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Pre Incorporation Contracts

A corporation, though regarded as an independent person in the eyes of law, never materializes by itself. Behind every company there are persons or association of persons who strive to actualize the being of a company. These persons are most times referred to as promoters.

The promoter is obligated to bring the company in the legal existence and to ensure its successful running and in order to accomplish his obligation he may enter into some contract on behalf of prospective company. These types of contract are called 'Pre-incorporation Contract'.

These are contracts which the promoters of the company make before the company is incorporated, on the assumption the company will assume responsibility for the contract.

"A pre-corporation contract is one which is entered into when the Company is in the process of being incorporated but is not yet completed it. At common law such contracts were held to be void, as the Company is not yet in existence."

The person who enters into a pre-incorporation agreement is usually called the Promoter. The Indian Companies Act 2013 defines the Promoter under Section 2(69). The Job of promoter is not only limited towards, performing certain duties, but surely it extends toward the incorporation of a company. It depends on the nature of the company which is to be established, to arrange their respective persons.

Pre-incorporation contracts perform a valuable function. By permitting valid and binding legal commitments with third parties, nascent companies are able to secure significant and sometimes essential services necessary to become a fully capitalized and stable corporation.

Cockburn C.J., described a promoter as:
"one who undertakes to form a company with reference to a given project and to set it going and who takes the necessary steps to accomplish that purpose"

In Lagunas Nitrate Co. v. Lagunas Syndicate, it was stated that:
"To be a promoter one need not necessarily be associated with the initial formation of the company; one who subsequently helps to arrange floating of its capital will equally be regarded as a promoter."

"There are, however, significant problems that plague pre-incorporation contracts, such as the spectre of fraud by entrepreneurs and promoters, as well as the possibility of pre-incorporation commitments being disregarded or voided after the fact.

These problems give rise to certain legal issues and questions which include, could the company ratify or adopt a pre-incorporation contract so as to become liable upon it?; if the company cannot, were those who acted for the company before its incorporation personally liable on the contracts made by them? In these situations, parties look to legal statutes and case laws to determine the enforceability of such pre-incorporation contract, liability of parties if any, remedy available for parties to the contracts, and finally the issue of who bears the risk of loss." The project discusses all these questions in detail.

Legal Status Of Pre-Incorporation Contracts

"The legal status of a pre-incorporation contract is not easy to assess. Going by the definition of the contract, there have to be at least two parties/persons who enter into contract with each other. "So, the general principle is that if one of the parties to the contract is not in existence at the time of entering into the contract then no contract will there.

Hence, the company can't enter into a contract before it comes into existence, and it comes into existence only after its registration. Thus it is said that the pre-incorporation contract is entered into by the promoters on behalf of the company.

The promoters, while entering into the contract, act as agents of the company. However when the principal, that is the company is itself not in existence, how can it appoint an agent to act for it." So, the promoters, themselves" and not the company, become personally liable for all contracts entered into by them even though they claim to be acting for the prospective company.

But under section 230 of the Indian Contract Act , "an agent cannot personally enforce contracts entered into by him on behalf of his principal, nor is he personally bound by them if he specifies clearly, at the time of making the contract, that he is only acting as an agent and he is not personally liable under the contract. So if this principle is applied, the contract becomes in fructuous as neither of the parties is liable under the contract."

Before Specific Relief Act, 1963

"A pre-incorporation contract never binds a company since a person (legal or juristic) cannot contract before his or its existence and a company before incorporation has no legal existence. Another reason is that promoters are proverbially profuse in their promises and if the corporation were to be bound by them, it would be subject to many unknown, unjust and heavy obligations."

"Even where there is a request purported to enforce such a contract, the company cannot be found because ratification is not possible as the ostensible principal did not exist at the time the contract was made. In re English and colonial Produce Company case , a solicitor was engaged to prepare the necessary documents and obtain the registration of a company. He paid the registration fee and incurred the certain expenses incidental to registration. It was held in this case that the company was not liable or bound to pay for his services and expenses."

"The company is also not entitled to sue on a pre-incorporation contract. As it was held in the case of Natal land and Colonisation Company v. Pauline Colliery Syndicate that the syndicate was not entitled to its claim as it was not in existence when the contract was made and a company cannot obtain the benefit of a pre-incorporation contract in the suit of specific performance.

So, fact of this case was that the a 'N' company contracted with 'A', the nominee of the syndicate company which was not even incorporated, to grant a lease of certain coal mining rights for three years. After the syndicate was registered, it claimed the contracted lease which the company 'N' refused."

After Specific Relief Act, 1963

"Until the passing of the Specific Relief Act, 1963, in India the promoters found it very difficult to carry out the work of incorporation. Since contracts prior to incorporation were void and also could not be ratified, people hesitated to either supply any goods or services for the cause of incorporation. However, the Specific Relief Act, 1963 came as a relief to the promoters.

Section 15(h) and 19(e) of the Specific Relief Act provides as" follows:
  1. The contract should have been entered into by the promoter for the purpose of the company.
  2. The terms of incorporation should warrant should warrant such contract.
  3. The company should accept the contract after incorporation.
  4. Such acceptance should be communicated to the other party to the contract.
"Section 15(h) of the Specific Relief Act, 1963, the definition, it expressly states that the contracts incorporated before the incorporation stage are "entered into by the promoters of the for the very purpose and utility of the company and subject to terms of incorporation of the company, the company may ask for specific performance from the third party.

However, this condition can only be applied if, after the registration/incorporation, the company has expressly demonstrated acceptance of those contracts, and communicated such contracts to the third party concerned." Under identical circumstances the other party to the contract under Section 19(e) of The Specific Relief Act, 1963 may enforce specific performance against the company.

Accordingly, in order for the company to enforce the contract against the other party to contract, the members must ratify the contract followed by a communication of acceptance. The company may not receive any benefit from such a contract unless the contract is accepted by the company and the promoters would be personally liable for the contracts."

Role Of The Promoter

The Common Law propounds that "the term promoter is a short and convenient way of designating those who set in motion the machinery by which the Act enables them to create an incorporated company" and therefore promoter is one who "undertakes to form a company with reference to a given project and to set it going, and who takes the necessary steps to accomplish that purpose."

"Promoter plays a very important role in a company. Formation of a company starts with the promotion of a company. Usually the idea of the company will be of the promoters, they have the idea of the business and its feasibility.

"Promoter is a person who brings about the incorporation and organization of a corporation. He brings together the persons who become interested in the enterprise, aids in procuring subscriptions, and in motion the machinery which leads to the formation itself."

Under Section 2 (69) Companies Act, 2013 "promoter" means a person:
  1. Who has been named as such in a prospectus or is identified by the company in the annual return referred to in section 92; or
  2. Who has control over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise; or
  3. In accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act: provided that nothing in sub-clause (c) shall apply to a person who is acting merely in a professional capacity; i.e. CA, Attorney

"The eminence of a promoter is generally terminated when the Board of Directors has been formed and they start governing the company. Technically, the first persons who control the company's affairs are its promoters. They carry out the necessary investigation to find out whether the formation of a company is possible and profitable. Thereafter, they organize the resources to convert the idea into a reality by forming a company. In this sense, the promoters are the originators of the plan for the formation of a company.

They are the ones who It to arrange or find ones who can arrange the share and loan capital and other financial resources, Promoters are the one who arrange for the company to acquire the business which the company is to conduct or the property or assets from which it is to derive its profits or income, when these things have been done, the promoter hand over the control of the company to its director, who are themselves under a different name."

Functions Of A Promoter

  1. The formation of idea and forming the company and explore the possibilities.
  2. To conduct the negotiation for the purchase of business.
  3. To collect the number for signing of the MOA and the AOA.
  4. To decide the name of the company, location of the registered office, amount and form of share capital.
  5. To get the MOA and the AOA drafted and printed.
  6. To arrange for the minimum subscription.
  7. To arrange for the registration of company and certificate of incorporation.

Liability Of The Promoter

"Promoters are generally held personally liable for pre-incorporation contract. If a company does not ratify or adopt a pre-incorporation contract under the Specific Relief Act, then the common law principle would be applicable and the promoter will be liable for breach of contract.

"The common Law in this context gave prime importance to the intention of the parties in adjudicating the contract. If the promoter purported to act for the corporation, then he was held personally liable for the contract. However, if the contract is entered in name of the proposed company and the promoter merely authenticated the signature, the promoter was absolved from all liability." The justification for the same was based on the intention of the parties i.e. who they look to when contracting."

A promoter is subjected to liabilities under the various provisions of the Companies Act:
  • Section 26 of the Companies Act, 2013 lay down matters to be stated in a prospectus. A promoter may be held liable for non-compliance of the provisions of the section
  • Under section 34 and 35, Companies Act, 2013 a promoter may be held liable for any untrue statement in the prospectus to a person who subscribes for shares or debentures in the faith of such prospectus. However, the liability of the promoter in such a case shall be limited to the original allottee of shares and would not extend to the subsequent allotters.
  • According to section 300, a promoter may be liable to examination like any other director or officer of the company if the court so directs on a liquidator‟s report alleging fraud in the promotion or formation of the company.
  • A company may proceed against a promoter on action for deceit or breach of duty under section 340, where the promoter has misapplied or retained any property of the company or is guilty of misfeasance or breach of trust in relation to the company.
  • The Madras High Court in Prabir Kumar Misra v. Ramani Ramaswamy, has held that to fix liability on a promoter, it is not necessary that he should be either a signatory to the Memorandum/Articles of Association or a shareholder or a director of the company. Promoter's civil liability to the company and also to third parties remain in respect of his conduct and contract entered into by him during pre-incorporation stage as agent or trustee of the company."

Novation Of Contract

Novation of contract is defined in Scarf v Jardine as, 'being a contract in existence, some new contract is substituted for it either between the same parties (for that might be) or different parties, the consideration mutually being the discharge of the old contract'.

"Novation is different from the Ratification; because in Novation, a new contract is made on the same terms but this time between the company and the third party, whereas in Ratification, dates back to the time of the act ratified, so that if the company ratifying, who is not in existence, cannot itself have then performed the act in question its subsequent ratification of it is ineffective.

In the situation of Novation of Contract, the Company can replace the promoter from the pre-incorporation contract. But one might say that such contract would not be called pre-incorporation contract, but it should be called post-incorporation contract; because novation of contract result into a new contract." In Howard v Patent Ivory Manufacturing , the English Court accepted the novation of contract. It was observed by the court that even though the promoter is personally liable for the pre-incorporation contract, he can shift his liability to the company. This novation of contract principle was later incorporated into the Specific Relief Act, 1963."

Under Specific Relief Act

Under the Specific Relief Act 1963, section 15(h) and 19(e) are the two important sections for pre-incorporation contract. (As explained under second sub-heading).

Relationship Between The Promoter And The Company

Though the case laws and the academic discourse on this issue has been multifaceted and inconclusive but the Indian Supreme Court has affirmed that the relation between the two as that of a fiduciary relation. "It rejected the position of the promoter with respect to that of the unincorporated company as that of agency or trustees." In the case of Weavers Mills v. Balkis Ammal , it was held that even without express conveyance of property by the promoter to the unincorporated company, since the promoter stands in fiduciary duty to the company, all the benefits of the pre-incorporation contract would pass on to the company.

"Position of the promoter is fiduciary concerning the company which the promoter promotes his position is quasi legal. A promoter is neither a trustee nor an agent of the company which he promotes because there is no trust or principal in existence at the time of his efforts. But certain fiduciary duties, like an agent, have been imposed on him under the Companies Act. As such he is said to be in a fiduciary position (a position full of trust and confidence) towards the company and the original allottee of shares." Consequently, a promoter must make full disclosure of the relevant facts, including any profit made.

"One position can be that if the company accepts the benefits of the contract, then it must accept the burden too and hence must compensate the promoter for all his expenses under the said contract. However, if the company doesn't ratify the contract, then the promoter can't claim for reimbursement."

"As he has a fiduciary relationship with the company so generally there is no issue with regard to his remuneration. The Chancery Court in the Re English & Colonial Produce Co. case held that a promoter is not entitled" to claim expenses in his duty unless there is an express provision to do so but he is entitled to a reasonable remuneration as stated in the Article of Association.

In Touche v Metropolitan Rly Warehousing Co. Lord Hatherly highlighted the importance of remuneration saying that "the help of the promoter is unique which requires great efficiency, power and which is employed in developing a business plan and making it so to the best benefit and thus should be given his fees."

Case Laws

Kelner V. Baxter

In this case, "on behalf of unformed company i.e. before the incorporation of the company, the promoter accepted an offer of Mr. Kelner to sell wine, subsequently the company failed to pay Mr. Kelner, and he brought the against the promoter with whom he entered a contract. The court found that the principal-agent relationship cannot be in existence in the pre-incorporation contract that means before incorporation of a company and if the company is unformed, the principal of an agent cannot be in existence.

He further explains that the company cannot take the liability of pre-incorporation contract through adoption or ratification of the contract and the company was stranger at the time they enter a contract." So, he held that promoters are personally liable for the pre-incorporation contract because they act on behalf of the unformed company as they are the consenting party to the contract.

Newborne V. Sensolid (Great Britain) Ltd

This case explain the facts of in a different way and developed the principal further. "If the company entered a contract before incorporation, the other contracting party can have refused to perform his duty to that contract." The court observed that before incorporation the company cannot come into existence and if it is not in existence then the contract which the unformed company signed would not be in existence. So, company cannot bring an action for pre-incorporation contract, and the promoter cannot bring the suit because they were not the party to contract.

Goodman V. Darden

In the instant case both the parties were aware of the fact, that the corporation is non-existent at the time of making the contract and further that, the corporation accepted the contract and the promoter who is acting on behalf of the corporation directed all the payments received under the contract by the corporation itself. "Still the court went ahead to hold that the intention of the third party was never to release promoter form their personal liability for entering the contract on behalf of the corporation having an intent that corporation has not yet formed.

The knowledge of it being a pre-incorporation contract would indicate that to reduce the uncertainty, the third party was never had an intent to release the promoter from their liability too which didn't end of corporation adopting the contract. This is going to ask for warranty that the corporation would perform its obligations, which is comparable to the South African statutory law.

Thus, what the court examines is this the third parties as to limit the liability of the promoter on the corporation adopting the contract the third party intended to do it." This case clarified that just because the co rporation adopted the contract, that doesn't mean the promoter would be dissolved from all his personal liability.

Weavers Mills V. Balkis Ammal & Ors.

In this case:
"The promoters have agreed to purchase some property for and on behalf of the company. On incorporation, the company assumed possession and constructed structures upon it. The Madras High Court held that without disclosure of all the facts and the materials related to the contract the promoter has entered, since the promoter stands in fiduciary duty to the company, all the benefits of pre-incorporation contract would pass on the company".

The company's title of the property would not be set aside.

Conclusion And Suggestions
"The promoter is obligated to bring the company into the legal existence and to ensure its successful running, and in order to accomplish his obligation; he may enter into some contract on behalf of the prospective company. These types of contract are called 'Pre-incorporation Contract'. Therefore, Pre-incorporation contracts, though at first stage may appear to be with no legal status but they are very much legally acceptable and enforceable in the tribunal and courts.

There is no legal position of a promoter as he only has a fiduciary relationship with the company as he is neither an agent nor a director or an employee. He cannot make secret profits or else he will be held accountable. Therefore there are many liabilities on him as he does the duties of the drafting of the prospectus, entering into pre-incorporation agreements etc.

In Indian Law the rule of Kelner v. Baxter is applicable but under the Specific Relief Act 1963, section 15(h) and 19(e) promoter can shift his right and responsibility to the company, if it is warranted by the terms of incorporation. The principle of novation of pre-incorporation contract is also applicable, the reason behind is that, the novation replace the old contract with the new contract, so there is no problem of non-existence of company."

Books And Articles
  • Pre-incorporation contracts by Suryabhan Singh
  • K.S. Anantharaman, 'Lectures on Company Law & Competition Act (including Secretarial Practice)', Tenth ed., Nagpur, LexisNexis Butterworths Wadhwa; 2005, p.49.
  • William J.R and, High Pressure Sales Tactics and Dead Trees: What to do with Promoters' Pre-Incorporation contracts, Rutgder's business law journal (2007).
  • Arden & Prentice ed., buckley on companies act (17 ed., lexisnexis, 2009).
  • Andrew Ggriffiths, contracting with companies (hart publishing, 2005).
  • Harry g. Henn & John R. Alexander, law of corporations (3 ed., west publishing co. 2007)
Case Laws
  • Newborne v. Sensolid, (1953) 1 All ER 708
  • Twycross v. Grant, 1872 2 C.P.D. 469
  • Lagunas Nitrate Co. v. Lagunas Syndicate [1889] 2 Ch. 392
  • Parker v. Modern Woodman 181 All. 214, 234
  • Kelner v. Baxter [1866] 15 LT 213
  • Natal land and Colonisation Company v. Pauline Colliery Syndicate [1904] AC 120
  • Erlanger v New Sombrero Phosphate Co, (1878) 3 App Cas 1218
  • Prabir Kumar Misra v. Ramani Ramaswamy [2010] 104 SCL 174
  • Scarf v Jardine 1882 7 APP CAS 345
  • Howard v Patent Ivory Manufacturing [1888] 38 Ch. D 156
  • Weavers Mills v. Balkis Ammal, (1969) AIR Mad 462
  • Touche v Metropolitan Rly Warehousing Co. (1871) LR 6, Ch App 671
  • Goodman v. Darden (Wash. 1983) 670 P.2d 648

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