JNTU MBA 2020 LEGAL AND BUSINESS ENVIRONMENT Previous Question Paper (October/November-2020 - R19)

A company cannot ratify contracts entered into by promoters on its behalf prior to its incorporation. Under the doctrine of incorporation, a company does not exist as a legal entity until it is registered; therefore, it lacks the capacity to enter into a contract or to ratify one made before its birth. A contract can only be ratified by a principal who was in existence at the time the contract was made.

Since the company cannot ratify these pre-incorporation contracts, they are not binding on the company, and the company cannot sue or be sued upon them. Even if the company adopts the contract after incorporation or receives benefits from it, this does not constitute ratification. To make such contracts binding, the company must enter into a new contract with the third party after incorporation, effectively novating the original agreement.

Regarding the remedy available to the third party, the following legal positions apply:

1. Personal Liability of Promoters: Because the company cannot be held liable, the promoters who signed the contract are personally liable for the obligations incurred. The third party can sue the promoters for breach of contract or for damages.
2. Breach of Warranty of Authority: If a promoter represented that they had the authority to act for the company, the third party may sue the promoter for breach of implied warranty of authority.
3. Novation: The third party's primary practical remedy is to enter into a fresh agreement with the company after its incorporation. Once the company formally accepts the terms, the liability shifts from the promoters to the company, provided the new contract explicitly adopts the terms of the pre-incorporation agreement.

In summary, the third party cannot enforce the contract against the company directly and must look to the promoters for personal liability unless a new, valid contract is executed between the company and the third party post-incorporation.

The principle that a company should be wound up when its substratum is gone refers to the situation where the primary object or the main purpose for which the company was incorporated has become impossible to achieve. When the core business activity for which the company was formed ceases to exist or becomes legally or physically impossible, the court may order a winding up under the just and equitable clause of the Companies Act.

The courts apply several tests to determine whether the substratum has truly disappeared:

1. Impossibility of Purpose: The court examines the Memorandum of Association to identify the main objects. If the specific venture for which the company was formed is abandoned, or if the subject matter of the business has been destroyed, the substratum is considered gone.
2. Failure of Main Object: If the company is formed for a specific project (e.g., to work a specific mine or exploit a specific patent) and that project is completed, abandoned, or becomes unviable, the court may conclude that the company has no further reason to exist.
3. Deadlock in Management: While distinct from substratum, if a domestic deadlock exists where the company cannot function, the court may apply the just and equitable clause. However, for substratum cases, the focus remains on whether the company is still pursuing its original purpose.
4. Loss of Commercial Viability: The court assesses whether the business can be carried on at a profit. If the company is functionally incapable of achieving its objects due to a lack of funds or resources, it may be deemed that the substratum has failed.
5. Scope of Memorandum: The court will not order winding up if the Memorandum of Association is drafted broadly enough to allow the company to pursue alternative business activities. If the company can still legally and practically engage in other objects listed in its charter, the substratum is not considered gone.

Before passing a winding up order, the court exercises its discretion cautiously. It considers whether the shareholders' interests are protected and whether there is any reasonable hope of the company reviving its activities. The winding up order is a measure of last resort, granted only when the court is satisfied that the company's existence has become futile and it is no longer equitable to keep it alive.