Pre-Incorporation Contracts under Company Law - Essay Example

Pre-Incorporation Contracts under Company Law 0 Resolution of Problems relating to Pre-Incorporation Contracts The pre-incorporation contracts are entered into on behalf of the company by the promoters of the company. Usually such contracts may include leasing or purchasing real estate property and equipment, hiring of executives, financial arrangements with third parties or agreements with prospective clients. The general provision is that the company is not liable on such pre-incorporation contracts entered in to on behalf of the company prior to its formation. But the promoter may nevertheless incur a personal liability both under common law and statute. The established principle in the case of Kelner v Baxter (1866) states that the promoter who signed a contract on behalf of a company which had not at that time been incorporated was liable on the contract. Section 32A (1) (a) of the Companies Ordinance of Hong Kong contains the statutory provisions governing the pre-incorporation contracts. According to this section where a person or a promoter who enters in to a contract on behalf of the company as agent before the incorporation of the company, then that person will become personally liable under the contract unless there is an agreement to the contrary entered into between the company and such person. However it is not possible that a contract between the company and the person can be entered into subsequent to the incorporation which makes the company liable on the contract. (IQS) Normally a pre-incorporation contract is an incomplete contract. It is incomplete because it doesn't specify the obligations of the different parties under the contract in case it was not possible to form the company. Similarly it doesn't state the remedy for the other party in case the company after incorporation is not able to perform. Three different rules can be adopted to resolve the situation: Non-Enforcement Rule: It doesn't allow the contractor to perform the contract and the risk under the contract is borne by the contractor. Personal Liability Rule: Under this rule the risk and responsibility is undertaken by the promoter for non-performance under the contract. Corporate Liability Rule: This rule requires the company to perform the contract when it is formed. These rules for the settlement of disputes arising out of pre-incorporation contracts are being applied by courts in different circumstances depending upon the circumstances of each case. 2.0 Jiangsu Higher People's Court' guidelines on resolving disputes on pre-incorporation contracts in China: The Jiangsu Province Higher people's Court of China had promulgated certain decisions and passed on some opinions in the adjudication of certain types of company law cases that can be taken as guide lines for the determination of civil liabilities in the pre-incorporation contracts. According to the Higher People's Court, a 'company being incorporated' refers to an organization which is formed to carry out the acts necessary for the incorporation of the company. It can be assumed that its existence starts on the day on which the execution of the company constitution or incorporation agreement takes place and ends on the day on which the business certificate is issued to the company. In this context the 'necessary acts' implies the legal and economic acts done for the purposes of incorporating the company and complying with the requirements for the establishment of the company in the Company Law of the People's Republic of China. The Higher People's court had expressed the following remarks on the adjudication of certain company cases: Where a promoter does a necessary act for the incorporation of the company in the name of the company, the legal consequence of such an act shall be borne by the company. Where a promoter does a civil act unnecessary for the incorporation of the company, in the name of the company, the creditor may hold the promoter responsible for the consequential civil liability. When the company after incorporation ratifies the act of the promoter then the creditor has the cause of action against the company. Where the promoter has done an act for the purpose of incorporation of the company in the name of the company being incorporated, the creditor may take action against the promoter. When the action of the promoter is subsequently ratified by the company, the creditor has the option to take action against the company or the promoter. But the option once exercised cannot be reversed. Under normal circumstances the pre-incorporation contracts do not pose any problems, once the company is incorporated the company and the respective third parties perform their parts of the contract. However, when the company does not come in to existence or after having come into existence refuses to adopt the contract, difficulties arise to the parties in relation to the settlement of the rights and liabilities of the individual parties under the contract. Where under any circumstances it is not possible to complete the incorporation of the company, the statute provides that the law relating to partnerships shall become applicable to determine the civil liability between the promoters themselves or between the promoter s and other parties to the transaction: In an action that is necessary for the incorporation of the company the liability shall be borne by all the promoters jointly. Where there exists a liability to a third party by a promoter, then the promoter may demand the fellow promoters to share the liability in accordance with the relevant agreement. Where a debt is incurred by a promoter in his own name, necessary for the incorporation of a company it is the option of the creditor to take action against the individual promoter severally or against all the promoters jointly. Where a debt is incurred by a promoter in the name of the company and is necessary for the incorporation of the company then all the promoters shall be jointly liable for the debt, if such action was ratified by them. Where a debt is incurred by a promoter in the name of the company and is unnecessary then the promoter who incurred the liability shall be personally liable for the debt incurred. 3.0 Rules on Pre-Incorporation Contracts Stipulated by Different Courts in China from a Law and Economic Point of View: In the case of Hunan Province Huachu Company v Hainan Wuzhishan Development Joint Stock Limited Company, Bank of Communications Hainan Branch, Hainan Province Travel Head Company and Others the court of first instance held that: 1. Though it was inappropriate for the preparatory committee to enter into subscription agreements in the name of the company with the third parties, it was considered legal and necessary for the incorporation of the company as stated in the incorporation permit. 2. Since shares were not allotted to Huachu, the third party for some omission on the part of the preparatory committee, its claim for refund of its payment towards shares is acceptable under law 3. The court also ruled that the contract between the third party and the preparatory committee in the form of share subscription agreement should be set aside and also the preparatory committee should refund the share subscription amount together with the interest thereon. 4. However since the preparatory committee was a temporary organization formed to look after the incorporation of the company it ceases to exist once the company is formed and hence the liability for refunding the amount of share subscription is shifted to the company. 5. According to the legislative intent of Article 97 (1) of the Company Law of the Peoples Republic of China, after the incorporation of Wuzhishan, the promoters should not be liable for debts incurred during the incorporation period. The views of the court of first instance were later upheld by the Higher People's court. Thus under various judgments different courts of China had issued orders specifying the liabilities that are being attracted by the promoters in various instances. The basic factor in all these cases remain is the determination of the necessity of the act undertaken by the promoter and the subsequent ratification of the action of the promoters by the company concerned after incorporation thereof. This gives rise to the two basic principal strands of scholarship in the economic analysis of the Corporate Law; one being the 'agency theory' that details the problems arising out of the separation of ownership and control and the second being the 'transaction cost economies'. The scope of the agency theory includes the 'nexus of contracts' signifying that it not only covers those agreements which are contracts in the strict legal sense of the term but also includes those arrangements being in the nature of voluntary and adaptive and which are made between the participants of the business venture. Thus the agency theory also covers the 'pre-incorporation' contracts which are both voluntary and adaptive in nature. The company becomes the principal and the promoters being the agents in respect of the contracts. Under economic theory it is assumed that the managers of the firm are rational economic actors guided by self interest. They may at times take action for the maximization of their self interest rather than the maximizing the firm's profits. In the case of the pre-incorporation contracts also the promoters of the company will be considered as the managers and the liabilities created by them sometimes would have been contracted by them to increase their earnings and in such cases the courts have provided for the settlement of the liability by the promoter. However in those cases where the company has subsequently ratified the action of the promoters then there can be no action against the promoter. This implies that the company as the principal has ratified the act of its agent, the promoter irrespective of whether the contract had been entered for the personal benefit of the promoter or for the company's benefit. The agency theory also leads to some costs both on the part of the company as the principal and the managers as the agents. In order that the principal, in this case the investors to keep a close watch on the agents, the managers they have to incur some 'monitoring costs' and at the same time the agents in order to retain their positions and assure the investors that their interests will be protected, incurs 'bonding cost'. The costs incurred both by the agents and the principals are collectively known as 'agency costs'. Both the parties may enter in to contracts for reducing the agency costs; but the effectiveness of follow up and monitoring out of these contracts is highly questionable. However in the case of pre-incorporation contracts the incidence of such agency costs is minimum as the promoters themselves represent the investors at the initial stages of the company and therefore there might not be any need to incur the agency costs. 4.0 Allocation of Risks in Pre-Incorporation Contracts by Courts in China and Common Law Country: As has been decided in the case of X company v Y primary school, the court has ordered the school to return the funds it had received from the preparatory committee for the establishment of a fast food city as a joint venture with the preparatory committee. The court held that "according to the Enterprise Legal Person Registration Administration Regulations, reg 36, the preparatory committee of a proposed enterprise, the establishment of which has been approved by the relevant department of the State Council or the planning departments of various levels of government, should be registered with the relevant authority, if the duration of preparation is to be one year or longer." After such registration the preparatory committee acquires the right to enter into contracts necessary for the incorporation of the company. In this case the establishment of the fast food city was outside the purpose for which the preparatory committee was set up. Under Article 61 of the General Principles of Civil law the property acquired pursuant to a civil juristic act becoming void, the property should be returned to the party who has lost it. There are various other decisions given by the courts under the common law for the restitution of rights as well as settlement of claims under the pre incorporation contracts in all the cases the courts have looked into the elements of: The nature of the contract entered into; whether it is necessary for the incorporation of the company or not The extent of the liability of the promoters as well as the company under such contracts where the contracts are later on ratified by the company. The nature and extent of the liability of the co-promoters in case the debt is contracted by any one promoter on behalf of the company in the name of the company proposed to be incorporated. Based on these judgments all the pre-incorporation contracts can be classified into those which are necessary for the purpose of the incorporation of the company and those not necessary for the incorporation of the company. In the case of contracts where they are considered necessary then the company should bear the risk and responsibility under the contract, irrespective of whether the contract is ratified or not, as the promoter entered into such contract in utmost good faith on behalf of the company. In the case of contracts that are entered even though not necessary for the incorporation of the company, then the promoter who has entered into the contract should be made liable under the contract. Wherever such contracts are ratified by the company subsequent to the incorporation then the company should be made liable under those contracts. In case where the actions taken by the promoters like preparatory committees that are beyond the purposes of incorporation of the company the liability thereon should be decided based on the merits of the individual cases and the decision taken for allocating the risks of such pre-incorporation contracts. In the given instance of the case of the school, the formation of a fast food city has nothing to do with the incorporation of the company and hence the court has ordered for the restitution of the property to in this the money advanced by the preparatory committee to committee itself.. Reference: IQS International Qualifying Scheme: Hong Kong Corporate Law http://www.hkics.org.hk/PDFs/HK_Corp_Law_answers_to_pilot_paper.pdf. Read More