Pre-incorporation contracts under the new Companies Act 2008.
A company comes into existence as a legal entity with effect
from the date recorded in what the old Companies Act of 1973 called
the certificate of incorporation and what the new Companies Act of
2008 calls the company's registration certificate. Prior to
that date, the company does not exist and is incapable of entering
into any transaction or binding itself in any way.
Where it is proposed to bring a financially substantial company
into existence, its promoters usually lay the groundwork for the
company's future business well in advance of its formal
registration as a legal entity. Thus, for example, the promoters
may wish to secure the acquisition of assets to be held by the
company. Indeed, the registration of the company is often the last
step in the overall scheme to establish a new commercial
venture.
Consequently, it is often necessary for the as yet non-existent
company to enter into contracts in its own name, such as contracts
for the acquisition of assets. What is thus needed is a legal
process whereby the company, once it is registered, can smoothly
take over the contracts that have already been made in its
name.
At common law, an agent cannot act for a non-existent principal
In this regard, the common law presented an insurmountable difficulty by way of the principle that it is impossible for an agent to enter into a contract for a non-existent principal, and that where an agent professes to do so, the contract is a nullity and the company– once it comes into existence – cannot validly ratify (that is to say, approve and take over) the contract that was purportedly made in its name.
The solution provided by the old Companies Act of 1973
To overcome the difficulty presented by this common law
principle, the old Companies Act of 1973 made provision in section
35 for pre-incorporation contracts (that is to say contracts
entered into in the name of a company before it came into
existence) to be ratified and adopted by the company once it had
been registered.
However, the old Companies Act was highly prescriptive as to the
formalities that had to be complied with for such ratification to
be valid, and if there was any non-compliance with those
formalities, the pre-incorporation contract was void and incapable
of being taken over by the company.
The formalities in this regard included the requirement that the
contract had to be in writing, that the company's Memorandum of
Association had to include the ratification of the contract as one
of the objects of the company, and that the contract had to be
lodged with the Registrar of Companies at the time the other
documents were lodged for the registration of the company.
It was very easy for an inadvertent slip-up to occur in meeting
these mandatory formalities, particularly the requirement that a
copy of the contract had to be lodged with the Registrar of
Companies.
The new Companies Act of 2008 is far simpler in regard to pre-incorporation contracts
When the new Companies Act 2008 was being drafted, the opportunity was taken to simplify the statutory formalities for a valid pre-incorporation contract. Section 21 of the new Act thus requires only that the contract in question be in writing and entered into in the name of, or on behalf of, the still to be incorporated but as yet non-existent company.
The simpler formalities required by the new Act lend themselves to abuse
On the one hand, these simpler formalities – which require
only that the contract be in writing – have effectively ruled
out the risk of inadvertent non-compliance with the legal
formalities required for a valid pre-incorporation contract.
On the other hand, however, the new simplified process has opened
the way for the newly formed company's board to consider
whether or not it is in the company's best interest to ratify
or reject the pre-incorporation contract and indeed the board
should be sure to apply its mind to this matter, for if it has
neither ratified nor rejected the contract in the three months
after the company was incorporated, the Act provides that the
company will be regarded as having ratified the agreement.
Some anomalies in the pre-incorporation provisions of the new Companies Act
There are some strange anomalies in the new Act in relation to
pre-incorporation contracts.
For example, the Act provides in section 21(5) that if the
company's board of directors neither ratifies nor rejects a
pre-incorporation contract within three months of the formation of
the company, the contract is treated as having been ratified by the
company.
However, there is no formal process by which the existence of such
a contract is notified to the board.
It could conceivably happen, therefore, that the board of
directors is unaware that someone has professed to enter into a
pre-incorporation contract on behalf of the company, and that the
board therefore takes no action to reject the contract, and then
finds that the contract is deemed to have been ratified and is now
binding upon the company. This hazard could have been avoided if
the new Companies Act had retained the requirement that the
company's Memorandum of Incorporation has to include a
reference to the pre-incorporation contract, or if it created some
other safeguard.
A further worrisome provision of section 21 of the new Act is that
section 21(2) provides that the person who enters into the
pre-incorporation contract on behalf of the yet to be formed
company is personally liable under that contract if the company in
question is not subsequently incorporated or if the company rejects
any part of the contract.
However, the Act does not explicitly provide that the
pre-incorporation contract can validly contain a term releasing
that person from such liability. And since the Act does not
explicitly allow such a deviation from its provisions, it seems
that the personal liability provided for in section 21(2) is not an
alterable provision of the Act and that a term that is inconsistent
with section 21(2) – such as one releasing the person in
question from liability – would consequently be
invalid.
A further significant omission from the new Act is a provision
that makes clear whether the other party to the pre-incorporation
contract is entitled to withdraw from the contract before the
company ratifies it. It is of course highly desirable, from the
company's point of view, that there should not be a right of
unilateral withdrawal by the other party, but the Act is silent in
this regard, thereby creating a very undesirable zone of
uncertainty.
The common law stipulatio alteri may return to favour in this context
It goes without saying that few individuals will be prepared to
sign a substantial contract on behalf of a company, yet unformed,
if there is any possibility that they can be held personally liable
under that contract, as envisaged in section 21(2) of the new
Companies Act. As was noted, above, it is uncertain whether the
individual in question can validly contract out of the statutory
personal liability that is triggered if the company is never
incorporated or if it fails to ratify the contract.
Ironically, therefore, the common law stipulatio alteri (a
contract for the benefit of a third party, in this case, the
unformed company) may henceforth be favoured above a section 21
pre-incorporation contract. For, although a person entering into a
stipulatio alteri binds himself as a principal (until such time as
the company accepts the benefit of the contract) and not as an
agent, there is no impediment to the inclusion of a term that
releases him from personal liability if the company is not formed
or fails to ratify.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.