Company law: Promotion and Pre-incorporation Contracts

Title: In March 2006 Fiona and Graham agreed to promote a company to be called Tidy plc, which would provide cleaning services to schools and colleges. In April Fiona entered into contracts with (1) Compu Ltd for the supply of computers for the new company and (2) Cleanit Ltd for the supply of vacuum cleaners for the new company.. The computers have been delivered, although they have not been paid for, but the vacuum cleaners have not been delivered. Tidy plc was incorporated on 1 June 2006.. On 1 August Graham sold a quantity of office chairs, which he had purchased for £1000, to Tidy plc for £4000 Tidy plc consults you and seeks your advice as to:

a) whether it is bound to pay for the computers;

b) whether it can insist on the delivery of the vacuum cleaners if it tenders payment for them;

c) the liability, if any, of Fiona and Graham.

ANSWER

This question concerns company law and specifically the law relating to company promoters and pre-incorporation contracts. Every company is formed or “promoted” by individuals known as a promoters. The promotion of a company consists in the actions that are necessary to establish the company by its incorporation by registration under the Companies Act 1985. It includes those steps necessary to see that it has share and loan capital and to obtain the property, business and other assets which the company is being created to control..

No definition of promoter is provided by the Companies Act 1985. Sections 152^[1] and 168^[2] of the Financial Services Act 1986 exempt from liability those who merely give advice in a professional capacity, such as solicitors and accountants. Therefore, those independent professionals who assist only on legal or financial matters in connection with incorporation will not be considered as promoters but all other individuals involved in organising the incorporation of a company are likely to be.

The courts have been similarly reluctant to elaborate on the expression promoter, however the role was defined by Cockburn CJ in Twycross v Grant (1877)^[3] as:

“…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”.

It is submitted that this well known definition includes those who take the procedural steps necessary to form the company and those who establish the company’s business which will typically involve the conclusion of pre-incorporation contracts. In Whaley Bridge Printing Co v Green (1880)^[4] Bowen J opined:

“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..”

Whether a person is a promoter or not is a matter of fact and not of law. In simple words a promoter is an individual who promotes a business project by means of setting up a company. The facts of the scenario under review indicate that both Fiona and Graham will be considered promoters of Tidy plc in the eyes of the law.

Three questions are posed by the scenario under review. These will be answered in turn.

A) Is Tidy plc bound to pay for the computers?

Tidy plc can be advised that where a company promoter enters into a contract on behalf of a company that has yet to be incorporated a problem can arise in contract law, due in particular to privity of contract, because the company does yet exist as an entity and therefore it cannot be bound by the terms of any contract made.

In the case of Kelner v Baxter (1866)^[5] a contract for the delivery of goods (bottles of wine) was entered into by a promoter on behalf of a company that had yet to be formed, with the intention that the company would sell the goods after its incorporation. The invoice for the wine was ultimately left unpaid but the court held that the company could not be found liable for the debt. The promoter who had acted on behalf of the company was deemed personally liable to pay the bill. The case Re National Motor Mail Coach Co Ltd, Clinton’s Claim [1908]^[6] is further authority for the point that a company, once it is formed, is not bound by a pre-incorporation contract even when it has taken some benefit from it..

In confirmation of this principle of the common law, section 36C(1) of the CA 1985 states 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 or she is personally liable on the contract accordingly.”

Given that Fiona entered into the contract for the computers she is subject to personal liability to pay the bill for them if Tidy plc fails to make payment on the contract itself. Tidy plc does not owe any legal liability to do so. The case Newborne v Sensolid [1954]^[7] underlines the point that a company cannot be bound to a pre-incorporation contract.. In the case Phonogram Ltd v Lane (1982)^[8] pre-incorporation financial transactions took place in connection with the formation of a pop group and a management company. When a default subsequently occurred and the matter was brought to litigation the court ruled that the only way that a promoter can avoid personal liability is by ensuring that the contract in question must include a term that expressly stipulates that he or she will be excluded from the contract and replaced by the company itself at the point of the incorporation of the company. This is sometimes referred to as novation^[9] agreement. It is not known whether or not Fiona has done this and the assumption is that she has not because such would be material to the scenario. There is also a possibility that Fiona might have negotiated the inclusion of a rescission clause in the contract for the purchase of the computers, which would have allowed her to rescind the contract if the company fails to be incorporated. However it makes no commercial sense for the vendor to have agreed to such and then supplied the computers in the circumstances.

Advice:

Fiona is liable to pay for the computers. Tidy plc cannot be held liable to pay for the computers because at the point in time when the contract for their purchase was concluded Tidy plc was not in existence and therefore cannot under any circumstances be deemed privy to the contract.

B) Can Tidy plc insist on the delivery of the vacuum cleaners if it tenders payment for them?

The contract for the vacuum cleaners is also a pre-incorporation contract and so strictly speaking the same law discussed in answer to A) is also applicable here. As Kelner v Baxter and Phonogram v Lane indicate, and as section 36C of the CA 1985 confirms, it is not possible Tidy plc is not a party to the contract for the vacuum cleaners and thus it has no right to insist on the delivery of the vacuum cleaners due to the simple principle of privity of contract.. The Kelner v Baxter rule was applied in the case Natal Land & Colonization Co v Pauline Colliery Syndicate [1904]^[10], in which a company was unable to enforce a pre-incorporation contract made on its behalf. There is also a long-standing principle of agency law which stipulates that a company as principal cannot ratify, retrospectively adopt, any contract made on its behalf by an agent before it was incorporated and Natal Land is a good example of this rule in operation.

The rule in section 36C CA 1985 is however “subject to any agreement to the contrary” and if there is a clause in the contract between Fiona and the vacuum cleaner vendor for the contract to be novated by the company on incorporation it should be possible for the company to assume Fiona’s position under the contract and thus pay for and demand delivery of the vacuum cleaners. However, no such clause is mentioned in the scenario and therefore advice must be offered assuming it does not exist.

Advice:

As matters stand, Tidy plc cannot insist on delivery of the vacuum cleaners even if it tenders payment for them because it was not party to the original contract and is incompetent to ratify the original contract as principal because it did not exist at the point of contract. It may be possible to adopt the contract or negotiate a replacement contract on the same terms but this will probably be a matter for mutual agreement (given that the facts are silent as to the exact terms of the original agreement) and not something on which Tidy plc could insist.

C) Do either Fiona and/or Graham owe any liability?

As the authority in the foregoing answers indicates, it is submitted that Fiona owes a personal liability to pay for the computers and for the vacuum cleaners that she has ordered, see inter alia: Kelner v Baxter, Phonogram v Lane and section 36C of the CA 1985. Fiona must consider coming to some form of compromise with the company in regards to her liability under these contracts..

Graham is not a party to either of the two stated pre-incorporation contracts and thus has no liability under them. However, On 1 August Graham sold a quantity of office chairs, which he had purchased for £1000, to Tidy plc for £4000 and it is submitted that this transaction is likely to prove incompatible with the law.

In terms of the law of equity a promoter owes a fiduciary duty to the company he or she is promoting. As a consequence, Graham is forbidden from making a profit out of his position unless he has fully and frankly disclosed his interest in a transaction from which any profit arose and the company consents to the retention of the profit by him. Any undisclosed profits must be disgorged by Graham to the company.

There is no information as to any disclosure to the company as to the existence or extent of Graham’s profit, and this is of particular significance given the size of the profit and the fact that Graham has sold the chairs on to Tidy plc for four times the price he purchased them for.

In the case Erlanger v New Sombrero Phosphate Co (1878)^[11], the promoter of a company, Erlanger, acquired the lease of a phosphate mine in the West Indies for a sum of £55,000. Later he sold the mining rights to the newly incorporated company for £110,000. The purchase was thereafter approved by the board of directors of the new company, who had been appointed by Erlanger and were largely under his influence. Subsequently the company went public and the original board of directors was replaced. The new board discovered the true nature of the transaction and sued Erlanger to rescind the contract for the sale of the mining rights.

It was held by the court that the contract should be rescinded because the profit made by Erlanger had not been properly disclosed to an independent board and therefore could not be retained.

The case of Gluckstein v Barnes [1900]^[12] offers further authority on the point that a promoter is not entitled to undisclosed profits in his dealings with or on behalf of the company he is promoting. Here the court confirmed that not only is the remedy of rescission available, but also the promoter can be compelled to account for the full amount of any profit actually made in the transaction.

Interestingly the scenario is silent as to when the chairs were purchased by Graham. This information may affect the status of the transaction and the remedies available to Tidy plc.

If the chairs were in fact purchased by Graham at some point prior to the time at which he began his work as a promoter then the company may rescind the contract, recovering the £4000 paid and returning the chairs.. However, if Tidy plc wishes to retain the property it is not entitled to recover the profit in these circumstances as Re Cape Breton (1887)^[13] provides. It might be possible to sue Graham for damages in common law negligence if an exorbitant price has been paid, see: Jacobus Marler Estates Ltd v Marler (1913)^[14]. Alternatively there might be an action for fraud or under the Misrepresentation Act 1967^[15] subject to an investigation of Graham’s misstatements as to the value of the chairs.

If the chairs were purchased after Graham began work as a promoter of Tidy plc then alongside the remedy of rescission it will be possible to regard the promoter as an agent of Tidy plc when he acquired the chairs and thus the company could recover the profit made by Graham. This is the position at equity, but also at common law Graham will be liable to disgorge his profit. Promoters owe a common law duty in negligence to exercise reasonable skill and care in the promotion and Graham certainly falls short of that standard in this transaction.. Authority to support this assertion can be found in the case Re Leeds and Hanley Theatres of Varieties [1902]^[16].

Advice:

Fiona is personally liable to pay for the vacuum cleaners and the computers that she ordered.. Graham’s sale of chairs to the company is liable to rescission and he may either be required to disgorge his undisclosed profit to the company or sued for negligence, fraud or misrepresentation.

THE END

GLOBAL DOCUMENT WORD COUNT: 2393

BIBLIOGRAPHY

Griffin S.., Company Law Fundamental Principles, (2005) Longman

Sealy L. S., Sealy: Cases and Materials in Company Law, 7th ed (2001) LexisNexis UK

Shepherd (ed.), Company Law Casebook, (1994) HLT Publications

Hicks A & Goo S.H., Cases & Materials on Company Law, 5th ed, (2004) Oxford University Press.

Mayson, French and Ryan, Mayson, French and Ryan on Company Law, (2005) Oxford University Press

Keenan D., & Bisacre J., Smith & Keenan’s Company Law For Students, (2005) Longman

Dine J, Company Law, 5th ed, (2005) Palgrave Macmillan

French, Statutes on Company Law 2005-2006, (2005) Oxford University Press

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Footnotes

^[1] In the case of listed companies.

^[2] In the case of unlisted companies.

^[3] 2 CPD 469.

^[4] 5 QBD 109.

^[5] LR 2 CP 174.

^[6] 2 Ch 515.

^[7] 1 QB 45 (CA).

^[8] QB 938.

^[9] Where one party to a contract is replaced by a third party, who assumes all the rights and responsibilities of the former under the contract.

^[10] AC 120.

^[11] 3 App Cas 1218.

^[12] AC 240.

^[13] 12 App Cas 652.

^[14] 114 LT 640n.

^[15] Section 2.

^[16] 2 Ch 809.