Analysis of California Bar Exam, February 2022

This question is probably a contract, business associations and torts (fraud) cross-over. Below is the question and my analysis. Note that in a real answer, there would be more space spent stating the relevant rules.

Question 5

Arnold and Betty agreed to launch a business selling a durable paint that Arnold had developed and patented. They agreed to share all profits and to act as equal owners. Betty agreed to contribute $100,000 to the business venture. Arnold agreed to contribute his patent for durable paint. Arnold told Betty that he thought the patent was worth $100,000. He did not tell Betty that he had previously tried to sell the patent to several reputable paint companies but was never offered more than $50,000. Arnold and Betty agreed that Betty would be responsible for market research and marketing and Arnold would be responsible for incorporating the business and taking care of any other steps needed to start the enterprise.

Arnold first located a building within which to operate the business, owned by Landlord Co., and entered into a one-year lease in the name of Durable Paint, Inc.  Subsequently, after Arnold took the necessary steps, Durable Paint, Inc. was incorporated. At the corporation’s first board of directors meeting, Arnold and Betty were named as sole directors and officers. During that meeting, Arnold and Betty voted for the corporation to assume all rights and liabilities for the lease and to accept assignment of Arnold’s patent rights.

Over the next six months, Durable Paint, Inc. faced unforeseen and costly manufacturing and supply problems. At the end of the first six months, the corporation had exhausted all its capital and was two months behind on rent. To make matters worse, a competitor developed a far superior product, making Durable Paint, Inc.’s patent effectively worthless. Durable Paint, Inc. had no other assets.

Landlord Co. sued Arnold and Betty personally for damages for breach of the lease.  Betty sued Arnold.

1. On what theory or theories might Arnold be found personally liable for damages to Landlord Co.? Discuss.
2. On what theory or theories might Betty be found personally liable for damages to Landlord Co.? Discuss.
3. On what theory or theories might Arnold be found personally liable for damages to Betty? Discuss

My Analysis

Part 1:

Arnold and Betty seem to have formed a partnership by agreeing to operate a business selling paint.  They could argue that their agreement at the outset was to form a corporation which would then operate a business.  In other words, they did not intend and did not in fact operate a business until the corporation was formed.  At that point it would own the patent and would have some money and start operating.  But the landlord would argue that the execution of the lease was in furtherance of operating the business so it was “operating.” And courts generally hold that activities by one or more persons before incorporation constitute a partnership. 

There is probably a partnership so they are both personally liable for the debts of the partnership.  Is the lease a “debt of the partnership”?  It was if the partnership was a party to the contract and Arnold had authority to enter into the lease on behalf of the partnership.  The contract indicates that the tenant was a corporation which had not yet been formed.  The corporation cannot be a party to the contract, at least when the contract was entered into.  That leaves it that a contract was entered into by the partnership since it is in furtherance of the partnership business.  Did Arnold have authority to enter into the contract?  There are no facts suggesting he and Betty agreed that he would do that so there is no express authority to enter into the contract.  But they agreed Arnold would be “taking care of any other steps needed to start the enterprise.”  From that Arnold could have reasonably believed he had authority to enter into the lease and thus he had implied authority.  It could also be implied since general partners generally have authority to enter into contracts for the entity.  Thus the partnership is liable and both Arnold and Betty are liable for partnership debts. 

Arnold could also be liable for the debt because he was a promoter of the corporation to be formed.  The general rule is that the promoter is liable for contracts entered into by the promoter on behalf of a corporation to be formed.  Arnold might argue that there was simply no contract because there was no corporation.  He would argue that the parties, i.e., he and the landlord, intended the contract to apply only once the corporation was formed (and not until then).  That would depend on the facts.  He could also argue that the corporation was de facto.  A de facto corporation is one where the parties mistakenly believe a corporation exists.  But here Arnold knew he did not form the corporation.  He could also argue that when the corporation ratified the lease later, that ended his liability for the lease.  But the corporation’s ratification of the lease does not absolve him from the liability unless the landlord agreed to exonerate him.  He might argue that the fact that the landlord intended to enter into the contract with the corporation in the first place, and not with Arnold and/or Betty, and the corporation did in fact assume it, that shows that the parties intended the contract to be enforceable only against the corporation.

If the debt is a corporate debt and not personal to Arnold, the landlord could seek to pierce the corporate veil to make Arnold personally liable for the corporate debt.  But there are no facts that suggest that the corporation and Arnold were alter egos of each other.  There may be an argument that it was undercapitalized since it ran out of money quickly.  But they seemed to have complied with the formalities of operating a corporation, did not form it for any fraudulent purpose and it is not unfair therefore to allow him to be protected by the corporate shield.

Part 2:

The analysis as to Betty is largely the same.  In addition to Arnold’s arguments, she would argue that Arnold had no authority to enter into the lease because the agreement was that they would form a corporation so until then there was either no partnership or there was no authority to enter into a lease.  She would also argue that she was not a “promoter” of the unformed corporation because they agreed Arnold would take care of that part of the business.  Further she did not sign or negotiate the lease.  She is therefore not liable as a promoter.  She would have a little better chance at the de facto argument as she probably believed that the corporation was formed.  The de facto corporation concept does not work in most states.  But it is an equitable argument and the equities are in Betty’s favor, certainly more than Arnold. 

Part 3:

Arnold has definitely misled Betty as to the value of the patent.  Forgetting what kind of entity this might be, if his statements to her about the value of the patent were false, and he knew they were false and intended to deceive her, he has committed fraud and is liable for her damages.  Once a partnership was formed, Arnold also owed Betty a fiduciary duty of loyalty meaning he had an obligation to disclose everything to her that she might need to know, meaning tell her about his prior efforts to sell the patent.  So he has also violated that duty to her and must pay all damages caused by the violation.  If he made false statements to her as part of setting up the corporation, in other words as part of the process of her receiving stock in the corporation, he has an obligation under Rule 10b5 to disclose anything necessary so that the statements he made about the patent was not misleading.  Arnold might argue that the company failed because a competitor created a better product which is not uncommon.  In other words, his lack of candor and disclosure did not cause the injury.   

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