It is not uncommon for contracts to be concluded before one of the parties to the contract has been incorporated. This blog explores some of the risks associated with doing this and outlines steps that can be taken to mitigate them.
The Inconsistent History of Pre-Incorporation Contracts
The common law previously held that a contract made by individuals acting on behalf of an as-yet unincorporated company (or “promoters”) binds only the promoters. Further, once the company was incorporated, it could not adopt or ratify the contract. Instead, it had to enter into a new contract on the same terms, so long as the other party was agreeable to this. This was the state of the common law, as established by the leading UK case of Kelner v. Baxter in 1886.
Over time, other cases have found that if the parties to a contract intended for the promoters not to be personally liable, courts would sometimes give effect to that intention. There seemed to be little consistency in the law as to when a party would have a remedy against a promoter personally in relation to companies that were not incorporated at the time the contract was agreed upon.
Section 21 of the Business Corporations Act
The Ontario Business Corporations Act includes provisions intended to rectify the confusion at common law on the topic. Section 21 consists of several subsections summarized as follows:
- A promoter who contracts on behalf of a company before it is incorporated is “personally bound” by that contract and also entitled to its benefits.
- If that company is subsequently incorporated and adopts the contract, it is bound by it and entitled to its benefits, while the promoter is not.
- The other party to the contract can apply to court for an order that fixes liability under the contract on the newly incorporated company and/or the promoter on a “joint or joint and several” basis or apportioned between them. This is the case even if the company has not adopted the contract.
- The promoter and the other party to the contract can expressly agree in that contract that the promoter will not be bound by it.
Ontario Court of Appeal’s Section 21 “Trilogy”
Beginning in 1998, the Ontario Court of Appeal provided significant guidance on how to apply section 21 of the Business Corporations Act.
Adoption of a Pre-Incorporation Contract Requires Only a Simple Notification of Intent
The first of these essential cases was Sherwood Design Services Inc. v. 872935 Ontario Ltd. In this case, the individual defendants signed an agreement to purchase certain assets of Sherwood Design Services Inc. The agreement provided that the individual defendants were buying the assets “in trust for a corporation to be incorporated.” Thereafter, a numbered company was incorporated, and the lawyer for the purchasers advised the lawyer for the seller that such company had been “assigned … as the corporation that will complete the asset purchase.” The transaction fell through. The plaintiff sued and, among other things, alleged that the numbered company was liable for breach of the contract.
The Court of Appeal found that the letter from the purchasers’ lawyer to the seller’s lawyer signified “the company’s intention to be bound by, and accordingly to adopt, the contract.” In reviewing section 21, the Court noted that the section stated that a corporation’s adoption of a contract could be “by any action or conduct signifying its intention to be bound thereby.” The section did not specifically say how a company was to adopt the contract, and so the Court reasoned it would be wrong to require any “formal documentation.” All that was required was “a simple notification of intent.” Accordingly, the Court granted judgment against the corporate defendant.
To Avoid Personal Liability in a Pre-Incorporation Contract, the Contract Must Expressly State that the Promoter Is Not Bound By It
The issue before the Court of Appeal in Szecket v. Huang was different. In that case, a technology license agreement was signed among various parties, including an individual who signed “on behalf of a company to be incorporated.” However, the company was never formed, and the agreement was not performed. The individual respondents claimed that the appellant was personally liable for the breach under section 21, but the appellant claimed he was not bound because he had shown a clear intention not to be bound.
The Court of Appeal referred to section 21 and said that an agreement personally binds a promoter until it has been adopted by a newly incorporated company “unless, under s. 21(4), the parties expressly provide that the promoter is not bound by the contract or entitled to its benefits.” The Court noted that this subsection requires “an express provision to that effect” in the pre-incorporation contract. Since the agreement at issue in Szecket did not contain such an express provision, and the company had never been incorporated or adopted the agreement, the appellant was personally liable for its breach.
A Company That Adopts a Pre-Incorporation Contract Can Sue and Be Sued for Breaches That Occurred Before Adoption
The last of these cases was 1394918 Ontario Ltd. v. 1310210 Ontario Inc. That case concerned a contract in which the defendant agreed to sell land to an individual “in trust for a company to be incorporated and not in his personal capacity.” The vendor’s lawyer later stated that the contract had expired, and the purchaser’s lawyer, who was acting “in trust for a company to be incorporated,” indicated that the contract had been repudiated and that the purchaser intended to seek damages. The purchaser thereafter assigned his rights under the contract to the newly incorporated corporate plaintiff, who sued. The defendant filed a motion to dismiss the suit, arguing that the corporate plaintiff lacked the capacity to bring the action.
The Court of Appeal found that, by commencing an action, the corporate plaintiff had shown an intention to adopt the contract. It noted section 21(2), which provides that a corporation is bound by and entitled to benefits retroactively to the date the adopted agreement is made. This means that the newly incorporated corporation “can be liable for any breach on the promoter’s part that occurred before adoption and can sue on any breach by the third party regardless of when it occurred.” While the promoter may have accepted repudiation of the contract, that did not extinguish rights and obligations accrued before that time, which were assigned to the new company. The defendant’s motion was thus dismissed.
Contact Tierney Stauffer LLP for Top-Tier Business Law Advice in Ottawa
If you are entering into agreements on behalf of a business that has not yet been incorporated, it is crucial to understand how pre-incorporation contracts work and how to protect yourself from unintended personal liability. The experienced corporate commercial lawyers at Tierney Stauffer LLP can help you draft, review, or adopt agreements to ensure compliance with Ontario’s business laws and minimize legal risk. Contact us online today or call 1-888-799-8057 for clear, practical guidance on all corporate formation and contract law issues.
