The wheels of commerce would not go round smoothly if person dealing with companies were not compelled to investigate thoroughly the internal machinery of a company to see something is wrong

“The wheels of commerce would not go round smoothly if person dealing with companies were not compelled to investigate thoroughly the internal machinery of a company to see something is wrong.”

Introduction

If the law can impact on our everyday private lives, the same is true for any business activity we may pursue. Those who are engaged in business may be slightly more streetwise when it comes to the ‘legal stuff’ than their less commercially oriented brethren but, even so, ignorance or misunderstanding of the law and its effects is hardly a rare phenomenon and attitudes ranging from complacency to outright hostility can often be detected wafting through the corridors of business. Often, professional legal advice is only sought when a problem, which perhaps initially was avoidable, has escalated to a point where extrication at the lowest possible cost is the only option. On the other hand, however, there are those engaged in businesses that recognize that law is part of the environment in which they must operate. This fraternity appreciates that, like it or not, the law does regulate, or at least affects, many aspects of business activity. They consider that, in strategic planning[1], it is far better to identify relevant legal issues as early as possible in the process. Taking these into account at this stage and making necessary adjustments should facilitate, not hinder, the attainments of commercial objectives. Alternatively, initially adopting a ‘head in the sand’ approach, which fails to identify legal pitfalls, can later present problems that are either insurmountable or, at the very least, expensive to address. Nor should the law’s relationship with business always be looked at from a negative perspective. There are many situations where an adept use of the law can protect vital business interests; for example, an appropriately drafted contract can be employed as a vehicle for minimizing, transferring or, in some circumstances, entirely excluding a variety of commercial risks; or, alternatively, the effective management and assertion of intellectual property rights[2] can be crucial factors when seeking to maintain the integrity of a brand name; and so on. Although business can be and very often is conducted in a purely national context, there are ever increasing possibilities for such activity to develop an international dimension. This may follow a decision of a domestic producer actively to establish a presence in a foreign market by co-operating with a local ‘partner’ in one way or another, or going it alone and establishing a branch office or legal entity in the chosen location. International business of even the simplest variety can present problems that are not present in a purely domestic trans-action. As in most cases, if the problems can be spotted in advance, the chances are they can be headed off or at least minimized

Formation of company by law

Memorandum of Association[3] and articles of association[4] are two most vital ID needed for the incorporation of a company. The memorandum of a company is the constitution of that company. It sets out the (a) object clause, (b) name clause, (c) registered office clause, (d) liability clause and (e) hub clause; whereas the articles of association enumerate the internal rules of the company under which it will be governed.

Undoubtedly, both memorandum of association and the articles of association are public ID in the sense that any person under section 610 of Indian company act, 1956[5] may inspect any document which will include the memorandum and articles of the company kept by the registrar of companies in accordance with the rules made under the destruction of records act, 1917 being ID filed and registered in pursuance of the act. As a consequence, the knowledge about the contents of the memorandum and articles of a company is not necessarily restricted to the members of the company alone. Once these ID are registered with the registrar of companies, these become public ID and are reachable by any members of the public by paying the requisite fees. Therefore, notice about the contents of memorandum and articles is said to be within the knowledge of both members and non-members of the company. Such notice is a deemed notice in case of a members and a constructive notice in case of non-members. Thus every person dealing with the company is deemed to have a constructive notice of the contents of the memorandum and articles of the company. An outsider dealing with the company is presumed to have read the contents of the registered ID of the company. The further presumption is that he has not only read and perused the ID but has also understood them fully in the proper sense. This is known as the rule of constructive notice. So, the doctrine or rule of constructive notice is a presumption operating in favor of the company against the outsider. It prevents the outsider from alleging that he did not know that the constitution of the company rendered a fastidious act or a fastidious delegation of authority ultra virus.

Doctrine of Indoor management

The doctrine of indoor management is an exception to the rule of constructive notice. It imposes a vital limitation on the doctrine of constructive notice[6]. According to this doctrine “persons dealing with the company are free to presume that internal requirements prescribed in memorandum and articles have been properly observed”. A transaction has two aspects, namely, substantive and procedural. An outsider dealing with the company can only find out the substantive aspect by reading the memorandum and articles. Even though he may find out the procedural aspect, he cannot find out whether the course of action has been followed or not. For example, a company may have borrowing powers by quick a pledge according to its memorandum and articles. An outsider can only found out the borrowing powers of the company. But he cannot find out whether the pledge has in fact been passed or not. The outsiders dealing with the company are presumed to have read and understood the memorandum and articles and to see that the proposed dealing is not variable therewith, but they are not bound to do more; they need not question into the regularity of the internal proceedings as required by the memorandum and articles. They can presume that all is being done evenly.

Turquand’s Rule and internal Management of the Company

It is important to note that the notice of constructive notice can be invoked by the company and it does not operate against the company. It operates against the person who has failed to inquire but does not operate in his favor. But the doctrine of “indoor management” can be invoked by the person dealing with the company and cannot be invoked by the company.

The rule had its genesis in the case of Royal Bank v Turquand[7]. In this case the Directors of the Company were authorized by the articles to borrow on bonds such sums of money as should from time to time by a special resolution of the Company in a general meeting, be authorized to be borrowed. A bond under the seal of the company, signed by two directors and the secretary was given by the Directors to the plaintiff to secure the drawings on current account without the authority of any such resolution. Then Turquand sought to bind the Company on the basis of that bond. Thus the question arose whether the company was liable on that bond.

The Court of Exchequer Chamber[8] overruled all objections and held that the bond was binding on the company as Turquand was entitled to assume that the resolution of the Company in general meeting had been passed. The relevant portion of the judgment of Jervis C. J. reads:

“The deed allows the directors to borrow on bond such sum or sums of money as shall from time to time, by a resolution passed at a general meeting of the company, be authorized to be borrowed and the replication shows a resolution passed at a general meeting, authorizing the directors to borrow on bond[9] such sums for such periods and at such rates of interest as they might deem expedient, in accordance with the deed of settlement and Act of Parliament; but the resolution does not define the amount to be borrowed. That seems to me enough……We may now take for granted that the dealings with these companies are not like dealings with other partnerships, and the parties dealing with them are bound to read the statute and the deed of settlement. But they are not bound to do more. And the party here on reading the deed of settlement, would find, not a prohibition from borrowing but a permission to do so on certain conditions. Finding that the authority might be made complete by a resolution, he would have a right to infer the fact of a resolution authorizing that which on the face of the document appear to be legitimately done.”

The Turquand’s rule has also obtained statutory recognition in Section 9(1) of the European Communities Act, 1972[10].

Exceptions to the doctrine of indoor management:

The exceptions to the doctrine of indoor management are as under:

1.     Knowledge of wrongdoing: when a person dealing with a company has actual or constructive notice of the wrongdoing as regards internal management, he cannot claim subsidy under the rule of indoor management. He may in some cases, be himself a part of the internal course of action. The rule is based on common sense and any other rule would promote ignorance and condone dereliction of duty.

2.     Neglect: where a person dealing with a company could find out the wrongdoing if he had made proper inquiries, he cannot claim the subsidy of the rule of indoor management. The safeguard of the rule is also not available where the circumstances surrounding the contract are so suspicious as to invite inquiry, and the outsider dealing with the company does not make proper inquiry. If, for example, an officer of a company purports to act outside the scope of his evident authority, suspicion should arise and the outsider should make proper inquiry before entering into a contract with the company.

3.     Forgery: the rule in turquand’s case does not apply where a person relies upon a document that turns out to be forged since nothing can make lawful forgery. A company can never be held bound for forgeries committed by its officers.

4.     Acts outside the scope of evident authority: if an officer of a company enters into a contract[11] with a third party and if the act of the officer is beyond the scope of his authority, the company is not bound. In such a case, the applicant cannot claim the safeguard of the rule of indoor management simply because under the articles the power to do the act could have been delegated to him. The applicant can sue the company only if the power to act has in fact been delegated to the officer with whom he entered into the contract.

Conclusion

Thus the doctrine of indoor management seeks to care for the interest of the shareholders who are in minority or who remains in dark about whether the working of the internal friend of the company are being carried out in accordance with the memorandum and articles. It lays down that persons dealing with a company having satisfied themselves that the proposed transaction is not in its nature variable with the memorandum and articles, are not bound to question the regularity of any internal proceeding. In this way the wheels of commerce would go round smoothly.

Bibliography

Turquand’s Rule and internal Management of the Company. Colleted from

www.lexvidhi.com/…/turquand-s-rule-and-internal-management-of-the-company-319.html at 25th November, 2010

Indoor Management. Collected from www.legalserviceindia.com/…/l203-Indoor-Management.html at 25th November, 2010

Reiner Kraakman, Henry Hansmann, Paul L. Davies, Klaus Hopt, Gerard Hertig,

Hideki Kanda, The Anatomy of Corporate Law (OUP 2004)

David Kershaw, Company Law in Context (OUP, Oxford 2009)

LCB Gower, ‘Some Contrasts between British and American Corporation Law’ (1956) 69(8) Harvard Law Review 1369

AA Berle, ‘The Theory of Enterprise Entity’ (1947) 47(3) Columbia Law Review 343

BS Black and JC Coffee, ‘Hail Britannia?: Institutional Investor Behavior Under Limited Regulation’ (1994) 92 Michigan Law Review 1997-2087

PL Davies, E Schuster and E Van de Walle de Ghelcke, ‘The Takeover Directive as a Protectionist Tool?’ (2010) EGCI Working Paper

PL Davies, ‘Workers on the Board of the European Company?’ (2003) 32(2) Industrial Law Journal 75

EM Dodd, ‘Book Review’ (1945) 58 Harvard Law Review 1258

A Garrett, ‘A Comparison of United States and United Kingdom Approaches to Board Structure’ (2007) 3 The Corporate Governance Law Review 93

R Grantham, ‘The Doctrinal Basis of Company Law’ (1998) 57 Cambridge Law Journal 554

PL Davies, Gower’s Modern Company Law (8th edn Sweet and Maxwell, London 2008)

D Kershaw, Company Law in Context (OUP, Oxford 2009)

R Kraakman, J Armour, PL Davies, L Enriques, H Hansmann, G Hertig, K Hopt, H

Kanda and E Rock, The Anatomy of Corporate Law (2nd edn OUP 2009)

J Lowry and A Dignam, Company Law (6th edn OUP 2010) ISBN 978-0-19-928936-3 ·

J Micklethwait and A Wooldridge The company: A short history of a revolutionary idea (Modern Library 2003)

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[1] Strategic planning is an organization‘s process of defining its strategy, or direction, and making decisions on allocating its resources to pursue this strategy, including its capital and people

[2] Intellectual property (IP) is a term referring to a number of distinct types of creations of the mind for which property rights are recognized—and the corresponding fields of law

[3] The memorandum of association of a company, often simply called the memorandum is the document that governs the relationship between the company and the outside. It is one of the documents required to incorporate a company in the United Kingdom, Ireland and India, and is also used in many of the common law jurisdictions of the Commonwealth.

[4] The term articles of association of a company, or articles of incorporation, of an American or Canadian Company, are often simply referred to as articles (and are often capitalized as an abbreviation for the full term). The Articles are a requirement for the establishment of a company under the law of India, the United Kingdom and many other countries. Together with the memorandum of association, they constitute the constitution of a company.

[5] An Act to consolidate and amend the law relating to companies and certain other associations. Be it enacted by Parliament in the Sixth Year of the Republic of the India

[6] The ‘doctrine of constructive notice’ is more or less an unreal doctrine. It does not take notice of the realities of affair life.

[7] Royal British Bank v Turquand (1856) 6 E&B 327, and the eponymous “Rule in Turquand’s Case” refer to the rule of English law that a third party dealing with a company is entitled to presume that a person held out by the company has the necessary authority to act on behalf of the company.

[8] The Court of Exchequer Chamber was an English appellate court for common law civil actions, prior to the reforms of the Judicature Acts of 1873-1875.

[9] Bond (finance), in finance, a type of debt security

[10] The European Communities Act 1972 (c. 68) is an Act of the Parliament of the United Kingdom providing for the incorporation of European Community law into the domestic law of the United Kingdom. It is not to be confused with the European Communities Act 1972 (Ireland) which did the same thing for the Republic of Ireland.

[11] In law, a contract is a legally binding agreement between two or more parties which, if it contains the elements of a valid legal agreement, is enforceable by law or by binding arbitration. A legally enforceable contract is an exchange of promises with specific legal remedies for breach. These can include compensatory remedy, whereby the defaulting party is required to pay monies that would otherwise have been exchanged were the contract honoured, or an Equitable remedy such as Specific Performance, in which the person who entered into the contract is required to carry out the specific action they have reneged upon.