A Comparative Study of the Ultra-Vires Rule in Corporate Law

INTRODUCTION

lawzmag.comThe purpose of this paper is to contrast the application of the ultra vires rule in corporate law in the legal jurisdiction of England with that in India. After a brief review of the origin and development of the ultra vires doctrine, the paper examines the reasons for the reform of this rule and the legal reforms actually carried out in England. Thereafter, the legal position in this respect in India is discussed with suggestions for reforms therein.

ORIGIN OF THE ULTRA VIRES RULE IN CORPORATE LAW

With the introduction of the Limited Liability Act in 1855 in England, it was deemed proper that the use of the shareholders and the creditors’ funds with the company should be only for certain specified objects. The elaboration of such a rule was facilitated by the Act of 1856, which specified that a company should include an ‘objects clause’ within its memorandum that would define the contractual capacity of the company. However insofar as the 1856 Act failed to stipulate any method by which the alteration of the ‘objects clause’ could be achieved, the status of the clause and its effect on contractual capacity was unclear. The position in this regard was not finally settled until 1875 when the House of Lords decided the celebrated case of Ashbury Railway Carriage & Iron co. v Riche. The House of Lords held that a contract that was ultra vires the company’s objects was altogether void. Lord Cairns L.C. after stating that the subscribers “ are to state the objects for which the proposed company is to be established, and the existence, the coming in to existence of the company is to be for those objects and for those objects alone” and after referring to the words at the end of section 12 (re-enacted in an amended form in section 4 of the act of 1948) said that “no alteration shall be made by any company in the conditions contained in its Memorandum of Association.

THE HARMFUL EFFECTS OF THE ULTRA VIRES RULE AND THE NEED FOR REFORM.

In the practical working of the companies, the ultra vires rule creates difficulties both for the management as also for persons dealing with the company. The critics have even gone to the extent of stating that in the Ashbury Railway Carriage Company case, the court got obsessed with the question of protection of the property of the shareholders. There were two things that the court should have taken into consideration .One was of course the protection of the shareholder’s property, but the other was of social obligationof the company or social safeguards of third parties in respect of dealings and transactions with the company. Shareholders, when they invest in shares of a company ask for one protection, namely, limited liability. This limitation of further liability is the basic part of the bargain and that is the only protection which the statute had given them. It does not seem correct that in addition to the rights and protection of limited liability, a further protection should have been given to the shareholders at the cost of the rest of the society.

Ultra Vires doctrine was first borne in England

It appears that in choosing between the protection of property of the shareholders and the social commitments and obligations of a person, the house of lords failed to take adequate note of the more important consideration, and laid down the foundation of a doctrine that has since then impeded business and commerce through companies, and have in any event been an illusory safeguard to shareholders

However, while considering the question of the reform of the ultra vires rule on the above counts, one has to also consider some other equally important aspects; such as the fact that the liberal interpretation of the objects clause works both ways : to increase the scope for the company’s operations as well as to bring a transaction with a third party within the vires of the company. Moreover, in actual practice the courts have even allowed relief to the third parties in many cases keeping the ends of justice in mind. Exceptions to the ultra vires rule have been carved out to protect third party claims. Inspite of these factors that may appear to mitigate the harshness of the ultra vires rule the fact remains that this doctrine has often enough perpetrated injustice upon innocent third parties.

If at all relief to third parties has been allowed, then it has been only in those cases where a part of the contract has been performed. On the other hand, in the case of executory contracts, there is no remedy available to the third parties for the realisation of their legitimate expectations. Moreover, even where the contract is executed (the promise by only one party having been performed) the law relating to the grant of relief to the third party is complex and lacking in principle. The courts have dealt with situations adhoc, according to the kind of contract involved, and the mere fact that one party has fulfilled his promises under an ultra vires contract does not in itself entitle him to sue the other party for non-fulfilment of his obligations.

DOCTRINE OF ULTRAVIRES IN INDIA

The doctrine of ultravires was first recognised in India in 1866 in Jahangir R. Modi v Shamji Ladha, and since then this rule has been applied and acted upon in a number of decisions. The doctrine was affirmed by the Supreme Court in A.Lakshamana Swami Mudaliar v Insurance Corporation of India.

In 1952 the Company Law Committee had the occasion to consider the ultra vires rule in relation to the objects clause of the company and specially it considered whether any distinction could be made between the main and the subsidiary objects of the company. After due deliberations, the committee concluded that they were not in a position to suggest realistic measures by which any distinction could be drawn between the main and the subsidiary objects. They therefore left the matter to the responsible judgment of the management and the periodical vigilance of the shareholders. It was only in the year 1965 with the enactment of Companies Amendment Act, 1965 that the distinction between the main objects and the subsidiary objects of the company came to light. The act was passed on the basis of the recommendations made by the Vivian Bose Commission. As a result of the recommendations, the Indian Companies Act was amended in 1965. The amended section 13 provides that in the case of a company in existence immediately before the commencement of the Company’s Amendment Act 1965, its memorandum must state its objects [clause (c)] and in the case of a company formed after such commencement its memorandum must state [vide clause (d)];

The rule keeps the company confined to set objections

The main objects of the company to be pursued by the company on its incorporation and objects incidental or ancillary to the attainment of the main objects, and

• Other objects of the company neither included in the main objects nor included in the ancillary objects The purpose of this amendment is to enable shareholders and others interested, to have a clear idea of the main objects and the other objects. Moreover, in the case of an existing company that is existing prior to the Amendment Act, if any new business not germane to the business which it is already carrying on, is to be started, the provisions of section 149(2-A) clause (a) read with subsection (2-B) should becomplied with, and in the case of a company formed after the amendment Act, if any business coming under the ‘other objects’ clause (d) is to be started, again the provisions of the said section 149(2-A) read with subsection 2B of that section should be complied with.

The idea behind a provision such as section 149 (2) was to limit management ‘s freedom in changing at will the objects to be actually pursued by the company. This, in the case of the companies coming in to existence after the 1965 Amendment was achieved by categorizing all the objects stated in the memorandum into the main and the other objects. While the main objects were to be the objects that the company would actually pursue on its incorporation any additional objects were to be stated separately as ‘other objects’. Any shift or expansion in the company’s activities to include any of the ‘other objects’ would by virtue of the section 149(2) necessitate the general assembly’s approval. Thus while keeping the shareholders aware of where their funds were in fact being deployed, this provision would also give them a say in any change in the company’s activities. However, the 1965 amendment was found to be failing in the achievement of its purpose due to reasons that were not far to seek. While section 13 after the amendment, provided for the classification of the objects into different categories, yet it did not make any stipulation as to the number of objects that could be included in the main objects clause, nor did the act provide for rules of construction for such objects clause, and thus it was still left open to the management to have a number of sub clauses in the main object clause. In fact, in one case, it was found that as many as 106 sub clauses had been included in the main objects clause itself. This dismal scenario continued for long, even after the 1965 amendment, until the department of company affairs finally issued instructions to the registrars of companies to put an end to such practice.

Hence, in practice, now the ROCs usually insist upon having only one object in the main objects clause with this object being reflected in the company’s name as far as possible. For a diversified company, stating of different objects is allowed, provided those objects are not completely unrelated and are intended to be pursued by the company immediately after incorporation or within a reasonable time from the date of incorporation

On the whole now it would be difficult for the management to pursue any object outside of main objects clause without letting the shareholders be in the know of it. This would also go a long way in preventing the shareholders from being befooled by unscrupulous management. The combined result of the 1965 amendment and the actual practice of the ROCs pursuant to the department’s instructions has been to disallow a company from drifting away from its main objects unless it is with the approval of the shareholders. Thus in its this aspect of keeping the company confined to set objectives, the doctrine in India has been made more effective

 

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