This article is written by Prithika Vajpeyi, University School of Law and Legal Studies, GGSIPU, an intern under Legal Vidhiya.
Abstract:
Promotion is the first stage in the formation of a company. People who help complete the formalities for the formation of a company are called its promoters. In this article, we will look at the relationship between a company and its promoters, analyse the position of a promoter concerning his liability for pre-incorporation contracts and the company’s rights to enforce these contracts and its liability for the same. We will also explore the development of company law with respect to pre-incorporation contracts by taking a look at the introduction of the Specific Relief Act, 1963 and its impact on the legal status of pre-incorporation contracts.
Keywords: promotion, promoters, pre-incorporation contract, liability, legal status
Introduction:
There are four major stages in the formation of a company: promotion, registration, incorporation, and commencement of business. Promotion is that stage in which the feasibility of an idea is analysed from various perspectives: technical, economic and legal. Thus, a promoter, is as defined in Section 2(69) of the Companies Act, 2013:
(a) who has been named as such in a prospectus or is identified by the company in the annual return
(b) who has control over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise; or
(c) in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act
For the purpose of facilitating the formation of a company, promoters enter into contracts for the supply of goods or services on behalf of the company. Since the company has not been incorporated yet, it has not been issued a certificate that validates the company’s establishment in the records, these contracts are known as pre-incorporation contracts.
The legal issues that arise in the context of these contracts are:
1) A contract is always between atleast two parties and since the company has not been formed yet, are pre-incorporation contracts binding on companies?
2) Can the promoters said to be agents of the company as the principal i.e. the company was non-existent when the promoters are said to have assumed agency?
3) Can the promoters be held personally liable for these contracts?
4) Can promoters shift their liability to the company?
5) Can a company ratify a pre-incorporation contract since it dates back to when the company was non-existent?
Are pre-incorporation contracts binding on companies?
Before the introduction of the Specific Relief Act, 1963, companies could not at any cost be held liable for pre-incorporation contracts as at the time of making the contract, the company did not exist. Thus, there is no contract between a third party and the company. Also, it is difficult to expect companies to fulfil every contract entered into by promoters because promoters sometimes are verbose and make impractical promises.
Thus, even if the company wished to enforce the contract, it was not possible as ratification would date back to when the company did not exist. Hence, the question of ratifying the contract does not arise.
This, however, led to the problem of lack of trust of third parties in the ability of the promoters to fulfil their promises as these pre-incorporation contracts could not be ratified. Thus they were not willing to supply goods and services to promoters. This led to the introduction of the Specific Relief Act, 1963.
According to the definition in Section 15(h) of the Specific Relief Act of 1963, contracts entered into prior to incorporation are those that entered into for the purpose and utility of the company by the promoters, and subject to the terms of incorporation of the company, the company may ask for specific performance from the third party.[1]
Can promoters said to be agents of the company?
The Supreme Court has affirmed that the relationship between the two is one of a fiduciary relation, despite the fact that the case laws and academic discourse on this matter have been complex and ambiguous. It dismissed the promoter’s claim that they were acting as trustees or an agency on behalf of the unincorporated firm.
In the case of Weavers Mills v. Balkis Ammal[2], it was determined that since the promoter has a fiduciary duty to the company, all the benefits of the pre-incorporation contract would pass on to the company even in the absence of an express conveyance of the property by the promoter to the unincorporated firm.[3]
Two significant findings are derived from promoters’ fiduciary obligations:
Any unauthorised profits made by a promoter are not permitted. He will be required to return the money to the company if it is discovered that he made a concealed benefit for himself in any particular transaction of the business.
In the absence of full disclosure of all material information, the promoter is not permitted to profit from the sale of his own property to the firm. If he enters into a contract with the company to sell his own property without fully disclosing it to them, the company will either revoke the sale or uphold the contract and collect the promoter’s profit from it.
Can promoters be personally held liable for pre-incorporation case?
Pre-incorporation contracts are typically subject to personal liability for the promoter. The common law concept would be applied and the promoter would be liable for breach of contract if a business did not ratify or adopt a pre-incorporation contract under the Specific Relief Act.
A promoter is liable under the following clauses of the Companies Act:
Section 26 of the Companies Act of 2013 specifies the information that must be included in a prospectus. A promoter may be held accountable for failing to comply with the section’s provisions.
A promoter may be held accountable under sections 34 and 35 of the Companies Act, 2013 for any untrue statement in the prospectus to a person who subscribes for shares or debentures in reliance on such prospectus. However, the promoter’s culpability in such a case would be restricted to the original allottee of shares and would not extend to subsequent allotters.
Section 300 states that a promoter may be subjected to scrutiny like any other director or officer of the company if the court orders it based on a liquidator’s report claiming fraud in the promotion or establishment of the company.
A company may sue a promoter under section 340 for fraud or breach of duty if the promoter misapplied or kept any company property or is guilty of misfeasance or breach of trust in connection to the company.
In Prabir Kumar Misra v. Ramani Ramaswamy[4], the Madras High Court ruled that it is not required for a promoter to be a signatory to the Memorandum/Articles of Association, a shareholder, or a director to be held liable.[5]
Section 19(e), on the other hand, says that the company can be sued by the other party of a pre-incorporation contract if the terms of incorporation warrant and adopt the contract. This provision decreases the promoter’s obligation under the pre-incorporation contract.
Can promoters shift their liability and rights to the company?
Sections 15(h) and 19(e) of the Specific Relief Act of 1963 are the two most crucial sections for pre-incorporation contracts. Section 15 deals with a stranger’s right to sue if he is entitled to a benefit or has an interest in the contract, however it is subject to certain limitations. Section 15(h) states that as a stranger to the pre-incorporation contract, the firm has the right to sue the other contracting party. The contract, on the other hand, must be warranted by the provisions of its incorporation. This section expressly contradicts the common law notion that the company cannot ratify or adopt the pre-incorporation contract. Under this rule, the promoter may transfer his right to suit to the corporation. This viewpoint was recognised in the case of Vali Pattabhirama Rao v. Sri Ramanuja Ginning and Rice Factory Pvt. Ltd[6].
Can a company ratify a pre-incorporation contract since it dates back to when the company was non-existent?
Contract ratification by the corporation is unavoidable for the purpose of enforcing it. For such acceptance or ratification, the proponents can use either of the techniques listed below:
- Accept the contracts by passing a contract acceptance resolution, as well as the promoter’s action to incorporate the company and associated items.
- Scarf v Jardine [7]defines novation of contract as “being a contract in existence, some new contract is substituted for it, either between the same parties (for that might be) or between different parties, the consideration mutually being the discharge of the old contract.” Novation differs from Ratification in that in Novation, a new contract is made on the same terms but this time between the company and the third party, whereas in Ratification, the contract dates back to the time of the act ratified, so that if the company ratifying, which is no longer in existence, cannot have performed the act in question, its subsequent ratification of it is ineffective.[8]
Comparative Analysis:
We now take a look at some British cases and the provisions in British and American laws to understand the development of law in this respect in the three countries:
In Kelner v Baxter[9], the promoter on behalf of an unformed company accepted Mr. Kelner’s offer to sell wine; however, the company neglected to pay Mr. Kelner, and he filed a case against the promoters. The principal-agent relationship cannot exist prior to incorporation, and if the firm does not exist, the principal of an agent cannot exist. He goes on to clarify that the company cannot assume the obligation of a pre-incorporation contract by adoption or ratification because a stranger cannot ratify or adopt the contract and the company was a stranger because it did not exist at the time the contract was formed. Therefore, he ruled that the promoters are personally accountable for the pre-incorporation contract because they consented to it.
The Court of Appeal in Newborne v Sensolid (Great Britain) Ltd [10]viewed Kelner v Baxter’s decision differently and expanded on the idea. In this example, an unformed corporation entered into a contract, but the other contracting party refused to perform his duty. Lord Goddard stated that the company cannot exist prior to incorporation, and if it does not exist, then neither does the contract signed by the unformed company. As a result, the company cannot file an action for a pre-incorporation contract, and the promoter cannot bring a suit because they were not a party to the contract.[11]
Although the rule that promoter is personally accountable for pre-incorporation contract is recognised under English Common Law, American Law and Indian Law, American Laws and Indian Law are far more imaginative and effective in solving the problem of Pre-Incorporation Contract. Whereas the English Courts continue to apply the Kelner v. Baxter premise. Although the Contracts (Rights of Third Parties) Act 1999 provided some relief in the United Kingdom, it is not as wide as American and Indian laws.
Under English Common Law, ratification or acceptance after incorporation did not remove the promoter from liability under a pre-incorporation contract. In contrast, American courts recognise that after incorporation, the company might ratify or accept the contract, and this would bind the company rather than the promoter. The rule of Kelner v Baxter applies in Indian law, although under the Specific Relief Act 1963, sections 15(h) and 19(e), the promoter can transfer his rights and responsibilities to the business if the terms of incorporation support it.[12]
The principle of novation of pre-incorporation contracts is applicable in the above three counties. The reason for this is that the novation replaces the old contract with the new contract, therefore there is no problem of business non-existence.
Thus, we conclude that the promoter is personally liable for the pre-incorporation contract because the company does not exist at the time the contract is formed, hence neither the principal-agent relationship nor the company becomes a party. The company is not liable for the pre-incorporation contract when it comes into existence, but under the arrangement of Sections 15(h) and 19(e) of the Specific Relief Act 1963, the company can take the rights and liability of the promoter. It is also discovered that the promoter is personally accountable for the pre-incorporation contract under American, English, and Indian law.
[1]https://www.legalserviceindia.com/legal/article-9585-pre-incorporation-contracts.html visited on 10-04-23
[2] AIR 1969 Mad 462
[3] https://www.legalserviceindia.com/legal/article-9585-pre-incorporation-contracts.html visited on 10-04-23
[4] [2010] 104 SCL 174
[5] https://www.legalserviceindia.com/legal/article-9585-pre-incorporation-contracts.html visited on 10-04-23
[6] 1986 60 CompCas 568 AP
[7] [1904] 1 K.B.838
[8] https://www.soolegal.com/roar/validity-and-ratification-of-pre-incorporated-contracts-in-india visited on 12-04-23
[9] (1866) LR 2 CP 174
[10] (1953) 1 QB 45
[11] https://www.lawteacher.net/free-law-essays/contract-law/pre-incorporation-contracts-and-the-promoter.php visited on 11-04-23
[12] https://www.lawteacher.net/free-law-essays/contract-law/pre-incorporation-contracts-and-the-promoter.php visited on 11-04-23
