Pre-Incorporation Contracts: Meaning, Legality and FAQs

Pre-Incorporation Contract

A Pre-Incorporation Contract is entered into when the company is in the process of being incorporated but is not yet completed. In legality, such contracts are held to be void since the company is not yet in existence.

A corporation represents a distinct legal entity, distinct from an individual, recognized by the law. It operates as an entity that can possess assets, enter into contractual agreements, and conduct business activities. This legal concept is acknowledged in both English and Indian law. Promoters are the individuals or groups responsible for the behind-the-scenes work required to establish a company. They serve as the architects and builders of the corporate structure, playing a pivotal role in ensuring the legal formation and successful operation of the company.

Before a company initiates its operations, it is necessary to establish various contractual agreements and incur initial expenses. These agreements, created by promoters on behalf of a company that is yet to be formally established, are commonly referred to as Pre-incorporation Contracts or Preliminary Contracts.

The process of incorporating a company offers several advantages within a corporate structure, including safeguarding individual owners or shareholders from financial liabilities. Once incorporated, the company assumes the burden of debt. Consequently, before incorporating a company, pre-incorporation contracts can be used to determine the roles, functions, and liabilities of the company. 

Following are the two situations in which individuals may prefer to draft pre-incorporation contracts.

• Internal Arrangements: A pre-incorporation agreement allows the incorporators to clearly define the roles, functions, and liabilities of each individual involved in the company’s formation. This includes determining who will serve as directors, financial head, legal head, and other key positions, along with their respective responsibilities and potential liabilities. Additionally, the agreement can be used to draft rules and regulations that will govern the company’s operations once it is incorporated.
• Business Agreements: As a company interacts with other firms and entities, a pre-incorporation agreement safeguards its interests. This agreement can specify whether the company operates with limited liability, ensuring that the personal assets of the incorporators are protected from potential liabilities incurred by the company. It also outlines the transfer of ownership from promoters to the company after incorporation, ensuring a clear transfer of authority and responsibility.

Promoters:

According to the Company’s Act, 2013, a Promoter is defined as:

1. A person who has been named as such in a prospectus or is identified by the company in the annual return in Section 92; or

2. A person who has control over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise; or

3. A person who is in agreement with whose advice, directions or instructions the Board of Directors of the company is accustomed to act.

Pre-incorporation Agreements: Role of the Specific Relief Act, 1963 in India

In India, Section 19(e) of the Specific Relief Act of 1963, signifies a significant departure from common law principles. It allows for the enforcement of specific performance against a company under specific conditions. When promoters, before the company’s formal incorporation, enter into a contract on the company’s behalf, and if these contract terms are included in the company’s Articles of Association, it becomes legally possible. Additionally, the company must accept the contract after its incorporation and communicate this acceptance to the other party involved.

Section 15(h) of the same act outlines a similar process for a company to seek specific performance. These provisions have prompted a re-evaluation of previous English court rulings, which regarded pre-incorporation contracts made by promoters on behalf of the company as null and unenforceable by or against the company. After the enactment of the Specific Relief Act, there have been instances where promoters have been held personally responsible.

Before the Specific Relief Act of 1963, in India, promoters encountered significant challenges during the incorporation process. Contracts entered into, before a company’s formal incorporation were void and unratifiable, causing uncertainty around pre-incorporation agreements. The Act marked a pivotal moment in Indian company law, offering a legal mechanism for the validation and enforcement of pre-incorporation contracts, thereby providing a secure and reliable avenue for promoters to engage in necessary transactions with confidence.

Incorporation refers to the formal process of establishing and registering a company as a legal entity, complete with its own distinct rights and responsibilities.

Sections 15(h) and 19(e) of the Specific Relief Act, 1963, outline specific conditions for the enforcement of pre-incorporation contracts. Firstly, the contract must serve the company’s interests, with terms aligned with the company’s expected incorporation and future goals. Upon formal incorporation, the company’s explicit acceptance of the pre-incorporation contract is a vital condition, requiring effective communication to validate the agreement.

Section 15(h) allows the company to seek specific performance from a third party if these conditions are met, with a similar provision under Section 19(e) for the other party. To effectively enforce the contract, the company must ensure its members ratify the contract, followed by acceptance communication. Failure to do so would result in personal liability for the promoters, highlighting the importance of compliance with the specified conditions for the protection and interests of all parties involved.

Legality of Pre-incorporation Contracts: An Examination

Pre-incorporation contracts raise intricate legal questions in the realm of contract law. A typical contract involves the mutual consent of at least two existing parties who agree to certain terms and obligations. However, a fundamental tenet of contract law stipulates that for a contract to be valid, all participating parties must exist at the time of its formation. This foundational principle complicates the status of pre-incorporation contracts.

A Pre-incorporation contract is one that is entered into, prior to the official registration and establishment of a company as a legal entity. The crux of the issue lies in the fact that a company, as a legal entity, cannot enter into a contract before its formal existence, which is only actualized upon registration. As a result, pre-incorporation contracts are usually negotiated and executed by the promoters of the future company, who essentially act as agents on behalf of the yet-to-be-formed corporate entity.

In simple terms, pre-incorporation contracts are intricate due to their nature as agreements made on behalf of a yet-to-be-formed company. This complexity can result in personal liability for the promoters unless they clearly articulate their agency role, which, in turn, can render the contract unenforceable if neither party bears personal responsibility for its stipulations. This highlights the intricate legal aspects surrounding pre-incorporation agreements and the legal challenges they present when the formal corporate entity has not yet come into existence.

Legal Ramifications of Pre-Incorporation Contracts

The process of establishing a company often involves the active participation of individuals known as Promoters, who frequently engage in contracts on the company’s behalf. These contracts, executed prior to the formal incorporation of the company, are commonly referred to as Pre-incorporation Contracts. The legality and enforceability of such contracts are contingent upon the company’s acceptance or adoption of these agreements.

For example, let us consider a scenario in which a group of promoters intends to establish a real estate development company. Before the company attains its official corporate status, these promoters negotiate with a construction firm to initiate a development project. The contracts arising from these negotiations will only become enforceable under the law if the company subsequently acknowledges and adopts these pre-incorporation contracts.

A fiduciary relationship in Indian law is a position of trust. It’s like when you rely on someone, like a friend or a lawyer, to make decisions that benefit you. In this special trust, that person has a legal duty to always prioritise your interests, even above their own. This duty ensures they act honestly and selflessly, and if they don’t, they can face legal consequences.

Promoters who enter into Pre-incorporation contracts on behalf of a company that is yet to be formally established assume personal liability for these contractual agreements. In practical terms, this means that if, for any reason, the company fails to fulfill its contractual obligations, the promoters themselves bear the legal responsibility for ensuring that the terms of the contract are met. They may be held individually accountable for upholding the contractual obligations.

For instance, let us contemplate a situation where promoters of an emerging technology startup engage a software developer to create a proprietary application before the company attains official registration. In the event following incorporation, the company encounters difficulties in meeting its commitments to the software developer, the promoters may become personally liable for the fulfillment of the contractual terms.

Proprietary application refers to a software application or computer program that is owned and controlled by a specific entity or organization, typically a company or individual.

Conclusion

In conclusion, company law and pre-incorporation contracts are complex legal subjects. Promoters play a crucial role in forming companies, and pre-incorporation contracts help address initial agreements and expenses. The Specific Relief Act of 1963 in India has introduced provisions for the enforcement of such contracts, enhancing legal clarity for promoters. However, these contracts raise questions about personal liability for promoters. Cases like Phonogram Ltd v. Lane, Cotronic (UK) Ltd v. Dezonie, and Erlanger v. New Sombrero Phosphate company emphasize the fiduciary relationship between promoters and the company. Thus, pre-incorporation contracts are vital tools in company formation, but promoters should be cautious about their personal liability, ensuring they meet legal requirements.

Frequently Asked Questions (FAQs)

1. What is a pre-incorporation contract, and how does it relate to company formation?

A pre-incorporation contract is an agreement made on behalf of a company that has not yet been formally established, typically negotiated and executed by promoters before the company’s registration.

2. What role do promoters play in the establishment of a company, and why are they important?

Promoters are individuals responsible for behind-the-scenes work in setting up a company, playing a pivotal role in ensuring its legal formation and operation.

3. How is the legal concept of a corporation distinct from an individual under English and Indian law?

A corporation is a distinct legal entity separate from individuals, recognized by the law in both English and Indian legal systems.

4. What are the legal implications of pre-incorporation contracts in India, and how does the Specific Relief Act of 1963 impact their enforcement?

In India, the Specific Relief Act of 1963 has provisions for the enforcement of pre-incorporation contracts under specific conditions, enhancing legal clarity for promoters.

5. Can pre-incorporation contracts result in personal liability for promoters, and under what circumstances does this occur?

Pre-incorporation contracts can result in personal liability for promoters when the company fails to fulfill its obligations, depending on factors like agency status and contract acceptance.