ANALYZE PRE-INCORPORATION CONTRACTS AND EXPLAIN HOW THEY WORK

This Article is written by Shaista Waseem, a third-year BA.LL.B. (Hons) student at the Unity degree and law college Lucknow, Intern under legal Vidhya

ANALYZE PRE-INCORPORATION CONTRACTS AND EXPLAIN HOW THEY WORK

Abstracts

Most contracts in India are governed by the Indian Contracts Act, of 1872. Section 11 of the said Act deals with who has the right to conclude a contract. According to the act, a person who has reached the age of majority, who is of sound mind, and who has not been debarred by any law, enters into a contract. There are certain exceptions to the above conditions. 

When a company is formed and registered in India, it becomes a legal entity. The company may enter into contracts on its own behalf, taking full responsibility for the organization. After the company is incorporated, it becomes a legal fiction equipped with the right to enter into contracts and agreements. However, the company’s “promoters” can contract even before the company is formed. These agreements are valid on behalf of the sponsors and are called pre-incorporation contracts or preliminary contracts. Before the company is established, a preliminary contract is made by the company promoter on behalf of the company to acquire specific property or rights.

Keywords: Pre-incorporation contract, promoters, companies liability in a pre-incorporation company, the legal status of the pre-incorporation contract.

INTRODUCTION

Pre-Incorporation Contracts, also known as Preliminary Contracts or Preliminary Agreements, refer to an agreement or a contract entered into before the company acquires a legal status. Promoters supplement the non-incorporated legal entity (company) by directing or enforcing agreements concluded at the pre-incorporation stage, including attribution and disclosure by third parties. These contracts entered by the promoters are termed “Pre-Incorporation contracts”. 

Contracts made before the incorporation of the company have no legal effect or value but can be legally enforceable. In the past, the company law had many disadvantages because it lacked a legal explanation of the contracts before the corporation and had many structural issues, making it difficult for the judiciary to decide whether promoters can shift their responsibilities to the company or if it’s justifiable to hold the company accountable. As can be seen, many changes have been made in company law to solve the problems in Pre-Incorporation Contracts law to facilitate the coexistence of companies.

The company needs to be incorporated to enjoy the legal rights and benefits bestowed upon it under any law of the time being in force. Generally, Pre-Incorporation Contracts are used as a means to purchase property or for acquisition rights or to secure the services of certain directors and specialists before the company is incorporated. 

THE LEGAL STATUS OF THE PRE-INCORPORATION CONTRACT

The legal status of Pre-Incorporation contracts is not easy to interpret in context. If determined according to the definition of contract in the contract law, there should be at least two parties to constitute a valid contract and to make it legally binding. As a general rule, a contract is void if there is no party in existence to the contract at the time of the contract. This prevents the company from entering into a contract before it is formed as it has yet to acquire the status of a legal entity. A company is said to exist only when it is incorporated under the company act 2013.

Here, the company’s promoter can act as its agent, but there is also an effect here, if the principal, namely the company itself, is not in existence, how can the authorized person act on his behalf? For this reason, the promoter is personally responsible for all contracts that do not affect the company unless the company accepts them.

However, according to Section 230 of the Indian Contract Act, an agent cannot personally enter into a contract or his personal liability or compliance with the contract he has entered into on behalf of his company if he declares when concluding the contract that he is acting only as an intermediary or an agent of the company, and he is not personally responsible for this contract.

However, section 15(h) and section 19(e) of The Specific Relief Act 1963 make the pre-incorporation contract valid. Section 15(h) provides that when the company’s promoter enters into an agreement for the purposes of the company prior to its incorporation, and that agreement is accepted by the company after its incorporation and it’s communicated to the third party the specific performance of the contract is obtained. Thus, the promoter has the right to sue the company with the help of provisions of the Specific Relief Act 1963. In Vali Pattabhirama Roa v SriRamanuja Ginning and Rice Factory Pvt. Ltd., This position of the promoter was accepted by the apex court. The facts of the case were, that the promoter of the company accrued a lease interest for it. He held it for a partnership firm for a certain period of time and later converted the firm into a company that adopted the lease. The court held that the lessor was held bound to the company under the lease.

On the other hand, section 19(e) of the said act states that the company can be sued for the Pre-Incorporation Agreement by a third person if the terms of the formation accept and guarantee the contract. This clause reduces the promoter’s liability in the Pre-Incorporation Contract.

In the case of Weavers Mills Ltd. v. Balkies Ammal, the Madras High Court expanded the application of this doctrine of law. Promoters bought certain properties on behalf of the company. Once incorporated, the company was to take over and build a model on it. The court held that the company ownership over the property cannot be withdrawn even if the founders do not pay for the transfer of property after the company is formed.

EFFECT OF THE PRE-INCORPORATION CONTRACT

The analogy of pre-incorporation contracts lies around the fact that it is signed on behalf of the company even before the company is established or incorporated. As explained above these are called pre-incorporation agreements. There must be the consent of both parties in the contract as it is not placed before the company due to its non-existence. So, the following are the effects of the pre-incorporation agreement.

• Corporations cannot be sued for preliminary agreements – A company cannot be sued for Pre-Incorporation agreements during incorporation. In the case of English and Colonial Produce Co, Re, a solicitor at the request of the promoters of the company prepared legal documents and spent time and money to get it incorporated. It was held that the company was not liable to pay him for the time and money he spent on the basis of the principle of pre-incorporation contacts. prepared a company’s documents and spent time and money in getting it registered. 
• A company cannot sue under a pre-establishment contract – A company cannot benefit from a particular contract through adoption or approval because it was represented prior to integration under the law. In Natal Land and Colonization Co. v. Pauline Colliery Syndicate, the promoters of a proposed company entered into a contract with the landlord to allow the company the lease to mine coal rights. The company would not execute the contract after it was incorporated.
• Personnel liability of the agent – Agents contracting with a non-existing company can sometimes be held personally liable. In the case of Kelner v. Baxter, The company’s promoter purchased liquor from the Claimant on behalf of the company. The company was born but went into liquidation before the price could be paid. They are personally liable to the plaintiffs.

RATIFICATION OF PRE-INCORPORATION CONTRACTS

According to the law, approval of the contract is inevitable for the company to perform the contract. For the purpose of acceptance or ratification, the sponsor may use one of the following:

• Acceptance of contracts or all other actions taken by the promoter before the incorporation of the company by passing a resolution.
• Novation of Contract: – It refers to Contract renewal i.e. replacing the existing contract with a new contract between the same parties or different parties. But the most important is the termination of the old contract. Once the contract extension is complete, the new contract is binding on both parties. In this way, the novation of contracts provides a new opportunity to change the sponsor’s role with the company.

STIPULATIONS TO BE SET OUT IN THE PRE-INCORPORATION CONTRACT

The following are a few stipulations that are to be set out in the pre-incorporation contract:

1. Company name-  The name of the company under which it is going to be incorporated.
2. Registered office- in order to determine the jurisdiction of the registrar in which the company is going to be incorporated in the future.
3. Directors and officers: The name and address of the directors and other officers of the company.
4. Corporate purpose: The object for which the company is to be incorporated.
5. Capital structure: The capital structure of the company. This discusses the capital contributions of each shareholder in the company.
6. Separate bank account: The opening of a separate bank account where all the monies received are to be kept.
7. Due date: the targeted date when the procedure of incorporation is expected to be completed.
8. Agent of the company: This clause states the persons who are authorized to act as an agent of the company.
9. Reimbursement: This states the reimbursement of money to shareholders and other persons for handling the incorporation matters.
10. Company Shares – This is a very important part of the contract that discusses the shareholder’s authority and released capital of the company. It also discusses the details of the total authorized capital of the company, what the capital is, and how much the paid and unpaid capital of each owner of the company is.
11. Termination: This states the conditions and circumstances when the contract will be deemed to be terminated.
12. Confidentiality – This section discusses how to keep all confidential information shared by promoters and others safe while establishing company security procedures, and who should be responsible in the event of a data breach.

LIABILITY IN INCORPORATION CONTRACT 

In the above paragraph, it has been determined that the Independence of a Company will not be at risk from any commitment included in the preliminary contract. This opinion is upheld by the Rajasthan High Court in the case of Seth Sobhag Mal Lodha v. Edward Mills Co. Ltd., The court stated that for a lawsuit to be filed for breach of contract two conditions must be met: “(1) the company is a registered company and (2) the plaintiff has appeared in the enlist of firms as accomplices of the firm. Unless these two conditions are satisfied, the transaction will be a dead block and will be completely inept in a court of law. A similar condition was accepted by the Apex court in the case of  India in CIT v. City Mills Distributors Ltd.

But this approach was later criticized and overruled in later cases. The key purpose of the dispute was held to the unconscious of the provisions of the Specific Relief Act, of 1963. Along these lines, the company’s promoters are capable of blocking obligation by utilizing the arrangements of the Specific Relief Act.

Promoters liability for full disclosure

It is the promoter’s responsibility to ensure adequate disclosure is made when the contract is concluded, otherwise, the company may: 

• cancel the contract and retract the contract price message, 
• Recover the profit even though the contract is not claimed or cannot to possibility claimed.  
• If the promoter breaches its fiduciary duty, the Company has the right to indemnify its losses. 

LANDMARK CASE LAWS

• Vali Pattabhirama Rao v. Sri Ramanuja Ginning:

In this case, the court held that the promoter has the power to transfer his right to sue to the company by including it in the Articles or Terms of Association, according to the court. 

• Howard v. Patent Ivory Manufacturing Co:

In this case, it was held that “A Company cannot ratify a Contract established before its creation, but it can enter into a new contract after it has been formed to give effect to any dealing made before its formation.”

• Kelner v. Baxter: 

In this case, the promoters of the hotel company have made a preliminary contract for the purchase of wine. But the wine was consumed first and for some reason, the company went into liquidation. Others in the contract sued the sponsor for not paying for the wine. The promoters said that since this contract is with the company, the responsibility passes to the company, so they do not have any personal responsibility. The court said that since the company was not established at the time of the contract, it could not reduce its responsibilities, so the promoters had to pay other people.

CONCLUSION

Pre-Incorporation agreements are legally binding and enforceable even if they are deemed to have no legal value or value. There have been many problems with pre-company agreements in the past as Indian corporate law does not provide clear guidance on the legal nature of pre-company contracts and set-up. Therefore, the judges do not believe that the entrepreneurs can change the liability or whether the company is exempt from liability. As we can see, many amendments have been made to the Companies Law to solve the pre-contract issue, making it easier for companies to register to do business. In accordance with American law and Indian law, the partners are personally responsible for the agreements prior to the establishment of the company.

American and Indian law is more advanced and specialized than English law and is more effective in dealing with pre-contractual matters. On the other hand, English courts continued to abide by the law and the rules set in Kelner v Baxter.