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 law

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.

  • Novation

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

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.

Final words

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 Joanna McKenzie or you can find out more about our legal services by clicking here.