An Introduction to Section 51 Companies Act 2006 Explained

Examination of the extent to which section 51 Companies Act 2006 has clarified the law relating to pre-incorporation contracts.


Introduction

A pre-corporation contract is a legal agreement by a juristic person, which is entered into when a Company being in the process of being incorporated has not yet completed it, such contracts are void at common law,  as the Company is not yet in existence (Griffiths, 1993, p245)[1]. Section 51,[2] defines it as a contract that purports to be made on behalf of or by a company at a time when the company has not been formed has effect, subject to any agreement to the contrary, as one made by the person acting for the company or as agent for it, and he is personally liable on the contract accordingly.

 

The purpose of pre-incorporation contracts is to encourage entrepreneurship and efficiency in creating simplicity and flexibility in formation and maintenance of companies. It also satisfies the need of an upcoming company to acquire rights and liabilities. This ensures that the company can start with business after incorporation. The challenge is that these companies do not have legal personality, due to their inexistence, and thus cannot make agreements. It is therefore important to evaluate the advantages and the shortcomings, and the future of the same on the role of promoters.

 

If the Company does nothing, it is taken to have ratified to the agreement and the promoter is not be personally liable for the agreement. However, if the incorporation of the company has not been done or, after incorporation, rejects the agreement, the promoter becomes automatically liable for liabilities that may be created in the course of acting as promoter and entering into agreements. The liability is then discharged only if the company subsequently enters into an agreement on similar terms or in exchange of, the pre-incorporation contract; or to the ends that the Board ratifies or is taken to have ratified the contract or action.

 

The only option is then to have a promoter or agent contract in the company’s behalf. They thus incur liability for the company before incorporation. A promoter, according to the case of Twycross v Grant, [3]  is one who forms a company with reference to specific projects and set it going, and take necessary steps to meet that purpose. This includes those who take the procedural steps necessary to form the company, or sets up the company’s business, but not those acting merely in professional capacity on the instructions of a promoter. They deal with formalities of registration of companies, from finding directors and shareholders to holding negotiations for business contracts for the new companies. They are also involved in the formation of a company and are thus personally liable for the pre-incorporation contracts as neither the principle and agent relationship exists. Reason being the lack of that relationship between the agent and the principal as there is in real sense no principle.

 

The common law puts in obstacles to those wishing to contract on behalf of such companies. This is to discourage people from signing or contracting on behalf of non-existent companies. These companies are not legal entities and thus are not permitted to perform juristic acts. According to common law, no person has the right to act as an agent of a company not yet established, in the expectation of ratification after it becomes incorporated.

 

A company cannot then gain legal status before its existence of attaining contractual rights or sustaining contractual liabilities that exist from pre-incorporation agreements. These contracts cannot then oblige a company. The status of promoters ceases to exist after formation of the board of directors. Promoters of the company may also undertake to enter into contracts on the entity’s behalf, where the company may later refute to approve or consent after incorporation.

This position is important as it prevents fiduitiary promoters claiming to be acting for the company, as in the case of Erlanger v New Sombrero Phosphate Co,[4] where the promoter, acquired on his own account in the name of another  the lease of a mine. He then sold the mining rights to the newly formed company. The purchase was approved by the board of directors of the company, appointed by the promoter and was either under his influence or, simply did not have time to give to the enterprise. The prospectus that offered the company’s shares to the public did not disclose the promoter’s profit. When the original board of directors was replaced, the new directors, on sued the promoter to have the contract for the sale of the mining rights rescinded.  It was held that the contract should be rescinded because the profit made by him  was not properly disclosed and therefore could not be kept by him.

A problem is that when the promoters or agents enter into agreements in the company’s name before its incorporation, it would amount to being void ab initio. This was the position in the case of Kelner v Baxter,[5] which is according to section 51, where some individuals purportedly acting for a hotel, in the process of being formed entered into a contract for the purchase of wine which was delivered to the Company after its formation. The  Company went into liquidation before payment. The Court held that the Company was not liable. The liability was on the individuals. Even though the court felt that there was an intended contract, and the only way in which the contract could be valid is through a third party and the promoters were the respective parties. The rationale for this case was that two consenting parties are bound to contract; under the terms of contract, the third parties had no connection to the enforcement and liability. Thus, a pre-incorporation contract exists even when the individual who acted on as a promoter or an agent thereof would be legally liable. The High Court of Australia in Black v. Smallwood & Cooper[6]  took the same route. This confirmed that there might be no ratification by a principle, in this case the company as he was not in existence at the time.

Section 51,[7] holds promoters personally liable for the pre-incorporation contracts they sign on behalf of the company. In failure to then ratify or adopt a pre-incorporation contract, the common law principle would then be useful where the promoter would be held accountable or liable. This would mean that the company after incorporation to act retrospectively. However, if a promoter were doing so as a director of the unformed company then the contact would be unenforceable. Windeyer J found this in the case of Black v Smallwood. The rule can be avoided in Phonogram Limited v Lane,[8] where Lord Denning found that if an unformed company enters into the contact, it does not bind  the company, although it is not entirely short of the legal effects of contract. Further, In the case of Buffington v. Bardon,[9] the court observed that: “The law is that a corporation is liable for its own acts only after it has a legal existence. Until that time no one whether a promoter or not can sustain to the corporation the relation of agent, were this not so, we would have an agent without a principal, which is an absurdity”. The effect of this is that no one was liable for such a contract. Under section 51,[10] subject to any contrary agreement, the person claiming to have acted for the company or as an agent is personally liable on the contract.[11]

The interpretation of the case of Kelner v Baxter,[12] which is also the position in section 51, came into question in Wickberg v. Shatsky,[13]  where the court opined that it was not the case that a person signing on behalf of a non-existing company automatically becomes personally liable. Further, in Black v. Smallwood, the third party could not enforce the contract against the company. Moreover, Newborne v. Sendolid Ltd involved the promoter and or the company not enforce the purported contract. The  risk that accrues here is that that reliance on the alleged contracts  would be  defeated together  with the potential for unjust enrichment of promoters at the expense of third parties or vice versa.

While considering the case of Weavers Mills Ltd. v. Balkies Ammal,[14]  it was held that even if the properties were not conveyed on to the company at the time of making the contract, the company’s title over the property could not be set aside. Further, in the case of Nordis Construction Co(Pty) Ltd v Theron, Burke & Isaac,[15] also disagreed with Keller V Baxter, as it was to the respectful opinion that the questions seemed to be more of construction that intendment of law. This is that the courts cannot create a contract which they never intended, as the parties were ignorant about the non-existence.

The questions that arise from this type of contracts is who is exactly is liable for them. This is what section 51 is silent about, as it does not give any provision on the same or any exception. The common law rules on the same are that until the company is formed, legally it is non- existent until the date of its certificate of incorporation. This is because it is an impossibility to enter into a contract with a non-existent entity.  Further, the contract cannot be saved by making attempts to ratify it after its formation.  If the signing of the contract was done not as an agent but just as an authentication of the signature of the company, then no contract exist at all.

The court took a different approach, totally against section 51,[16] in Newborne v Sensolid,[17] where the holding was that neither the unincorporated company nor the promoter could sue personally on the contract. Lord Goddard stated that,” the contract purported to be a contract by the company but not by the promoter. The only person entitled to have any contract was the company, and the promoter’s signature merely confirmed the company’s signature.”  The correct approach was whether the promoter was intended to be party to the contract or not.  Therefore, given the way in which the promoter signed the contract, his intention was that it be a contract with only the company. He could thus not enforce the contract in his name.

The major legal issue is that the company, for the sake of whom the contract is entered, does not exist. Thus, the existence of the company is complete only when it obtains a certificate of incorporation. Thus, the promoter is not an agent in law as the principal that is the company does not exist. This is as demonstrated in the case of Kelner v Baxter.[18]

Thus, the problems under the law in the case for both the promoter and the third party were that the contract was not enforceable. These problems are because of the artificial personality of the company. In reality, the existence of a company is not like that of a natural person. Its existence cannot be determined quickly and is a concern of legal formality.

The key points is that when any contract is made by the promoter either on behalf of or as the company then contractual liability is imposed on the promoter and related rights to enforce the contract as well falls on the shoulders of the promoter. This rule was confirmed in the case of Phonogram Ltd v Lane [1981].

Salomon v A Salomon & Co Ltd was a turning point case in UK company law where it was undisputedly ruled the doctrine of corporate personality, as laid down in the Companies Act 1862. After this case many exceptional considerations have been defined, by  legislatures and also by the judiciary, in England and elsewhere  where courts lawfully ignores a company’s separate legal personality especially at times when crime or fraud were been committed under the corporate veil.

In a case where a solicitor may be authorized to sign on behalf of a pre-incorporated company, in that competence, instead of a client, the law cannot strictly limit that unless for the consideration of identity ratification and individual liabilities. It becomes even more complicated when a company signs for another pre-incorporation contract a section 51,[19] does not give any provision on such instances. This is because even though the company is legal, it is fundamentally an artificial entity with composite legal conditions in terms of liabilities, possession and corporate lawfulness.

Section 51,[20] therefore is not really clear on this issue or in my opinion is rather too strict as it only limits itself on the instances where the promoter acts for the company and does not provide anything about what happens after ratification of the company and on  Pre-incorporation contracts which they are allowed to enter into contractual accords. It focuses on the ways which individuals can restrict their responsibility on activities or contracts that they may enter into for the company. It only enshrines inhibitions with regard to the lack of ability on the part of directors or other individuals, which includes the solicitors as well to vindicate themselves from any obligation with regard to contracts signed on behalf of the company at its pre-incorporation stage. It is unexpected that the resultant 2006 act also failed to address this area amply.

Therefore, this provision creates loopholes for companies that are later incorporated to abscond from being liable from acts that they may have contracted to do. Further, companies need these contracts in order for them to be able to establish themselves ant to attain assets necessary to their running when they start. This Act discourages those who would have wished to contract on behalf of these companies to shy away from that, as they will be in fear of that personal liability for the companies. The Act may have a good motive of preventing fiduituary dealings but it does not cover very much on the issue on pre-contractual contracts as it leaves very many questions asked about it.

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