Promoters' Cases and Pre-incorporation Contracts

• Author: Christopher C. Nicholls
• Pages: 123-160

123

CHAPTER FIVE

Promoters’ Cases and

Pre-incorporation Contracts

INTRODUCTION

Because a corporation is a legal person distinct from the human beings that sponsor or

promote its creation, two types of legal issues frequently arise around the time of a

corporation’s formation. The first issue involves a unique conflict-of-interest problem. It

occurs when the founder of a new corporation (usually referred to by the courts as the

“promoter”1) makes a contract with the very corporation he or she is organizing. Consider

this simple example. Suppose a promoter establishes a new corporation, ABC Corp., then

seeks to sell a factory that he owns to ABC Corp. The promoter’s understandable desire

to obtain the highest possible price for himself will inevitably conflict with the corpora-

tion’s interest in paying the lowest possible price. If the promoter is also in a position to

make decisions for the corporation, he can ensure that ABC Corp. will agree to pay

whatever price he chooses to set. Should the law be concerned with this sort of conflict?

The second legal issue arises when the promoter2 has just begun the process of setting

up a corporation—he has planned to create a new corporation, but the necessary paper-

work has not been filed, so the corporation does not yet exist. Difficulties can arise when

the promoter in this situation attempts to enter into contracts with third parties on behalf

of the yet-to-be formed corporation. If those contracts are not honoured, how should the

law sort the matter out? Who can sue whom?

Cases of the first sort that involve conflicts between the promoter and the corporation

itself are often referred to as “promoters’ cases.” Cases of the second sort that involve

promoters’ disputes with third parties are usually called “pre-incorporation contracts cases.”

1As Lord Blackburn observed in Erlanger v. New Sombrero Phosphate Company, [1877-78] 3 AC 1218

(HL), at 1268: “Throughout the Companies Act, 1862 … , the word ‘promoter’ is not anywhere used. It

is, however, a short and convenient way of designating those who set in motion the machinery by which

the Act enables them to create an incorporated company.”

2The recently passed BC Business Corporations Act, SBC 2002, c. 57, s. 20(1) refers to such a person as a

“facilitator.”

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.

124 Chapter 5 Promoters’ Cases and Pre-incorporation Contracts

PROMOTERS’ CASES

Framing the Issue

Corporations do not spring forth spontaneously like weeds in a garden. They are deliber-

ately created by entrepreneurs to perform specific business tasks. The individuals who

undertake to form a business corporation have come to be known as “promoters”—a

name, as some have noted, not always associated with the most esteemable practices.3

When a promoter first decides to incorporate a company, he or she may intend, as well,

that this new company will eventually purchase from the promoter some assets for use in

its new business. Often, the very reason for choosing to incorporate in the first place is to

transform what was an unincorporated business (a sole proprietorship or a partnership)

into an incorporated entity, and so benefit from enjoying limited liability, perhaps some

income tax advantages, and so on.

We often speak informally of a sole proprietor “incorporating his or her existing busi-

ness.” But as a legal matter, the process involves two distinct steps. First, the corporation

must be incorporated—that is, the articles (or, perhaps, the memorandum) filed with the

appropriate government office, initial directors named, and so on. Then, once formed, the

corporation will need to act through its duly appointed officers to acquire the assets and

undertaking of the business. The sole proprietor’s business, in other words, is not simply

endowed mystically with corporate status; rather, the sole proprietor must legally convey

the assets of the business from himself or herself to the new corporate entity. This convey-

ance might take the form of a contribution of capital—that is, the sole proprietor might

transfer the assets and undertakings of the business to the corporation in exchange for

shares of the new corporation. In Canada, the transfer of such business assets in exchange

for the issuance of shares is the usual way in which previously unincorporated businesses

are incorporated, because, in such cases, the Income Tax Act explicitly allows for a capital

gains “rollover.” In other words, the transferor is allowed to avoid the immediate payment

of tax on any capital gains that have accrued on the business assets. How does the promoter

arrive at the price at which he or she will sell these assets to the new corporation? Does the

price, in fact, matter? After all, if the new corporation is never going to have any investors

other than the promoter, who will care if the price the corporation agrees to pay is too high?

(Recall from chapter 3 that this very point was made by Lord Macnaghten in Salomon’s case.)

But what if the corporation has other shareholders or creditors? If an overvaluation

leads to an inflated balance sheet, creditors of the corporation might well be deceived if

they were to advance money to the corporation on the basis of the presumed accuracy of

the stated values that appeared on the corporation’s financial statements. And, if shares in

the new corporation are to be sold to other shareholders, the investment decision of those

shareholders will surely be based on the presumed value of the assets owned by the

corporation. If the corporation has grossly overpaid for the assets, the shareholders will

have been induced to invest on unfair terms. It is precisely this concern that animates

what are sometimes called “promoters cases.”

3See, e.g., Paul L. Davies, Gower & Davies: Principles of Modern Company Law, 7th ed. (London: Sweet

& Maxwell, 2003), at 90.

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.

Promoters’ Cases 125

So, for example, in Erlanger v. New Sombrero Phosphate Co.,4 the defendants pur-

chased for £55,000 a leasehold interest in the island of Sombrero in the West Indies—an

island on which phosphate of lime was mined. This sale was arranged on August 30,

1871, although for technical reasons not relevant here, it could not formally be completed

until sometime later.

The defendants then initiated the incorporation of a corporation. This new corporation

agreed to purchase the leasehold interest from the defendants for £110,000—that is, for

twice the price that the defendants paid for it. The purchase contract between the defend-

ants and the corporation was dated September 20, 1871, less than a month after the

original purchase. Had the value of the leasehold interest really doubled in just three

weeks, or was something else afoot here?

The initial directors of the new corporation, appointed at the time of its incorporation,

included a majority of individuals who were “friendly” to the promoters. It was this

friendly board that approved the purchase contract on the part of the corporation. The

corporation raised the money to fund the purchase by issuing shares. The new sharehold-

ers who were enticed to invest were not informed about this rather remarkable increase in

the island’s value. They were not the only ones left in the dark. Evidently, the minority of

the corporation’s directors who were genuinely independent of the promoters had not

been told, when they approved the purchase contract, that the leasehold interest the

corporation was buying for £110,000 had been acquired just three weeks earlier for half

this amount.

The company fell on hard times a year later. A new board of directors was appointed.

Under its new management, the corporation brought an action against the promoters

seeking, among other remedies, to have the contract by which the island interest had been

originally sold to the corporation set aside. The case was argued all the way to the House

of Lords. The Law Lords held that the contract should indeed be set aside. The judgments

delivered included a number of sternly worded passages. Consider the words of Lord

Cairns, for example. He did question whether, on the specific facts of this case, the

company had sought its remedy on a sufficiently timely basis. And he did concur with the

general proposition that a promoter was certainly not absolutely barred by law from ever

selling property to a corporation that he or she had incorporated. However, he also said:

If he [i.e., the promoter] does [sell property to a corporation in such a case] he is bound to

take care that he sells it to the company through the medium of a board of directors who can

and do exercise an independent and intelligent judgment on the transaction.5

Lord O’Hagan put the matter this way. Yes, the law certainly might permit promoters

to seek to sell their property to the corporation they created, but such a sale

involved obligations of a very serious kind. It required, in its exercise, the utmost good

faith, the completest truthfulness, and a careful regard to the protection of the future

shareholders.6

4Supra footnote 1.

5Ibid., at 1236.

6Ibid., at 1255.

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.