Block - II
Working of a Company
CONTENTS
Unit-5 : Memorandum of Association
Unit-6 : Articles of Association
Unit-7 : Prospectus
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UNIT 5
MEMORANDUM OF ASSOCIATION
Structure
5.0
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
Introduction
Objectives
Meaning and Importance of Memorandum
Content of Memorandum
Alternation of Memorandum
5.4.1 Alteration of Name Clause
5.4.2 Alternation of Registered Office Clause
5.4.3 Alternation of Object Clause
5.4.4 Alternation of Liability Clause
5.4.5 Alternation of Capital Clause
Doctrine of Ultra Vires
Consequences of Ultra Vires Transactions
Summary
Check Your Progress
5.0
Introduction
During the incorporation of a company one of the important document that is to
be filed with the registrar is the memorandum of association. This memorandum
of association is the constitution of the company. It contains various clauses viz.
name clause, registered office clause, object clause, liability clause and capital
clause. These clause lay the foundation of the company formation. These clauses
can also be altered by following the prescribed procedure.
5.1
Objectives
The main objective of this unit is to enlighten the students with the importance of
memorandum of association and to study in detail the contents of the
memorandum and to understand the consequences in case on act is done outside
the powers given by the memorandum. After completing this unit you will be able
to understand.
 The importance of memorandum of association in the functioning of a
company.
 The various clauses that a memorandum contains.
 The alterability of these closures.
 Doctrine of ultra-vires and it consequences.
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5.2
Meaning and Importance of Memorandum
The memorandum of association of a company is its principle document to be
prepared in order of formation of a company. The memorandum of association of
a company contains the fundamental conditions upon which alone the company
has been incorporated.
Section 2(28)
of the Companies Act, 1956 defines memorandum as
"Memorandum means the memorandum of association of a company as originally
framed or as altered from time to time in pursuance of any previous company laws
or of this Act."
This definition, however, does not throw any light on the nature and importance of
this document.
Palmer, in his works, has opined that the memorandum of association is a
document of great importance in relation to the proposed company. it contains the
objects for which the company is formed and therefore identifies the possible
scope of its operations beyond which its actions cannot go. It defines as well as
confines the powers of the company. If anything is done beyond these powers,
that will be ultra vires (beyond powers of) the company and hence void. [Palmer's
Company Law, 20th Ed.; 1954]
Lord Cairns in the leading case Ashbury Railway Carriage Co. v. Riche, (1875),
L.R. 7 H.L. 653, observed that "The memorandum of association of a company is
its charter and defines the limitation of the power of company. It states
affirmatively the ambit and extent of vitality and power which by law are given to
the corporation and it states negatively, that nothing shall be done beyond its
ambit…"
Thus the memorandum serves two important functions. It enables shareholders,
creditors and all those who deal with the company to know what its powers are
and what is the range of its activities.
From the above discussion, the importance of the memorandum of association can
be clearly understood. The memorandum is the foundation on which the structure
of the company is based. The memorandum spells the name of the company, the
place of its registered office, the objects for which the company is incorporated,
the liability of the members of the company, and the capital with which the
company is going to start its venture. It also limits the capacity to contract of the
company. A company cannot undertake operations that are not mentioned in its
memorandum. Any act of the company that is outside the scope of activities that
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are made out in the memorandum is said to be ultra-vires (beyond the power) an
not binding on it.
The memorandum of association is the constitution of the company in its relation
to the outside world. It is a public document and persons dealing with the
company are presumed to have gone through its contents and shall be bound by its
provisions. No company can temper with the contents of its memorandum of
association without the sanction of the Central Government or the court of law or
the Company Law Board.
5.3
Contents of Memorandum
According to section 15, read with sections 12 and 13, requires the memorandum
to be printed, divided into paragraphs, numbered consecutively and singed by at
least seven persons (two in the case of private company) in the presence of at least
one witness, who will attest the signature. The memorandum must contain the
following clauses :
1. The name clause
2. The registered office clause
3. The objects clause
4. The liability clause
5. The capital clause
6. The association or subscription clause.
5.3.1 The Name Clause : [Sec. 13(1)(a)]
A company being a distinct legal entity must have a name of its own to establish
its separate identity. Under this clause a company may choose any suitable name,
subject, however, to the following restrictions :
(a)
In the case of companies limited by shares or limited by guarantee, the
world "Limited" or "Private Limited" must be the last word in the name of every
public or private company, respectively. The only exception provided is in favour
of an "association not for profit", incorporated as a company and licenced by the
Central Government, not to use the word 'limited' or 'private limited' as part of its
name, even though the liability of its members is limited. [Section 25].
In the case of unlimited companies, only the name is to be given. It is to be noted
that the inclusion of the word "company" is not essential in the proposed name of
the company.
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(b)
In the opinion of the Central Government, the name chosen is not
undesirable. The Act is silent about what names shall be considered undesirable
and this given wide discretion to the Central Government in this matter.
According to section 20(2), a name is considered undesirable and therefore, not
allowed to be used as such, if it is either :
(i)
too identical or similar to the name of another existing company or firm
(whether registered or unregistered) so as to lead to confusion; or
(ii)
misleading, e.g. suggestion that the company connected with a
government department or any municipality or other local authority, or
that it is an associations of a particular type e.g. "co-operative society",
"Building society", etc. when this not the case.
In Ewing v. Buttercup Margarine Co. Ltd. [1917] 2 Ch. 1, the plaintiff who carried
on business under the name of Butter Cup Dairy Co. succeeded in obtaining an
injunction against the defendant on the ground that the public might think that the
two business were connected since the word 'Buttercup' was an unnecessary and
fancy one.
In Montari Overseas Ltd. v. Montari Industries Ltd. [1996] 20 CLA 313 (Delhi) it
was held that the name adopted was sufficiently close to the name under which the
respondent was trading, acquired a reputation and the public at large was likely to
be misled. The same principle of law which applied to an action for passing off of
a trademark would apply more strongly to the passing off a trade or corporate
name of one for the other. The appellant was liable for an action in passing off.
Merely that few words are common may not render the name too identical and
thus undesirable. In Society of Motor Manufactures & Traders Limited vs. Motor
Manufactures & Traders Mutual Assurance Limited [1925] 1 Ch. 675. the plaintiff
company brought an action to restrain the defendant company from using the said
name. But, Lawrence, J. held "anyone who took the trouble to think about the
matter, would see that the defendant company was an Insurance company and that
the plaintiff society was a trade protection society and I do not think that the
defendant company is liable to have its business stopped unless it changes its
name simply because a thoughtless person might unwarrantedly jump to the
conclusion that it is connected with the plaintiff society."
Executive Board of Methodist Church in India v. Union of India, [1985] 57 Comp.
Cas. 443 (Bom.), the Methodist Church in India sought registration of a company
in the name of 'Methodist Church in India Trust Association'. There was already
existing a company bearing the name Methodist Church in Northern India Trust
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Association (P) Ltd. in Calcutta. The former secretary of the latter association
informed the Registrar that the said company had not functioned since 1970; that
no annual report or minutes has been filed with the Registrar since 1970; and that
some directors died and some had left. The question was whether in these
circumstances the Calcutta Company was a bar to the registration of the new
company.
If a company is practically defunct, it is not a bar to registration of a new company
with a similar name.
Guidelines / Principles for deciding availability of names : According to the
clarification issued by the Department of Company Affairs, a name is considered
undesirable and a company is not allowed to be registered with such name :
(a) if the name is identical with or too nearly resembles the name by the which
a company is already registered. Names under which well-known firms
and other bodies are doing business are also considered undesirable for a
new company;
(b) if the proposed name is identical with or too nearly resembles the name of
a company in liquidation. It is because the name of the company in
liquidation is borne on the register till it is finally dissolved. A name which
is identical with or too closely resembles the name of a company dissolved
as a result of liquidation proceedings cannot also be allowed for a period of
two years from the date of such dissolution since the dissolution of the
company could be declared void within the period aforesaid by an order of
the Court under section 559 of the Act;
(c) if the proposed name differs from the name of an existing company merely
in the addition or subtraction of word like New, Modern etc. Thus names
such as New Bata Shoe Company, Nav Bharat Electronic etc. should nto
be allowed:
(d) if the proposed name closely resembles a popular or abbreviated
description or names of important companies, for example, TISCO or ICI,
WIMCO, etc. Such words should not be allowed even though they have
not been registered as trade marks;
(e) it attracts the provisions of Emblem and Names (Prevention of Improper
Use) Act, 1950;
(f) if it connotes Government participation or patronage unless circumstances
justify (for example, National, Union, Central, President, Rashtrapati, etc.)
(g) if it implies association or connection with, or patronage of a national hero
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or any person held in high esteem;
(h) if it includes the word Co-operative (or Sahkari or the equivalent word 'Cooperative' in regional languages of the country);
(i) if it includes the word like 'bank', 'banking' 'insurance', 'investment', 'trust'
unless the circumstances of a particular case justify the inclusion of such a
word;
(j) if it includes a proper noun which is not a name or a surname of a director.
However, for sentimental reasons, sometimes the names of relatives such
as wife, son and daughter of the director may be allowed, provided one
other word suggested makes the name quite distinguishable;
(k) if it includes the name of a registered trade mark unless the consent of the
owner of the trade marks has been produced by the promoters;
(l) if it is intended or is likely to produce a misleading impression regarding
the scope of its activities which would be beyond the resources at its
disposal, e.g., Universal Engineering Company Pvt. Ltd. operating only as
a small scale unit with limited range of product and financial resources;
(m) if the name suggests a business which is not proposed to be undertaken by
the company;
(n) if the proposed name is exact Hindi translation of the name of an existing
company.
There are further instructions to the effect that if a name falls within the categories
mentioned below it will not generally by made available. Thus –
(i)
if it is not in consonance with the proper objects of the company as set
out in its memorandum of association;
(ii)
if it includes any word or words which are offensive to any section of
the public;
(iii)
if the name is only a general one, like Cotton Textile Mills Limited;
(iv)
if the proposed name has a close phonetic resemblance to the name of a
company in existence, for example, J.K. Industries Limited and Jay Kay
Industries Limited;
(v)
if it is different from the name / names of the existing company /
companies only to the extent of having the name of place within
brackets before the word 'limited' for example, Indian Press (Delhi)
Limited should not be allowed in view of the existence of the company
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named Indian Press Limited.
Once the name is chosen and the company is registered in that name, section 147
mandates that the name along with the address of the registered office, must
appear on the outside of every office or place of business of the company in a
conspicuous, position, in letters easily legible and in the language in general use in
the locality. Also, the company should get its name engraven in legible characters
on its seal and have its seal and have its name and address of its registered office
mentioned in legible characters in all business letters, bill heads, negotiable
instruments, invoices, receipts, etc. of the company.
Penalty – If a company does not affix its name and address of its registered office
in the prescribed manner, the company and every officer of the company who is in
default shall be punishable with fine upto Rs. 500 per day till the default
continues. Section 147 (4) marks an officer of a company or any person on its
behalf who signs or authorises to be signed on behalf of the company any bill of
exchange, hundi, promissory note or cheque etc. wherein the name of the company
is not mentioned in the prescribed manner, personally liable to the holder of such
bill of exchange, hundi, promissory note cheque etc. for the amount thereof, unless
it is paid by the company.
5.3.2 The Registered Office Clause [Sec. 13(1)(b)]
This clause mentions the name of the state in which the registered office of the
company is to be situated. Every company must have a registered office which
establishes its domicile i.e. the place of registration. Domicile of a company is
different from residence. Where domicile is the place of registration of a company,
residence is the place of its management and control (i.e. where the Board of
Director meet).
The importance of registered office is that it is the address of the company where
all communications and notices are to be sent and where the company's statutory
books must normally be kept.
The notice of the exact address of the registered office shall be given to the
Registrar of companies, in the prescribed form (Form No. 18), within 30 days
from the date of incorporation [Sec. 146].
5.3.3 The Objects Clause [Sec 13(1) (c) & (d)]
This is most important clause of the memorandum because it sets out the objects
and indicate the sphere of its activities. A company cannot legally do any business
or act outside its objects and anything done beyond that will be ultra vires and
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void and cannot be ratified even by the assent of the whole body of shareholders.
However, a company may do anything which is incidental to and consequential
upon the objects specified and such act will not be an ultra vires act [Attorney
General v. G.E.Rly. Co. [1880] S.A.C. 473].
This rule is meant to protect, in the first place, the members of the company, who
can at once known the purpose for which their money is to be utilized and can also
be sure that there money is not going to do risked in an unknown activity or
project, and secondly, to protect the public at large, who deal with the company
and can know the extent of Company's Powers and whether a transaction which is
to be entered into with them is ultra vires the company or not. Also it provides
security to the creditors as they known that the company's capital cannot be spent
on any venture outside the object clause.
The following points must be kept in mind by the subscribers to the memorandum
while drafting the object clause:
(i)
the object must not be illegal;
(ii)
they must not be against the provisions of the Companies Act;
(iii)
they must not be against the public policy;
(iv)
they must be stated clearly and should not be ambiguous;
(v)
they must be quite elaborate.
After the passing of the Companies (Amendment) Act, 1965 the objects clause of
a company must be divided in two sub clauses:
(a)
The main objects: The main objects to be pursued by the company and
objects incidental or ancillary to the attainment of the main objects must be stated.
(b)
Other Objects: Other objects of the company not included in the above
clause must be stated. In the case of 'non-trading companies' the object clause
should also mention the names of those states to whose territories the objects of
the company will extend.
The 'main objects' shall be pursued by the company immediately on its
incorporation. But if a company wishes to start a business included in 'other
objects' it shall have to obtain either the authority of special resolution or an
ordinary resolution and sanction of the Central Government.
5.3.4 The Liability Clause [Section 13(2)]
This clause states the nature of liability of the members. The liability of a
company may be limited or unlimited. In the case of the company with limited
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liability, the liability clause must state that liability of members is limited, whether
it be by shares or by guarantee. Thus, in the case of a company limited by shares, a
member may be called upon at any time to pay to the company the amount unpaid
on the shares. Thus, if his shares are fully paid up, his liability is nil.
In the case of companies limited by guarantee, this clause will state the
amount which every member undertakes to contribute to the assets of the company
in the event of its being wound up.
In the case of unlimited liability company, this clause need not be given in
the memorandum of association. Rather, the absence of this clause in the
memorandum means that the liability of its members is unlimited.
5.3.5. The Capital Clause [Section 13(4)(9)]
Under this clause every limited company (either by shares or by guarantee),
having a share capital must state the amount the share capital with which the
company is registered and the mode of its divisions into shares of fixed value i.e.
the number of shares into which the capital is divided and the denomination of
each share. Usually it is expressed as "the capital of the company is Rs. 10 lakhs
divided into one lakh equity shares of Rs. 10 each.".
This clause lays down the limit beyond which the company cannot issue shares
without altering the memorandum as provided by section 94 of the Companies
Act, 1956.
This capital is also described as 'registered capital', 'authorised capital' or 'nominal
capital' and the stamp duty is payable on this amount. These is no legal limit to the
amount of share capital, but the denomination of each share should be Rs. 10 or
Rs. 100 in case of equity shares and Rs. 100 in case of preference shares.
However, the companies whose shares are in dematerialized from, shall have the
freedom to issue equity shares in any denomination which should not be less than
rupees one (vide press release issue by SEBI on 11th June, 1999). An unlimited
company having a share capital is not required to have the capital clause in its
memorandum. For such a company, section 27(1) provides that the amount of
shares capital with which the company is to be registered must be stated in the
articles of association of the company.
5.3.6 The Association Clause or Subscription Clause [Sec. 13(4)(c)]
At the of the memorandum of every company there is a "declaration of
association", which is made by the signatories of the memorandum under their
signatures duly attested by witness, that they desire to be formed into a company
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and that they agree to the purchase of qualification shares, if any. Each subscriber
must take at least one share. There must be at least seven signatories in case of a
public company and at least two in case of a private company. The subscribers
usually act as first directors of the company.
It may be noted that each subscriber to be memorandum must pay for the shares he
agree to subscriber for. He cannot, after registration of the company, repudiate his
liability to subscribe, even on the ground that he was induced to sign by
misrepresentation. Every subscriber to the memorandum, on the incorporation of
the company, becomes its members and as such contributory, irrespective of
whether he has made payment for the shares subscribed. To the extent the
subscribed shared remain unpaid, the same is debt owed to the company [Sec.
36(2)].
5.4
Alteration of Memorandum
Section 16 of the Companies Act provides that the company cannot alter the
conditions contained in memorandum except in the cases and in the mode and to
the extent express provisions have been made in the Act. We shall now discuss the
provisions in detail.
5.4.1 Alternation of Name Clause
According to section 21 the name of a company may be changed at any time by
passing a special resolution and with the approval of Central Government in
writing. However, no approval of the Central Government is necessary if the
change of name involves only the addition or deletion of the word "private", when
a public company is converted into a private company or vice-versa.
If through inadvertence or otherwise a company's name is wrongly registered,
which is identical or too closely resembles the name of an existing company, the
company may change its name by passing an ordinary
resolution and by
obtaining the approval of the Central Government in writing [Sec. 22].
The rectification of the name must also be carried out if the Central Government
so directs within a period of 12 months from the date of registration of the
company. If a direction is issued, the company must change its name within three
months from the date of direction. Any default in complying with the direction of
the Central Government renders the company and its officers in default liable for
punishment with the fine which may extend to Rs. 1000 for every day during
which the default continues [Sec. 22(2)].
The Registrar shall enter the new name on the Register in place of the former
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name and shall issue a fresh certificate of incorporation with necessary alterations.
The change of name becomes effective on the issue of fresh certificate of in
corporation. The registrar will also make the necessary alteration in memorandum
of association of the company[Sec. 23].
The change of name shall not affect any rights/ obligations of the company or
render the same defective in legal proceedings by or against it. Moreover, any
legal proceedings which might have been continued or commenced by or against
the company by its former name may be continued by or against the company by
its new name [Sec. 23(3)].
It has been held in Economic Investment Corporation Ltd. v. CIT, [1970] 40
Comp. Cas. 1 (Cal.), that by change of name the constitution of the company is not
changed. The only thing that changes is its name; all the rights and obligations
under the law of the old company pass to the new company. It is not similar to the
reconstitution of a partnership, which in law means creation of a new legal entity
altogether.
5.4.2 Alternation of Registered Office Clause
This may be due to :
(a)
Change of registered office from one premise to another premise in the
same city, town or village [Sec. 146].
A company can change its registered office from one place to another within the
local limits of the city, town or village where it is situated, by passing a resolution
of the Board of Directors. The notice of the change should be filed with the
registrar within 30 days of the change.
It is important to note that change of registered office within the same city, town
or village does not require alteration of memorandum because in the registered
office clause, only the name of the state is mentioned and not the address of the
registered office.
(b)
Change of registered office from one town or city or village to another
town or city or village in the same state [Sec. 17 A and Sec. 146] A company desiring to the change its registered office from one town, city or
village to another town, city or village in the same state has to pass a special
resolution at a general meeting of the shareholders, authorizing the change and file
its copy with the registrar within 30 days.
Section 17 A, which has been added by the Companies (Amendment) Act, 2000
provides that if the registered office is to be shifted from the jurisdiction of one
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Registrar of Companies to another Registrar of Companies within the same state,
then in addition to passing of special resolution confirmation of the regional
director is also to be obtained. At present, this provision is applicable only to
companies situated in Tamil Nadu and Maharashtra which have more than one
office of Registrar of Companies. In Tamilnadu, one office is in Chennai and
another in Coimbatore . In Maharashtra, one office is in Mumbai and the other at
Pune.
A copy of the special resolution and of the confirmation by the Regional Director,
shall be filed with the Registrar of the Companies within 30 days and 2 months
respectively.
Within 30 days of the removal of the registered office, the notice of the new
location has to be given to the Registrar.
Penalty – A company must have a registered office and must give notice of the
situation of the registered office and of every change therein to the registrar of
companies within 30 days after incorporation of the company or after the date of
change and in case of default in complying with these provisions every officer of
the company who is in default shall be liable for punishment under section 146(4).
(c)
Change of registered office from one state to another state -
Section 17 of the Companies Act Provides for the shift of the registered office
from one state to another and such shift involve alteration of memorandum.
According to this section, registered office of a company can be shifted from one
state to another by passing special resolution and getting confirmation from the
Company Law Board [Central Government, after the Companies (Amendment)
Act, 2002]. The Company Law Board (Now Central Government) before
confirming a resolution will satisfy itself that sufficient notice has been given to
every creditor and all other person whose interest are likely to affected by the
alternation including the Registrar of Companies and Government of the State in
which registered office is situated. All the interest parties must be given an
opportunity to be heard by the CLB (now Central Government).
Los of revenue or employment of State, whether Relevant Consideration to
Refuse Confirmation of Shifting :
In Orient Paper Mills Ltd. v. State, AIR 1957 Ori. 232, the Orissa High Court held
that a state whose interests are affected by the change of the registered office to a
different state has a locus standi to oppose shift of the registered office of a
company. Accordingly the court declined to confirm change of registered office
from Orissa to West Bengal on the ground that in a Federal Constitution every
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state has the right to protect its revenue and, therefore, the interest of the State
must be taken into consideration.
But in another case Minerva Mills Ltd. v. Govt. of Maharashtra [1975] 45 Comp.
Cas. 1 (Bom.), Bombay High Court held that the Company Law Board (now
Central Government) cannot refuse confirmation of the shifting of the registered
office on the ground of the loss of revenue to State or on the ground that such a
shift would have adverse effects on the general economy of the State. The Court
said : The question of loss of revenue to one State would have to be considered in
the prospects of total revenues for the Republic of India and no parochial
considerations should be allowed to turn the scale in regard to change of registered
office from one state to another within India.
A company can shift its registered office from one state to another for certain
purpose only. The grounds on which a company can shift its registered office from
one state to another are provided by Section 17 of the Companies Act as:
(i)
To carry on its business more economically and more efficiently [Sec.
17 (1)(a)].
(ii)
To attain its main purpose by new or improved means [Sec. 17(1)(b)].
(iii)
To enlarge or change the local area of is operation [Sec. 17(i)(c)].
(iv)
To carryon some business which under existing circumstances may
conveniently or advantageously be combined with the business of the
company [Sec. 17(1)(d)].
(v)
To restrict or abandon any of the objects specified in the memorandum
[Sec. 17 (1)(e)].
5.4.3. Alteration of Objects Clause
Section 17 empowers a company to alter its object clause by passing a special
resolution on the grounds similar to those on which the company can shift its
registered office from one state to another (discussed above). The grounds are
discussed herein some detail.
(i)
To carry on its business more economically and efficiently [Sec.
17(1)(a)]- In Dalmia Cement (Bharat) Ltd., In Re [1964] 34 Comp. Cas. 729
(Mad.), the Court observed that whether a company can carry on its business more
economically or more efficiently is a matter to be judged by the Directors. If the
directors are of the opinion that under the existing circumstances, it will be
convenient and advantageous to combine the new objects with the existing object,
and if it appears that such a conclusion may be fairly arrived at, the court will not
14
go behind it to hold an enquiry whether the opinion of the directors is well
founded or is justified.
The Delhi High Court, in Delhi Bharat Gain Merchants Assn. Ltd., In Re [1974]
44 Comp. Cas. 214 (Delhi), has opined that the true legal position is that business
must remain substantially the same and the additions, alterations and changes
should only be steps-in-aid to improve the efficiency of the company.
(ii)
To attain its remain purpose by new or improved means [Sec. 17
(1)(b)]-The companies registered after 10th October, 1965 contain in their
memorandum their 'main object' as well as other object. But for the companies
registered prior to 1965, apart from looking at the memorandum one has to look
also to what actually being done.
(iii) To enlarge or change the local area of its operation [Sec. 17(1) (c)]- A
company can change its object clause (as well as registered office clause) in order
to enlarge or change the local area of its operation.
(iv) To carry on some business which can be suitably combined with the present
business of the Company [Sec. 17(1)(d)]. – Most of the alterations in object clause
are sought on this ground. This clause enables the company to carry on any
activity which may conveniently or advantageously be combined with the existing
business of the company, e.g. a company formed for generating power was
allowed to carry on 'cold storage and other allied business'- In Re, Ambala
Electric Supply Co. Ltd., [1963] 33 Comp. Cas. 585 (Punj); A company formed for
business in jute was allowed to add business in rubber- Juggilal Kamlapat Jute
Mills v. Registrar of Companies, [1966] 1 Comp. L.J. 292; However in Re, Cyelist
Touring Club Ltd. [1907] 1 Ch. 269, Cyclists Touring Club Ltd. was not allowed
to change its objects so as to admit motorists since one of the object was to protect
cyclists from motorists.
But, it was held in New Asiatic Insurance Co. Ltd., In Re [1967] 37 Comp. Cas.
331 (Punj), that confirmation of alternation of objects is not to be refused only
because new businesses in wholly different from existing business.
(v)
To restrict or abandon any of the objects specified in the memorandum
[Section 17(1) (e)]: Even for deleting any portion of object clause the procedure as
laid down in Sec. 17 is to be followed. One important change made by the
Companies (Amendment) Act, 1996, is that now the confirmation of company
Law Board (CLB) is no more required in cause of abandonment of its objects.
(vi) To sell or dispose of the whole or any part the undertaking of the Company
[Sec. 17(1)(f)]:
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When a company feels that it has grown too big or diversified in various directions
that management of the company has become difficult or uneconomical and want
to adopt a cut-back or retrenchment strategy, it may alter its objects to sell or
dispose of any of its undertakings.
(vii) To amalgamate the company with any other company or body of persons
[Sec. 17(1)(g)]: .
5.4.4. Alteration of Liability Clause [Sec. 38]
Liability of a member of a company can not be increased unless the members
agrees in writing. The consent of the member may be given either before or after
the alteration.
However, if the company is a club or other similar association, any alteration in its
memorandum, which requires the members to pay recurring or periodical
subscription at a higher rate, shall be binding upon the members although they do
not agree in writing to be bound by the alteration.
The liability of directors, managing director or manager can be made unlimited by
passing a special resolution, if the articles so permit and if the officer concerned
has given his consent to his liability becoming unlimited [Sec. 323].
In case of unlimited liability company, the liability may be made limited or
reduced by re-registration of the company. The alteration will not affect any debts,
liabilities, obligations contracts entered into by or with the company before the
registration of the unlimited company as a limited company [Sec. 32(3)].
5.4.5 Alteration of Capital Clause
Alteration of the capital clause may take any of the following shapes –
(i) Alteration of share capital (Secs. 94, 95 and 97).
(ii) Reduction of share capital (Secs. 100 to 104).
(iii) Variation of the shareholders (Secs. 106-107).
(iv) Re-arrangement of share capital (Sec. 391)
(i) Alteration of share capital. According to section 94, a company limited by
shares or a company limited by guarantee and having a share capital can alter the
capital cause of its memorandum, in any of the following ways :
(a) it may increase its authorised share capital. It is to be noted that further issue of
unissued shares within authorized capital is governed by Section 81 of the Act and
shall not alter the memorandum. The board of directors, if so authorized by the
16
article may increase the issued capital within the limit of authorised capital, by
passing a board's resolution.
(b) it may consolidate or sub-divide the whole or any part of its existing shares
into shares of larger or smaller denomination.
(c) It may convert its fully paid-up shares into "stock" or vice versa.
(d) It may cancel its unissued shares, i.e. shares which have not been subscribed
for by any person, and diminish the amount of its authorised shared capital by the
amount of the shares so cancelled. It is to be remembered that diminution of
authorised share capital by canceling of unissued shares does not amount to
reduction of share capital, for the cancelled shares have never been issued to
anyone. The object of such cancelling may be to get rid of an unissued class
carrying inconvenient rights.
A company can make any of these alterations by simply passing an ordinary
resolution, provided it is authorized by its articles to do so. If the articles do not
provide for it, then firstly article must be changed by passing a special resolution.
Within thirty days of the date of passing the resolution notice must be given to the
Registrar together with a copy of resolution and altered memorandum, who will
then register the altered memorandum. It is from the date of passing the ordinary
resolution that the change becomes effective.
It is worth nothing that is no necessity of passing a resolution for alteration of
authorised capital where it stands increased by reason of :
(a) an order made by the Central Government for conversion of any loans or
debentures into shares of the company; or
(b) an order made by the Central Government on the application of any 'public
financial institution' which proposes to convert any debentures or loans with
conversion clauses into shares of the company. [Section 94 A(1) and 94 A (2)].
(ii) Reduction of Share Capital : With a view to ensuring that the company's
assets (cushion of safety to the creditors) are not freely distributed to the
shareholders, the reduction of the share capital is closely guarded under the
Companies Act. It is permitted for legitimate purposes only. For instance, a
company may be allowed the reduction of share capital (1) to write off lost capital
(capital unrepresented by any tangible asset owing to heavy trading losses or
unsound investments, or (2) to pay off surplus capital. Sometimes a company may
find itself over-capitalised, that is its rate or earnings may be less than the average
rate of return in similar other companies. In such a case it may genuinely decide
for reduction of share capital as a corrective step for improving its rate of earnings
17
vis-à-vis other companies in the same industry by accepting pro-rata surrender of
shares by members.
In so far as the methods of reducing the share capital are concerned, the
Companies Act leaves the company free to adopt any method it likes. Section 100,
however, specifies the following three methods which a company may adopt fro
reducing its share capital:
(a) it may reduce the liability of members an any shares not fully paid-up, to the
extent of uncalled capital; or
(b) it may write off the lost capital, e.g. capital unrepresented by any available
assets; or
(c) It may pay off any paid – up share capital which is in excess of the need of the
company.
The other methods of reduction may be cancellation of fully paid-up shares which
the holders is willing to get cancelled for the benefit of the company, or reduction
of share capital by means of canceling the 'reserve capital' (i.e. that portion of
uncalled capital which cannot be called up except in the event of winding up) is
not permitted [Natal Land Company v. Paulin Colliery Syndicate, (1904) A.C.
120].
It must, however, be noted that "forfeiture of shares" for non-payment of calls and
"redemption of redeemable preference shares" are not treated as a reduction in
share capital. The reason for not treating these as reduction of capital is that by
resorting to any of these act, the fund, out of which creditors are to be paid does
not diminish.
(iii) Variation of the rights of shareholder - An alternation of the memorandum
will also result from a modification of the rights of a class of shareholders where
such rights are conferred by the memorandum. When there are different classes of
shareholders in a company enjoying different dividend and voting rights, then any
change in their rights without prejudice to any existing rights of other classes of
shareholders may be brought in accordance with the procedure laid down under
Section 106-107 of the Act. Accordingly, for effecting the variation of the rights
of different classes of shareholders – Firstly, memorandum or articles of company
or terms of issue of that class of shares must permit such a variation of rights.
Secondly, a special resolution sanctioning the variation must be passed at a
separate meeting of the shareholder of the class affected.
Under Section 107 the shareholders who dissent from the variation have a special
right of appeal. Dissenting members, holding not less than ten per cent of the
18
issued shares of the class affected, may, within twenty –one days after passing of
resolution, apply to the Court to cancel the variation. If such an application is
made, then variation shall not take effect until it is confirmed by the Court. If the
Court is satisfied that the variation would unfairly prejudice the interests of the
class of shareholders which have moved the application, it may disallow the
variation, otherwise it will confirm the variation.
(iv) Re-arrangement of share capital (Sec. 391) . The capital clause will also be
altered where the share capital is stated by the memorandum to consist of
preference share and equity shares and its is proposed to consolidate all such
shares into one class of equity shares, or where the capital is stated by the
memorandum to consist entirely of equity shares and it is proposed to convert a
part of those into preference shares. The change is effected by means of a
"scheme of arrangement" under Section 391.
Note : It may be recalled that an unlimited company having a share capital is not
required to have the Capital Clause in its memorandum. In the case of such a
company, Section 27(1) provides that the amount of 'Registered Share Capital'
must be stated in the 'articles' of the company. Alteration of capital clause,
therefore, does not involve alteration of memorandum in the case of companies
with unlimited liability and having a share capital.
In the end, it may be noted that where an alteration is made in the memorandum of
a company, every copy of the memorandum subsequently issued must be in
accordance with the alteration. For non-compliance with this requirement, the
company and every officer of the company who is in default, shall be punishable
with fine which may extend to Rs. 100 for each copy so issued (Sec. 40).
5.5
Doctrine of Ultra Vires
A company which is incorporated by statutory authority cannot do anything
beyond the powers conferred upon it by the statute itself or by memorandum of
association.
The doctrine of ultra vires means that those transaction or acts of a company
which are outside the ambit of its object clause are deemed to be ultra vires the
company. Any purported activity beyond such power will be ineffective and void
even if agreed to by all the members. The word 'ultra' means beyond and the word
'vires' means power. 'Ultra vires' therefore means beyond the powers. The
application of the doctrine of ultra vires to the Joint Stock Companies was first
explained by the House of Lords in Ashbury Rly. Carriage & Iron Ltd. v. Riche
[1875] LR 7 HL 653. In this case the company had been formed with the object of
19
carrying on business as Mechanical Engineers and General Contractors'. The
contractors entered into an agreement with riche for financing the construction of
railway line in Belgium and the company subsequently purposed to ratify the act
of the directors by passing a special resolution at a general meeting. The company
repudiated the contract and thereupon riche sued the company for breach of
contract. His contentions were : firstly, that the contract in question come well
within the meaning of the words 'general contractors' and was therefore, within the
powers of the company, and secondly, that the contract was satisfied by the
majority of the shareholders.
The House of Lords held that the term 'general contractors' must be taken to
indicate the making generally such contracts as were connected with the business
of mechanical engineers, any other interpretation would virtually allow the
carrying on business of any kind and making the object clause unmeaning. Hence
the contract was entirely beyond the powers of the company hence void.
The court also, explained the object of the doctrine as :
(i)
to protect investors of the company so that they may known the objects
in which their money is to be employed, and
(ii)
to protect the creditors by ensuring that the company funds to which
they must look for payment are not dissipated in unauthorized activities.
In Lakshamanawami Mudaliar v. LIC, AIR 1963 SC 1185, the Supreme Court of
India has affirmed that an ultra vires contract remains ultra vires even if all
shareholders agree to ratify it. In this case, the directors of the company were
authorized 'to make payment towards any charitable or any benevolent object or
for any general public or useful object.' In accordance with the shareholder
resolution, the directors paid Rs. 2 lakhs to a trust for the purpose of promoting
technical and business knowledge. The company's business having been taken
over by LIC, it had no business left of his own. The court held that the payment
was ultra vires the company. They could spend for the promotion only on such
charitable objects as would be useful for the attainment of the company's own
objects.
One important facts is to be noted that the ultra vires doctrine is now a days very
largely frustrated by the ingenuity of company promotes who, by enumerating all
objects possible under the sun have in actual practice made the doctrine
ineffective, except in very rare cases. For example in the case of Bell Houes Ltd. v.
City Wall Properties Ltd. [1966] 36 comp. Cas. 779, the object clause included a
power 'to carry on any other trade or business whatsoever we can, in the opinion of
the Board of Directors, be advantageously carried on by the company. The said
20
clause was held to be valid by the court.
Therefore, the 'doctrine of ultra vires' was dropped by the English Companies
(Amendment) Act, 1989. Any document signed or contract entered by any office
on behalf of the company even beyond the power of the company is now binding
against the company in England. The company is allowed to proceed against the
officer at fault.
Here, it is important to note that section 13(1)(d) of the Companies Act, 1956
provides that objects incidental to or ancillary to the main objects can well be
pursued. In case, any such incidental objects has not been specified, it would be
allowed by the principle of reasonable construction of memorandum.
It is also to be noted, that if the act instead of being ultra vires the company is ultra
vires the directors only, the whole body of the shareholders can ratify it by passing
an ordinary resolution and make it binding upon the company. Also, if an act is
ultra vires the articles, the company can alter the articles by passing a special
resolution, so as to make the same intra vires (within the powers) the articles with
retrospective effect.
5.6 Consequences of Ultra Vires Transactions
Some of the important consequences of ultra vires transaction are : (i)
Void ab-initio :
The ultra vires acts are null and void ab-initio. The company is not bound by
these acts and cannot sue or be sued upon it.
(ii)
Personal Liability of Directors:
It is one of the duties of directors to ensure that the funds of the company is used
only for the legitimate business of the company, and hence if such capital is
directed into purpose not warranted by the memorandum of the company, the
directors will be personally liable to replace it.
In Weeks v. Propert, [1873] LR 8 CP 427, a railway company invited applications
for a loan on debentures, although it had already exhausted its limits as laid down
in the memorandum. On seeing the advertisement the plaintiff offered a loan of
£500 which was duly accepted by the directors. The loan being ultra vires the
company was held to be void and not binding upon the company but the directors
were held personally liable because by inserting the advertisement, they had
warranted that they had the power to borrow which they did not, in fact, posses
and as such their warranty of authority was broken.
21
Similarly, in Jehangier R. Modi v. Shamji Ladha [ 1866-67] 4 Bom. HCr 1855, the
Bombay High Court held that a shareholder can maintain an action against the
director to compel them to restore to the company the funds of the company that
have been employed in a transaction that they have no authority to enter into
without making the company a party to suit.
Also, in case of deliberate misapplication, criminal action can also be taken for
fraud.
(iii) Property Acquired Ultra Vires :
Where the company's money has been spent in purchasing same ultra vires
property, the company's right over the property is held secured. For the asset,
though wrongly acquired, represents the corporate capital. Besides the company
has also the right to protect such property against damage by third persons.
(iv) Ultra Vires Contracts :
A contract which is ultra vires the company is null and void ab-initio and devoid
of any legal effect. Thus, any one entering into an ultra vires contract cannot make
the company liable for his claim.
In Re, Jon Beauforte (London) Ltd. is an illustration on the point. In this case, a
company formed for the purpose of carrying on business as 'costumiers and gown
makers' directed to change to the manufacture of 'veneered panels' which was
admittedly ultra vires. The company entered into contracts for the construction of
a factory, for the purchase of veneers and for the purchase of coke. The company
failed and went into liquidation shortly afterwards. It was held that none of
supplier could prove for their debts in the company's liquidation as every one
dealing with a company is supposed to know its objects and if he acts carelessly,
he takes the risk.
However, in Deonarayana Prashad v. The Bank of Borada Ltd., 58 Bom. L.R.
1056, it was held that if money or property obtained under ultra vires contract has
been used to pay intra vires debts of the company, then by the principle of
subrogation the creditor can, to that extent, stand in the shoes of those creditors
who have been paid off, but he cannot claim any securities held by such creditors
for their debits.
Also, is Sinclair v. Brogham, (1914) A.C. 398, it was held that if the property
handed over to the company or money lent to the company under an ultra-vires
contract, exists in specie or if it can be traced in specie, or if it has been expanded
in purchasing some particular assets, the person handing it over can get it back,
and obtain an injunction restraining the company from parting with it, provided he
22
intervenes before the money is spent or the identity of the property is lost or the
property passes into the hands of the bonafide purchasers for value.
(v) Ultra Vires Torts :
A company cannot be liable for torts committed by its officers in connection with
a business which is entirely outside its objects. The company can be made liable in
tort only if these are committed in the course of intra vires transactions by its
officers within the course of their employment.
(vi) Injunction :
If a company is about to undertake an ultra vires act, any member or members of
the company can get an order of injunction from the court restraining the company
from going ahead with the ultra vires act – Attorney General v.G.R. Eastern
Railway Company, [1880] 5 AC 473.
5.7
Summary
Memorandum of association of a company is a document of great importance. It
defines as well as confines the power of the company. Ay act beyond the scope of
the memorandum is ultra vires the company and thus unenforceable. Section 13
requires the memorandum of a limited company to contain information about its
name (with 'limited' or 'private limited' as the last word(s), as the case may be );
the name of the State in which registered office is to be situated; the objects stating
separately the 'main objects' and 'other objects' the liability being limited; the
amount of authorised share capital and its division into shares of fixed amounts.
Nothing should contain in the memorandum which is contrary to the provisions of
the Companies Act.
Under Name Clause : Promoters are free to choose any suitable name for the
company provided (i) the last word / (s) is / are 'limited' or 'private limited' as the
case may be (except in case of 'association not for profit' if licensed by the Central
Govt.); (ii) the name chosen is not undesirable.
Every company is required to paint or affix it name and address of its registered
office outside of every office or place of business in a conspicuous position and in
letters which are easily liable and in the language in general use in the locality.
Registered office clause : This clause statues the name of the State in which the
registered office of the company will be situated. Registered office of a company
established its domicile.
The Objects Clause : Section 13(1)(d) of the Companies Act, 1956 requires the
company to divide its objects into three parts :
23
(i)
the main objects;
(ii)
objects incidental or ancillary thereto; and
(iii)
other objects.
Any Act beyond the objects stated in the memorandum is ultra-vires the company
and thus void. However, besides the powers stated in the memorandum, every
company has certain implied powers like the power to borrow, power to sell and
purchase. But power likes acquiring a business similar to company's own entering
into partnership, promoting other companies or helping them finically have been
held to be outside the scope of implied powers of a company.
Liability clasue : This clauses states the nature of liability of the members. In the
case of a limited company, it must also state that the liability of its members is
limited. Memorandum of an unlimited liability company need not have this
clause.
Association or Subscription Clause: At the end of the memorandum of every
company there is an association or subscription clause. Each subscriber must write
opposite his name the number of shares he takes.
Alternation of Memorandum: The contents of a memorandum can be altered only
in the manner and to the extent provided in the Companies Act.
Name of a company can be changed by passing a special resolution and obtaining
the approval of the Central Government. However, approval of the Central
Government is not necessary where the only change sought is addition or deletion
of word 'private'.
Where a company has been registered by undesirable name, the Central
Government may direct it to alter its name. In such a case, the company may
change its name by passing an ordinary resolution and then obtaining confirmation
of the Central Government for the new name.
Registered office of a company may be shifted from one premises to another
premises by passing a resolution of the Board of directors and intimating the
change of RoC within 30 days thereof. But where the registered office is proposed
to be shifted from one city to another city within the same State, special resolution
at a general meeting of shareholders must be passed. However, if shift of
registered of office from one city / town, etc. to another but within the same State
result in change of jurisdiction of one RoC to the other, approval of Regional
Director shall also be necessary. The change should be intimated to RoC within 30
days of passing the resolution. However, shifting of registered office from one
State to another State is considered a serious matter and is allowed only on
24
ground stated under section 17(1) and subject to passing special resolution of
shareholders as well as the approval of the Company Law Board (now Central
Government).
The grounds for altering objects are the same as required for shifting of registered
office from one State to another. But no longer, the approval of Company Law
Board is necessary. However, in case of shifting of registered office, intimation
shall be required to be set not only to the Registrar wherefrom the office is
proposed to be shifted but also to the Registrar of the State to which it is proposed
to be shifted.
Liability of the member cannot be increased unless the member agrees in writing.
However, the liability of members of an unlimited liability company may be made
limited or reduced by re-registration of the company.
Alteration of capital clause may involve increase or decrease of authorized capital
of the company, or sub-division or consolidation of shares or cancellation of
shares not taken or agreed to be taken by any person. Any of these changes can be
done, as per Sec. by passing an ordinary resolution in general meetings of
shareholders.
5.8
Check Your Progress
1.
"The memorandum of a company is its charter of existence". Discuss.
2.
How and for what purposes the various clauses of the memorandum can be
altered?
3.
What is alteration of share capital ? How is it different from reduction of
share capital?
4.
Discuss the 'doctrine of ultra vires'. What are the consequences of the ultravires acts of the company?
25
Unit-6 : Articles of Association
Structure:
6.1
Meaning
6.2
Relation between Memorandum and Articles
6.3
Contents of Articles
6.4
Alteration of Articles
6.5
Binding Force of Memorandum and Articles
6.6
Doctrine of Constructive Notice
6.7
Doctrine of Indoor Management
6.8
Summary
6.9
Check Your Progress
6.1 Meaning
The articles of association of a company contain the rules, and bye-laws that
govern the management of its-internal affairs. They are similar to the ‘partnership
deed’ in a partnership. They prescribe rules and regulations for the general
management of the company and for the attainment of its objects as given in its
memorandum.
Section 2(2) of the Companies Act, 1956 defines articles as ‘articles’ mean the
articles of association of a company as originally framed or as altered from time to
time in pursuance of any previous companies laws or the present Act i.e., the Act
of 1956.
The Article define the power of its officers. They also create a contract between
the company and the members and between the members inter-se. They also
provide for the matters like the making of calls, forfeiture of shares, qualifications
26
of directors, appointment of auditors, powers and duties of auditors, procedure for
transfer and transmission of shares and debentures.
The general functions of articles of association were clearly stated by Lord Cairns
in Ashbury Railway Carriage Co. vs. Riche [(1875),L.R.7H.L.653, p.670.] where
he observed that “the articles play a part subsidiary to the memorandum of
association. They accept the memorandum as the charter of incorporation of the
company, and so accepting it, the articles proceed to define the duties, the rights
and the powers of the governing body as between themselves and the company at
large, and the mode and form in which the business of the company is to be
carried on, and the mode and form in which changes in the internal regulations of
the company may from time to time be made.” Being subordinate to the
memorandum, they cannot extend the objects as defined in the memorandum.
Section-26 states that a public company limited by shares may register articles,
while company limited by guarantee or an unlimited company or a private
company limited by shares must register articles along with the memorandum at
the time of registration. In other words, it is optional for a public company limited
by shares to register-articles, whereas other types of companies are required to do
so compulsorily. There arises a question as to what happens if a public company
limited by shares does not register any articles. The answer to this question is
provided by Section 28(2) which states that if a public company limited by shares
does not register any articles, “Table A” (the model set of 99 articles given in
Schedule 1 at the end of the Companies Act) shall automatically apply to such a
company. Even if such a company registers articles of its own, “Table A” will still
apply automatically on all such points on which the said articles are silent, unless
its regulations have expressly been excluded by the company in its articles.
27
The articles of association shall be (a) printed, (b) divided into paragraphs
numbered consecutively, and (c) signed by each signatory of the memorandum in
the presence of at least one attesting witness (Sec. 30).
6.2 Relation between Memorandum and Articles
The memorandum of a company defines the company’s objects and various
powers of the company whereas the articles regulate the manner in which the
company’s affairs will be managed and how the objects of the company shall be
achieved and how the powers are to be exercised. The articles of a company are
subordinate to the memorandum of association. The memorandum, being the
fundamental document, can be altered only in certain circumstances provided by
the Act. But the articles are only internal regulations and can be altered by the
company as and when it thinks fit. The only precaution to be taken is to see that
the regulations provided for in the articles do not exceed the powers of the
company as given in its memorandum. Despite the rule that the memorandum
prevails in case there is any conflict between the memorandum and articles, they
are contemporaneous documents and must be read in conjunction and any
ambiguity and uncertainty in one document may be removed by reference to the
other document. But if the memorandum is perfectly clear, a doubt as to its
meaning cannot be raised by reference to the articles and in such a case the articles
are supply inconsistent with the memorandum and are disregarded.
As to distinctions between the functions of the memorandum and the articles of
association, Lord Justice Bowen observed in Guineness vs. Land Corporation of
Ireland [(1882),22Ch.D.349]. “The memorandum contains the fundamental
conditions upon which alone the company is allowed to be incorporated. They are
conditions introduced for the benefit of the creditors, and the outside public, as
well as of the shareholders. The articles of association are the internal regulations
of the company and are for the benefit of the shareholders.” To quote Lord Cairns
28
[Ashbury Railway Carriage Co. vs. Riche, (1875) L.R.7 H.L.653, p.671.] again :
“The memorandum is, as it were, the area beyond which the actions of the
company cannot go; inside that area the shareholders may make such regulations
for their own management as they think fit in the form of the articles of
association.”
The fundamental points of distinction between these two important documents are as follows:
(1) The memorandum contains the fundamental conditions upon which
alone the company is allowed to be incorporated. It defines and limits the objects
of the company beyond which the actions of the company cannot go. The articles
are the internal regulations of the company and are subsidiary to the
memorandum.
(2) The memorandum is subordinate to the Act only, while the articles are
not only subordinate to the Act but also to the memorandum..
(3) The memorandum must compulsorily be filed with the Registrar by all
types of the companies at the time of incorporation while a public company
limited by shares need not file a separate set of articles at the time of incorporation
as it may choose to adopt Table ‘A’ - the model set of articles.
(4) The memorandum defines the relation between the company and the
outsiders, i.e., creditors, buyers, sellers, debtors and members, etc. Articles govern
internal relationship between the company and the members and generally have
nothing to do with the outsiders.
(5) The memorandum cannot be easily altered while articles are easily
alterable by passing a special resolution only.
(6) Acts done by a company ultra vires the memorandum are void and
cannot be ratified by the shareholders. But acts done by a company ultra vires the
29
articles but intra vires the memorandum are simply irregular and not void and can
be ratified subsequently by the shareholders.
(7) Outsiders have no remedy against the company for contracts entered
into ultra vires the memorandum, while they can enforce contract against the
company even if it is ultra vires the articles, i.e.. where some formality relating to
internal regulation like passing of the required resolution, might have not been
performed, provided they act carefully and had no notice of the irregularity.
6.3 Contents of Articles
Articles usually deal with the rules and bye-laws on matters like :
(1)
The extent to which “Table A” is applicable.
(2)
Different classes of shares and their rights.
(3)
Procedure of making an issue of share capital and allotment thereof.
(4)
Procedure of issuing share certificates and share warrants.
(5)
Forfeiture of shares and the procedure of their re-issue.
(6)
Procedure for transfer and transmission of shares.
(7)
The time lag in between calls on shares.
(8)
Conversion of shares into stock.
(9)
Lien on shares.
(10)
Payment of commission on shares and debentures to underwriters.
(11)
Rules for adoption for 'preliminary contracts', if any.
(12)
Re-organisation and consolidation of share capital.
(13)
Alteration of share capital.
(14)
Borrowing powers of directors.
(15)
General meetings, proxies and polls.
(16)
Voting rights of members.
(17)
Payment of dividends and creation of reserves.
(18)
Appointment, powers, duties, qualifications and remuneration of directors.
(19)
Use of the Common Seal of the company.
30
(20)
Keeping of books of account and their audit.
(21)
Appointment, powers, duties, remuneration, etc., of auditors.
(22)
Capitalisation of profits.
(23)
Board meetings and proceedings thereof.
(24)
Rules as to resolutions.
(25)
Appointments, powers, duties, qualifications, remuneration, etc., of
managing director, manager and secretary, if any.
(26)
Arbitration provisions, if any.
(27)
Provision for such powers which cannot be exercised without the authority
of articles, for example, the issue of redeemable preference shares; issuing
share warrants to bearer; refusing to register the transfer of shares; reducing
share capital of the company; accepting payment of Calls in advance; the
appointment of additional or alternate director(s).
(28)
Winding up.
In addition to the above matters, the articles of an unlimited company should state
the number of members with which the company is to be registered and if it has a
share capital, the amount of share capital with which it is to be registered [Sec.
27(1)]. In the case of a company limited by guarantee, the articles must state the
number of members with which the company is to be registered [Sec. 27(2)]. The
articles of a private company having a share capital must contain the four
restrictions as given by Section 3(1) (iii) under sub-clauses (a), (b), (c) and (d),
namely:
(a)
restriction on the right of the members to transfer shares;
(b)
limitation of the number of its members to fifty, excluding members who
are or were in the employment of the company; joint holders of shares to be
treated as single member;
(c)
prohibition of any invitation to the public to subscribe for any shares in, or
debentures of, the company; and
31
(d)
prohibition of acceptance of deposits from the public.
In the case of a private company not having a share capital, the articles must
contain provisions relating to the matters specified in the above mentioned subclauses (b), (c) and (d) only. [Sec. 27(3)].
It must, however, be remembered that articles should not contain anything which
is against the law of the land, the Companies Act, the public policy and ultra vires
the memorandum. Any such clauses shall be inoperative and void.
32
6.4 Alteration of Articles
As already told that being the internal regulations of the company, the articles can
be freely altered by the company. The right to alter the articles is expressly
conferred by Section 31 which states that a company may alter its articles, as often
as required, by passing a special resolution only. A copy of special resolution
authorising the alteration together with a printed copy of the altered Articles must
be filed with the Registrar within 30 days of passing the said resolution. The
alteration will be effective from the date of registration by the Registrar.
It is to be observed that this power to alter articles is a statutory power and cannot
be negatived in any way. A company cannot deprive itself of this statutory right
either by inserting a clause in the articles or by a contract with any one (Andrews
vs. Gas Meter Co.) [(1897), 1 Ch. 361]. Further, articles can be re-altered by
passing a special resolution and they can also be altered with a retrospective effect
(Allen vs. The Gold Reefs of West Africa Ltd.) [91990), 1 Ch. 656, Also see All
India Railwaymen’s Benefit Fund vs. Bareshwar Nath, I.L.R. (1945) Nag. 599].
The freedom of the company to alter its articles is, however, subject to certain
limitations.
Limitations Regarding Alteration of Articles
(1)
The alteration must not be inconsistent with the provisions of the
Companies Act or any other statue (Sec.3). Thus a company cannot alter its
articles so as to exclude or limit the rights of its shareholders to present a petition
for the winding up of the company, because this right is conferred by Section 439.
The alteration cannot be made so a to increase the liability of any member without
his written consent, for, it shall be contrary to Section 38 of the Act. However, it is
possible that the articles may impose on the company conditions stricter than those
provided under the law, for example, they may provide that a resolution should be
passed by a special majority when the Act requires it to-be passed by an ordinary
33
majority. Similarly, the articles may provide that all the directors would be liable
to retire by rotation when the Act provides that in the case of a private company all
the directors can be permanent and in the case of a public company one-third of
the total number of directors can be permanent.
(2)
The alteration must not be inconsistent with the conditions contained
in the memorandum (Sec. 31). The articles are subject to the memorandum and
so must not over-ride the memorandum. As such they cannot be altered so as to
give powers which are not given by the memorandum. In the event of conflict
between the memorandum and the articles, the memorandum will prevail.
(3)
The alteration must not be inconsistent with the alteration ordered by
the Company Law Board (now Tribunal). In the exercise of its powers to
remedy “oppression” and “mismanagement” under Section 397 and 398, the
Company Law Board has power to alter a company’s memorandum and articles in
any way it thinks fit. When the Company Law Board (now Tribunal) has amended
the memorandum or articles, the company can make no alteration which is
inconsistent with the Company Law Board’s (now Tribunal) order without the
permission of the Board (Sec. 404).
(4)
Approval of the Central Government must also be obtained in certain
cases. For example, in the following cases alteration made in the articles shall be
valid and operative only if such alteration has also been approved by the Central
Government:
(a) If alteration results in the conversion of a public company into a private
company. (Sec.31)
(b) In the case of a public company, if alteration relates to any provision
regarding the appointment or re-appointment of a managing or whole-time
director or of a director not liable to retire by rotation, and the proposed
34
alteration is not in accordance with the conditions specified in Schedule
XIII in that regard. (Sec. 268 read with Schedule XIII).
(c) In the case of a public company, if alteration results in an increase of
remuneration to a director including a managing or whole-time director
beyond the limits prescribed in Schedule XIII (Sec. 310 read with Schedule
XIII).
Where the alteration has been approved by the Government, a printed copy of the
Articles as altered shall be filed by the company with the Registrar within one
month of the date of receipt of order of approval.
(5) The alteration must not deprive any person of his rights under a
contract. Alteration should not destroy any of the rights possessed by any person
by virtue of a contract. In British Murac Syndicate Ltd. v. Alperton Rubber Co.
[1915] 2 Ch. 186 ..... (p.171 Majumdar). In Allen vs. The Gold Reefs of West
Africa Ltd., [(1900), 1 Ch. 656]. Lord Lindley observed “................. Thus a person
appointed in accordance with the provisions of the articles as a director on a fixed
remuneration of Rs. 2,000 p.m. under an independent contract of services, cannot
be made to accept a lesser amount by altering the articles.” It is to be observed,
however that in case a person accepts the appointment purely on the terms of the
articles, the alteration shall be valid and binding upon such a person. For example,
in C. Chettiar vs. Krishna Ajyanger’s case the articles provided Rs. 250 p.m. as
pay for the company’s secretary. The post was accepted by the plaintiff and in the
specific agreement with him the articles were referred to show the terms of the
contract. Later on the company changed the articles so as to reduce the secretary’s
pay to Rs. 25 p.m. The alteration was held valid and operative. It was stated that
any one accepting an appointment purely on the terms of the articles takes the risk
of those terms being altered.
35
The facts of Hari Chandra vs. Hindustan Insurance Society [A.I.R. (1925)
Cal. 690] also involved a situation of this kind. In this case the plaintiff had taken
out a policy of life insurance in the defendant company. Under the Policy the
plaintiff was entitled to draw from the company a certain sum on a certain date.
Later the company altered its articles to the effect that such withdrawals of money
could be made only out of a special fund. At the time the amount became payable
to the assured, there was no money in the special fund. The plaintiff sued for his
payment under the original contract. Held, the alteration of articles was not valid
because it involved a fundamental breach of contract which the company had
previously entered into with the plaintiff.
It is also important to note that an alteration in the articles cannot be made
to avoid a contract which is validly undertaken. But, where the damage is capable
of being measured in terms of money, the company may alter its articles, subject
to the its liability for damages in breach of contract.
(6)
The alteration must not constitute a fraud on the minority by the
majority. An alteration to the articles must not discriminate between the majority
shareholders and minority shareholders so as to give the former an advantage over
the later. Alteration would be liable to be invalid if the effect of it were to defraud
or oppress the minority shareholders, so as to give the majority shareholders an
advantage of which the minority shareholders were deprived. This principle was
laid down in the case of Menier vs. Hooper’s Telegraph Works [(1874), 9 Ch.
App. 350]. In this case the majority of the members of Company A were also
members of Company B. At a meeting of Company A, they passed a resolution to
compromise an action against Company B in a manner alleged to be favourable to
Company B but unfavourable to Company A. On an action by the minority of
Company A, the resolution was held invalid and the compromise was set aside.
The Court observed, “It would be a shocking thing if that could be done, because
the majority have put something into their pockets at the expense of the minority.”
36
Similarly, the Court will certainly intervene if the majority pass a resolution
sanctioning a sale of the company’s property to themselves at an undervalue.
Again in Brown v. British Abrasive Wheel Co. [1919] 1 Ch. 290, the majority
which held 98% of the shares passed a special resolution that upon the request of
holders of 9/10th of the issued shares, a shareholder shall be bound to sell and
transfer his share to the nominee of such holder at a fair value. The alteration was
held to be invalid since it amounted to oppression of minority.
(7)
The alteration must be bonafide for the benefit of the company as a
whole. Alteration shall not be valid if it has been made for the benefit of an
aggressive or fraudulent majority. On the other hand, alteration made bonafide in
the interests of the company shall be valid even if it is likely to inflict hardship on
an individual shareholder. Thus, in Sidebottom vs. Kershaw, Leese & Co. [1920), 1
Ch. 154], the Court upheld an alteration of the articles of a private company,
which authorised the directors to order any shareholder, carrying on a competitive
trade to that of the company, to transfer his shares at a fair value to the persons
nominated by the directors, on the ground that the alteration was for the benefit of
the company as a whole, individual hardship being irrelevant. The distinction
between these two cases must, however, be noted. Whereas in the former case the
alteration was clearly for the benefit of an aggressive majority, in the latter it was
not, because under the given circumstances it would likewise have operated
against the majority.
6.5 Binding Force of Memorandum and Articles
Regarding the binding force or legal effect of the memorandum and articles of the
Act provides that, “subject to the provisions of the Act, the memorandum and
articles shall, when registered, 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 (agreements) on its and his part to observe all
37
the provisions of memorandum and of the articles.” It follows from the language
of the Section that the memorandum and articles bind the company to its members,
the members to the company, the members to each other in an exceptional case.
But in relation to articles, neither a company nor its members are bound to
outsiders. To clarify the position we shall now see the legal effect of this provision
(i.e., Sec. 36) under the following heads in some details :
1. Company bound to members. The articles and memorandum constitute a
contract binding the company to its members in their capacity as members, and as
such a company is bound to comply with the provisions of these documents. As a
result each member can restrain the company from committing a breach of the
articles or/and memorandum which would affect his rights as a member, by
bringing an injunction against it (Re Peveril Gold Mines Ltd.) [(1889), 1 Ch. 122.].
The members can retain a company from spending money on ultra vires
transaction. An individual member can make the company fulfill its obligation to
him, such as to send the notice for the meetings, to allow him to cast his vote in
the meeting etc. In Johnson vs. Lyttle’s Iron Agency [(1877), 5Ch. 687], a
forfeiture of shares, irregularly effected by the company, was set aside at the
instance of the aggrieved member as the company did not comply with the
provisions of the articles.
It must be noted that these documents bind the company to members and vice
versa in respect of their membership rights only and not contractual rights of other
kinds. Even a member enjoying certain rights in capacity other than a member
cannot enforce them against the company. Thus, where the articles provided that
the company should purchase certain property belonging to a member, there was
held to be no contract between the company and the member to that effect (Re
Tavarone Mining Co.). [(1873), 8 Ch. App. 956].
38
In Wood v. Odessa Waterworks [1889] 42 Ch. D. 636, the directors proposed to
pay dividend in kind by issuing debentures. The articles provided for payment of
dividends. The court held that payment means payment in cash and therefore the
company could be compelled to pay dividend in terms of the articles.
Normally, action for breach of articles against the company can be brought only
by majority of the members. Individual or minority members cannot bring such a
suit except when it is intended for enforcement of personal rights of members or to
prevent the company from doing any ultra vires or illegal act, fraud, or acts of
oppression and mismanagement.
2. Members bound to the company. Members are bound to the company to
observe and follow the provisions of the memorandum and articles, just as if every
one of them had contracted to conform to them. All money payable by any
member to the company under the memorandum or articles shall be a debt due
from him to the company (Sec. 36). It follows, therefore, that a company can sue
its members for the enforcement of its articles as well as for restraining their
breach. Thus, if the articles provide to refer any dispute between the company and
its member to arbitration, the court will stay an action by the member, in such a
dispute on an application made by the company. In Borland Trustees vs. Steel
Brothers & Co. Ltd. [(1901), l Ch.279], the articles of the defendant company
provided that the shares of any member who became bankrupt should be sold to
certain other persons at a certain price to be fixed by the directors. ‘B’ a
shareholder became bankrupt. His trustee in bankruptcy claimed that he was not
bound by the articles and he could dispose of the shares as he liked. It was held
that he was bound by the terms of the articles and could not claim the shares
against the company.
But this binding force on members is only in respect of their rights and obligations
as members. In Beattie vs. Beattie [(1938), Ch. 708], the articles provided that a
39
dispute arising between the company and any member would be referred to
arbitration. A director, who was also a member of the company, was sued for
wrongs done in his capacity as director. It was held that the arbitration clause was
not applicable to this dispute because it did not relate to the rights of director as
member but as director.
The article of association are the regulations of the company binding on the
company and its shareholders. Shareholders, therefore, cannot, among themselves.
Enter into an agreement which is contrary to or inconsistent with the articles of
association of the company [V.B. Rangaraj v. V.B. Gopalkrishnan (1992) 73
Comp. Cas. 201 (SC)].
3. Members bound to members. The articles bind the members inter-se as far as
rights and duties arising out of the articles are concerned.
In Smt. Claude-Lila Parulekar v. Sakal Papers (P) Ltd. [(2005) 59 SCL 414 (SC)]
it was held that the articles of association will have a contractual force between the
association or company and its members as also between members inter-se in
relation to their rights as such members.
Articles or/and memorandum do not create an express agreement between the
members of the company inter-se, because in usual course a member is not
allowed to sue another member directly for any wrong done to the Company or to
recover money alleged to be due to the company. The action must be brought by
the company itself or if it is in liquidation, by the liquidator (Borland v. Earle)
[(1902), A.C. 83]. If a shareholder defaults in making payment of a call made,
only the company may sue him because if other members are allowed to sue him,
there may be thousands of suits (if the number of members is that large) filed
against him, which shall be absurd.
In Rayfield v. Hand [1960] Ch. 1, the articles of a company provided that
whenever any member wished to transfer his shares, he was under an obligation to
40
inform the directors of his intention and the directors were under an obligation to
take the said shares equally between them at a fair value. The directors refused to
take shares of a particular member on the ground that the articles did not impose
an enforceable liability upon them. It was held that the directors were under an
obligation to purchase the shares, as members of the company, in terms of the
provisions of the articles. There was a personal liability of members amongst
themselves.
However, articles do not create an express content among the members of the
company. A member of a company cannot bring a suit to enforce the articles in his
own name against any other member or members. The company alone is
empowered to sue the offender in order to protect the aggrieved member.
A shareholder may, however, sue in his own name to restrain others from doing
fraudulent or ultra-vires act. Thus, in Jahangir R. Modi v. Shamji Ladha [1866-67]
4 Bom HCR [1855], the Bombay HC held that - “a shareholder can maintain an
action against the directors to compel them to restore to the company the funds of
the company that have been employed by them in ultra-vires transactions, without
making the company a party to the suit.
The only exception, where articles form a contract between individual members
qua members and where an individual member in his personal capacity, may sue
other member or members directly without joining the company as a party to the
action, is when the persons against whom relief is sought control the majority of
shares and will not allow an action to be brought in the name of the company and
the acts complained of, are either fraudulent or ultra vires (The Dhakeshwari
Cotton Mills Ltd. vs. Nilkamal) [(1937), A.I.R. Cal. 645].
4. Neither; the company nor, the members are bound to outsiders. The articles
and memorandum do not create any contract with outsiders, even though the name
of the outsider is mentioned in the articles e.g., solicitors, secretary, etc. A member
41
is also an outsider, if the matter in question is not connected with his membership
rights and obligations. An outsider cannot take advantage of these documents to
found a claim thereon against the company or its members, even though his name
may have been mentioned in the articles, for, such a person is not a party to the
contract constituted by the articles and memorandum. Thus, for instance, where
the articles provided for remuneration to be paid to promoters, it was held that the
promoters had no right of action againstthe company (Re Rotherham Alum & Co.)
[(1883), 25 D. 103].
Similarly in the case of Eley vs. Positive Goyernment Life Assurance Co. Ltd.
[(1876), 1 Ex. D.88] :
The articles provided that Eley should be the company's solicitor for life. Eley was
employed by the company and he also purchased certain shares of the company.
But the .specific contract with him did not contain the term that he shall be the
company’s solicitor for life.. After sometime the company dismissed him. He then
sued the company for damages for breach of contract. It was held that he had no
cause of action, because the articles did not constitute any contract between the
company and himself.
It may be noted that outsiders may acquire rights under the articles and can
enforce them against the "company if articles have been referred to show the
terms of the contract in the specific agreement between the outsider and the
company. Thus, where the directors were appointed under a specific contract
referring to therein the provisions of the articles in that regard which provided a
remuneration of Rs. 5,000 p.m. to a director, the terms of the articles become apart
of the contract which the directors could enforce against the company (Re New
British Iron Co.) [(1898), 1 Ch. 324].
6.6 Doctrine of Constructive Notice
42
After registration with the Registrar of Companies, the memorandum and articles
become “public documents” and every one who deals with the company is
presumed to have the knowledge of these documents (Mahony vs. East Holyford
Mining Co.) [(1875), 7 H.L. 869]. This is called the “Doctrine of Constructive
Notice.” The legal effect of this doctrine is that if a person deals with a company
in a manner which is inconsistent with the provisions contained in its
memorandum or articles (i.e., enters into a transaction which is beyond the powers
of the company as set out in those documents), he must be deemed to have dealt
with the company at his own risk and cost and shall have to bear the consequences
thereof. For example, if the articles provide that a bill of exchange must be signed
by two directors, a person who has a bill signed by only one director cannot claim
payment upon such bill.
Thus, persons dealing with a body corporate are bound to take notice of
disabilities imposed on the body corporate and its officials by the memorandum
and articles or other documents of constitution.
6.7 Doctrine of Indoor Management
The rule of ‘constructive notice’ caused too much inconvenience in business
transactions especially when the directors or other officers of the company were
empowered under the articles to exercise certain powers subject only to prior
approvals or sanctions of the shareholders.
As observed above, the “Doctrine of Constructive Notice” will estop a person
dealing with a company from pleading ignorance of the provisions contained in its
memorandum or articles. But where these documents prescribe some condition or
procedure to be fulfilled or adopted before a transaction is entered into, a perusal
of these public documents will give no indication whether the required condition
or procedure has been complied with. Also, the outsider cannot be deemed to have
43
constructive notice of any procedural failure, which he has no means of
discovering. It is for this reason that the courts have allowed an exception to the
“doctrine of constructive notice” and have enunciated a rule for the protection of
persons dealing with companies. The rule is that persons dealing with the
company in good, faith have a right to assume that the' internal requirements
prescribed in public documents have been observed. They are not bound to
enquire into the regularity of the internal proceedings.
This rule is known as the “Doctrine of Indoor Management.” The genesis of the
doctrine of indoor management could be traced back to the year 1856; when the
decision in the famous case of Royal British Bank vs. Turquand [(1856), 6E. & B.
327],was delivered. In this case the directors of a company were authorised by the
articles to borrow on bonds such sums of money as should from time to time, be
authorised to be borrowed, by a resolution of the company in general meeting. The
directors gave a bond to ‘T’ without the authority of any such resolution. The
question arose whether the company was liable on the bond. It was held that the
company was liable on the bond, as T was entitled to assume that the resolution of
the company in general meeting had been passed. The observation made by V.
Haldane in the case of Pacific Coast Coal Mines Ltd. vs. Arbuthnot [(1917), A.C.
607] is worth noting in this connection : “A person can be presumed to know the
constitution of the company, but not what may or may not have taken place within
the doors that are closed to him.”
The facts of County of Gloucester Bank vs. Rudry Merthyr & Co. [(1895), 1 Ch.
629], case provide another good illustration on the point. In that case a person was
issued a mortgage deed to which the seal of the company had been affixed at a
Board meeting at which no quorum was present. It was held that mortgage deed
was valid because the mortgagee had no means of knowing the internal
irregularity in the management.
44
Briefly stated the “doctrine of indoor management” lays down that 'persons
dealing with the company are only required to see that the proposed dealings are
apparently regular and consistent with the memorandum and articles. They need
not enquire into the regularity of the internal proceedings of the company. They
are entitled to presume that the directors are acting lawfully in what they do, and
can hold the company liable even if the internal formalities are found hot to have
been completed.’ The doctrine is of great importance in the world of commerce,
because in its absence the general plight of the persons dealing with companies
would have been miserable, for, the company, very often, could have escaped
liability by denying the authority of the officials to act on its behalf.
Thus, it is clear from the foregoing discussion that the ‘doctrine of constructive
notice’ put a burden on people entering into contracts with a company by making
presumption that they would have read the memorandum and articles of the
company even though they might not have actually read them. The ‘doctrine of
indoor management on the other hand allows all those who deal with the company
to assume that the provisions of the articles have been observed by the officers of
the company or, in other words the persons dealing with the company are not
bound to require into the regularity of internal proceedings.
Exceptions to the Doctrine of Indoor Management
In the following cases protection under this doctrine cannot be claimed :
(1)
Outsider had knowledge of irregularity. A person who has actual or
constructive notice (i.e., be presumed to know in the given circumstances) of .the
internal irregularity cannot obviously claim the protection of this rule. Thus in
Howard vs. Patent Ivory Co. [(1888), 38 Ch. D. 156], the directors, under the
articles, had no authority to borrow more than £ 1,000 without the sanction of a
resolution of the company in general meeting. Without such consent they
borrowed £ 3,500 from themselves and took debentures. It was held, that as they
45
had notice, of the internal irregularity, their debentures were good, only to the
extent of £ 1,000.
(2) Negligence on the part of the outsiders. If the circumstances are so
suspicious as to invite further enquiry and the outsider had not made proper
enquiries which would have revealed the irregularities, he would not be entitled to
the protection of the “doctrine of indoor management.” For example, if an officer
acts outside his apparent authority, the outsider cannot claim the protection of this
rule under the pretext that he presumed that the relevant power might have been
delegated to the officer, as per the articles. In such a case he must make further
enquiries otherwise he is taking the risk. A clear illustration is the case of Anand
Bihari Lal vs. Dinshaw & Co. [(1942), A.I.R. Oudh. 417)], where the plaintiff
accepted a transfer of company’s property from its accountant, the transfer was
held void. The plaintiff should have insisted on seeing the ‘power of attorney’
executed in favour of the accountant by the company before accepting the transfer,
as the transaction is apparently beyond the scope of an accountant's authority.
Even the unusual magnitude of the transaction may. put a person dealing with a
company upon enquiry as to its being authorised (Houghton & Co. vs. Nothard
Law & Wills) [(1928), A.C. 1].
(3) Forgery. The rule is of no avail where the outsider is found to have relied
upon a document which is a forged one, forgery is a nullity (i.e., void ab initio). In
the case of forgery it is not that there is absence of free consent but there is no
consent at all.
Thus, in Ruben vs. Great Fingall Ltd. [(1906), A.C. 439], the secretary of the
company forged the signatures of two of the directors, as required under the
articles, on a share certificate and issued the same to the plaintiff. The company
refused to accept him as a shareholder. The plaintiff pleaded that whether the
signatures were genuine or forged was a part of internal management and,
therefore, the company should be estopped from denying genuineness of the
46
document. But it was held that the plaintiff was not a shareholder and the
certificate was a nullity because this doctrine only applies to irregularities which
otherwise might affect a genuine transaction and it cannot apply to a forgery
which is void ab-initio.
Similarly in Kreditbank Cassel GmbH v. Schenkers Ltd. [1927] 1 KB 826, a bill
of exchange signed by the manager of a company with his own signature under
words stating that he signed on behalf of the company when actually it was drawn
in favour of a payee to whom the manager was personally liable, was held to be a
forgery. The bill is this case was held to be forged because it purported to be a
different document from what it was in fact.
It must, however, be observed that although a company is not liable for forgeries
committed by its officers, yet it may be held [Cf. Lectures on Company Law by
S.M. Shah, p. 55 (1975 ed.)] liable for fraudulent acts of its officers acting under
their ostensible authority on its behalf. Thus, where (Ibid) a director or a manager
of a company with ostensible authority under the memorandum. and articles of the
company, practices a fraud upon the company by not placing the money borrowed
by him on a hundi or a bill of exchange in the coffer of the company, the company
is bound to honour the hundi or the bill of exchange, as the case may be, and
cannot defeat a bonafide creditor’s claim for recovery of the money on the ground
o own officers (Shri Kishan vs. Mondal Bros. & Co.) [(1967), A.I.R. Cal. 75].
(4) No knowledge of Article & Memorandum. The rule cannot be invoked in
favour of a person who did not consult the memorandum and articles and thus did
not rely on them. In Rama Corporation v. Proved Tin & General Investment Co.
[1952] 1 All. E.R. 554, ‘A’ was a director in the investment company. He
purporting to act on behalf of the company, entered into a contract with the Rama
Corporation and took a cheque from the latter. The articles of the company did
provide that the directors could delegate their powers to one of them. But Rama
Corporation people had never read the articles. Later, it was found that the
47
directors of the company did not delegate their powers to ‘A’. Plaintiff relied on
the rule of indoor management. It was held that they could not rely on doctrine of
indoor management as they even did not have the knowledge that power could be
delegated.
(5) Oppression. Doctrine of indoor management can be invoked only with
reference to acts which relate to provisions of memorandum and articles, and not
in case where oppression is alleged - Navin R. Shah v. Simshah Estates and
Trading Co. (P) Ltd. [2007] 74 SCL 372 (CLB).
(6) Acts beyond authority. Doctrine is also not applicable where a pre-condition is
required to be fulfilled before company itself can exercise a particular power, or,
the act done is not merely ultra vires the directors/officers but ultra vires the
company itself - Pacific Coast Coal Mines v. Arbuthnot [1917] AC 607.
6.8 Summary
The articles of association of a company contain the rules and by-laws that
govern the management of its internal affairs. The articles also define the power of
its officers and create a contract between the company and the members and
between the members inter-se. Articles are subordinate to the memorandum and in
case of conflict between the two, the memorandum prevails.
The articles should be divided into paragraphs, numbered consecutively and
signed by each subscriber of the memorandum, and should be in printed form.
Articles can be altered by passing a special resolution of the shareholders
but subject to certain restrictions like the alteration should not be inconsistent with
the Companies Act, or any other statute, it should not be illegal or opposed to
public policy, it should not constitute fraud on the minority, should be in the
interest of the company as a whole, it should not result in breach of contract with
third parties and that any alteration should generally be prospective and not
retrospective.
48
Since the articles and memorandum are the public documents hence
‘doctrine of constructive notice’ presumes that anyone desirous of dealing with the
company has read those documents and also understood them, whether, in fact, the
parties have the knowledge of the contents or not.
But, the rule of constructive notice is not applicable in case of internal
proceedings of the company. The doctrine of indoor management enunciated in
the landmark case of Royal British Bank v. Turquand, offers protection to the
persons dealing with the company through its officers who fail to follow the
procedures prescribed under the articles before exercising those powers. The
persons dealing with the company are not bound to inquire into the irregularity of
internal proceedings.
The doctrine of indoor management is not applicable if the outsider has
knowledge of irregularity, or there is forgery, or he has no knowledge of articles
and memorandum, or the act is ultra-vires the company itself.
6.9 Check Your Progress
1.
Discuss & distinguish between Memorandum & Articles of Association.
2.
Explain the doctrine of indoor management stating the exceptions.
3.
Discuss the binding effect of memorandum and articles of association on
the company and the outsiders.
49
Unit-7 : Prospectus
Structure:
7.0
Introduction
7.1
Meaning of Prospectus
7.2
Contents of Prospectus
7.3
Issue of Prospectus
7.4
Guidelines of SEBI relating to Issue of Prospectus
7.5
Abridged Prospectus
7.6
Statement in lieu of Prospectus (Sec. 70)
7.7
Deemed Prospectus or Prospectus by Implication
7.8
Shelf Prospectus & Information Memorandum
7.9
Misstatements in Prospectus and its Consequences
7.10 Remedies for Misstatements and Omissions in a Prospectus
7.10.1 Remedies against the Company
7.10.2 Remedies against the Directors, Promoters and Experts
7.0 Introduction
As already discussed in previous units, a private company is prohibited from
inviting public to subscribe to its shares or debentures. It arranges its share capital
from relatives and friends.
A public company may also choose not to invite public to subscribe to its share
capital and arrange its share capital from friends and relatives just like a private
company. In this case, the public company has to submit a ‘statement in lieu of
prospectus’ with the Registrar.
50
But if the promoters and directors of a public company, decide to invite the public
to subscribe to its shares or debentures, they have to issue a document called
“Prospectus”. The object of a prospectus is to arouse the interest of the potential
investors in the company and induce them to invest in its shares or debentures.
Lest the prospective investors be misled, there are a large number of statutory
provisions, aimed at their protection, relating to the form and contents of a
prospectus. If a company needs more funds for expansion in future, a prospectus
may also be issued at a later stage.
7.1 Meaning of Prospectus
Section 2(36) defines the term prospectus, in these words : “a prospectus means
any document described or issued as a prospectus and includes any notice,
circular, advertisement, or other document inviting deposits from the public or
inviting offers from the public for the subscription or purchase of any shares in, or
debentures of, a company”. The term ‘prospectus’, therefore, includes any
document, however informal, which invites deposits from the public or offers
shares or debentures of a company for subscription to the public.
The responsibility of the company, its directors and promoters remains the
same in the case of “offer for sale to public” by an Issue House, as that in the case
of direct issue of prospectus by a company.
What constitutes an offer to the public - “Offer to the public” is an important
condition in the above definition which determines whether a document is a
prospectus or not. It is difficult to say exactly how many persons constitute “the
public”. Section 67 clarifies the position and states that “public” includes any
section of the public, however selected. For example, if a document inviting
persons to buy shares is issued, to all teachers, or to all students of commerce, or
to all the clients of a particular share broker or to all the shareholders of a
51
company concerned, it is still issued to "the public" and therefore is a prospectus.
It follows from this that even if there were only one person in the particular
section of the public selected, he alone shall constitute public. Subsection (3),
however, limits the effect of this Section by stating that: (a) if the offer can be
accepted only by persons to whom it is made, the offer is not one ‘made to the
public’ or (b) if the offer is made to a few friends of the directors or if it is the
domestic concern of those making and receiving the offer, the offer is not made to
the public.
The Companies (Amendment) Act, 2000 has amended Section 67, by adding a
proviso to sub-section (3), which has put a limit to the number of persons to whom
a private offer could be made without treating the same as an ‘offer to the public’.
The amendment provides that any offer or invitation to subscribe for shares or
debentures to fifty or more persons will be treated as an ‘offer made to the public’.
The amendment is a welcome step since it seeks to plug the loophole of raising
capital from public under the garb of ‘private placement’ by simply inviting
subscriptions through letters addressed as ‘private and confidential’. As the
invitations sent to such persons could be accepted only by the persons to whom
they were sent, such offers were not regarded as ‘public offer’. After the
amendment such ‘private placement’ will come under the purview of ‘public
offer’, if such offer or invitation is made to fifty persons or more.
The stipulation laid down in the above said amendment shall not apply to the nonbanking financial companies or public financial institutions specified in Section
4A of the Act. As a result, these institutions will be free to offer securities through
the route of ‘private placement’.
The word ‘subscription’ in the definition means taking the shares for cash. Hence
a circular by a company offering the new shares to the shareholders of two
existing companies in exchange for their shares in these companies was not an
52
offer for subscription within the definition (Government Stock Investment Co. Ltd
vs. Christopher) [(1966) 1 AII. E.R. 490]. Therefore, the document making the
offer could not be called a prospectus within the meaning of the term in Section
2(36).
7.2 Contents of Prospectus
In New Brunswick, etc., Co. vs. Muggeridge [(1860), 1 Drew, and Sm. 363,
381], it has been opined that prospectus is the only window through which the
potential investor can look into the soundness of the company’s venture. Hence
the Companies Act intends to secure the fullest disclosure of all material and
essential particulars in a prospectus. The Act provides that every prospectus issued
by or on behalf of a company must state the matters and set out the reports
specified in “Schedule II” given at the end of the Companies Act, 1956 [See
Section 44(2) and 56(1)].
The Government has revised the format of prospectus given in Schedule II of the
Companies Act; 1956 with effect from 1st November, 1991. The revised format of
prospectus requires the prospectus to be divided into three parts. This has been
done to provide for greater disclosure of information regarding the company, its
management, the project proposed to be undertaker, by the company and the
management perception of risk factors so as to enable the investors to take an
informed decision regarding investment in shares or debentures offered through
public issue.
Matters to be specified. As per revised “Schedule-II”, a prospectus must contain
the following particulars :
(1) The main objects of the company, its history and present business.
(2) Company’s name and address of its registered office.
53
(3) The date of opening and closing of the subscription list and the date of
earliest closing of the issue.
(4) The name and address of the trustee under debenture trust deed (in case
of debenture issue).
(5) The names and addresses etc., of company promoters, and their
background.
(6) Consent of directors, auditors, solicitors, managers to the issue, bankers
to the company, bankers to the issue and experts.
(7) The names, addresses and occupation of manager, managing director
and other directors (giving their directorships in other companies).
(8) The amount payable on application and allotment of each share, along
with details about availability of forms, prospectus and mode of payment.
(9) The names and, addresses of the company secretary, legal advisor,
auditors, lead managers, bankers and brokers to the issue.
(10) The details of option to subscribe for securities in the depository mode
[Inserted by the Depositories Act, 1996. For details of the ‘Depository System’
refer to Chapter 12].
(11) The procedure and time schedule for allotment and issue of share
certificates.
(12) The size of present issue giving separately reservation for preferential
allotment to promoters and others.
(13) The rights, privileges and restrictions attached to several classes of
shares.
(14) Contents of the articles or any contract relating to the appointment of
managing director or manager, the remuneration payable to him or them and the
compensation, if any, payable to him or them for loss of office.
54
(15) Minimum Subscription Clause. As per the SEBI (Disclosure and
Investor Protection) Guidelines, 2000, the following statements must appear:
(a) For non-underwritten public issues: If the company does not receive the
minimum subscription of 90% of the issued amount on the date of closure of the
issue, or if the subscription level falls below 90% after the closure of issue on
account of cheques having been returned unpaid or withdrawal of applications, the
company shall forthwith refund the entire subscription amount received. If there is
a delay beyond 8 days after the company becomes liable to pay the amount, the
company shall pay interest at the rate of 15% per annum, as prescribed in Section
73.
(b) For underwritten public issues : If the company does not receive the
minimum subscription of 90% of the net offer to public including devolvement of
Underwriters within 60 days from the date of closure of the issue, the company
shall forthwith refund the entire subscription amount received. If there is delay
beyond 8 days after the company becomes liable to pay the amount, the company
shall pay interest at the rate of 15% per annum, as prescribed under Section 73.
(16) The names of Regional Stock Exchange and other stock exchanges
where application has been made for listing of present issue.
(17) The names and addresses of the underwriters, underwritten amount,
underwriting commission and declaration by Board of Directors that the
underwriters have sufficient resources to discharge their respective obligations.
(18) The material details about the project, namely, its location, plant and
machinery, technology, process etc., collaboration, any performance guarantee or
assistance in marketing by the collaborators, infrastructure facilities for raw
materials and utilities like water, electricity etc., schedule of implementation of the
project and progress so far.
55
(19) The nature of the. produces)- whether consumer or industrial, approach
to marketing and proposed marketing set up and export possibilities and export
obligations, if any.
(20) Future prospects - expected capacity utilisation during the first three
years from the date of commencement of production, and the expected year when
the company would be able to earn cash profits and net profits.
(21) Stock exchange quotations - the high/low stock exchange price in each
of the last three years and monthly high/low during last six months (where
applicable).
(22) The particulars of public issues made during the last three years by the
company and other listed companies under the same management.
(23) The particulars of outstanding litigation and criminal prosecution.
(24) The particulars of default, if any, in meeting statutory dues,
institutional dues and towards instrument holders like debentures/fixed deposits,
etc., in relation to the company and other companies promoted by the same private
promoters and listed on stock exchanges.
(25) Management perception of risk, factors, e.g., sensitivity to foreign
exchange rate fluctuations, difficulty in availability of raw materials or in
marketing of products, cost/time over-run, etc.
(26) The disclosure of credit rating obtained from CRISIL (Credit Rating
and Information Services of India Limited) or any recognised rating agency for the
proposed debenture/preference shares issue. If the company has not obtained any
rating, the prospectus should state that no rating has been obtained.
(27) Expenses of the issue giving separately fee payable to advisors,
registrars and managers to the issue and trustees for the debenture holders.
(28) Particulars of any property to be acquired by the company and the
price whereof is to be paid out of the proceeds of the issue, together with the
56
names, addresses, etc., of the vendors, the purchase price and the mode of
payment.
(29) Amount of benefit paid or given within two preceding years to any
promoter or officer of the company and the consideration thereof.
(30) Particulars of any property acquired within two preceding years in
which any director or promoter was interested.
(31) Particulars of the length during which the business has been carried on
by the company - profit & loss and balance sheet particulars for the last five years.
(32) Particulars of any revaluation of the assets of the company during the
last five years.
(33) Any special tax .benefits for company and its shareholders.
(34) A reasonable time and place at which copies of all balance sheets and
profit and loss accounts, if any, on which the report of auditors is based, may be
inspected.
(35) A declaration that all the relevant provisions of the Companies Act,
1956, and the guidelines issued by the Government or the guidelines issued by the
Securities and Exchange Board of India, as the case may be, have been. compiled
with and no statement made in prospectus is contrary to the provisions of the
aforesaid Act or rules or guidelines [This declaration has been substituted by
Notification No. GSR 650(E) dated 17-9-2002, effective from 17-9-2002].
Section 68-A further provides that it must be prominently printed in every
prospectus and in every application form for shares issued by the company that
any person, who makes in a fictitious name an application to a company for
acquiring any shares therein, or otherwise induces a company to allot or register
any transfer of shares therein to him or any other person in a fictitious name, shall
be punishable with imprisonment upto five years.
57
In addition to the above statutory list of contents of a prospectus, the
authors of a prospectus are free to give any such additional facts which may
influence the judgement of the prospective investor.
7.3 Issue of Prospectus
The legal requirements as to the Issue of a prospectus are as follows :
(1) the “guidelines for disclosure and investor protection” issued by SEBI
(Securities and Exchange Board of India), as amended from time to time,
regarding capital issues to the public must have been complied with for the
proposed issue of shares or debentures to the public, and a statement to that effect
must be made in the prospectus.
(2) A copy of the prospectus, duly dated and signed by all the directors,
must have been registered with the Registrar. The copy for registration must be
accompanied with:
(a) the consent in writing of the expert if his report is to be published in the
prospectus. The expert should be unconnected with the formation or management
of the company;
(b) a copy of every material contract and of every contract relating to
appointment and remuneration of managerial personnel;
(c) a written statement relating to adjustment, if any, made by the auditors
or accountants in their reports relating to profits and losses, assets and liabilities or
the rates of dividends, etc.;
(d) the consent in writing of auditors, legal advisor, banker and broker, etc.,
of the company to act in that capacity. (Sec.60)
(3) The prospectus must be issued within90 days of the date on which a
copy thereof is delivered for registration. If it is not issued within this period, it
58
shall be deemed to be a prospectus, a. copy of which .has not been delivered to the
Registrar. The reason for imposing the time limit is that if the issue of the
prospectus is delayed too long, conditions may alter and what is stated in the
prospectus may no longer be valid. The company and every person who is
knowingly a party to the issue of the prospectus without registration shall be
punishable with fine upto Rs.50,000 [Substituted for “Rs.5,000” by the Companies
(Amendment) Act, 2000]. (Sec.60)
7.4 Guidelines of SEBI relating to Issue of Prospectus
The company should ensure strict compliance with the guidelines issued by
SEBI (Securities and Exchange Board of India), regarding advertisements issued
in connection with capital, issues. For the purpose of these guidelines the
expression “advertisement” means notices, brochures, pamphlets, circulars,
showcards, catalogues, hoardings, playcards, posters, insertions in newspapers,
pictures, films, radio/television programmes and would also include the cover
pages of offer documents. The code of advertisements set out in these guidelines is
reproduced below:
1. An issue advertisement shall be truthful, fair and clear and shall not
contain any statement which is untrue or misleading.
2. An issue advertisement shall be considered to be misleading, if it
contains :
(i) Statements made about the performance or activities of the company in
the absence of necessary explanatory or qualifying statements, which may give an
exaggerated picture of the performance or activities, than what it really is.
(ii) An inaccurate portrayal of a past performance or its portrayal in a
manner which implies that past gains or income will be repeated in the future.
59
(iii) As investors may not be well versed in legal or financial matters, care
should be taken to ensure that the advertisement is set forth in a clear, concise and
understandable language. Extensive use of technical, legal terminology or
complex language and the inclusion of excessive details which may detract the
investors should be avoided.
(4) An issue advertisement shall not contain statements which promise or
guarantee an appreciation or rapid profits.
(5) An issue advertisement shall not contain any information or language
that is not contained in the offer document.
(6) All issue advertisements in Newspapers, Magazines, brochures,
pamphlets containing highlights Relating to any issue should also contain risk
factors with the same print size. It should mention the names of Lead Managers,
Registrars to the Issue.
(7) No corporate advertisement except product advertisements shall be
issued between the date of opening and closing of subscription of any public issue.
Such product advertisement shall not make any reference directly or indirectly to
performance of the company during the said period.
(8) No advertisement shall be issued stating that the issue has been fully
subscribed or over-subscribed during the period the issue is open for subscription,
except to the effect that the issue is open or closed. No announcement regarding
closure of the issue shall be made except on the last closing date. If ^he issue is
fully subscribed before the last closing date as stated in the prospectus, the
announcement should be made only after the issue is fully subscribed and such
announcement is made on the date on which the issue is to be closed.
(9) No models, celebrities, fictional characters, landmarks or caricatures or
the likes shall be displayed on or form part of the offer documents or issue
advertisements.
60
(10) No slogans, expletives or non-factual and unsubstantiated titles should
appear in the issue advertisements or offer documents.
(11) If any advertisement carries any financial data, it should also contain
data for the past three years and shall include particulars relating to sales, gross
profit, net profit, share capital, reserves, earnings per share, dividends and the
book values.
(12) No incentives, apart from the permissible underwriting commission or
brokerage, shall be offered through any advertisements to anyone associated with
marketing the issue.
7.5 Abridged Prospectus
Section 56(3), as amended by the Amendment Act of 1988, states that no
application form can be issued for shares or debentures of a company unless it is
accompanied by an abridged prospectus, which complies with the requirements of
the Act. However, the full prospectus is to be furnished on a request being made
by any person before the closing of the subscription list. If any person acts in
contravention of this provision, he shall be punishable with fine which may extend
to fifty thousand rupees [Substituted for ‘Rs. 5,000’ by the Companies
(Amendment) Act, 2000].
The Central Government has prescribed on 3-10-1991 the salient features
of abridged prospectus. For the purpose, rule 4CC has been inserted in the
Companies (Central Government’s) General Rules and Forms, 1956. As per rule
4CC, the salient features required to be included in the ‘abridged prospectus’ shall
be in “Form 2A”. The abridged prospectus contains information very much similar
to a 'prospectus' in a concise and compact manner so that cost of public issue of
capital may be reduced.
61
Exceptions. There are, however, certain exceptions to the above provision,
where ‘an abridged prospectus’ containing all the prescribed details need not
accompany the Application Forms sent out. These exceptions .are :
(a) In the case of bonafide underwriting agreement [Sec. 56(3)(a)]
(b) Where the shares or debentures are not offered to the public. [Sec.
56(3)(b)].
(c) Where the offer is made only to existing members or debenture holders
of the company, whether with or without the right of renunciation. [Sec.
56(5)(a)]
(d) In the case of issue of shares or debentures which are in all respects
similar with those previously issued and dealt in oh a recognised stock exchange.
[Sec. 56(5)(b)]
The logic behind these exceptions should be noted. In the first two
exceptions the public are not involved hence no need of protection. In the case of
last two, the offeree, being already a member or the shares being quoted one, must
have enough information about the company to protect himself.
SEBI guidelines with respect to obridged prospectus provide that the Lead
Merchant Banker shall ensure that :
(i)
Every application form distributed by the Issuer Company or anyone
else is accompanied by a copy of the Abridged Prospectus.
(ii) Abridged prospectus shall contain a disclosure under the heading ‘IPO
Grading’, stating all the grades obtained for the IPO, alongwith the
rationale/description furnished by the credit rating agency(ies) for
each of the grades obtained.
62
(iii) The application form may be stapled to form part of the Abridged
Prospectus. Alternatively, it may be a perforated part of the Abridged
Prospectus.
(iv) The Abridged Prospectus shall not contain matters which are
extraneous to the contents of the prospectus.
(v) The Abridged Prospectus shall be printed at least in point 7 size with
proper spacing.
(vi) Enough space shall be provided in the application form to enable the
investors to file in various details like name, address, etc.
7.6 Statement in lieu of Prospectus (Sec. 70)
A public company having a share capital may sometimes decide not to
approach, the public for securing the necessary capital because it may be confident
of obtaining the required capital privately. In such a case it will have to file a
‘statement in lieu of prospectus’ with the Registrar instead of a prospectus. A
‘statement in lieu of prospectus’ must be drafted in accordance with the particulars
set out in Schedule III of the Act. This document contains information very much
similar to a prospectus. It must be duly signed by all the directors and a copy
thereof must be filed with the Registrar at least three days before the allotment of
the shares. Liability for misrepresentation of any material fact therein is the same
as in the case of a prospectus.
Let us not forget that a private company is free from filing either a
prospectus or a statement in lieu of prospectus with the Registrar.
7.7 Deemed Prospectus or Prospectus by Implication
The provisions of the Companies Act relating to prospectus are meant to
observed in cases where the invitation is made to the public by or on behalf of a
63
company for subscription to its shares and debentures. To avoid these statutory
provisions the companies at times allot whole of the shares or debentures to an
intermediary known as an ‘Issue House’, which in turn invite subscription from
the public through their own offer documents. Thus, the company could indirectly
raise subscriptions from the members of the public without issuing prospectus.
Section 64 now covers documents issued by the Issue Houses. it provides that all
documents containing offer of shares or debentures for sale shall be included
within the definition of the term ‘prospectus’ and shall be deemed as prospectus
by implication of law, provided it is shown :
(i)
that the offer was made within six months offer the allotment or
agreement to allot to the issue those; or
(ii) that at the date of offer to the public, the whole consideration in
respect of the shares or debentures had not been received by the
company.
7.8 Shelf Prospectus & Information Memorandum
The Companies (Amendment) Act, 2000 has introduced two new sections
viz. Section 60A and 60B relating to ‘Shelf Prospectus’ and ‘Information
Memorandum’ respectively. ‘Shelf prospectus’ means a prospectus issued by any
financial institution or bank for one or more issues of securities or class of
securities specified in that prospectus.
New Section 60A provides as follows:
(1) Any public financial institution, public sector bank or scheduled bank
whose main business is ‘financing’ is entitled to file a ‘shelf prospectus’.with the
Registrar of Companies.
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‘Financing’ here means making loans to or subscribing in the capital of, a
private industrial enterprise engaged in infrastructural financing or such other
company as the Central Government may notify in this behalf.
(2) The ‘shelf prospectus’ will be valid for one year from the date of
opening of the first issue of securities under the prospectus. A company filing a
'shelf prospectus' with the Registrar need not file a fresh prospectus as and when it
makes any offer of securities during the currency of the prospectus.
(3) A company filing a shelf prospectus shall be required to file an
‘information memorandum’ on all material facts relating to new charges created,
charges in the financial position that have occurred after the first offer of
securities. Central Government has prescribed three months time limit for filing
the information memorandum.
(4) An ‘information memorandum’ shall be issued to the public alongwith
‘shelf prospectus’.
(5) An update ‘information memorandum’ is to be filed every time an offer
of securities is made and such memorandum together with ‘shelf prospectus’ shall
constitute the prospectus.
Rationale behind the concept of ‘shelf prospectus’. A public company, is
required to issue a prospectus for raising finance from the public. Every time a
fresh issue of securities is made, issuing a fresh prospectus is a costly and time
consuming process. In order to minimise such burden, the concept of ‘shelf
prospectus’ is introduced which will be valid for a period of one year. For any
subsequent offering within the validity period only an ‘information memorandum’
for updating the information under the specified heads is required to be filed. This
provision is of special significance in case of developmental financial institutions
like IDBI and ICICI who raise money from the public through issue of Bonds in a
series.
65
Information Memorandum
Section 60B seeks to provide a provision for ‘Information Memorandum’.
‘Information memorandum’ means ‘a process undertaken prior to the filing
of a prospectus by which a demand for the securities proposed to be issued by a
company is elicited, and the price and the terms of issue for such securities is
assessed, by means of a notice, circular, advertisement or document’ [Section 2
(19B)].
The provisions of Section 60B in this regard are :
(1) A public company making an issue of securities may circulate the
information memorandum' to the public prior to the filing of prospectus. Since the
object of' information memorandum' is to explore the demand for securities and
the price offered for the same, it should contain major information regarding the
issuer company.
(2) The company is required to file a prospectus, prior to the opening of the
subscription lists and the offer, as a ‘red-herring prospectus’, at least three days
before the opening of the offer.
A ‘red-herring prospectus’, means a prospectus which does not have
complete particulars on the price of the securities offered and the quantum of
securities offered.
(3) Any misstatement or omission of any material fact in the ‘Information
Memorandum’ or the ‘Red-herring Prospectus’ will attract the same civil and
criminal liabilities as are attracted in the case of prospectus.
(4) Any variation between the ‘information memorandum’ and the ‘redherring prospectus’ shall be highlighted by the issuing company and shall be
individually intimated to the persons invited to subscribe the issue. Non-intimation
of the variations will tentamount to a mis-statement in the prospectus.
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(5) In the event of the issuing company or the underwriters to the issue have
received advance subscription by way of post-dated cheques or stock invest, they
shall not encash such subscription moneys before the date of opening of the issue,
without having individually intimated the prospective subscribers of the variation
and without having offered an opportunity to such prospective subscribers to
withdraw their application. The prospective subscriber shall have a right to
withdraw his application within 7 days of an intimation of variation.
(6) Once the offer of securities is closed, a ‘final prospectus’ stating therein
the total capital raised, whether by way of debt or share capital, the closing price
of securities and any other details which were not complete in the ‘red-herring
prospectus’ shall be filed in the case of a listed public company with the Securities
and Exchange Board of India (SEBI) and Registrar of Companies, and in any other
case with the Registrar of Companies only.
By introducing these concepts the Companies (Amendment) Act, 2000, has
sought to legally recognise the issue of securities through the “Book Building
Process” by introducing the concept of ‘Information Memorandum’, and ‘Redherring Prospectus.’
7.9 Misstatement in Prospectus and its Consequences
A prospectus constitutes the basis of the contract between the company and
the shareholders arid .therefore, it must disclose all material facts (i.e., facts likely
to influence the judgement of a prospective investor in deciding whether to take
shares or debentures or not) very accurately. It must not misrepresent or conceal
material facts and thereby improperly influence and mislead the prospective
investor into becoming an allottee of shares or debentures and in consequence
suffer Joss (Peek vs. Gurney) [(1873), L.R. 6 H.L. 377]. A prospectus containing
false, misleading, ambiguous or fraudulent statements of material facts, is termed
as “misleading prospectus”, and in that case a misled investor (original allottee of
67
shares who had relied on the prospectus and not a buyer in the open market) is
entitled to proceed against those who misled him.
What is a false or untrue statement? A general commendation, even if too
highly coloured, is not a false statement, but to say that something has been done,
when it is not so, is a misstatement of fact (Karberg’s Case)[(1892), 3 Ch. 1,
p.11]. If there is omission of material facts from a prospectus or/and where the
statement is ambiguous in the form and context in which it is included, the
prospectus shall be deemed to be untrue (Sec. 65). Hence a prospectus should be
honestly framed and should not by any half statement of the truth or ambiguous
phraseology give a false impression or misled the investor for, the whole
prospectus is to be read, and if, as a whole, it be misleading, those who issue it
cannot escape on the ground that there is not a single statement which, standing'
alone, can be challenged as false. A case on the point is R v. Kylsant (1932), 1
K.B. 442. In this case, a prospectus was issued in 1928 stating that dividends
varying from five to eight per cent had been regularly paid over long term of years
up to the., date of the prospectus, whereas the truth was that the company had been
incurring substantial trading losses during the seven years preceding the date of
the prospectus and dividends could be paid only out of accumulated earnings in
the abnormal war period. It was held that the prospectus was false not because of
what it stated, but because of what it did not state and of what, as a whole, it
implied.
The facts of Smith vs. Chadwick [(1884), 9 A.C. 187] also provide a good
illustration on the point. The prospectus, in this case stated that the ‘present value
of the turnover’ is £ 10 lakhs per annum. The statement ‘present value of the
turnover’ might bear two meanings — ‘actual produce’ or ‘capable of producing’.
It was held that as the statement is ambiguous — might bear two meanings, one of
which, i.e., actual produce is false, liability for misstatement cannot be escaped.
Lord Blackburn observed : “if they put forth a statement which they knew may
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bear two meanings one of which is false to their knowledge and thereby the
plaintiff putting that meaning on it is misled, they cannot escape by saying — he
ought to have put the other”.
It must, however, be observed that in order to call a prospectus a
‘misleading prospectus’, there must be misrepresentation of facts and not of law or
expectation. For example, if a prospectus represents that the company's shares will
be issued at half their nominal value, whereas Section 79 prohibits the issue of
shares at a discount exceeding ten per cent, it is a misrepresentation of law and a
person deceived by it will have no remedy. Also note the facts of Shiromani Sugar
Mills Ltd. vs. Debi Prasad [(1950), A.I.R. All. 508]. The prospectus,, in this case,
stated that “the managing agents with their friends, promoters and directors have
already promised to subscribe shares worth six lakh rupees.” But they actually
subscribed much lesser number of shares. It was held that there was no
misrepresentation of fact and the prospectus was not misleading because, “the only
fact asserted was the existence of promise and the existence of promise is not
falsified by the breaking of it”.
7.10 Remedies for Misstatement & Omissions in a Prospectus
The remedies available to a person who has subscribed for shares on the
faith of a misleading prospectus, may broadly be grouped into two categories :
I. Remedies against the company.
II. Remedies against the directors, promoters and experts.
We shall now examine the nature of these remedies in detail.
7.10.1 Remedies against the Company
The following two remedies are available to an injured party against the
company for misrepresentation in the prospectus under general law: (1) Rescission
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of the contract, (whether the statement is a fraudulent or an innocent one), (2)
Claiming damages, (where the statement is a fraudulent one).
(I) Rescission of the contract. Under the Indian Contract Act, a contract
induced by a mis-statement of any material fact, either innocent or fraudulent, is
voidable at the option of the aggrieved party. The subscriber [The word
‘subscriber’ has been used in the text for one who takes shares by allotment
directly from the company], therefore is entitled to rescind his contract and return
the shares and receive back his money. If necessary, he may apply to the Court for
a declaration of rescission of the contract. It may be noted here that if a statement
is true when it is made, but subsequently becomes untrue before allotment, of
shares is made, the contract to take shares may be rescinded (Re Scottish
Petroleum Co.) [(1823),23Ch.D.413]. For example, if a director named in the
prospectus has meanwhile resigned, the subscriber could rescind the contract. The
contract can also be rescinded where misrepresentation is made in a document by
which an “offer for sale” is made to the public by an Issue House and which is
deemed to be a prospectus issued by the company under Section 64.
Necessary conditions for succeeding in a suit of rescission. In order to
succeed in a suit of rescission of the contract, the subscriber must prove the
following facts:
(a) The prospectus was issued by the company or on its behalf by the
directors or it was deemed to be a ‘prospectus issued by the company by
implication’ under Section 64. Thus responsibility of the company for the issue of
prospectus must, in the first instance, be established,
(b) The prospectus contained a misrepresentation of facts, and not of law or
of opinion or expectation. Thus, the statement that due to honest and efficient
management, the company is expected to progress by leaps and bounds, is only a
statement of opinion and will give no right of rescission. Whereas, a statement that
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“more than half the shares have already been sold”, is a statement of fact and, if
false, will give rise to the right of rescission. In Re Metropolitan Coal Consumer’
Association [Karberg’s Case, (1892), 3 Ch. 1]: The prospectus stated that B and
M, two leading businessmen of repute, have agreed to become directors of the
company, whereas they had only expressed their willingness to help the company,
it was held that the prospectus contained a misrepresentation of fact and as such
the subscriber has a right to rescind the contract.
(c) The misrepresentation was material. The misrepresentation, whether
innocent or fraudulent, related to such facts as are likely to influence the
judgement of a reasonable man in deciding whether to take shares and debentures
or not.
(d) Lastly, it must be proved that the subscriber has actually relied upon the
statement in question while applying for shares. Thus, where it is proved that, he
did not read it or that he knew that the statement in question were untrue, or he
made the investigations himself to verify, or purchased shares in the open market,
or subscribed to the memorandum before the company came into existence, the
subscriber shall not be allowed to rescind the contract, for, in any such case he
cannot claim to have been misled by the prospectus.
Loss of the right of rescission. The right of rescinding the contract,
however, is lost in the following circumstances:
(i) If the allottee does not start the proceedings within a reasonable time
after coining to know the misrepresentation (Shiromani Sugar Mills Ltd. vs. Debt
Prasad) [(1950, A.I.R. All. 508].
(ii) If he expressly or impliedly affirms his contract after becoming aware
of the falsity of the statements, e.g., attends meetings, accepts dividends, pays calls
or tries to sell the shares.
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(iii) If the company goes into liquidation before he has started the
proceedings to rescind the contract, for, upon the commencement of liquidation
the rescission of the contract and the repayment of money to the subscriber would
injure the interest of the creditors by decreasing the assets available for the
payment of their debts (Oakes vs. Turqucmd) [(1867), L.R. 2, H.L. 325].
(iv) If he is a man of such experience that he is not likely to be misled by
the mis-statements. For example, a vendor of the building cannot rescind his
contract if he complains about the inflated price of the building purchased.
(2) Claiming damages for fraud. The subscriber is also entitled to claim
damages by way of interest. But to avail this remedy the subscriber must prove :
(a) that the mis-statements were mate fraudulently (and not innocently in which
case, only the right of rescission is available), and (b) that he has actually been
deceived, in addition to proving other facts necessary to succeed in a suit of
rescission mentioned earlier. “Fraud” was defined by Lord Herschell in Derry vs.
Peek [(1889), 14 A.C. 337] as “a false statement made : (a) knowingly, or (b)
without belief in its truth, or (c) recklessly, careless whether it be true or false”. It
must be noted that this right can be exercised only after the rescission of the
contract and the allottee cannot both retain the shares and get damages against the
company (Houldsworth vs. City of Glasgow Bank) [(1880), 5 A.C. 317]. It follows
from this, therefore, that this right of claiming damages for fraud against the
company shall also be lost under the same circumstances in which the right to
rescind the contract is lost (these circumstances have been discussed in detail
under the preceding sub-heading ‘Loss of the Right of Rescission’).
It is to be remembered that the right to bring an action for damages for
fraud is an elective one. An action under this right may be brought either against
the company or the directors. If the subscriber chooses to sue the directors, he
need not rescind the contract.
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7.10.2 Remedies against the Directors, Promoters & Experts
At the very outset it must be noted that these remedies are available Id a
misled investor whether he rescinds his contract or not. In other words, rescission
of the contract is not necessary for availing these remedies. Usually these
remedies are resorted to when the mislead subscriber does not want to rescind the
contract or cannot rescind the contract because the company goes into liquidation.
A misled investor may also make all or any of the following persons
[Section 62(1)] liable to pay compensation or/and penalty for mis-statements in
the prospectus.
(a) The directors at the time of issue of the prospectus.
(b) Every person who has authorised himself to be named and is named in
the prospectus as present or future director.
(c) Every promoter.
(d) Every other person who has authorised the .issue of prospectus.
Experts like an engineer, a valuer, an auditor, an accountant, legal adviser,
etc., are not included under clause (d) above except in respect of their own untrue
statements.
The liability of the above mentioned persons can be studied under the
following heads:
(1) Damages for fraud. (Under the general law.)
(2) Damages for misrepresentation.
(3) Liability for omissions.;
(Under the Companies Act.)
(4) Criminal liability.
(1) Damages for fraud. An action of deceit to recover damages, against all
or any of the persons authorising the issue of prospectus, may be brought by a
subscriber, if he chooses not to bring an action of deceit against the company. (The
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right to bring an action of deceit being an elective one.) Here the damages will be
equal to the difference of the amount paid and the market value of shares at the
date of allotment. The subscriber will have to prove:
(a) that the defendant was guilty of fraudulent misrepresentation of material
facts; and
(b) that he. has actually been deceived.
It is to be noted that this action can be taken even if the company goes into
liquidation (Derry vs. Peek) [(1889), 14 A.C. 337] because in an action against
directors, etc., interest of creditors of the company is not involved.
(2) Damages for misrepresentation (Sec. 62). Here the remedy to claim
damages is available for any loss sustained by the subscriber by reason of any
untrue statements in a prospectus, irrespective of whether they were made
fraudulently or innocently. Notice that in the absence of this provision, the misled
investor could have only rescinded his contract on the basis of misrepresentation.
But now he can keep his contract and claim the loss as damages. “The true
measure of damage is the difference between the amount paid and the value of the
shares at the date of allotment” (Adams vs. Thrift) [(1915), 2 Ch. 21].
In order to recover damages or compensation under this Section the
subscriber will have to prove:
(a) that the prospectus contained untrue statements of material facts (he is
not required to prove fraud or intent to deceive); and
(b) that he has actually sustained loss or damage by reason of untrue
statements.
This action can also be taken after the company goes into liquidation.
Defences available to directors, etc. The person (other than expert) so
sought to be made liable may escape liability, if he proves [Section 62(2)]:
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(i) that, he withdrew his consent to acting as director before the prospectus
was issued and it was issued without his consent; or
(ii) that, the prospectus was issued without his knowledge or consent, and
on becoming aware of its issue he gave reasonable public notice that it had been so
issued; or
(iii) that, he was ignorant of the untrue statement and on becoming aware
of the same, after the issue of the prospectus and before allotment, he withdrew his
consent and gave a public notice to that effect; or
(iv) that, he believed on reasonable grounds that the statement was true; or
(v) that, the statement was in fact made on the authority of a competent
expert and the expert had given his consent as required by Section 58 and had not
withdrawn it; or
(vi) that, the statement was .a correct and fair copy of an official document
or was based on the authority of an official person.
Defences available to experts. An expert may be made liable only in
respect of any untrue statement purporting to be made by him as an expert. He
may, however, avoid his liability; if he proves [Section 62(3)]:
(i) that, having given his consent under Section 58 he withdrew it in writing
before delivery of a copy of the prospectus for registration; or
(ii) that, after delivery of a copy of the prospectus for registration and
before allotment, he, on becoming aware of the untrue statement, withdrew his
consent in writing and gave a reasonable public notice to that effect; or
(iii) that, he was competent to make the statement and believed on
reasonable grounds that it was true.
The following points must also be noted in this connection :
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1. According to Section 62(4) every such director or expert who has
escaped liability on the above grounds, shall be entitled to be indemnified by
others directors or experts who continue to be liable, against all damages; costs
and expenses which he may have incurred.
2. As per [Sec. 62(5)], the right of contribution between persons jointly
liable is there, if only one or few of them have paid damages for loss arising out of
misrepresentation.
3. A number of subscribers may join as plaintiffs in one action but each will
have to prove separately the untruth of the statement, and also a subscriber may
combine in the same action his claim for rescission and damages for fraud or
compensation for misrepresentation against the company, directors and other
persons.
(3) Liability for omissions. Section 56 imposes liability for omissions, ie.,
leaving out items which the II Schedule of the Act, requires to be disclosed in a
prospectus. Omission need not make the prospectus false or misleading. The
simple fact that certain clauses (necessary to be included as per II Schedule of the
Act) have been omitted from the prospectus shall make the persons responsible for
the issue of prospectus liable to pay damages to the subscriber for shares. The
subscriber must, however, satisfy the court (i) that if the said omissions would not
have been there in the prospectus he would not have taken the shares and (ii) that
he has actually sustained loss.
It should be noted that as the omission need not amount to fraud or
misrepresentation, an action for rescission of the contract will not lie under this
Section.
(4) Criminal liability (Sec. 63). Criminal liability involves a fine or a term
of imprisonment on the guilty party whereas civil liability (as discussed under the
above points) involves a remedy to the aggrieved party, e.g., paying damages by
way of compensation.
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Section 63 states that where a prospectus contains an untrue statement,
every person authorising its issue shall be punishable with imprisonment for a
term not exceeding two years or with fine not exceeding Rs. 50,000 [Substituted
for “Rs. 5,000” by the Amendment Act, 2000] or with both, unless he proves
either (i) that the statement was immaterial, or (ii) that he believed on reasonable
grounds that it was true.
Section 63(2) exempts experts from liability under this Section.
Penalty for fraudulently inducing persons to invest, money. Under Section
68, any person who, either by knowingly or recklessly making any statement,
promise or forecast which is false, deceptive or misleading or by any dishonest
concealment of material facts, induces or attempts to induce another person to
enter into or to offer to enter into :
(a) any agreement for; or with a view to acquiring, disposing of,
subscribing for, or underwriting shares or debentures; or
(b) any agreement the purpose of which is to secure profit to any of the
parties from the yield of shares or debentures or by reference to fluctuations in
value of shares or debentures;
shall be punishable with imprisonment for a term which may extend to five
years or with a fine which may extend to Rs. l,00,000 [Submitted for “Rs. 10,000”
by the Amendment Act, 2000] or with both.
Thus, there are heavy liabilities prescribed for persons making misstatements in a prospectus both under the general law and the Companies Act. All
these heavy liabilities have saved the innocent investors from being misled by an
extravagant and flattering prospectus to a very great extent.
7.11 Summary
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A public company generally arranges its share capital by inviting public to
subscribe to its share capital. For this it has to issue a prospectus inviting
subscription. A prospectus is defined as any document described or issued as
prospectus and includes any notice, circular, advertisement or other document
inviting deposits from the public or inviting offers from the public for the
subscription or purchase of any shares or debentures of a body corporate.
Regarding the contents of prospectus, Section 56 of the Companies Act
provides that the matters stated in Schedule II to the Companies Act must be
included in a prospectus. The format of Schedule II as revised in 1990, requires
the prospectus to be divided into three parts. The first part contains the general
information and the salient features of the contents of the prospectus. Part two
requires the company to give certain detailed information. Part three requires that
the company should give explanation of certain terms and expressions used under
Part-I and Part-II of the schedule.
However, in certain cases, a company is not required to issue a prospectus,
like :
(1) If a public company does not invite public for subscription, in which
case it is required to issue a ‘statement in lieu of prospectus’ with the
Registrar of Companies.
(2) Where there is a bonafide agreement with an underwriter with regard to
shares and debentures.
(3) If the issue relates to shares which are uniform in all respects with
shares previously issued and quoted on a recognised stock exchange.
(4) Where the shares are offered to existing holders of shares by way of
right.
Shelf Prospectus & Information Memorandum -
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Public financial Institutions and Scheduled Banks can file ‘Shelf
Prospectus’ which will remain valid for one year. Thus, they do not have to issue a
prospectus every time they offer securities to public. They are required to file an
‘information memorandum’ with respect to new charges created and other change
in financial position.
Also, any company proposing a public issue may circulate an information
memorandum to elicit the demand for securities and the price at which public is
ready to subscribe. In this case, the company is required to file a ‘red-herring
prospectus’ at least 3 days before the opening of the offer. A ‘red-herring
prospectus’ does not contain complete information regarding the price of securities
and quantum of securities offered.
Statement in lieu of prospectus - Section 70 requires that a public
company having a share capital should file a ‘statement in lieu of prospectus’ with
the Registrar of either it does not issue a prospectus or where it issued a prospectus
but does not proceed to allot any of the shares offered thereunder.
Deemed Prospectus - To check the practice of by-passing the provisions
relating to prospectus, Section 64 declares that all documents containing offer of
shares or debentures for sale shall be included within the definition of the term
‘prospectus’, and shall be deemed as prospectus by implication of law if certain
conditions are satisfied.
Misstatement in Prospectus and Remedies In order to protect the investors from frauds by making certain
misrepresentations or by omitting some material information, certain remedies
have been provided to the aggrieved persons who have subscribed to the shares or
debentures on the faith of such misrepresentations or omission which are
calculated to deceive. The remedies provide for the right to rescind the contract of
purchase of shares or debentures, claim for damages and also Prosecution of the
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Company and the guilty officers as well as imprisonment upto 2 years and fine
upto Rs. 50,000/-.
7.12 Check Your Progress
1.
What is statement in lieu of Prospectus?
2.
What is a Prospectus? Explain the liability of the company as well as the
Directors in case of misstatements in a Prospectus.
3.
What are the remedies available to a shareholder who on the faith of the
misstatements in a prospectus is induced to enter into a contract for the
purchase of shares or debentures?
4.
Explain (i)
Shelf Prospectus.
(ii) Information Memorandum.
(iii) Red Herring Prospectus.
(iv) Deemed Prospectus.
(v) Book Building.
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