Introduction
The term "pre-incorporation" denotes the period preceding the formal legal creation of a corporation. This preliminary phase involves several crucial steps, including planning, decision-making, and the fulfillment of specific requirements before a business is officially established as a separate legal entity. While the specifics may vary depending on the jurisdiction, the core principles of pre-incorporation remain consistent. Key elements during this phase are establishing the foundational legal structure of the new entity and addressing the legal ramifications associated with such an act. The pre-incorporation process is not merely an administrative task, but a process during which the fundamental technical and legal characteristics of the future corporation are decided.
The proper management of this preliminary stage is important as the legal and functional framework of the corporation will be created. Failing to attend to this period can lead to complications and potential liabilities for the individuals who intend to create the entity. This legal process ensures that the company is not in breach of legal requirements in the initial phases of trading. This stage often involves numerous complex legal considerations, including the chosen structure of the business, ensuring that it complies with the relevant codes of conduct, the allocation of duties amongst managers, as well as protecting minority shareholder interests.
Key Considerations in Pre-Incorporation
Before a business can transition into a corporation, there are a number of key considerations. These fall under a number of areas.
Selecting the Appropriate Business Structure
One of the first steps in pre-incorporation involves determining the suitable legal structure for the business. The choice of business entity impacts the legal and financial responsibilities of the owners, the structure for decision-making and the overall operational framework of the business. The alternatives can include the following:
- Sole Proprietorship: This structure, where a single person owns and controls a business, is simple to set up and maintain. However, it offers no separation between the business and its owner, leaving the owner personally liable for business debts.
- Partnership: Involves two or more individuals who agree to share in the profits and losses of a business. They must form a partnership agreement which sets out what rules govern the relationship between each member.
- Limited Liability Partnership (LLP): A mix of partnership and corporate structure offering the benefits of a partnership but also limiting the partner’s liability, so that they are only liable to the extent of their own actions.
- Private Company Limited by Shares: The most common form of incorporation, it is an entity that is legally separate from its owners who enjoy limited liability. A private company also has certain statutory obligations.
- Public Limited Company (PLC): A company with an initial offer of shares on the stock market, with a more detailed legal and regulatory framework compared to a private company.
The chosen structure has a significant effect on taxation, personal liability of members and the operational processes of the business.
Financial Planning and Capitalization
The pre-incorporation stage also includes the development of a robust financial plan and the establishment of capital investment. This includes creating a budget, assessing the cost of initial operations, and identifying the methods for securing initial funding. The capital structure is significant and depends on the type of incorporation, and whether this will be through debt, equity or retained funds. The key is to ensure the financial resources are sufficient for the initial stages of the company’s development, whilst also satisfying the legal requirements and providing security to creditors.
Drafting Foundational Documents
This process involves creating key company documentation such as the memorandum and articles of association, and shareholder’s agreements. These documents lay out the company’s mission, purpose, internal governance arrangements and the responsibilities and rights of directors and members. It is critical that this documentation is properly constructed and legally sound because these documents are the constitution of the company.
Understanding Ethical and Professional Conduct
As part of the pre-incorporation process there is a need to comply with ethical and professional conduct. Candidates are expected to show their ability to act honestly and with integrity, and to conform to the SRA Standards and Regulations, which consist of:
- The purpose, scope and content of the SRA Principles
- The purpose, scope and content of the Code of Conduct, which consists of:
- SRA Code of Conduct for Solicitors, RELs and RFLs
- SRA Code of Conduct for Firms in relation to:
- Managers in authorized firms
- Compliance Officers
In relation to taxation, the assessment requires that candidates understand how the tax system works, such as for Business Law and Practice, Property Law and Practice and Wills and Estate Administration, where candidates need a specific understanding of various tax thresholds and reliefs.
Legal Principles and Rules
The pre-incorporation phase is subject to significant legal principles and rules which will apply at all stages of a company. These standards are based upon common law and equity, as well as statutory provisions found within the Companies Act 2006.
Corporate Personality
The concept of corporate personality, is the core principle underpinning company law. This notion, as outlined in Salomon v A Salomon & Co Ltd [1897] AC 22, establishes that upon incorporation, a company becomes a distinct legal entity, separate from its shareholders or directors. This means that the company is able to own property, engage in legal proceedings and operate its own business, independent of the people who are responsible for managing it. The impact of this is significant, because it creates the concept of limited liability which protects the personal finances of shareholders and directors, by limiting their liability to the extent of their investment in the company.
Ultra Vires Doctrine
Although not so important today, at one time the doctrine of ultra vires was a fundamental legal restraint upon the company. As outlined in Ashbury Railway Carriage and Iron Co. Ltd v Riche (1875) LR 7 HL 653, the doctrine previously determined that a company was only permitted to act within the boundaries of the objects clause, thereby rendering any action outside of this ‘ultra vires’ and illegal. The modern legal framework under the CA 2006 has since abandoned this rule by ensuring that any action by a company is considered to be legally valid (section 35), albeit, directors are still required to comply with the company’s constitution (section 171)
Directors’ Duties
During the pre-incorporation phase, individuals acting on behalf of the yet-to-be-formed company, such as the promoters, owe fiduciary duties to the company and potential investors. These duties include acting in good faith and within their powers, and disclosing any potential conflicts of interest. Once the company is incorporated, directors have a duty to act in a manner that is deemed to promote the best interests of the company, using reasonable care and skill. These duties are codified in sections 171 to 177 of the Companies Act 2006. Section 172 provides a comprehensive consideration of this ‘best interests’ standard.
Pre-Incorporation Contracts
A key consideration in pre-incorporation is to understand the treatment of contracts that are entered into on behalf of a company, before the company’s legal incorporation. Generally, a company cannot ratify or be bound by a contract entered into pre-incorporation, unless it agrees to it through a process of ‘novation’, or replacement contract, after incorporation. These principles are set out in Kelner v Baxter (1866) LR 2 CP 174 and more recently in Natal Land and Colonization Company Limited v Pauline Colliery Syndicate [1904] AC 120. It is also important to be mindful of the application of s. 51 of the Companies Act 2006 where a company cannot be held liable for pre-incorporation actions unless it enters into a novated contract.
Minority Shareholders Protections
There are also significant protections in place to ensure the rights of minority shareholders are protected; for example, shareholders can initiate a derivative action in the event of abuse of power by directors or breach of directors’ duties. As the CA 2006 intends to promote the engagement of minority shareholder and shareholder activism, it also provides the right of members to bring a claim in the event of unfairly prejudicial action.
Case Studies and Examples
These illustrate how some of the legal principles outlined above have been applied in practice:
The Case of Randhawa v Turpin [2018] 2 WLR 1175
This case examines the issue of who can consent to a business undertaking in the context of a quorum. Here, one of the registered shareholders was a dissolved corporation which was not capable of consenting, as held by Vos V-C who stated "the Duomatic principle simply cannot apply in a situation where one of the registered shareholders is a corporation which does not exist, because it requires the consent of all the registered shareholders and one of them is incapable of consenting". The case demonstrates that a company, albeit a defunct one, remains in existence and therefore, must be considered for all legal purposes. This illustrates the importance of considering all aspects of a corporate framework, and not just the main controlling shareholders.
The Case of Bowman v Secular Society Ltd [1917] AC 406
This case considered whether the certificate of incorporation was definitive. The issue arose where a company was formed with aims to further the purpose that human welfare was the proper end of all thought and action. It was argued that it should not have been registered because the aim was the denial of Christianity. The House of Lords ruled the company to be lawful, stating once the certificate is out there, there is little that can be done to attack it. Lord Finlay stated that ‘it is for the purpose of incorporation, and for this purpose only, that the certificate is made conclusive’.
The Case of Prest v Petrodel Resources Ltd [2013] UKSC 34
This landmark ruling has greatly limited the exceptions to lifting the veil of incorporation. The issue arose during divorce proceedings and whether a variety of properties that were concealed within several companies could be transferred to the wife as part of the divorce settlement. The Supreme Court ruled that the corporate veil could not be pierced, because the husband was not attempting to evade an existing legal liability by using a company structure. Lord Sumption stated that "the court may then pierce the corporate veil for the purpose, and only for the purpose, of depriving the company or its controller of the advantage that they would otherwise have obtained by the company’s separate legal personality". This demonstrates that corporate law does not allow for abuse of a company structure unless the company was specifically put in place for that purpose, which must be an existing liability.
Conclusion
The pre-incorporation phase constitutes a critical juncture in a company’s life. It is a stage that warrants careful planning and adherence to a number of complex legal processes. By selecting the suitable business structure, securing adequate financial planning and creating a sound constitutional framework, while complying with ethical standards and the law, it is possible to secure the long-term stability and sustainability of a business entity. Further, it is essential to consider the wider legal and social framework in which all business must operate. The case studies provided serve as potent reminders of the importance of carefully considering all aspects of the law in the pre-incorporation phase. The correct application of the law in this crucial time, lays a solid base to create an effective, dynamic, and successful business entity.
