Preliminary and Incorporation of Companies — Practice

Question 1

Mr Sharma owns all but one share in Sharma Textiles Private Limited and insures the company's stock in his own name. A fire destroys the stock and the insurer refuses to pay. Advise, and state the consequences of separate legal personality generally.

Accepted Answer

The insurer's refusal is well founded. On incorporation a company becomes a body corporate, a legal person distinct from the members who compose it, and the first consequence of that separation is that the company owns its property. Mr Sharma, although he holds all but one share, has no proprietary interest in the company's stock and therefore no insurable interest in it; a contract of insurance requires the insured to stand to lose by the event insured against, and his loss is a fall in the value of his shares, not a loss of the stock. The remedy is that the company should have insured in its own name. The other consequences of separate personality follow the same logic and are examined alongside this one. Limited liability means a member's liability is confined to the amount unpaid on their shares, or in a guarantee company to the amount undertaken. Perpetual succession means the company's existence is unaffected by the death, insolvency or departure of members, who may change entirely while the company continues. The company can sue and be sued in its own name. And it can contract with its members, including employing them, since two distinct persons can contract with each other.

Question 2

Distinguish statutory from judicial lifting of the corporate veil, giving two instances of each, and state the unifying principle.

Accepted Answer

Separate personality is a rule and not an absolute, and the veil is disregarded where it is being used to defeat the law or to perpetrate a fraud, which is the unifying principle behind both categories. Statutory lifting occurs where the Act itself imposes liability on individuals notwithstanding incorporation: liability for misstatements in a prospectus, where those responsible are made personally answerable; and misdescription of the company's name on a negotiable instrument, where the signing officer becomes personally liable on the instrument. Failure to return application money and fraudulent conduct of business are further statutory instances. Judicial lifting occurs where a court disregards the separate personality on general principle, and the reported instances cluster around identifiable purposes: where the company is a mere sham or cloak for the person controlling it; where it has been formed to evade a legal obligation or a contractual duty, such as a covenant not to compete; where it is used to commit fraud or improper conduct; to determine the enemy character of a company in wartime by looking at the nationality of those in control; and to protect revenue where the company is a device for tax evasion. In every case the court is not abolishing separate personality but declining to let it be used as an instrument of the very wrong the law forbids.

Question 3

Determine whether each is a small company

Accepted Answer

A

Question 4

State the restrictions specific to a One Person Company. A non-resident Indian citizen wishes to incorporate an OPC to invest in securities of other companies, and is already the nominee of another OPC. Advise.

Accepted Answer

Several restrictions apply and the proposal fails two of them. Only a natural person who is an Indian citizen, whether resident in India or otherwise, may incorporate a One Person Company or be its nominee, so the applicant's non-residence is no obstacle in itself, the residence requirement having been removed. But a person may incorporate only one OPC and may be the nominee of only one, and a person who is already the nominee of an OPC is on that footing disqualified from being the member of another; the applicant is already a nominee, which bars the proposal. Separately, an OPC cannot carry out non-banking financial investment activities including investment in securities of any body corporate, which is precisely the purpose stated, so the proposal fails on that ground independently. Two further restrictions complete the picture: an OPC cannot be incorporated as, or converted into, a company under section 8; and the memorandum must name a nominee, with that person's prior written consent, who becomes the member on the subscriber's death or incapacity to contract, the nomination being capable of withdrawal or variation. The advice is therefore that the applicant cannot incorporate this OPC, and that if the investment purpose is genuine a different form of company is required.

Question 5

Set out the clauses of the memorandum of association and state what each contains. What is the position where the memorandum and the articles conflict?

Accepted Answer

The memorandum states the company's constitution and its relationship with the outside world, and section 4 prescribes six clauses. The name clause states the company's name, which must not be identical with or too nearly resemble the name of an existing company and must not be undesirable in the opinion of the Central Government; a public company's name ends with Limited and a private company's with Private Limited, except a section 8 company. The registered office clause states the State in which the registered office is to be situated. The objects clause states the objects for which the company is proposed to be incorporated and any matter considered necessary in furtherance of them. The liability clause states whether members' liability is limited or unlimited, and in a company limited by guarantee the amount each member undertakes to contribute. The capital clause states the amount of authorised share capital and its division into shares of a fixed amount. The subscription clause records the subscribers' declaration of intention to form the company and their agreement to take the shares stated against their names, a minimum of one share each. Where the memorandum and articles conflict, the memorandum prevails: it is the dominant document, defining what the company may do, while the articles are the internal regulations governing how it does it. Both, once registered, bind the company and its members as if signed by each of them.

Question 6

Explain what entrenchment of articles means, when it may be introduced, and the approvals required in a private and a public company.

Accepted Answer

Entrenchment means that specified provisions of the articles may be altered only if conditions are met, or a procedure is complied with, that are more restrictive than those applicable to a special resolution. Its purpose is to give particular protections a stability that ordinary articles do not have, so that a provision protecting a minority shareholder or preserving a class right cannot be swept away by the same three-quarters majority that alters anything else. Entrenchment may be introduced at two points only. It may be included in the articles on formation of the company. Or it may be introduced afterwards by amendment, and the approval then required differs by class of company: in the case of a private company, the amendment must be agreed to by all the members; in the case of a public company, it requires a special resolution. The distinction reflects practicality as much as principle, unanimity being achievable in a company of a few members and not in one with a dispersed body of shareholders. Where the articles contain an entrenchment provision, the company must give notice of it to the Registrar in the prescribed form, so that a person inspecting the public record can discover that the ordinary alteration procedure does not apply.

Question 7

A company's articles require board approval for borrowings above ₹50 lakh. A manager borrows ₹80 lakh from a bank without any board resolution. Advise the bank. Would your answer differ if the loan document bore a forged director's signature, or if the bank's own officer had attended the board meeting at which the loan was refused?

Accepted Answer

On the base facts the bank can enforce the loan. The doctrine of constructive notice deems every person dealing with a company to have read the memorandum and articles, which are public documents, so the bank is fixed with knowledge that borrowings above 50 lakh require board approval. But constructive notice would be intolerably harsh if it also required outsiders to verify that internal procedures had actually been followed, since board resolutions are not on the public record and no outsider can inspect them. The rule in Turquand's case accordingly entitles a person dealing with the company in good faith to assume that the internal proceedings have been regularly carried out, so the bank may assume the board approved the borrowing. Both variations defeat the bank. Where the loan document bears a forged signature, the indoor management rule does not apply at all: a forgery is a nullity, not an irregularity, and there is no act of the company that any assumption could regularise. Where the bank's own officer attended the board meeting at which the loan was refused, the bank has actual knowledge of the irregularity, and the rule protects only those who deal in good faith without such knowledge. The other exceptions are suspicious circumstances putting the outsider on inquiry, and the case of an outsider who never read the memorandum and articles at all and so cannot claim to have relied on them.

Question 8

A company whose objects clause covers manufacturing textiles lends ₹2 crore to a film production venture. All members ratify the loan unanimously in general meeting. Advise on the validity of the transaction and the position of the directors.

Accepted Answer

The loan is ultra vires the company and is void, and the unanimous ratification does not cure it. An act beyond the objects stated in the memorandum is outside the company's capacity, and the limitation exists not for the members' benefit alone but to define what the company is and may do, so it cannot be waived by those members however complete their agreement. Ratification presupposes that the act was capable of being done and merely lacked authority; an ultra vires act was never within the company's power at all, so there is nothing to ratify. The consequences follow from voidness. The company cannot sue on the transaction and cannot be sued on it, so it has no contractual claim to repayment and equally no liability under the arrangement. The directors who applied the company's funds to an ultra vires purpose are personally liable to restore them to the company, since they have applied corporate property to a purpose the company could not authorise. And property acquired with ultra vires expenditure belongs to the company and may be traced into whatever it has become, so the company may pursue the fund itself rather than relying on a personal claim. If the company genuinely wishes to conduct the new activity, the route is to alter the objects clause by special resolution before entering into the transaction, not to ratify it afterwards.

Question 9

A promoter contracts on 10 March to buy machinery for a company incorporated on 2 May. The company takes delivery and uses the machinery but refuses to pay, saying it was not a party. Advise the seller, and explain why ratification is unavailable.

Accepted Answer

The seller's remedy against the company depends on acceptance rather than on ratification, and on these facts the company's conduct is likely to constitute acceptance. Ratification is unavailable as a matter of principle: the doctrine requires a principal in existence at the time the agent acted, since ratification relates back to the date of the act and treats the principal as having authorised it then, and on 10 March the company did not exist. Nothing the company does afterwards can make it a party to a contract made before it was capable of being a party to anything. What the law provides instead is that a pre-incorporation contract may bind the company where the contract is warranted by the terms of incorporation and the company accepts it after incorporation and communicates that acceptance to the other party. Here the machinery purchase appears to be warranted by the terms of incorporation if it falls within the company's objects, and taking delivery and using the machinery is strong evidence of acceptance, communicated by conduct. Until acceptance, the promoter remains personally liable on the contract, which is the practical significance of the rule: a seller in this position has a claim against the promoter in any event, and the acceptance question determines whether the claim also lies against the company. A promoter also stands in a fiduciary relationship to the company and must not make a secret profit on such a transaction.

Question 10

Distinguish a subsidiary company from an associate company, and state the effect on a private company of becoming a subsidiary of a public company.

Accepted Answer

A company is a subsidiary of another where that other controls the composition of its 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 test is therefore one of control, and it has two independent limbs, so a holding below half the voting power still creates a subsidiary if the board's composition is controlled. An associate company is one in which another company has significant influence but not control, 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; the definition includes a joint venture company and expressly excludes a subsidiary. The two are therefore points on a scale of influence, with control marking the boundary. The effect on a private company of becoming a subsidiary of a public company is significant and frequently examined: it is deemed to be a public company for the purposes of the Act even where its articles contain the three private company restrictions and continue to do so. The consequence is that it loses the exemptions private companies enjoy, and provisions applying to public companies apply to it, so a group cannot obtain public company benefits at the top while retaining private company relief below.

Question 11

State the requirements for a section 8 company and the privileges it enjoys. Can a One Person Company be registered under section 8?

Accepted Answer

A section 8 company is one formed for 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, if any, or other income in promoting those objects, and which prohibits the payment of any dividend to its members. It is licensed by the Central Government, and the licence is what confers its special status. Its principal privilege is that it may be registered as a limited company without adding the word Limited or the words Private Limited to its name, which is why charitable companies bear ordinary-sounding names. Further relaxations attach to its governance and filing obligations. The prohibition on dividends is the substantive condition, since it is what ensures that the profits are in fact applied to the stated objects rather than distributed. A One Person Company cannot be registered under section 8, and cannot be converted into one; the restriction is express, and it fits the underlying logic of both forms, an OPC being a vehicle for a single individual's business while a section 8 company exists to pursue objects that are not that individual's private benefit. Where a section 8 company contravenes its conditions, the Central Government may revoke the licence, after which the company must add Limited or Private Limited to its name.

Question 12

State the time limits applicable at incorporation: name reservation validity, the registered office requirement, and the declaration before commencement of business. What are the consequences of incorporation by false information?

Accepted Answer

Three limits are examinable. A name, once reserved by the Registrar, is valid for twenty days from the date of approval, within which the incorporation application must be made. The company must have a registered office capable of receiving and acknowledging all communications within thirty days of its incorporation, and at all times thereafter, and must furnish verification of it to the Registrar. A company having a share capital may not commence business or exercise any borrowing powers unless a declaration is filed by a director within one hundred and eighty days of incorporation stating that every subscriber to the memorandum has paid the value of the shares agreed to be taken by them, and unless the company has filed verification of its registered office. On false information, the consequences are severe and reach individuals. Where a company has been incorporated by furnishing any false or incorrect information or representation, or by suppressing any material fact, the promoters, the persons named as first directors and the persons making the declaration are each liable for fraud under section 447. The Tribunal, on application, has wide powers: it may pass orders regulating the management of the company, direct that the liability of members be unlimited, order removal of the name of the company from the register, or order that the company be wound up.

Question 13

Define an inactive company and a dormant company, and state why the dormant status exists.

Accepted Answer

An inactive company is one which has not been carrying on any business or operation, or has not made any significant accounting transaction during the last two financial years, or has not filed financial statements and annual returns during the last two financial years. A dormant company is one which is formed and registered under the Act for a future project or to hold an asset or intellectual property and has no significant accounting transaction, or is an inactive company, and which has applied to the Registrar in the prescribed manner for the status of a dormant company. A significant accounting transaction is one other than payment of fees to the Registrar, payments made to fulfil the requirements of the Act or any other law, allotment of shares to fulfil the requirements of the Act, and payments for maintenance of its office and records. The status exists to recognise a commercial reality: a company may legitimately be formed and then hold no activity for a period, because a project has not yet started or because it exists only to hold an asset or a trade mark, and requiring such a company to comply with the full apparatus of meetings, filings and audit would impose cost for no informational benefit. Dormant status therefore reduces those obligations while keeping the company on the register and its status visible to anyone who inspects it.

Question 14

Alpha Ltd, a listed company, holds 55% of Beta Private Ltd, which has paid-up capital of ₹1 crore and turnover of ₹8 crore. Beta holds 25% of Gamma Ltd. Classify Beta and Gamma and identify every consequence you can for Beta.

Accepted Answer

Beta is a subsidiary of Alpha, since Alpha exercises more than one half of the total voting power. Two consequences follow immediately from that single fact, and both are commonly missed. First, Beta is a private company that is a subsidiary of a public company, and it is therefore deemed to be a public company for the purposes of the Act, notwithstanding that its articles contain the three private company restrictions; it loses the exemptions available to private companies and must comply with the provisions applicable to public companies. Second, Beta cannot be a small company however small its figures, because a subsidiary company is one of the four categories excluded from the small company definition whatever its capital and turnover, the others being a holding company, a section 8 company and a company governed by a special Act. On its own numbers Beta would comfortably qualify, capital of 1 crore being within the four crore limit and turnover of 8 crore within the forty crore limit, which is exactly the trap. Gamma is an associate company of Beta, since Beta controls at least twenty per cent of the total voting power, which is the threshold for significant influence, and Gamma is not a subsidiary of Beta because 25 per cent is neither more than half the voting power nor, on these facts, control of the board's composition. Beta is also, being a subsidiary of a listed holding company, likely to face further group-level obligations.

Question 15

Define a promoter under the Companies Act, 2013 and state the nature of the duties owed. Does a solicitor who drafts the memorandum become a promoter?

Accepted Answer

A promoter is 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 is deliberately functional rather than formal, catching those who in substance bring the company into being or control it, and it expressly excludes a person acting merely in a professional capacity. A solicitor who drafts the memorandum, or an accountant who prepares projections for a fee, is therefore not a promoter, however central their contribution, because they act professionally rather than as principals; the exclusion would fall away if the same person also took shares and directed the venture. The duties are fiduciary. A promoter stands in a fiduciary relationship with the company he is forming and must not make a secret profit out of that position; he must disclose any interest he has in a transaction with the company, and disclosure must be to an independent board or to the whole body of shareholders, not merely to a board he himself controls; and he must account to the company for profits made in the character of promoter. Where a secret profit is made, the company may rescind the transaction or recover the profit.

Practice — Preliminary and Incorporation of Companies

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