This blog explains the problems with pre-incorporation contracts and sets out what you can do if you find yourself in this situation.
What is incorporation?
A company does not legally exist until it is incorporated. Incorporation is the process by which a new or existing business registers as a company. Once a company is incorporated, it will receive a certificate of incorporation confirming its existence and showing the company number and date of formation. Before a company is incorporated, it cannot enter into commercial contracts. Consequently, nobody can sign a contract for that company as an agent. A contract entered into by a party on behalf of a company, where that company has not yet been formed, is called a pre-incorporation contract.
The general rule relating to pre-incorporation contracts is set out in section 51 of the Companies Act 2006. The section states 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.”
This means that anyone who signs a contract on behalf of a company before that company is incorporated will be liable as if they were the contracting party. Section 51 also has dual effect, as confirmed in the case of Braymist Ltd v Wise Finance. As well as having personal liability, the person who signs on behalf of a company can personally enforce the pre-incorporation contract.
What exactly is an “agreement to the contrary”?
There has been some disagreement over the years as to the exact meaning of “agreement to the contrary”. Thankfully, case law has provided some clarity. If you can prove that there is an “agreement to the contrary” you may be able to negate liability and get yourself off the hook.
In Phonogram v Lane, Lord Denning took the phrase “subject to any agreement to the contrary” to mean that for a person to avoid personal liability the contract would have to expressly provide for his exclusion.
In Royal Mail Estates Ltd v Maples Teesdale, Mr Johnathan Klein took a similar but even more restrictive approach. Mr Johnathan Klein stated that an “agreement to the contrary” would only exist if it could be established that, by relevant words properly construed, the parties intended that the contract would not take effect as one made with that person. In other words, there was only a contrary agreement if there was found to be an agreement between the parties by which they intended to exclude the effect of section 36C(1), which is now section 51 Companies Act 2006.
In the case the defendant firm of solicitors signed the contract “for and on behalf of the buyer”. The contract related to the sale and purchase of a property in London and included a clause which stated that the benefit of the contract was personal to the buyer. As both parties were unaware that the company in question had not in fact been incorporated Mr Klein concluded that the contract was not drafted with section 36C(1) in mind. The terms in question were clearly intended for a different purpose, which was to prevent or restrict a third party from becoming a buyer by way of an assignment of sub-sale.
The fact that the defendants here were a firm of solicitors shows just how easy it is to be caught out by section 51. Proving that there was “an agreement to the contrary” is a high hurdle to overcome.
What can I do to avoid liability?
As the saying goes, prevention is better than cure. As the risk sits with the person who has signed the contract, it is extremely important for that person to carry out appropriate checks to confirm that the company in question has been properly incorporated, and continues its corporate existence, before a contract is concluded. If you have already signed a pre-incorporation contract on behalf of a company, and you cannot prove an “agreement to the contrary”, you may still be able to avoid personal liability as explained below.
A novation is a three-way agreement that extinguishes one contract and replaces it with another, in which a third party takes up the rights and obligations of one of the original parties. In this scenario, the third party taking up those rights and obligations would be the company. All parties to the original contract, as well as the company, must consent to a novation for it to be valid. In addition, consideration must be provided. The various promises between the parties to the novation are generally regarded as adequate consideration however some parties may prefer to novate under a deed just to be sure.
Ratification is a process by which a party can give retrospective authority to someone who has entered into an agreement on their behalf. Although some commentators suggest that ratification may be of assistance in these circumstances, we do not consider that ratification is possible in the case of pre-incorporation contracts. There are a number of conditions that must be met for an action to be capable of being ratified. One of these conditions is that the principal (here, the company) must be in existence at the time of the contract. As a company is not legally in existence before it is incorporated, these conditions will not be satisfied.
This blog should serve as a timely reminder of the risks of signing documents on behalf of a company; and in particular where a company itself is not in existence. If you have any questions about pre-incorporation contracts or contractual issues more generally please contact Neil Williamson or Sasha Bark Jones or you can find out more about our legal services by clicking here.