Ultra Vires and Third Party Rights

Ultra vires in company law is used to indicate an act of the company which is beyond the powers conferred on the company by the objects clause of its memorandum. [1] An ultra vires act is void and cannot be ratified even if all the directors wish to ratify it. [2]

There can be substantive and procedural ultra-vires. When the company lacks power/authority to undertake certain act that is when the object clause is not providing for such an act, any act undertaken in such situations is called as substantive ultra vires The company is not bound by the acts constituting substantive ultra vires, since every person contracting with the company is supposed to know the constitutional documents of the company. But even here the directors may be held personally liable by the third party.

Procedural Ultra Vires is when the company is having power/authority to undertake certain acts as provided by the object clause, but the organ of the company (authority exercising the power) has no authority to undertake such an act. Procedural ultra vires binds the company as an outsider is not always expected to know the power arrangement inside the company and the act has been literally allowed by the company.

The doctrine of ultra vires was, thus, developed as a matter of judicial control to protect the investors and creditors of the company. This doctrine prevents a company to spend the money of the investors for a purpose other than those stated in the objects clause of its memorandum. Thus, the investors and the company may be assured that their investment will not be used for the objects or activities which they did not have in contemplation at the time of investing their money in the company.

This doctrine protects the creditors of the company by ensuring them that the funds of the company to which they must look for payment are not dissipated in unauthorized activities. The wrongful application of the company’s assets may result in the insolvency of the company, a situation when the creditors of the company cannot be repaid. Besides the doctrine of ultra vires prevents directors from departing from the objects for which the company has been formed and, thus, puts a check over the activities of the directions. It enables the directors to know within what lines of business they are authorized to act.

The result of the development of the doctrine of ultra-vires, in the field of company law, is that a company is expected to have the following powers:

(i) Power to do whatever (such things) is necessary to do with a view to the attainment of the objects specified in the memorandum

(ii) Power to do whatever else (all such other things), which may fairly be regarded as incidental to, and consequential upon, its objects.

(iii) Power to do such other things as are authorised to be done by the Companies Act or by any other statute. Thus, such transactions, which do not fall under any of the three categories mentioned above, are regarded as ultra-vires. [3]

This research paper shall be an attempt to discuss the problems faced by innocent third party in transactions which are ultra-vires and how this problem is being dealt in India and UK.

A Brief History: UK perspective

Early Developments

In Ashbury Railway Carriage and Iron Company Ltd v. Riche [4] the doctrine of ultra vires was firmly established by the House of Lords in 1875. It was held that a contract beyond the objects as defined in the objects clause of its memorandum is void as the company had no capacity to either make or ratify the contract. If the shareholders are permitted to ratify an ultra-vires act or contract, it will be nothing but permitting them to do the very thing which, by the Act of Parliament, they are prohibited from doing.

More importantly, the House of Lords has expressed the view that a company incorporated under the Companies Act has power to do only those things which are authorized by its objects clause of its memorandum and anything not so authorized (expressly or impliedly) is ultra vires the company and cannot be ratified or made effective even by the unanimous agreement of the members. This principle was reiterated in the case of Attorney General v. Great Eastern Railway Co [5] , however in order to make it more reasonable it was widened so that the objects incidental to, or consequential upon the main objects could be carried out by the company. A company now had power to carry out the objects set out in the objects clause of its memorandum and also everything that is reasonably necessary to enable it to carry out those objects.

The doctrine was further enlarged in Attorney General v. Mersey Railway Co [6] where it was held that an act reasonably necessary to effectuate the purpose for which the company has been incorporated is within the powers of the company, although these are not expressly mentioned in the objects clause of the memorandum of the company, or the statute creating it. In Re, Patent File Co [7] it was held that a company which has been authorized to deal with its property has implied power to pledge or mortgage the property for its debts.

In Evans v. Brunner Mond & Company [8] a resolution which was incidental or conductive to the attainment of the main object of the company was held to be not ultra-vires. In Deuchar v. Gas Lights & Coke Co [9] , it was held that “Acts incidental or ancillary” are those acts, which have a reasonable proximate connection with the objects stated in the objects clause of the memorandum.

The rule of ultra-vires was devised for the protection of the company’s interest and it is not capable of being used against the company’s interest and for an innocent third party. This point was raised in Anglo Overseas Agencies Ltd v. Green [10] but the court held the transaction ultra-vires without dealing with the above question. The question was again raised in Bell Houses v. City Wall properties Ltd [11] , where an attempt to defeat a company’s claim for consultancy charges earned by the managing director was allowed not to be frustrated by holding that the services were rendered not outside but within the company’s general powers. Where the contract or transaction is only in an executor stage, such a plea will be accepted.

New Drafting Techniques: More misery for third party

The immediate consequence of Ashbury was careful consideration in drafting of objects clauses which were too wide [12] or where either an exhaustive list of objects was being provided or confusing language was being used to widen the objects clause and avoid doctrine of ultra-vires. In response, however, the courts would use two techniques to set limits on the proliferation of clauses. The first was to distinguish between objects and powers and to state, in an application of the ejusdem generis rule, that powers could only be used in furtherance of the objects. The second was to locate, even where only objects were concerned, the paragraph which appeared to the courts to contain the main or dominant object and to construe all others as ancillary to this main purpose.

The main object rule of construction has been avoided by inserting a statement in the objects clause to that effect that “all the objects are independent and in no way ancillary or subordinate to one another.” this is known as ‘independent objects clause’. Initially, such a clause was considered valid. [13] However, in In Re, Introductions Ltd [14] court held that an “independent objects clause” could not convert a power into an object. There is a difference between a power and an object. Only the objects are required to be stated in the objects clause of the memorandum and not powers but if the powers are also stated in the objects clause, they must be exercised to effectuate the objects stated therein.

Another construction used by the drafters was adding a sub-clause in the memorandum that the carrying on of any business which in the view of the directors was beneficial to the company would be authorised. In Bell Houses Limited v City Wall Properties Limited [15] the same was authorized. However, Bell Houses is viewed as the death for the ultra vires doctrine, the use of these drafting devices appearing ‘to destroy any value that the ultra vires doctrine may have had as a protection for members or creditors; it had become instead merely a nuisance to the company and a trap for unwary third parties.

Doctrine of constructive notice

This doctrine placed the onus on contracting parties to read the constitutional documents prior to every transaction and satisfy themselves that their contracting partners had the semblance of contractual capacity, a position that was never entirely without its risks. The development of the constructive notice doctrine deeming that parties have knowledge of the contents of memoranda merely added to this. [16] This theory clubbed with the doctrine of ultra-vires has brought nothing but misery for innocent third parties, even with the respite provided by the converse doctrine of indoor management.

The Jenkins Committee in 1962 recommended abandonment of the constructive notice rule by the introduction of rules protecting persons dealing with the company in good faith, subjecting liability to actual knowledge of the contents of the memorandum except where the third party ‘honestly and reasonably’ failed to appreciate the memorandum prevented the company from transacting. Curiously, it did not recommend abolition of the ultra vires doctrine itself.

Theoretically, the courts application of the doctrine of constructive notice of the contents of the memorandum may appear to be sound but when it comes to practice, its impropriety become evident because every lay member of the public cannot be expected to go through and understand the correct scope of the memorandum of association of the company with which he proposes to deal. Thus, this case is evidence that the ultra vires rule was capable of ‘operating as a trap for the general public as it proved to be for the unlucky claimants in this case.

European Communities Act, 1972

Soon there were critiques calling for the abolition of the ultra-vires doctrine. [17] This doctrine presumes that an outsider dealing with the company has the knowledge of the provisions of the memorandum and articles of the company. A contract made by an outsider with the company in respect of anything which is not covered under the objects clause in its memorandum is ultra vires and therefore void. [18] Also, even if the shareholders are willing to honor the contract they are unable to do so. Furthermore, at every step the management is required to see whether the acts sought to be done are covered in the objects clause of its memorandum. It restricts the frequency of the business activities. Also, the rule causes much nuisance by preventing the management from changing its activities as altering the objects clause is a long procedure. [19]

As a result the European Communities Act, 1972 was passed which modified the doctrine ultra vires to a large extent. A company now had the capacity to do an act or to exercise a power, which has been conferred on it by the companies Act or any other statute, even if such act is not covered by the objects clause in the memorandum of the company. Also, a company, in addition to the powers conferred on it by the objects clause of its memorandum, has power to do all those acts, which are necessary for, or Incidental to, or incidental to or consequential upon, the exercise of those powers. Also, a company is not allowed to take up the plea of ultra-vires against a third party who has bona-fide entered into the contract. Though the third party shall be protected, the company itself might have its remedies against its own errant directors, managers or other officers responsible for it. As of the 2001 amendment the doctrine of ultra vires has been totally replaced.

A Brief History: India perspective

In India there is no legislation like the European Communities Act. Consequently, the principles laid down in Ashbury Railway Carriage and Iron Company Ltd v. Riche and Attorney General v. Great Eastern Railway Co. is still applied without restrictions and modifications [20] .

It was the Bombay High court which first recognized the concept of ultra vires in Jahangir R. Modi v. Shamji Ladha [21] as early as in 1868 but a more significant Indian case in this regard was Lakshmanaswami Mudaliar v. Life Insurance Corporation Of India [22] in which it was held that in addition to the powers specifically conferred by the memorandum, a company has the power to do whatever may fairly be regarded as incidental to its express objects.

However, it was only after the decision of Re Port Canning Co [23] that the critiques questioned the utility of ultra-vires vis-à-vis innocent third party. By declaring trading of rice by a company as ultra-vires to their object’s clause, innocent third party had to suffer losses for, practically, no fault of theirs but due to the technical rule of ultra vires.

Some High Courts while dealing with ultra-vires doctrine were more sympathetic to innocent third party. For instance, in Ahmed Sait A others v. The Bank of Mysore Ltd [24] the Madras High Court the rule of ultra vires was not allowed to prevent the Bank of Mysore from recovering the money which it had advanced on mortgage though it seemed that the memorandum of association of the bank did not permit it to advance money on mortgage.

In Sivashanmugham v. Butterfly Marketing (p) Ltd, [25] the court observed that a third party may not take advantage of the doctrine of ultra-vires acts in order to avoid the performance of obligations voluntarily undertaken with full opportunity to know the extent of the company’s power before entering into the transaction.

In respect of ultra-vires transactions, the directors and other officers shall be personally accountable to third parties. It is one of the duties of the directors. If a director utilises the company’s money for purpose outside the memorandum, he shall be personally liable to replace it. [26] This hardly helps a third party as many a times the directors are unable to make good the loss and as such the transaction remains void.

Thus in India the ultra vires act or transaction neither can be enforced by the company against the third party nor by the third party against the company and thus, both the third party and company can plead against each other that the transaction or act was ultra vires. However, the provisions similar to those inserted in the European Communities Act, 1972 should also be inserted in the Indian Companies Act, 1956 to protect the innocent third party.

Conclusions

The doctrine of ultra vires can be a pitfall for the outsider who deals with the company because there can always be such activities which the company cannot pursue under its “objects clause” If the company pursues that very activity, the persons who deal with the company in connection with that activity cannot recover anything from the company which may be due to them in regard to that dealing.

It is therefore suggested that the companies, in their dealings with outsiders, should have the same legal capacity to act as a natural person and so, as between the outsiders and the company, the company should take full responsibility for its acts. The memorandum of association should lay down the powers of the company and, as between the company and its directors, if the directors take the company beyond those powers, the directors should refund to the company the entire money spent on, or due to, activities beyond those powers. [27]

Though European community have passed laws to lessen the impact on the third party, India is still a long way from bringing any such change, though Sachchar Committee has expressed strong desires to adopt such a law in India. [28]