Promoters: Position, Duties and Liabilities

Look at what the three limbs are doing, because they are three very different ideas.

Limb (a) is formal. You are a promoter because a document says so, either the prospectus or the annual return under section 92. It is easy to prove and easy to avoid.

Limb (b) is factual control. It catches the person who runs the company whatever the paperwork says, and the words "directly or indirectly whether as a shareholder, director or otherwise" are drawn as wide as the drafter could manage.

Limb (c) is the shadow. A person whose advice, directions or instructions the Board is accustomed to act on is a promoter even if he holds no shares and no office. "Accustomed" means habitually, not once.

The proviso is essential and is regularly missed. A person acting merely in a professional capacity is outside limb (c). So the company's solicitor, its chartered accountant and its merchant banker do not become promoters by giving the advice they were engaged to give. If they step outside that role and start directing the business, the proviso stops protecting them.

The promoter's position: a fiduciary, not a trustee and not an agent

This is the part MU asks as "position of a promoter", and the answer is best given by saying what he is not first.

He is not an agent of the company, because an agent needs a principal and before incorporation there is no company to be the principal. This is why pre-incorporation contracts are a problem at all.

He is not a trustee of the company, because a trustee holds specific property for a beneficiary, and a promoter usually holds nothing of the company's.

He is in a fiduciary relationship with the company he is bringing into existence. From that single proposition the duties follow.

The duties

1. To disclose any interest and any profit. If the promoter sells his own property to the company, or takes a commission, he must disclose it. Disclosure is the operative duty; the profit itself is not unlawful.

2. To disclose to somebody capable of receiving the disclosure. Telling himself is not disclosure. It must be made either to an independent board of directors, or to the existing and intended shareholders, ordinarily through the prospectus. This is why section 26 requires a prospectus to state the promoters' interests and the amounts paid to them.

3. Not to make a secret profit. The corollary of the first two. A profit made and not disclosed must be handed over.

4. To give the company the benefit of what he acquires for it. Where the promoter acquires property while acting for the company in formation, he cannot keep the upside for himself.

5. To make full and truthful disclosure in the prospectus. This duty is enforced by sections 34, 35 and 36 and is the subject of its own chapters.

6. To act with reasonable care and not to mislead. Sections 7(5) and 7(6) make this concrete for the documents filed at incorporation.

The liabilities, section by section

This is where an answer earns its marks, because these are citable.

Section 7(5). Any person who furnishes false or incorrect particulars of any information, or suppresses any material information of which he is aware, in any document filed with the Registrar for registration, shall be liable for action under section 447.

Section 7(6). Where it is later proved that the company was got incorporated by false or incorrect information or representation, by suppressing a material fact, or by any fraudulent action, then the promoters, the persons named as first directors, and the persons who made the declaration under section 7(1)(b) shall each be liable for action under section 447. The promoter is named expressly.

Section 7(7). The Tribunal's consequential powers, including making the members' liability unlimited and winding the company up, are set out in [Lifting the Corporate Veil].

Section 35: civil liability for the prospectus. Where a person subscribes for securities acting on a misleading statement, or on the inclusion or omission of any matter, in the prospectus and sustains loss, then the company and every person who falls in clauses (a) to (e) is liable to pay compensation to every person who sustained the loss. Clause (c) is "is a promoter of the company", so the promoter's liability is written into the section by name, alongside directors, persons who authorised the issue, and experts.

Section 35(2) gives the defences, and they are the promoter's escape route: that he withdrew his consent to be a director before issue and the prospectus was issued without his authority; that the prospectus was issued without his knowledge or consent and that on becoming aware he forthwith gave a reasonable public notice to that effect; or, as regards an expert's statement, that it was a correct and fair representation and that he had reasonable ground to believe, and did believe up to the time of issue, that the expert was competent and had given and not withdrawn his consent.

Section 35(3) is the severe one. Where it is proved that a prospectus has been issued with intent to defraud the applicants or any other person, or for any fraudulent purpose, every person referred to in sub-section (1), which includes the promoter, shall be personally responsible, without any limitation of liability, for all or any of the losses or damages incurred by any person who subscribed on the faith of it.

Section 300. In a winding up by the Tribunal, the Tribunal may direct the public examination of a promoter where the Company Liquidator's report alleges fraud in the promotion or formation of the company. The promoter can be put in the witness box and questioned on oath.

Section 447. The Act's general fraud provision, which sections 7(5), 7(6) and several others route into.

Pre-incorporation contracts

A promoter often has to contract before the company exists: to take a lease, to order machinery, to engage an architect.

The company is not bound by such a contract, because it did not exist and could not have authorised anyone to act for it. And it cannot ratify it after incorporation, because ratification requires that the principal existed and was competent at the time the act was done.

The promoter is personally liable on it. He purported to contract, there was no principal, and he cannot escape by pointing at a company that did not exist.

What can be done instead. After incorporation the company can enter into a fresh contract on the same terms, which is a novation: the old contract is discharged and a new one, to which the company is a party, takes its place. Where the contract was for the purposes of the company and warranted by the terms of incorporation, the specific relief legislation allows the company to enforce or be held to it, and this is the route ordinarily used in practice.

A worked example

Pravin owns a warehouse in Bhiwandi that he bought for thirty lakh rupees.

He decides to form Bhiwandi Cold Chain Limited to run a cold storage business. Before incorporation he signs a contract with a refrigeration supplier in the company's name, and he arranges for the company, once formed, to buy his warehouse for ninety lakh rupees. He then issues a prospectus inviting the public to subscribe, which states the object and the warehouse purchase but says nothing about the fact that the seller is Pravin or that he paid thirty lakh for it.

Is he a promoter? Yes, on all three limbs of section 2(69): he is named in the prospectus, he controls the affairs, and the first board acts on his instructions.

The warehouse sale. The sixty lakh rupee profit is not unlawful in itself. What makes it wrongful is that it was not disclosed to an independent board or to the intended shareholders. It is a secret profit, and the company may recover it, or rescind the sale and return the warehouse.

The prospectus. The omission of Pravin's interest is an omission of a matter in the prospectus within section 35(1). A subscriber who bought on the faith of it and lost money may claim compensation from the company and from Pravin, who is caught expressly by section 35(1)(c). Pravin cannot use any of the section 35(2) defences: he knew of the issue, he consented to it, and no expert's statement is involved.

If the omission is shown to have been made with intent to defraud, section 35(3) applies and Pravin is personally responsible without any limitation of liability for the losses.

The refrigeration contract. The company is not bound and cannot ratify it. Pravin is personally liable to the supplier. The sensible course after incorporation is a fresh contract between the supplier and the company on the same terms.

If the company is later wound up and the liquidator's report alleges fraud in its promotion, section 300 allows the Tribunal to direct Pravin's public examination on oath.

Distinctions that carry marks

What this does NOT mean

It does not mean a promoter cannot profit. He may. He must disclose, and disclose to someone able to act on the information.

It does not mean a professional adviser is a promoter. The proviso to section 2(69)(c) takes out a person acting merely in a professional capacity.

It does not mean a promoter is an agent or a trustee. He is neither, and saying so is a common error. He is a fiduciary.

It does not mean the company can ratify a pre-incorporation contract. It cannot. It can make a new one.

Limits and criticism

Disclosure is a weak remedy where the disclosure is made to a board the promoter selected. The Act tries to compensate through section 26's mandatory prospectus contents and through section 35's compensation regime, but the underlying problem, that the promoter chooses who receives the disclosure, is not fully solved.

The definition in section 2(69) has the opposite problem. Limb (b) is so wide that a controlling shareholder years after incorporation is a "promoter" for the Act's purposes, which is useful for regulation and is a long way from the ordinary meaning of the word.

Quick revision

• Definition, section 2(69): named as such in a prospectus or identified in the annual return under section 92; or has control over the affairs, directly or indirectly, as shareholder, director or otherwise; or the Board is accustomed to act on his advice, directions or instructions. Proviso: not a person acting merely in a professional capacity.
• Position: a fiduciary. Not an agent, not a trustee.
• Duties: disclose interest and profit, to an independent board or to the intended shareholders; make no secret profit; account for benefits acquired for the company; full disclosure in the prospectus.
• Liabilities: section 7(5) false particulars; section 7(6) incorporation obtained by fraud; section 35(1)(c) compensation for prospectus mis-statements, with the section 35(2) defences; section 35(3) personal liability without limit where the intent was to defraud; section 300 public examination in winding up; section 447 fraud.
• Pre-incorporation contracts: company not bound, cannot ratify; promoter personally liable; cure by a fresh contract after incorporation.

Test yourself

1. Define a promoter. Section 2(69): a person named as such in a prospectus or identified by the company in the annual return under section 92; or who has control over the affairs of the company directly or indirectly, whether as shareholder, director or otherwise; or in accordance with whose advice, directions or instructions the Board is accustomed to act. A person acting merely in a professional capacity is excluded from the third limb.

2. What is the legal position of a promoter? He stands in a fiduciary relationship to the company he is forming. He is neither its agent, because there is no principal before incorporation, nor its trustee, because he holds no specific property of the company.

3. A promoter sells his own land to the company at a profit and tells the two directors, both of whom he appointed and controls. Is that good disclosure? No. Disclosure must be to an independent board or to the existing and intended shareholders. Disclosure to a board the promoter controls is disclosure to himself, and the profit remains a secret profit that the company may recover.

4. Is a company bound by a contract its promoter made before incorporation? No, and it cannot ratify it, because the company did not exist when the contract was made. The promoter is personally liable. The company may make a fresh contract on the same terms after incorporation.

5. Under which clause of section 35 is a promoter liable for a misleading prospectus, and what is the effect of section 35(3)? Section 35(1)(c) names a promoter among those liable to pay compensation. Section 35(3) provides that where the prospectus was issued with intent to defraud, or for any fraudulent purpose, every person referred to in section 35(1) is personally responsible without any limitation of liability for the losses.

6. Can a promoter be examined on oath? Yes. Under section 300, in a winding up by the Tribunal, where the Company Liquidator's report alleges fraud in the promotion or formation of the company, the Tribunal may direct the public examination of a promoter.