9 Aug 2018, 12:00 — 7 min read
Summary: The legality of pre-incorporation contracts explored. The laws around such contracts are different than when a company that is incorporated enters into a contract.
The prime characteristic of the company structure is that it is a separate legal identity, which allows it to enter into contract with parties and own assets in its own name. A company obtains the legal identity after its incorporation and registration. However, more often, it is observed that the promoters enter into contract with third parties even before Pvt Ltd company registration in India, whether for the registration purpose itself or otherwise. Here, we are discussing whether these contracts made in name of promoters are valid or not. These contracts are known as promoter’s contracts or pre-incorporation contracts in legal terms.
What is a pre-incorporation contract?
Promoters are company appointed representatives obliged to promote a company to operational level ensuring it running successfully. Therefore, the promoters enter into various contracts necessary to promote company. These contracts also include those executed with the professionals for company registration or those imperative to float the company.
As a company is an artificial person that is unborn unless the registration process is completed, it cannot enter execute any agreement before incorporation. Therefore, these contracts entered by the promoters are made in their own name. Hence, these contracts are known as pre-incorporation contracts or promoter’s contracts. Such contracts are inevitable for company registration and therefore are also recognised by Companies Act and also by Specific Relief Act.
Now, the question is whether these contracts entered by promoters are valid or binding to the company?
While these contracts are executed by promoters in company’s name, the promoters act as agents of the company to represent its interest, while registration, the principal is not in the existence. It is a fiduciary responsibility of every company’s promoter. 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 it’s strict enforceability & compliance 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 the 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 executed in pre-incorporation stage.
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 the pre-incorporation contracts?
As said, it is inevitable to ratify the contracts for the purpose of its enforcement by company. For acceptance or ratification, the promoters can follow either of the below mentioned methods:
Accept the contracts through passing a resolution for acceptance of contracts and actions by the promoters for the incorporation of the company and related matters.
Novation of contract
Novation of contract typically means the substitution of existing contract with new contract either between same parties or different parties; the prime consideration being the discharge of the old contract. On completion of novation of contract, the new contract would be binding the parties. The novation provides an opportunity to replace the liability of the promoters with that of company. In simple words, the contract would be reconstituted in a manner that contracting party was the company and no longer the promoters.
Such actions of acceptance are essential after registration of private company as it owns a separate legal identity to operate in its own name. Also, such action would be favourable to promoters. They are not personally liable for contracts entered for and on behalf of the company.
While executing a contract on behalf of a company, some promoter may end up contracting in name of company even before it is incorporated. Will this be still valid? Let’s explore this in the next section.
A company is an 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 it’s validity bearing upon 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 and are important instruments to get the company up & running instead of floating the company first & then executing contracts for it’s operations, a time saving mechanism. Process like Pvt Ltd 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. Also, it would be advisable to ask professionals while executing such a contract about what exactly needs to be kept in mind.
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