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Who is liable when money is paid to an non-existent firm?

Handing over money to a firm that has not yet been formed can speed deals up, but be sure you know who you are dealing with or you could end up out of pocket, writes Rudi Klein

A FEW years ago there was an aspiring rock band called Cheap, Mean and Nasty. Never heard of it? Well maybe I can explain why.

The band was going to be managed by a company, especially formed for the purpose, called Fragile Management.

Before the company was formed the group's intended manager, Brian Lane, conducted negotiations on behalf of the band with record producer Phonogram.

Mr Lane asked Phonogram to provide £12,000 as pump priming for the band with an initial instalment of £6,000 requested for the band's first album.

The money was paid but Fragile was never incorporated and the £6,000 was not repaid.

Naturally Phonogram wanted its money back and it sued Mr Lane for the debt.

Phonogram's case relied on a letter, sent on its behalf to Mr Lane, which said: 'In regard to the contract now being completed between Phonogram and Fragile Management concerning the recording of a group? with a provisional title of 'Cheap, Mean and Nasty'? I send you herewith our cheque for £6,000 in anticipation of a contract signing, this being the initial payment for the initial LP called for in the contract.

'In the unlikely event that we fail to complete within, say, one month you will undertake to pay us £6,000.

'I should be appreciative if you could sign the attached copy of this letter and return it to me so that I can keep our accounts people informed of what is happening.' Mr Lane signed the copy for, and on behalf of, Fragile.

Phonogram argued that Mr Lane was personally liable on the contract since Fragile could not be sued ? it had never come into existence.

Phonograph relied on what is now section 36(4) of the Companies Act 1985: 'Where a contract purports to be made by a company, or by a person or agent of a company at a time when the company has not been formed, then subject to any agreement to the contrary the contract has effect as one entered into by the person purporting to act for the company or as agent for it, and he is personally liable on the contract accordingly.' Since Mr Lane had purported to make the contract on behalf of the non-existent company he was, therefore, personally liable for the money under section 36(4), argued Phonogram.

One of the arguments Mr Lane put forward was that he had expressly signed the contract on behalf of Fragile. This meant that he had not accepted personal liability.

The case went all the way to the Court of Appeal where the late Lord Denning held that section 36(4) clearly applied to this case and that Mr Lane was personally liable to return the money.

Lord Denning explained that the only way to avoid this consequence was for there to be an express agreement that the person signing was not to be personally liable.

OK, let's now leave the chaotic world of popular music and look at a similar issue in a construction context. The case is Cotronic (UK) v Dezonie t/a Wendaland Builders (1991).

In 1973 a company by the name of Wendaland Builders was set up, but by 1981 it had been struck off and dissolved.

Then, in 1988, another company using the same name was set up.

The defendant in the 1991 case had entered into a contract to procure certain building works in 1986 using the name of Wendaland Builders.

He had been unaware at the time that this company had been struck off and dissolved and there was no evidence that he had attempted to contract on behalf of the new company going under the same name.

Since Wendaland Builders was not in existence in 1986 it could not enter into a contact and, therefore, the agreement in 1986 was void and of no effect.

Also, section 36(4) was not relevant as it only applied to a company that had yet to be formed. But who was to pay for the building work that had been carried out under a contract that was void as a result of the paying party not being in existence?

The Court of Appeal held that this was a case of 'unjust enrichment', where work had been done and a valuable benef it had been conferred.

In this situation the defendant was liable to make payment on a quantum meruit basis.

Such payment was to be calculated in accordance with what the court considered to be a fair price for the work, taking into account the value of benefit conferred rather than expenditure incurred by the claimant.

The moral of these stories is that you should always doublecheck the identity of the party you are dealing with.

This may sound the most obvious thing to do but in practice many firms simply do not bother. Even if an individual is held responsible ? as in the Phonogram case ? he may be a 'man of straw' and incapable of providing compensation.

If there are doubts about the identity of the other party, an appropriate search at Companies House may provide the answer or, alternatively, try an inquiry to a credit reference agency.

I never found out what happened to Cheap, Mean and Nasty. Just as well, perhaps.

Key points Section 36(4) of the Companies Act 1985 makes a person purporting to act for a company that has not yet been formed personally liable for the contract.

Personal liability in these circumstances can only be avoided if there is an express agreement that the person signing the contract is not to be held personally liable.

Always double-check the identity of the party you are contracting with.

An individual who is held personally liable might be a 'man of st raw' and unable to provide compensat ion.