The Companies Act, 2013 — Practice

Question 1

State the characteristics of a company and explain how each follows from separate legal personality.

Accepted Answer

The foundation. On registration under the Companies Act, 2013 a company becomes a person in law, distinct from the members who compose it. This was established in Salomon v Salomon and Co Ltd, where a trader who incorporated his business and took debentures over its assets was held entitled to rank as a secured creditor ahead of the company's unsecured creditors, although he held all but six of the shares. The company was neither his agent nor his trustee; it was a different person.

The characteristics, each a consequence of that.

Separate legal entity. The company can hold property, enter into contracts, and sue and be sued in its own name. This is simply what being a person in law means.

Separate property. Because the company is a distinct person, its assets are its own and not the members'. A member has no insurable interest in the company's property even if he holds virtually all the shares — which is a direct application of Salomon's reasoning.

Limited liability. Since the company's debts are the company's own, members are not liable for them. Their liability is confined to the amount unpaid on their shares, or in a company limited by guarantee to the amount undertaken to be contributed on winding up.

Perpetual succession. The company's existence does not depend on the identity of its members, so death, insolvency or transfer of shares does not affect it. Members may come and go; the company continues until wound up according to law.

Capacity to sue and be sued in its own name, which again is an incident of legal personality.

Transferability of shares. Membership is an interest in the company rather than in its assets, so it can be dealt with independently. Shares of a public company are freely transferable; a private company restricts transfer by its articles.

Common seal. Historically the artificial person's signature, since a company cannot physically sign. It is now optional, and where a company has none, documents may be signed by two directors or by a director and the company secretary.

Artificial person but not a citizen. The company is a juristic person created by law and has no citizenship, so it cannot claim fundamental rights conferred only on citizens, though it may claim those available to all persons.

Question 2

Explain the doctrine of lifting the corporate veil, giving the statutory and judicial grounds. Advise whether the veil should be lifted where a person bound by a covenant not to compete forms a company to carry on the competing business.

Accepted Answer

The doctrine. The general rule is that a company is a person distinct from its members, and the courts will not go behind that separateness. Where, however, the corporate form is used to defeat the law or to perpetrate a wrong, the law disregards the separate personality and treats the company and those behind it as one. This is called lifting or piercing the corporate veil.

Statutory grounds under the Act include liability for a misstatement in a prospectus, where those responsible must compensate persons who subscribed on its faith; failure to return application money where the minimum subscription is not received; misdescription of the company's name, where an officer signing a bill of exchange, promissory note, cheque or order for goods without the company's name properly stated is personally liable; fraudulent conduct of business in the course of winding up, where persons knowingly party to it may be made personally responsible without limit; liability for ultra vires acts; and the furnishing of false statements in returns or reports.

Judicial grounds include the company being a mere cloak or sham formed to evade an existing obligation; fraud or improper conduct; determination of enemy character in wartime, where the nationality of the controllers is examined; evasion of tax or of a statutory obligation; the company acting in substance as the agent of its members; protection of public interest or public policy; and the avoidance of welfare legislation.

The unifying principle is that separate personality is a privilege conferred for legitimate commercial purposes, and it is withdrawn where the form is used as an instrument of evasion.

Application.

A person bound by a covenant not to compete has an existing legal obligation. By forming a company to carry on the very business he has undertaken not to carry on, he seeks to achieve through a separate person what he may not lawfully do himself.

This is the paradigm case of the company as a mere cloak or sham. The company has no independent commercial purpose; it exists solely to enable the evasion of the covenant, and its business is in substance the covenantor's business.

The court will lift the veil. The company will be treated as the covenantor himself, and an injunction will be granted against both the individual and the company restraining the competing business. It is no answer that the company is technically a distinct person, because the very reason for its formation was to exploit that distinctness against the covenantee.

Conclusion. The veil should be lifted. The doctrine of separate personality is not available to a person whose object in invoking it is to escape an obligation he has already undertaken.

Question 3

Distinguish a private company from a public company, and explain the special features of a One Person Company and a section 8 company.

Accepted Answer

Private company. A company which by its articles restricts the right to transfer its shares; limits the number of its members to two hundred, excluding present and former employees who are or were members and counting joint holders as one member; and prohibits any invitation to the public to subscribe for any securities of the company.

Public company. A company which is not a private company, and includes a private company which is a subsidiary of a company that is not a private company.

The distinctions.

Minimum members: two for a private company, seven for a public company. Maximum members: two hundred for a private company, no limit for a public company.

Minimum directors: two for a private company, three for a public company.

Transfer of shares: restricted by the articles in a private company; freely transferable in a public company.

Invitation to the public: prohibited for a private company; permitted for a public company, subject to the provisions on prospectuses and public offers.

Name: must end with the words 'Private Limited' for a private company and 'Limited' for a public company.

Exemptions: private companies enjoy a number of exemptions and relaxations from provisions relating to meetings, related party transactions and managerial appointments that apply in full to public companies.

One Person Company.

A company which has only one person as a member. Only a natural person who is an Indian citizen may incorporate an OPC or be a nominee in one, and a person may form only one OPC at a time.

The memorandum must contain a nomination clause naming, with that person's prior written consent, the individual who shall become the member of the company in the event of the subscriber's death or incapacity to contract. The nominee may withdraw consent, and the member may change the nomination.

An OPC is treated as a private company for the purposes of the Act, with substantial procedural relaxations — it need not hold an annual general meeting, and where there is only one director, a resolution entered in the minutes book and signed by him suffices.

An OPC cannot be incorporated as or converted into a section 8 company, and cannot carry on non-banking financial investment activities including investment in the securities of any body corporate.

Section 8 company.

A company formed with the object of promoting commerce, art, science, sports, education, research, social welfare, religion, charity, protection of the environment or any such other object, which intends to apply its profits or other income only in promoting those objects and prohibits the payment of any dividend to its members.

It is licensed by the Central Government and may be registered as a limited company without adding 'Limited' or 'Private Limited' to its name. It enjoys certain exemptions and concessions in return for accepting those restrictions.

The licence may be revoked where the company contravenes the conditions, and on revocation the Central Government may direct that the company be wound up or amalgamated with another section 8 company.

Question 4

State the clauses required in the memorandum of association and explain the function of each. What additional clause is required for a One Person Company?

Accepted Answer

The memorandum is the charter of the company. It defines the company's relationship with the outside world and the scope of its powers, and section 4 requires it to state the following.

Name clause. The name of the company, with the last word 'Limited' for a public limited company and the last words 'Private Limited' for a private limited company, subject to exemption for a section 8 company. The name must not be identical to or too nearly resemble the name of an existing company, must not be undesirable in the opinion of the Central Government, and must not contain words suggesting connection with government or with any state without approval. Its function is to identify the company as a distinct legal person and to warn those dealing with it that liability is limited.

Registered office clause. The State in which the registered office of the company is to be situated. Its function is to fix the jurisdiction of the Registrar and of the courts, and to establish the address at which communications and notices may be served on the company.

Object clause. The objects for which the company is proposed to be incorporated, and any matter considered necessary in furtherance thereof. Its function is to define the company's capacity — the limits within which it may act. Under the 2013 Act the earlier division into main objects, objects ancillary to the main objects, and other objects has been dispensed with. This clause is the source of the doctrine of ultra vires.

Liability clause. Whether the liability of the members is limited or unlimited, and if limited, whether limited by shares or by guarantee. Where limited by guarantee, the amount up to which each member undertakes to contribute to the assets in the event of winding up. Its function is to inform members and creditors of the extent of members' exposure.

Capital clause. The amount of authorised share capital with which the company is to be registered and its division into shares of a fixed amount, together with the number of shares each subscriber agrees to take. Its function is to fix the ceiling on the capital the company may raise, and to record the subscribers' initial commitment. An unlimited company having share capital states the amount differently, and a company without share capital omits this clause.

Subscription or association clause. The declaration by the subscribers that they wish to be formed into a company and agree to take the number of shares stated opposite their respective names. This is what actually brings the company into being on registration.

Additional clause for a One Person Company.

The memorandum of an OPC must contain the name of the person who, in the event of the subscriber's death or incapacity to contract, shall become the member of the company. The nomination requires the prior written consent of the person nominated, which must be filed with the Registrar at the time of incorporation.

The purpose is continuity. Because the company has a single member, its membership would otherwise be in doubt on that person's death, and the nomination ensures that perpetual succession operates in practice as well as in theory.

Question 5

Explain the doctrine of ultra vires and its consequences. Distinguish acts ultra vires the company, ultra vires the directors and ultra vires the articles, stating whether each can be cured.

Accepted Answer

The doctrine. A company is created by registration and its capacity is defined by the object clause of its memorandum. An act beyond those objects is ultra vires the company — beyond its powers — and is void from the outset.

The justification is that a company is an artificial person whose existence and capacity derive entirely from its constitution. It has no general capacity to contract in the way a natural person does; it has only the capacity the memorandum confers. An act outside that capacity is therefore not merely unauthorised but impossible, and there is nothing for the law to enforce.

Consequences of an ultra vires act.

The act is void and cannot be ratified, even by the unanimous consent of all the members. This is the point most often tested. Members cannot confer on the company a capacity that the constitution withholds; to do that, the memorandum itself must be altered in the manner the Act prescribes.

Neither the company nor the other party can sue on an ultra vires contract. The company cannot enforce it, and the other party cannot enforce it against the company.

The directors who authorised the act are personally liable to the company for any loss, because they exceeded the powers entrusted to them.

Property acquired under an ultra vires transaction belongs to the company and its title is protected; the company may recover and protect it.

Money lent under an ultra vires borrowing is not recoverable as a debt, but the lender may trace the money if it remains identifiable, and may be subrogated to the rights of creditors whose lawful debts were paid with it.

The three levels.

Ultra vires the company. Beyond the objects in the memorandum. The act is void and incurable by ratification. Only an alteration of the memorandum, effected in the prescribed manner, can enable the company to do such acts in future — and even then the alteration operates prospectively and does not validate what was already done.

Ultra vires the directors but intra vires the company. The act is within the company's objects but beyond the authority the directors were given. It is not void. The members may ratify it, ordinarily by resolution in general meeting, and on ratification the company is bound.

Ultra vires the articles but intra vires the memorandum. The act is within the company's objects but contrary to a provision of the articles. This is curable, because the articles may be altered by special resolution, and the alteration may be made so as to regularise the position.

The hierarchy reflects the standing of the documents. The memorandum defines capacity and is dominant; the articles regulate internal management and are subordinate; and the directors' authority is a delegation from the members, who may therefore approve what they could have authorised in the first place.

Question 6

Distinguish the memorandum of association from the articles of association, and explain the effect of section 10 on the relationship between a company and its members.

Accepted Answer

Purpose and scope. The memorandum is the charter of the company. It defines the company's constitution, its relationship with the outside world and the scope of its powers. The articles contain the regulations for the internal management of the company — the rules governing shares, calls, transfer, meetings, directors, dividends and accounts.

Status. The memorandum is the dominant document and the articles are subordinate to it. Any provision of the articles inconsistent with the memorandum is void to the extent of the inconsistency.

Contents. The memorandum must contain the six clauses prescribed by section 4 — name, registered office, objects, liability, capital and subscription — and for a One Person Company, the nomination clause. The articles may contain whatever regulations the company chooses, subject to the Act and to the memorandum.

Alteration. The memorandum can be altered only in the manner specified for each clause, and some alterations require the approval of the Tribunal or of the Central Government. The articles may be altered by a special resolution, subject to the Act and to the conditions in the memorandum. The articles are therefore far more readily changed.

Compulsory nature. Every company must have a memorandum. A company may adopt the model articles in the relevant Table of Schedule I rather than registering articles of its own, and if it registers none, the applicable Table applies.

Relation to ultra vires. An act beyond the memorandum is void and cannot be ratified. An act beyond the articles but within the memorandum can be ratified or regularised by altering the articles.

The effect of section 10.

Section 10 provides that, subject to the provisions of the Act, the memorandum and articles, when registered, shall bind the company and the members thereof to the same extent as if they respectively had been signed by the company and by each member, and contained covenants on the part of the company and each member to observe all the provisions of the memorandum and of the articles.

The practical effect is that the two documents constitute a statutory contract, and it operates in three directions.

The company is bound to its members in their capacity as members. A member may enforce against the company a right conferred on him as a member, such as a right to receive a declared dividend or to vote.

Each member is bound to the company. The company may enforce the provisions against a member, for example to recover calls or to enforce a lien on shares.

Members are bound to one another in their capacity as members, which is the basis on which provisions such as pre-emption rights over share transfers are enforced between shareholders.

What section 10 does not do is equally important. The documents do not constitute a contract between the company and an outsider, so a third party cannot enforce a provision of the articles as a contract. Nor can a member enforce a right conferred on him in a capacity other than that of member — a person named in the articles as the company's solicitor cannot sue on that provision, because the right is conferred on him as a solicitor and not as a member. Section 10 also provides that all monies payable by any member to the company under the memorandum or articles shall be a debt due from him to the company.

Question 7

Explain the doctrines of constructive notice and indoor management, their relationship, and the exceptions to indoor management. Advise a lender who advanced ₹50,00,000 to a company on a board resolution that was in fact never validly passed, the articles permitting borrowing on such a resolution.

Accepted Answer

Constructive notice. The memorandum and articles of a company are public documents, registered with the Registrar of Companies and open to inspection by any person. Every person dealing with the company is therefore deemed to have read those documents and to have understood their contents properly, whether or not he has in fact done so.

The consequence is that a person who deals with the company in a manner inconsistent with its public documents cannot complain. If the articles limit borrowing to a stated amount, a lender advancing more is deemed to know of the limit and cannot enforce the excess.

The doctrine protects the company against outsiders.

The doctrine of indoor management. Constructive notice alone would make dealing with a company impossibly hazardous. An outsider can inspect the public documents, but he has no means whatever of ascertaining whether the company's internal procedures have actually been complied with — whether a meeting was properly convened, a quorum present, or a resolution validly passed.

The rule in Royal British Bank v Turquand answers this. A person dealing with the company in good faith is entitled to assume that the internal proceedings of the company have been regularly carried out. He must read the public documents; he need not, and cannot, inquire into the indoor management.

The doctrine protects outsiders against the company.

The relationship between the two. They are complementary rather than contradictory, and together they draw a line at the door of the registered office. What is on the public file is the outsider's responsibility, because he can inspect it. What happens inside the company is the company's responsibility, because only it can know. Constructive notice tells the outsider what he must check; indoor management tells him what he need not.

Exceptions to indoor management.

Knowledge of the irregularity. A person who actually knows that the internal procedure was not complied with cannot rely on the doctrine, since it protects only those misled.

Suspicion of irregularity. Where the circumstances surrounding the transaction are suspicious and would put a reasonable person on inquiry, a failure to inquire forfeits the protection.

Forgery. A forged document is a nullity and the company is not bound at all. The doctrine assumes a genuine act irregularly performed; it cannot convert a forgery into an act of the company.

Acts outside apparent authority. Where an officer purports to act beyond the authority his position would ordinarily carry, the outsider cannot assume an authority he had no basis to expect.

No knowledge of the articles. A person who has not read the articles and did not rely on them cannot claim a protection derived from what they permitted.

Acts void ab initio, such as acts ultra vires the company, which no assumption of regularity can validate.

Application.

The articles permitted the directors to borrow on the passing of a board resolution. That is a public document, and the lender is deemed to have read it. Having done so, he was entitled to see that the company had power to borrow in this manner.

Whether the resolution was in fact validly passed is a matter of the company's internal management. The lender had no means of verifying it, and the rule in Turquand's case entitles him to assume that it was.

Provided the lender acted in good faith, had no knowledge of the irregularity, was not put on inquiry by suspicious circumstances, and the document was not forged, he may rely on the doctrine.

Conclusion. The company is bound and the lender may recover the ₹50,00,000. The company's remedy lies against the directors who purported to act on a resolution that had not been passed.

The answer would differ if, for example, the articles had capped borrowing below ₹50,00,000, in which case constructive notice would fix the lender with knowledge of the cap and the doctrine of indoor management would not assist him.

Question 8

Who is a promoter under the Companies Act, 2013? State the duties of a promoter and explain the position of pre-incorporation contracts, including how a company may obtain the benefit of one.

Accepted Answer

Definition. Section 2(69) defines a promoter as a person who has been named as such in a prospectus or is identified by the company in the annual return; or who has control over the affairs of the company, directly or indirectly, whether as a shareholder, director or otherwise; or in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act.

The definition expressly excludes a person acting merely in a professional capacity. A solicitor who drafts the memorandum, an accountant who prepares projections and a banker who arranges finance are not promoters by reason of that work alone.

The promoter is the person who conceives the idea of forming the company, takes the necessary steps to incorporate it, arranges its capital, procures its first directors and brings it into existence.

Duties of a promoter.

A promoter stands in a fiduciary relationship with the company he is forming. He is not an agent of the company, because the company does not yet exist and can have no agent; nor is he a trustee, since there is no trust property. The fiduciary obligation is imposed by law because of the position of influence he occupies over an entity that cannot yet protect itself.

The duties are: not to make any secret profit at the expense of the company; to disclose fully any interest he has in a transaction with the company, disclosure being made to an independent board or to the members; to account to the company for any profit made where disclosure has not been given; to make full disclosure of all material facts relating to the formation; and to act in good faith in the company's interest.

Where a promoter sells his own property to the company without disclosure, the company may rescind the sale and recover the price, or affirm the sale and recover the undisclosed profit, or claim damages for breach of fiduciary duty.

Pre-incorporation contracts.

These are contracts entered into by promoters on behalf of the company before it is incorporated, typically for premises, equipment or professional services needed to commence business immediately on registration.

The company cannot ratify such a contract. Ratification requires that the act was done on behalf of a principal who was in existence and competent at the time of the act, and that ratification relate back to that date. A company that had not been incorporated did not exist, could have no agent, and cannot retrospectively adopt an act done when it had no legal existence.

It follows that the company is not bound by the contract and cannot enforce it merely by adopting it, and the promoter who made the contract is personally liable on it.

How the company may obtain the benefit.

By entering into a fresh contract after incorporation on the same terms. This is a novation: it creates a new obligation from the date of the new agreement rather than retrospectively, and it requires the consent of the other party. The promoter is released only if the other party agrees to accept the company in his place.

Under the Specific Relief Act, 1963, where the contract was entered into by the promoters for the purposes of the company and is warranted by the terms of its incorporation, and the company has accepted the contract and communicated that acceptance to the other party, the contract may be enforced by or against the company. This provision is the practical route by which pre-incorporation contracts are given effect in India, and it should be stated in any complete answer.

Promoters commonly protect themselves by providing in the contract that their personal liability ceases on the company adopting the contract after incorporation, and by ensuring the company's objects are drawn widely enough for the contract to be warranted by the terms of incorporation.

Question 9

Distinguish a company limited by shares from a company limited by guarantee, and explain the circumstances in which the guarantee form is used.

Accepted Answer

Company limited by shares. A company having the liability of its members limited by the memorandum to the amount, if any, unpaid on the shares respectively held by them.

The member's obligation is to pay the issue price of his shares. Once the shares are fully paid he owes nothing further, and no call can be made on him whether the company is a going concern or in liquidation. If shares are partly paid, the unpaid amount may be called up during the company's life by the directors, and on winding up by the liquidator.

Company limited by guarantee. A company having the liability of its members limited by the memorandum to such amount as the members may respectively undertake to contribute to the assets of the company in the event of its being wound up.

The member's obligation is contingent and arises only on winding up. Nothing is payable while the company is a going concern, however much it may need funds. The memorandum states the amount each member undertakes to contribute, and that amount is called only if the company is wound up and its assets are insufficient to meet its liabilities.

A company limited by guarantee may or may not have share capital. Where it has share capital, members have a dual obligation: to pay for their shares in the ordinary way, and to contribute the guaranteed amount on winding up.

The distinctions in summary. Liability arises during the company's life in the share form and only on winding up in the guarantee form. The amount is measured by the unpaid share price in one case and by the sum undertaken in the memorandum in the other. Working capital comes from members in the share form and must come from elsewhere in the guarantee form.

When the guarantee form is used.

It suits bodies that do not need capital contributions from their members but do need the protection of limited liability and a fund available to creditors on dissolution. Clubs, trade and professional associations, chambers of commerce, research bodies, educational institutions and charitable organisations are the standard cases.

Such organisations are funded by subscriptions, fees, grants or donations rather than by share capital, and members join for participation rather than investment. The guarantee gives creditors a contingent fund without requiring members to invest, and it avoids the awkwardness of members holding transferable shares in an organisation that is not run for profit.

Many section 8 companies, formed to promote charity, education, art, science or similar objects and prohibited from paying dividends, are constituted as companies limited by guarantee for exactly these reasons.

Question 10

A company's memorandum states its objects as manufacturing textiles. The directors, with the approval of all shareholders at a general meeting, invest ₹2,00,00,000 in a real estate venture, which fails. Advise on the validity of the transaction, the position of the shareholders' approval, and the liability of the directors.

Accepted Answer

Provision. A company's capacity is defined by the object clause of its memorandum. An act beyond those objects is ultra vires the company and is void from the outset. The doctrine rests on the fact that a company is an artificial person whose existence and powers derive entirely from its constitution: it has only the capacity the memorandum confers, and an act outside that capacity is not merely unauthorised but beyond the company's power to perform.

Application — validity of the transaction.

The stated object is manufacturing textiles. Investing in a real estate venture is not that object, nor is it a matter reasonably necessary in furtherance of it — real estate investment is a distinct commercial activity, not an incident of textile manufacture.

The transaction is therefore ultra vires the company and void. The company cannot enforce it, and the other party cannot enforce it against the company. No rights arise on either side under the contract itself.

The position of the shareholders' approval.

This is the point the question is testing, and the answer is that the approval is ineffective. An ultra vires act cannot be ratified even by the unanimous consent of all the members.

The reason is that the memorandum defines the company's capacity, and members acting in general meeting cannot confer on the company a capacity that its constitution withholds. Ratification presupposes that the act was one the ratifying body could have authorised in advance, and here no organ of the company could have authorised it, because the company itself lacks the power.

The only route by which the company could lawfully undertake such business is an alteration of the object clause of the memorandum, effected by the procedure the Act prescribes. Even then the alteration would operate prospectively and would not validate the transaction already entered into.

Contrast the position had the act been within the objects but beyond the directors' delegated authority. That would be ultra vires the directors but intra vires the company, and the members could ratify it, because they could have authorised it in the first place.

Liability of the directors.

The directors are personally liable to the company for the loss of ₹2,00,00,000. They exceeded the powers entrusted to them and applied the company's funds to a purpose the company had no power to pursue, which is a breach of the duty to act within the powers conferred by the memorandum and articles.

The shareholders' approval does not protect them. Since the members could not have authorised the act, their purported approval cannot operate as a defence to the directors, and a resolution that is itself ineffective cannot exonerate those who acted on it.

Ancillary points. Property acquired under an ultra vires transaction nonetheless belongs to the company and its title is protected, so the company may recover whatever remains of the investment. Where money has been lent to a company under an ultra vires borrowing, the lender may trace it if identifiable and may be subrogated to the rights of creditors whose lawful debts were discharged with it — a principle relevant here to the extent any part of the funds is traceable.

Conclusion. The transaction is void, the unanimous shareholder approval is of no effect, and the directors are personally liable to make good the loss.

Question 11

Explain how the doctrines of constructive notice and indoor management allocate risk between a company and those dealing with it, and evaluate whether the allocation is sensible. Illustrate with a borrowing that exceeds a limit in the articles and one made on an improperly convened board meeting.

Accepted Answer

The allocation of risk.

Constructive notice places on the outsider the risk of everything that is on the public file. The memorandum and articles are registered with the Registrar and open to inspection by anyone, so every person dealing with the company is deemed to have read them and to have understood them correctly. If those documents disclose a limitation, the outsider bears the consequences of transacting inconsistently with it, whether or not he actually looked.

Indoor management places on the company the risk of everything that happens inside it. A person dealing with the company in good faith may assume that its internal proceedings have been regularly carried out — that meetings were duly convened, quorums present, resolutions properly passed and authorities validly delegated. If in truth they were not, the company is bound and must look to its own officers.

The line between the two runs at the door of the registered office: what can be inspected is the outsider's responsibility, and what cannot is the company's.

Illustration one — borrowing exceeding a limit in the articles.

Suppose the articles cap borrowing at ₹1,00,00,000 and the directors borrow ₹1,50,00,000.

The cap is in a public document. The lender is deemed to have read it and to know that the directors had no power to borrow beyond that figure. Constructive notice applies, and indoor management does not assist him, because he is not complaining of an internal irregularity he could not discover but of a limitation he could and should have discovered.

The company is not bound as to the excess, and the lender's remedy is against the directors for breach of warranty of authority.

Illustration two — borrowing on an improperly convened board meeting.

Suppose the articles permit borrowing up to ₹1,00,00,000 on a board resolution, and the directors borrow ₹80,00,000 on a resolution passed at a meeting for which proper notice was never given to one director.

The public documents disclose the power and the manner of its exercise, and the transaction is within both. Whether notice was properly given is a matter of internal procedure that no outsider could verify. Turquand's rule applies, and the lender may assume regularity.

The company is bound and must repay, and its remedy lies against the directors who conducted the meeting irregularly.

Is the allocation sensible?

It is, and for a reason of information rather than of fairness in the abstract. Risk is placed on the party who could have prevented the loss at least cost.

An outsider can inspect the public file cheaply and before contracting, so it is efficient to require him to do so and to hold him to what it says. He cannot attend board meetings or examine minute books, so requiring him to verify internal compliance would either be futile or would make transacting with companies prohibitively slow and expensive.

The company, conversely, controls its own procedures entirely. It appoints the officers, convenes the meetings and keeps the records. If those procedures fail, the failure is within its own organisation and it is best placed to prevent it and to discipline those responsible.

The exceptions to indoor management confirm the logic rather than qualifying it. Protection is withdrawn where the outsider knew of the irregularity or was put on inquiry by suspicious circumstances — in either case he was no longer the party unable to discover the problem. It is withdrawn for forgery, because a forgery is not an irregular act of the company but no act of the company at all. And it is withdrawn for acts ultra vires the company, because no assumption of regularity can supply a capacity the constitution withholds.

A qualification worth noting is that constructive notice has been criticised as a fiction, since in practice few outsiders inspect the file, and several jurisdictions have modified or abolished it. Its retention in India is defended on the ground that the documents are genuinely public and that the burden of inspection is slight in transactions of any size.

Question 12

Explain the concept of the corporate veil, the reasons courts are reluctant to lift it, and the circumstances in which they will. Discuss whether a holding company can be made liable for its subsidiary's debts.

Accepted Answer

The corporate veil. On incorporation the company becomes a person in law distinct from its members. The metaphorical veil is the separation between the company and those who own and control it: the company's acts, property, rights and liabilities are its own, and the members' are theirs.

Salomon v Salomon and Co Ltd established the principle in its strongest form. A trader who incorporated his business, took debentures over its assets and held all but six of the shares was held entitled to rank as a secured creditor ahead of the company's unsecured creditors. The company was neither his agent nor his trustee; it was simply a different person.

Why courts are reluctant to lift it.

Separate personality is not a technicality but the foundation of the entire system of corporate finance. Investors subscribe capital on the express understanding that their exposure is limited to what they have invested, and that understanding is what makes it rational to invest in enterprises one does not manage. If the veil could be lifted whenever a court thought the result unattractive, limited liability would become unpredictable and the willingness to invest would fall.

Creditors, for their part, deal with the company knowing that its assets are the fund available to them, and they price credit accordingly. They can protect themselves by taking security, by requiring guarantees from members, or by declining to lend. A creditor who did none of these has accepted the risk.

There is also a rule-of-law consideration: the separateness is conferred by statute, and courts should not casually undo what the legislature has provided.

When the veil will be lifted.

Statutory grounds under the Companies Act include misstatement in a prospectus, failure to return application money, misdescription of the company's name on negotiable instruments and orders, fraudulent conduct of business in winding up, liability for ultra vires acts, and furnishing false statements.

Judicial grounds include the company being a mere cloak or sham formed to evade an existing obligation; fraud or improper conduct; determination of enemy character in wartime; evasion of tax or of a statutory obligation; the company acting in substance as agent of its members; protection of public interest; and avoidance of welfare legislation.

The unifying principle is that separate personality is a privilege conferred for legitimate commercial purposes and is withdrawn where it is used as an instrument of evasion. It is not lifted merely because the result is harsh, nor because one person controls the company, nor because the company is undercapitalised.

Can a holding company be made liable for its subsidiary's debts?

The starting point is no. A holding company and its subsidiary are separate legal persons, each with its own assets and liabilities, and the mere fact of control does not make one answerable for the other. The Companies Act requires consolidated financial statements to be prepared, but consolidation is a reporting requirement and does not merge the two entities in law.

The position changes in defined circumstances.

Where the subsidiary is a mere sham or facade, having no independent business and existing only to shield the parent from an obligation the parent would otherwise bear, the veil may be lifted and the two treated as one.

Where the subsidiary is in substance acting as the agent of the holding company, on the facts of the relationship rather than by mere shareholding, the parent may be liable as principal.

Where the group has been structured to defraud creditors or to evade a statutory obligation, the fraud grounds apply.

Where the holding company has expressly guaranteed the subsidiary's obligations, it is liable on the guarantee — though this is contractual liability rather than a lifting of the veil.

And where fraudulent trading is established in the winding up of the subsidiary, persons knowingly party to it, which may include officers of the parent, can be made personally liable without limit.

The practical conclusion is that a holding company's exposure is normally confined to its investment, and creditors of a subsidiary who want recourse to the parent must obtain a guarantee or comfort letter rather than rely on the group relationship.

Question 13

Compare a company, a limited liability partnership and a partnership firm as vehicles for a growing business, covering legal status, liability, continuity, compliance and the raising of capital. Recommend a form for a manufacturing business expecting external investment.

Accepted Answer

Legal status. A company is a body corporate and a legal person distinct from its members, with perpetual succession. An LLP is likewise a body corporate and a separate legal entity with perpetual succession. A partnership firm is not a separate legal entity; the firm name is a compendious description of the partners.

Liability. In a company, a member's liability is limited to the amount unpaid on his shares. In an LLP, a partner is not personally liable for the LLP's obligations solely by reason of being a partner, though he remains liable for his own wrongful acts, and liability becomes unlimited where business is carried on with intent to defraud creditors. In a firm, every partner is jointly and severally liable without limit for all acts of the firm.

Continuity. A company and an LLP both have perpetual succession, so changes in membership do not affect existence, contracts or registrations. A firm has none; subject to the deed, the death or insolvency of a partner dissolves it, and every change is a reconstitution.

Management and governance. A company separates ownership from management: shareholders own, directors manage, and their duties and powers are extensively regulated. An LLP combines the two, with partners managing directly under an LLP agreement they are largely free to draft. A firm is managed by the partners under the partnership deed, with mutual agency making each an agent of the others.

Compliance. A company bears the heaviest burden: board meetings, general meetings, statutory registers, extensive annual filings and audit regardless of size. An LLP is materially lighter: no board or general meetings, an annual return and a Statement of Account and Solvency, with audit only above prescribed thresholds. A firm is lightest, with no statutory filings, though section 69 of the Partnership Act makes registration effectively necessary since an unregistered firm cannot sue on its contracts.

Raising capital. This is the decisive difference for a growing business. A company can issue equity and preference shares, debentures and other securities; it can admit investors without disturbing management; a public company can offer securities to the public; and shares are transferable, giving investors an exit. An LLP cannot issue securities and cannot raise capital from the public; a partner's economic rights may be transferred but the transferee does not thereby become a partner. A firm can raise capital only by admitting partners, which requires the consent of all and exposes the new partner to unlimited liability.

Investor expectations. Institutional and venture investors invest through equity instruments with defined rights — preference shares, convertible instruments, anti-dilution and liquidation preferences — and these depend on a share capital structure that only a company possesses. Due diligence, valuation and exit through sale or listing are all built around the company form.

Recommendation.

A private limited company. The manufacturing business is expected to attract external investment, and that consideration outweighs the compliance burden.

The reasons. Only a company can issue shares and other securities, which is the mechanism through which external investors take an economic interest without assuming management responsibility or unlimited liability. Only a company allows the separation of ownership from management that outside investors require, with a board accountable to shareholders. Only a company offers investors a credible exit through transfer of shares or an eventual public offering. And limited liability for members is essential in manufacturing, where product liability and environmental exposure can be substantial.

The private form is preferred initially because it restricts share transfer, prohibits public offers and enjoys exemptions from several provisions applying to public companies, while remaining convertible to a public company when a listing becomes appropriate.

The LLP would be preferable only if external equity investment were not contemplated, since it offers limited liability and perpetual succession at a fraction of the compliance cost. The partnership firm should be rejected outright: unlimited joint and several liability is inappropriate for manufacturing, there is no perpetual succession, and capital cannot be raised except by admitting partners on the same unlimited terms.

Question 14

A company's articles provide that the managing director may enter contracts up to ₹25,00,000 and that larger contracts require board approval. The managing director signs a ₹60,00,000 supply contract without board approval. Advise the supplier, and explain how your advice would change if (i) the limit appeared only in an internal policy note, or (ii) the supplier was a director of the company.

Accepted Answer

The basic position.

The articles of association are a public document registered with the Registrar and open to inspection. Under the doctrine of constructive notice, every person dealing with the company is deemed to have read the articles and to have understood them correctly, whether or not he actually did so.

The limit of ₹25,00,000 on the managing director's contracting power is therefore a limitation the supplier is deemed to know. He is fixed with notice that any contract above that figure required board approval.

The doctrine of indoor management does not assist him. Turquand's rule permits an outsider to assume that internal proceedings have been regularly carried out — that a required resolution was passed, a meeting properly convened, a quorum present. It does not permit him to assume that a limitation appearing in the public documents does not exist or has been complied with when the transaction on its face exceeds it.

The distinction is between an irregularity the outsider could not have discovered, which the doctrine covers, and a limitation he could have discovered by reading the file, which it does not.

Conclusion on the basic facts. The company is not bound by the ₹60,00,000 contract. The supplier's remedy is against the managing director personally for breach of warranty of authority, since he represented an authority he did not have.

(i) If the limit appeared only in an internal policy note.

The answer reverses. An internal policy note is not a public document. It is not registered, not open to inspection, and there is no means by which an outsider could discover it. Constructive notice therefore does not apply to it.

The supplier is entitled to rely on the apparent authority of a managing director. A person holding that office would ordinarily be understood to have authority to enter supply contracts in the course of the company's business, and a contract for ₹60,00,000 is not on its face outside what such an officer would normally do.

An internal restriction on an officer's authority does not bind a third party who deals with the company without knowledge of it — the same principle that applies to a restriction on a partner's implied authority under the Partnership Act.

Conclusion. The company is bound and the supplier may enforce the contract. The company's remedy lies against the managing director for exceeding his internal mandate.

(ii) If the supplier was a director of the company.

The answer reverses again, and against the supplier.

The protection of the indoor management doctrine is available only to a person dealing with the company in good faith and without knowledge of the irregularity. A director is presumed to know the company's articles and the limits on its officers' authority, and to know whether the board has approved a transaction. He is an insider, not an outsider.

Even if the limitation had appeared only in an internal policy note, a director would be taken to know of it, so the reasoning in (i) would not save him.

The transaction would also engage the provisions of the Companies Act on contracts in which a director is interested, requiring disclosure of interest and, depending on the nature and value of the transaction, board or shareholder approval. Non-compliance may render the contract voidable at the company's option and expose the director to liability to account for any gain.

Conclusion. The company is not bound, the supplier-director cannot rely on either constructive notice reasoning or indoor management, and he may additionally face liability for failing to disclose his interest and for any profit made.

Question 15

Explain the classification of companies by size and activity under the Companies Act, 2013 — small company, dormant company, government company, foreign company, holding, subsidiary and associate — and explain why the Act distinguishes them.

Accepted Answer

Small company. A company, other than a public company, whose paid-up share capital and turnover do not exceed the limits prescribed under the Act, which the Central Government has revised from time to time. Expressly excluded, however small, are a holding company, a subsidiary company, a section 8 company, and a company governed by any special Act.

Dormant company. A company formed and registered for a future project, or to hold an asset or intellectual property, which has no significant accounting transaction, may apply to the Registrar for the status of a dormant company. An inactive company — one that has not carried on business or made any significant accounting transaction in the preceding two financial years, or has not filed financial statements and annual returns for that period — may also obtain the status.

Government company. A company in which not less than fifty-one per cent of the paid-up share capital is held by the Central Government, by any State Government or Governments, or partly by the Central Government and partly by one or more State Governments, and includes a company which is a subsidiary of such a government company.

Foreign company. A company or body corporate incorporated outside India which has a place of business in India, whether by itself or through an agent, physically or through electronic mode, and conducts any business activity in India in any other manner.

Holding and subsidiary. A subsidiary is a company in which another company controls the composition of the board of directors, or exercises or controls more than one-half of the total voting power, either on its own or together with one or more of its subsidiary companies. The company exercising that control is the holding company.

Associate company. In relation to another company, a company in which that other has significant influence — meaning control of at least twenty per cent of the total voting power, or control of or participation in business decisions under an agreement — but which is not a subsidiary. It includes a joint venture company.

Why the Act distinguishes them.

The distinctions exist to match regulatory burden and disclosure to the public interest at stake, and each classification is doing a different job.

Size-based relief. Small companies and dormant companies are given substantial exemptions — reduced board meeting requirements, simplified annual returns, relaxed audit rotation and cash flow statement requirements. The justification is proportionality: the compliance regime is designed for entities whose failure would affect many stakeholders, and applying it in full to a two-person company or to a shell holding a patent would impose cost without corresponding benefit. The exclusion of holding and subsidiary companies from the small company definition prevents a large group from fragmenting itself into small units to claim the relief.

Ownership-based distinction. Government companies are subject to a different accountability architecture: their auditors are appointed by the Comptroller and Auditor General, who may also conduct supplementary audit, and they answer to Parliament or the State Legislature. Public money requires public accountability of a kind that shareholder-based mechanisms do not supply.

Jurisdiction-based distinction. Foreign companies are regulated because they operate in India while being incorporated elsewhere. The Act requires them to register particulars with the Registrar, to file accounts, and to display their name and country of incorporation, so that persons dealing with them in India can identify who they are contracting with and where liability lies.

Relationship-based distinctions. Holding, subsidiary and associate definitions exist because economic reality does not follow legal separateness. A group operating through many companies is one enterprise commercially, and without these definitions consolidated accounts, related party transaction controls, restrictions on cross-holdings and layering limits could all be evaded by interposing entities. The definitions are drawn by reference to control and to significant influence rather than to shareholding alone, precisely so that substance rather than form determines the classification.

Practice — The Companies Act, 2013

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