PRE-INCORPORATION CONTRACTS: A TRAP FOR THE UNWARY

Posted: January 29, 2020 | Last Updated: January 29, 2020
Written by: Edward D. Brown

Edward D. (Ned) Brown
Pitblado LLP
January, 2020

In the past, it was legally impossible for a corporation to be a party to an agreement where the agreement was entered into on behalf of the corporation prior to the incorporation of the corporation. So if "A", being a developer and promoter of an anticipated business venture, entered into a contract with "B" in connection with that business venture, and "A" did so on behalf of - and in anticipation of "A"'s incorporation of - his corporation, notwithstanding the subsequent incorporation, it could not be bound by - or obtain the benefits of - the contract*.

This changed when in 1976, when the Corporation's Act (Manitoba) (the "MCA") was amended to include what is now Section 14. This contemplates and provides for the validation of pre-incorporation contracts. In essence, Section 14 provides that:

  1. a contract (which must be in writing) which is entered into on behalf of a yet to be created corporation, if adopted by the corporation within a reasonable time after it comes into existence, will bind the corporation and the corporation will be entitled to the benefits thereof;  and
  2. the person who entered into the contract on behalf of the yet to be created corporation will be personally bound by (and entitled to the benefits under) the contract immediately upon his/her/it entering into the contract, except where:
     
    1. the corporation does in fact within a reasonable period of time after it has been incorporated, adopt the contract; or
    2. the contract expressly provides that the person who entered into it on behalf of the corporation (prior to its coming into existence) is not to be bound by same (or to obtain the benefits thereof).

If a pre-incorporation contract is entered into by the anticipated corporation's promoter and the corporation does not come into existence within what would be considered a "reasonable" period of time in the circumstances, the promoter continues to be personally liable (and entitled to the benefits) under the contract.

Since its enactment, Section 14 of the MCA has been used many times by business promoters where the promoter wants to have his/her/its business venture owned and/or operated under a corporation (typically owned or controlled by the promoter), but where "commercial necessity" dictated the need to have the contract entered into before the new corporation could be created. Frequently, such pre-incorporation contracts specify that the promoter will have no "personal" liability upon the incorporation of the corporation and its adoption of the contract. There is nothing wrong with such a provision because it merely recites what the law states in Section 14. However, some pre-incorporation contracts simply stipulate that the promoter will have "no personal liability". In certain situations, this last-mentioned "no personal liability" provision may not go far enough to shield the promoter from the legal consequences of the promoter's acts and omissions done and made in the context of the contract and the relationship between the parties.

This type of dilemma - for a corporate promoter - was considered in the Ontario Court of Appeal judgment in Benedetto v. 2453912 Ontario Inc., 2019 OSCA 149, judgment issued February 25, 2019 (hereinafter, the "Benedetto Case"). In the Benedetto Case, a promoter signed an agreement to purchase real property, and in that agreement the promoter stipulated that he was buying "in trust for a company to be incorporated without personal liabilities". The promoter paid the seller a deposit of $100,000.00. Although not expressly stated in the Court's judgment, it can be assumed that the deposit was intended to be dealt with as follows:

  1. if the deal closed, the deposit would be applied on account of the balance of the purchase price due on closing to the seller; and
  2. if the contract was repudiated - without legal justification - by the buyer (the promoter), the seller would be able to keep the deposit, as compensation for its loss of the bargain.

In fact, the promoter repudiated and did so before the corporation had come into existence and adopted it. Nevertheless, the promoter argued that the wording "without any personal liabilities" meant that he should be able to get back his $100,000.00 deposit. The Court disagreed. The Court pointed out that deposits paid under contracts perform two separate functions, namely those mentioned above. A deposit is both a mechanism for part payment of the purchase price and an "earnest" for the benefit of the seller whose function is to discourage the buyer from unilaterally and without justification reneging. Viewed in that manner, the making (or pledging) of a deposit should be considered as something separate from the remainder of the rights and obligations of the parties to a contract. The Court pointed out that in a situation like that of the Benedetto Case, to allow the promoter (the buyer) to get its deposit back on the basis that the promoter had no personal liabilities whatsoever in the situation would result in the aggrieved seller having no remedy whatsoever for the promoter's unjustified unilateral repudiation. That would have then been an absurdity.

In effect, the Court held that there are two separate contractual relationships involved.  One is between the buyer and the seller pertaining to the agreement of purchase and sale.  The other is between the promoter and the seller pertaining to the deposit in the deposit's capacity as a pledge or earnest.

Counsel should consider the Benedetto Case when engaged by a pre-incorporation promoter to advise on a pre-incorporation contract. Clear wording will be needed in order to enable the promoter to obtain the return of the deposit where the promoter repudiates or where the corporation doesn't come into existence within a reasonable period of time in the circumstances or where the corporation does not adopt the contract within a reasonable period of time. In so advising the promoter, counsel should also bear in mind that a potential counterparty (typically a seller) and its counsel, if they have an understanding of the Benedetto Case, will almost certainly reject any attempt to enable the promoter to get a full - and perhaps even a partial - return of the deposit in this scenario.

*Of course, "A" could enter into the pre-incorporation contract with "B", and then by agreement with "B", "A" could assign its rights (and obligations) under the contract to "A"s corporation once it came into existence.

 

Edward D. (Ned) Brown has extensive experience in Corporate and Commercial law. Ned is focused on the areas of lending and secured transactions, banking law, subdivisions and commercial real estate development.