II.

FORMATION OF A COMPANY
1. Promoters Promotion of a company is concerned with taking the steps necessary for incorporation. (a) Definition "Promoter" is not defined in the Companies Act. Some attempts at definition have been made by the courts: Case: Twycross v Grant (Case 1)

In describing the role and function of a promoter, Lord Cockburn said: " A promoter, I apprehend, is one who undertakes to form a company with reference to a given project and to set it going, and who undertakes the necessary steps to accomplish that purpose...and so long as the work of formation coninues, those who carry on that work must, I think, retain the character of promoters. Of course, if a governing body, in the shape of directors, has once been formed, and they take what remains to be done in the way of forming the company into their own hands, the functions of the promoter are at an end."

Case:

Whaley Bridge Printing Co v Green (Case 2)

A promoter negotiated the sale of a business from the seller to the company which he was intending to form. The seller agreed to pay a share of the profit he received from the sale to the promoter. It was held that the promoter was accountable to the company for that profit. In an attempt to define the term "promoter", Bowen J said: "The term promoter is a term not of law, but of business, usefully summing up in a single word a number of business operations familiar to the commercial world by which a company is generally brought into existence. Whether a person is a promoter or not is a question of fact and the determining factor is whether the individual in question will exercise control over the affairs of the company both before and after it is formed up until the process of formation is completed. A person is not to be treated as a promoter of a company simply on the basis that they act in a professional capacity with respect to the establishment of a company. Thus solicitors and accountants employed purely in their professional capacity in order to establish a company will not be considered to be promoters. (b) Duties of Promoters As with directors, promoters are in a fiduciary relationship with the company they are establishing. This is a position akin to that of a trustee and the most important consequence that flows from it is that the promoter is not entitled to make a profit from establishing the company, without full disclosure of that profit to either an independent board of directors, or to the existing and prospective shareholders in the company. Such a situation usually arises in situations where the promoters sell assets to the company they are in the process of forming. Failure to make such a disclosure will enable the company to: rescind the contract; claim damages or hold the promoter liable to account for any profit made (Erlanger v New Sombrero Phosphate Co (1878), Gluckstein v Barnes (1900); Re Leeds & Hanley Theatres of Varieties (1902)).

In the 19th century, it was common for promoters to sell their own property to a newly formed company at an inflated price, or to acquire assets for the company and receive a commission from the seller. The courts then began to impose a fiduciary duty on promoters similar to that imposed on agents. A promoter must disclose any profit or potential conflict of interest to either: (i) an independent board of directors, or Page 1 of 6

(ii) existing or intended shareholders. (c) Remedies for Breach of Promoters Duty (i) Where promoter has sold his own property to the company, without disclosing this - the company can rescind the contract and recover the purchase price: Case: Erlanger v New Sombrero Phosphate Co (Case 3)

A syndicate headed by Erlanger acquired the lease of an island in the Caribbean for 55,000. The leaseholder was a nominee of the syndicate. The syndicate later incorporated the New Sombrero Phosphate Co. At a meeting of the directors (some of whom were members of the syndicate) it was agreed that the company would buy the lease from the nominee. The company issued a prospectus which did not mention that anyone other than the nominee had any interest in the lease. Held: As there had been no disclosure by the promoters of the profit they were making, the company could rescind the contract and recover the price from Erlanger and the other members of the syndicate. Right of recission is lost if restitutio in integrum is not possible.

(ii)The promoter may have to account to the company for any profit he has made. Case: Gluckstein v Barnes (Case 4)

A syndicate bought property intending to sell it to a company they were forming. They nominally bought it for 140,000 but actually got it at a discount, so that it cost them 120,000. They then sold it to the newly formed company, of which they had become directors, for 180,000. A prospectus issuing to the public disclosed a profit of 40,000, but not the 20,000 discount. The company laterfailed and the liquidator claimed repayment of the 20,000. Held: The House of Lords upheld the liquidator's claim.

(iii)The company may be able to sue the promoter for damages for breach of fiduciary duty. Case: Re Leeds & Hanley Theatre of Varieties (Case 5) F Co contracted to purchase two music halls for 24,000 and had the property conveyed to a nominee, R, intending to sell it to the Leeds and Hanley when the company was formed. F Co then promoted the formation of Leeds and Hanley and agreed to sell it the music halls for 75,000. Held: The board of directors of Leeds and Hanley was not an independent board. A prospectus for issuing shares to the public gave R as the seller of the property and did not disclose the interest of F Co or the profit it was making. For breach of fiduciary duty to those invited to take shares the promoters were liable in damages to the company; the measure of damages being the promoters' profit. (d) Payment of Promoters A company cannot enter into a contract before incorporation - so a promoter has no legal claim against the company for fees and expenses. In Scotland, memorandum or articles of the company can be drawn up with a provision that the company will pay fees and expenses incurred in promoting the company. (e) Suspension of Promoters Page 2 of 6

Company Directors Disqualification Act 1986, s.2(1) The court can make a disqualification order against a person who has been convicted of an indictable offence in connection with the promotion, formation or management of a company. The order can be for a maximum of 15 years - a person who is disqualified is prohibited from directly or indirectly taking part in the promotion or formation of a company. 2. Pre-Incorporation Contracts A pre-incorporation contract is a contract which promoters enter into, naming the company as a party, prior to the date of the certificate incorporation and hence prior to its existence as a separate legal person. However, in law, the company cannot enter into a binding contract until it has come into existence through incorporation. The legal consequences of this situation are that: the company, when formed, is not bound by the contract even if it has taken some benefit under the contract. the company cannot ratify or adopt the contract even if it wishes to after it has become incorporated. The person who purportedly contracted on behalf of a company in respect of pre-incorporation contract is treated as if he had contracted on his own behalf. These consequences are a result of the ordinary rules of agency law as stated in Kelner v Baxter (1866) but the third one has been restated and confirmed in s.51 Companies Act (CA) 2006, which provides that: a contract that purports to be made by or on behalf of a company at a time when the company has not been formed has effect, subject to any agreement to the contrary, as one made with the person purporting to act for the company or as agent for it, and he is personally liable on the contract accordingly. It can be seen from the wording of s.51 that liability of the agent is contractual, but it should be noted that this liability arises whether the promoter contracts as agent or not. Thus in Phonogram Ltd v Lane (1982) it was proposed to form a company, FM Ltd, to run a pop group. L made a contract with Phonogram Ltd for and on behalf of FM Ltd. However, FM Ltd was never actually incorporated. Consequently the court held that Lane was personally liable for the money advanced to FM Ltd by Phonogram Ltd. The Court of Appeal held that the fact that Lane had signed for and on behalf of FM made no difference to his personal liability. To give effect to the words subject to any agreement to the contrary in s.51, the words used would need to amount to an express exclusion of liability. However, promoters can avoid liability for preincorporation contracts in a number of ways. For example: it is possible to avoid entering the contract until the company has actually been incorporated. the promoter may enter into an agreement subject to contract with the effect that there is no binding agreement until the company itself enters into one. As the promoters are usually the first directors of the company, they can assure that the company does in fact enter into the pre-arranged contract. the promoters can expressly provide that they will bear no responsibility for any pre-incorporation contracts.

(a) Effect of Pre-Incorporation Contract on the Company Company cannot be bound to the contract because it had no contractual capacity. Company cannot ratify the contract because it was not in existence at the time the contract was made. Company cannot sue or be sued on the contract. (b) Effect of Pre-Incorporation Contract on Person Purporting to Contract on Behalf of the Company Page 3 of 6

At Common Law: if third party knew company was not yet in existence, he could make the purported agent liable on the contract. if it appeared that the contract was with a company not in existence, the court might hold there was no contract at all, and neither the company nor the purported agent could enforce it.

Case: Newborne v Sensolid (GB) Ltd (Case 6) Tinned ham was sold to Sensolid under a contract headed "Leopold Newborne (London) Ltd" and ending "Yours faithfully, Leopold Newborne (London) Ltd" and signed by Leopold Newborne. Sensolid refused to take delivery of the ham. Held: Neither the then unincorporated company nor Mr Newborne personally could sue on the contract. Lord Goddard said: "This contract purports to be a contract by the company; it does not purport to be a contract by Mr Newborne. He does not purport to be selling his goods but to be selling the company's goods. The only person to have any contract here was the company, and Mr Newborne's signature merely confirmed the company's signature...In my opinion, unfortunate though it may be, as the company was not in existence when the contract was signed there never was a contract, and Mr Newborne cannot come forward and say: "Well, it was my contract." This was unsatisfactory and was first changed by legislation in 1972. Provisions are now in s.36C of the Companies Act 1985: "A contract which purports to be made by or on behalf of a company at a time when the company has not been formed has effect, subject to any agreement to the contrary, as one made with the person purporting to act for the company or as agent for it, and he is personally liable on the contract accordingly." This means the "agent" will always be personally liable on the contract unless there is agreement to the contrary. Exceptions: (i) Companies Bought "Off the Shelf" s.36C does not apply where promoter makes contract on behalf of existing company he later buys. The company can then ratify the contract. (ii) Companies Struck Off the Register s.36C does not apply where a company has been in existence but has been struck off the register. The section only applies where the company has never been in existence. Cotronic (UK) Ltd v Dezonie (Case 7) Dezonie signed a contract relating to some building work at a residential home, signing for and on behalfof his company, Wendaland Builders Ltd. Unknown to him, the company had been struck off the register about five years earlier. On learning this Dezonie registered a new company with the same name and sought to rely on s.36C to claim the benefit of the contract. Held: s.36C had no application here. This was not a case where a contract had been entered into on behalf of a company not yet formed, but on behalf of a company which had been formed many years before. (c) Avoiding Personal Liability Page 4 of 6

(i) s.36C does not apply if the parties have agreed that the promoter will not be personally liable. This requires express agreement - courts will not infer it. Case: Phonogram Ltd v Lane (Case 8)
A rock group intended to perform under the name "Cheap Mean and Nasty" and to form a company for the purpose to be called "Fragile Management Ltd". Mr Lane accepted a cheque from Phonogram for 6,000, signing his name "for and on behalf of Fragile Management Ltd". The money was to be used to finance production of an album and was repayable if this was not achieved. When the album was not produced, Phonogram sought to recover the money from Lane, the company having not been in existence at the time the contract was made. Lane argued that his signature "for and on behalf of" the company amounted to anagreement that he was not to be personally liable on it - an "agreement to the contrary" in terms of s.36C. (Then s.9(2) of the European Communities Act 1972). Held: This was not sufficient to exclude the operation of the section, which would be given full effect unless there was a clear and express exclusion of personal liability. Lane was thus liable to repay the money (ii)Promoter and third party could make an agreement for novation. (novation = substitution of a new obligation for an old one)

Promoter could agree with third party that promoters liability will end when the company, once formed, enters new contract on same terms. Remedies for non-disclosure If the promoter fails to make proper disclosure, the company may: Rescind the contract for the purchase of property Claim damages Recover any profit made by the promoter out of transactions effected during the period of promotion.

However, rescission may have become impossible if; The company can no longer restore the property in the same condition as it was purchased; or Third parties have meanwhile acquired an interest in it In a claim for damages the company must prove that it has suffered a loss.
Case: Omnium Electric Palaces v Baines Facts: The promoter agreed to sell to the company a lease which he was about to obtain. It was argued that because of his fiduciary position the promoter is accountable for any profit he makes out of transactions in the promotion. Held: His duty is to disclose; if he does so he may keep his profit. If the profit is made on property acquired before the promotion began the company cannot claim it even if the promoter does not make a proper disclosure.

Formation Expenses The promoter has no automatic right to recover his expenses from the company if the company has benefited. NB: prior to the certificate of incorporation 1. The company does not legally exist 2. The promoters are personally liable on all contracts entered into (even in the name of the company) 3. The company cannot ratify a contract made before it is incorporated 4. Contracts are known as per-incorporation contracts.

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Possible solutions for promoters 1. Delay binding contracts until the company is formed. 2. Buy an ;off the shelf company A company which is already incorporated with a standard memorandum and Articles. It can be bought by any person wishing to trade as a registered company. 3. ensure that the company can sue on the contracts. 4.Agree that there will be no personal liability 5. Purchase an option 6.Agree that either party may rescind 7. Formula of assignment

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