Doctrine of Ultra Vires

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Introduction

The Memorandum of Association of a company is regarded as its constitution. It defines the company’s internal and external scope and areas of activity. This Memorandum of Association also includes an object clause and the company is authorized to do only that much which is within the scope of the powers provided to it by the object clause. A company can also perform anything that is incidental to the memorandum’s core objects. Anything that goes beyond the scope of the memorandum’s authorization is an ultra-vires act and this is where doctrine of Ultra vires comes into picture.

Doctrine of Ultra Vires

Since the company should devote itself solely to the objects set out in the memorandum and to nothing else therefore it is the memorandum’s function “to delimit and identify the objects in such plain, clear and unambiguous manner as that the reader can identify the field of industry within which the corporate activities are to be confined.” It is also the responsibility of the courts to ensure that the company does not depart from that domain and this is where the doctrine of ultra vires comes into picture in relation to joint stock corporations. “Vires” means “powers,” and “ultra” means “beyond.” What exactly this doctrine means is to do something which is beyond the powers of a company, an activity taken outside of the company’s memorandum is considered ultra vires.

The application of this doctrine to such companies was first demonstrated by the House of Lords in Ashbury Railway Carriage and Iron Co Ltd v Riche. In this case, according to the memorandum of association, the company’s objectives were to provide and sell material used in the building of railways to carry on the business of mechanical engineers and general contractors. Here, the company engaged into an agreement for railway construction with Riche, a firm of railway contractors, which was not in the company’s memorandum and so was against them. The company, on the other hand, rejected the contract as being ultra vires. Riche subsequently filed a claim for breach of contract damages. His arguments were that the contract in question was clearly within the meaning of the terms “general contractors” and therefore within the company’s powers, and that it was also signed by a majority of the shareholders. The House of Lords, on the other hand, ruled that the contract was ultra vires and hence null and void.

In essence, Lord Cairns LC’s judgement was that “The subscribers are to state the objects for which the proposed company is to be established and then the company comes into existence for those objects and those only. Such a statement of objects has a two-fold operation. It states affirmatively the ambit and extent of powers of the company and it states negatively that nothing shall be done beyond that ambit, and that no attempt shall be made to use the corporate life for any other purpose than that which is so specified. The terms ‘general contractors’ must be taken to indicate the making generally of such contracts as are connected with the business of mechanical engineers. If the term ‘general contractors’ is not so interpreted, it would authorize the making of contracts of any and every description, such as, for instance, of fire and marine insurance and the memorandum in place of specifying the particular kind of business would virtually point to the carrying on of the business of any kind what so ever and would, therefore, be altogether unmeaning. Hence the contract was entirely beyond the objects in the memorandum of association. If so, it was thereby placed beyond the powers of the company to make the contract. If the company could not make it, much less could it be ratified. If every shareholder of the company had been in the room and had said: ‘That is a contract which we desire to make, which we authorise the directors to make’ the case would not have stood in any different position from that in which it stands now. The shareholders would thereby, by unanimous con sent, have been attempting to do the very thing which, by Act of Parliament, they were prohibited from doing.”

In terms of English law, this judgement and those like it are only of historical importance to a limited extent. Because the objects are not needed to be specified in the memorandum, this is the case. It’s possible that they’ll be stated in the articles. Articles of incorporation are a contract between the firm and its shareholders. Outsiders can’t be bound by it unless it can be proven that they were aware of the provision and were aware that it was being violated.

Consequences of ultra vires transactions

When a corporation engages in an ultra vires transaction the main issue that comes into picture is what consequences it will face. Some of the possible effects of indulging in an ultra vires transaction can be-

  1. Injunction: 

When there is a chance that a corporation has committed or is about to commit an ultra-vires conduct, the members can seek an injunction from the court to prevent it. The same was held in the case of Attorney general v. Gr. Eastern Rly. Co.

  1. Personal liability of Directors for Unauthorized use of Capital

The board of directors is responsible for ensuring that the company’s corporate capital is exclusively used for lawful purposes. If such revenues are diverted for a purpose that is not permitted by the company’s memorandum, the directors will be personally liable to replace the same. The same was held in the case of Jehangir R. Modi v. Shamji Ladha where the Bombay High Court decided that a shareholder can bring an action against the directors to compel them to return to the business monies that they have used in transactions that they didn’t had the authorization to enter into, without making the company a party to the litigation.

  1. Breach of warranty of authority:

An agent’s responsibility is to operate within the limits of his power. He shall be personally responsible to the third party for breach of warranty of power if he goes beyond. A company’s agents are its directors and as a result, it is their responsibility to stay within the company’s authority. If they induce, however innocently, an outsider to contract with the company in a matter in which the company does not have the power to act, they will be personally liable to him for his loss.

In the case of Weeks v. Propert a railway corporation requested offers for a debenture loan. The business had issued debentures in the amount of £60,000 at the time the advertising was published, which was the full amount that it was authorised to issue under its constitution. It has therefore used up all of its borrowing options. On the basis of such advertising, the plaintiff offered a £500 loan. The same was accepted by the directors and a corporate debenture was issued to him. Subsequently the loan was declared void since it was said to be ultra vires. In a lawsuit brought by the plaintiff against the directors, it was determined that by placing the advertising, the directors warranted that they had the right to borrow, which they did not. As a result, their guarantee was voided, and they were held personally liable.

Although it is important to note that in such situations the directors’ representation of authority must be based on representation of facts and not that of law.

Main objects rule of construction.

The ultra vires concept limits the scope of corporate action. While it hinders the ambitious manager, it also sets up a trap for the unsuspecting creditor. That is why, virtually from the beginning, there has been a backlash against it. That is why, nearly from the beginning, there has been a backlash against it. The businessman has always tried to get around the doctrine’s restrictions that have been imposed on his or her freedom of action. The technique of registering memorandum with a plethora of objectives and powers is one means of circumventing ultra vires doctrine.

One example of it can be the case of Cotman v. Brougham in which the House of Lords had to evaluate a memorandum that had an objects section with 30 sub-clauses that allowed the firm to engage in practically any activity imaginable. Such an object clause, by essence, negates the reason for which it was created. In an attempt to curb this trend “main objects rule” of construction was adopted by the courts. The ruling stems from the Ashbury judgement, which ruled that the phrase “general contractors” must be read in context with the company’s primary activity.

Another example of the application of this rule can be the case of German Date Coffee Co, re in which a company’s memorandum claimed that it was founded to work on a case pilot for a German patent that would be issued for making coffee from dates, to get other patents for improvements and extensions of the said invention, and to buy and purchase any other innovation for similar objectives. The intended German patent was never awarded to them so the corporation bought a Swedish patent and set up shop in Hamburg, making and selling coffee manufactured from dates without a patent. Following the presentation of a petition by two shareholders, it was determined that the principal purpose for which the business was founded had become unachievable, and that it was thus reasonable and equitable for the company to be wound up. The court said: “In construing a memorandum in which there are general words…they must be taken in connection with what are shown by the context to be the dominant or main objects. It will not do under general words to turn a company for manufacturing one thing into a company for importing something else. Taking that as the governing principle, it seems to be plain that the real objects of this company which is called German Date Coffee Co, was to manufacture a substitute for coffee in Germany under a patent. It is what the company was formed for and all the rest is subordinate to that.”

However, when a business is created for general objectives rather than a specific subject-matter, this approach will be useless. The same was pointed out in the case of Kitson & Co Ltd, re, where the court said that “the impossibility of applying such a construction seems to be manifest when one remembers that business is a thing which changes. It grows or it contracts. It changes; it disposes of the whole of its plant; it moves its factory; it entirely changes its range of products, and so forth. It is more like an organic thing. It must be remembered that in these substratum cases there is every difference between a company which on the true construction of its memorandum is formed for the para mount purpose of dealing with some specific subject-matter and a company which is formed with wider and more comprehensive objects. With regard to a company which is formed to acquire and exploit a mine, when you come to construe its memorandum of association you must construe the language used in reference to the subject-matter, namely, a mine and, accordingly, if the mine cannot be acquired or if the mine turns out to be no mine at all the object of the company is frustrated, because the subject-matter which the company was formed to exploit has ceased to exist. But when we come to the subject-matter of a totally different kind like the carrying on of a type of business, then, so long as the company can carry on that type of business, it seems that prima facie at any rate it is impossible to say that its substratum has gone.”

In the case of Cotman v Brougham the main objects rule was overruled by a declaration in the objects clause that “every clause shall be read as a substantive clause, not limited or confined by reference to any other sub-clause or by the company’s name, and none of them should be regarded as merely secondary or auxiliary.”

The House of Lords voiced significant opposition to the inclusion of such a section, but their Lordships ruled that it did not affect the interpretation of the “main objects rule.” As a result, the regulation has failed to prohibit ultra vires evasion. And now in the case of Bell Houses Ltd v City Wall Properties Ltd Court of Appeal’s ruling has given the green light to yet another method of evasion. What exactly happened in this case was that a company’s objects clause allowed it to engage in any other trade or activity that the Board of Directors thought would be beneficial in conjunction with the company’s main operation. The court ruled that the provision was legitimate and that an act performed in good faith in the exercise of it was intra vires. However, a clause like this doesn’t provide any objects at all. Rather, it relies on the bonafide of the directors to determine the objects.

Complexities in the Doctrine

This brief examination of the nature and implications of ultra vires theory highlights some of the theory’s inherent complexities, which can result in unfairness. Its elimination was suggested by the English Company Law Revision Committee. It must be admitted that the ultra vires theory is not founded on any doctrinal idea of a limited liability business. The declaration of objects specifies the scope of business action that is permitted. Everything else is impliedly forbidden in order to protect company capital for the benefit of shareholders and creditors. However, if the memorandum, like the articles, is converted into a contract exclusively between the shareholders and the corporation, that protection is unaffected. Every contract signed on the company’s behalf, whether inside or outside of its power, should be legitimate. However, if it includes a misapplication of corporate resources, the board of directors should be obligated to replace it, and they already are.

This reform has been adopted by the European Communities Act, 1972. It was incorporated in Section 35 of the [English] Companies Act of 1985. A company will now be liable to a person acting in good faith for every act decided on by the directors. As a result of the amendment made by the 1989 Act, Section 35(1) of the Act now is as follows: “The validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the company’s memorandum.” The mention of any objects in the memorandum is not required under the UK Act of 1996. Such statement, if considered necessary, should be in the articles. It is then only a contract between company and members.

Conclusion

After all the discussion we can make out the importance of the doctrine of ultra vires and what are the implications if we don’t follow this doctrine. The directors need to exercise extreme caution while borrowing funds and engaging in any activity related to the business because such actions may not only make them personally accountable for the consequences of their actions, but can also result in significant losses to investors and creditors.

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