Pre-Incorporation Contracts and Its Enforceability under Companies Act

Pre-Incorporation Contracts

Before a company commences business, it has to enter into several contracts and incur several initial expenses to get started. Contracts which are entered into by promoters with parties to acquire either some property or right for and on behalf of a company which is yet to be formed are called as ‘pre-incorporation contracts’ or ‘preliminary contracts’.

An agreement made by a person for a company which is not yet into existence at the time of signing of such agreement is called a pre-incorporation contract.

The person who enters into a pre-incorporation agreement is usually called the Promoter.  Promoter is a person who initially gets the idea of the formation of a company. The Companies Act however defines promoter as a person who is so named in the prospectus of the company, who has control over the affairs of the company and according to whom the directors of the company act.  

 Legal status of Pre-incorporation contract

 Legal status of a pre-incorporation contract is not at all easy to define in specific terms. If considered as per the definition of contract under the Contract Act, it is necessary to have at least two parties to constitute a valid contract so as to enter into a contract with each other. As the general principle is that no contract exists if one party to the contract is not in existence at the time of entering the contract. This in turn leads to that a company cannot enter into a contract before it comes into existence. A company is said to be existing only after it has been duly incorporated. This is one such facet of a pre-incorporation contract

However, it may be argued that, the pre-incorporation contract is entered into by the promoters on behalf of the company, representing the company. But here too, there is a catch. The promoters enter into the contract as agents of the company. The question which arises is if the principal i.e. the company, itself, is not into existence, how can it have authority to appoint agents to act on behalf of it?

So, its the promoters, and not the company, who become personally liable for all contracts entered into by them even though they claim to be acting for the prospective company.

But, u/s 230 of the Indian Contract Act, an agent does have authority to personally enforce contracts entered by himself on behalf of the principal and he also is not personally bound for them if it is very clearly stated by him about his being not liable under the contract. So if this principle is applied, the contract becomes in fructuous as neither of the parties is liable under the contract.

However, u/s 15 (h) and 19 (e) of the Specific Relief Act of 1963, lies the solution to our problem.

According to Section 15(h) of the Specific Relief Act, specific performance of a contract can be obtained by any party or a representative on behalf of the principal, when the Promoters of a company enter into a contract before the company’s incorporation and when such a contract is warranted under the company’s incorporation terms. 

Similarly, under Section 19(e) of the Specific Relief Act if the newly incorporated company has accepted the pre-incorporation contract and has communicated its acceptance to the other party, relief against parties can be claimed under subsequent title. 

Therefore, pre-incorporation contracts can be enforced in India by:

 (i)  Incorporating the contract in the terms of incorporation,

(b)  By entering into a new contract with the other party or the Promoter,

(c)  By expressly or impliedly accepting the benefits of the pre- incorporation contract.

These provisions, in a way deviate from the common law principles to some extent, which make pre-incorporation contracts valid under section 15. Except as otherwise provided by this Chapter, the specific performance of a contract may be obtained by–
(a) any party thereto;
(b) the representative in interest of the principal, of any party thereto

In Weavers Mills Ltd. v. Balkies Ammal [AIR 1969 Mad 462], the Madras High Court extended the scope of this principle through its given decision. In this case, the promoters had agreed to purchase some properties for and on behalf of the company which was yet to be incorporated. After incorporation of the company, the company assumed possession of the properties and constructed some structures on the property. It was held that even in absence of conveyance of property by the promoter in favor of the company after its incorporation, the company’s title over the property could not be set aside.

How does a company ratify a pre incorporation contract under Indian law?

It is a universal and wide known fact that the company is considered to be a separate legal entity and all the members of the company are separate from its members. Since a company is an artificial person and separate from its members, therefore it can enter into its own contracts and on the property in its own name. Company being an artificial person who is not born at the time of the incorporation, it cannot enter into any agreement before incorporation. It is the time where the work of the promoter comes into the picture where he is responsible and obliged to bring the company into the legal existence. Now, therefore, in order to ensure that the company is successfully brought into existence and is running smoothly and fulfilling its obligations, the promoter has to enter into some contracts on behalf of the company. Such contracts are called the contracts formed before the incorporation stage or the Promoter’s Contract. Such contracts cannot be ignored before the incorporation of the company and are inevitable for the registration and are therefore recognized under The Companies Act, 2013 and The Specific Relief Act, 1963. 

Promoter’s Liability during Incorporation 

Although the Promoters of the Company act as the agent of the company to represent their interest but the unique thing is that the Principal is not in existence while registration. Therefore, it becomes all the more important for the promoter to act diligently because due to non-existence of the principal the contracts are not binding on the company or third parties. Therefore, the validity and enforceability of pre-incorporation contracts lie in Section 15 and Section 19 of the Specific Relief Act, 1963. 

Section 15(h) of the Specific Relief Act, 1963 if we go by the definition of this, it expressly states that the contracts incorporated before the incorporation stage are entered into by the promoters of the for the very purpose and utility of the company and subject to terms of incorporation of the company, the company may ask for specific performance from the third party. However, this condition can only be applied if, after the registration/incorporation, the company has expressly demonstrated acceptance of those contracts, and communicated such contracts to the third party concerned. Under identical circumstances the other party to the contract under Section 19(e) of The Specific Relief Act, 1963may enforce specific performance against the company.  Accordingly, in order for the company to enforce the contract against the other party to contract, the members must ratify the contract followed by a communication of acceptance. The company may not receive any benefit from such a contract unless the contract is accepted by the company and the promoters would be personally liable for the contracts.

Responsibilities of Promoter: For Non-Disclosure:

The promoters have a responsibility to make sure there is full disclosure at the time of making the contract, otherwise the company may either: 

• Revoke the contract and can recover the price of the contract, or 
• Recover the profit even through rescission is not claimed or not possible,
• In case of any breach of the fiduciary duty which the promoter was obliged to, the company has a right to claim damages.

Liabilities under Companies Act.

Section 56 of Companies Act, 2013 – Promoters liable in case of non-compliance.

This section states that all the matters and the reports relating to incorporation are to be mentioned in the prospectus. If there is any non-compliance in these provisions, the promoter would be held liable.

Section 62(1)(C) – Liability for false statements 

Promoter of the company is held liable if there are any mis-statements published on the basis of which people subscribe to the securities of the company, in a good faith.  False statements may lead to any of the below-mentioned situations:

• The allotment of the securities may be set aside.
• May be sued for the damages and compensation.
• The promoter may also be charged with criminal liability, if need be.

Section 63 – Punishment for deceiving public

This section lays down the punishment for the promoter. If the promoter deceives the public with false and mis–leading statements in the prospectus he shall be liable for punishment. The punishment set is 2 years of imprisonment or fine which may extend to 50,000 INR or both. However, the promoter is always given an opportunity of being heard.

Section 478 – Liability for fraud during incorporation or promotion of company 

Section 478 applies at the time of winding up of the company wherein the court or the liquidator may report any sort of fraud at the time of incorporation or the promotion of the company, then the promoter, as well as other officers or directors, shall also be liable.  

Section 543 – Consequences in case of breach of duty 

If the promoter of the company has retained any property of the company during the time of incorporation, the members of the company have a right to sue the promoter.

Now, the question is whether these contracts entered by promoters are valid or binding to the company?

While execution, the contracts are entered by the promoters on behalf of the company. Although, the promoters act as agent of the company to represent its interest, while registration, the principal is not in the existence. Therefore, the contracts entered by the promoters do not bind the company or the third party. The validity and enforceability of the pre-incorporation contracts is always in question. However, the fix lies in Section 15 and 19 of the Specific Relief Act, 1963.

Section 15(h) provides that the company may ask for specific performance from the third party if the pre-incorporation contracts are entered by promoters for the purpose of the company and subject to terms of incorporation of company. This condition can only be applied if the company has expressly shown the acceptance of such contracts after its incorporation and communicated the same to concerned third party (i.e. the other party). Under similar circumstances, specific performance may be enforced against the company by the other party to the contract u/s 19(e) of Specific Relief Act.

Hence, for enforcement of the contract by the company against the other party to contract, the members must ratify the contract followed by communication of acceptance to other party. Unless the contract is accepted by the company, the company may not receive any benefit from such contract and the promoters would be personally liable for the contracts.

In case, the said contract is not accepted by the company in its meeting, such contract is binding to the promoters and the both, promoters and other party may demand specific performance against each other.

How to ratify pre-incorporation contracts?

As it is rightly said, it is inevitable to ratify the contracts for the purpose of its enforcement by a company. For the purpose of such acceptance or ratification, the promoters can follow either of the following methods:

1. Accept the contracts by passing a resolution by accepting the contracts and all other actions which were undertaken or did by the promoters in order for the incorporation of the company.

2. Novation of Contracts-
   Novation of a contract basically means the substitution of existing contract with a new contract either between the same parties or different parties. The most important aspect, however, is the old contract being discharged. On completion of novation of contract, the new contract would be binding the parties. In this way, novation of a contract provides a new opportunity to replace the liabilities of the promoters with that company.

While executing contract on behalf of company, some also mistake to contract in name of company even before it is incorporated. Let us analyze its validity too.

• Company is artificial person which comes into existence after completion of incorporation process. Unless a company is born, it cannot execute any agreement or be a party of contract. Therefore, such contracts entered in name of company are not valid due to its non-existence. Enforceability of such contracts would be questionable and may also be denied. Hence, it is preferable to enter into contract as promoter of the company with condition as to incorporation of company. Such contracts can be enforced by the company if it is accepted as discussed above.

Promoter’s contracts or pre-incorporation contracts are inevitable in most cases. Process like private limited company registration in India would always be allied with such contracts whether in form of contract with professional or property owners or otherwise that would affect the company operations in one or the other way. Hence, while such execution these prospects must be known by the promoters. Also, it would be advisable to ask the professionals while executing such contract that which aspects must be kept in mind.

LANDMARK CASES DEALING WITH PRE-INCORPORATION CONTRACTS

Lindsay International Pvt. Ltd. & … vs  Laxmi Niwas Mittal & Ors on 18 September, 2017.

An agreement can be oral. An oral agreement can be enforced. It can be proved by conduct and course of dealings between the parties.

It is for the plaintiff to prove at the trial the agreement pleaded in Paragraph 6 of the plaint.

Mr. Chidambaram has referred to Section 15(h) of the Specific Relief Act, 1963. The said section relates to pre-incorporation contracts. Where the promoters of company, that is, the persons who were engaged in setting up the company entered into contracts with parties would procure its formation and such contracts are within the limits of the objects of the company, then the company after its incorporation may sue to enforce the contracts and the other contracting party cannot raise any objection on the ground of privity. Conversely, the company if it ratifies such contract is bound by its obligation. This clause is conversed to Clause (e) of Section 19 of the Specific Relief Act on which Mr. Kapoor has relied on behalf of the plaintiffs.

Mr. Kapoor has emphasized on the expression “warranted by the terms of the incorporation” appearing in the said section and has argued that continuous support by the defendant No.1 prior and after incorporation of the plaintiff No.1 and its assurance that all supplies for the AM Companies would be procured solely through the plaintiff No.1 are now being breached by the defendant No.1. The other way of looking at is that if a situation arises as to whether the transactions made by the company are ultra vires for which the purposes for which the company was incorporated the said phrase in Section 19(e) comes to the aid of the company to relieve the company from its liability. This specific argument of Mr. Kapoor was that the record manifests that the buying and selling was indeed warranted by the terms of incorporation of the company.

Devi Prasad Sri Krishna Prasad  vs  Secretary Of State on 29 August, 1941.

There is one other aspect of the case which might at this stage be considered. This is not an action for specific performance of contract either by or against the Secretary of State or against the company. The plaintiffs in this action are seeking to recover a sum of Rs. 25,000, which plaintiff 2 had deposited with the Conservator of Forests as security money for execution of a contract of lease and purchase of grass and other forest produce and for fulfilment of its terms. This deposit was made by a letter of the plaintiff, dated 21st May 1931, and was accepted by a letter of the Conservator, dated 26th May 1931. The security money was thus deposited by plaintiff 2 with the defendant under an agreement in writing. The very fact that it was security money implies that it was given as a guarantee for the performance of an obligation and was liable to be forfeited if the obligation was not performed.

One of the obligations for which the security money was deposited was the execution of a formal deed of lease and sale by the plaintiff. If plaintiff 2 or, for the matter of that, plaintiff l, has unjustifiably refused to execute the deed, on what ground of law and equity can they ask for the return of the deposit money? Their agreement, as expressed in the letter of 2lst May 1931, is, in our view, a complete answer to this action, and we need not consider the difficulty which might have arisen if the suit had been brought by any party to specifically enforce the contract of 12th May 1931; and this also disposes of the remaining contention of the plaintiffs that the agreement of 12th May was a pre-incorporation agreement and was not binding on the company. Nobody is enforcing a contract against the company. It is the company which is seeking to recover a deposit which was not made by it but by plaintiff 2 in the circumstances mentioned above, and the company therefore has no right to recover this money. The appeal fails and is dismissed with costs.

CONCLUSION

Pre-incorporation contracts at first, might appear to be with no legal status and value, but they are very much important and legally valid as well as enforceable. Pre-incorporation contracts may be undertaken by the company after its incorporation either by
(a) incorporating the contract in the terms of incorporation, or
(b) making a fresh new contract with the other party or with promoters,  or
(c) the benefits from the contract, either expressly or impliedly,

And hence, in this way it becomes legally enforceable against the company.

The choice of whether the parties want to enter into preliminary or pre-incorporation agreement is up to the parties involved in the incorporation and whether the promoters believe that it would benefit them and the future company. However, the best option is to always to form an agreement legally with parties to clearly delineate the rights and responsibilities of each side.

Furthermore, it helps in resolving a lot of disputes that merely oral or handshake agreements could bring about.  In the current COVID-19 pandemic times, when even parties to written contracts, an unwritten pre-incorporation agreement would add to confusion between the parties and a dispute which could have avoided had they entered into a written agreement.  

Once the company is incorporated the parties can always ask the preliminary agreement to be ratified by the company or ask for novation. Novation is defined as entering into a new contract, by substituting new obligations or parties to the contract for the previous agreement. Under novation, the old contract (the pre-incorporation contract here) and a new contract would be entered into between the parties.  The principle of novation is also recognized under Section 62 of the Contract Act.

Therefore, it can be stated that it is always better to enter into a written agreement between parties before the incorporation of a company to demarcate the rights and liabilities of each party and to have a mechanism for damages in the event of a breach of a pre-incorporation agreement.

References:

• http://www.legalservicesindia.com/article/134/Pre-incorporation-contracts.html
• https://www.inc.com/articles/1999/10/14623.html
• https://enterslice.com/learning/sample-format-pre-incorporation-  agreement/
• https://ukdiss.com/examples/pre-incorporation-contracts-liability-india.php
• https://blog.ipleaders.in/novation-rescission-alteration-under-the-indian-contract-act/#:~:text=The%20word%20’novation’%20literally%20means,the%20Indian%20Contract%20Act%2C%201872 

Author Details: Shrusti Ajay Kamdar [Student, Y. C. Law College]