corporate
This question is about the company’s legal capacity and how far it extends.
Historically the company’s total power to do something was determined by its objects clause. After an extensive reform process, unless a company chooses to have an objects clause which sets out the limit of its power, CA 2006, s 31 now provides that companies have unrestricted objects, i.e. they are empowered by Parliament to take part in any business they wish. It is worth noting however that most companies were incorporated under previous companies acts which required an objects clause and so will still be operating (unless they remove that objects clause) within the power conferred by Parliament in that objects clause. A large part of that limited or unlimited power is then delegated in the articles to the board who may exercise it itself or may delegate part of the power to the company’s agents or employees. Those agents and employees may then contract with outsiders in the exercise of that delegated power. The power of the company in effect gets narrower as it moves away from the original source. Thus, a stationery manager when he transacts to buy stationery is exercising a minute part of the total power of the company.
Historically, where there was some doubt as to whether a transaction was authorised two questions arose:
(i)First, was the act within the power of the company? If the answer was yes then we moved to the second question. If the answer was no, the transaction was void and unenforceable—this could have very serious consequences as we will see.
(ii)Second, if the act was within the power of the company was the individual who contracted on the company’s behalf authorised to do so? If they were, the transaction was valid but if not it was voidable at the instance of the company.
As a result the area was full of uncertainty and danger for people dealing with companies. However, over time some judicial intervention and a largely successful reform process have combined to protect those dealing with the company.
The ultra vires doctrine
The 19th-century companies legislation created registered incorporated companies with a requirement that the memorandum of association specify the objects of the company. This was a hangover from the period when companies were formed by charters or grants from the Crown and Parliament. Organisations like the Church or local authorities whose main function was to serve the public interest were among the first to exploit corporate status. Over time this practice expanded to encompass trading companies formed to exploit trade, transport or technology rights. In theory these grants of corporate status to private businesses were still granted primarily because of the public interest in promoting a specific business venture. However, the registered company was somewhat different because those forming the company set out its objects rather than Parliament itself which, in most cases, would have no public interest element at all.
Legal theory at the time the registered companies appeared was dominated, by concession theory. Legal theorists considered that companies were similar to public bodies. A public body is conferred with certain power by Parliament and cannot go beyond that power. If it did act ultra vires that act was void. For public bodies to be subject to such restrictions was necessary in order to safeguard democracy because if a public body takes more power than the elected representatives of the people have given it, an act in furtherance of that excessive power has no legitimacy. There was another reason why the ultra vires doctrine was deemed to apply to a registered company, it was thought to protect the shareholders and the creditors. If the company was restricted to one function, the members and the creditors were protected because the directors were restricted in their choice of business to that which the shareholders and the creditors had initially provided money to fund.
However, as we will see historically three particular issues combined to make ultra vires a very tricky problem for the courts:
(i)First, initially the objects clause was unalterable and then only alterable in limited circumstances until 1989.
(ii)Second, unlike public bodies whose functions are relatively fixed, registered companies often did change the central nature of their business.
(iii)Third, the doctrine of constructive notice could combine with the ultra vires rule to leave unwary third parties with unenforceable contracts. The doctrine applies to public documents and deems anyone dealing with registered companies to have notice of the contents of its public documents. Therefore, anyone dealing contractually with a company was deemed to have knowledge of its objects clause and was presumed to enter into the void transaction with that knowledge. The doctrine makes it impossible for someone dealing with the company to argue that they did not know that the company lacked capacity to enter the transaction.
The classic rule
As a result of the moveable nature of business, constructive notice and the fact that the memorandum was unalterable for much of the 19th and 20th century, the courts at first had some difficulty applying the ultra vires principle strictly to registered companies. In Riche v Ashbury Railway Carriage & Iron Co (1874) the trial court adopted a flexible approach to the concept by allowing the company to do anything not prohibited in its constitution. However, the judge’s relatively simple solution to the problem did not ultimately find favour when the case reached the House of Lords. In Ashbury Carriage Company v Riche (1875) the House of Lords took the opportunity to state clearly that the ultra vires doctrine did apply to registered companies. Thus, if a company incorporated by or under statute acted beyond the scope of the objects stated in the statute or in its memorandum of association such acts were void as beyond the company’s capacity even if ratified by all the members. This is a useful reminder that in this period the judiciary still largely viewed the registered company as a part of the state and applied a concession theory approach to its regulation.
However, the courts quickly began to recognize the difficulty with treating registered companies as if they were public bodies and started to erode that statement of high principle by applying a certain ingenuity to avoid the ultra vires doctrine. For example, in A-G v Great Eastern Rly the House of Lords outlined a very important broad interpretation of the powers that could be exercised in the pursuit of its objects. They considered a company could enter into transactions which were fairly regarded as incidental or consequential to its objects. This provided companies with some room to manoeuvre.
While this represented some progress with the issue it still left problems where the object could not strictly be achieved. For example, in Re German Date Coffee Co (1882) the company’s object was to acquire and exploit a German patent for producing coffee from dates. The company failed to get the German patent but obtained a Swedish one instead. Despite the fact the company had a thriving date coffee business it was wound up by the court because it could not achieve its stated object. As a result of the dangers posed to companies by this rule much legal ingenuity went into framing objects clauses to minimise the impact of the ultra vires rule. Some objects clauses listed a large number of activities the company could carry on. This was sometimes successful but at other times the courts interpreted anything following the main object as being only a power that must be exercised in furtherance of the main object. In response companies then drafted objects clauses which stated that each object or power was to be treated as independent and in no way attached to the main object. In Cotman v Brougham (1918) the House of Lords reluctantly accepted an objects clause that was very widely drafted with a clause at the end stating that any of the objects listed could be carried on as the company’s main object.
By the 1960s companies had objects clauses which stated their objects widely. As a result of the judicial acceptance of these wide clauses the courts were not faced with objects issues as frequently as they once had been. However, the problem did not go away and occasionally the courts would be presented with an objects issue which no amount of flexibility could solve. In Re Jon Beauforte (London) Ltd (1953) the company’s objects stated it was to carry on a business as gown makers but the business had evolved into making veneered panels. No change had been made to the objects clause to reflect this change. A coal merchant had supplied coal to the company which was ordered on company notepaper headed with a reference to the company being a veneered panel maker. The coal merchant was deemed because of constructive notice to know of the original objects clause and because of the headed notepaper to have actual notice of the change in the business. As a result the transaction was ultra vires and void.
Ultra vires and the benefit of the company
Certain decisions of the company which have no immediate tangible benefit to the company have also fallen foul of the ultra vires doctrine. During their lifetime companies often make charitable donations, political donations and gratuitous payments to employees. All of this is generally deemed to be of benefit to the company while it is a going concern. However, once the company ceases to do business such payments become problematic. In Hutton v West Cork Rly Co (1883) the court held that a railway company, whose undertaking had been transferred to another company and whose affairs were being wound up, could not pay gratuitous compensation to its former employees or to its directors for loss of employment. This was so despite the fact that they had never been paid during the life of the company. The company was in liquidation and could not benefit from the gift to the directors, any such transaction being ultra vires and void. This introduced a new formulation into the objects debate to the effect that not only did the act of the company have to be within the objects clause but the company’s power had to be exercised bona fides for the benefit of the company.
There was however something odd about the addition of the benefit of the company criterion to the ultra vires issue. The courts eventually decided (see Rolled Steel Ltd v British Steel Corpn and Brady v Brady that these decisions are in fact not ultra vires cases at all but are rather cases where the issue was whether directors exceeded their powers (as opposed to the company’s power) or a question of whether they exercised their power properly. Corporate capacity questions were solely to be determined by the construction of the objects clause. The question of whether the power was exercised for the benefit of the company had nothing to do with whether the company had capacity to do the act in question.
The reform of ultra vires
The slow liberalisation of the judicial concession approach was accompanied by occasional recommendations for reform of the area. In 1945 the Cohen Committee recommended doing away with the ultra vires concept where third parties were involved. However, nothing came of this recommendation and it was not until the UK was forced to act as part of its obligations on joining the European Community that legislation reforming ultra vires was introduced in s 9(1) of the European Communities Act 1972. The domestication of the First European Community Company Law Harmonisation Directive a version of which remains in what is now CA 2006, s 39 (formerly contained in CA 1985, s 35) removed the doctrine of constructive notice where it concerned the memorandum and articles of association. It also contained a saving provision for ultra vires transactions where the transaction was dealt with by the directors and the third party was acting in good faith (now CA 2006, s 40). While this reform narrowed the extent of the ultra vires rule it still left the potential for problems to arise. In 1986 the DTI produced a report (the Prentice Report) recommending much deeper reforms. The Prentice Report formed the basis of a number of provisions introduced in the CA 1989 amending the CA 1985 with respect to its ultra vires sections.
The reforms had a dual approach:
1.First, it made it easier for companies to arrange their constitution to avoid ultra vires issues. Thus, s 110 of the CA 1989 introduced a new s 4 into the CA 1985 which allowed the memorandum to be changed by special resolution (now CA 2006, s 21). This had the effect of allowing companies who wished to diversify, to change the objects clause with relative ease. The same section of the CA 1989 also introduced a new s 3A into the CA 1985 which allowed companies to have an objects clause which stated that it was to carry on business as a general commercial company. This allowed the company to carry on any trade or business whatsoever and the company had the power to do all such things as were incidental or conducive to the carrying on of any trade or business.
2.Second, it dealt directly with ultra vires transactions by repealing the old s 35 and introducing new ss 35, 35A and 35B in the CA 1985. Section 35 stated:
(1) The validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the company’s memorandum.
As a result of this section a transaction which was technically ultra vires the company was still valid and enforceable.
The memorandum and the articles form a statutory contract between the company and the members and therefore if the company entered into an ultra vires act it was bound to the outsider because of s 35 but the same act would also breach the contract with the members for which the directors were potentially liable. The amendments to the CA 1985 in 1989 dealt with this issue in two ways. The 1989 amendments introduced a new s 35(2) whereby if a member was aware of an imminent ultra vires act he could bring proceedings to restrain the doing of that act. Second, s 35(3) was also introduced to emphasise that the directors had a duty to observe any internal restrictions on their powers flowing from the memorandum. However, an ultra vires transaction could be ratified by a special resolution of the general meeting but this would not affect the liability of the directors for breach, thus a separate special resolution passed by the members was the only way the directors could be relieved from liability for an ultra vires act.
The CLRSG in their Final Report (July 2001) recommend simplifying this and that any company formed under a new Companies Act have unlimited capacity whether or not it chooses to have an objects clause. The White Paper (2002) and the Government’s Consultative Document of March 2005 also broadly followed these recommendations.
As a result, the CA 2006 attempted yet again to reform this area. A company’s constitution means only the articles of association and associated resolutions of the general meeting (CA 2006, s 17). The memorandum still exists but it is not part of the constitution and acts purely as a statement by the founders of the company that they wish to form the company and become members of it (CA 2006, s 8). Everything else that was formerly in the memorandum now forms part of the articles of association or the application for registration (CA 2006, s 9 and s 28). Under the CA 2006 all companies are deemed to have unrestricted objects unless the company’s articles specifically restrict the objects of the company (CA 2006, s 31). As most companies currently in existence were formed under principal Companies Acts that required an objects clause, this change will only really affect companies newly incorporated under the CA 2006. For companies already in existence with an objects clause, that clause still operates to restrict them, and will now become part of their articles of association (CA 2006, s 28). Companies with such an objects clause could if they wished choose to remove it but it is doubtful whether there would be any particular advantage in doing this for companies with a general objects clause—again the vast majority. In recognition of the fact that a large number of companies will still have an objects clause s 35 of the CA 1985 has been replaced by an almost exact replica in s 39 which states:
(1)The validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the company’s constitution.
It is worth noting that the shareholder injunctive provisions and the director’s duty to observe internal restrictions which were in the CA 1985 s 35(2) and (3) are not similarly repeated in the CA 2006.
However, given that the reason for replicating s 35 in the new s 39 was to cover companies that retain a restrictive objects clause and thus to protect against the problems that have historically been evident with restrictive objects, this seems an odd omission.
1.Is s.14 of the Companies Act 1985 still a problem? Discuss.
2.
One of the questions that arose from the s 33(1) (former s 14 of the Companies Act 1985) contract is whether it binds the members ‘inter se’. That is, while we know from the above that it binds the members and the company together, does it also mean each member has a binding enforceable contract with every other? This can be an important issue for shareholders who find that they wish to enforce a particular provision of the articles against another shareholder. For example pre-emption rights (the right to buy the shares of a member who wishes to leave the company) contained in the articles may drastically affect the shareholding of a member if they are not complied with. If the member can enforce the rights directly by virtue of s 33(1) it makes the rights easier to enforce. If the company is the only one who can enforce such rights then enforcement becomes more complex and the shareholder may be at risk of the majority shareholders taking advantage of the constitution to do nothing. The question as to the enforceability of the contract between members is one which has caused some difficulty and there has been much judicial debate as to whether a member can enforce a right contained in the articles directly against another member or whether the company is the proper claimant in such an action.
The following examples should provide some taste of the back and forth nature of the judicial debate. In Wood v Odessa Waterworks Co (1889) Stirling J considered that “the articles of association constitute a contract not merely between the shareholders and the company, but between each individual shareholder and every other”.
In Salmon v Quin & Axtens Ltd (1909) Farwell LJ considered Stirling J’s words in Wood v Odessa and stated, ‘I think that is accurate subject to this observation, that it may well be that the Court would not enforce this covenant as between the individual shareholders in most cases’.
In Rayfield v Hands (1960) Vaisey J considered all the conflicting authorities on the issue and concluded that there was a contract inter se which was directly enforceable by one member against another. Vaisey J did not however think that his view was of general application, rather he emphasised the quasi-partnership nature of the company he was dealing with.
There is still confusion as to whether the contract is enforceable between members. Barc and Bowen argue that Lord Herschell’s dicta, with the quasi-partnership exception, represents the correct position. Thus, in their view a member cannot enforce the articles of association of a company directly against another member unless the company is a quasipartnership. The proper claimant in such a situation is the company itself.
However, Davies (2008) considers that a “direct action between the shareholders concerned is here possible; and for the law to insist on action through the company would merely be to promote multiplicity of actions and involve the company in unnecessary litigation”.
The CLRSG in their Final Report recommend ‘the clarification of the nature of the company’s constitution (currently laid down by the outmoded and inadequate s 14), including increased certainty as to what rights are enjoyed and may be pursued by members personally under the constitution’. The solution they recommended was to allow all rights in the constitution to be enforced against the company and the other members unless the constitution provides otherwise. This also seemed to be reflected in the Government’s Consultative Document, March 2005 although it is not entirely clear what the Government intended. This lack of clarity continues in the CA 2006 as the guidance notes to the Act state:
A company’s articles are rules, chosen by the company’s members, which govern a company’s internal affairs. They form a statutory contract between the company and its members, and between each of the members, and are an integral part of a company’s constitution.
This appears to indicate that the uncertainties about enforceability are resolved but the wording of CA 2006, s 33 in terms of its central contract which replaced s 14 is almost unchanged. This is a shame given that during the Grand Committee stage of the Bill in the House of Lords, Lord Wedderburn tabled an amendment to s 33 which would have clarified the relationship between the company and the members. The Government rejected the amendment stating ‘notwithstanding the valuable work of the Company Law Review in this area, we have yet to be convinced that there is anything better and clearer’.
As a result we are left somewhat strangely with a ‘new’ section governing the relationship between the members and the company which is almost exactly the same as its predecessor which the CLRSG described as ‘the outmoded and inadequate s 14’.
Who can sue?
One of the key questions that arises with the s 33 contract is, who is entitled to sue to enforce it? While we have seen from the above that members may be able to enforce it against each other, a more complex situation occurs where the members wish to enforce it against the company. The question becomes whether the wrong complained of is a wrong done to the company or to the member. The company operates through its constitutional organs. Either the board of directors agrees to take an action or the general meeting does so.
As a general rule, individual shareholders are not empowered to initiate proceedings for a wrong to the company. This is known as the rule in Foss v Harbottle (1843). This can lead to situations where the majority abuse their power to commit fraud on the minority. If this is the case there are a number of common law and statutory provisions to deal with the minority complaint. The situation with regard to who can sue to enforce the s 33 contract is similar. A majority of the members may vote to do something which breaches the constitution. The minority shareholders may wish to sue to enforce the s 33 contract. Whether they can do so depends on how the breach of the constitution is perceived.
–If the breach in question is a wrong to the company, then only the company can sue.
–However, if it is classified as a personal right of the shareholder then the individual shareholder can sue.
In Mozley v Alston (1847) the directors failed to retire by rotation as provided by the articles. They were treated as having committed a wrong to the company rather than breaching individual members’ rights regarding re-election. The company was therefore the only one who could complain.
On the other hand, in Pender v Lushington (1877) a shareholder’s votes were refused at a general meeting. The member obtained an injunction stopping the directors acting on the resolution passed at the meeting. Jessel MR considered that the shareholder ‘is entitled to have his vote recorded—an individual right in respect of which he has the right to sue. That has nothing to do with the question raised in Foss v Harbottle (1843) and that line of cases.’
We can conclude from this that some rights are personal and others not. How can one tell if it is a personal right? Lord Wedderburn (1957) in an article on Foss v Harbottle (1843) set out a list of rights the courts have in the past considered personal in nature. These included voting rights, share transfer rights, a right to protect class rights, pre-emption rights, the right to be registered as a shareholder and obtain a share certificate, to enforce a dividend that has been declared and to enforce the procedure for declaring the dividend, the right to have directors appointed in accordance with the articles and other procedural rights such as notices of meetings. While this list provides some guidance the matter is still less than clear. The root of the difficulty in separating out general membership rights from personal membership rights is that many breaches of membership rights contained in the articles can be interpreted either way, as pure internal irregularities which only the company can put right, or as personal rights which allow the shareholders to sue.
The articles of association may not be the final word on how the rights and obligations of the members and the company are allocated. Agreements between shareholders have become an increasingly common feature of company law as a result of the uncertainty surrounding s 33. Shareholders’ agreements are agreements between shareholders themselves (that is all the shareholders or just between some of them) or between the company and the shareholders (that is all of them or just between some of them). A share is a bundle of rights that can be bought and sold. A shareholder, as a result of his ownership of a share, can also agree to exercise the rights attached to the share in a particular way. The shareholders’ agreement has the advantage that compared to altering and enforcing the articles it is a relatively easy way to achieve agreement and enforcement. It also has the advantage that it is private and you can easily identify who you wish to transact with. A shareholder can therefore secretly contract to control the majority voting rights in a company without owning a majority of the shares. The disadvantage of a shareholders’ agreement is that it does not bind the new owner of the shares. Once a party to a shareholders’ agreement sells them on, the new owner has no obligations under the shareholders’ agreement. Note here this is in contrast to the way the s 33 contract operates to bind future shareholders to the company’s constitution.
Shareholder agreements purely between shareholders present little difficulty for the parties involved. They can agree the matters they wish and as long as they all agree, they can also alter their agreement formally or informally. The courts have also been willing to enforce such agreements. For example, in Puddephatt v Leith the court compelled a shareholder to vote as was agreed in a shareholders’ agreement. However, agreements purely between the shareholders can only attempt to regulate the rights and obligations belonging to those shareholders. As those rights and obligations largely concern the operation of a company it often makes sense to make the company a party to the agreement. This adds an extra element of security to the agreement as the company will still be bound by the agreement even if some of the parties to the agreement sell their shares and the new shareholders do not join the agreement. Here in practice we are probably talking about small to mediumsized companies where there is little or no separation of ownership from control. Therefore, the shareholders and directors will often be the same people and getting the company to join the agreement is easily achieved.
Adding the company to the agreement, however, also adds an additional problem. That is, if the subject matter of the agreement affects a statutory obligation of the company it may not be enforceable. CA 2006, s 21 allows the company to alter its articles by special resolution if three-quarters of the members vote in favour of the resolution. In Punt v Symons & Co Ltd the court held that a company could not contract out of the right to alter its articles. This means in effect that a provision of a shareholders’ agreement which binds the company not to alter its articles will not be enforceable. The company would be in breach of contract if it does so, but it is free to alter its constitution.
However, the courts once again have not been entirely consistent when dealing with the question of the ability of the company to contract out of statutory provisions. In Bushell v Faith the articles contained a provision whereby in the event of a resolution to remove a director that director’s shares in the company would be multiplied by three. This in effect entrenched the director on the board of directors as the other shareholders could never outvote him. In effect the article attempted to remove the ability of the members conferred by CA 2006, s 168 to remove a director for any reason whatsoever.
The House of Lords in a very interesting judgment held that the article in question was not inconsistent with the statutory power. The statute only specified the type of resolution needed to remove a director but was completely silent on the matter of how the company allocated voting rights for such resolutions. In essence the House of Lords treated the issue as no different from a complaint from a 49 per cent shareholder that a shareholder with 51 per cent of the shares in the company could not be removed. It’s not that they cannot be removed, it’s simply that the other shareholder has not enough votes to remove the 51 per cent shareholder. The same is true where weighted voting rights are concerned.
The issue was reconsidered in the context of a shareholders’ agreement in Russell v Northern Bank Development Corpn. Here the House of Lords considered a shareholders’ agreement where the company agreed not to increase the share capital of the company without the agreement of all the parties to the shareholders’ agreement. The company did attempt to increase the share capital of the company and one of the shareholders who was a party to the shareholders’ agreement objected and attempted to enforce the agreement. The statutory conflict here was between the agreement and CA 1985, s 121 which allowed companies to increase their share capital if their articles contain an authority. The article of the company did provide such an authorisation. The House of Lords found that the company’s agreement not to increase its share capital was contrary to the statutory provision and, therefore, unenforceable. However, the court did not declare the whole shareholders’ agreement invalid, just the company’s agreement not to increase the share capital. This meant that the shareholder who objected could not enforce it against the company but could enforce it against the other members. As all the members of the company were party to the shareholders’ agreement this has the same effect as if the company was bound. The shareholders could not vote to increase the share capital.
It is important to note here that this judgment greatly enhances the ability of shareholders’ agreements to contract out of statutory provisions. If the shareholders place a provision in the articles that purports to contract out of a statutory provision it will probably be invalid, however if they place the same provision outside the articles in a shareholders’ agreement and either all the shareholders or a large majority of them are party to it, the provision will be effective. It represents only a private agreement between the shareholders as to how they will exercise their voting rights. Tangentially this has an effect on lenders’ ability to protect themselves by placing restrictions on the company’s ability to change the articles of association as a condition of their continued lending. A lender has no way of knowing of or restricting shareholders’ private agreements which affect the operation of the articles. The recommendation of the CLRSG Final Report (July 2001) and the Government’s Consultative Document of March 2005 all agreed that allowing certain provisions of the articles to be entrenched by allowing them to be changed only by unanimity would potentially offer a solution to the problem and the CA 2006 s 22 makes this possible.