South Africa: The Strengths And Weaknesses Of The New Companies Act As Regards Pre-Incorporation Contracts

Last Updated: 19 November 2013
Article by Roodt Inc

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.

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