LAW OF ASSOCIATIONS 200018

Copyright 2002 Thomas Feerick Lecturer School of Law, UWS

Lecture 6 Week 6

PRE-REGISTRATION CONTRACTS & INTERNAL GOVERNANCE RULES

This lecture has 2 parts. Part 1 examines the legal implications of pre-registration contracts. Part 2 discusses internal governance rules. 1. PRE-REGISTRATION CONTRACTS

The people who form a company or procure its formation are commonly known as promoters. The courts have construed the term promoter broadly. In Twycross v Grant (1877) 2 CPD 469, for example, Cockburn CJ declared that a promoter was: one who undertakes to form a company with reference to a given project and to set it going, and who takes the necessary steps to accomplish that purpose. In Tracy v Mandalay Pty Ltd (1953) 88 CLR 215, the High Court held that non-active participants in the formation process may be promoters. In this case it was alleged that various people associated with a newly formed company (Mandalay Pty Ltd) had breached their fiduciary duties to the company. They had participated in a scheme whereby the new company purchased land and shares at inflated prices, producing substantial gains for the participants. The High Court first confirmed that promoters owe fiduciary duties to their charge. The second issue was whether all of the defendants were promoters, as some were not directly involved in the formation process or the impugned transactions. Dixon CJ, Williams and Taylor JJ jointly declared that: persons who leave it to others to get up the company upon the understanding that they also will profit from the operation may become promoters. The Corporations Act does not provide a definition of promoter. However, s 9(1) of the former Corporations Law provided an exclusionary definition of promoter which applied only in the context of issuing a prospectus. The definition excluded: a person [who] by reason only of acting in proper performance of the functions attaching to his professional capacity or his business relationship with a promoter of the corporation. Promoters frequently incur liabilities personally to cover the expense of forming a company or to secure property or rights for the unformed company to utilize once it comes into existence. Alternatively, promoters may purport to incur debts or contractual obligations in the name of,

and perhaps for the benefit of, an unformed company. Such transactions originally were described as pre-formation or pre-incorporation contracts. Now they are called preregistration contracts, presumably in order to highlight the point that a company comes into existence immediately upon registration: s 119. Three questions frequently arise in relation to pre-registration contracts: Is the newly formed company liable to perform or pay damages for breach of a contract that was purportedly made in its name or on its behalf prior to its registration? Can the newly formed company seek specific performance or damages for breach of a contract that was purportedly made in its name or on its behalf prior to its registration? Is the company promoter personally liable to perform the contract or pay damages to a third party if the company fails or refuses to perform contractual obligations that were undertaken in the companys name prior to its registration?

These can be solved by applying three basic propositions: A company does not become a legal person and therefore does not exist in law until and unless it has been formed (ie, registered); A non-existent legal person cannot have legal rights or obligations and therefore cannot enter into contracts or incur debts; and A person cannot be an agent for a non-existent principal.

The Corporations Act deals with pre-registration contracts in Part 2B.3 While s 133 states that Pt 2B.3 replaces any rights or obligations that anyone would otherwise have on the pre-registration contract, it is arguable that s 133 does not cover the entire field since it does not purport to affect rights or liabilities that may exist separately from the preregistration contract: eg, collateral contracts, warranties that induced entry into pre-registration contracts etc. The following statutory provisions should be read in the light of the underlying case law. Corporations Act s 131 (1) [Ratification after registration] If a person enters into, or purports to enter into, a contract on behalf of, or for the benefit of, a company before it is registered, the company becomes bound by the contract and entitled to its benefit if the company, or a company that is reasonably identifiable with it, is registered and ratifies the contract: (a) (b) within the time agreed to by the parties to the contract; or if there is no agreed time within a reasonable time after the contract is entered into.

s 131 (2) [Liability for damages if company does not ratify or register] The person is liable to pay damages to each other person to the pre-registration contract if the company is not registered, or the company is registered but does not ratify the contract or enter into a substitute for it: (a) (b) within the time agreed to by the parties to the contract; or if there is no agreed time within a reasonable time after the contract is entered into.

The amount that a person is liable to pay to a party is the amount the company would be liable to pay to the party if the company had ratified the contract and then did not perform it at all. s 131 (3) [Powers of the court] s 131 (4) [Failure to perform all or part of the contract] The following are seminal case authorities on company promoters: In Gluckstein v Barnes (Official Receiver and Liquitator of Olympia Ltd) [1900] AC 240, a syndicate purchased a property for 140,000 and then sold it for 180,000 to a company which they had incorporated for that purpose. The syndicate had disclosed in its prospectus that the founders would make a personal profit of 40,000 profit on the sale. However, they had failed to disclose a further profit of 20,000 which was made when mortgages purchased at a discount were repaid in full to the founders by the liquidator. The liquidator claimed successfully that one of the promoters should repay a proportion of the secret profit. Lord Macnaghten was prepared, if asked, to make all promoters repay the whole secret profit together with penalty interest. In a stinging rebuke to the promoters, Lord Macnaghten (Lords Halsbury and Robertson agreeing) stated: These gentlemen set about forming a company to pay them a handsome sum for taking off their hands a property which they had contracted to buy with that end in view. They bring the company into existence by means of the usual machinery. They appoint themselves sole guardians and protectors of this creature of theirs, half-fledged and just struggling into life, bound hand and foot while yet unborn by contracts tending to their private advantage, and so fashioned by its makers that it could only act by their hands and only see through their eyes. They issue a prospectus representing that they had agreed to purchase the property for a sum largely in excess of the amount they had, in fact, to pay. On the faith of this prospectus they collect subscriptions from a confiding and credulous public. And then comes the last act. Secretly, and therefore dishonestly, they put into their own pockets the difference between the real and the intended price. After a brief career the company is ordered to be wound up. In the course of liquidation the trick is discovered. To talk of disclosure to the thing called the company, when as yet there were no shareholders, is a mere farce. To the intending shareholders there was no disclosure at all. On them was practiced an elaborate system of deception.

In Bay v Illawarra Stationery Supplies Pty Ltd (1986) 4 ACLC 429, the defendants (appellants) appealed successfully against a judgment on the basis that the plaintiff (respondent) had not established that the person (Dyke) who had executed a purchase contract had done so on behalf of the unformed company with their authority. Grove Js reasoning was as follows:

[CA, s 131] only declares the liability of persons who purport to execute contracts on behalf (ie, as agent for) or for the benefit of unformed companies; If a person [A] executes a contract in the name of a non-existent company [C] while acting as agent for a promoter [P], then: o [A] does not purport to act on behalf of the unformed company rather [A] purports to act on behalf of [P] who acts on behalf of the unformed company. o [TP] can sue [P] directly if TP can prove agency between [A] and [P]. Hence, the question is whether [A] acted with [Ps] authority: common law on agency.

Grove J ultimately decided that: The appellant did not purport to enter into a contract on behalf of a non-existent company within the meaning of [CA, s 133] and there is no evidence to support a finding that at the time Dyke did so he was an agent of the appellant. Dyke actually had purported to act as sub-agent for the unformed company. He did not purport to execute the contract on behalf of the unformed company, but rather he had purported to act as agent for a prospective director (including Bay) who in turn had purported to be an agent for the unformed company; Since Dyke had no authority to bind Bay, neither of them had purported to contract on behalf of the unformed company. This case shows that people may purport to contract as: A. Principal in their own right but for the benefit of the company (eg, as trustee or gratuitously); or B. Agent on behalf of the unformed company; or C. Agent on behalf of a natural or other legal person; or D. The company neither principal or agent: Newborne v Sensolid (Great Britain) Ltd [1954] 1 QB 45. However, another person may understand the first person to be contracting as:

1. Principal in their own right but for the benefit of the company (eg, as trustee or
gratuitously);

2. Agent on behalf of the unformed company;

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3. Agent on behalf of a natural or other legal person; or 4. The company neither principal or agent: Newborne v Sensolid (Great Britain) Ltd
[1954] 1 QB 45. The possible combinations are as follows: A1 B1 C1 D1 A2 B2 C2 D2 A3 B3 C3 D3 A4 B4 C4 D4

C2 applied in Bays case: Dyke believed (mistakenly) that he was Bays agent, and Illawarra believed (mistakenly) that Dyke was acting as agent for a company. It is important to determine the (legal) capacity in which the relevant people are acting. In Bays case, Dyke was not acting: for himself (he did not contract in his own name); as agent for a non-existent company (impossible); as agent for Bay (Bay had not granted authority); or as the company (impossible).

In Collen v Wright (1857) 120 ER 241, it was held that: a person, who induces another to contract with him (her) as the agent of a third by an unqualified assertion of his (her)being authorized to act as agent, is answerable to the person who so contracts for any damages which he (she) may sustain by reason of the assertion of authority being untrue. Willes J also stated that the contract would be binding upon the person dealing with the professed agent if the alleged principal were to ratify the act of the latter, but this runs against the settled principles of ratification. The suggested warranty of authority must be contained in a collateral contract with the purported agent since there is no contract between the third party and that purported principal. Subsection 131(1) now enables companies to ratify pre-registration contracts that were purportedly made on behalf of the company prior to its formation. Black v Smallwood (1966) ALR 744, confirms that company promoters will not be obliged to specifically perform contracts unless they were acting as principal. This approach avoids the absurdity that might otherwise arise in contracts for personal service. Could a purported agent be ordered to specifically perform a contract for musical performances by Elton John? Could a

brides father be compelled to specifically perform the marriage contract if his daughter refused to marry the promisee? Holding the purported agent liable in damages for breach of warranty of authority does not completely solve the problem since it introduces a quantum problem. The measure of common law damages is assessed as being the amount needed to compensate the third party for not having an effective contract with the purported principal. Thus, it is necessary to calculate the amount that the third party would have recovered from the unformed company for nonperformance of the contract. In this respect, Professor Ford has observed (at [15-230]) that a purported agent can only be liable for nominal damages since it is impossible to execute a judgment against an unformed company. However, s 131(2) now states that the appropriate measure of damages is the amount the company would be liable to pay to the party if the company had ratified the contract and then did not perform it at all. Four points should be noted here: It is the hypothetical liability of the registered company rather than the amount that would have been recovered against an unregistered company But for s 131(1), the company could not effectively ratify the pre-registration contract Subsection 131(2) applies whether or not the company is registered subsequently Damages should run from the time of ratification or failure to ratify because s 131(2) indicates that damages should compensate post-ratification non-performance CORPORATE (INTERNAL) GOVERNANCE RULES PRELIMINARY

2. 2.1

It is usual for most associations to adopt rules which govern the following matters: The object(s) or purpose(s) of the association Membership: admission and expulsion, rights and duties Appointment and powers of officers Alteration of rules or objects Procedure upon dissolution.

The internal rules that corporations adopt are called internal governance rules. There are two sources of internal governance rules:

The Corporations Act provides replaceable rules which corporations may adopt, wholly or partially: s 141. A corporate constitution. This document contains rules which supplement, modify and / or exclude the replaceable rules: s 135(2).

Partnership and incorporated associations have analogous regimes. Also see Ford at p 178 ff. 2.2 LEGAL OPERATION OF INTERNAL GOVERNANCE RULES s 140(1) [Effect] A companys constitution (if any) and any replaceable rules that apply to the company have effect as a contract: (a) (b) (c) between the company and each member; between the company and each director and company secretary; and between each member and each other member.

(a)

In the capacity of a member: Eley v Positive Government Security Life Assurance Co Ltd (1876) 1 Ex D 88. Not between the company and a third person: Hickman v Kent or Romney Marsh Sheep-Breeders Association [1915] 1 Ch 881. Not respecting every small detail: Stanham v The National Trust of Australia (1989) 15 ACLR 87. Members may enforce the [s 140] statutory contract or an actual contract (see unregistered members): Bailey v New South Wales Medical Defence Union Ltd (1995) 132 ALR 1; This approach is novel: Jones v Money Mining NL (1995) 17 ACSR 351; Southern Foundries (1926) Ltd v Shirlaw [1940] AC 701; Peters American Delicacy Co Ltd v Heath (1939) 61 CLR 457, 480. PERMISSIBLE OBJECTS?

(b) (c)
2.3

Historically companies only had the capacity to do the things that were declared in their memorandum and articles of association. This approach forced lawyers to draft allencompassing statements of objects. It also invited argument that transactions went beyond the permissible objects of a company (ie, ultra vires) and were, for this reason, wholly void: Ford at p 638 ff. However, the courts managed to circumvent these problems by construing memoranda very broadly: Rolled Steel Products (Holdings) Ltd v British Steel Corp (1985) 3 All ER 52. 2.4 THE CURRENT POSITION

The post-CLERP Act position is different from the historical common law position:

Companies do not need a memorandum or statement of permissible objects; By virtue of s 124(1), companies have all of the powers of an individual and a body corporate and the specific powers enumerated in paras (a) (h). Companies may have a constitution that sets out the objects or restricts / prohibits use of the companys powers: s 125(1). However, a transaction is not invalid merely because it is prohibited by the constitution s 125(2) operates to validate. Breach of the corporate constitution or replaceable rules is not of itself a contravention of Corporations Act. FORMER DOCTRINE OF ULTRA VIRES (BEYOND POWER)

2.5

In Rolled Steel Products (Holdings) Ltd v British Steel Corp (1985) 3 All ER 52, Slade LJ said: (1.) The basic rule is that a company incorporated under the Companies Acts only has the capacity to do those things which fall within its objects as set out in its memorandum of association or are reasonable incidental to the attainment or pursuit of those objects. (2) Nevertheless, if a particular act is of a category which, on the true construction of the companys memorandum is capable of being performed as reasonably incidental to the attainment or pursuit of its objects, it will not be rendered ultra vires the company merely because in a particular instance its directors, in performing an act in its name, are in truth doing so for purposes other than those set out in its memorandum. Subject to any express restrictions on the relevant power which may be contained in the companys memorandum, the state of mind or knowledge of the persons managing the companys affairs or of the persons dealing with it are irrelevant in considering questions of corporate capacity. (3) While due regard must be paid to any express conditions attached to or limitations on powers contained in the companys memorandum (for example, the power to borrow only up to a particular amount), the court will not ordinarily construe a statement in a memorandum that a particular power is exercisable for the purposes of the company as a condition limiting the companys corporate capacity to exercise the power: it will regard it as simply imposing a limit on the authority of the directors (4) At least in default of the unanimous consent of all the shareholders (as to which see below), the directors of the company will not have actual authority from the company to exercise any express or implied power other than for the purposes of the company as set out in the memorandum of association. (5) A company holds out its directors as having ostensible authority to bind the company to any transaction which falls within the powers expressly or impliedly on it by its memorandum of association. Correspondingly such a person in such circumstances can hold the company to any transaction of this nature. (6) If, however, a person dealing with a company is on notice that the directors are exercising the relevant power for purposes other than the purposes of the company, he (she) cannot rely on the ostensible authority of the directors and, on ordinary principles of agency, cannot hold the company to the transaction.

His Lordship then went on to observe: None of the authorities which have been cited to us have convinced me that a transaction which (i) falls within the letter of the express or implied powers of a company conferred by its memorandum and (ii) does not involve a fraud on its creditors and (iii) is assented to by all the shareholders will not bind a fully solvent company merely because the intention of the directors, or the shareholders, is to effect a purpose not authorized by the memorandum. Importantly, His Lordship also said: If confusion is to be avoided, it seems highly desirable that, as a matter of terminology, the phrase ultra vires in the context of company law should for the future be rigidly confined to describing acts which are beyond the corporate capacity of a company. A person will not have constructive notice of a limitation imposed by the companys constitutional rules merely because a document has been lodged with ASIC and is available for inspection: s 130(1). Registered charges are exceptions to the general rule: s 130(2)). Transactions entered into by outsiders other than in good faith, or by directors in disregard of the companys interests, may still be voidable notwithstanding ss 124(2) and 125. While a director is no longer automatically liable for causing a company to act outside its powers (since s 162(7)(g) was repealed), s 125 does not mean that directors will always be treated as if they had acted within their authority. 2.6 CORPORATIONS ACT MAY LIMIT COMPANY POWERS

In ANZ Executors and Trustee Co Ltd v Qintex Australia Ltd (1990) ACSR 676, McPherson J held: Our order cannot compel QAL to do something that, apart from the order, the law does not permit. We cannot order a shareholder to require the company to execute the instrument of guarantee if to do so would involve infringing the essential principle that corporate powers and funds may be used only for corporate purposes. Shareholders possess no general authority, whether actual, implied or ostensible, to bind the company, much less to bind it to a result that is not for its benefit. ANZ does not suggest that by entering into the trusts deeds QAL contractually bound each subsidiary to execute instruments of guarantee when demanded by ANZ. QAL bound itself and no one else. What is now attempted is to compel QAL to do an act that the subsidiary companies, whether by their officers, agents or, I would add, shareholders, are themselves not permitted by law to do. This was a case dealing with (internal) matters between a company and its shareholders. Therefore, it strictly did not invoke the doctrine of ultra vires (or s 125) and, since the

subsidiaries had not dealt with ANZ (an outsider), their corporate capacity was not really an issue. The real question in this case was whether a controlling shareholder (QAL) could, acting as a shareholder, compel its subsidiary companies to execute guarantees in favour of ANZ in circumstances where there was no possible benefit for the subsidiaries: ie, the subsidiaries effectively give away all of their property. Transactions that are liable to be set aside (ie, voidable rather than void) include: Insolvent transactions s 588G; Transactions prejudicial to creditors s 588FB; Reductions in share capital gifts (CA, Ch 2J); CORPORATE CONSTITUTION V CORPORATIONS ACT

2.7

Some internal governance rules cannot be excluded or altered by the corporate constitution. Section 203D (former s 227), dealing with the procedure to remove public company directors, is one such example. Shanahan v Pivot Pty Ltd (1998) ACSR 740, was a case involving a clash between a public companys constitution and s 227. The companys constitution provided that: The Company may by special resolution remove any shareholders Director before the expiration of his period of office However, s 227 (now s 203D) stated: A public company may, by [ordinary] resolution, remove a director before the end of the directors period of office, notwithstanding anything in its articles or in any agreement between it and the director. Kenny JA held that the company (ie, its shareholders) were entitled to choose whether to remove a director under the constitutional provision (by special resolution) or under s 227 (by ordinary resolution). The word may in s 227 was decisive.

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