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Court rules on validity of contracts entered into by unincorporated companies - International Law Office

International Law Office

Litigation - India

Court rules on validity of contracts entered into by unincorporated companies

June 15 2010

Facts
Issues
Decision
Comment


In Andhra Pradesh Tourism Development Corporation v Pampa Hotels Ltd(1) the Supreme Court of India held that an unincorporated company could not enter into a contract, and that consequently it could not enforce a contract entered into before its incorporation, including a dispute resolution mechanism provided therein, as it did not exist on the date on which the contract was agreed. This judgment has a wide range of implications for companies that enter into pre-incorporation contracts - in particular, contracts providing for arbitration - and that have to arrange their affairs in such a manner that allows them the benefit of an arbitration agreement for dealing with future disputes that may arise under the contract.

Facts

Pampa Hotels Ltd, a company incorporated on April 9 2003, had entered into a lease agreement and a management agreement, both dated March 30 2002, with Andhra Pradesh Tourism Development Corporation. The agreements dealt with a hotel property called Hill View Guest House. The dispute resolution clause contained in both agreements provided that if the parties could not find an amicable solution, the matter should be referred to arbitration. On April 21 2004 the appellant terminated the agreements and took possession of the property. In 2005 the respondent approached the chief justice of the Andhra Pradesh High Court through an application under Section 11 of the Arbitration and Conciliation Act 1996, seeking the appointment of a sole arbitrator. The appellant resisted the application on the grounds, among other things, that there was no arbitration agreement between the parties. The designate of the chief justice of the Andhra Pradesh High Court, although acknowledging the contentions with respect to the non-existence of an arbitration agreement and relying on past precedents,(2) held that the appointment process envisaged a limited administrative role. Accordingly, the designate of the chief justice left all contentious issues to be decided by the sole arbitrator. Aggrieved, the appellant appealed the decision to the Supreme Court.

Issues

Two key issues arose for determination. The first was whether the respondent was an entity that did not exist at the time of execution of the agreements and thus could not have entered into a valid arbitration agreement. The second was whether the chief justice of India or his designate can determine the validity of an arbitration agreement under Section 11 of the Arbitration and Conciliation Act.

Decision

With regard to the first issue, the Supreme Court considered Sections 34 and 149 of the Companies Act 1956 and observed that once incorporated, a company must be registered and cannot commence business until registration is completed. The court further observed that had such an agreement been entered into by the promoters, it would be considered valid. In the context of this case, the court noted that the respondent had been incorporated only on April 9 2003, and held that the respondent was non-existent on the date of execution of the agreements (March 30 2002). Relying on the requirements of Section 7 of the Arbitration and Conciliation Act,(3) the court held that in a situation where one party to an arbitration agreement was not in existence when the contract was made, the entire contract will not exist. Consequently, any arbitration agreement contained in such a contract will also be non-existent.

With regard to the second issue, pertaining to the appropriate authority to decide on the question of a valid existence of an arbitration agreement, the court reiterated that the chief justice or his designate exercises a judicial power under Section 11 of the Arbitration and Conciliation Act. Therefore, in view of SBP & Co v Patel Engineering Ltd,(4) the chief justice or his designate can satisfy himself or herself of the existence of an arbitration agreement before the appointment of the arbitral tribunal. The arbitral tribunal would have to decide only post-decision on the issue of whether there was an arbitration agreement between the parties. The second issue arose despite the fact that the SBP & Co judgment was issued a couple of weeks later and overruled the Konkan Railways case. As a result of this controversy, the SBP & Co judgment was not brought to the court's attention.

Comment

This judgment highlights a number of red flags for companies intending to enter into agreements before their incorporation:

  • A pre-incorporation contract must be entered into by the promoters of a company in their capacity for and on behalf of the company proposed to be incorporated.
  • The promoter should avoid the temptation of designating himself or herself as a director, managing director or other designated person of the unincorporated company, as in such a situation the court will be inclined to believe that an unincorporated company has entered into the agreement, which will not be binding.
  • The promoter should indicate that he or she is entering into the contract for the purpose of the company's incorporation, and that such a contract is warranted by the terms of the incorporation.
  • The contract entered into by the promoter must be duly ratified by the company upon its incorporation.

If these steps are not followed, Indian courts are likely to disregard the contract and the arbitration agreement contained therein, on account of the fact that they have been executed by a non-existent entity.

The judgment also indicates the extent to which the courts will go to hold that an arbitration agreement exists between the parties. In the past, the courts have been very permissive and have not insisted on technical compliance when looking into the existence of an arbitration agreement (eg, the agreement need not have been signed by both parties and an exchange of correspondence evidencing the intention to arbitrate will suffice). However, when non-compliance with legal formalities arises on account of the non-incorporation of a company, such non-compliance goes to the very root of the agreement and its existence cannot be overlooked by the court. The court will be duty bound to hold that no contract has been entered into at all, and that consequently no benefits under the contract are available to the parties on account of the non-incorporation of the company at the time of entering into the contract.

For further information on this topic please contact Vijayendra P Singh or Surjadipta Seth at Amarchand & Mangaldas & Suresh A Shroff & Co by telephone (+91 11 2692 0500), fax (+ 91 11 2692 4900) or email (vijayendra.singh@amarchand.com or surjadipta.seth@amarchand.com).

Endnotes

(1) Civil Appeal 3272/2007, decided on April 20 2010.

(2) Konkan Railways Corporation Ltd v Mehul Constructions 2000 (7) SCC 201; Konkan Railways Corporation Ltd v Rani Constructions Pvt Ltd 2002 (2) SCC 388.

(3) Section 7- Arbitration Agreement -

  • "(1) In this Part, 'arbitration agreement' means an agreement by the parties to submit to arbitration all or certain disputes which have arisen or which may arise between them in respect of a defined legal relationship, whether contractual or not.
  • (2) An arbitration agreement may be in the form of an arbitration clause in a contract or in the form of a separate agreement.
  • (3) An arbitration agreement shall be in writing.
  • (4) An arbitration agreement is in writing if it is contained in-
    • (a) a document signed by the parties;
    • (b) an exchange of letters, telex, telegrams or other means of telecommunication which provide a record of the agreement; or
    • (c) an exchange of statements of claim and defence in which the existence of the agreement is alleged by one party and not denied by the other.
  • (5) The reference in a contract to a document containing an arbitration clause constitutes an arbitration agreement if the contract is in writing and the reference is such as to make that arbitration clause part of the contract."

(4) 2005 (8) SCC 618.


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