Assume that Laverne and Shirley decide to form a corporation. Before the incorporation process is complete, Laverne enters into a contract on behalf of the corporation to purchase office furniture and equipment for $20,000. After the incorporation process has been completed, the corporation formally accepts the contract made by Laverne. Is Laverne personally liable on the contract before corporate acceptance? After corporate acceptance? Why?
The Correct Answer and Explanation is:
Answer:
Yes, Laverne is personally liable on the contract before corporate acceptance. After the corporation formally accepts the contract following incorporation, Laverne may be released from liability, but she remains personally liable unless the corporation and the third party novate the contract (i.e., substitute the corporation in place of Laverne with all parties’ consent).
Explanation
When individuals take steps to form a corporation, they often engage in business activities before the corporation is legally created. In this case, Laverne entered into a contract to purchase office furniture and equipment for $20,000 on behalf of a corporation that had not yet been formed. At the time of contracting, the corporation did not legally exist and therefore had no legal capacity to be a party to the contract.
Under common law and corporate law principles, a promoter (Laverne, in this case) who enters into a contract on behalf of a not-yet-formed corporation is personally liable on that contract. This is because a nonexistent entity cannot be bound by, nor ratify, a contract until it comes into existence. Ratification requires the existence of a principal at the time the contract is made, which is not possible before incorporation.
After the corporation is formed, it can adopt the contract made by the promoter. Adoption means the corporation agrees to be bound by the terms of the pre-incorporation contract. However, adoption does not automatically relieve the promoter of personal liability. To relieve the promoter of liability, a novation is typically required—a new agreement between the corporation, the promoter, and the third party (e.g., the seller of the furniture) that replaces the promoter with the corporation as the obligor.
Therefore, Laverne is personally liable before incorporation and remains liable after incorporation unless a novation occurs. The corporation’s later acceptance of the contract may shift performance duties to the corporation, but Laverne remains secondarily liable unless the other party agrees to substitute the corporation entirely.
