What is a pre-incorporation contract? Why could it lead to problems later down the line in relation to a breach of the contract? And how can you avoid them?
What is a pre-incorporation contract?
Essentially, a pre-incorporation contract is a contract made with a Company before its date of incorporation. If the company you are contracting with does not exist at the time you have entered into the contract then Section 51 of the Companies Act 2006 says:
‘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.’
A company only exists as a legal entity when it is incorporated and registered at Companies House. Prior to incorporation, it is likely that your contract will in fact be with the individual or agent acting on behalf of the company as you cannot contract with an entity that does not exist.
Whilst this seems fine on the surface as you may be able to enforce the contract against the individual, it could lead to problems later down the line in relation to a breach of the contract.
For example, In Kelner v Baxter (1866) LR 2 CP 174, promoters agreed to purchase wine for a new hotel business. They claimed to be acting for the company, but the company had not been incorporated at the time of entering into the contract. The wine was consumed before the money was paid and the company was liquidated. The promoters were sued as agents of the company and the court held them personally liable.
Erle CJ held the promoters were personally liable. He said the following:
I agree that if the Gravesend Royal Alexandra Hotel Company had been an existing company at this time, the persons who signed the agreement would have signed as agents of the company. But, as there was no company in existence at the time, the agreement would be wholly inoperative unless it were held to be binding on the defendants personally.
Using the above case as an example, what if the promoters had no means to repay the debt? What if the item purchased was a car or something much more expensive than wine?
Is the individual going to have the money to settle your debt, given that the goods or services provided will be passed to the company and the company will receive the full benefit and, importantly, any profits generated by them?
There is a significant risk that you could be left red-faced, empty-handed and owed significant sums by an individual as a result of a pre-incorporation contract because essentially you have contracted with someone you didn’t know you were contracting with.
Avoiding pre-incorporation contracts
Throughout the course of your business, you may enter into thousands of contracts with your customers, suppliers and possibly third-parties. Whether the contract is written or oral it is of paramount importance that you know and understand with whom you are contracting and negotiate the terms accordingly.
A simple Companies House check for the purported company will confirm whether or not it exists. We would suggest that a Companies House check is conducted on all new customers claiming to be a limited company before any contracts are entered into and goods or services provided.
I think I have entered into a pre-incorporation contract, what do I do?
Whilst you may have remedies against the individual personally, the obligations of that individual can sometimes be transferred (novated) to the company after its incorporation. Sometimes the conduct of the parties is enough to give rise to a novation of the contract. For more information on Novation please click this link to a useful article written by Laura Stanley, an Associate in our Dispute Resolution team.
How does this apply to debt recovery?
To maximise your chances of recovery you must be sure you are chasing the correct entity. You certainly don’t want to expend time and money only to find out that the entity you are chasing is not the one that owes you the debt.