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Corporate Liability to Third Parties: Where We Were and Where We Are

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About The Author

Konstantina Michalopoulou (Guest Contributor)

Konstantina is a law graduate from Sussex University. After completing her LLB, she has worked as a legal trainee in a Greek civil law firm and as a legal secretary in a company related to International Business Affairs. Outside the law, Konstantina works as a volunteer with autistic children in her hometown of Kastoria, Greece.

Corporate executives and business owners need to realize that there can be no compromise when it comes to ethics.

Vivek Wadhwa

Once a company is incorporated, it acquires a separate legal personality and becomes a separate entity that is distinct from its shareholders and directors. Thus, it is the company itself which conducts business, owns property, incurs debts and enters into contracts.

As a result, any contract entered into by a third party concerning the company’s operations are entered into with the company itself, rather than with the directors or share-holders. This has triggered a crucial question as to who actually bears the risk of such contracts. In light of this, this article seeks to examine how the Companies Act 2006 (CA 2006) – English law’s primary and most recent legislation in this area – has changed the law governing third party transactions with companies.

The Law Prior to the Companies Act 2006

The Ultra Vires Doctrine

Before the CA 2006 reformed this area of the law, the common law doctrine of ultra vires was used as a regulatory device to prevent a registered company from entering into transactions that exceeded the scope of its contractual capacity.

A company’s contractual capacity would be delineated by the company’s object clause, contained within its Memorandum of Association. The importance of the objects clause was firmly established in Ashbury Railway Carriage and Iron Company v Richie [1875] LR 7 HL 653: here, a company’s object clause stated its objects were to ‘make and sell, or lend on hire, railway-carriages’ but it subsequently entered into a contract to finance the construction of a railway line in Belgium. The company later attempted to repudiate the contract – and thus avoid a claim for breach of contract – by claiming it had been made ultra vires. The House of Lords agreed, holding that every act outside a company’s objects clause was ultra vires, rendering it null and void.

The rationale for the ultra vires doctrine was to provide shareholders and the creditors of the company with protection. They could invest in the company knowing with almost absolute clarity the range of activities that it was able to carry out. However, the extent to which this rationale held true was questionable: the ultra vires doctrine was also increasingly being circumvented, as lawyers employed shrewd ingenuity to draft broad objects clauses that allowed companies to argue that any and every activity they pursued was permitted. This created a situation where companies could hide their true objects from the shareholders and creditors, thus undermining the rationale for the doctrine.

Furthermore, for third parties entering into contracts with companies in good faith, the ultra vires doctrine could have disastrous effects. Despite acting legitimately, they would be left unprotected when a transaction was not within the capacity of the company: the company would not be bound and the third party could not enforce the transaction. Indeed, as Paul Omar observes, it enabled companies to evade the consequences of unprofitable bargains.

The Doctrine of Constructive Notice

The effects of the ultra vires doctrine were worsened when it was combined with the doctrine of constructive notice. Established in the case of Ernest v Nicholls [1857] 6 HLC 401, the doctrine of constructive notice created a presumption that third parties had knowledge of the contents of the company's public documents. Therefore, as a company’s public documents includes its Memorandum of Association, third parties were deemed to know when transactions were beyond the company's objects clause, such that they could not enforce them.

However, there was some mitigation of the constructive notice rule. In Royal British Bank v Turquand [1856] 6 E&B 327, the ‘indoor management rule’ was developed: it held that a third party could assume that any necessary procedures required to enter contracts that were ‘a matter of internal management’ had been correctly carried out, unless the third party is given some reason to believe there has been a failure to adhere the procedures.

Furthermore, the decision in Rolled Steel Products (Holdings) Ltd v British Steel Corp [1986] Ch 246 lessened the effects of the doctrine of ultra vires. Here, a company’s object clause gave it capacity to give guarantees. A director – in breach of their duties as a director – entered into a guarantee to benefit themselves rather than the company, which the company tried to avoid. However, the Court of Appeal concluded that the guarantee was made within the company’s capacity: for an act to be ultra vires, even if it is done with an improper purpose, the act must be wholly outside the company’s objects clause.

Today, the harshness of the two doctrines to third parties has been fully alleviated thanks to their abolition. Constructive notice was abolished by Section 35B of the Companies Act 1985 (CA 1985), as inserted by the Companies Act 1989: third parties are no longer deemed to know anything in relation to company’s documents and capacity. Meanwhile, following multiple recommendations for abolition and statutory amendments from a range of academics and bodies, the doctrine of ultra vires was (ironically) rendered null and void by the changes adopted under the CA 2006.

The Companies Act 2006

The CA 2006 is the primary source of company law in the UK. Providing a comprehensive code that saw an overhaul of almost every aspect of company law, the CA 2006 was adopted with the aim of making the regulation of companies more flexible and adaptable in the present-day circumstances. At the time of its introduction, its 1,300 sections and 700 pages made it the longest Act of Parliament in history.

The Impact on Objects Clauses

Section 31 of the CA 2006 removed the requirement for new companies to state their objects and confirmed that – unless a company’s articles specifically restrict the objects of the company – a company’s objects are now unrestricted. Therefore, companies without specific restrictions have unrestricted capacity that means the doctrine of ultra vires is no longer applicable.

For pre-existing companies incorporated under the CA 1985 or its predecessors – which were required to have objects clauses in their Memorandum of Association – the CA 2006 sets out two alternate options. Firstly, because Section 28 of the CA 2006 deems the Memorandum of Associations of old companies to be part of the company’s Articles of Association, the company may remove their objects clause by amending their Articles of Associations under Section 21 of the CA 2006. This would leave them in the same position as companies formed under the CA 2006.

The second option is to retain the objects clause under Section 31 of the CA 2006 and treat it as a specific restriction. At first sight, this would suggest that companies that elect to do so could still rely on the ultra vires doctrine when a transaction breaches their objects clause. However, this is no longer the case: Section 39(1) of the CA 2006 has removed that option by stating for companies that are not charities:

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.

The removal of the doctrine of ultra vires has a myriad of benefit. For one thing, in light of the increasingly common practice of drafting very broad objects clauses, the CA 2006 arguably represents an acceptance of the doctrine’s emasculation, and its failure to uphold its primary rationale – the protection of shareholders and creditors.

It might also be noted that the removal of the doctrine benefits companies themselves by removing the costs associated with diversification: when companies were required to have objects clauses under the old law, legitimate diversification required the incorporation and running of a separate company in a way that discouraged the pursuing of business that is less risky and more profitable. The enactment of Section 39 of the CA 2006, therefore, allows for companies to operate more flexibly in the commercial world in a way which arguably aids survival.

Furthermore, it enhances a third party’s position: companies cannot rely on arguments that a transaction is outside its objects clause and thus not binding on them anymore. The certainty this provides can be taken to benefit companies too: it incentives third parties to contract with more companies by removing the risk that incapacity might be pleaded.

The Introduction of ‘Good Faith’

Section 40 of the CA 2006 restates the protection that was provided under Section 35A of the CA 1985 for third parties dealing with companies ‘in good faith’. It holds that where a person is dealing – defined as where a person is ‘a party to any transaction or other act to which the company is a party’ – in good faith with a company:

[T]he power of the directors to bind the company, or authorise others to do so, is deemed to be free of any limitation under the company's constitution.

This create a more secure position for the third parties by giving them the ability to enforce contracts entered into by directors without authority: it quashes any required knowledge of constitutional limitations on directors’ authority that could allow the company to avoid transactions. The section also removes the burden on the third party to inquire as to the existence of such limitations on the company in a way that allows third parties to be more efficient and avoid paying costs to analyse company constitutions. Indeed, under Section 40(2)(b)(i) of the CA 2006, the person dealing in good faith is not bound to enquire as to any limitation on the powers of the directors to bind the company or authorise others to do so.

The extent of the protection is bolstered by presumptions that persons are acting in good faith. Section 40(2)(b)(ii) of the CA 2006 holds that a person is ‘presumed to have acted in good faith unless the contrary is proved’ while Section 40(2)(b)(iii) of CA 2006 establishes that a person cannot act in bad faith even if they know ‘that an act is beyond the powers of the directors defined under the company’s constitution’.

Importantly, in EIC Services Ltd v Phipps [2004], it was confirmed that the definition of a ‘person dealing with a company in good faith’ does not include the company’s shareholders. By contrast, in Smith v Henniker-Major & Co [2002], the Court of Appeal accepted that it does include a director of a company, so long as they are not themselves responsible for the error that meant there was a lack of authority.

By allowing third parties to enforce contracts entered into by directors without authority, it is clear that Section 40 of the CA 2006 is of vital importance to third parties. Thus, for the CA 2006 to provide third parties with maximum protection, Section 40 of the CA 2006 would need to be absolute. However, this is not necessarily the case. Section 40(2)(b)(ii) of the CA 2006 clearly sets out a presumption that the person is dealing with the company in ‘good faith’. It therefore follows that, in certain circumstances, it is possible that the presumption could be rebutted.

This occurred in Wrexham Association Football Club Ltd v Crucialmove Ltd [2006]. Here, the managing director and the company secretary executed a Declaration of Trust on behalf of a company that the freehold of the football ground was held on trust for the third party. However, at the time of making this declaration, it had not been disclosed that the managing director and the third party had entered into a joint venture agreement for the redevelopment of the ground in a way that benefited their personal interests.

Clearly, the third party was aware of the conflict between the interests of the director and the company. It knew that the director had entered into the transaction for an improper purpose and in breach of his fiduciary duty to the company; the third party was therefore bound to inquire whether the transaction had been authorised or ratified by the company and its board. The Court of Appeal concluded that the third party’s failure to inquire despite being on notice meant the presumption under Section 40(2)(b)(ii) of the CA 2006 was rebutted, and the third party had forfeited the right to rely on the statutory protection.

This case is a useful illustration of the limits of the presumption of good faith under Section 40(2)(b)(ii) of the CA 2006. It shows that, while the section’s aim is to reduce the burden of third parties to acquire knowledge of a company’s constitutional limitations on the powers of the directors, this does not mean that the section completely absolves third parties from their duty to inquire when the circumstances may require it. Indeed, it is clear from the decision in Wrexham Association Football Club Ltd v Crucialmove Ltd [2006] that the CA 2006’s failure to provide third parties with full protection is for fully legitimate and justified reasons.

However, it might be argued that Section 40 of the CA 2006 is overprotective of third parties: certainly, as the facts of Wrexham Association Football Club Ltd v Crucialmove Ltd [2006] show, it takes an obvious conflict for a third party to be held in bad faith, to the extent that active dishonesty may be required. Indeed, as Lord Wedderburn observed:

[T]hese sections always take the part of the third party even when he isn’t a nice chap; when he knows everything and has grabbed an opportunity.

Conclusion

It seems clear that the provisions of CA 2006 represented an improvement in the extent of protection for third parties dealing with companies, rendering transactions void only when the third parties themselves acted in a dishonest way. For companies too, it arguably allowed them to transact more flexibly and diversify more easily in that it legitimately sets the dealings void when third parties are acting in a dishonest way. Ultimately, it is argued that – for third party transactions at least – the CA 2006 achieved what its predecessors had not.

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Tagged: Company Law, Trusts

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