Pre-Incorporation contracts thought to have no legal status and value, but are legally valued and enforceable. In past, there are lot of flaws in the law of pre-incorporation contract as there were no proper statement of law had explained in the companies act of India regarding pre-incorporation contract and the problem of drafting which leads to a uncertainty for the judiciary to decide whether to promoters can shift their liability or company is safe from being held liable. As we have seen a lot of changes made in the company act to tackle the problem in the law of pre-incorporation contract to make it easy for the corporate company at the time of incorporation of their company. There are some problems regarding the ratification of the contracts made at the time of incorporation to protect the company or their members from any liabilities. As we are going to discuss in this research the liability of the promoters after pre-incorporation contracts and the problem arises due to pre-incorporation contracts.
As Per the companies act India 1956 pre-incorporation contracts are contracts purported on behalf of an unformed company or in other words the company which does not have any legal existence (i.e. before its incorporation). This is the fact that for new incorporation very often there is a necessity of the pre-incorporation contracts.
It is very important that the process of incorporation must be done before the company can be said to have come into existence to attain its legal features otherwise, if the process is not complete the independent legal entity does not come into existence. Most of the times the pre- incorporation contracts can be done for purchase of property of rights or rights to be acquired or for securing the services of some mangers and experts. The persons incorporating the company will want to offer as an inducement to the public for benefits of such agreements and contracts to take shares hence it become necessary that these contracts be made before the formation of the company.
Pre-incorporation contracts are also known as preliminary contracts or preliminary agreements which means that contracts or agreements before the company came into legal existence. The attempt has been to look at the uncertainties and the controversies formed due to conflicting judicial interventions in case law and half-hearted legislative attempt. The focus of research is on common law as it has a great relevance in the Indian context and specific instances in English also. As common law is the most practiced form of law in the world.
Promoter plays the important role on acting behalf of the company while entering an agreement with another company before its incorporation. The term “promoter” find its place in company law, still it has not defined under the companies act 1956. The reason for not defining the term promoter under the companies act 1956 is because the term does not have any legal implication but still consist of some business element which is important for the companies. The work of the promoter is to promote the company for entering an agreement with the other company acting on behalf of the company they are promoting. Promoter may be an independent person or a group of association.
As the term promoter not defined in the companies act 1956, but it has been defined under Section 2(69) of Companies Act 2013, Promoter means a person-
- Who has been identified by the company in the annual return or named as such in prospectus referred to section 92, or
- Who has control directly or indirectly over the affairs of the company, whether as a shareholder, director of the company or otherwise,
- The board of directors of the company in accordance with whose advice, direction or instruction accustomed to act,
Person who is acting merely in professional capacity for them nothing in sub clause (c) shall apply.
In Tengku Abdullah v Mohd Latiff bin Shah Mohd, Gopal Shri Ram JCA said,” A promoter is a one who starts off with a venture not solely for himself but for others too, but whom, he may be one”
The Securities Exchange Board of India (Disclosure and Investor Protection), 2000 (“DIP Guidelines”) explain the concept of promoter clearly. The term “promoter” finds its place in the SEBI (Substantial acquisition of Shares and Takeover Regulation),1997 (“Takeover Code”). Promoter is neither act as an agent or a trustee of a company, but under incorporation but must practice certain fiduciary duties imposed on him under both English Companies Act and Indian Companies Act.
- Duties of the promoter
Promoters have a relationship of trust and confidence with the company. This means promoters have been described to be in a fiduciary relationship with a company. To make a full disclosure of all the facts and the material in the formation of the company it requires the relationship of trust and confidence. As there is a relationship of trust has been developed with the company promoters cannot make any secret profit on the expense of the company he promotes, if the promoter make any secret profit without the consent and without the proper knowledge of a company, the company can compel him for that or held liable for those breaches of duties.
A promoter is restricted to make a secret profit but no restrict on making profit of which company has a knowledge and consent before making that profit. In Gluckstein v Barnes an association of persons was forced to buy a property called ‘Olympia’ and resell it to the other company which has been formed for this purpose. The association first bought the debentures of old ‘Olympia’ company at discount. Then they bought the company itself for £1,40,000. Money for this amount has been provided by the association itself and the debentures were repaid in full and a profit of £20,000 was an undisclosed profit i.e. in other words it means secret profit. For £1,80,000 the association decided to promote a new company and sold the existing Olympia company. They make a profit of £40,000 which was revealed in the prospectus of the company the profit of £20,000 they made it earlier is not revealed in the prospectus of the company. It was held, that undisclosed profit of £20,000 was a secret profit which is against the fiduciary duty of the promoters and in this case promoters of the company were bound to pay it to the company because the disclosure of the profit by themselves in the capacity of vendors to themselves in the capacity of directors of the purchasing company was not sufficient.
- DISCLOSURE TO BE MADE TO WHOM
As we have discussed in the above topic that promoters are liable for not disclosing all the facts to the company they are promoting. Now in this topic we are going to discuss to whom the disclosure should be made. Erlanger v. New Sombrero Phosphate Co., it was held that the disclosure must be made to the whole body of persons have and this can be done through the prospectus. It is the duty of the promoters to disclosed all the facts to the company members whom they have persuaded to join the company. Disclosure can be made to the Board of Directors when there is no independent director is present, it should be made to the prospective shareholders. It was held in Lagunas Nitrate Co. v. Lagunas Syndicate, the profit of promoters shall be treated as secret unless explicitly disclosed to an independent Board of Directors. There are lot of ways of disclosing the secrets but the disclosure made to the Board of Directors who were nominees of the promoters shall not be a valid disclosure and the promoter shall be liable for non-disclosure.
Section 56 of the Companies Act, 1956 requires that the profit made by the promoters should be disclosed in the prospectus itself. The disclosure should be made of any interest of the promoter in the promotion of the company or any property acquired by or proposed to be acquired by the company during the preceding two years.
In Vali Pattabhirama Rao v. Ramanuja Ginning & Rice Factory (P) Ltd., the promoter purchased a leasehold interest in the company which he intended to form. But he first formed a partnership and then converted it into a company. The court held that from the very first day of the purchase leasehold purchased by the promoter became the property.
In Fairview Schools Sdn. Bhd v. Indrani a/p Rajaratnam, “Promoter have a legal duty not to make a secret profit out of the promotion of the Company without the consent and to disclose to the company any interests the promoters have in any transaction proposed to be entered to the company”.
- PROMOTER’S LIABILITIES
The promoter or promoters of a company have a fiduciary relationship with the company which they have promoted at the time of pre-incorporation contracts or incorporation contracts. This fiduciary relationship or the relationship of trust and confidence give rise to certain liabilities on the part of the promoters in various cases. The Companies Act mentions the various liabilities that can be put upon the promoter in case of default on the part of the promoter. The various liabilities which can be incur upon the promoters are:
- For Non-Disclosure:
The liabilities in case of not making full disclosure at the time of contract was made, the company may either:
Revoke the contract and recover the price of the contract they purchase or
Recover the profit made, even though rescission is not claimed or not impossible,
In case of breach of fiduciary duty and trust company can claim damages.
- Liabilities Under Companies Act:
It states that matters and the reports are to be mentioned in the prospectus. For non-compliance of the provision of this section promoter will be liable.
A promoter is liable for false statement in the prospectus to a person who has subscribes shares or debentures on the faith of the prospectus present by the promoter. False statement leads to following consequences: –
- The allotment of shares and debentures may be set aside;
- The promoter may sue for damages and asked for compensation;
- The promoter may incur criminal liability and proceedings may be instituted against him.
This section set the punishment for the false or deceptive statements in the prospectus. The punishment for the false statement under section 63 is 2 years of imprisonment or fine which may extend to fifty thousand rupees or both.
Promoter prove reasonable ground that the statement issued in the prospectus is true , then promoter can escape the liability.
At the time of wounding up of the company by the court order and the liquidator report any fraud in the formation of the company or promotion of the company, then promoter shall be liable to public examination like any other officer or director of the company.
Court can restraint promoter form engaging into the management of the company for a period of five years if it appears guilty of any offence punishable under section 542 (whether he is convicted or not) or while being an officer has otherwise been guilty of any fraud and breach of duty in respect of the company of which he is a promoter.
Where a promoter retained the property of the company or is guilty of misfeasance or breach of trust in the relation to the company, he can be sued by the company for breach of duty or deceit.
- PROMOTER’S OBLIGATIONS UNDER PRE-INCORPORATION CONTRACTS
- PRE-INCORPORATION CONTRACT
This is an obligation off the promoter to bring the company into legal existence and to ensure its successful running, and to fulfill this obligation the promoter may enter some contract on behalf of the prospective company.
Nature of Pre-incorporation contract is somewhat different from the ordinary contract. It has a feature of tri-party contract. In this contract, promoter draft the contract on behalf of the company with an interested person and that contract between them becomes a bilateral contract. But the most remarkable part of this contract is that, this contract help the perspective company, who is not party to the contract.
- LIABILITY OF PROMOTER CONCERNING PRE-INCORPORATION
The position of India regarding pre-incorporation contract, was like the English Common Law before the passing of the Specific Relief Act 1963, by the Government of India. This is a 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 the contract. And as we know company does not have any legal existence before its incorporation, so the promoter sign the contract on behalf of the unformed company with third party to enter a contract, and as the company has no legal existence the promoter was solely liable for the pre-incorporation contract under the established ruling of Kelner v Baxter.
Promoters are liable for the pre-incorporation contract. If a company does not ratify or adopt a pre-incorporation contract under the Specific Relief Act passed by Government of India to tackle the problem of pre-incorporation contract in the future. If they don’t adopt under this act, then the common-law principle which is practiced in most part of the world would be applicable and the promoter will be held liable for the breach of the contract.
In Kelner v Baxter, on behalf of unformed company i.e. before the incorporation of the company, the promoter accepted an offer of Mr. Kelner to sell wine, subsequently the company failed to pay Mr. Kelner, and he brought the against the promoter with whom he entered a contract. Erle CJ found that the principal-agent relationship cannot be in existence in the pre-incorporation contract that means before incorporation of a company and if the company is unformed, the principal of an agent cannot be in existence. He further explains that the company cannot take the liability of pre-incorporation contract through adoption or ratification of the contract and the company was stranger at the time they enter a contract. So, he held that promoters are personally liable for the pre-incorporation contract because they act on behalf of the unformed company as they are the consenting party to the contract.
In Newborne v Sensolid (Great Britain) Ltd, explain the facts of Kelner v Baxter in a different way and developed the principal further. If the company entered a contract before incorporation, the other contracting party can have refused to perform his duty to that contract. Lord Goddard observed that before incorporation the company cannot come into existence and if it is not in existence then the contract which the unformed company signed would not be in existence. So, company cannot bring an action for pre-incorporation contract, and the promoter cannot bring the suit because they were not the party to contract.
- UNDER SPECIFIC RELIEF ACT 1963
Under the Specific Relief Act 1963, Section 15(h) and 19 (e) are the two-main important section which tackle the problem of the pre-incorporation contract.
Section 15 talks about stranger’s right to sue if he entitled or benefit or has any interest under the contract, although it has certain limitation. Section 15(h) talks about the company, has a right to sue to the other contracting party as being a stranger to pre-incorporation contract. But the necessary condition is that the contract should be warranted by the terms of its incorporation. The common-law doctrine which says that the company cannot ratify or adopt the pre-incorporation contract negates this provision. Under this provision promoter can give right to sue to sue the company with the help of provisions of Specific Relief Act 1963. In Vali Pattabhirama Roa v Sri Ramanuja Ginning and Rice Factory Pvt. Ltd. This position was accepted.
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.
- BRIEF COMPARISON BETWEEN INDIA AND OTHER COUNTRIES LAW REGARDING PROMOTER’S LIABILITY FOR PRE-INCORPORATION CONTRACT
Under the English Common Law, the American Law and the Indian Law they have a same recognition that promoter is personally liable for pre-incorporation contract, American Laws and Indian Laws are much more advanced and innovative than the English Common Laws and effective in solving the problem of Pre-incorporation contract. On the other hand, English courts still follows the principle and the rule of law established in the case of Kelner v Baxter. This means that English Laws are following the same old principle of pre-incorporation contract. Although in UK, Contracts (Rights of Third Parties) Act 1999 brought some relief, but it still not broads as American and Indian laws are.
Under English Common Law, promoter cannot be released from the liability after pre-incorporation on the adoption or ratification. Whereas in American Court recognize that if after the incorporation company can ratify or adopt the contract, and this would bound the company not the promoter. Indian law the rule of Kelner v Baxter is applicable but under the specific relief act 1963, section 15(h) and section 19(e) promoter can shift their liability and responsibility to the company, if it is warranted by the terms of incorporation.
the reason behind is that, the novation replaces the old contract with the new one, so there is not a problem of non-existence of company.
Now after the Contracts (Rights of Third Parties) Act 1999, English Laws may also allow company to become the part of pre-incorporation contract, when it acquire its legal existence.
II. PRE-INCORPORATION CONTRACTS
Promotes on behalf of the company entered a contract before incorporation and are liable to company as well as the third parties in respect of their conduct of entering the contracts during the pre-incorporation stage including the statement in prospectus, either treating the as the agent or the trustees of the company to be incorporated, still they recognized to focus the legal fiction of corporate personality. Commercial transactions or promises of commercial transaction fall under within this category. To spot the difference between the ordinary contract and the “pre-incorporation contract” is the terms of the beneficiary. Although the contracting parties are the promoters and the third-party, the intended beneficiary is the prospective of the company which is yet to be incorporated.
- PROMOTER AND THE COMPANY REALTIONSHIP
On this issue the case laws and academic discourse or their principal explanation has been multifaceted and inconclusive. But the previous High Court ruling has been affirmed by the Supreme Court of India which has defined the relationship between the two as that of a fiduciary relationship. The position of the promoter as a trustees or agent with respect to that of the unincorporated company. In the case of Weavers Mills v. Balkis Ammal & ors., it was held that without disclosure of all the facts and the materials related to the contract the promoter has entered, since the promoter stands in fiduciary duty to the company, all the benefits of pre-incorporation contract would pass on the company.
“While we accept that the position of the promoter is neither an agent or a trustee of the company under incorporation, we are inclined to think that in respect of any transaction done on behalf of the company by the promoter he always stands in a fiduciary position. The legal position of the promoter in relation to his acts, particularly purchase of immovable property on behalf of the company under incorporation, is a peculiar on not capable of being brought into any established or recognized norms of the law as to its character as an agent or a trustee. At the time of purchase of immovable property and as promoter stand in relation of fiduciary duty, do certain things for the benefits of it. He is not at the liberty to deny the benefits of the company when incorporated. In all such cases the benefits from the purchase will pass to the company when incorporated”.
Being in the position of fiduciary duty, can promoter force the company to compensate it for the pre-incorporation expenses that the promoter incurs on behalf of the company? If company wants to take all the benefits of the contracts, then the company must accept the burden too and hence must compensate the promoter for all this expenses under the said contract. But if the company doesn’t ratify the contract, then promoter at that stage can’t claim for any reimbursement.
The reimbursement claimed by the prompter can be in the form of increased pay up during the allotment of shares. In American jurisprudences in lieu of pre-incorporation contract the allotment of shares is not treated as a good consideration. Under the Indian Contract Act, consideration for past services is a good consideration, allotment of shares in lieu of pre-incorporation services can be permissible.
- LIABILITY OF THE CO-PROMOTOER
Here the issue not arise by the facts of the liabilities of the promoter acting on behalf of the company. The issue of non-existent of a principle doesn’t arise. When the promoter acts to incorporate a subsidiary of a foreign company it becomes relatively pertinent. One could ask for the promoter remuneration and re-imbursement from this company on which the promoter claim to be acting on behalf of an already existing holding company.
The restriction came in the English Law; the co-promoter’s liability has been restricted only to the cases where an express authority to act as an agent is conferred. The court has been slow to read the implied authority and have explicitly rejected conferring such liability. English law suggests, albeit weakly, that pre-incorporation association to be that of partnership. However, what is pertinent to prove is that the association is with the common objective of earning profit. This become difficult to show when the object is merely administrative in nature i.e. to get the company organized. However, when it was shown that the object was more than administrative, i.e. for acquiring a business and operating it before incorporation (pre-ordering good for bakery), then it can be considered, to be a partnership and expenses were recovered from all promoters. It became difficult to hold them liable as an association sui generis but, if the association was a partnership that was later incorporated then one can say that the acts of the promoter can bind the partnership completely.
In India, partnership act lays down that partnership must be the result of an agreement,which need to be formal or written it is indispensable to carry out the business under the Indian Partnership Act.
South African law has again take a leap forward by holding all the promoters jointly and severally liable for a pre-incorporation contract entered by any of the promoter. It must be taken care of that not only focus merely on the signatory but the focus will also be on any implied authority by other promoters.
- PRE-INCORPORATION OR DEFECTIVE CORPORATION?
The basis of Newborne case and Kelner case which commented upon by mentioning how the promoter held liable hinged on technical distinction of how the contract was signed. However, it must be noted that case of Newborne dealt with a contract with a defective corporation. The confusion is not new and people often tend to put both of them under the same umbrella. To deal with the problem of pre-incorporation contracts it has been suggested that the doctrine of corporation by estoppel and de facto corporation can be used or considered. These doctrines protect the promoters or directors from being personally liable on contracts that were entered into with a company, that both parties, in good faith, believed to have been incorporated, when it was not. What most analysts can miss that the distinction lies in the knowledge of the parties. In a pre-incorporation, no effort is undertaken to incorporate. Only having a good faith intent to incorporate is not sufficient requirement for the doctrine of corporation by estoppel to operate. Some attempt must be undertaken to bring it into operation. Further, another difference that lies in the knowledge of the parties. Whereas at the time of pre-incorporation contract, both parties have the knowledge that the company is yet to be incorporated, in a defective incorporation both have a bona fide but fallacious belief in the existence of the company. If the promoter lies about the same to the other party, then he can clearly be held liable for fraud or breach of warranty of authority.
In the Indian scenario, on account of the name approval certificate, it is quite clear that the doctrine of corporation by estoppel or de facto corporation would come into play only when attempts are made to file a certificate of registration.
III. ENFORCEMENT OF THE CONTRACT
The anomaly of a pre-incorporation contract revolves around the fact that a contract is entered on behalf of a non-existent company which has no legal personality or has not been incorporated . The third party has been left on the uneven ground in number of jurisdictions with the contract being declared null and void due to lack of competent person entering the contract. There are various ways in which these situations are dealt under the common law where some protection is given to the third party.
The first question that needs to be dealt with is the relationship between the promoter and the company, to the trustees of the unincorporated company. The usual argument which has been made rand often selectively applied is to treat the promoter as an agent of the unincorporated company. As it was explained in the companies act that contract at the time of entering the pre-incorporation contract if the principal is non-existent, the promoter can’t be bind as the agent of the company. Another implication of this is at the time of post-incorporation stage and ratification is still not permitted. In Indian law ratification, can be done to tackle the problem of the liabilities but in English law bars ratification of pre-incorporation contract by the company on the basis that even for ratification, the company need to have a legal capacity at the time the contract was completed, which is absent for a pre-incorporation contract.
The doctrine of persona fictameans “the person in imagination or juridical person” is so strictly followed in English law that unless novation (mutually agreement between the parties to replace once obligation) of the contract take place to replace the company as a party to the contract, no unilateral ratification is permitted as any act of ratification or adoption by the company is considered an offer to the third party, and not acceptance of the offer of the third party. This is on the recommendation of the Jenkins Committee to allow the process of the ratification for commercial expediency reasons. To allow the company to ratify pre-incorporation contract one theory suggests and which has been adopted with some flexibility in certain jurisdiction. Resemblance is drawn to ratification of unauthorized act of agent by the principle.
South African Law confer the power on the board to ratify and in fact, has a provision for deemed ratification, i.e. within the period of 3 months if the corporation doesn’t act on the contract, it will be deemed to be ratified by the company. This provision is the next step ahead of other common law jurisdictions might prove harmful for the company especially because of no specific knowledge of the contract and the time period might be arbitrary, without giving the consideration to the kind of contract. As some contract, might take more than 3 months to be examined and ratified.
American jurisprudence tries to avoid the theoretical difficulties of ratification by introducing or adopting another concept of ‘adoption’ instead of ratification. Legal effect for both is same, the only difference lies in being technically correct. The concept of adoption benefits the contract for the company to automatically becomes a party to the contract. Principal-Agent relationship does not justify the liability is to be impinged on the company but the power can be located within its inherent powers of forming contract as body corporate. Thus, the company though might not be free to ‘ratify’ in the strictest legal sense, but is free to adopt the contract with the equitable reason to protect the third parties, if the company has taken the benefits from the contract.
It has been noted that Indian Law along with South African law has been very liberal in this aspect and gives companies the power to ‘ratify’ pre-incorporation contracts entered on its behalf. As we have discussed above in the topic of Specific Relief Act 1963 of India , the same power can be located within the framework of this act under section 15(h) and section 19(e).
It has been explained in the case of Seth Sobhag Mal Lodha and ors. v. Edward Mills Co. Ltd. The court denied any scope for enforcement of a pre-incorporation contract. It has been noted that in this judgement they court failed to take into the consideration of the provisions of Specific Relief Act into an account.
A breakdown of the provisions of specific relief act section 15(h) and section 19(e) for a pre-incorporation contract to gain the validity in the eye of the law.
As we have talked about Specific Relief Act 1963, that gives the way to shift the liability of the promoter or promoters to the company at the time of incorporation. There is a legal vacuum in India when it comes to the enforcement of the contract without such ratification. The question raised can the promoter be held liable personally for this contract as is followed in number of jurisdiction mainly USA, UK, EU? There is another important question whether the promoter can be relived of all their liabilities at the time of ratification of the Pre-incorporation contract by the company. The judiciary in India is silent on this aspect of the law.
According, to the inroad to the Common-Law position would be helpful in this problem. In this context, common law gave prime importance to the intention of the parties adjudicating the contract. If the promoter on his behalf act for the corporation, then he was held personally liable for the contract. However, if the contract entered in the name of the proposed company and the promoter merely authenticated the signature acting as a mere agent, then the promoter was relived from all the liability. The most cited case for enabling enforcement against the promoter has been Kelner v. Baxter in which, the promoter signed on behalf of the proposed company, the company which still hasn’t formed and the enforcement of the contract was bought before the court. Therefore, court held that since it was conspicuous to both the parties that the company was ‘proposed’ to be formed, hence the intention of both the parties is to hold promoter personally liable in case, the company is not formed. As we have studied the case ofNewborne v. Sensolid in this case, the company was entered a contract at the time when the company itself has not been properly formed. From the signature, the court concluded that the contract was rendered void since the director of the company itself authenticated the signature and didn’t purport to sign as an agent of the company.
This distinctive approach has often criticized as it is more technical with intention being reduced to focus on the form of signature rather than focusing on other aspects. Lord Denning also propounded that the real intent is to be discerned not on the technical distinction of signature but based on the knowledge of the parties and the contract itself and that’s the reason he criticized this approach. However, Newborne doesn’t stand as an authority to deny enforcement of the contract vis-à-vis the promoter. In this case the parties wrongfully presumed that the company was in existence when the contract was entered into. The company pleaded its unconstitutionality to get away with the contract. The principle that we can take it from these two important cases in the foundation of the promoter liabilities at the time of enforcement of the pre-incorporation contract that when both the parties are aware of the non-existent of the company, then the question that must be asked to determine the intention of the parties is whether the promoter had wished to assume the liability in the contract was not novated. Furthermore in Newborne the court failed to account the promoters for breach of warranty or authority.
The common-law distinction between the signatures was exterminate by Section 9(c) of the EEC directive and further Section 36 of the Companies Act which laid down that any person who purports to contract for a company, will be held liable for it personally, unless expressly agreed otherwise by the parties. Thus, to prevent the contract to being declared a nullity and leaving behind the dead tree where no one is held liable, the statutory enactment reinforced the security of transactions. It is to note that in India, in the absence of such statutory enactment, the question of liability is left open.
Section 36C of the Companies Act, which harden common law and obliterated technical inconveniences, also took within its fold cases where no formal contract was entered but services were rendered under some arrangement. In the case of Braymist Ltd. V. WiseFinancial Co Ltd. , in this case it was held that not only can the agents be sued under the contract but can also sue on the contract.
As in the American jurisprudence which suggests a strict liability for the promoter in case the corporation is not formed or doesn’t adopt the contract. In the case of RKO- Stanley WarnerTheatres, Inc. v. Graziano, the promoter was held personally liable despite explicitly denying the liability for such contract and placing it on the corporation to be formed. It never going to adopt the contract even the corporation was formed, hence the court turned down the plea to limit the personal liability to the pre-incorporation stage.
There are three routes suggested by the restatement agency available in case of a pre-incorporation contract are: firstly, make the corporation liable on the contract or; secondly, liability of the promoter to ensure that the corporation adopt the contract and thirdly, termination of promoter’s liability on the corporation adopting the contract. However, the default rule is to make the promoter personally liable on all such contracts. Out of three routes suggestions given by the restatement agency the first route would not be allowed in India since Specific Relief Act requires acceptance by the company and such acceptance cannot be pre-imposed on the company without its will. The third route case is ambiguous in India.
In South African Law, they not only make the promoter personally liable but also hold liable for the breach of dual warranty of statutory authority. One is that promoter will incorporate the company within reasonable period, of time and the company would ratify the contract. This provides the much-needed security of transaction to the third party but “the statutory warranty approach brings an existence of uncertainty by leaving lacunae and gaps during the interim period of the execution of the pre-incorporation contract by the agent and its ratification by the company itself. Due to this there is a rise in number of practical problem and challenges, which include the issue of unilateral withdrawal of the third party and mutual cancellation of the agreement during the interim period”.
The question of promoter’s liability on the contract is an unsettled issue in Indian law due to the absence of any statutory enactment to the effect and lack of any judicial pronouncement to define the contours of the issue. Ramaiya’s commentary suggests that under section 230 of the Indian Contract Act, a promoter cannot be held liable for the pre-incorporation contract since under the section 230 of the Indian Contract Act, an agent is not personally bound by the contract enters for behalf of his principal. Once the company get incorporated the promoter can’t sue or be sued in case the company refused to ratify the contract. Except on the principal of quantum merit or breach of warranty of authority. The principal of Quantum merit that if promoter has rendered his services to the other party and other party has accepted those services rendered by the promoter, then he can sue under the contract. However, it is submitted that such position is incorrect because of the agent-principal relation. The move to make promoter personally liable would always depend on the intention of the parties and no such rule can make the contract void can be deduced from even Indian Jurisprudence.
The promoter’s liability can be avoided by constructing a pre-incorporation contract as revocable offer under which, the corporation can on adoption accept the contract, if the offer is not revoked.The promoter gets an advantage under this interpretation of the contract is that he has no rights or liabilities regarding the contract provided there was no fraudulent intent or breach of warranty of authority. If we look at the Specific Relief Act of India it also suggests that one can interpret the Company’s ratification as acceptance of an offer given by the third party. The promoter merely locks in the third party of the company. This doctrine is not very popular in the American courts because of the nugatory defeating the very intention of the parties to give some legal effects in the contract.
As however an issue arises because of the note put in the Name Approval Certificate. It clearly says that no contract can be entered on behalf of the unformed or proposed company till it is registered i.e. incorporated as said in the Certificate, issued by the Registrar under its statutory power. It is not clear, if it is a condition subsequent to issuance of certificate and to harmoniously construct this note with the Specific Relief Act, one might have come to the conclusion that unless the company ratify the contract that contract would never bind on that company. Thus, one strand of interpretation suggests that contract can’t be void and be enforceable. Other strand would still hold the promoter liable personally and would only bar burdening the company with any such contract.
B. Ratification by company
As we have discussed the ratification and adoption in detail in the above topic there is some problem and the uncertainty that underlies the continuance of the promoter’s liability after corporation ratifies or adopt the contract.
As we have mentioned before, the English Law denies ratification of pre-incorporation contract. But under English law instead of ratification novation is permitted which requires the corporation to take promoter’s place. Such substitution of parties is termed as novation. Theory of Novation has been propounded by Williston and has been accepted by the courts too. Novation undoubtedly releases promoter from all the liability under the contract they are liable when they have entered the contract on behalf of the unformed company or in another word pre-incorporation contract.
With Specific Relief Act in place by the government of India and unilateral ratification being permitted, the position resembles the American position more. The work of the Specific Relief Act is to convey the acceptance to the other party and it is not necessary to get the assent from the third party. That’s the reason the American position resembles more in this respect. For this precise reason, American Jurisprudence will be looked to ascertain the position and the case of Goodman v. Darden which clarified that just because the corporation adopted the contract, that doesn’t mean the promoter would be dissolved from all his personal liability. In this case, both the parties were aware of the fact, that the corporation is non-existent at the time of making the contract and further that, the corporation accepted the contract and the promoter who is acting on behalf of the corporation directed all the payments received under the contract by the corporation itself. Still the court went ahead to hold that the intention of the third party was never to release promoter form their personal liability for entering the contract on behalf of the corporation having an intent that corporation has not yet formed. The knowledge of it being a pre-incorporation contract would indicate that to reduce the uncertainty, the third party was never had an intent to release the promoter from their liability too which didn’t end of corporation adopting the contract. This is going to ask for warranty that the corporation would perform its obligations, which is comparable to the South African statutory law. Thus, what the court examines is this the third parties as to limit the liability of the promoter on the corporation adopting the contract the third party intended to do it.
In the Indian context, what might be suggested is to whether to amend the provision for ratification or ask for novation, otherwise mere adoption made by the corporation won’t be considered as a guarantee for the promoter to get relived from all the liabilities. For abolishing promoter liability once the company adopts the contract can also be rooted on the principles of fairness and equity. This principle will help in reducing the burden on one party and would even distribute the benefits and liabilities of the parties. Also, it fetters the third-party choice of holding anyone of his choice liable under the contract. it is also submitted that in the case of Goodman has been fallaciously interpreted the intent of the parties since it failed to give due acknowledgment to the intent of the promoter, since the primary feature of the incorporation’s is that it ensures limited liability who on adoption by the company would naturally not intend to bound personally. Another argument in support of abolishing the personal liability of promoter would be by the principle of contractual mutuality. On incorporation, the promoter has no personal interest in the contract and it is solely by the virtue of the company. Therefore, it is unfair to make promoter liable. When it involves a one person company an interesting fact would arise, following test has been suggested:
First, has the promoter entered a contract on behalf of a non-existent corporation? Second, has the corporation adopted or ratified the contract? Third, have the corporation and the third-party contractor entered a novation to release the promoter from liability, or has the third party agreed to look solely to the corporation for liability? Finally, is the corporation genuine or has it been established to defeat promoter liability in relation with a fraudulent scheme?
Further, the practices of other jurisdictions in the world can be of greater help for solving the issue or problem related to the pre-incorporation contracts as it become a legal puzzle even the jurisdiction has provided a lot of solutions and done a lot of reforms in the companies act to tackle the issue of the pre-incorporation contract. As in other jurisdictions to tackle the problem of pre-incorporation contract they have some innovative solutions introduced by the legislature to deal with the problem of pre-incorporation contracts and the liability of promoters for the pre-incorporation contracts. The point of ratification is simplified that once the company get incorporated the process of ratification of the contract should be automatically done for the benefit of the company.
In civil law jurisdiction like Germany where promoter can make other promoter liable along with him and the pre-incorporation association can be treated like that of a partnership. Another important aspect in the German law is the theory of identity which states that once the company get incorporated it will get the same rights and obligations enjoyed by the pre-incorporation contract of the company. later this theory names as the theory of continuity. Under this theory the company did not have to ratify the contract after the formation i.e. incorporation as all the obligation and the rights will be accrued to the company as if under the succession.
It is submitted that this theory adopted by the German can be considered as the best solution to avoid the liability for the promoters. In India, as earlier it has stated the usually the promotes has the major control in the company so if the contracts are accrued to the company as if under succession then the promoters will be saved from the liabilities and even the third party will also have a better debtor as the company will get obligations towards them and they will have a better security against the dues that must be paid to them or any services if any, must be rendered to them. In the Indian context, this will be apt as most of the companies are family based and pre-incorporation contracts entered also will be beneficial to the company in most instances. Legislature should consider this option as the issue of pre-incorporation contracts is a special case and it’s not a simple one as it appears.
Under the Australian Laws, in which Section131 of the Australian Corporation Act 2001states that in the matter of pre-incorporation contract the court can interfere as if the companies don’t ratify the contract own its own. Under this law court can order for the damages of payment to the promoter. It has been submitted that this step is radical step by the court to interfere to protect the promoters whose contracts haven’t been ratified by the company. In the Indian context, also this may hold good because there may be promoter who also may be a minority shareholders and the majority might not ratify the contract after the incorporation of the company. This might suit for our country as even the available remedies are not targeted to protect the promoters but only for the protection of the third party and this also depends upon the discretion of the company.