Wednesday, March 30, 2011

Pre-incorporation contracts: legal enforceability

The formation of a legal entity or a company is in simple words a matter of legal formality. A contract is that legal obligation by which a legal entity ascertains its legal status. Contracts can be considered as the basis of these formalities. As the formation of these contracts involve various discussions at different stages by more than one person pre-incorporation contracts become inevitable. A company normally will not be able to enter into a contract without coming into existence.

Usually a pre-incorporation contract comes into existence prior to the formation of a company. Such contracts will be entered into by the promoters of a company on behalf of the company before the company comes into existence. These promoters are the people who are involved in the formation of a company. They deal with the required formalities of a company's registration from finding directors and share holders to doing negotiations for business contracts for the new company.

But is it possible for a company which is not in existence to enter into an enforceable contract on behalf of the company? According to common law, a company before existence cannot attain a legal status to attain contractual rights or sustain contractual liabilities existing from a pre-incorporation agreement and so the pre-incorporation agreements cannot oblige a company.

In each case promotion of a company varies according to the factual circumstances. Those aspects range from the day when the promoters begin to make contacts on behalf of the company to the starting of the company continuing to the day when the directors of the company take their place. The status of the promoters cease to exist immediately after the formation of the board of directors and from then onwards they start controlling the company. In the process they may be required to constitute different types of contracts.

The promoters of the company may enter into contracts on behalf of the proposed entity which they may refuse to approve or consent once it is incorporated. These contracts include pre-incorporation contracts, provisional contracts and residuary contracts.  

English Law: The Common Law

In English law the case Kelner V. Baxter (1866) 2LR 2CP 174[1] was one of the first case to consider pre-incorporation contracts. The court held a pre-incorporation contract shall exist when the individual who actually acted as a promoter or agent on behalf of the non-existing entity would be legally liable.  Kelner v. Baxter thus confirmed that a company cannot ratify a contract, or purported contract, entered into on its behalf if the company was not in existence at the time a person purported to enter into a contract on its behalf.

Kelner v. Baxter also highlighted the potential for promoters to be liable on contracts they purport to enter into on behalf of an as yet unincorporated entity. What was not clear after Kelner v. Baxter was whether promoters were automatically liable in these situations, sometimes referred to as the “rule of law” approach, or whether the promoter’s liability depended on whether it was intended that the promoter be a party to the contract, sometimes referred to as the “rule of construction” approach.[2]

But while considering the case Newborne v Sensolid (GB) Ltd [1954] [3] the court took a different approach. A consignment of tinned ham was sold to Sensolid under a contract headed "Leopold Newborne (London) Ltd" and ending "Yours faithfully, Leopold Newborne (London) Ltd" and signed by Leopold Newborne. Sensolid refused to take delivery of the ham. It was held that neither the then unincorporated company nor Mr Newborne personally could sue on the contract. Lord Goddard said: This contract purports to be a contract by the company; it does not purport to be a contract by Mr Newborne. He does not purport to be selling his goods but to be selling the company's goods. The only person to have any contract here was the company, and Mr Newborne's signature merely confirmed the company's signature...In my opinion, unfortunate though it may be, as the company was not in existence when the contract was signed there never was a contract, and Mr Newborne cannot come forward and say: "Well, it was my contract."[4]

The English Court of Appeal held that the correct approach was a rule of construction approach. The real test was whether the promoter was intended, in the circumstances, to be a party to the contract or not. It was held that given the way in which the contract was signed by Leopold Newborne it was intended to be a contract with the company and only the company. In other words, given the way in which it was signed it indicated that it was not intended that Leopold Newborne be a party to the contract himself. Thus Leopold Newborne could not enforce the contract in his own name.[5]

In Buffington v. Bardon 80wis 635(1891) the English court observed that: “The law is that a corporation is liable for its own acts only after it has a legal existence. Until that time no one whether a promoter or not can sustain to the corporation the relation of agent, were this not so, we would have an agent without a principal, which is an absurdity”. That the contract should be between the contractor and the company, in which case the company being non –existent, there is no contract at all & no one is liable on it.[6]

Under section 51 of the Companies Act 2006, subject to any agreement to the contrary, the person purporting to act for the company, or as an agent of the company, is personally liable on the contract (Phonogram Ltd v Lane [  1982  ] QB 939). It was held that such a person can also enforce a pre-incorporation contract (Braymist Ltd v Wise Finance Co Ltd [2002] EWCA Civ 127, [  2002  ] 3 WLR 322).[7]

High Court of Australia

Considering the case Black v. Smallwood & Cooper (1966), 117 C.L.R. 52 the High Court of Australia took the similar rule of construction approach to Kelner v. Baxter. Western Suburbs Holdings Pty. Ltd. was not incorporated at the time and Smallwood and Cooper signed as directors thinking the company had been incorporated and that they were directors. The plaintiffs wanted to impose liability on the basis of a rule of law reading of Kelner v. Baxter saying that a contract was clearly intended and since it could not be with the principal (i.e. the company) which was not in existence it must have been with the purported agents Smallwood and Cooper personally.[8]

The majority of the court followed the earlier English case of Newborne v. Sensolid Ltd.
It was held that Kelner v. Baxter was not authority for the principle that an agent signing for a non-existent principal is bound.[9] Wickberg v. Shatsky (1969), 4 D.L.R. (3rd) 540 (B.C.S.C.) is a British Columbia case that also addresses the question of the interpretation of Kelner v. Baxter and addresses the possibility of an action against the promoters on the basis of a breach of warranty of authority.[10] The court held that it is not the case that a person signing on behalf of a non-existent company is automatically personally liable.[11]

The common law position created a risk for both the promoter and the third party that there would be no enforceable contract. Black v. Smallwood and Wickberg v. Shatsky involved cases in which the third party could not enforce the contract against the company. Newborne v. Sendolid Ltd. involved a situation in which the neither the promoter nor the company could enforce the purported contract. This creates a risk that reliance on the purported contract will be defeated along with the potential for an unjust enrichment of promoters at the expense of third parties or third parties at the expense of promoters.[12]

Pre-contractual liability

The German legal system was the most receptive to the idea of pre-contractual liability. The first one to point out the need to introduce the concept of pre-contractual liability for failure to observe the fair conduct (good faith) rule, was the German lawyer Rudolf von Iering.[13] In India the Specific Relief Act 1963 provides provisions for enforcing performance against a company where its promoters have entered a pre-incorporation agreement on behalf of the company. Section 19(e) of the act can be invoked only if the company after its incorporation have approved and accepted the contract and have communicated its acceptance or approval to the other contracting party.

According to section 230 of the Indian Contract Act an agent cannot enforce a contract personally entered by him on behalf of his principle, nor he can be personally liable if he clearly mentions at the time of entering the contract that, he is only acting on behalf of the principle as an agent and so he is not personally liable under the contract. Therefore applying this theory the contract can be infructuous as none of the parties is legally liable under the contract.

Nevertheless, section 15(h) and 19(e) of the Specific Relief Act provides specific answer to this. Section 15 states as follows:

15. Who may obtain specific performance.- Except as otherwise provided by this Chapter, the specific performance of a contract may be obtained by-
            (a) any party thereto;
(b) the representative in interest or the principal, of any party thereto: Provided that where the learning, skill, solvency or any personal quality of such party is a material ingredient in the contract, or where the contract provides that his interest shall not be assigned, his representative in interest of his principal shall not be entitled to specific performance of the contract, unless such party has already performed his part of the contract, or the performance thereof by his representative in interest, or his principal, has been accepted by the other party;

(h) when the promoters of a company have, before its incorporation, entered into a contract for the purposes of the company, and such contract is warranted by the terms of the incorporation, the company: Provided that the company has accepted the contract and has communicated such acceptance to the other party to the contract.[14]

The section enables pre incorporation contracts valid even though it is slightly contrary to the common law principles to a certain extent. Going by the act specific performance of a contract is enforceable against a company where its promoters or agents have entered into a valid contract on behalf of the company before its incorporation. In such a situation a contract is acceptable by the stipulations of the company's incorporation.

The Madras High Court while considering the case Weavers Mills Ltd. v. Balkies Ammal [AIR 1969 Mad 462][15] had made a comprehensive decision. The promoters of the company had consented to buy for the company some properties on behalf of the company to be incorporated. After incorporation structures were constructed on the property by the company after assuming possession. The court took its view that even if the properties were not conveyed on to the company at the time of making the contract by its promoters the company's title over the property could not be set aside.

Therefore, in India, despite the fact that pre incorporation contracts are entered into by promoters or agents of the company before the company's existence they are legally enforceable and has contractual obligations that continue to exist under the Specific Relief Act.


[4] Ibid
[6] Ibid
[9] Ibid
[10] Ibid
[11] Ibid
[12] Ibid
[13] Alyona N. Kucher Doctor of Law, Moscow State University School of Law, Russia -paper rtf


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