Company Law

Erlanger v. New Sombrero Phosphate Co.

(1878) 3 App Cas 1218

Facts

Erlanger headed a syndicate that purchased a lease of Sombrero Island, which contained valuable phosphate deposits.
The syndicate acquired the property for approximately £55,000.
It then promoted and incorporated the New Sombrero Phosphate Co.
Through the corporate arrangement, the syndicate sold the same property to the newly formed company for approximately £110,000.
The promoters therefore stood to make a very large profit.
The company’s first board of directors was not genuinely independent.
Some directors were absent, while others were associated with or influenced by Erlanger and the syndicate.
The promoters did not place the transaction before an independent board capable of judging whether the purchase was in the company’s interests.
Nor did they make full and clear disclosure of their interest and profit to the whole body of shareholders.
A prospectus was issued, and members of the public subscribed for shares.
The company later discovered the true circumstances of the acquisition.
It sought rescission of the contract and return of the purchase money.
The promoters argued that:
the board had approved the transaction;
the company had worked the island for some time;
phosphate had already been extracted; and
complete restoration of the parties to their original position was impossible.

Whether promoters owe fiduciary duties to a company being formed.
Whether disclosure to a board controlled or influenced by the promoters is sufficient.
Whether the company could rescind the property purchase despite partial use of the asset.

A promoter is not an ordinary arm’s-length seller when dealing with the company being promoted.
Promoters occupy a fiduciary position because they:
create the company;
select its first directors;
arrange its initial contracts; and
invite the public to invest.
A promoter may sell personal property to the company and earn a profit, but only after full disclosure.
Disclosure must be made either:
to a genuinely independent and competent board; or
to the existing and prospective shareholders.
A board selected or controlled by the promoter cannot provide informed approval.
Breach of duty may entitle the company to:
rescind the contract;
recover the secret profit; or
claim compensation.
Rescission remains possible where substantial restoration can be achieved through accounts and financial adjustments.

Erlanger was on both sides of the transaction.
As promoter, he organised the company and its initial management.
As seller, he sought to obtain approximately twice the price paid by the syndicate.
This conflict required complete and independent scrutiny.
The first board could not provide that scrutiny:
it was not selected independently;
important directors did not participate;
others were under the promoters’ influence; and
the company had no genuinely independent negotiating mind.
Disclosure to such a board was effectively disclosure by the promoters to themselves.
The public shareholders were not clearly informed of:
the syndicate’s original purchase;
the size of the profit; and
the promoters’ conflicting position.
The adoption of the purchase at a later meeting was therefore not informed ratification.
The House of Lords also rejected the argument that rescission was impossible merely because phosphate had been extracted.
The court could require:
return of the island;
repayment of the purchase price; and
an account for benefits and deterioration.
Practical financial adjustments were sufficient to achieve substantial restoration.

The House of Lords held that Erlanger and the syndicate had breached their fiduciary duties as promoters.
The company was entitled to rescind the purchase.
The judgment established that promoters must ensure approval by an independent board or make full disclosure to shareholders.
Use this case for: promoters selling property to their own company must disclose their interest and profit to a genuinely independent corporate decision-maker.