PRE-INCORPORATION CONTRACTS

PRE-INCORPORATION CONTRACTS

 Ninaad Deshmukh

 Maharashtra National Law University, Mumbai

Ever since ancient times, humankind has believed in the concept of coming together in order to be able to survive greater calamities. It is this very fact that became the primary foundation of civilization. Today, as one big society, we have moved forward and diversified. But the notion of herding for better results is still fairly prevalent and very commonplace as well. Even in the fiercely competitive economic sphere, individuals come together to form partnerships or establish companies in order to increase their chances of having an edge over their rivals.

While it constitutes of all of its members, the company itself has its own separate legal identity that is distinct from its members. This provides the company as an entity with the power to enter into contracts in its own name as well as to acquire the contractual rights and obligations ensuing from such contracts. As such, being an ‘artificial person’, the company itself cannot enter into any contracts before its own formal establishment. Even to establish itself and start its business, it needs to go through several contracts and incur several initial expenses. But, as it cannot do so for itself, these become designated jobs for people who are known as promoters, who are tasked with giving birth to the company i.e. bringing the company into valid legal existence. These promoters can enter into a contract with third parties even before the registration of the company. Such contracts, which are entered into by promoters with these third parties to acquire some property or right for and on behalf of a company that is yet to be formed are called as ‘pre-incorporation contracts’. These contracts are valid in the name of promoters and are necessary to ensure that the company is properly incorporated and operational, and continues running successfully.

Such contracts are hence inevitable for the registration of companies. In India, these contracts are recognized by The Companies Act, 2013 and The Specific Relief Act, 1963. More specifically, the validity and enforceability of pre-incorporation contracts lie in Section15 and Section 19 of The Specific Relief Act, 1963.

But, even with due recognition, the actual legality and value of these contracts in India is somewhat difficult to pinpoint. Going by the definition of a contract, there have to be at least two parties who enter into a contract with each other. So, the general principle is that the contract isn’t valid if one of the parties to the contract is not in existence at the time of entering into the contract. Hence, the company can’t enter into a contract before it comes into existence, and it comes into existence only after its registration. On the same lines, it can thus be argued that, the pre-incorporation contract entered into by the promoters on behalf of the company has no validity whatsoever. The promoters, while entering into the contract, act as agents of the company. But when the principal, i.e. the company is itself not in existence, it cannot possibly be assumed to have appointed an agent for itself. But, at the same time, as the principal is not in existence before the registration, the contracts entered into by the promoters would therefore not be binding on the company or third parties. So it has to be the promoter that would become liable for the same.

But, as per Section 230 of the Indian Contract Act, an agent cannot personally enforce contracts entered into by them on behalf of their principal, nor are they personally bound by them if they specifies clearly, at the time of making the contract, that they are only acting as an agent and that they are not and will not be personally liable under the contract. So if this principle is applied, the contract becomes redundant as neither of the parties is liable under the contract.

On the other hand, Section 15(h) of The Specific Relief Act, 1963 reads that, where the pre-incorporated contracts are entered into by promoters for the purpose of the company and subject to terms of incorporation of the company, the company may ask for specific performance from the third party. This condition can only be applied if, after incorporation, the company has expressly demonstrated acceptance of such contracts, and communicated the same to the third party concerned (i.e. the other party). Under similar circumstances the other party to the contract under Section 19(e) of The Specific Relief Act, 1963 may further enforce specific performance against the company.

Thus, in order for the company to enforce the contract against the other party to contract, the members must ratify the contract followed by a communication of acceptance. The company may not receive any benefit from such contract unless the contract is accepted by the company and the promoters would be personally liable for the contracts. In the event that the company does not accept the said contract at its meeting, such contract is indeed binding on the promoters and both, the promoters and other party, may demand specific performance against each other.

But even the scheme of ratification does not come by without its own separate challenges. Firstly, in cases where the company shows reluctance in warranting the terms of contract or has refused to warrant the terms of contract, if a company does not ratify the pre-incorporation contract, then all the parties are pushed into a corner with no remedy at all, as there is no background as such to use or rely upon in cases of such anomalies.

Secondly, even if a company does ratify the contract, the provisions allowing such ratification would fail to justify the foundational jurisprudence of Contract law and Company Law. If the legal base of such ratification is Section 196 of Contract Act, then as per the law, once an act done on the behalf of another person is ratified, the relationship of principal agent is thereby created. Since a promoter is neither an agent nor a trustee, it becomes unclear how the provisions related to agency law are or can be applied. The position of promoter itself is quite peculiar as it holds the position of a sort of a quasi-trustee.

Thirdly, in cases where such a contract has already been ratified, even though it may be admitted that Section 196 of the Contract Act gets applied but the agency created then would lead the enforcement rights of promoter to fall under two dichotomized provisions i.e. Section 15(h) of Specific Relief Act and Section 230 of Contract Act.  The effect of operation of the former one will make the contract enforceable only against the third party whereas in latter’s case the contract will not become enforceable, since as per Section 230 of Indian Contract Act an agent can’t be sued unless there is an agreement contrary to that effect.

Lastly, even if a company ratifies a pre-incorporation contract and if such contract falls outside the object clause under the memorandum, then it would become ultra vires and such contract would be rendered void and unenforceable, even if all shareholders give assent to it.

Hence it is an established fact that companies cannot enter into any contracts before incorporation. It has thus become necessary for promoters to carry out this job. But, the kinds of difficulties faced in this already complex process is something that points towards the dire need for our legislature to come up with relevant solutions and appropriate policy reforms. It needs to clarify the positions of both promoter and third party in absence of subsequent ratification by the company, and also cover up for the loopholes created by conflicting legislations. It must strive to provide remedy to both promoters and third parties so as to prevent ends of justice. The judiciary is also required to do its part and move away with common law practice in this regard, since common law practices itself is riddled with flaws.

Thus, even though, prima facie, one may fail to see the importance of pre-incorporation contracts, on a detailed analysis of the scenario, no one can deny the value as well as necessary legality of the same.

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