war broke out and since gas could be bought at retail from dealers at a price less than the defendant was paying under his contract, he demanded to enter into a written contract between Shell and himself as an individual, so that he could take advantage of the lower gas prices. The defendant's business later went into bankruptcy. When Shell demanded payment from the defendant for the gas provided to him under the contract, he argued that the only reason for the written contract was to prevent any later disputes over the price he was to pay for gasoline, and that the parties' earlier oral agreement and understanding (as evidenced by the plaintiff modifying its practice from billing the defendant to billing the corporation) was that the corporation, not the plaintiff, was liable for the payment of the gas. Shell argued that even if the oral contract controlled over the written contract, the defendant would still be liable because he entered into such agreement before his corporation came into existence and without any express agreement that Shell was to look only to the corporation for payment. The court held in favor of Shell, stating that, even though the defendant may have assumed to be acting on behalf of the soon-to-be-formed entity, he could not have entered into a contract as an agent for the corporation since it had not yet been formed.

Instances Where Promoter Liability May Fail

However, there are circumstances that would prevent a party from holding the signatory liable as a promoter. If there is evidence sufficient to support a claim that the parties intended the contract to be made in the name of, and solely on the credit of, the future corporation, and the defendant did not represent that the corporation was then in existence, the signatory would not be liable as a promoter of an entity not-yet-formed. (MacDonald v. Arrowhead Hot Springs Co. (1931), 114 Cal. App. 496, 501.) Whether a contract is incurred on the credit of the corporation to be formed, as opposed to the individual, can be a question of fact or law, depending on the circumstances. (Id.)

Plaintiffs have argued that if the entity existed but was suspended at the time of entering into a contract, the individual signatory should be liable under the contract. However, courts have held that the suspension of a corporation's powers, rights and privileges does not cause the corporation to cease to exist. Consequently, the actions that would have been considered those of the corporation before the suspension continue to be viewed as the actions of the corporation during the suspension. (United States v. Standard Beauty Supply Stores, Inc. (9th Circuit, 1977), 561 F.2d 774, 777.) In Standard Beauty, the sole shareholder of the company, Hal Linden, purchased the shares of Standard Beauty, unaware that the company was delinquent in the payment of its California franchise taxes. Linden, in his capacity as president of the company, then entered into a contract on behalf of Standard Beauty for the purchase of assets owned by O'Henri's, Inc. The purchase of the assets was subject to any then-existing indebtedness, including a loan guaranteed by the Small Business Association (SBA). Due to the delinquent payment of the franchise taxes, at the time of its purchase of the O'Henri's, Inc. assets, Standard Beauty's corporate powers, rights and privileges were suspended pursuant to California Revenue & Taxation Code Section 23301. The plaintiff, SBA, argued that since the company's rights were suspended at the time of Linden's execution of the contract, Linden was individually liable under the loan. The court held that although California Revenue & Taxation Code Section 23304 provides that any contract made by an entity during a period of suspension is voidable by any other party to the contract, the code does not support holding the individual signatory liable. The court rejected the plaintiff's argument that Linden was personally liable, and held that the corporation, not the individual signatory, is liable under its contracts even if such contracts are entered into during a period of suspension. (U.S. v. Standard Beauty Supply, supra, 561 F.2d at 777.)

How Can a Landlord Avoid This Situation?

There are some simple things that every landlord can do to avoid falling into this situation. First, the landlord should confirm that the entity it is entering into a lease which does, in fact, exist at the time of entering into the contract. This usually can easily be accomplished by a quick and free search on the secretary of state's website. The landlord can require, as a condition to the lease, that the tenant provide copies of its corporate filings and a corporate resolution approving entering into the lease. The lease should also include a representation and warranty by tenant that the entity is lawfully organized, is in good standing, and is authorized to operate business in the state in which the premises is located. Taking these steps will help ensure that the landlord knows with whom it is doing business and can be reasonably assured that it will know against whom its recourse lays in the event of a tenant default.

How Can a Promoter Avoid This Situation?

A promoter, even more so, ought to be careful to avoid this situation. Typically, tenant-entities will be single-purpose entities formed to shield the principals from personal liability. If the principals and promoters are careless, they may be exposing themselves to the liability that they inended to avoid by forming a separate tenant-entity. The best answer is not to enter into any agreements as an authorized signatory for the entity until it is, in fact, lawfully formed. However, if for any reason the entity is not lawfully formed at the time of entering into the lease, the promoter must disclose to the landlord that the entity is not yet formed, and obtain the landlord's written agreement that once the entity is formed, it will only look to the entity for performance under the agreement. Once the entity is formed, the promoter should also have the entity ratify the contract.

Conclusion

Discovering upon an event of default that the tenant-entity did not exist when it entered into the lease may seem like an unfortunate event but it may actually be a boon. Under promoter liability law, the landlord quite possibly could be in a better position than it would be if the entity had been formed at the time of execution of the lease. Since the tenant is likely in default because of financial failure, seeking a judgment against the tenant-entity could be a pointless endeavor. However, under the right circumstances, promoter liability law might provide the landlord with recourse that it would otherwise not have.

Kevin Montee is a Partner at the firm of Horner & Singer, LLP, Walnut Creek, CA. His practice focuses on business and commercial real estate litigation, primarily in the areas of commercial landlord representation including commercial unlawful detainers, breach of lease actions, the enforcement of judgments and tenant bankruptcies. Monica Sloboda is an Associate at the firm.