To Enforce a Loan Agreement Entered into with a Non-Incorporated Entity a Party Must Prove that the Non-Incorporated Entity is a De Facto Corporation

Andrew Braverman 

St. John's University School of Law

American Bankruptcy Institute Law Review Staff

In In re Maidan, the Eastern District of New York held that Joshua Maiden (“Plaintiff”) failed to demonstrate that Harrison Realty, the borrower in a loan agreement, was an incorporated entity or a de facto corporation at the time the agreement was executed.[i] As a result, the court found that Harrison Realty lacked the capacity to enter into an enforceable loan agreement and Plaintiff failed to put forth a viable claim against Harrison Realty.[ii]

On November 26, 2018, Plaintiff entered into a loan agreement with his father (“Debtor”) to cover the initial deposit for the purchase of real property.[iii] The loan was made on behalf of Harrison Realty, a non-incorporated entity established by the father.[iv] Pursuant to the loan agreement, Plaintiff would advance $81,500 to Harrison Realty on the condition that proceeds from the sale of the property would be set aside to cover repayment of the loan.[v] Following the execution of the loan agreement, the father filed for chapter 11 bankruptcy.[vi]

When the property sold, Plaintiff received $41,903.69, a $39,595.31 shortfall remained under the loan.[vii]Thereafter, Plaintiff commenced an action against his father’s bankruptcy estate to recover the shortfall.[viii] Plaintiff’s complaint asserted causes of action for declaratory judgment, breach of contract, and unjust enrichment.[ix] In response to the complaint, the Defendant filed a 12(b)(6) motion arguing that Plaintiff failed to state a viable claim since the complaint is predicated on a loan to Harrison Realty, “an entity that was not formed until four months after the purported loan was made and failed to adequately plead that Harrison Realty was a de facto corporation at the time of the loan transaction.”[x]

A corporation must be incorporated or qualify as a de facto corporation to enter into a valid loan agreement.[xi]An entity will qualify as a de facto corporation if there exists “(1) a law under which the corporation might be organized, (2) an attempt to organize the corporation and (3) an exercise of corporate powers thereafter.”[xii] “To be considered a de facto corporation, a business ‘must function as if it were a corporation and make substantial efforts to either incorporate or remedy any defects of incorporation upon their discovery.’”[xiii] In addition, courts in New York have “recognized a business as a de facto corporation in cases where the business inadvertently failed to meet the requirements of the law or was operating with the formalities of a corporation and was attempting to achieve legal status.”[xiv] Here, the Court found that Plaintiff failed to demonstrate that Harrison Realty was a de facto corporation at the time of the loan transaction.[xv] This is because Harrison Realty failed to make a “colorable attempt” to file Articles of Organization with the New York Department of State before the loan agreement was consummated and did not otherwise make any attempt to achieve legal status.[xvi] Under this rationale, the Court found that Plaintiff failed to prove that there was a substantial controversy between Plaintiff and Harrison Realty as to warrant the issuance of a declaratory judgment.[xvii]

Moreover, in regard to the breach of contract and unjust enrichment claims, the Court found that “‘Under New York Law, a nonexistent corporation does not have the legal capacity to form a contract.’”[xviii] Therefore, because Harrison Realty was a non-incorporated entity and failed to qualify as a de facto corporation at the time the loan agreement was executed, Plaintiff was found to be incapable of asserting a viable claims for breach of contract and unjust enrichment. Accordingly, the Court dismissed the Plaintiff’s Complaint seeking the collection of a debt against an unincorporated entity.