Company Promoters And Shareholders: Liability For Pre-Incorporation Contracts
Background
Given that Steve is the Founder(promoter) of WA Gold Exploration Ltd, is he liable for the breach of Thor Mining Machinery Ltd? Also, as a shareholder with 90%, is he liable for the WA Gold Exploration Ltd debts with Volvo Trucks (Australia) Ltd?
Company founders or promoters are the initial persons who exist before its incorporation, and they are the one who takes the responsibilities of the incorporation work(Slorach et al, 2017 p.46). Unregistered companies have no legal personality, and one element of a contract requires parties to have a contractual capacity which runs together with legal personality (Jones, 2015, p. 131). Therefore, no company can be either directly or indirectly become a party to contract prior to its incorporation. When promoters enter into contracts in the name of the unregistered company, they take the risk of becoming liable for those pre-registration contracts. Therefore, the safest way is to wait for the registration or purchase an already existing company. In other words, as getting into contract on behalf of a company creates an agency, common law did not allow an agency to exist before its principal.
In English law, the landmark case that set these rules was (Kelner v Baxter (1866) LR 2 CP 174) which among the first cases that dealt with situations of pre-incorporation contracts. In this case, the court ruled that when contracts are executed for a contemplated company, individuals who had acted as the promoters of the unregistered entity would be the one legally liable for those contracts. The case of (Kelner v Baxter (1866) LR 2) was ruled with the application of common law. During those times, common law or the law in general did not have any provision for ratification of contracts entered on behalf of a company that did not exist.
The rule that was highlighted by the case of (Kelner v Baxter (1866) LR 2) was that promoters were the one who would be liable on any contract they form before incorporation. However, this law did not set out whether the founders were to automatically become liable in such circumstances.
The case of (Newborne v. Sensolid Co. Ltd (1954) 1 QB 45) is one of the cases that took another twist that rejected the idea that promoters can become automatically liable. The case involved a consignment that Newborne contracted to buy from Sensolid, signing the contract as “Leopold Newborne (London) Ltd”. He also ended it as “Yours faithfully, Leopold Newborne (London) Ltd.” When the defendant (Sensolid) refused to deliver the consignment, Mr. Newborne sued for breach. The court held that both Leopold Newborne (London) Ltd and Mr. Newborne himself could not sue. This court interpreted a contract as one that was entered by the Leopold Newborne (London) Ltd but not Mr. Newborne. Therefore, as Leopold Newborne (London) Ltd did not exist, same as the contract was with a non-existing party. The rationale held here was mainly on the intent of the contracting parties. Did the parties intend to contract as individuals or as companies? If the intention was to contract as a company, no one can later assert that an individual would take the liability.
Legal Analysis of Pre-Incorporation Contracts
In Australia, the case of (Black v. Smallwood and Cooper(1964) N.S.W.R. 1121.) followed the same construction set in (Kelner v Baxter (1866) LR 2) Smallwood and Cooper entered into a contract on behalf of Western Suburbs Holdings Pty. Ltd before its incorporation. When they breached the contract, the claimant sued them for breach. The majority court used the law set in (Newborne v. Sensolid Co. Ltd (1954) 1 QB 45) and held that individuals could not be liable when the first intention, which was contemplated at the time of creation the contract shows that the parties wanted to transact as companies.
Since then, the law in Australia has undergone a transformation and section 131 (Corporations Act, 2001) deals with matters of agency in unregistered companies. The section 131(1) of this act has now allowed the agents of unregistered companies to ratify their pre-incorporation contracts but this can only happen if the contemplated company is registered before the lapse of the contract duration (Australia, 2011, p. 192). However, if the contemplated company is not registered, the rule set in (Kelner v Baxter (1866) LR 2) would apply, and promoters would be held liable where the interpretations seem to favor a contract made with individuals. Also, if the registered company instead refuses to ratify the pre-registration contract, again, the rules of (Kelner v Baxter (1866) LR 2) would apply and the persons who entered into the contract may be personally liable.
Shareholders are members of a company and they are not legally liable for companies debts just because they are shareholders (Kershaw, 2012, p. 20). However, there are only three chances when they can be liable. For one, they are liable for executing their obligation which is the payments of the money owed on unpaid shares. They may also be liable if agreed terms with the company stipulated as such. Lastly, they can be liable if they were directors under the circumstances in which directors become liable e.g. in misconduct. These provisions are contained in Section 1.5.1 (1.2 Limited liability of shareholders) (Corporations Act, 2001).
Applying (Kelner v Baxter (1866) LR 2) rules on Steve situation, the problem is not only with the contract formed on behalf of a non-existing company, but also the pre-registration contract was not ratified as per the provisions of the Corporations act section 131. Again, as seen the facts of this case, Steve Jones, signed the contract stating that he had done so ‘on behalf of WA Gold Exploration Ltd.’ What this implies is that both Steven and Thor Mining Machinery Ltd intended to contract as companies. This situation matches the case mentioned above of Black v. Smallwood and Cooper(1964) N.S.W.R. 1121 and Newborne v. Sensolid Co. Ltd (1954) 1 QB 45.
Case Law from English and Australian Courts
What amounts to ratification was explained in (Aztech Science v Atlanta Aerospace (Woy Woy) (2005) NSWCA 319, 2005). A company can be said to have ratified a contract either expressly or impliedly. The court explained that express (communication) ratification is only necessary where there is a short timeframe. As can be seen in the case of Steve, there was no express ratification and when the company contracted bought a drill from United Mining Machinery Ltd instead of moving on with Thor Mining Machinery Ltd, the conducts here shows that they never intended to ratify the contract. Again, the action by Volvo Trucks (Australia) Ltd on Steve would likely to fail. The main reason is that Steve is only a shareholder, and SECT 1.5.1 provides that unless stipulated in the Shareholders and Company agreement, shareholders cannot he held liable of the company’s failures just because they are members.
Conclusion
The action of Thor Mining Machinery Ltd on Steve would fail on the basis that the contract was entered with a non-existing company. Similarly, the action by Volvo Trucks (Australia) Ltd would fail because Steve is a shareholder and he is not liable for company debts.
Did Simon bind Computer Solutions with Sunstar Computer Hardware Ltd and You Beaut Ute Ltd? Also, was Computer Solutions supposed to pay for the Second Hand Ute or that should be held as Simon’s personal transaction?
In agency law, an agent has the power to bind the principal with a third party as they are deemed to act on the principal’s authority (Mann et al, 2012, p. 522). Unless stipulated in the agreement, partnership business gives apparent authority to its partners and all of them have the power to bind the entire partnership to a third party (Mann et al, 2012, p. 572). In partnership business, apparent authority is generally broad and does not have the same limitation as that found in an agency relationship. For instance, unlike in agency law where apparent requires a manifestation by the principal that the agent is acting on his authority, in partnership, all that is required is a proof to the third party that the person (agent) is a partner (Parisi, 2017, p. 414). For instance, in (Mann v D’Arcy (1968) WRL 893) the court held even the innocent partners liable for the damages. The court found that even though the contract was made with between one partner and the Joint Ventures, that one partner had the authority to bind the others with the Joint Ventures.
Power of Partners to Bind a Partnership
In (Partnership Act, 1892) section 5 (1), the law states that every partner in a partnership other than in the cases of limited partnership or incorporated limited partnership is qualified to act as an agent. The law extends to say that a partner’s action can bind the business as well as other partners. The only chances when this rule may not apply is when the partner has no authority in executing whatever act he purports to execute, and the third party is aware of the limited authority (Emerson, 2009, p. 321). Also, section 8 restricts the application of this rule to only contracts that partners make for the usual course of the business. A contract to purchase personal item would not be binding to the firm. authority: The Court will prevent the partner from asserting that he or she had implied authority on behalf of other partners to purchase those items that are not related to the ordinary course their partnership business (Sze et al, 2011, p. 231). However, a proof of express authority can refute this exception.
For the protection of third parties from any misconduct of the partners, section 8 of (Partnership Act, 1892) states that no internal agreement made between partners purporting to limit their authority can prevent the third party’s action unless in situations where the third party is aware of the limitation. In (Mercantile Credit Co Ltd v. Garrod (1962) 3 All ER 1103), one of the partners sold the car from their garage yet they had agreed to not sell more cars. The 3rd party returned the car, but he sued the garage for the breach. When the innocent partner tried to avoid the liability, the court affirmed that both were liable since the third party did not know about the limiting agreement.
By applying the rules set in section the court will prevent the other partners from denying the authority of Simon in binding the entire partnership with Sunstar Computer Hardware Ltd. Like as ruled in the case of (Mercantile Credit Co Ltd v. Garrod (1962) 3 All ER 1103), the court will assume that Simon had the authority of acting on behalf of the firm since he was a partner. Even though other partners may state that Simon had not sought their approval, the court will prevent them from walking away since Sunstar Computer Hardware Ltd and You Beaut Ute Ltd had no information about their arrangements.
Exceptions to the Rule
An illustration of when the court has previously made such comments was in the case of (Singapore Branch v Asia Pacific Breweries (Singapore) Pte Ltd (2011) 3 SLR, 2011). The Judge said at [38] that there is an “established principle” in law that the law never recognizes any idea of ‘self-authorizing’ agents”. Applying the same statement, the law will never accept that Simon was acting on his authority but that of the partnership.
On the part of the transaction with You Beaut Ute Ltd, the firm would not be liable for this transaction since it is not part of their ordinary course their partnership business(Sze et al, 2011, p. 231). However, the partners would need to prove to the Court that the second-hand ute was not something that the company deals with. In this case, Simon would be personally liable.
Conclusion
On analysis, even though Simon had no approval from other partners while entering into a contract with Sunstar Computer Hardware Ltd, costing $ 15 000, all the partners will have to accept the transaction. However, on the transaction with You Beaut Ute Ltd and the idea of freight business, the court will hold Simon liable by himself. They would also need to prove to the court that You Beaut Ute Ltd freight business was not part of their dealings. Another action they could possibly take is to sue Simon for the violation of the partnership agreement. From their case with Simon, they can they recover the damages that he had caused.
References
Australia. (2011). Australian Corporations & Securities Legislation 2011: Corporations Act 2001, ASIC Act 2001, related regulations. CCH Australia Limited.
Aztech Science v Atlanta Aerospace (Woy Woy) (2005) NSWCA 319, 2005.
Black v. Smallwood and Cooper (1964) N.S.W.R. 1121.
Corporations Act (2001).
Emerson, R, W (2009). Business Law. Barron’s Educational Series.
Jones, L (2015). Introduction to Business Law. Oxford University Press.
Kelner v Baxter (1866) LR 2 CP 174.
Kershaw, D (2012). Company Law in Context: Text and Materials. OUP Oxford.
Mann, R, A and Roberts, B, S (2012). Essentials of Business Law and the Legal Environment. Cengage Learning.
Mann v D’Arcy (1968) WRL 893.
Mercantile Credit Co Ltd v. Garrod (1962) 3 All ER 1103.
Newborne v. Sensolid Co. Ltd (1954) 1 QB 45.
Parisi, F (2017). Law and Economics. Oxford University Press.
Partnership Act (1892).
Singapore Branch v Asia Pacific Breweries (Singapore) Pte Ltd, 3 SLR 540 (2011).
Slorach, J, S and Ellis, J (2017). Business Law 2017-2018. Oxford University Press.
Sze, P, and Choy, K (2011). Corporations and Partnerships in Tonga. Kluwer Law International.