Pre-Incorporation Contracts of Companies Act 2006 - Essay Example

? Pre-incorporation Contracts and Section 51 of Companies Act 2006 School Lecturer Pre-incorporation Contracts and Section 51 of Companies Act 2006 Introduction A pre-incorporation contract (PIC) is any contract that a company may have entered into with another party before it was actually registered as a company. Usually such contracts may be vital for the formation of the company may have to be eventually accepted as they form a responsibility of the company. An example is for building a minimal set of infrastructure and other resources for the company including offices, contracts need to be organised with the third parties by the promoters. Such contracts may get accepted since they provide immense benefits for the company. However, there may be certain circumstances under which such contracts may not be valid especially if the company does not reach into formal incorporation and the individual who has entered into such contracts (usually the promoter) would be held liable for the contract. The promoter is a person who would perform the various activities on behalf of the company even before it has been incorporated and in this way is an agent of the company. He would make several leases and contracts for the company such that the company can be incorporated are able to start off with its required functions that may arise from its objectives. Hence, supposing the company fails to get incorporated or if the shareholders do not accept the contracts, then the promoter may be personally held liable for all the pre-incorporated contracts (National Paralegal College 2003). The problem is actually more serious when the promoter is dealing with a party who may be interested in starting their own company and the promoter is an implied agent for a non-existing birth upcoming company. Hence, the position of the promoter is said to be ambiguous (Singh 2011). On the other hand, contracts are utmost needed for parties to legally be obliged into providing services or goods for a company to be formed. Contracts may be formed at different stages before pre-incorporation and without the presence of pre-incorporation contracts; the company would not be able to come into existence (University of London 2007 p. 43). In several instances, the legal question has been asked whether it is possible for a company to enter into a legally enforceable contract even before it comes into existence. Hence during the period of promotion of the company, the promoters may act as agents (make decisions on behalf of the company), and their role would end once they appoint the board of directors for the company. According to common laws, pre-incorporation contracts would not oblige a company. Once the promoter incorporates the company and appoints the board of directors, he has to hand over all matters to the board of directors, including the contracts that were made during pre-incorporation. The board of directors may accept these contracts or reject it which in turn would hold the promoter personally liable and not the company. Basically there are three types of contracts that may be entered into including pre-incorporation contracts, residuary contracts and provisional contracts (Expedite 2010 p. 10.7). In this paper, the stand of the promoter would be assessed with regards to the pre-incorporation contracts based on the statutory provisions (such as Section 36C of the Companies Act 1985, section 51 of the Companies Act 2006 & Article 7 of the First Directive of the EEC1) and common laws (such as Kelner vs. Baxter2 and Phonogram vs. Lane3). Since the liability on the promoter is very high, recommendations would be made that the promoters can implement in order to reduce or avoid liability with the pre-incorporation contracts. Common laws on pre-incorporation contracts One of the leading and initial cases regarding pre-incorporation contracts was Kelner vs. Baxter4 held before the Court of Common Pleas in England. In this case, there were a group of promoters who had created a contract with other parties for a company that had not been registered. The company was supposed to be a new hotel and they were dealing with wine. Once the company had been incorporated it ratified the presence of the contract, but within a short period of time, even before the dues of the contractual vendors had been completed, the company was liquidated and in turn the liability of paying the dues to the vendors was placed on the promoters, since the wine had already been consumed. The Honourable Judge Erle CJ placed the liability on the promoters even though the new hotel and the shareholders had ratified the contract. The judge held that the promoters who signed the contract on behalf of the company even before it was incorporated were in fact the agents of the company. However, the judge said that the contract was not operative till the hotel was created and could be held liable. Here, even though the agent exists, the principal was not present at the time of contract creation and the agents knew all the details of the contract (Expedite 2010 p. 10.7). Subsequent mere ratification of the contract by the company when it was formed (who was in fact a mere stranger) cannot relieve the promoters of their liabilities and instead shift the responsibility to mere strangers (third parties with whom the contract was agreed). When a company is created it would be having rights and liabilities that may arise from that time onwards, and not retrospectively. The company cannot take responsibilities of contracts that were formed before it came into existence as it would not be in line with the principle of the law of contract. Hence, based on the common law that was created in Kelner vs. Baxter, a contract could not be created before a company was incorporated, and in such circumstances the promoters were to be held personally liable (Sealy 2007 p. 87-88). In the Newborne v Sensolid (Great Britain) Ltd5, the promoter was found liable as he had signed on behalf of the company. However, after going into the finer details of the case, it was found that though the contract was signed by the promoter before it was incorporated, he was merely acting as an authority of the company since there was no other authority of the company, and as such the company had purported to enter into the agreement (Lawyers & Jurists 2010). Here the Honourable Judge Oliver stated that in all circumstances difference should be made between a supposed principal and an agent, as in this case, the promoter was acting as a supposed principal and not agent (Goulding 1999 p. 53). Another case that deals with liabilities of pre-incorporation contracts is Phonogram vs. Lane6. In this case, there was a proposal to form a company named FM, and L was acting as the promoter who was acting for and on behalf of the proposed company. L entered into an agreement with Phonogram Ltd so as to finance the musical group to be incorporated as a company. However, the proposed company FM was never incorporated and as per the agreement, L had to repay the money within 1 month in case the group had not been formed (Expedite 2010 p. 10.8). The Honourable Judge found although it was a pre-incorporation contract, Section 36C applied as the group to be formed had contracted with L the promoter to act as its agent and make decisions on behalf of FM. There was an existing contract between L and FM for agency. However, in this case, L had taken responsibility and had undertaken to pay Phonogram Ltd in case the company was not formed. Section 9(2) was used in this circumstance to apply the liability to L for personally covering the pre-incorporation contracts with Phonogram (Goulding 1999 p. 50). In the first instances where the liability of the promoters was suggested to be reduced was in the work by Lord Dunning titled Cheshire and Fifoot’s Law of Contract7. If the promoter had expressively signed a contract mentioning him to be an agent for the company and acting on behalf of the company, then the same could be considered as ‘an agreement to the contrary’ and thus preventing the action from Section 36C from being applied. If Section 36C should not be applied to include the personal liability of the promoters, then there should be a clear indication of the same and a good way in which this should be demonstrated is through a contractual agreement or the use of disclaimers by the promoters excluding them from liability from all pre-incorporation contracts (Goulding 1999 p. 50). One of the first cases in which Section 36C was being used was in Oshkosh B’Gosh v Dan Marbel Inc Ltd8. Here the company tried to change its name to avoid liability and instead tried to hold one of the Directors personally liable for contracts he had signed with the company known by its previous name. The registrar did not approve the change of name, and in case the name had changed, the liability would have instead have been on the director of the company. The court held that even if the company changed its name, the rights, liabilities and its obligations would remain the same, and in turn it cannot be considered a pre-incorporation contract (Section 36C would not apply). A company once created is capable of existing perpetually, and a name change is a mere change of its brand name or label. Another case where the agent was not held liable was in Badgerhill Properties Ltd v Cottrell9. Here the name of the company was spelt wrongly in one of the contracts and the agent who was acting on behalf of the company was held liable. The company claimed that since a company did not exist by the name that was spelt wrongly, it was a pre-incorporation contract and hence the agent was liable. However, this argument was turned down as it was found that the misspelt name was a mere error made similar to a changing the label of the company, and hence the liability was placed on the company and not the promoter (Sealy 2007 p. 94). Section 51 of the Companies Act 2006 Section 51 comes under Part 4 dealing with Company’s capacity and related matters and it specifically deals with pre-incorporation contracts, deeds and obligations. Section 51 simple restates section 36c of the Companies Act 1985 and reads:- “…A company is not bound by a contract purportedly made on its behalf before it came into existence unless the obligations are novated, i.e. a new contract must come into existence after incorporation on the same terms as the old one. Novation may be expressed or implied…”10 (Quoted from Section 51 of the Companies Act 2006 - UK Legislation 2012) According to the wordings of section 51, the company is not bound by the contracts made by the promoters or agents before it came into existence. The liability of the company would only arise when such contracts are novated (either in an expressed or implied manner) after the company has been incorporated. The liability of the promoter would only be excluded if there is an agreement to the contrary, wherein the liability of the promoter (or agent) would be expressively excluded (University of London 2007 p. 43). Following the case Kelner vs. Baxter, there was a very unhappy state of affairs (as promoters were finding it very difficult to start-up companies), as both the promoter and the third party could not enforce the contract and this was a huge risk. It was only in 1980’s when the UK became a member of the European Union did some amount of relief occur to promoters and the companies that were to be incorporation. Article 7 of the First Directive11 was enacted in 1973 which basically arose from the European Communities Act 1972 that provided some relief to the promoters when a contract is present between the proposed company and the agent (promoter) for representing the proposed company on its behalf, then such a agreement would be legally binding and the agents cannot be personally held liable. This was evident in the Phonogram vs. Lane12. Once Article 7 of the First Directive, there was no immediate UK legislation that reflected the same, and only in the year 1985, the Companies Act contained the provision Section 36C that set the limits of the liability of the promoters (Goulding 1999 p. 51). The First Directive which gave birth to Section 36C of the Companies Act 1985 and later to Section 51 of Companies Act 2006 has given a very narrow margin for promoters and has been one of the first attempts to reduce the liabilities of the promoters for pre-incorporation contracts. The section holds the liability on the promoters to a personal extent. It is likely that the First Directive included the words personal into to be clearer as to who would be responsible in such circumstances. However, it has that Section 51 in most circumstances have not given the promoter an opportunity to enforce the contracts mainly because once a company would not accept such contracts; the promoters would have to pay from their pockets towards such liability. Promoters are not even given a chance to enforce such agreements that would be beneficial to the company (Goulding 1999 p. 51). Section 51 uses the wording ‘subject to the agreement to the contrary’ so that the Promoters may not be held liable for such contracts. This has provided several means by which promoters can avoid liability. One of the means is to have a contract with the company expressing appointment of the promoter as an agent. Another way is to delay into entering into an agreement until the company is actually incorporated. Promoters can also reduce their liabilities having provisional agreements with the third parties that would have to be finalized once the company is formed, or to have pre-arranged contracts, that would finally get settled once the company is incorporated. The Contracts (rights of third parties) Act 1999 provided greater benefits for the Promoter and the third party as Pre-incorporation contracts were enforceable and a range of remedies were available. Besides, both the promoter’s and the third party’s interests were protected to some extent. Such contracts till the time of incorporation would be very minimal in nature so as to provide support until the company has formed. Once the company is incorporated and the Directors have agreed to take such contracts forward, then, the contract can go full-fledged with greater financial transactions. This process is known as ‘novation’ and is clearly mentioned under section 51. It was first demonstrated in the case Re Patent Ivory Manufacturing Co Howard Vs. Patent Ivory Manufacturing co13. Here the original contract was being modified following the incorporation of the company, in which the promoter’s name was removed and the company’s name was included (Goulding 1999 p. 52). Another way by which the promoters can reduce their liability would be to have disclaimers that bear no responsibilities on them for the pre-incorporation contracts. All these provisions for providing greater freedom for the directors are provided by Section 51 of the Companies Act 2006. The last but the most effective mean by which the promoter any avoid his liability would be incorporate the company first and then hold discussions with contractors. The promoter could also buy a shelf company that could be more involved in creating the required contracts, as the shelf company is already a legal person and can enter into contracts with a third party without the need for any further incorporation (University of London 2007 p. 43). Conclusion Thought the wordings of Section 51 of the Companies Act 2006 may be limited and may not seem to provide protection for the promoter, it can be seen that promoters have several protective mechanisms by which they can avoid personal liability in spite of acting in best interests of the proposed company. One mean is by novation, and the others include entering into contracts or signing disclaimer that would provide them with an authority to make such discussions on behalf of the company. However, the best manner in which the promoter may act is to hold back signing and finalizing all contracts till the actual incorporation of the company. Section 51 also aims towards protecting the interests of third parties who may not have any mechanism for obtaining payment in case the company does not agree upon the validity of such contracts that were created before it was incorporated. In case the promoters may not be held liable, then the third parties are set to suffer. However, in general it is found that in most instances, promoters would be acting on behalf of the company and since they have created the company, it is less likely that conflicts would arise over opinions regarding necessary contracts organized before incorporation (Lawyers and Jurists 2010). Bibliography Expedite 2007. Corporate and Business Law. [online], Available: http://www.theexpgroup.com/content/media/expand/debrief/178.pdf , [accessed: 3 May 2012]. Goulding S Company Law 2nd ed (Cavendish Publishing, 1999). Lawyers and Jurists 2012. A Promoter. [online], Available: http://www.lawyersnjurists.com/resource/articles-and-assignment/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-explain-and-illustrate/ , [accessed: 3 May 2012]. Legislation UK 2012. Section 51 Companies Act. [online], Available: http://www.legislation.gov.uk/ukpga/2006/46/notes/division/5/12/13, [accessed: 3 May 2012]. National Paralegal College 2003. Liability of the Corporation. [online], Available: http://nationalparalegal.edu/public_documents/courseware_asp_files/businessLaw/CorpotationForm&Features/LiabilityCorporation.asp, [accessed: 3 May 2012]. Sealy L and Worthington S Cases and Materials in Company Law (Oxford University Press, 2007). Singh PR Promoter and Pre-Incorporation Contract’ (2011) SSRN. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1938065#captchaSection University of London. 2007. Agency. [online], Available: http://www.londoninternational.ac.uk/current_students/programme_resources/laws/subject_guides/commercial/commercial_ch3.pdf, [accessed: 3 May 2012]. Read More