Promoters and pre-incorporation contract

Company formation and promoter

A promoter is a person who takes the necessary steps to incorporate a company (Twycross v Grant (1877)).

The promotion period continues until the board of directors is elected (Robinson v Randfontein Estates Gold Mining Co Ltd (1921)).

A promoter is a fiduciary who owe a duty of loyalty (act in the best interest) to his principal, which is the unformed company in question. On the other hand, he must not allow his own self-interests, or the interests of others, to govern his behaviour in any way that would conflict with the principal’s best interest (Erlanger v New Sombrero Phosphate Co (1873)).

Where a promoter sells property to the company in which he has a personal interest, he is required to make full and frank disclosure of any profit derived from the sale (Re Lady Forrest (Murchison) Gold Mine Ltd (1901)).

In Erlanger v New Sombrero Phosphate Co, Erlanger purchased a mine for £55,000. He then promoted the company and sold the property to it for £110,000. All of the directors of that company were his nominees and two of them were directly under his control. The mining operations were fruitless and the shareholders removed the original directors and the new board successfully brought an action to have the sale rescinded. The court held that there had been no adequate disclosure of the sales, thus the company was entitled to rescind it.

It was accepted by the House of Lords in Salomon v Salomon & Co Ltd that in the absence of an independent board of directors (as in the previous case), the full disclosure of all material facts must be made to the original shareholders.

However the House of Lords in Gluckstein v Barnes (1900) further stressed that the disclosure to the original shareholders would not be sufficient, if the original shareholders are not truly independent and the scheme as a whole is designed to defraud the investing public. 

The common law position on pre-incorporation contract

A pre-incorporation contract is contract entered into by promoters on behalf of the unformed company.

It is clear that a company does not come into existence until the promoters have completed the registration requirements and the Registrar of Companies issues a certificate of incorporation. Prior to this time a company cannot enter into a contract in its own name, but it may be necessary for a company to contract with a third party before its incorporation. Hence, the promoters will enter into the contract on behalf of the company.

However, according to the doctrine of privity in the law of contract, a person who is not a party to the contract cannot acquire any rights under that contract or be subject to any of its burden. Hence an unformed company would be considered as a stranger to the pre-incorporation contract and not subject from any rights and liabilities derived from the pre-incorporation contract (Kelner v Baxter (1867)).

The law of agency takes the view that a person cannot be an agent of a non-existent principal. Hence, a promoter cannot be considered as an agent to the unformed company (Kelner v Baxter).

On the strength of these, the promoters will be held personally liable for the pre-incorporation contract.

There are several ways for a promoter to avoid personal liability to the pre-incorporation contract.

First, if the third party, after the incorporation of the company in question, substitutes the original pre-incorporation contract with a new contract on similar term with the company (Natal Land Co & Colonization Ltd v Pauline Colliery and Development Syndicate Ltd (1904, Privy Council)). This is known as novation.

Novation can also be inferred by the conduct of the parties such as where the terms of the original agreement are changed (Re Patent Ivory Manufacturing Co, Howard v Patent Ivory Manufacturing Co (1888)).

Novation will not be effective if the company adopts the contract due to the mistaken belief that they are bound by it (Re Northumberland Avenue Hotel Co Ltd (1886)).

Second, a promoter will not be personally liable on a contract where he signs the agreement merely to confirm the signature of the company because in doing so he has not held himself out as either agent or principal. The signature, and indeed the contractual document, will be a complete nullity because the company was not in existence (Newborne v Sensolid (Great Britian) Ltd (1954)). 

However, the promoter may be liable to the other party for breach of warranty of authority on the principle of Collen v Wright (1857), in that he misrepresented his authority by purporting to represent a director of a non-existent company which, lacking legal existence, had no validly appointed officers.

The common law has now been modified by section 51 of the Companies Act 2006.

You can download Companies Act 2006 here: http://www.legislation.gov.uk/ukpga/2006/46/pdfs/ukpga_20060046_en.pdf

Section 51 of the Companies Act 2006

Section 51 provides that ‘a contract which purports to be made by or on behalf of a company at a time when the company has not been formed has effect, subject to any agreement to the contrary, as one made with the person purporting to act for the company or as agent for it, and he is personally liable on the contract accordingly’. In short, promoters contracting on behalf of a putative company will be held personally liable.

Section 51 is enacted with the objective to protect third parties who contracted in the belief that they were dealing with registered companies by making pre-incorporation contract legally enforceable as personal contracts with promoters unless the personal liability of the latter has been unequivocally excluded.

Lord Denning MR in Phonogram Ltd v Lane (1982) took the phrase ‘subject to any agreement to the contrary’ to mean that for a promoter to avoid personally liability the contract must expressly provide for his exclusion. It is not necessary for the company to be in the process of creation at the time the contract was entered into.

In Royal Mail Estates Ltd v Maple Teesdale (2015), the contract was signed ‘for and on behalf of the buyer’ and ‘the benefit of this contract is personal to the buyer’. The ‘buyer’ was defined in the contract as being the company. The contract was signed on behalf of the company by its solicitors. The contract did not complete and the claimant brought an action against the solicitors. The question arose as to whether the terms amount to ‘an agreement to the contrary’ under section 36C(1) of the Companies Act 1985 (now section 51(1) of the Companies Act 2006).

The court held that a contrary agreement had to be a clear agreement to exclude section 36C(1) and should not be inferred from other terms of the contract. Here the parties were unaware that the company in question had not been incorporated, they cannot have section 36C(1) in mind when they were signing the contract. In addition, the terms in question were clearly intended for a different purpose, which were to prevent or restrict a third party from becoming a buyer by way of an assignment of sub-sale, rather than exclude the personal liability of the solicitors.

In Braymist Ltd v Wise Finance Co Ltd (2002), a form of solicitors contracted as agents on behalf of a company yet to be incorporated, in which the putative company agreed to sell land to property developers. Subsequently, the developers changed their minds and the solicitors sought to enforce the contract. The issue for the Court of Appeal is whether a person acting as agent of an unformed company could enforce a pre-incorporation contract under section 51. It was held that they could do so, even though the terms of the first Directive referred only to liability and not to enforcement. Thus, section 51 has dual effect: a promoter is personally liable to the contract, and the promoter can personally enforce the pre incorporation contract.

Remedies

The company may have a claim for equitable compensation for breach of fiduciary duty (Erlanger v New Sombrero Phosphate Co).

The court may order the promoter to restore the trust assets. If this is not possible, he may be ordered to pay sufficient compensation to the trust assets to put it back to what it would have been had the breach not been committed (Target Holdings Ltd v Redferns (1996)).

Where a promoter fails to make a full and frank disclosure of his interest in a pre-incorporation with the company, its principal remedies are rescission and an accounting of secret profits. 

If it is satisfied that there is no effective disclosure made to the company, the contracts is voidable at the company’s option (Erlanger v New Sombrero Phosphate Co). The company therefore has the option either to rescind the contract or to affirm it.

However the right to rescind the contract will be lost where the company affirms the contract, or delays in exercising its right to rescind the contract.

If the company by its actions, after it becomes aware of the promoter’s breach of duty, shows an intention to affirm the contract, rescission will not be available (Re Cape Breton Co (1885)).

Similarly, the company’s delay in rescinding the contract may also bar its right to the remedy (Lloyd v Lloyd).

The contract is considered as valid until it was rescinded, that being said, if a third party bona fide without notice and for value acquires rights in the contract’s subject matter, those rights are valid against the company, provided it has not rescinded the contract before that time (Re Leeds and Hanley Theatres of Varieties Ltd (1902)).

For rescission to be available there must be restitutio in integrum. In other words, it must be possible to restore, at least substantially, the parties to their original position unless, due to the fault of the promoter, this possibility has been lost (Lagunas Nitrate Co v Lagunas Syndicate (1899)).

Even though the contract has been affirmed, or the company elects not to rescind the contract, the company can nevertheless sue the promoter to account for the secret profit (Gluckstein v Barnes).

Where a promoter has been offered but not yet received a bribe or some other benefit, the company may itself enforce his claim for payment against the promisor, on the ground that the promoter holds the claim as constructive trustee for it (Whaley Bridge Calico Printing Co v Green (1879)).

It should be noted that the company may have an action against the promoter in the tort of deceit. 

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