Relevance and Enforceability of Pre-Incorporation Contracts of a Company

Ishan Shivakumar1

Introduction

According to Indian laws, “company”means a company incorporated and registered in

accordance with law.1 In other words, it is only after a company has been duly “registered” that it
is recognized as a company in India law. Therefore, prior to the formal incorporation of the
company, the “association of persons”2is not considered to be a separate legal entity.

Prior to the incorporation of the company, there is a need to promote the functioning of the
company. Promoters will be obligated to make adequate arrangements in order to ensure the
smooth beginnings of the company. Such tasks may include: renting of office space, procuring
raw materials, hiring workers, etc. Thus, agreements on behalf of a prospective company or
“association of persons” (preceding the formal incorporation of the company) is known as a
“pre-incorporation contract”.

This paper seeks to explore the relevance and enforceability of pre-incorporation contracts of a
company under Indian law. Contractual law is governed by the Indian Contract Act, 1872 along
with the Specific Relief Act, 1963. Company law is governed by the Companies Act, 2013 –
which is an updated legislation based upon the Companies Act, 1956.

This first section of this paper deals with understanding fundamental concepts including: what is
a company, the need for pre-incorporation contracts and the role of promoters of a company.The
next section deals with the liability of the promoter or company vis-à-vis the pre-incorporation
contract. This section sets out the conditions under which the liability of either the promoter or
the company is established insofar as the obligations of the pre-incorporation contract are

1
B.A., LL.B. (Hons.) 5th Year, NUJS, Kolkata, Email: [email protected], Mob. 9051378377
concerned.The third and final section presents a comparative analysis of the enforceability of
pre-incorporation from other jurisdictions outside India.

Who is a “Promoter?”

Indian laws did not define a “promoter” until the enactment of the Companies Act, 2013.
According to the new Act “promoter”3means a person—

(a) who has been named as such in a prospectus or is identified by thecompany in the annual
return referred to in section 92; or
(b) who has control over the affairs of the company, directly or indirectlywhether as a
shareholder, director or otherwise; or
(c) in accordance with whose advice, directions or instructions theBoard of Directors of the
company is accustomed to act:
Provided that nothing in sub-clause (c) shall apply to a person who is actingmerely in a
professional capacity.

Judicial pronouncements also clarify the functional meaning of a promoter. The earliest
definition of promoter is a person who as principal procures or aids in procuring the
incorporation of a company.4Justice Cockburn said that “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”.5 Later, Justice Bowen held that “the term promoter is a term
not of law, but of business, usefully summing up in a single word a number of business
operations familiar to the commercial world by which a company is generally brought into
existence.”6

According to the Madras High Court:

“the promoters of the Company act before the incorporation of the legal person. The
promoter is a "midwife" of the business as coined by Henn and Alexander in Law of
Corporations. Nevertheless, before the legal person has come into existence, it is the
 promoter who does the major role for the purpose of bringing the corporate person into
existence like proposing the objects of the company to be incorporated, arranging
finance, formation of the original scheme, making arrangement to get the company
registered, preparing prospectus, Memorandum and Articles of Association, etc., which
are very crucial for the company to come into existence.”7

Pre-Incorporation Contracts

Promoters perform vital functions to bring out a corporate person (the Company) into existence
and are liable to the Company as well as the third parties in respect of their conduct and contracts
entered during the pre-incorporation stage including the statement in prospectus, either treating
them as the agents or trustees of the Company to be incorporated, but still they are not
recognized in order to focus the legal fiction of corporate personality.8

Such agreements are called “Pre-Incorporation Contracts”. Thus, all commercial transactions or
promises of commercial transactions which is intended for the benefit of the future company fall
within this category. The theoretical difference between an ordinary contract and the “Pre-
Incorporation contract” is the distinction in terms of the beneficiary. Although the contracting
parties are the promoters and a third-party, the intended beneficiary is the prospective company
which is yet to be incorporated. As established in earlier sections, it is not legally possible for an
unincorporated company to enter into contracts because its existence is not recognized in the
eyes of the law.

Privity of Contract

It is pertinent to examine a fundamental principle of contract law – privity of contract – in light

of the abovementioned juridical discussion. The doctrine of privity dictates that that only a party
to a contract can sue.9No third party has the right to sue if they are not a party to the contract.

In Kelner v Baxter10, it was held that because the company was not in existence at the time of the
agreement, the contract would be wholly inoperative unless it was held to be binding on the
promoter-defendants personally. There must be two parties to a contract; and the rights and
obligations which it creates cannot be transferred by one of them to a third person who was not
in a condition to be bound by it at the time it was made.

The same position was affirmed in Phonogram Ltd. v. Lane11, where the promoters were held
liable was the breach committed by the company. Finally, Lord Goddard CJ held: “as the
company was not in existence when the contract was signed there never was a contract, and
MrNewborne cannot come forward and say: ‘Well, it was my contract.’ The fact is, he made a
contract for a company which did not exist.”12

Thus, the Common Law position is that a company is not bound by contracts entered into on its
behalf by its promoters or other persons before its incorporation. After incorporation, it cannot
ratify or adopt any such contract because there is no agency and the contract is that of the parties
making it.13

Liability in “Pre-Incorporation Contracts”

It has been established in the above sections that the unincorporated company shall not be liable
for any obligations arising out of a pre-incorporation contract. This view has been affirmed by
the Rajasthan High Court inSeth Sobhag Mal Lodha v. Edward Mills Co. Ltd.14, where the Court
held that two mandatory conditions must be satisfied in order to sue for breach of contract: “(1)
that the firm must be a registered firm, and (2) that the persons suing are or have been shown in
the register of firms as partners of the firm. Unless these two conditions are fulfilled, there
would be a fatal bar to the entire suit and it would be wholly incompetent in a court of law.” The
same position of law has been upheld by the Supreme Court of India in CIT v. City Mills
Distributors (P) Ltd.15where is was held where the assessee company did not exist when the
income concerned was earned, it is, therefore, not liable to pay tax on it.

However, this approach has been criticized 16and even overruled by subsequent decisions. The
key point of contention is the ignorance of the provisions of the Specific Relief Act, 1963 17.
Thus, the promoters are entitled to preclude liability by using the provisions of the Specific
Relief Act, under novation of contract and use the doctrine of equity.

The Specific Relief Act

The relevant provisions of the Act are:

15. Who may obtain specific performance.—Except as otherwise provided by this Chapter, the
specific performance of a contract may be obtained by—
(h) when the promoters of a company have, before its incorporation, entered into a contract for
the purposes of the company, and such contract is warranted by the terms of the incorporation,
the company: Provided that the company has accepted the contract and has communicated such
acceptance to the other party to the contract.

19. Relief against parties and persons claiming under them by subsequent title.—Except as
otherwise provided by this Chapter, specific performance of a contract may be enforced against
—
(e) when the promoters of a company have, before its incorporation, entered into a contract for
the purpose of the company and such contract is warranted by the terms of the incorporation,
the company: Provided that the company has accepted the contract and communicated such
acceptance to the other party to the contract.

These provisions have been discussed and interpreted in ValiPattabhiramaRao v. Sri Ramanuja
Ginning,18 where the Court held that the promoter can give his right to sue to the company by
incorporating the same within the articles or terms of association. Thus, if the company comes
into existence by incorporation before the determined date, and applies in any form, it may even
be by a letter approbating and accepting the acts of the promoter, which would make the
application by the company a perfectly valid one – the same could be justified, either on the
principle of adoption, or novation by a substituted application.19

Novation of Contract
The classic definition of ‘novation’ was rendered by Lord Selborne LC in Scarf v. Jardine20:
“there 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”.

Therefore, the doctrine of novation gives the company an opportunity to replace the liability of
the promoter with its own. In other words, upon incorporation, the pre-incorporation contract
shall be reconstituted as if the contracting party was the company; and no longer the promoter.

In Howard v. Patent Ivory Manufacturing Co.21, it was held that a company cannot ratify a pre-
incorporation contract, but it is open to it to enter into a new contract after its incorporation to
give effect to a contract made before its formation. According to Palmer's Company Law, 22nd
edition, volume 1, at page 271, “there is nothing to prevent the company, when incorporated,
from entering into a new contract to put into effect the terms of the pre-incorporation contract”.22

In Weavers Mills Ltd. v. BalkiesAmmal23, the Madras High Court extended the ambit of this
principle. In this case, the promoters had purchased certain properties for the company.
Subsequently, upon incorporation, the company constructed structures on the said properties.
Applying the principle of equity, the Court held that even in absence of conveyance of property
by the promoter in favour of the company after its incorporation, the company could be held
liable because it is enjoying benefits from the act of the promoters by using the properties.

Conclusion

Section 71 of the South African Companies Act, empowers the company to ratify preliminary
agreements made by promoters: “any contract made in writing by a person professing to act as
agent or trustee for a company not yet formed, incorporated or registered shall be capable of
being ratified or adopted by or otherwise made binding upon and enforceable by such company
after it has been duly registered”. A reading of the provision clearly provides all the requirements
for "adoption" of a preliminary contract (or pre-incorporation agreement) and it will be legally
sufficient to adhere to the terms of the said contract – nothing more is required.24
The United Kingdom enacted the Contracts (Rights of Third Parties) Act 1999 which permits a
company to become a party to the “pre-incorporation contract”, upon acquiring its legal
existence once duly registered.

In light of the issues raised, arguments advanced and authorities cited,the author believes that the
correct position of law is that the promoters should be held personally liable for “pre-
incorporation contracts”. The jurisprudential reasoning for this position is evident from the
various judgments discussed in this paper. The principle of privity of contract clearly dictates
that a valid contract is between contracting parties only. Furthermore, how can something that
does not exist have legal rights and obligations? The Indian Company Laws specifically mandate
that companies by duly registered in accordance with law before being recognized as legal
entities.

The doctrine of novation as constructed by Indian Courts is based upon a different principle of
contract law. Upon incorporation, the company can utilize the doctrine of novation in order to
legitimize the agreement. However, this can only be done after the acceptance by the third-party.
In other words, the third-party would only agree to the novation if the company indemnifies it
against all breach related losses.
Therefore, the legal position in India is clear and the law expounded in Kelner v. Baxter is
correct.
1
Section 2(20) of Companies Act, 2013; and Section 3(1)(i) of the Companies Act, 1956
2
Borrowed from the definition of a “company” as rendered by Lord Justice Lindley: “ an association of many persons who
contribute money or money's worth to a common stock and employed it in some trade or business and who share the profit
or loss arising there from. The common stock so contributed is denoted in money and is the capital of the company. The
persons who contributed it or to whom it belongs are members. The portion of capital to which each member is entitled is
his share.The shares are always transferable although the right to transfer them may be restricted.”
3
Section 2(69) of the Companies Act, 2013
4
Phosphate Sewage Co. v. Hartmount, (1877) 5 Ch D 394
5
Twycross v. Grant, (1877) 2 CPD 469
6
Whaley Bridge Calico Printing Co. v. Green, (1880) 5 QBD 109
7
Probir Kumar Misra v. RamaniRamaswamy and Ors., [2010] 154 CompCas 658 (Mad)
8
Ibid
9
Dunlop Pneumatic Tyre Co Ltd v. Selfridge & Co Ltd, [1915] UKHL 1
10
[1866] L.R.2 CP 174
11
[1982] QB 938
12
Newborne v. Sensolid (Great Britain) Ltd., [1954] 1 QB 45
13
Halsbury states in fourth edition at page 435, paragraph 727; as cited in ValiPattabhiramaRao v. Sri Ramanuja Ginning,
(1986) 60 Comp Cas 568 AP
14
[1972] 42 CompCas 1 (Raj)
15
(1996) 219 ITR 1 (SC)
16
A. Ramaiya, Guide to Company Act, (Ed. 17th, 2010) pg. 689
17
Sections 15(h) and 19(e) of the Specific Relief Act, 1963
18
(1986) 60 CompCas 568 (AP)
19
G.K.Palaniswami v. Sri Nandhi Transports (P) Ltd., 1967 (3) Mad 80
20
(1882) 7 App Cas 345, pg. 351
21
(1888) 38 Ch D 156
22
As cited in ValiPattabhiramaRao v. Sri Ramanuja Ginning, (1986) 60 Comp Cas 568 AP
23
AIR 1969 Mad 462
24
G Ex parte Universal Property (Pty.) Ltd., 1947 (4) S.A. 12 (D)