1. What steps should MGS have taken to help limit their promoter liability?

2. What steps could Branch have taken to limit his losses?

Branch agreed to provide $75,000 in short-term financing to three individuals, Mullineaux, Gefter, and Satsky (MGS), for purposes of starting up a venture called “Stereo House” in which the principals would profit by arranging par-ties in a luxury beach house in the Hamptons (Long Island, New York) and charging guests to attend these events. Branch entered into an agreement with MGS whereby they agreed that the yet-to-be-formed venture would pay back the money to Branch at an interest rate of 10 percent over four months. After Branch provided the funding and entered into the agreement, MGS allegedly formed the Stereo House entity but did not open a bank account, did not execute the proper legal documents, and did not ratify any of the Branch transactions. The venture was ultimately unsuccessful, and Stereo House was unable to pay back the majority of the loan. Branch sued MGS as individuals under a theory of promoter liability. MGS defended by claiming that the $75,000 was an investment and therefore the entire amount was at risk without any liability on MGS’s part. 

The New York court held in favor of Branch. The court ruled that because the agreement was executed prior to formation of the entity, MGS created individual liability to Branch. MGS were liable as individuals since promoters who execute preincorporation contracts in the name of a proposed corporation are personally liable on the contract unless the parties have agreed otherwise. In this case, it was undisputed that the corporate entity did not exist at the time that the agreement was entered into. Thus, as preincorporation promoters, MGS were personally liable for the agreement executed prior to the incorporation of an entity, even if the entity would otherwise be considered the contracting party.

“Indeed, a corporation which did not exist at the time the contract was entered into, cannot be bound by the terms thereof unless the obligation is assumed in some manner by the corporation after it comes into existence by adopting, ratifying, or accepting it. [W]hen a promoter executes a contract on behalf of a nonexistent corporation, the promoter is presumed to be personally liable under that contract absent proof of the parties’ contrary intent or until there has been a novation between the corporation and the other contracting party. Here, defendants have proffered no evidence that the Stereo House entity adopted, ratified or accepted the agreement they made with plaintiff. Thus, there is no basis for the court to overcome this presumption and shift the individual [MGS’s] liability for repayment to [the Stereo House entity].”