Pre-incorporation Contracts and the Promoter

In order to get the benefits of a ‘corporate personality’ [1] , it is very necessary for ‘an association of persons’ to become incorporated under the Companies Act, 1956. After the incorporation of association of persons the company comes in existence, and it can start its business operations as company only after that [2] . The simple reason behind it is that before incorporation company do no has any legal existence before incorporation [3] , and if the ‘association of persons’ enters into an agreement in the name of company before incorporation; the agreement would be void ab initio [4].

It would be a matter of inconvenience that ‘an association of persons’ cannot perform any official business operation in the name of company before its incorporation or the issue of certificate of commencement of business; they may have to make arrangement for office, place of work, worker, etc. In order to do away with these inconveniences, the promoter [5] can enter into the agreements in the benefit of ‘association of persons’ or prospective company; these agreements are known as pre-incorporation contract.

Under the strict principles of contract law, the promoter is solely liable for the breach of contract. The reason behind is that the promoter is party who enters into the contract, and not the company. The rule of privity of contract keeps away the company from pre-incorporation contract. But recent development in corporate law and contract law makes the company liable for pre-incorporation contract.

Research Question

Whether the promoter is liable for pre-incorporation contract or not? If he is liable, under what circumstances he can be held liable?

Whether there is any difference among Indian Law, American Law and English Law concerning the liability of promoter in relation to pre-incorporation contract?

Chapter I: Meaning of Promoter and Nature of Pre-incorporation Contract

Promoter

The Company Act, 1956, does not provide a common definition of Promoter. Although few section like 62, 69, 76, 478, 519 of Company Act and SEBI Guidelines 2000 Chapter VI Explanation I to III to clause 6.4.2(k) does discuss about promoter, but definition provided under those section would be restricted to the area of those section. Resent Company Bill does have the definition of Promoter in the definition clause under section 2(zzq), it says that “promoter means a person who has (a) been named as such in a prospectus; or (b) control over the affairs of the company, directly or indirectly whether as a shareholder, director”. But this Bill is not in force till now, so the old Act of 1956 would be applicable in present day, which does not has the common definition clause of promoter. Even the English law does not provide the definition [6] . Joseph H. Gross in his celebrated article ‘Who is a Company Promoter?’ found that it was rather intentional to not providing definition in English Legislation, because if legislation try to define it then someone might escape from the liability who enjoy the place of promoter but not come under the definition of promoter [7] . In this situation, where the legislature if silent about the definition, it is necessary to see the judicial interpretation.

According to Bowen J., the ‘Promoter’ is not the term of law but it is a term of business [8] , who play main role in the setup of a company. Whereas Cockburn CJ in Twycross v Grant observed that a 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’.

In conclusion, one can say that promoter connote any individual, syndicate, association, partnership or a company, which takes all the necessary steps to create company and mould a company and set it going [9] .

Pre-incorporation Contract

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’.

Nature of Pre-incorporation contract is slightly different to ordinary contract. Nature of such contract is bilateral, be it has the features of tripartite contract. In this type of contract, the promoter furnishes the contract with interested person; and it would be bilateral contract between them. But the remarkable part of this contract is that, this contract helps the perspective company, who is not a party to the contract.

One might question that ‘why is company not liable, even if it a beneficiary to contact’ or one might also question that ‘doesn’t promoter work under Principal-Agent relationship’.

Answer to all those question would be simple. The company does not in legal existence at time of pre-incorporation contract. If someone is not in legal existence, then he cannot be a party to contract, and ‘Privity to Contract’ doctrine excludes company from the liability. In Kelner v Baxter, Phonogram Limited v Lane

In pure common law sense, Pre-incorporation contract does not bind the company. But there are certain exceptions to this contract, and these exceptions were developed in USA, India and later in England.

Chapter II: Liability of Promoter Concerning Pre-incorporation Contract

Before the passing of the Specific Relief Act 1963, the position in India, regarding pre-incorporation contract, was similar to the English Common Law. This was based on the general rule of contract where two consenting parties are bound to contract and third party is not connected with the enforcement and liability under the terms of contract. And because company does not come in existence before its incorporation, so the promoter signs contract on behalf of company with third party, and that is why the promoter was solely liable for the pre-incorporation contract under the established ruling of Kelner v Baxter.

Liability of 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.

Whether Promoter is personally Liable for Pre-incorporation Contract?

In Kelner v Baxter, where the promoter in behalf of unformed company accepted an offer of Mr. Kelner to sell wine, subsequently the company failed to pay Mr. Kelner, and he brought the action against promoters. Erle CJ found that the principal-agent relationship cannot be in existence before incorporation, and if the company was not in existence, the principal of an agent cannot be in existence. He further explain that the company cannot take the liability of pre-incorporation contract through adoption or ratification; because a stranger cannot ratify or adopt the contract and company was a stranger because it was not in existence at the time of formation of contract. So he held that the promoters are personally liable for the pre-incorporation contract because they are the consenting party to the contract.

In Newborne v Sensolid (Great Britain) Ltd, Court of Appeal interpreted the finding of Kelner v Baxter in a different way and developed the principle further. In this case an unformed company entered into a contract, the other contracting party refused to perform his duty. Lord Goddard observed that before the incorporation the company cannot be in existence, and if it is not in existence, then the contract which the unformed company signed would also be not in existence. So company cannot bring an action for pre-incorporation contract, and also the promoter cannot bring the suit because they were not the party to contract.

This case created some amount of confusion that, if the contract was sign by the agent or promoter, then he will be liable personally and he has the right to sue or to be sued. But if a person representing him as director of unformed company enters into the contact then the contact would be unenforceable. This distinction was found objectionable by the Windeyer J in Black v Smallwood and this was also criticized by Professor Treitel in the Law of Contract. Later in Phonogram Limited v Lane, Lord Denning settled the position, he found that if an unformed company enters into the contact, then it cannot bind the company, but the legal effect of contract does not entirely lack. And even in that situation the promoter or representor are personally liable for the pre-incorporation contract.

In Phonogram Limited v Lane, a person was attempting to from a company which was going to run a pop artists group and that person arranged financial assistance from a recording company. But this company never came in existence, and the amount was due. The recording company brought an action against the person who represented the unformed company. Lord Denning analyzed Kelner v Baxter, Newborne v Sensolid, Black v Smallwood and the section 9(2) of the European Communities Act, 1972 [10] , and found that the promoters are personally liable for the pre-incorporation contract.

These principles were found applicable in Indian case. In Seth Sobhag Mal Lodha v Edward Mill Co. Ltd., the High Court of Rajsthan followed the approach of Common Law regarding liability of pre-incorporation contract. This case was criticised by A. Ramaiya in Guide to Companies Act (Sixth Edition), he found that learned judges did not noticed the Specific Relief Act [11] .

How can promoter shift his liability and right to company

Although under common law promoter is personally liable for the pre-incorporation contract, but there are some scope where the promoter can sift his liability to company. He can shift to company his liability under the Specific Relief Act 1963 or he can go for novation under contract law.

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. Section 15 is about stranger’s right to sue if he entitled to a benefit or has any interest under the contract, although it has certain limitation. Section 15(h) talks about the company, being a stranger to pre-incorporation contract, has the right to sue to the other contracting party. But the necessary condition is that the contract should be warranted by the terms of its incorporation. This provision clearly negates the common law doctrine [12] which says that the company cannot ratify or adopt the pre-incorporation contract [13] . Under this provision promoter can give his right to sue to sue to the company. In Vali Pattabhirama Roa v Sri Ramanuja Ginning and Rice Factory Pvt. Ltd.

On the other hand, section 19(e) states that the company can be sued by the other party of pre-incorporation contract, if the terms of incorporation warrant and adopt the contract. This provision reduces the promoter of liability of pre-incorporation contract.

Under Novation of Contract

Novation of contract is defined in Scarf v Jardine [14] 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’ [15] .

Novation is different from the Ratification [16] ; because in Novation, a new contract is made on the same terms but this time between the company and the third party [17] , 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 [18] .

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.