Many states have created a standardized document for forming a legal entity. These standardized forms were created partly to prevent lawyers from drafting and submitting extremely long incorporation documents and partly as a way to create ease of use for the general public. Most standardized forms contain a section for the name of the entity, the name of the resident agent, the name of the officers and/or directors, and a section for the corporate purpose.
We are going to take a closer look at the “purpose” section of an entity formation document. Today, lawyers generally use broad language such as, “any lawful purpose” in the purpose section of these documents. However, such was not the case many years ago. Incorporation documents used to be drafted with a very specific corporate purpose. As such, the doctrine of ultra vires was created by the courts. The doctrine of ultra vires was the cause of much litigation and judicial interpretation. The dictionary definition of ultra vires is “beyond the legal power or authority of a corporation, corporate officer, etc.” It is important to note that this doctrine, although traditionally applied to corporations, applies to all types of legal entities.
In plain terms, the doctrine of ultra vires applied to the “purpose” of corporate formation. For example, if a corporation was formed for the purpose of laying railroad tracks, that corporation could not engage in any other business. This makes sense if you think about it, but you can only imagine the limitations such a doctrine creates in this modern age. Today, corporations engage in so many different types of businesses and investments that if this doctrine was statutory majority law, instead of common law minority, you would see many more lawsuits due to a company’s participation in an enterprise that was not originally committed to paper in that pesky “purpose” section in the articles of
incorporation.
The ultra vires doctrine was used both by the corporations and by other
contracting parties. The problem with this doctrine is that it was easy to abuse. For example (using the same railroad laying track example above), if a corporation stated on its articles of incorporation that its purpose was to lay railroad tracks, the corporation was limited to pursuing only that business. Let us say that this corporation entered into a contract to manufacture railroad tracks. According to the doctrine of ultra vires, the corporation was prohibited from doing this. However, a court could only get involved if one of the parties
complained. Therefore, as long as everybody got along, it technically did not
matter that the corporation was conducting business beyond the limits of
its stated purpose.
However, problems arise when a party wants out of the contract. For example, let us say that the railroad laying company is losing money on the contract for the manufacturing of railroad tracks. If the company wanted, it could get out of the contract by using the doctrine of ultra vires. It could argue that although it freely entered into the contract, it could repudiate the contract by stating that the doctrine of ultra vires prevented it from performing under the contract (in other
words, the corporation was prohibited from manufacturing railroad tracks). The irony of this is that the other party that entered into the contract could assert the same thing if he/she/it wanted out of the contract. Basically, both parties in this example had a sure fire way out of a losing contract.
The dangers, pitfalls, and areas of abuse were wide. Additionally, you could see how this doctrine could create very unjust results. Two parties that freely entered into a contract could essentially screw the other if one was losing money. Due to this inherent unfairness, the doctrine has fallen out of favor. However, the doctrine is not non-existent.
Lawyers combat this doctrine by creating a very broad “purpose” section. For example, as I stated above, usually lawyers use the “any lawful purpose” language when drafting a purpose section. However, you must be careful. Some state laws prevent the use of such broad language. Additionally, using broad language is not a guarantee against a lawsuit. Your safest bet is to know your local laws, draft broad purpose statements, and write a solid contract. So, for all of you entrepreneurs that want to form a legal entity, make sure your draft your articles correctly and carefully because something as simple as a “purpose” section can end up destroying a future contract!