Whether the Promoter Can be Personally Liable

Often promoters of companies try to enter into contracts on behalf of proposed corporations in order to secure the contract before the time for incorporation or to confirm the contracts for the corporation before the expense of incorporation is incurred. Normally the promoter does not have any intention of being personally liable on the contracts.

In some cases the promoter is aware that the corporation has not been incorporated but the person dealt with is not aware that the corporation has not been incorporated. In other cases neither the promoter nor the person the promoter deals with is aware that the corporation has not been incorporated. In some cases the corporation is never actually incorporated. In other cases the corporation in incorporated and purports to ratify contracts entered into on its behalf before it was incorporated. In some cases the corporation that is purporting to ratify the contract is insolvent. The third party may be left to bear a loss if the promoter is relieved of personal liability and the third party’s claim is solely against the insolvent corporation. The questions that typically arise are whether the promoter can be personally liable on the contract and whether the corporation can ratify the contract.

Since a pre-incorporation contract involves a situation in which the corporation has yet to be incorporated, a person who purports to act on behalf of the corporation cannot have any authority as an agent for the corporation [1] . The questions raised here whether a corporation could a ratify a contract that was entered into on its behalf before it was incorporate.

To understand this problem that arose with the common law position, it is important to review the circumstances in which a principal can ratify a contract that a promoter purported to enter into on behalf of the corporation. A person can ratify a contract entered into by another person on his or her behalf if:

(i) the other person purported to act on behalf of the person who seeks to ratify;

(ii) the person who seeks to ratify must have been in existence and ascertainable at the time the other person purported to act on his or her behalf; and

(iii) the person who seeks to ratify must have the capacity to do the act both at the time the other person acted and at the time of the ratification.

Conditions (ii) and (iii) above make it impossible for a corporation to ratify pre incorporation contract. The corporation would not have been in existence at the time the person acted on behalf of the corporation and the corporation would not have had the capacity to do the act [2] at the time the other person purported to act on its behalf.

A company has no status prior to incorporation. “Two consenting parties are necessary to a contract, whether as the company before incorporation is a non-entity” [3] It can have no income before incorporation for tax purposes. Share can not be acquired in the name of a company before its incorporation.

Chapter 1:

Ratification of pre-incorporation Contract

The company is neither bound nor can have the benefit of a pre-incorporation contract. But this is subject to the provisions of The Specific Relief Act, 1963. Section 15 of the Act provides that where the promoters of a company have made a contract before its incorporation for the purpose of the company and if the contract is warranted by the terms of incorporation, the company may be adopt and enforce it. “Warranted by the terms of incorporation” means within the scope of the company‘s object as stated in the memorandum. The contract should be the purpose of the company. A contract to allot shares after the company is incorporated is not for the purpose of the so that the company cannot enforce it against the other party.

Section 19 of the same Act provides that the other party can also enforce the contract if the company has adopted it after incorporation and the contract is within the terms of incorporation.

The legal position in respect of the pre-incorporation contract was illegal concept before passing the Specific Relief Act, 1963. A pre-incorporation contract never binds a company since a person [4] can not 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 bound because ratification is not possible as the ostensible principal did not exist at the time the contract was made.

In the case of In Re English and Colonial Produce Company [5] , a solicitor was engaged to prepare the necessary documents and obtain the registration of a company. He paid the registration fee and incurred certain expenses incidental to registration. Court held that the company was not bound to pay for his services and expenses.

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 heisted to either supply any goods or service for the cause of incorporation.

Personal liability and liability of contracting agent:

In reference to contract which do not fall within the purview of the section 15 and section 19 of the Specific Relief Act the question had arose in the context that whether they can be enforce by or against the agent who acted on behalf of the corporation. The answer will be depend on the construction of the contract. If the contract is made on behalf of a company not yet in existence, the agent might incur personal liability. For, where a contract is made “on behalf of a principal known to both the parties to be non-existent the contract is deemed to have been enacted into personally by the actual marker” [6] . Similarly, “where a person purports to contract as agent he may never less disclose himself as being in truth a principal, and bring an action in his own name” [7] .

Where the contract is purported to be made by the company itself, it cannot be enforce by or against the agent through whom the company contracted. Because, the relationship between a company and its director is not the ordinary one of the principal and agent. Where a company contracts, it is the company who contracts and its contract is merely authenticated by the signature of one of the directors. Newborn V Sensolid [8] , the plaintiff was a promoter and perspective director of a limited company, which at the material time has not been registered. The plaintiff was signed a contract behalf of a company for supplying of good to the defendant. In an action for breach of the contract brought by the plaintiff against the defendants it was held that the contract was made, not with the plaintiff whether as agent or as principal, but with a limited company which at the date of the making was non-existent and therefore it was a nullity and the plaintiff could not adopt it or sue on it as his contract.

Hence it seems that the desire of the courts is to protect the new company from the burden of promoter’s promises for they 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 obligation. With this protection goes some sacrifice also, for a company could not sue a person who before its incorporation had contracted to buy its share. Here in some cases found that court will as far as possible encumber the promoters personal liability. In the case of Touch v Metropolitan Rly Warehousing Co [9] under a contract with a promoter services were rendered by a third party to a company before its incorporation. The third party not being able to sue, it was held that the promoter must sue the company as a constructive trustee for the benefit of the party of the third party.

If a company is to acquire rights or liabilities in consequence of negotiations before it was incorporated, it must be shown that a fresh contract has been made with it since its incorporation. It is not sufficient that the company’s memorandum provides that it shall carry out the pre-incorporation contract, nor that the company has acquired in the other contracting party treating it as liable to him.

A company will be bound by a new contract made after its incorporation only if it intended to enter into such a contract. Where it carries out part of the contract made before its incorporation because its directors mistakenly believe that it is bound by that contract, the company’s acts are explicable by the mistaken belief the company has no intention of entering into a new contract and consequently no new contract is entered into [10] . The explanation of this lenient treatment of the company is not to be found in the rules relating to mistake may well be one of law. The reason invalidates a contract, for the directors mistake may well be one of law. The reason why there is no contract is that the company had no intention of entering into one, because its directors believed it to be bound by the pre-incorporation contract and the company is permitted to give evidence of its director’s state of mind to prove this. But whatever the directors beliefs may be if the company agree with the other party to very the terms of a contract made before its incorporation, the company will be bound by a contract as varied, because it must have had an intention to enter into a contract on the original terms as modified by the variations when it assented to the variation. [11]

2nd chapter:

Common Law Position

In the English law context in additional to dealing with the fraudulent activities of promoters, certain other problems confronted the court relating to the practicalities of promoting the company, particularly with respect to contract entered into prior registration. A company comes into existence only when the certificate of incorporation is issued by the Registrar of Companies. Until incorporation a company cannot be bound by contract entered into in its name or on its behalf: it simply does not exist. However, as part of the process of creating its promoters will generally contract with third parties for such things as a lease of premises and connection to utilities so that once incorporation is completed the company can begin trading without delay. The issue which arises in relation to such pre-incorporation contracts is whether the promoter can avoid being held personally liable notwithstanding that the company did not exist at the time such contracts were concluded on its behalf. The response of the common law was to apply principles of contract and agency to the issue, but partial reform was implemented by sec9(2) of the European Communities Act 1972 now re-enacted in sec 51 of the Companies Act,2006. This part reviews several cases that set out the common law position on pre-incorporation contracts.

Kelner v. Baxter [12]

In this case, the plaintiff and the defendants were promoters of the Gravesend Royal Alexandra Hotel Company, Limited. The plaintiff was to be the manager of the hotel under the new company. Before the company was incorporated the plaintiff offered to sell a stock of wine to the proposed company for £900 which was accepted by the defendants on January 27th, 1866 on behalf of the Gravesend Royal Alexandra Hotel Company Limited. On February 1st the directors of the Gravesend Royal Alexandra Hotel Company Limited ratified the agreement. However, the promoters did not receive a certificate of incorporation for the Gravesend Royal Alexandra Hotel Company Limited until February 20, 1866. The directors then purported to ratify the agreement again on April 11, 1866 just days before the company made an assignment in bankruptcy.

The court held that the ratification of February 1, 1866 was not a valid ratification because the company was not in existence at the time. The ratification on April 11 was also held not to be a valid ratification because of the requirement that ratification can only be done by a principal having capacity to contract at the time the contract was entered into as well as at the time of the ratification. It was also not valid on the basis that the company was not in existence at the time of the promoters purported to act on its behalf. The court nonetheless still felt there was clearly an intended contract and the only way in which there could be a valid contract was if the defendants were the other contracting parties. They thus held that there was a valid contract in which the plaintiff was one party and the defendants were the other parties.

Thus it 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. Here 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).

B. Newborne v. Sensolid (Great Britain) Ltd [13]

Many years later in the instant case the English Court of Appeal made it clear that promoter liability was to be based on a rule of construction approach – i.e. promoters were only liable if it was intended in the circumstances that they were themselves to be parties to the contract.

Here Newborne had entered into a contract with Sensolid Ltd. To supply tinned ham to Sensolid Ltd. The price of tinned ham fell and Sensolid Ltd. refused to take further deliveries of tinned ham from Newborne. The contract had been signed by Leopold Newborne underneath the words Leopold Newborne (London) Ltd. It was not formally signed “on behalf of Leopold Newborne (London) Ltd. Unfortunately, Leopold Newborne (London) Ltd. had not been incorporated. Leopold Newborne (London) Ltd. was later incorporated and it brought an action against Sensolid Ltd. That action was dismissed because Leopold Newborne (London) Ltd. had not been incorporated at the time the contract was entered into. Leopold Newborne then sued Sensolid Ltd. in his own name seeking to enforce the pre-incorporation contract on the basis that he was a party to the contract himself. The argument was made on the basis of Kelner v. Baxter saying that if the contract was not with Leopold Newborne (London) Ltd. then it must have been with the person who signed on behalf of the company, namely, Leopold Newborne.

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.

C. Black v. Smallwood & Cooper [14]

The High Court of Australia took the same rule of construction approach in this case. Black and others had contracted to sell land to Western Suburbs Holdings Pty. Ltd. which was signed by the defendants. 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.

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. The court said that the basis of the decision in Kelner was the inference that the defendant promoters were bound by the contract according to the nature of the contract itself. In this case it appeared to be clear that a contract with the company was intended. The company did not exist and thus it was a contract with a non-existent party and therefore no contract at all. It was nonetheless suggested that the defendants could be liable for a breach of warranty of authority.

D. Wickberg v. Shatsky [15] It 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.

Lawrence and Harold Shatsky became shareholders in Rapid Addressing Systems Ltd. and became directors. They decided to expand the business and to incorporate a new company, Rapid Data (Western) Ltd., to take over Rapid Addressing Systems Ltd. Rapid Data (Western) Ltd. was never formed. It was later proposed that Celer Data Ltd. be formed to do the takeover. A certificate of incorporation for Celer Data Ltd. was issued on 1966. On May 1966, a day two before the certificate of incorporation was issued the plaintiff (Wickberg) was hired as a manager. The terms of employment was written in a letter dated May 9 and were on letterhead with the name of Rapid Data (Western) Ltd. on top. The letter was signed by Lawrence Shatsky. The letter noted that Wickberg was to get a salary of $15,000 per annum. A few days later

Lawrence Shatsty told Wickberg that the company was to be referred to as Rapid Data

(Western) without the “Ltd.” The business did not go as well as had been anticipated and Lawrence and Harold Shatsky could not keep up with paying Wickberg’s salary. They asked him to work on straight commission. With the company’s business not doing particularly well, Wickberg refused to work on straight commission. On Aug. 26, 1966 Wickberg was dismissed for his failure to work on straight commission. Wickberg sued and his claim was for wrongful dismissal. His difficulty though was that he had to prove he had an employment contract. It couldn’t be a contract with Celer Data Ltd. because the purported contract was concluded on May 9th, two days before as certificate of incorporation was issued for Celer Data Ltd [16] .

The court held that it is not the case that a person signing on behalf of a non-existent company is automatically personally liable [17] . In other words, the court took the rule of construction approach [18] .The court concluded that it was not the intention that either Lawrence Shatsky or

Harold Shatsky would be personally liable on the employment contract [19] .The court further held that there was a breach of warranty of authority in that Lawrence Shatsky and Harold Shatsky represented the existence of Rapid Data (Western) Ltd. And that they could sign on behalf of Rapid Data (Western) Ltd. while they knew the company did not exist. However, there was no connection between the damage suffered by the plaintiff and the breach of warranty of authority. There were no damages because all Wickberg would have had the representations been correct would be an action against Rapid Data (Western) Ltd. on a claim of wrongful dismissal. Such an action would have yielded nothing because the company through which the business was operated was now bankrupt and thus had the business been carried on through Rapid Data (Western) Ltd. as originally planned that business would have been bankrupt on Wickberg would have collected nothing on a wrongful dismissal claim against that company.

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. For instance, had the court not found the promoters liable in Kelner v. Baxter Kelner would have borne the entire loss on the wines that he

supplied for the hotel company rather than having that loss shared amongst all the promoters [20] . A similar problem could arise if promoters performed the purported contract but could not enforce the contract against the third party.

The common law position also creates unnecessary costs. To deal with the risk of a potentially unenforceable contract both parties will have to take precautions to ensure that the corporation has in fact been incorporated. It would make more sense to have just one party incur the cost of confirming that the corporation has in fact been incorporated. Then it would make sense to allocate this cost to the person who can confirm the existence of the corporation at least cost. In most cases the promoters will know whether the corporation has been incorporated or not without having to do any checking. In other cases, where they were in doubt, they could simply check with their lawyer.

The third party would have expected to have a contract with the corporation itself so, in most cases, it would be reasonable to allow the corporation to adopt the contract as its own and relieve the promoter of liability unless it was genuinely intended that the promoter be a party to the contract. However, one needs to address the opportunistic use of an adoption of a contract by a corporation. This might arise in a situation where the contract is no longer beneficial to the promoters. The promoters might then incorporate the corporation but fail to put any assets in the corporation. They could then have the corporation adopt the contract relieving the promoters of liability and leaving the third party with an action against an insolvent corporation. This would give the promoters the opportunity to gain on a contract if it continued to be beneficial to them but avoid liability on the contract if it was not beneficial to them – i.e. they would be speculating at the expense of the third party.

CONCLUSION:

It is clearly unjust that neither the company nor the other party should benefit by the acquisition of property or money or the performance of services under contracts made before the company’s incorporation without giving the consideration promised in return. The courts have therefore tried in some cases to give relief to the company or other party on some ground outside the law of contract. Thus it has been held that where before the company’s incorporation its promoters have performed services which have in creased the value of the company’s property, they can either enforce an equitable claim against that property for the value of their services, or may recover the reasonable value of their services from the company by suing for a quantum merit.

Although a contract made before a company’s incorporation cannot bound the company it is not wholly devoide of legal effect, even if all the persons who negotiated the contract are aware that the company has not yet been incorporated.

The contract tekes affect as a personal contract with the person who purports to contract of the companies behalf and they are liable to pay damages for failure to perform the promises made in the company’s name or his behalf. This is so despite fact that the contract expressly provides that only the company’s paid up capital shall be answerable for performance. The person who makes the contract are liable to each other as parties and the person who purports to represent the company are not merely liable to pay damages for breach of their implied warranty that they had authority to contract on the company’s behalf.

Formerly, these consequences did not ensure when a contract was made in the name of a company before its incorporation by a person who did not purpose to contract on its behalf or as it agent, but simply described himself in the offer or acceptance as an officer of the company or as being in some other way connected with it. Such contracts were simply as non-existent as the company in whose name they were made. However, statute now equates such contracts with those expressed to be made on behalf of a company before its incorporation andthey therefore take effect as contracts entered into personally by the persons who make them and the knowledge or ignorance of those persons of the fact that the company has not been incorporated is immaterial.