PRE-INCORPORATION CONTRACTS: CONTRACT OUT OF PERSONAL LIABILITY

PRE-INCORPORATION CONTRACTS: CONTRACT OUT OF PERSONAL LIABILITY

Published: 7 December 2018

Why use pre-incorporation contracts?

A company has no legal existence until it is incorporated in terms of the Companies Act, 71 of 2008 (as amended) (“the Act“). As such, any agreement it purportedly concludes prior to such incorporation is invalid and unenforceable. Fortunately, section 21 of the Act ameliorates this position by rendering agreements concluded by companies not yet incorporated valid. These are commonly called pre-incorporation contracts or pre-incorporation agreements (“PIA“). This has meant that potential company founders are given statutory authority to enter into agreements in the name of a company that is still to be formed. This is of huge practical importance given that a company that has not been incorporated yet can already secure business premises, contract for urgent corporate opportunities and even secure supplier agreements before it is incorporated. Such PIAs have also been said to encourage investor confidence. However, it is important for founders to protect themselves by contracting out of personal liability if the company is not subsequently incorporated or does not ratify the PIA post incorporation, among other reasons.

Personal liability in terms of section 21: Can it be avoided?

Section 21(1) of the Act provides that the individuals concluding a PIA may “enter into a written agreement in the name of, or purport to act in the name of, or on behalf of” a contemplated company. According to Venalex (Pty) Ltd v Vigraha Property CC and others [2015] 2 All SA 645 (KZD) if the PIA is concluded in terms of the Act, the individual(s) will be acting as an agent of a company not yet incorporated. Such individuals will in turn become “jointly and severally liable” if the contemplated company is not subsequently incorporated or fails to fully ratify the PIA post incorporation. In other words, all agents will be liable for any loss suffered by the third party because of the company’s repudiation. This is an unalterable provision of the Act meant to protect the third party to the PIA and means that agents cannot avoid such liability when using section 21 PIAs.

The only way to escape such liability is to structure the written PIA in terms of the common law principle, stipulatio alteri or contract as a principal (not an agent) for the benefit of a third party. This form, unlike the statutory section 21 version, does not provide the third party with disproportionate protection against the party(ies) acting for the benefit of the contemplated company. In terms of the stipulatio, there are no harsh consequences of personal liability for the parties acting for the benefit of the company that is yet to be incorporated. If the contemplated company is not incorporated, or it rejects the PIA upon incorporation, the contract simply falls away, unless otherwise provided in the written PIA.

How to ensure you are using the appropriate type of PIA

Structuring the agreement to clearly reflect the intentions of the parties as to the type of PIA can be done in various ways. In the Venalex case the court’s analysis concluded that the individuals acting on behalf of the company were not acting as agents in terms of section 21 of the Act, but that they contracted as “principals for the benefit” of the company that is to be incorporated, in terms of common law.

A way in which to determine if a court will declare an agreement to be a section 21 PIA or a common law stipulatio, is by establishing when the parties intended the PIA to give rise to contractual obligations. For example, when a newly incorporated company in a section 21 PIA ratifies the PIA (completely, partially or conditionally), such ratification happens retrospectively. In other words, performance obligations in terms of the PIA will be interpreted to have arisen from the time that the agent entered the PIA, not when the company ratifies it. If the PIA is not ratified or rejected within three months after the company is incorporated, there will be deemed ratification. If the company is not incorporated, or the PIA is rejected by the company, the agents become personally liable (together with the company, if incorporated) to the third party for any loss suffered.

In terms of the common law stipulatio, a newly incorporated company will have an election of whether to accept the PIA or to reject it. If the company accepts the PIA, then obligations to such contract will only arise from the day of such acceptance, not when the principals concluded the contract for the benefit of the contemplated company. If the company is not incorporated or it rejects the contract upon incorporation, the principals acting for the benefit of the contemplated company are not held personally liable, unless otherwise stated by the PIA specifically, and the contract will simply fall away. Lastly, the common law does not indicate a strict time period for election (in contrast to the statutory section 21 PIA), in that the election simply needs to be made within “a reasonable time”, without sanctions if not made. The stipulatio PIA can never be deemed accepted without the newly incorporated company’s knowledge if it fails to make an election within a reasonable time.

Conclusion

In conclusion, the court has previously stated that it will look at the written agreement when it exercises its discretion in determining whether the parties have concluded a section 21 PIA or a stipulatio alteri PIA, in the absence of such express provisions indicating their preference. Therefore, it is important to state clearly which form of PIA you are concluding. For the commercial attorney representing the person contracting on behalf of a company to be incorporated, it is important to structure the agreement in terms of the stipulatio. On the contrary, an attorney acting for the third party must insist on a section 21 PIA, given that it offers greater protection to such third parties.