This fiduciary relationship imposes an obligation on the promoters to disclose fully all material facts relating to the formation of the company. Though the fiduciary relationship really arises when the company is formed, the fiduciary obligation of a promoter begins as soon as he sets out to act as promoter of the company. Promoters should not make any secret profits at the cost of the company without its knowledge and consent. The disclosure of all material facts, regarding contracts made and the profits earned by them from the formation of the company, should be made to an independent and competent board of directors. If the promoters fail to disclose complete facts, company may set aside the transaction and recover the benefit earned by them.
A case is illustrated:
Erlanger v. New Sombrero Phosphate Co. (1878):
Erlanger together with some of his friends purchased an island containing phosphate mines for ? 55,000. The island was then sold to a newly formed company for ? 1, 10,000. All the five directors of the new company were nominated by Erlanger. At the time of this purchase agreement with Erlanger, two directors were abroad, while out of the remaining three, who signed the purchase deed, two were completely under the control of Erlanger.
Later on, a prospectus was issued inviting the public to subscribe for the shares of the company. The purchase agreement was approved at the first meeting of the shareholders, but they were not told all material facts regarding the transaction. After some time the company went into liquidation. The liquidator filed a case against. Erlanger to recover the profit made by him on account of sale of island to the company. Erlanger defended the case on the plea that the board of directors had full knowledge of the facts. His contention was rejected and he was asked to return the benefit to the liquidator.
The Court held “If they (promoters) propose to sell their property to the company, it is incumbent upon them to take care that they provide the company with an executive who shall both be aware that the property which they are asked to purchase is the promoter’s property, and who shall be competent and impartial judges as to whether the purchase ought or ought not to be made. They should sell the property to the company through the medium of a board of directors, who can and do exercise an independent and intelligent judgment on the transaction.” Thus, it is the duty of the promoters to provide the company with an independent board. However, if the board of directors is not independent from the company, as generally is the case, the disclosure to be effective must be to the would-be shareholders as a whole. The disclosure can be made to the members of the purchasing company by its articles or prospectus or any other method.
If this has been done, absence of an independent board of directors will not invalidate the agreement. Secret profits or undisclosed benefits of any type received by the promoters can be recovered from them by the company. Company can proceed against the promoters for any damage caused to it on account of their fraud or breach of duty. The estate of the promoter shall remain liable in an action by a company for deceit or breach of trust if any benefit has accrued to the estate. A promoter can also be liable for any omission of fact (section 56) or false statement in the prospectus (section 62).