You have put in the long hours, and although it pains you, you decided that you must abandon the business venture. What liability do you have to those people who promised to buy your stock when you finally formed your corporation?

The law has long been clear that a subscriber to purchase stock is the owner of that stock by right of contract, even before the stock is actually issued.¹Mitchell v. Beckman (1883) 64 Cal. 117, 121 [28 P. 110]. The ownership exists immediately when the corporation ratifies the subscription agreement.²Mitchell v. Beckman, supra, 64 Cal. 117, 121 [28 P. 110]. If the subscriber owns the stock before it is issued, do they have a special claim for damages against you, when you are in full control of whether the corporation is formed or abandoned?

Short Answer

I reviewed California case law. I found only one case that came close to addressing this issue. I’ll review that case below. Johnson v. Hulse (1927) 83 Cal.App. 111 comes close to answering our question, but it is slightly different in that the subscriber had paid already for the subscription, and when I started this inquiry I was really curious about what happened when a subscriber had not yet paid. In that situation where a subscriber had not yet paid but had a contract that said that upon incorporation that the subscriber would pay and in return would receive stock, could the subscriber claim some kind of damage against the corporate promoter?

In short, it appears that the answer is, “no.” Johnson v. Hulse, supra, 83 Cal.App. 111, shows us that where a subscriber has paid, the only remedy they have is to have their full investment returned. Any money spent from that investment is taken as a loss to the promoters and not to the subscriber.³Johnson v. Hulse, supra, 83 Cal.App. 111, 116.

Below, we will also consider the cases of MacDonald v. Arrowhead Hot Springs Co. (1931) 114 Cal.App. 496 and Coast Amusements, Inc. v. Stineman (1931) 115 Cal.App. 746. In MacDonald, we see a different set of circumstances, because there, the corporation incorporated first and then started seeking investors. You will see that this has a big change in how the rule plays out, because the law of promoters affects the relationships of promoters to each other, but once a corporation forms, the promoter can be personally liable, but he or she cannot make other promoters liable on subscription contracts. In Coast Amusements, Inc., the court looks at whether the corporation can sue a subscriber when it is unable to issue stock, which is interesting but wholly unrelated to our search.

Johnson v. Hulse (1927) 83 Cal.App. 111.

Hulse, Dye, Abbott and Little agreed to form a corporation.⁴Johnson v. Hulse, supra, 83 Cal.App. 111, 113. The purpose of their corporation to purchase an oil lease in Texas and drill for oil.⁵Johnson v. Hulse, supra, 83 Cal.App. 111, 114. The four promoters hired Brumbly to sell subscriptions in the new company, and they allowed Brumbly to keep a percentage as commission for his labors.⁶Johnson v. Hulse, supra, 83 Cal.App. 111, 114.

Brumbly entered into subscription agreements with Johnson and Stavron.⁷Johnson v. Hulse, supra, 83 Cal.App. 111, 114. Each subscribed for half a share at $250.⁸Johnson v. Hulse, supra, 83 Cal.App. 111, 114. Brumbly’s agreements with Johnson and Stavron contained the following text: “it is understood anda greed that I am to receive a certificate for my investment when the Association is incorporated.”⁹Johnson v. Hulse, supra, 83 Cal.App. 111, 115. Both claim that at the time of their subscription that Brumbly orally asserted that if the corporation failed to form that they would each receive a refund of their money.¹⁰Johnson v. Hulse, supra, 83 Cal.App. 111, 115. The court notes that “even if such promise had not been expressly made, it would have been implied by law.”¹¹Johnson v. Hulse, supra, 83 Cal.App. 111, 115.

Brumbly collected between $14,000 and $17,000 in subscription payments, but Brumbly never transferred the money paid by Johnson and Stavron to Abbott, who managed the money.¹²Johnson v. Hulse, supra, 83 Cal.App. 111, 114. Brumbly did not raise the $25,000 needed to exercise the lease option, which frustrated the purpose of the corporation.¹³Johnson v. Hulse, supra, 83 Cal.App. 111, 114. The promoters decided to abort the operation and returned all money to subscribers, but they did not send a refund to Johnson and Stavron, because they were not aware of these agreements.¹⁴Johnson v. Hulse, supra, 83 Cal.App. 111, 114-115. Johnson and Stavron sue to recover their investment.

To settle the matter, the court notes that “[m]oney paid to an agent of the promoters is as if paid to the promoters themselves; and in so far as the promoters or their agents received money from subscribers for shares in the projected corporate enterprise which was afterward abandoned, they are jointly and severally liable for the return of money paid on a consideration which has failed.”¹⁵Johnson v. Hulse, supra, 83 Cal.App. 111, 116.

The rule is thus expressed in section 162 of Alger on the Law of Promoters and the Promotion of Corporations: ‘When a subscriber for shares in a projected corporation has paid money thereon in advance to the promoters, and the scheme proves abortive, he may recover back his money. This right rests on the failure of the consideration on which the money was paid. But the scheme is not to be deemed abortive until the formation of the corporation has been abandoned or has become impracticable, or a reasonable time for the formation has elapsed. It is reasonable, in the absence of agreement to the contrary, that the expense of exploiting the proposed undertaking should, in case it collapses, fall upon the original projectors, and not on those who advanced their money on the faith of the ability of the projectors to do that which they undertook to do.’ (See, also, 14 C. J. 276, sec. 322.)

(Johnson v. Hulse, supra, 83 Cal.App. 111, 116.)

“Under such circumstances, the promoters became liable for the return of the money of the subscribers, whether it was actually transmitted by Brumbly to Abbott or not.”¹⁶Johnson v. Hulse, supra, 83 Cal.App. 111, 117.

MacDonald v. Arrowhead Hot Springs Co. (1931) 114 Cal.App. 496

We see a case of promoter liability to subscribers in MacDonald v. Arrowhead Hot Springs Co. (1931) 114 Cal.App. 496 [300 P. 105]. However, in this case, the promoter formed the company first and then issued the stock.¹⁷MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 498 [300 P. 105].

When the promoter (Mr. Marshall) formed the corporation, he hired Mr. Anthony to assist him in selling the authorized shares.¹⁸MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 498 [300 P. 105]. By their agreement, Mr. Marshall agreed to pay any expenses associated with the sale of the stocks above Mr. Anthony’s commissions.¹⁹MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 498 [300 P. 105]. Mr. Marshall became ill, and Mr. Anthony pushed on without him.²⁰MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 498 [300 P. 105]. Mr. Anthony hired MacDonald to make plans and drawings of a proposed hotel, casino, gardens and improvements.²¹MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 498 [300 P. 105]. After the plan for the sale of stock failed, the corporation returned all funds to stockholders less the 20% authorized by the commissioner to be retained as necessary expenses incident to the sales of stock.²²MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 499 [300 P. 105]. None of the money was retained by Mr. Marshall.²³MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 499 [300 P. 105].

The question addressed in MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496 is what obligation does Mr. Marshall have to MacDonald, who made the drawings at the request of Mr. Anthony.

The trial court found that the corporation was in existence at the time of the contract with MacDonald.²⁴MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 500 [300 P. 105]. MacDonald had also directly inquired about whether the corporation existed prior to entering into the contract.²⁵MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 500 [300 P. 105]. Anthony, acting as the Vice President of the Corporation, was also filling the role of a promoter, and because the corporation already existed, Anthony did not have the ability to bind MacDonald to personal liability on the contract.²⁶MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 500 [300 P. 105].

On appeal, the appellate court noted that “services of the architect were performed after the corporation was fully organized and as a part of the proposed enterprise of that company.”²⁷MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 500 [300 P. 105]. Whether the contract with MacDonald was binding upon Anthony as a promoter or upon the corporation depends upon findings of fact.²⁸MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 502 [300 P. 105]. Regardless the settling of that issue by the trial court, the facts do not support any liability for Marshall, because the corporation had already been formed and Anthony did not have the ability to personally bind Marshall to a contract to which he was not a party.²⁹MacDonald v. Arrowhead Hot Springs Co., supra, 114 Cal.App. 496, 502 [300 P. 105].

Coast Amusements, Inc. v. Stineman (1931) 115 Cal.App. 746

Although Coast Amusements addresses a completely different situation, I thought it to be a fun case, so I include it here anyway. In Coast Amusements, the court asks the question, can a corporation force a subscriber to pay the money for stock when the corporation is not allowed to issue stock by law?

In Coast Amusements, Inc. v. Stineman, supra, 115 Cal.App. 746, 751 [2 P.2d 447], the corporation was denied the right to issue stock when the commissioner cancelled the permit that gave the corporation license to issue the approved shares. The subscribers claimed that they could not be bound by their subscription contract if the corporation did not have a right to issue stock. On review of the subscription agreements, the court found that the subscribers had obligated themselves to taking stock when it became available to issue but not to paying the associated par value.³⁰Coast Amusements, Inc. v. Stineman, supra, 115 Cal.App. 746, 752 [2 P.2d 447]. Because the corporation did not allege that it could issue valid stock upon payment by the subscribers, it could not support a claim against them for the money owed.³¹Coast Amusements, Inc. v. Stineman, supra, 115 Cal.App. 746, 752 [2 P.2d 447].

In the case of Klinker v. Guarantee Title Co. of Long Beach, 98 Cal. App. 469 [277 P. 177], an action to recover money paid to a corporation for stock issued in violation of a permit, it was held that upon payment of the money the obligation arose either to issue to plaintiff value received in the shape of valid stock, or lacking authority to do so, to return the money to him. This is supported by National Stone Corp. v. Voorheis, 93 Cal. App. 738 [270 P. 286].

(Coast Amusements, Inc. v. Stineman, supra, 115 Cal.App. 746, 752-753 [2 P.2d 447].)

Final Thoughts

Johnson gave us the most direct answer. In Johnson, the California court highlights an excerpt from the Law of Promoters which lays out two expectations of subscribers. In the event that the corporation is formed, the subscriber is entitled to receive the stock in exchange for their payment. When the corporation is abandoned, however, the subscriber is entitled only to a full refund of money already paid. Thus, it is unlikely that a subscriber could claim that you owe him or her the benefit of the bargain, and thus they could not likely pursue any form of lost investment income or forced incorporation.

In Coast Amusements, we learn that the subscriber’s right to receive the stock when the corporation forms may rely on other conditions. In Coast Amusements, the corporations commissioner prevented the issuance of stock which superseded the stock subscribers right to receive a valid share. In that circumstance, the stockholder did not have to pay. We may infer that if the stock subscriber had paid already that the corporation would have a reasonable amount of time to fix any issues with the State or refund the stock subscriber’s investment.

If you enjoyed this article, then check out some of my other articles pertaining to the law of securities.