International Tax Law

TAX AVOIDANCE AND EVASION

What is Tax Avoidance as compared to Tax Evasion?

The classic distinction between tax avoidance and tax evasion can be attributed to Justice Oliver Wendell Homes (once an Associate Justice of the US Supreme Court).

He made the distinction in the case of Bullen –vs- Wisconsin (1916), 240,
U.S. 625 at page 630.

In the Bullen Case, Justice Oliver Wendell Holmes Stated, “when the law draws a line, a case is on one side of it or the other, and if on the safe side is none the worse legally that a party has availed himself to the full of what the law permits. When an act is condemned as evasion, what is meant is that it is on the wrong side of the line...”

The distinguishing characteristic of evasion is illegality.

If on the wrong side of the law, it is evasion.

If on the right side of the law, it is avoidance.

An author known as Emanuel Mchani defines tax avoidance as the act of structuring once affairs legally so that one is paying less taxes than he or she might otherwise pay.
Tax avoidance could involve making use of loopholes, which are inadvertent errors in the tax legislation, but more using the provisions of the law to ones advantage.

On the other hand, tax evasion is the attempt to reduce ones taxes or increase refundable credits by illegal means, e.g. making false statements about once income or deductions, or destroying records.

In the Indian case of McDowell & Co. Ltd – vs – CTO 154 ITR 148 [1985] Justice Reddy defined tax avoidance as the “art of dodging tax without breaking the law.”

It is the avoidance of tax payment without the avoidance of tax liability.

If the tax law is broken in the process of avoiding tax, it becomes tax evasion.

A classic example of a case on tax avoidance is the case of Duke of Westminster – vs – CIR [1936] AC in which it was held, “Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Act is less than otherwise would be. If he succeeds in ordering them so as to secure this result, then however unappreciative the commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity he cannot be called upon to pay increased tax.

In a House of Lords decision of 1997, Lord Noland in the case of IRC –V – Willoughby & Another [1997] distinguished tax avoidance as follows;
“The hallmark of tax avoidance is that the tax payer reduces his liability to tax without incurring the economic consequences that parliament intended to be suffered by any taxpayer qualifying for such a reduction in his tax liability.”

There is no attempt by any of the Kenyan tax legislations, to define either tax avoidance or tax evasion.


How does Tax Evasion Occur?

Broadly, tax evasion occurs when a tax payer uses fraudulent methods or deceptive behaviour to hide the actual tax liability.

Tax evasion would usually involve the following:
Failure by a taxable person to notify the tax authorities of his presence/residence or occurrence of taxable activities.
The failure to report the full amount of taxable income
The deduction claims for expenses that have not been incurred, or which exceeded the amounts that have been incurred but not for the purpose stated.
Falsely claiming tax relief (s) that is/are not due.
Failure to pay over to the tax authorities the tax properly due.
The departure from a country without paying taxes and with no intention of paying them.
Failure to report items or sources of taxable income, profits or gains, where there is a tax obligation to declare.
Transfer pricing.
  This is also a mechanism of tax evasion. A company based in a country with high rates of corporation tax could deliberately overpay for raw materials supplied by one of its subsidiaries in the low tax country where it will pay less.
  We shall expound on the issue of transfer pricing later.

How does Tax Avoidance Occur ?

  The following are examples of mechanisms employed to achieve tax avoidance:
Income splitting
  This entails the splitting of income between more than one tax payer so as to reduce the marginal tax rate.
  If one can manage to split one figure into several, the applicable marginal rate will be lower and therefore little taxable income.
  For example, if by earning Kshs. 1, 000, 000/= per month, one falls into the 30% tax rate, he can avoid tax by splitting the income into 4 individuals, if possible. The effect is, each of the individuals will have Kshs. 250, 000/= which may each fall into a lower tax rate, say 10% and thereby reducing the total payable.
  Is it plausible?
  How would it be logical to split ones income and give to others, and still retain that income as yours?
  If the income is still yours, wouldn’t it be illegal?

Thin Capitalization
  “Thin capitalization‟ is usually used to describe “hidden equity capitalization” through excessive loans.
  It is the artificial use of interest bearing debt instead of equity by shareholders with the sole primary motive to benefit from its tax advantages.  

  The loan may be provided on a market rate of interest but the size of the loan cannot be justified on bona fide business considerations.
  Such excessive interest payments constitute  hidden distributions that should be properly treated as dividend on equity capital. (i.e. equity capital is amount or capital raised by the equity owners or shareholders whereas debt capital is amount or capital obtained by way of loans).
  In case of equity capital, the shareholders would receive dividends which are taxable.
  On the other hand, in the case of debt capital or loans, the entity would be paying interest on the debt or loans, which interest would then be deducted from the income as an expense thus reducing the amount of income taxable.

Asset shifting
  This is achieved by shifting the asset producing income to another person or entity that is taxed preferentially, i.e. taxed less that the person or entity shifting the asset.
  You could transfer the asset to a charitable trust which enjoys preferential tax treatment.

                   iv. Sheltering of income
  This    is    done    by    receiving    incomes    in    tax    havens    e.g.
Switzerland and Cayman islands.
  Tax havens have lower tax rates or no tax charge at all.

  We shall later examine tax havens at length.

Income capitalization
  This means the conversion of taxable income into capital e.g. not declaring of dividends but instead converting of profits into capital to avoid non – payment of tax on dividends.

Measures Against Tax Evasion
  Generally, since tax evasion is illegal, legal penalties are used to deter tax evasion.

  However, certain measures can be used to minimize the weaknesses that are exploited by tax evaders.

  The most notable anti-evasion measures are those adopted by the European Union.

  These measures are based on the reality that tax evasion is a cross-border problem.

  These measures are as follows: Savings Tax Directive
  The EU operates by way of directives given for implementation by EU member countries.

  The EU Savings Tax Directive creates an information exchange system for tax authorizes to identify individuals who receive savings income in a member state other than his own.
  By doing so, the member states can collect data on the savings on the savings of non – resident individuals, and automatically provide this data to the authorities where the individual resides.

Savings Tax Agreements
  These are agreements entered between countries so as to assist countries in taxing citizens who have savings accounts in respective countries.

Administrative Co-operation
  This is done by strengthening administrative co-operation between member states by enabling tax authorities to benefit from exchanged data, information and experiences to better tax evasion.

Code of conduct on Business Taxation
  The code provides that the EU Member States should refrain from introducing, or amending any harmful tax measures that unfairly undermine other member state‟s revenue raising capacities.

    Iv.   Improving the exchange of information
  Rapid access to information is important in fighting tax evasion.
  More efficient methods of information exchange should be put in place.

Class should research on other measures applied against tax evasion.

 Measures against tax avoidance

Even though tax avoidance is not illegal, it nonetheless minimizes the revenue collected by government. There should therefore be ways of curbing tax avoidance. Some of the anti-avoidance approaches proposed are as follows:

Sniper approach
  This entails the enactment of specific provisions that identify with precision the type of transactions to be dealt with and prescribe against tax consequences.

Shotgun approach
  This entails the enactment of general provisions to hit broad types of avoidance practices in specific areas.

Administrative approach
  The control of tax avoidance is left to the discretion of tax authorities.
  In this case section 23 of the Kenyan Income Tax Act, gives discretion to the Commissioner of Income Tax Act to direct that adjustments be made as respects liability to tax to counteract the avoidance or reduction of liability to tax.
   This is done where the Commissioner is of the opinion that the main purpose or one of the main purposes for which a transaction was effected was avoidance or reduction to tax.

Judicial avoidance doctrines
  Courts have stated certain principles that are intended to curb tax avoidance.
  These doctrines are also known as General Anti – Avoidance Rules (GAAR).
  The main guiding principles are:

The Motive Test/Business Purpose Rule
This rule attacks tax avoidance schemes that do not have a business purpose and those artificially designed merely to avoid tax.
Under this doctrine, a transaction must have a main or predominant business purpose (i.e. commercial justification) other than tax avoidance.
The mere tax advantage cannot be acceptable business purpose; it must show a business or non – tax purposes.
Thus it must have a valid business or economic purpose other than reduction of tax liability.
If the primary purpose is something other than tax avoidance, the transaction represents acceptable tax planning.
On the other hand, if the primary purpose is to obtain tax benefits and the transaction would not be carried without those benefits, the transaction is treated as unacceptable tax avoidance.

Artificiality Test / Substance over Form Rule
The acts must be assessed according to bona fide economic and commercial substance and not the formal content.
It requires the establishment of the underlying economic reality, not what is displaced on form/paper.
Taxation will then be based on the true commercial transaction, not what is portrayed on paper.
An example is where transactions have been shown on paper to have happened but have not really happened.
In this case, courts will apply tax rules on the true position, i.e. the alleged transactions have not happened.
A company, in order to avoid tax on dividends, may label a transaction as loan with exaggerated interest when in the real sense it is equity (the company would then claim to be paying interest on loan which is deductible from the company‟s income and thus reducing the amount of tax payable, yet in the real sense it is capital equity given by a shareholder that should attract tax when dividends are paid on it).
What is appearing on form is loan with exaggerated interest but the underlying on substantive economic transaction is equity capital.
The courts would then treat such „loan‟ transaction as equity and not loan, which in that case will attract taxes on dividends therefrom.
In case of Ridge Securities – Vs – IRC, court rejected a loan with interest at over 400% per annum as a loan transaction.
The 400% interest per annum would mean that a lot of the entity‟s income would be channeled to paying huge interests on the „loan‟, and thus depleting the taxable income and denying the tax collector the true tax.











TAX FRAUD

Types of Tax Fraud
Tax fraud involves tax evasion which is a deliberate attempt to illegally obtain a tax benefit.
This comes in many forms including:
Forging books of accounts
Using cooked statements
Failing to register as a tax entity
Failure to furnish tax returns
Failure to pay taxes,
Failure to keep records,
Failure to withhold taxes,
Obstructing, bribing and, or impersonating a tax official
Aiding and abetting a tax crime

Actions that lead to Tax Fraud/Tax Evasion?

a) Manifest Fraud
This occurs when shipping agents illegally alter manifests prior to uploading them to the Customs Manifest Management System (MMS), thereby setting the stage for false declarations.
b) Use of fake security bonds to clear transit goods
Some importers and clearing agents use fake Customs transit bonds to clear transit goods. This happens by collusion between clearing agents, insurance companies and Customs officers.
c) Diversion/Dumping of transit goods
Transit goods are goods imported through the East African Community (EAC) region to a country outside the region. Transit goods within the EAC region are not subject to import duty. However if the consignment fails to exit the region within the prescribed period and no official extension is granted, duty becomes due (this is diversion of transit goods). Customs department secure the duty due on transit cargo through the execution of a security bond. Goods prone to diversion include sugar, petroleum, rice and motor vehicles.

d) Customs Mis-declarations
A Customs declaration is a statement showing goods being imported on which duty will have to be paid. This is done by filling in a Customs declaration form. However, some importers/clearing agents make wrong declarations with the objective of evading payment of duties or reducing the duties payable. Making a wrong declaration (i.e. mis-declaration) is a prosecutable offence.

e) Smuggling
This involves importation or export of goods secretly in violation of the law, especially without payment of duties. Recent cases include: importation of high end vehicles cleared as mattresses, baby car seats, bed sofas, toys, clothes, beach beds, shoes, belts and handbags.
f) Fraudulent cancellation of export entries
This is use of fake Customs entries as proof of export, which thereafter leading to fraudulent VAT refund claims.

g) Import/Export of prohibited or restricted goods
Prohibited goods are the goods that cannot be imported/exported into/out of the country. Restricted goods are those which must meet certain conditions before clearance through Customs.
Examples: ivory, macadamia nuts, flora and fauna etc.

h) Fake payments of import taxes
This happens when Customs entries are fraudulently posted in the Customs system and validated with fake bank payment receipts.

i) Dealing with excisable goods without a valid licence
By Law, dealers in excisable products (especially tobacco, wines and spirits) should be licensed.

j) Nil/non filing income tax returns
All individuals with income are required by law to submit Income tax returns together with accounts where applicable. The returns are due on or before the end of the 6th month after the end of accounting period. Non-submission of tax return may result into prosecution.

k) Invoice fraud
The scheme involves shell companies through which money is channeled as payments for purchase of goods while in actual sense no goods are supplied.

l) Under declaration of income
By Law, all income earned in Kenya is taxable. However, some individuals under declare their income for purposes of reducing their tax liability.

TRANSFER PRICING
Transfer price is the price that one department or division of an entity charges for the products or services supplied to another division of the same entity.
Transfer pricing is the general term for the pricing of cross – border, intra – firm transactions between related parties.
Transfer pricing as such refers to the setting of prices at which transactions occur involving the transfer of property or services between associated enterprises, forming part of a Multinational Enterprise Group (MNE Group).
Transactions between these associated entities are also referred to as “controlled” transactions, opposed to “uncontrolled” transactions between non – related entities which can be assumed to operate independently. (On “an arm‟s length basis”).
Transfer pricing is a normal incident of how MNEs must operate, and as such transfer pricing does not necessarily give rise to an avoidance or tax evasion.
However, where the pricing does not accord with applicable norms internationally or as per domestic law, issues of “mispricing”, “incorrect pricing”, “unjustified pricing” or tax avoidance or evasion, arise.
Transactions between two related parties must be based on the “arm‟s length principle” (ALP).
Under ALP, transactions within a group are compared to transactions between related entities to determine acceptable transfer prices.

Transfer Pricing Methods
How is the arm‟s length principle applied in practice in order to determine the arm‟s length price of a transaction?
Various transfer pricing methods include:
i.  Comparable Uncontrolled Price (CUP).
  This method compares the price charged for a property or service transferred in a controlled transaction to the price charged for a comparable property or service transferred in a comparable uncontrolled transaction in comparable circumstances.
Resale Price Method (RPM).
  This method is used to determine the price to be paid by a reseller for a product purchased from an associated enterprise and resold to an independent enterprise.
Cost Plus
  This method is used to determine the appropriate price to be charged by a supplier of property or services to a related purchaser.
  The price is determined by adding to the cost the supplier incurred, an appropriate gross margin so that the supplier makes an appropriate profit in light of the market conditions.
Profit – based methods
  These are the profit comparison and profit split methods
Profit Comparison Method
  This method compares the level of profit that would have resulted from controlled transactions with the profits that would have been realized by comparable uncontrolled transactions.
Profit Split Method
  This method takes the combined profits earned by two related parties from one or a series of transactions and then divides the profits so as to replicate the division of profits that would have been anticipated in an agreement made at arm‟s length.

Transfer Pricing in Treaties
As seen, the UN and OECD Model Conventions at Article 9 provides for taxation of incomes of associated enterprises.
  Article 9 is a statement of the arm‟s length principle and allows for profit adjustments if the actual price on transactions between associated enterprises differs from the price that would be charged by independent enterprises under normal market terms.
 Transfer Pricing in Domestic Law
Article 9 of the Model conventions regulates the basic conditions for adjustment of transfer pricing and advises the application of arms length principle, but does not go into the particulars of transfer.
Article 9 is not „self – executing‟ as it does not create transfer pricing regime in a country.
Transfer pricing regimes are creatures of domestic law.
Each country is required to formulate detailed legislation to implement transfer pricing rules.
In Kenya, Section 18(3) of the ITA empowers the commissioner to adjust the profits accruing to a resident person from a course of business  conducted with related non – resident persons to reflect such profit as would have accrued if the course of the business had been conducted by independent persons dealing at arm‟s length.
The Transfer Pricing Rules 2006 (TP Rules) were introduced in Kenya in 2006, to supplement the provisions of Section 18 (3) of the ITA.
The TP Rules provide guidelines to be applied by related entities in determining the arm‟s length prices of goods and services in transactions involving them and to provide administrative regulations, including the types of records and documentation to be submitted to the commissioner by a person involved in transfer pricing arrangements.

WHAT IS BEPS?
Base erosion and profit shifting (BEPS) refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low, resulting in little or no overall corporate tax being paid.

INTRODUCTION
In September 2015, the G20 Finance Ministers called on the OECD to build an inclusive framework for the implementation of the , with the involvement of interested non-G20 countries and jurisdictions, particularly developing economies, on an equal footing
The G20 Leaders reiterated this request in their November 2015 communique, in which they strongly urged the timely implementation of the project and encouraged all countries and jurisdictions, including developing ones, to participate. The OECD/G20 BEPS package had been developed by OECD and G20 countries working together on an equal footing through the BEPS Project of the OECD’s Committee on Fiscal Affairs (CFA). In 2016, the CFA decided to extend the BEPS Project and establish the OECD/G20 Inclusive Framework on BEPS. The CFA identified an initial group of 123 countries and jurisdictions1 that might be interested in joining OECD and all G20 members2 in the Inclusive Framework on BEPS. All members of the Inclusive Framework participate on an equal footing.




WHAT IS THE INCLUSIVE FRAMEWORK ON BEPS DOING?
Inclusive Framework members are working on the implementation and updating of the OECD/G20 BEPS package. With respect to implementation, the Inclusive Framework is focusing in particular on the four minimum standards:
1.    In the areas of harmful tax practices,
2.    abuse of tax treaties,
3.    Country-by-Country reporting for the activities of Multinational Enterprises, and
4.    improving dispute resolution mechanisms.
A Peer review processes ensure the effective and consistent implementation of the minimum standards in order to achieve a level playing field and protect countries’ tax bases. These existing standards and peer review processes are currently being reviewed to ensure they remain appropriate and fit for purpose. The Inclusive Framework also provides support to developing countries to facilitate understanding and implementation of the BEPS measures. Importantly, the Inclusive Framework is also working on new measures to help ensure the international tax system can meet the challenges of increasing digitalisation of the economy. The proposals under discussion include the possibility of a new taxing right which could allocate a percentage of residual profits of MNEs to the jurisdiction of their users or customers even where, because of digitalisation, the company may not have a traditional taxing presence in that country; and a set of rules to ensure all MNEs pay at least a minimum level of taxes on their profits somewhere in the world.

WHAT IS A DIGITAL ECONOMY?
The digital economy is the result of the widespread and transformative process brought on by Information and Communication Technology (ICT). All sectors, ranging from retail, financial services to education and broadcasting and media have been transformed by ICT technologies. So much so, that the digital economy is increasingly becoming the economy itself. It would therefore be difficult, if not impossible, to ring fence the digital economy from the rest of the economy for tax purposes.

Common Tax Planning

Individuals as well as corporate entities can mitigate their tax exposure by keeping the following points in mind as they conduct their affairs.

Keeping Complete and Accurate Records

Proper record keeping enables individuals and companies, first, to support allowable deductions from their gross income.

Accurate records will also help in the event of a tax audit or other proceedings against the taxpayer.

Getting Timely, Competent Tax Advice

Working with a competent tax consultant enables individuals and corporate entities to conduct their affairs in compliance with existing tax laws.

Challenging Tax Assessments

As we shall se later, the tax statutes provide avenues for individuals and companies to challenge tax assessments made upon them by tax authorities.

At times, it turns out that the assessments by the tax authorities are on the higher side.

Compliance

Taxpayers can avoid exposure to tax problems (stiff penalties, interest, possible shutdown of business, and distractions from

usual activities) by complying with tax laws and regulations

However, it is not illegal to arrange one’s affairs in such a manner as to minimize tax burden.


TRANSFER PRICING
Transfer price is the price that one department or division of an entity charges for the products or services supplied to another division of the same entity.
Transfer pricing is the general term for the pricing of cross – border, intra – firm transactions between related parties.
Transfer pricing as such refers to the setting of prices at which transactions occur involving the transfer of property or services between associated enterprises, forming part of a Multinational Enterprise Group (MNE Group).
Transactions between these associated entities are also referred to as “controlled” transactions, opposed to “uncontrolled” transactions between non – related entities which can be assumed to operate independently. (On “an arm‟s length basis”).
Transfer pricing is a normal incident of how MNEs must operate, and as such transfer pricing does not necessarily give rise to an avoidance or tax evasion.
However, where the pricing does not accord with applicable norms internationally or as per domestic law, issues of “mispricing”, “incorrect pricing”, “unjustified pricing” or tax avoidance or evasion, arise.
Transactions between two related parties must be based on the “arm‟s length principle” (ALP).
Under ALP, transactions within a group are compared to transactions between related entities to determine acceptable transfer prices.

Transfer Pricing Methods
How is the arm‟s length principle applied in practice in order to determine the arm‟s length price of a transaction?
Various transfer pricing methods include:
i.  Comparable Uncontrolled Price (CUP).
  This method compares the price charged for a property or service transferred in a controlled transaction to the price charged for a comparable property or service transferred in a comparable uncontrolled transaction in comparable circumstances.
Resale Price Method (RPM).
  This method is used to determine the price to be paid by a reseller for a product purchased from an associated enterprise and resold to an independent enterprise.
Cost Plus
  This method is used to determine the appropriate price to be charged by a supplier of property or services to a related purchaser.
  The price is determined by adding to the cost the supplier incurred, an appropriate gross margin so that the supplier makes an appropriate profit in light of the market conditions.
Profit – based methods
  These are the profit comparison and profit split methods
Profit Comparison Method
  This method compares the level of profit that would have resulted from controlled transactions with the profits that would have been realized by comparable uncontrolled transactions.
Profit Split Method
  This method takes the combined profits earned by two related parties from one or a series of transactions and then divides the profits so as to replicate the division of profits that would have been anticipated in an agreement made at arm‟s length.

Transfer Pricing in Treaties
As seen, the UN and OECD Model Conventions at Article 9 provides for taxation of incomes of associated enterprises.
  Article 9 is a statement of the arm‟s length principle and allows for profit adjustments if the actual price on transactions between associated enterprises differs from the price that would be charged by independent enterprises under normal market terms.
 Transfer Pricing in Domestic Law
Article 9 of the Model conventions regulates the basic conditions for adjustment of transfer pricing and advises the application of arms length principle, but does not go into the particulars of transfer.
Article 9 is not „self – executing‟ as it does not create transfer pricing regime in a country.
Transfer pricing regimes are creatures of domestic law.
Each country is required to formulate detailed legislation to implement transfer pricing rules.
In Kenya, Section 18(3) of the ITA empowers the commissioner to adjust the profits accruing to a resident person from a course of business  conducted with related non – resident persons to reflect such profit as would have accrued if the course of the business had been conducted by independent persons dealing at arm‟s length.
The Transfer Pricing Rules 2006 (TP Rules) were introduced in Kenya in 2006, to supplement the provisions of Section 18 (3) of the ITA.
The TP Rules provide guidelines to be applied by related entities in determining the arm‟s length prices of goods and services in transactions involving them and to provide administrative regulations, including the types of records and documentation to be submitted to the commissioner by a person involved in transfer pricing arrangements.

COMPANY LAW NOTES

COURSE OBJECTIVES

1.         To expose the legal status of the company. Though an artificial person functions through its “Alter ego” or mind i.e. its officers.

2.         To discuss rules and regulations governing the operations of companies in particular the Companies Act.

3.         To prepare to overcome the challenges facing the ever dynamic corporate world and direct us to apply the rules and regulations in dealing with those challenges e.g. the powers of the Board of Directors vis-a-vis the general meeting for private and public companies and the minister for statutory companies e.g. CCK

4.         To make a case for reform of company law in Kenya.

MEANING, NATURE AND IMPORTANCE OF A COMPANY

Definition was considered in the English case of Re Stanley (1906) 1 ch 131 in which Buckley J noted that the term ‘company’ has neither a legal nor technical definition.

Company therefore has to be defined from a commercial perspective and this is why even the Companies Act both of the U.K and Kenya do not give a clear definition of a company.

Section 2 (1) Companies Act says a company means under the Act or an existing company.

A company is an association of persons with similar objectives as stated in its constitution. It must not be a business entity.

This is because some companies have limited guarantee and may engage in charitable rather than profitable activities.

Even statutory companies are not business oriented e.g. KBC, NSSF, TELCOM etc

At another level a company is an artificial legal person separate and distinct from its members (shareholders), directors, company officers and promoters.

The difficulty of defining a company is well captured by Frank Evans “what is a company? [1]

 

 

Private company

Under section 30 the private company limits the transfer of its shares from one member to another

Secondly, it does not issue its shares/equity and securities to the public debentures

A private company can be converted to a public company by approval of majority of members

 

Chartered

It gave the company the exclusive right to exploit specified business in an area without rivalry.

Created by Queen of England by letters of patent for example, Imperial British East Africa Company

Charter was granted on grounds of certain conditions or else the crown would withdraw the charter.

 

HISTORICAL BACKGROUND OF COMPANIES

 

In Medieval law, a primitive form of incorporation existed in relation to ecclesiastical and public bodies which received corporate personality through a royal charter

Then, the mercantile era which entailed maritime trade and organizations of traders necessitated the extension of the corporate personality to these organizations, the traders were then known as the guild merchants

A good example is the East India Company which had a monopoly of trade with Indies

Bubble act[2]

The first attempt at a unified law on companies was the Bubble Act of 1825 which governed joint stock companies and was preceded by the Bubble Act of 1720.

These two Acts put many obstacles on the path of incorporation of companies by putting tough conditions regarding the deed of settlement

In 1837, there were the chartered companies Act which provided for the liability of the members of the chartered companies.

 In 1844, Joint stock Companies Act which formed the basis for modern principles of company law.

1862 Companies Act which prohibited any alteration of the objects clause and established companies limited by guarantee and unlimited companies.

It had elaborate provisions on winding up but was later improved in 1867 Companies Act

1929 Companies Act which contributed towards the modernization of company law by establishing disclosure threshold for holding companies. This Act also allowed the admission of redeemable preference shares

The Act also offered more protection for minority shareholders, simplified the procedure for passing special resolutions and the procedure of winding up.

1948 companies Act upon which the Kenyan Act is based whose main concern was the public accountability of the company and introduced public disclosure for all companies except the exempt ‘private companies’.

These requirements included audit by professional auditors, group accounts for interconnected companies, publication of balance sheets, minority protection, investigation of company affairs (section 164 see and compare investigation by registrar ) 165 in Companies Act of Kenya

1948 Act amended in 1962 to give rise to the 1962 Companies Act which abolished the exempt private company and improved on the provisions of the 1948 Act

NB: the Kenyan Act commenced on 1^st January 1962 borrowed from the English Act of 1948, therefore the challenge for the reformer’s of company law is that while the English Act of 1948, therefore the challenge for the reformers of company law is that while the English act has been severally amended including in 1985 and the fact that the UK has come up with an insolvency law, the Kenyan law has largely remained static ignoring modern developments in company law.

Derivative action

Evasion of ultra vires rule

 Entrepreneurs will opt for one or more commercial vehicles that are most suited to their economic interest.

They are always on a dilemma to choose between forming a sole proprietorship, partnership or Sacco.

Comparative Advantages

Companies	Sole proprietorship	Partnership	Sacco
Companies Act Incorporation Separate legal persons Profit driven Winding up Regulated by registrar Documents Memorandum of Association and Articles Perpetual succession Management is by a board of directors	Registration of business names (cap 499) Registration Personal liability Profit driven Registrar of business names/local authority Certificate Death of owner Succession dies with the owner Management is by the proprietor	Partnership Act Registration Personal liability section 28 Profit driven Wound up in various ways section 36-39 Regulated by registrar of business names Governed by partnership, articles and deed Succession dies Managed by partners	Cooperatives Societies Act Registration Separate legal personality Welfare of society Order of commissioner of cooperatives Governed by the constitution Perpetual succession Central management committee

 

The distinction between a company and a partnership was laid bare in the case Fort Hall Bakery Supply Company v Wangoe 1959 the plaintiff sued the defendant for a business debt. During the hearing it emerged that the plaintiff was a business carried on by 45 people yet it had not been registered under the company’s act. The question that arose was whether the plaintiff was a legal entity within the meaning of section 389. It was held that the plaintiff could not be recognized as having any legal existence and were therefore incapable of maintaining any legal action.

 

PROMOTERS AND PROSPECTUS

Promoters are the initial founders of the company. They invented the business idea of the company and conceive the same in a prospectus therefore promoters and prospectus are pre-incorporation entities.  However, a recent practice has emerged where companies use the prospectus after incorporation when inviting for share subscriptions from members of public.

It is the duty of the promoters to look for business opportunities for the company. Furthermore logistical issues like the registered address of the company are decided on by the promoters.

A question arises as to the extent to which promoters can bind the company especially if they make a misrepresentation in the initial prospectus of the company. This is the situation which arose in the case of

 

Derry v Peek.[3]

In the case a bus company had the power to operate buses which were driven by horses. If the company obtained board of trade content then they could operate mechanically driven buses in a prospectus asking for subscribers the company represented that they had the right to operate mechanized buses. They assumed that the board of trade would grant permission. Derry bought shares in the company but the board later refused permission and the company wound up.

The question that arose in the court was whether the company was guilty of fraudulent misrepresentation?

Held: the court held that the promoters had not acted recklessly and were not guilty of fraudulent misrepresentation.[4]

 

Hedley Byrne and Company limited v Heller and partners limited (1963) 2 ALL ER 575

A bank gave an opinion that a company easy power was financially stable. The bank’s evaluation was later on held to be negligent. The opinion was given to a customer.

Hedley Byrne contacted A’s bankers, Heller and partners (defendants) for references Heller and partners gave a favorable report of A’s credit worthiness. Heller and partners headed the document ‘Without Responsibility’ Hedley Byrne acted on the misleading report, gave substantial credit and suffered heavy loss when A went into liquidation shortly after. Hedley Byrne sued Heller and Partnership in negligence House of lords held that the defendant banker Heller and partnership would have been liable in negligence had they not expressly disclaimed liability ‘where in a sphere in which a person is so placed that others could reasonably rely on his judgment or his skill on his ability to make careful inquiry, a person takes it on himself to give information or advice to, or allows his information or advice to be passed on to, another, who as he knows or should know, will place reliance on it, then a duty of care will arise.

 

The company has the following remedies[5]

1.         Rescind the contract and recover the purchaser money this is what happened in the above case

2.         Compel the promoter to account for the profit

3.         To sue the promoter for damages of breach of fiduciary duties

A syndicate headed by Erlanger purchased an island in the West Indies said to contain valuable mines of phosphate. The purchase price was 55000 pounds. E formed a company to buy the island and a contract was made between X who was a nominee of the syndicate and the company at a purchase price of 110,000 pounds. The court held that since there was no disclosure by the promoters of the profit they were making the company was entitled to rescind that contract and recover the purchase money from the syndicate Erlanger included (as he was a member of the syndicate

 

Section 45 (1) of the Companies Act the promoter is personally liable to pay compensation to shareholders who have been misled by the prospectus. If the same was issued with their knowledge and consent

NB: A preliminary contract is a term given to contracts entered in to before incorporation and normally they are signed by the promoters. [6]

 

PROCEDURE FOR INCORPORATION

1.         Search for suitable name of the company

2.         Prepare the company’s constitution memorandum of association together with the requisite forms

Caution should be taken on clause 3 of the memo which is the objects clause for purposes of the ultra vires rule

3.         Assessment of documents and presentation for stamp duty

Consequences

1.         Once incorporated or registered the company from the date of incorporation mentioned in the certificate becomes an artificial legal person or body corporate capable of the following

a)        Having separate legal personality

b)        Having limited liability

c)         Owning or holding property on its own

d)        Having locus standi (capacity to sue and be sued) in its own name

e)        Having perpetual succession

f)          Transfer and transferability of shares though limited for limited liability company’s and private companies section 30

g)        Borrowing in its own name on the security of its own assets

h)        Having the power to trade in its own name and issue financial products e.g. Debentures, shares, derivatives, fixtures, forwards, currency sways, options

A)        Separate legal entity

A company is a legal person distinct from its members this was affirmed in the case Salomon v Salomon and company limited 1892. Salomon promoted the company which he called Salomon and company. He was also the managing director of the company. His co-shareholders were his wife and five children. The company purchased Salomon’s existing business for 39000 pounds. The purchase was paid for using 10’000 pounds in debentures creating floating securities of 20,000 pounds. The company went in to liquidation and a receiver was appointed by the debenture holder. The unsecured creditors were not paid and they sued Salomon arguing that the company was merely a nominee and agent of Salomon and that Salomon was therefore liable to personally indemnify the receiver against the unsecured debts of the company. Court of Appeal agreed with the receiver and Salomon appealed to the House of Lords. The company is a distinct person from its subscribers or members. The company cannot be an agent of the subscribers therefore the debentures were perfectly valid (McNaughton) HL Holding

A company can be guilty of a crime on its own and can be charged with a criminal offence, tax evasion, section 23 penal code and is generally referred to as the organic theory of company law.

 

The net effect of separate legal personality is that even the largest shareholder has no insurable interest in the property of the company Macaura v northern Assurance Company limited (1925) ALL ER 51

 

The managing director, even if he owns 99.9% of the shares cannot lawfully pay cheques belonging to the company into his own bank account or draw cheques for his own purposes from the company’s account. (Al Underwood v Bank of Liverpool and Marine Limited)

 

A company’s money is not members’ money and any member who uses company’s money to discharge personal obligation is liable to the company for conversion

B)        Limited Liability

This forms the distinction between a company and a partnership and it protects the personal assets of the members from intrusion by creditors. This is especially so far limited liability companies bur for companies limited by guarantee and unlimited company’s their personal assets could be attached by the creditors should the company’s assets be exhausted.

 

 

 

 

 

C)        Ownership

Property of a company is distinct from that of its members and this is what makes it to create its own securities over its assets e.g. debentures, mortgages, charges etc hence a company can sue to recover or protect its property.[7]

 

D)        Locus standi

A company can only sue and be sued in its own name and the members can only sue the company through their own names.

 

E)        Perpetual succession

A company cannot die naturally but can only die legally but the company does not even have allocated life span like a lease or human beings have life expectations. This was affirmed in Re Noel Ted man holding property limited where the company survived the death of its only two members through a road accident

F)        Transfer and transferability of shares

Incorporation makes the transfer and transferability of shares physically and legally feasible and easy at the stock exchange.

A shareholder does not need to seek anyone’s permission in order to sell his or her shares.

Section 32 a capital markets Act

Section 30 Companies Act (limitation on private companies)

Two documents are important in the transfer of shares assuming that the share holder posses a share certificate which is the evidence of share ownership in a company.

1.         Certificate of transfer which signifies the shareholders voluntary assignment or sale of his or her shares or pursuant to a court order.

2.         Transfer from which signifies that the shares are negotiable instruments capable of being transferred to the buyer.

 

THE LAW OF BUSINESS ASSOCIATIONS

 

Section 2 (1) of the Companies Act states what company means as 'a company formed and registered under this Act or an existing company.  This is a very vague definition, in the statute the word company is not a legal term hence the vagueness of the definition.  The legal attributes of the word company will depend upon a particular legal system.

 

In legal theory company denotes an association of a number of persons for some common object or objects in ordinary usage it is associated with economic purposes or gain.  A company can be defined as an association of several persons who contribute money or money’s worth into a common stock and who employ it for some common purpose.  Our legal system provides for three types of associations namely

1.                     Companies

2.                     Partnerships.

3.                     Upcoming is the cooperative society.

 

The law treats companies in company law distinctly from partnerships in partnership law.  Basically company law consists partly of ordinary rules of Common law and equity and partly of statutory rules.  The common law rules are embodied in cases.  The statutory rules are to be found in the Companies Act which is the current Cap 486 Laws of Kenya.  It should denote that the Kenya Companies Act is not a self contained Act of legal rules of company law because it was borrowed from the English Companies Act of 1948 which was itself not a codifying Act but rather a consolidating Act.

 

Exceptions to the Rules are stated in the Act but not the rules themselves. Therefore fundamental principles have to be extracted from study of numerous decided cases some of which are irreconcilable.   The true meaning of company law can only be understood against the background of the common law.

FUNDAMENTAL CONCEPTS OF COMPANY LAW

 

There are two fundamental legal concepts

 

1.                     The concept of legal personality; (corporate personality) by which a company is treated in law as a separate entity from the members.

 

2.                     The concept of limited liability;

 

Concept of legal personality

 

(I)              

A legal person is not always human, it can be described as any person human or otherwise who has rights and duties at law; whereas all human persons are legal persons not all legal persons are human persons.  The non-human legal persons are called corporations.  The word corporation is derived from the Latin word Corpus which inter-alia also means body.  A corporation is therefore a legal person brought into existence by a process of law and not by natural birth.  Owing to these artificial processes they are sometimes referred to as artificial persons not fictitious persons.

 

LIMITED LIABILITY

 

Basically liability means the extent to which a person can be made to account by law.  He can be made to be accountable either for the full amount of his debts or else pay towards that debt only to a certain limit and not beyond it.  In the context of company law liability may be limited either by shares or by guarantee.

 

Under Section (2) (a) of the Companies Act, in a company limited by shares the members liability to contribute to the company’s assets is limited to the amount if any paid on their shares.

 

Under Section 4 (2) (b) of the Companies Act in a company limited by guarantee the members undertake to contribute a certain amount to the assets of the company in the event of the company being wound up. Note that it is the members’ liability and not the companies’ liability which is limited.  As long as there are adequate assets, the company is liable to pay all its debts without any limitation of liability.  If the assets are not adequate, then the company can only be wound up as a human being who fails to pay his debts.  Note that in England the Insolvency Act has consolidated the relationships relating to ….   That does not apply here.

 

Nearly all statutory rules in the Companies Act are intended for one or two objects namely

1.                     The protection of the company’s creditors;

2.                     The protection of the investors in this instance being the members.

 

These underlie the very foundation of company law.

 

FORMATION OF A LIMITED COMPANY

 

This is by registration under the Companies Act

 

In order to incorporate them into a company, those people wishing to trade through the medium of a limited liability company must first prepare and register certain documents.  These are as follows

a.                     Memorandum of Association:  this is the document in which they express inter alia their desire to be formed into a company with a specific name and objects.  The Memorandum of Association of a company is its primary document which sets up its constitution and objects;

b.                     Articles of Association; whereas the memorandum of association of a company sets out its objectives and constitution the articles of association contain the rules and regulations by which its internal affairs are governed dealing with such matters as shares, share capital, company’s meetings and directors among others;

 

Both the Memorandum and Articles of Associations must each be signed by seven persons in the case of a public company or two persons if it is intended to form a private company.  These signatures must be attested by a witness.  If the company has a share capital each subscriber to the share capital must write opposite his name the number of shares he takes and he must not take less than one share.

 

c.                     Statement of Nominal Capital – this is only required if the company has a share capital.  It simply states that the company’s nominal capital shall be xxx amount of shillings. The fees that one pays on registration will be determined by the share capital that the company has stated. The higher the share capital, the more that the company will pay in terms of stamp duty.

 

d.                     Declaration of Compliance:  this is a statutory declaration made either by the advocates engaged in the formation of the company or by the person named in the articles as the director or secretary to the effect that all the requirements of the companies Act have been complied with. Where it is intended to register a public company,   Section 184 (4) of the Companies Act also requires the registration of a list of persons who have agreed to become directors and Section 182 (1) requires the written consents of the Directors.

 

These are the only documents which must be registered in order to secure the incorporation of the company.  In practice however two other documents which would be filed within a short time of incorporation are also handed in at the same time.  These are:

 

1.                     Notice of the situation of the Registered Office which under Section 108(1) of the statute should be filed within 14 days of incorporation;

 

2.                     Particulars of Directors and Secretary which under Section 201 of the statute are normally required within 14 days of the appointment of the directors and secretary. 

 

The documents are then lodged with the registrar of companies and if they are in order then they are registered and the registrar thereupon grants a certificate of incorporation and the company is thereby formed.  Section 16(2) of the Act provides that from the dates mentioned in a certificate of incorporation the subscribers to the Memorandum of Association become a body corporate by the name mentioned in the Memorandum capable of exercising all the functions of an incorporated company.  It should be noted that the registered company is the most important corporation. 

 

STATUTORY CORPORATIONS

 

The difference between a statutory corporation (and parastatal) and a company registered under the companies Act is that a statutory corporation is created directly by an Act of Parliament.  The Companies Act does not create any corporations at all.  It only lays down a procedure by which any two or more persons who so desire can themselves create a corporation by complying with the rules for registration which the Act prescribes.

 

TYPES OF REGISTERED COMPANIES

 

Before registering a company the promoters must make up their minds as to which of the various types of registered companies they wish to form.

 

1.                     They must choose between a limited and unlimited company; Section 4 (2) (c) of the Companies Act states that ‘a company not having the liability of members limited in any way is termed as an unlimited company.  The disadvantage of an unlimited company is that its members will be personally liable for the company’s debts.  It is unlikely that promoters will wish to form an unlimited liability company if the company is intended to trade.  But if the company is merely for holding land or other investments the absence of limited liability would not matter.

 

2.                     If they decide upon a limited company, they must make up their minds whether it is to be limited by shares or by guarantee.  This will depend upon the purpose for which it is formed.  If it is to be a non-profit concern, then a guarantee company is the most suitable, but if it is intended to form a profit making company, then a company limited by shares is preferable.

 

3.                     They have to choose between a private company and a public company.  Section 30 of the Companies Act defines a private company as one which by its articles restricts

(i)                    the rights to transfer shares;

(ii)                   restricts the number of its members to fifty (50);

(iii)                  Prohibits the invitation of members of the public to subscribe for any shares or debentures of the company.

 

 A company which does not fall under this definition is described as a public company.

 

In order to form a public company, there must be at least seven (7) subscribers signing the Memorandum of Association whereas only two (2) persons need to sign the Memorandum of Association in the case of a private company.

 

ADVANTAGES OF INCORPORATION

 

A corporation is a legal entity distinct from its members, capable of enjoying rights being subject to duties which are not the same as those enjoyed or borne by the members.

 

The full implications of corporate personality were not fully understood till 1897 in the case of

 Salomon v. Salomon [1897] A C 22 

 

Facts of the case

 

Salomon was a prosperous lender/merchant.  He sold his business to Salomon and Co. Limited which he formed for the purpose at the price of £39,000 satisfied by £1000 in cash, £10,000 in debentures conferring a charge on the company’s assets and £20,000 in fully paid up £1 shares.  Salomon was both a creditor because he held a debenture and also a shareholder because he held shares in the company.  Seven shares were then subscribed for in cash by Salomon, his wife and daughter and each of his 4 sons.  Salomon therefore had 20,101 shares in the company and each member of the family had 1 share as Salomon‘s nominees.  Within one year of incorporation the company ran into financial problems and consequently it was wound up.  Its assets were not enough to satisfy the debenture holder (Salomon) and having done so there was nothing left for the unsecured creditors.  The court of first instance and the court of appeal held that the company was a mere sham an alias, agents or nominees of Salomon and that Mr. Salomon should therefore indemnify the company against its trade loss.

 

The House of Lords unanimously reversed this decision.  In the words of Lord Halsbury “Either the limited company was a legal entity or it was not.  If it was, the business belonged to it and not to Salomon.  If it was not, there was no person and no thing at all and it is impossible to say at the same time that there is the company and there is not”

 

In the words of Lord McNaughton “the company is at a law a different person altogether from the subscribers and though it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustee for them nor are the subscribers as members liable in any shape or form except to the extent and manner prescribed by the Act. …   in order to form a company limited by shares the Act requires that a Memorandum of Association should be signed by seven (7) persons who are each to take one share at least.  If those conditions are satisfied, what can it matter, whether the signatories are relations or strangers.  There is nothing in the Act requiring that the subscribers to the Memorandum should be independent or unconnected or that they or anyone of them should take a substantial interest in the undertaking or that they should have a mind and will of their own.  When the Memorandum is duly signed and registered though there be only seven (7) shares taken the subscribers are a body corporate capable forthwith of exercising all the functions of an incorporated company.

 

… The company attains maturity on its birth.  There is no period of minority and no interval of incapacity.  A body corporate thus made capable by statutes cannot lose its individuality by issuing the bulk of its capital to one person whether he be a subscriber to the Memorandum or not.”

 

There were several other Law Lords who decided business in the House. 

 

The significance of the Salomon decision is threefold.

 

1.                     The decision established the legality of the so called one man company;

2.                     It showed that incorporation was as readily available to the small private partnership and sole traders as to the large private company.

3.                     It also revealed that it is possible for a trader not merely to limit his liability to the money invested in his enterprise but even to avoid any serious risk to that capital by subscribing for debentures rather than shares.

 

Since the decision in Salomon’s case the complete separation of the company and its members has never been doubted.

 

Macaura V. Northern Assurance Co. Ltd (1925) A.C. 619

 

The Appellant owner of a timber estate assigned the whole of the timber to a company known as Irish Canadian Sawmills Company Limited for a consideration of £42,000.  Payment was effected by the allotment to the Appellant of 42,000 shares fully paid up in £1 shares in the company. No other shares were ever issued.  The company proceeded with the cutting of the timber.  In the course of these operations, the Appellant lent the company some £19,000.  Apart from this the company’s debts were minimal.  The Appellant then insured the timber against fire by policies effected in his own name.  Then the timber was destroyed by fire.  The insurance company refused to pay any indemnity to the appellant on the ground that he had no insurable interest in the timber at the time of effecting the policy.

 

The courts held that it was clear that the Appellant had no insurable interest in the timber and though he owned almost all the shares in the company and the company owed him a good deal of money, nevertheless, neither as creditor or shareholder could he insure the company’s assets.  So he lost the Company.

 

Lee v Lee’s Air Farming Ltd. (1961) A.C. 12

 

Lee’s company was formed with capital of £3000 divided into 3000 £1 shares.  Of these shares Mr. Lee held 2,999 and the remaining one share was held by a third party as his nominee.  In his capacity as controlling shareholder, Lee voted himself as company director and Chief Pilot.  In the course of his duty as a pilot he was involved in a crash in which he died.  His widow brought an action for compensation under the Workman’s Compensation Act and in this Act workman was defined as “A person employed under a contract of service” so the issue was whether Mr. Lee was a workman under the Act?  The House of Lords Held:

 

“That it was the logical consequence of the decision in Salomon’s case that Lee and the company were two separate entities capable of entering into contractual relations and the widow was therefore entitled to compensation.”

 

Katate v Nyakatukura (1956) 7 U.L.R 47A

 

The Respondent sued the Petitioner for the recovery of certain sums of money allegedly due to the Ankore African Commercial Society Ltd in which the petitioner was a Director and also the deputy chairman.  The Respondent conceded that in filing the action he was acting entirely on behalf of the society which was therefore the proper Plaintiff.  The action was filed in the Central Native Court.  Under the Relevant Native Court Ordinance the Central Native Court had jurisdiction in civil cases in which all parties were natives.  The issue was whether the Ankore African Commercial Society Ltd of whom all the shareholders were natives was also a native.

 

The court held that a limited liability company is a corporation and as such it has existence which is distinct from that of the shareholders who own it.  Being a distinct legal entity and abstract in nature, it was not capable of having racial attributes.

        

Limited Liability

1.         Since a corporation is a separate person from the members, its members are not liable for its debts.  In the absence of any provisions to the contrary the members are completely free from any personal liability.  In a company limited by shares the members’ liability is limited to the amount unpaid on the shares whereas in a company limited by guarantee the members’ liability is limited to the amount they guaranteed to pay.  The relevant statutory provision is Section 213 of the Companies Act.

 

Holding Property:

 

2.         Corporate personality enables the property of the association to be distinguishable from that of the members.  In an incorporated association, the property of the association is the joint property of all the members although their rights therein may differ from their rights to separate property because the joint property must be dealt with according to the rules of the society and no individual member can claim any particular asset to that property.

 

 

 

Suing and Being Sued:

 

3.                           As a legal person, a company can take action in it’s own name to enforce its legal rights.  Conversely it may be sued for breach of its legal duties.  The only restriction on a company’s right to sue is that it must always be represented by a lawyer in all its actions. 

 

In East Africa Roofing Co. Ltd v Pandit (1954) 27 KLR 86

Here the Plaintiff a limited liability company filed a suit against the defendant claiming certain sums of money.  The defendant entered appearance and filed a defense admitting liability but praying for payment by installments.  The company secretary set down the date on the suit for hearing ex parte and without notice to the defendant.  This was contrary to the rules because a defense had been filed.  On the hearing day the suit was called in court but no appearance was made by either party and the court therefore ordered the action to be dismissed.  The company thereafter applied to have the dismissal set aside.  At the hearing of that application, it was duly represented by an advocate.  The only ground on which the company relied was that it had intended all along to be represented at the hearing by its manager and that the manager in fact went to the law courts but ended in the wrong court.  It was held that a corporation such as a limited liability company cannot appear in person as a legal entity without any visible person and having no physical existence it cannot at common law appear by its agent but only by its lawyer.  The Kenya Companies Act does not change this common law rule so as to enable a limited company to appear in court by any of its officers.

 

PERPETUAL SUCCESSION

4.         As an artificial person, the company has neither body mind nor soul.  It has been said that a company is therefore invisible immortal and thus exists only intendment consideration of the law.  It can only cease to exist by the same process of law which brought it into existence otherwise; it is not subject to the death of the natural body. Even though the members may come and go, the company continues to exist.

 

TRANSFERABILITY OF SHARES  

5.         Section 75 of the Companies Act states as follows “The Shares or any other interests of a member in a company shall be moveable property transferable in the manner provided by the Articles of Association of the Company.”  In a company therefore shares are really transferable and upon a transfer the assignee steps into the shoes of the assignor as a member of the company with full rights as a member.  Note however that this transferability only relates to public companies and not private companies.

 

BORROWING FACILITIES:           

 

6.         In practice companies can raise their capital by borrowing much more easily than the sole trader or partnership.  This is enabled by the device of the ‘floating charge’ a floating charge has been defined as a charge which floats like a cloud over all the assets from time to time falling within a certain description but without preventing the company from disposing of these assets in the ordinary course of its business until something happens to cause the charge to become crystallized or fixed.  The ease with which this is done is facilitated by the Chattels Transfer Act which exempts companies from compiling an inventory on the particulars of such charges and also by the bankruptcy Act which exempts companies from the application of the reputed ownership clause.  As far as companies are concerned the goods in the possession of the company do not fall within the reputed ownership clause. 

 

The only disadvantages are three

 

(i)                    Too many formalities required in the formation of the company

(ii)                   There is maximum publicity of the company’s affairs;

(iii)                  There is expense incurred in the formation and in the management of a company.

 

In order to form a company, certain documents must be prepared whereas no such documents need to be prepared to establish business as a sole proprietor or partnership and throughout its life a company is required to file such documents as balance sheets and profits and loss accounts on dissolution of the company it is required to follow a certain stipulated procedure which does not apply to sole traders and partnerships.

 

IGNORING THE CORPORATE ENTITY (LIFTING THE VEIL OF INCORPORATION)

 

Although Salomon’s case finally established that a company is a separate and distinct entity from the members, there are circumstances in which these principle of corporate personality is itself disregarded.  These situations must however be regarded as exceptions because the Salomon decision still obtains as the general principle

 

Although a company is liable for its own debt which will be the logical consequence of the Salomon rule, the members themselves are held liable which is therefore a departure from principle.  The rights of creditors under this section are subject to certain limitations namely   (under statutory provision)

 

(i)                    REDUCTION IN THE NUMBER OF MEMBERS - Section 33 refers to membership that has fallen below the statutory minimum in a public company.  The Act provides that only those members who remain after the six month during which the company has fallen below the provided minimum period can be sued; even these members are liable if they have knowledge of the fact and only in respect of debts contracted after the expiration of the six months. Moreover the Section is worded in such a way as to suggest that the remaining members will be liable only in respect of liquidated contractual obligations.

 

FRAUDULENT TRADING – the provisions of Section 323

 

(ii)                   Of the Companies Act come into operation here.  It is provided that if in the course of the winding up of the company it appears that any business has been carried on with the intent to defraud the creditors, or for any fraudulent purpose, the courts on the application of the official receiver, the liquidator or member may declare that any persons who are knowingly parties to the fraud shall be personally responsible without any limitation on liability for all or any of the debts or other liabilities of the company to the extent that the court might direct the liability.  This Section does not define the term fraud nor have the courts defined it.  However, in

Re William C. Leitch Ltd (1932) 2 Ch. 71

The company was incorporated to acquire William’s business as a furniture manufacturer.  The directors of the company were William and his wife and they appointed William as the Managing Director at a Salary of £1000 per annum.  Within the period of one month, the company was debited with an amount which was £500 more than what was actually due to William.  By that time the company had made a loss of £2500.  Within 2 years of formation, and while the company was still in financial problems, the directors paid to themselves the dividends of £250.  By the end of the 3^rd year since incorporation the company was in such serious difficulties such that it could not pay debts as they fell due.  In spite of this William ordered goods worth £6000 which became subject to a charge contained in a debenture held by them.  At the same time he continued to repay himself a loan of £600 (six hundred pounds) which he had lent to the company at the beginning of the 4^th year the company with the knowledge of William owed £6500 for goods supplied.  In the winding up of the company the official receiver applied for a declaration that in no circumstances William had carried on the company’s business with intent to defraud and therefore should be held responsible for the repayment of the company’s debts.  It was held that since that company continued to carry on business at a time when William knew that the company could not comfortably pay its debts, then this was fraudulent trading within the meaning of Section 323 and William should be responsible for repaying the debts.  These are the words of Justice Maugham J. “if a company continues to carry on business and to incur debts at a time when there is to the knowledge of the directors no reasonable prospects of the creditors ever receiving payments of those debts, it is in general a proper inference that the company is carrying on business with intent to defraud.”

 

The test is both subjective and objective.  In the Case of

Re Patrick Lyon Ltd (1933) Ch. 786

On facts which were similar to the Williams case, the same Judge Maugham J. said as follows:  “the words fraud and fraudulent purpose where they appear in the Section in question are words which connote actual dishonesty involving according to the current notions of fair trading among commercial men real moral blame. No judge has ever been willing to define fraud and I am attempting no definition.”

 

The statutes are not clear as to the meaning of fraud the question arises that once the money has been recovered from the fraudulent director, is it to be laid as part of the company’s general assets available to all creditors or should it go back to those creditors who are actually defrauded.

 

In the case of Re William Justice Eve J. stated that such money should form part of the company’s general assets and should not be refunded to the defrauded creditors.

 

In the case of

Re Cyona Distributors Ltd (1967) Ch. 889

 The Court of Appeal ruled that if the application under Section 323 is made by the debtor then the money recovered should form part of the company’s general assets but where the application is made by a creditor himself, then that creditor is entitled to retain the money in the discharge of the debts due to him.

 

HOLDING AND SUBSIDIARY COMPANIES

One of the most important limitations imposed by the Companies Act on the recognition of the separate personality of each individual company is in connection with associated companies within the same group enterprise.  In practice it is common for a company to create an organization of inter-related companies each of which is theoretically a separate entity but in reality part of one concern represented by the group as a whole.  Such is particularly the case when one company is the parent or holding company and the rest are its subsidiaries.

 

Under Section 154 of the Companies Act Cap 486 a company is deemed to be a subsidiary of another if but only if

(a)                   That other company either

(i)                    is a member of it and controls the composition of its board of directors or

(ii)                   Holds more than half in nominal value of its equity share capital or

 

(b)     The first mentioned company is a subsidiary of any company which is that other’s subsidiary.

 

Under Section 150 (1) where at the end of the financial year a company has subsidiaries, the accounts dealing with the profit and loss of the company and subsidiaries should be laid before the company in general meeting when the company’s own balance sheet and profit and loss account are also laid.  This means that group accounts must be laid before the general meeting. 

 

The group accounts should consist of a consolidated balance sheet for the company and subsidiary and also of a consolidated profit and loss account dealing with the profit and loss account of a company.

 

Section 151(2) – it may be observed that the treatment of these accounts in a consolidated form qualify an old rule that each company constitutes a separate legal entity.  The statute here recognizes enterprise entity rather than corporate entity i.e. the veil of incorporation will be lifted so that they will not be regarded as separate legal entities but will be treated as a group.

 

MISDESCRIPTION OF COMPANIES

 

Under Section 109 of the Companies Act it requires that a company’s name should appear whenever it does business on its Seal and on all business documents.  Under paragraph 4 of this Section, if an officer of a company or any person who on its behalf signs or authorizes to be signed on behalf of the company any Bill of Exchange, Promissory Note, Cheque or Order for Goods wherein the Company’s name is not mentioned as required by the Section, such officer shall be liable to a fine and shall also be personally made liable to the holder of a Bill of Exchange Promissory Notes, Cheque or order for the goods for the amount thereof unless it is paid by the company.  The effect of this section is that it makes a company’s officer incur personal liability even though they might be contracting as the company’s agents.  Liability under this Section normally arises in connection with cheques and company officers have been held liable where for instance the word limited has been omitted or where the company has been described by a wrong name.

 

IGNORING THE CORPORATE ENTITY UNDER COMMON LAW

 

WHERE THERE IS AN AGENCY RELATIONSHIP

 

Generally there is no reason why a company may not be an agent of its share holders.  The decision in Salomon’s case shows how difficult it is to convince the courts that a company is an agent of its members.  In spite of this there have been occasions in which the courts have held that registered companies were not carrying on in their own right but rather were carrying on business as agents of their holding companies.  Reference may be made to the case of

 

Smith Stone & Knight v. Birmingham Corporation (1939) 4 All E.R. 116

 

In this case the Plaintiffs were paper manufacturers in Birmingham City.  In the same city there was a partnership called Birmingham Waste Company.  This partnership did business as merchants and dealers in waste paper.  The plaintiffs bought the partnership as a going concern and the partnership business became part of the company’s property. The plaintiffs then caused the partnership to be registered as a company in the name of Birmingham Waste Company Limited.  Its subscribed capital was 502 pounds divided into 502 shares.  The Plaintiff holding 497 shares in their own name and the remaining shares being registered in the name of each of the Directors.  Thereafter the Directors executed a declaration of trust stating that their shares were held by them on trust for the Plaintiff Company.  The new company had its name placed upon the premises and on the note paper invoices etc. as though it was still the old partnership carrying on business.  There was no agreement of any sort between the two companies and the business carried on by the new company was never assigned to it.  The manager was appointed but there were no other staff.  The books and accounts of the new company were all kept by the plaintiff company and the manager of this company did not know what was contained therein and had no access to those books.  There was no doubt that the Plaintiff Company had complete control over the waste company.  There was no tenancy agreement between them and the waste company never paid any rent.  Apart from the name, it was as if the manager was managing a department of the plaintiff company.

 

The Birmingham Corporation compulsorily acquired the premises upon which the subsidiary company was carrying on business and the Plaintiff Company claimed compensation for removal and disturbance.  Birmingham Corporation replied that the proper claimants were the subsidiary company and not the holding company since the subsidiary company was a separate legal entity.

 

If this contention was correct the Birmingham Corporation would have escaped liability for paying compensation by virtue of a local Act which empowered them to give tenants notice to terminate the tenancy.

 

The court held that occupation of the premises by a separate legal entity was not conclusive on a question of a right to claim and as a subsidiary company it was not operating on its own behalf but on behalf of the parent company.  The subsidiary company was an agent.   Lord Atkinson had the following to say

“It is well settled that the mere fact that a man holds all the shares in a company does not mean the business carried on by the company is his business nor does it make the company his agent, for the carrying on of that business.  However, it is also well settled that there maybe such an arrangement between the shareholders and the company as will constitute the company.  The shareholders agents for the purpose of carrying on the business and make the business that of the shareholders.  It seems to be a question of fact in each case and the question is whether the subsidiary is carrying on the business as the parents business or as its own.  In other word, who is really carrying on the business?

 

His Lordship then stated   that in order to answer the question six points must be taken into account.

 

1.                     Are the profits treated as the profits of the parent company?

2.                     Are the persons conducting the business appointed by the parent company?

3.                     Is the parent company the head and brain of the trading venture?

4.                     Does the parent company govern the venture decide what should be done and what capital should be embarked on in the venture?

5.                     Does the company make the profits by its skill and direction?

6.                     Is the company in effectual and constant control?

 

If the answers are in the affirmative, then the subsidiary company is an agent of the parent company.

 

Reference may also be made to the case of

 

 RE F G FILMS LTD [1953] 1 W.L.R

 

Here a British company was formed with a capital of 100 pounds of which 90 pounds was contributed by the president of an American Film Company.  There were 3 directors, the American and 2 Britons.   By arrangement between the two companies, a film was shot in India nominally by the British Company but all the finances and other facilities were provided by the American Company.  The British Board of Trade refused to recognize the Film as having been made by a British company and therefore refused to register it as a British film. 

 

The court held that insofar as the British company had acted at all it had done so as an agent or nominee of the American company which was the true maker of the film.

 

Firestone Tyre & Rubber Company v. Llewellin (1957) 1 W.L.R 464

 

Again in this case an American company had an arrangement with its distributors on the European continent whereby the distributors obtained the supplies from the English manufacturers who were a wholly owned subsidiary of an American company.  The English subsidiary credited the American company with a price received after deducting costs and a certain percentage.  It was agreed that the distributors will not obtain their supplies from anyone else.  The issue was whether the subsidiary company in Britain was selling its own goods or whether it was selling goods of an American company.

 

The court held that the substance of the arrangement was that the American company traded in England through the subsidiary as its agent and that the sales by their subsidiary were a means of furthering the American company’s European interests.

 

There have been cases where Salomon’s case has been upheld that a company is a legal entity.

 

Ebbw Vale UDC V. South Wales Traffic Authority (1951) 2 K.B 366

 

Lord Justice Cohen L.J  “Under the ordinary rules of law, a parent company and a subsidiary company even when a hundred percent subsidiary are distinct legal entities and in the absence of an agency contract between the two companies,  one cannot be said to be an agent of the other.”

 

2.               FRAUD & IMPROPER CONDUCT

 

Where there is fraud or improper conduct, the courts will immediately disregard the corporate entity of the company.  Examples are found in those situations in which a company is formed for a fraudulent purpose or to facilitate the evasion of legal obligations.

 

Re Bugle Press Limited [1961] Ch. 270

This was based on Section 210 of the Companies Act where an offer was made to purchase out a company if 90% of shareholders agreed.  There were 3 shareholders in the company A, B and C. 

A held 45% of the shares, B also held 45% of the shares and C held the remaining 10% of the shares. A and B persuaded C to sell his shares to them but he declined.  Consequently A and B formed a new company call it AB Limited, which made an offer to ABC Limited to buy their shares in the old company.  A and B accepted the offer, but C refused.  A and B sought to use provisions of Section 210 in order to acquire C’s shares compulsorily.

 

The court held that this was a bare faced attempt to evade the fundamental principle of company law which forbids the majority unless the articles provide to expropriate the minority shareholders.

 

Lord Justice Cohen said “the company was nothing but a legal hut. Built round the majority shareholders and the whole scheme was nothing but a hollow shallow.”  All the minority shareholder had to do was shout and the walls of Jericho came tumbling down.

 

Gilford Motor Co. v. Horne (1933) Ch. 935

 

Here the Defendant was a former employee of the plaintiff company and had covenanted not to solicit the plaintiff’s customers. He formed a company to run a competing business.  The company did the solicitation.  The defendant argued that he had not breached his agreement with the plaintiffs because the solicitation was undertaken by a company which was a separate legal entity from him.

 

The court held that the defendant’s company was a mere cloak or sham and that it was the defendant himself through this device who was soliciting the plaintiff’s customers.  An injunction was granted against the both the defendant and the company not to solicit the plaintiff’s customers.

 

Jones v. Lipman (1912) 1 W.L.R. 832

This case the Defendant entered into a contract for the sale of some property to the plaintiff.  Subsequently he refused to convey the property to the plaintiff and formed a company for the purpose of acquiring that property and actually transferred the property to the company.  In an action for specific performance the Defendant argued that he could not convey the property to the Plaintiff as it was already vested in a third party.

Justice Russell J. observed as follows

 

“The Defendant Company was merely a device and a sham a mask which he holds before his face in an attempt to avoid recognition by the eye of equity”

 

 

GROUP ENTERPRISE

 

In exercise of their original jurisdiction, the courts have displayed a tendency to ignore the separate legal entities of various companies in a group.  By so doing, the courts give regard to the economic entity of the group as a whole.

 

Authority is the case of Holsworth & Co. v. Caddies [1955]1W.L.R. 352

 

The Defendant Company had employed Mr. Caddies as their Managing Director for 5 years.  At the time of that contract the company had two subsidiaries and Caddies was appointed Managing Director of one of those subsidiaries.  He fell out of favour with the other Directors consequent upon which the board of directors stated that Caddies should confine his attention to the affairs of the subsidiary company only.  He treated this as a breach of contract and sued the company for damages.  It was held that since all the companies form but one group, there was no breach of contract in directing Caddies to confine his attention to the activities of the subsidiary company.

 

DETERMINATION OF A COMPANY’S RESIDENCE

De Beers Consolidated Mines Ltd (1906) K.C. 455

Lord Lorenburn said “in applying the conception of residence to a company, we ought to proceed as nearly as possible on the analogy of an individual.  A company cannot eat or sleep but it can keep house or do business.  A company resides for purposes of Income Tax where its real business is carried on.  The real business is carried on where the central management and control actually abides.”

 

The courts also look behind the façade of the company and its place of registration in order to determine its residence.

 

 

THE DOCTRINE OF ULTRA VIRES

A Company which is registered under the Company’s Act cannot effectively do anything beyond the powers which are either expressly or by implication conferred upon in its Memorandum of Association.  Any purported activity in excess of those powers will be ineffective even if agreed to by the members unanimously.  This is the doctrine of ultra vires in company law.

 

The purpose of this doctrine is said to be twofold

 

1.                     It is said to be intended for the protection of the investors who thereby know the objects in which their money is to be applied.  It is also said to be intended for the protection of the creditors by ensuring that the Company’s assets to which the creditors look for repayment of their debt are not wasted in unauthorized activities.  The doctrine was first clearly articulated in 1875 in the case of Ashbury Railway Carriage v. Riche (1875) L.R. CH.L.) 653

 

In this case the Company’s Memorandum of Association gave it powers in its objects clause

1.                     To make sell or lend on hire railway carriages and wagons.

2.                     To carry on the business of mechanical engineers and general contractors

3.                     to purchase, lease work and sell mines, minerals, land and realty.

 

The directors entered into a contract to purchase a concession for constructing a railway in Belgium.  The issue was whether this contract was valid and if not whether it could be ratified by the shareholders.

 

The court held that the contract was ultra vires the company and void so that not even the subsequent consent of the whole body of shareholders could ratify it.  Lord Cairns stated as follows:

                  “The words general contractors referred to the words which went immediately before and indicated such a contract as mechanical engineers make for the purpose of carrying on a business.  This contract was entirely beyond the objects in the Memorandum of Association.  If so, it was thereby placed beyond the powers of the company to make the contract.  If so, it was not a question whether the contract was ever ratified or not ratified.  If the contract was going at its beginning it was going because the company could not make it and by purporting to ratify it the shareholders were attempting to do the very thing which by the act of parliament they were prohibited from doing.”

 

The courts construed the object clause very strictly and failed to give any regard to that part of the Objects clause which empowered the company to do business as general contractors.  This construction gave the doctrine of ultra vires a rigidity which the times have not been able to uphold.  At the present day, the doctrine is not as rigid as in Ashbury’s case and consequently it has been eroded.

 

The first inroad into the doctrine was made five years later in the case of

Attorney General V. Great Eastern Railway 1880) 5 A.C. 473

 

Lord Selbourne stated as follows:

“the doctrine of ultra vires as it was explained in Ashbury’s case should … but this doctrine ought to be reasonably and not unreasonably understood and applied and whatever may fairly be regarded as incidental to or consequential upon those things that the legislature has authorized ought not to be held by judicial construction to be ultra vires.”

 

An act of the company therefore will be regarded as intra vires not only when it is expressly stated in the object’s clause but also when it can be interpreted as reasonably incidental to the specified objects.  As a result of this decision, there is now a considerable body of case law deciding what powers will be implied in a case of particular types of enterprise and what activities will be regarded as reasonably incidental to the act.

 

However businessmen did not wish to leave matters for implication. They preferred to set up in the Memorandum of Association not only the objects for which the company was establish but also the ancillary powers which they thought the company would need.  Furthermore instead of confining themselves to the business which the company was initially intended to follow, they would also include all other businesses which they might want the company to turn to in the future.  The original intention of parliament was that the companies object should be set out in short paragraphs in the Memorandum of Association.  But with a practice of setting out not only the present business but also any business which the promoters would want the company to turn to, the result is that a company’s object’s clause could contain about 30 or 40 different clauses covering every conceivable business and all that incidental powers which might be needed to accomplish them.

 

In practice therefore the objects laws of practically every company does not share the simplicity originally intended in favor of these practice it may be argued that the wider the objects the greater is the security of the creditors since it will not be easy for the company to enter into ultra vires transactions because every possible act will probably be covered by some paragraph in the Objects clause.

 

Unfortunately this does not ensure preservation of the Companies assets or any adequate control over the director’s activities thus the original protection intended vanishes, the highpoint of this development came in 1966 in the case of Bellhouse v. City Wall Properties (1966) 2 Q.B 656

 

In this case the Plaintiff Company’s business was requisitioned for vacant land and the erection thereon of Housing Estates.  Its objects as set up in the Memorandum of Association contained the Clause authorizing the company to “carry on any other trade or business whatsoever which can in the opinion of the Board of Directors be advantageously carried on by the company in connection with or as ancillary to any of the above businesses or a general business of the company”.

 

In connection with its various development skills the company’s managing director met an agent of the Defendants who required some finance to the tune of about 1 million pounds.  The Plaintiff’s Managing Director intimated to the Defendant’s agent that he knew of a source from which the Defendant could obtain finance and accordingly referred them to a Swiss syndicate of financiers.  In this action the Plaintiffs alleged that for that service, the Defendants had agreed to pay a commission of 20,000 pounds and in the alternative they claimed 20,000 pounds for breach of contract.  The Defendants argued that there was no contract between the parties.  In the alternative they argued that even if there was a contract such contract was in effect one whereby the Plaintiffs undertook to act as money-brokers which activity was beyond the objects of the plaintiff company and which was therefore ultra vires.

 

The issues were

1.                     Whether the contracts were ultra vires

2.                     Whether it was open to the defendant to raise this point;

 

The court of first instance decided that the company was ultra vires and it was open to the defendant to raise the defense of ultra vires.  However a unanimous court of appeal reversed the decision and hailed that the words stated must be given their natural meaning and the natural meaning of those words was such that the company could carry on any business in connection with or ancillary to its main business provided that the directors thought that could be advantageous to the company.

 

Lord Justice Salomon L.J stated as follows:

 

                  “It may be that the Directors take the wrong view and in fact the business in question cannot be carried on as they believe but it matters not how mistaken they might be provided that they formed their view honestly then the business is within the plaintiff’s company’s objects and powers.”

 

CURBING ULTRA VIRES DOCTRINE

 

The courts have introduced 2 methods of curbing the evasion of the ultra vires doctrine.

The ejusdem generis rule

1.                     Is also referred to as the main objects rule of construction.  Here a Memorandum of Association expresses the objects of a company in a series of paragraphs and one paragraph or the first 2 or 3 paragraphs appear to embody the main object of the company all the other paragraphs are treated as merely ancillary to this main object and as limited or controlled thereby.  Business persons evaded this method by use of the independent objects clause.  The objects clause will contain a paragraph to the effect that each of the preceding sub-paragraphs shall be construed independently and shall not in any way be limited by reference to any other sub-clause and that the objects set out in each sub-clause shall be independent objects of the company.  Reference may be made to the case of  

Cotman v. Brougham [1918] A.C. 514

In this case the objects clause of the company contained 30 sub-clauses.  The first sub-clause authorized the company to develop rubber plantations and the fourth clause empowered the company to deal in any shares of any company.  The objects clause concluded with a declaration that each of the sub clauses was to be construed independently as independent objects of the company.  The company underwrote and had allotted to it shares in an oil company.  The question that arose was whether this was intra vires the company’s objects.  The court held that the effect of the independent objects clause was to constitute each of the 30 objects of the company as independent objects.  Therefore the dealing of shares in an oil company was within the objects and thus intra vires.  However the power to borrow money cannot be construed as an independent object of the company in spite of this decision.

 

Re Introductions (1962) W.L.R. 791

 

In this case the company was formed to provide accommodation and services to those overseas visitors going to a festival in Britain.  The company did this during the first few years of existence.  Later the company switched over to pig breeding as its sole business.  While so engaged it borrowed money from a bank on a security of debentures.  The bank was given a copy of the company’s Memorandum of Association and at the material time knew that the company’s sole business was that of pig breeding.  The issue was, whether the loan and debentures were valid in view of the fact one of the sub clauses empowered the company to borrow money and the last sub clause was an independent object clause.

The court held that borrowing was a power and not an object.  The power to borrow existed only for furthering intra vires objects of the company and was not an object in itself. 

Therefore

1.         The exercise of powers which will be intra vires is exercised for the objects of the company and is ultra vires only if used for the objects not covered by the company’s Memorandum of Association.

2.         Even an independent object clause cannot convert what are in fact powers into objects.

 

2.               LOSS OF SUBSTRATUM

 

Where the main object of a company has failed, a petitioner will be granted an order for the winding up of a company.  Such a petitioner must however be a member or shareholder in the company.

 

The object of the ultra vires rule is to make the members know how and to what their money is being applied.  This is the rationale of members’ protection.

 

RE GERMAN DATE COFFEE CO. (1882) 20 Ch. 169

 

In this case the major object of the company was to acquire a German Patent for manufacturing coffee from dates.  The German patent was never granted but the company acquired a Swedish Patent for the same purpose.  The company was solvent and the majority of the members wished to continue in business.  However, two of the shareholders petitioned for winding up of the company on the grounds that the company’s object had entirely failed.

 

The court held that upon the failure to acquire the German patent, it was impossible to carry out the objects for which the company was formed.  Therefore the sub stratum had disappeared and therefore it was just inevitable that the company should be wound up.

 

Kay J.  stated “where a company is formed for a primary purpose, then although the Memorandum may contain other general words which include the doing of other objects, those general words must be read as being ancillary to that which the Memorandum shows to be the main purpose and if the main purpose fails and fails altogether, then the sub-stratum of the association fails.”

 

This substratum rule is too narrow and cannot sufficiently uphold the ultra vires rule.  Questions are, are members or shareholders really protected?  Do they know what the objects are?  The Directors may choose any amongst the many.

 

Secondly a member has to petition first and the court has to decide

 

John Beauforte (1953) Ch.d 131

 

A company was authorised by its Memorandum of Association to carry on the business of costumiers, gown makers and other activities ejusdem generis.  The company decided to undertake the business of making veneered panels which were admittedly ultra vires and for this purpose, it constructed a factory at Bristol.  The company later went into compulsory liquidation.  Several proofs of debts were lodged with the liquidator which he rejected on the ground that the contracts which they related to were ultra vires.

 

Applications by way of Appeal were lodged by the 3 creditors one of whom had actual knowledge that the veneer business was ultra vires.  The 3 creditors were a firm of builders who built the factory, a firm which supplied the veneers to the company and a firm which had contractual debts with the company.

 

The courts held dismissing the applications that no judgment founded on an ultra vires contract could be sustained unless it embodied a decision of the court on the issue of ultra vires or a compromise on that issue.  The contracts being founded on an ultra vires transaction were void.

 

3.               GRATUITOUS GIFTS

Can a company validly make a gift out of corporate property or asset?  The law is that a company has no power to make such payments unless the particular payment is reasonably incidental to the carrying out of a company’s business and is meant for the benefit and to promote the property of the company. 

 

This issue was first decided in the case of

 

Hutton V West Cork Railway Co. (1893) Ch.d

 

A company sold its assets and continued in business only for the purpose of winding up.  While it was awaiting winding up, a resolution was passed in the company’s general meeting authorizing the payments of a gratuity to the directors and dismissed employees.

 

The court held that as the company was no longer a going concern such a payment could not be reasonably incidental to the business of the company and therefore the resolution was invalid.  In the words of the Lord Justice Bowen said

 

                  “The law does not say that there are not to be cakes and ale but there are to be no cakes and ale except such as is required for the benefit of the company”

 

The question is, suppose there is a clause in the Memorandum of Association that such payments shall be made, is payment ultra vires?  The authority that dealt with this position was the case of

 

 RE LEE BEHRENS & CO. [1932] 2 Ch. D 46

 

The object clause of the company contained an express power to provide for the welfare of employees and ex employees and also their widows, children and other dependants by the grant of money as well as pensions.  Three years before the company was wound up, the Board of Directors decided that the company should undertake to pay a pension to the widow of a former managing director but after the winding up the liquidator rejected her claim to the pension.

 

The court held that the transaction whereby the company covenanted to pay the widow a pension was not for the benefit of the company or reasonably incidental to its business and was therefore ultra vires and hence null and void.

 

Justice Eve stated as follows

 

Whether they reneged an express or implied power, all such grants involved an expenditure of the company’s money and that money can only be spent for purposes reasonably incidental  to the carrying on of the company’s business and the validity of such grants can be tested by the answers to three questions:

(i)                    Is the transaction reasonably incidental to the carrying on of the company’s business?

(ii)                   Is it a bona fide transaction?

(iii)                  Is it done for the benefit and to promote the prosperity of the company?

 

These questions must be answered in the affirmative.  The question may be posed as to whether these tests apply where there is an express power by the objects.  This is one area where the courts are still insistent that creditors’ security must be reserved. 

 

Sometimes ultra vires can be excluded by good and clever draftsmanship

 

Parke v. Daily News [1962] 2 Ch.d 927

 

In this case the company transferred the major portion of its assets and proposed to distribute the purchase price to those employees who are going to become redundant after reduction in the stock of the company of the company’s business.  The company was not legally bound to make any payments by way of compensation.  One shareholder claimed that the proposed payment was ultra vires.

 

The court held that the proposed payment was motivated by a desire to treat the ex-employees generously and was not taken in the interest of the company as it was going to remain and that therefore it was ultra vires. 

 

The Court observed as follows “the defendants were prompted by motives which however laudable and however enlightened from the point of view of industrial relations were such as the law does not recognize as sufficient justification.  The essence of the matter was that the Directors were proposing that a very large part of its assets should be given to its employees in order to benefit those employees rather than the company and that is an application of the company’s funds which the law will not allow.”

 

Evans v. Brunner Mound & Co. 1921 Ch.d 359

 

The company carried on the business of chemical manufacturers.  Its object clause contained a power to do all such things as maybe incidental or conducive to the attainment of its objects.  The company distributed some money to some universities and scientific institutions, which was meant to encourage scientific education and research.  The company thereby hoped to create a reservoir of qualified scientists from which the company could recruit its staff.

 

The court held that even though the payment was not under an express power, it was reasonably incidental to the company’s business and therefore valid.

 

This is one of the few cases where payment was recognized as being valid.

 

THE RIGHTS OF THE COMPANY & 3^RD PARTIES UNDER ULTRA VIRES TRANSACTIONS:

 

These are remedies

 

Whether or not a contract is ultra vires depends on the knowledge of the party’s dealing with that company.  Such is the case as regards borrowing contracts.  Consider the case of

 

David Payne & Co. (1904) 2 Ch.d 608

 

X was a director of company B and at the same time had some interests in company A.  He learnt that company B wished to borrow some money which it intended to apply to unauthorised activities.  He urged company A to lend the money on the security of debentures.  The issues were

(a)              Whether the debentures were valid security;

(b)              Whether the knowledge of X as to the intended application of the money could be imputed to the company.

 

The court held that X was not company A’s agent for obtaining such information and therefore his knowledge was not the company’s knowledge and consequently the debentures were valid security.

 

This loophole however will be applied very rarely because everybody is presumed to know the contents of a company’s public documents.  Where a contract with that company is ultra vires, generally speaking the party dealing with that company has no rights under the contract.  The transaction being null and void cannot confer rights on the 3^rd party nor can it impose any obligation on the company.

In many instances however, property will be transferred under an ultra vires transaction. Such transaction cannot vest rights in the transferee and cannot divest the transferor of his rights.

 

1.               At common law therefore, the first remedy of a person who parts with property under an ultra vires transaction is that he has a right to trace and recover that property from the company as long as he can identify it.

 

This principle also applies to money lent to the company on an ultra vires borrowing so long as the money can be traced either in law or in equity.  The basis of this principle is that the company is deemed to hold the money or the property as a trustee for the person from whom it was obtained.

 

Therefore, if the money received is paid into a separate account, or is sufficiently earmarked e.g. by the purchase of some particular items, it can be followed and claimed by the lender.  Where tracing is impossible, because the money has become mixed with other money, the lender is entitled in equity to a charge on the mixed fund together with the other creditors according to the respective amounts otherwise money obtained on ultra vires transaction generally cannot be followed once it has been spent.  But if such money has been spent by discharging the company’s intra vires debts then the lender is entitled to rank as a creditor to the extent to which the money has been so applied.  Since the company’s liabilities are not increased but in fact decreased, equity treats the borrowing as valid to the extent of the legal application of such money.

 

2. The 3^rd party has a personal right against the directors or other agents with whom he has dealt.   The rationale is that such directors or other agents are treated as quasi trustees from whom it follows that a 3^rd party is entitled to a claim against them for restitution.

 

TO WHAT EXTENT ARE MEMBERS PROTECTED BY THE ULTRA VIRES DOCTRINE

 

The intra vires creditor does not have the locus standi to prohibit ultra vires actions.  Again there is the presumption of knowledge of a company’s documents and activities.  In spite of the fact that the doctrine of ultra vires is over due for reform, it has not undergone any reform in Kenya unlike in the United Kingdom where it has been severely eroded.

 

All the company can do is to alter its objects under the power conferred by Section 8 of the Companies Act.  The effect of the Section is that a company may by special resolution alter the provisions in its Memorandum with respect to the objects of the company.

 

Section 141 defines Special Resolution as a resolution which is passed by a majority of not less than three quarters of those members voting at a company’s general meeting either in person or by proxy and of which notice has been given of the intention to propose it as a special resolution. 

 

Within 30 days of the date on which the resolution altering the objects is passed, an application for the cancellation of the Resolution may be made to Court by or on behalf of the holders who have not voted in favor of the Resolution, of not less than 15% of the nominal value of the issued share capital of any class and if the company does not have a share capital, the application can be made by at least 15% of the members of the company.

 

If such an application is made, the alteration will not be effective except to the extent that it is confirmed by a court.  Normally a court has an absolute discretion to confer, reject or modify the alteration.

 

Re Private Boarding House Limited (1967) E.A. 143

 

In this case, it was held that the registrar of companies is entitled to receive a notice of any such application and to appear and be heard at the hearing of the Application on the ground that such matters affect his record.

 

Under Section 8 (9) of the Companies Act Cap 486 if no application is made to the court, within 30 days the alteration cannot subsequently be challenged.  The effect of this provision is that as long as an alteration is supported by more than 85% of the shareholders or so long as no one applies to the court within 30 days of the resolution, companies have complete freedom to alter their objects.

 

Note however, that such alterations do not operate retrospectively.  Their effect relates only to the future.

                                   

ARTICLES OF ASSOCIATION

 

A Company’s constitution is composed of two documents namely the Memorandum of Association and the Articles of Association.  The Articles of Association are the more important of the two documents in as much as most court cases in Company Law deal with the interpretation of the Articles.

 

Section 9 of the Companies Act provides that a Company limited by guarantee or an unlimited company must register with a Memorandum of Association Articles of Association describing regulations for the company.  A company limited by shares may or may not register articles of Association.  A Company’s Articles of Association may adopt any of the provisions which are set out in Schedule 1 Table A of the Companies Act Cap 486.

 

Table A is the model form of Articles of Association of a Company Limited by Shares.  It is divided into two parts designed for public companies in part A and for private companies in part B (II) thus a company has three options.  It may either

 

(a)                   Adopt Table A in full; or

(b)                   Adopt Table A subject to modification or

(c)                   Register its own set of Articles and thereby exclude Table A altogether.

 

In the case of a company limited by shares, if no articles are registered or if articles are registered insofar as they do not modify or exclude Table A the regulations in Table A automatically become the Company’s Articles of Association.

 

Section 12 of the Companies Act requires that the Articles must be in the English language printed, divided into paragraphs numbered consecutively dated and signed by each subscriber to the Memorandum of Association in the presence of at least one attesting witness.

 

As between the Memorandum and the Articles the Memorandum of Association is the dominant instrument so that if there is any conflict between the provisions in the Memorandum and those in the Articles the Memorandum provisions prevail.  However if there is any ambiguity in the Memorandum one may always refer to the Articles for clarification but this does not apply to those provisions which the Companies Act requires to be set out in the Memorandum as for instance the Objects of the Company.

 

Whereas the Memorandum confers powers for the company, the Articles determine how such powers should be exercised. 

 

Articles regulate the manner in which the Company’s affairs are to be managed.  They deal with inter alia the issue of shares, the alteration of share capital, general meetings, voting rights, appointment of directors, powers of directors, payment of dividends, accounts, winding up etc.

 

They further provide a dividing line between the powers of share holders and those of the directors.

 

LEGAL EFFECTS OF THE ARTICLES OF ASSOCIATION

 

Under Section 22 of the Companies Act it is provided that subject to the provisions of the Act, when the Memorandum and Articles are registered, they bind the company and the members as if they had been signed and sealed by each member and contained covenants for the part of each member to observe all their provisions.  This Section has been interpreted by the courts to mean that the Memorandum gives rise to a contract between the Company and each Member.

 

Reference may be made to the case of

 

Hickman v. Kent (1950) 1 Ch. D 881

 

Here the Articles of the Company provided that any dispute between any member and the company should be referred to arbitration.  A dispute arose between Hickman and the company and instead of referring the same to arbitration; he filed an action against the company.  The company applied for the action to be stayed pending reference to arbitration in accordance with the company’s articles of association.

 

The court held that the company was entitled to have the action stayed since the articles amount to a contract between the company and the Plaintiff one of the terms of which was to refer such matters to arbitration.

 

Justice Ashbury had the following to say: “That the law was clear and could be reduced to 3 propositions

1.                     That no Article can constitute a contract between the company and a third party;

2.                     No right merely purporting to be conferred by an article to any person whether a member or not in a capacity other than that of a member for example solicitor, promoter or director can be enforced against the company.

3.                     Articles regulating the right and obligation of the members generally as such do not create rights and obligations between members and the company”.

 

Eley v. Positive Government Security Life Association Co. (1876) Ex 88

 

In this case, the company’s articles provided that Eley should become the company Solicitor and should transact all legal affairs of the company for mutual fees and charges.  He bought shares in the company and thereupon became a member and continued to act as the company’s solicitor for some time.  Ultimately the company ceased to employ him.  He filed an action against the company alleging breach of contract.

 

The court held: that the articles constitute a contract between the company and the members in their capacity as members and as a solicitor Eley was therefore a third party to the contract and could not enforce it.  The contract relates to members in their capacity as members and the company so it’s only a contract between the company and members of that company and not in any other capacity such as solicitor.  But note that there can be an intra member contract.

 

Wood v. Odessa Waterworks Company [1880] 42 Ch. 636

 

Here the Plaintiff who was a member of the company petitioned the court to stay the implementation of a resolution not to pay dividends but issue debentures instead.  Holding that a member was entitled to the stay of the implementation of the Resolution Sterling J. had the following to say:  “the article of association constitutes a contract not merely between shareholders and the company but also between the individual shareholders and every other.”

 

This case was followed in

 

Rayfield v. Hands (1960) Ch.d 1

 

Here the company’s articles provided that every member who intends to transfer his shares shall inform the directors who will take those shares between them equally at a fair value. The Plaintiff called upon the directors to take his shares but they refused.  The issue was did the articles give rise to a contract between the Plaintiff and the directors.  In their capacity as directors they were not bound.

 

The court here held that the Articles related to the relationship between the Plaintiff as a member and the Defendants not as directors but as members of the company.  Therefore the Defendants were bound to buy the Plaintiff shares in accordance with the relevant article.

 

ALTERATION OF ARTICLES

 

Section 13 of the Companies Act gives the company power to alter the articles by special resolution.  This is a statutory power and a company cannot deprive itself of its exercise. Reference may be made to the case of

Andrews v. Gas Meter Co. (1897) 1 Ch. 361

 

The issue herein was whether a company which under its Memorandum and Articles had no power to issue preference shares could alter its articles so as to authorise the issue of preference shares by way of increased capital

 

The court held that as long as the Constitution of a Company depends on the articles, it is clearly alterable by special resolution under the powers conferred by the Act. Therefore it was proper for the company to alter those articles and issue preference shares.  Any regulation or article which purports to deprive the company of this power is therefore invalid, on the ground that such an article or regulation will be contrary to the statute.  The only limitation on a company’s power to alter articles is that the alteration must be made in good faith and for the benefit of the company as a whole.

 

Allen v. Gold Reefs of West Africa (1900) 1 Ch. 626

 

In this case the company had a lien on all debts by members who had not truly paid up for their shares.  The Articles were altered to extend the Company’s lien to those shares which were fully paid up.

 

The court held that since the power to alter the Articles is statutory, the extension of the lien to fully pay up shares was valid.  These were the words of Lindley L.J.

 

“Wide however as the language of Section 13 mainly the power conferred by it must be exercised subject to the general principles of law and equity which are applicable to all powers conferred on majorities and enabling them to bind minorities.  It must be exercised not only in the manner required by law but also bona fide for the benefit of the company as a whole.”

 

Further reference may be made to the case of

 

Shuttleworth v. Cox Brothers Ltd (1927) 2 KB 29

 

Here the Articles of the Company provided that the Plaintiff and 4 others should be the first directors of the company.  Further each one of them should hold office for life unless he should be disqualified on any one of some six specified grounds, bankruptcy, insanity etc.  The Plaintiff failed to account to the company for certain money he had received on its behalf.  Under a general meeting of the company a special resolution was passed that the articles be altered by adding a seventh ground for disqualification of a director which was a request in writing by his co-directors that he should resign.  Such request was duly given to the Plaintiff and there was no evidence of bad faith on the part of shareholders in altering the articles.

 

The Plaintiff sued the company for breach of an alleged contract contained in their original articles that he should be a permanent director and for a declaration that he was still a director.

 

The court held that the contract if any between the Plaintiff and the company contained in the original articles in their original form was subject to the statutory power of alteration and if the alteration was bona fide for the benefit of the company, it was valid and there was no breach of contract.  Lord Justice Bankes observed as follows

 

                  “In this case, the contract derives its force and effect from the Articles themselves which may be altered.  It is not an absolute contract but only a conditional contract.”

 

The question here is who determines what is for the benefit of the company?  Is it the shareholders or the Courts?

 

Scrutton L.J. had the following to say

 

                  “To adopt such a view that a court should decide will be to make the court the manager of the affairs of innumerable companies instead of shareholders themselves.  It is not the business of the court to manage the affairs of the company.  That is for the shareholders and the directors.”

 

Sidebottom v. Kershaw Leese & Co. [1920]1 Ch. 154

 

Director controlled share company had a minority shareholder who was interested in some competing business.  The company passed a special resolution empowering the directors to require any shareholder who competed with the company to transfer his shares at their fair value to nominees of the directors.  The Plaintiff was duly served with such a notice to transfer his shares. He thereupon filed an action against the company challenging the validity of that article.

 

The court held that the company had a power to re-introduce into its articles anything that could have been validly included in the original articles provided the alteration was made in good faith and for the benefit of the company as a whole and since the members considered it beneficial to the company to get rid of competitors, the alteration was valid..

 

Contrast this case with that of

 

Brown v. British Abrasive Wheel Co. (1990) 1 Ch. 290

 

Here a public company was in urgent need of further capital which the majority of the members who held 98% of the shares were willing to supply if they could buy out the minority.  They tried persuasion of the minority to sell shares to them but the minority refused.  They therefore proposed to pass a Special Resolution adding to the Articles a clause whereby any shareholder was bound to transfer his shares upon a request in writing of the holders of 98% of the issued capital.

 

The court held that this was an attempt to add a clause which will enable the majority to expropriate the shares of the minority who had bought them when there was no such power.  Such an attempt was not for the benefit of the company as a whole but for the majority.  An injunction was therefore granted to restrain the company from passing the proposed resolution.

 

EFFECT OF ALTERATION ON CONTRACT OF DIRECTORS

 

Sometimes the Articles may be altered in such a way that the implementation of those articles in the altered form would give rise to breach of an existing contract between the company and a third party and particularly so as regards contracts between companies and their directors. 

 

A director may hold office either

 

1.                     Under the Articles without a service contract;

2.                     Under a contract of service which is entirely independent of the articles; or

3.                     Under a service contract which expressly or by implication embodies the relevant provisions in the Articles.

 

Where a director holds office under the Articles without a contract of service, then his appointment is conditional on the footing that the articles may be altered at any time in exercise of statutory power.

 

If however, a director’s appointment is entirely independent of the articles then any alterations which affects his contract with the company will constitute a breach of contract for which the company will be liable in damages.

 

Southern Foundries v Shirlaw (1940) A.C. 701

 

The Plaintiff by a written contract was appointed the company’s Managing Director for 10 years. The agreement was not expressed to be subject to the Articles in any way.  The Articles provided various grounds for the removal of a director from office subject to the terms of any subsisting agreement.  The Articles further provided that if the Managing Director ceased to be a director, he would ipso facto cease to be Managing Director.  The Company’s Articles were subsequently changed to give the Directors power to remove a fellow director from office by notice.  Such notice was given to the Plaintiff who thereupon filed an action claiming damages from the company for breach of contract.

 

It was held that since his appointment was not subject to the articles, he could only be removed from office in accordance with the terms of his appointment and not by way of alteration of the articles.  Damages were therefore payable.

 

Lord Atkins said “if a party enters into an arrangement which can only take effect by the continuance of an existing state of circumstances there is an implied undertaking on his part that he shall be done of his own motion to put an end to that state of circumstances which alone the arrangement can be operative.”

 

If a director is appointed in very general terms and without limitation of time, then the provisions in the Articles are deemed to be incorporated in the appointment and in the absence of any provision in the articles to the contrary, the company may dismiss him at any time and even without notice.

 

Read v. Astoria Garage (1952) 1 All.E.R 922

 

A Company’s Articles provided that the appointment of a Managing Director shall be subject to termination if he ceases for any reason to be a director or if the company in general meeting resolved that his tenure of office as managing director be terminated.  The Plaintiff was appointed as the company’s Managing Director 17 years later the directors decided to relieve him of his duties as Managing Director.  The decision was subsequently ratified by the company in general meeting.  He claimed damages for wrongful dismissal.

 

The court held that on a true construction of the company’s articles the Plaintiff’s appointment was immediately and automatically terminated on passing of the Resolution at the general meeting since the company had expressly reserved to itself the power to dismiss the Managing Director.

 

7The question is, can a company be restrained by injunction from altering its articles if the alteration is likely to give rise to a breach of contract?

 

Part of the answer to this question was given in the case of

-

47British Murac Syndicate Ltd v. Alperton Rubber Co. Ltd. 1950 2 Ch. 186

 

By an agreement binding on the Defendant Company it was provided that so long as the operative syndicate should hold over 5000 shares in the Defendant’s company, the Plaintiff’s syndicate should have the right of nominating two directors on the Board of the Defendant Company.  A clause to the same effect was contained in Article 88 of the Defendant Company’s Articles of Association.

 

Another Article provided that the number of directors should not be less than 3 nor more than 7. The Plaintiff syndicate had recently nominated 2 persons as directors.  The Defendant Company objected to these two persons as directors and refused to accept the nomination and a meeting of shareholders was called for the purpose of passing a special resolution under Section 13 of the Companies Act cancelling the article.

 

The court held that the defendant company had no power to alter its articles of association for the purpose of committing a breach of contract and that an injunction ought to be granted to restrain the holding of the meeting for that purpose.

 

Punt v. Symens & Co. 1903 2 Ch.d 506

 

This case had words to the effect that the company cannot be restrained but this was overruled in the case of

 

British Equitable Assurance Co. v. Baily (1906) S.C. 35

 

Allen v. Goldreef

 

In this case an article was altered in such a way as to prejudice one shareholder.  The article gave a lien on partly-paid shares for debts of members.  Zuccani owed money in respect of unpaid calls on partly-paid shares but was the only holder of fully paid shares as well.  The court held that it was for the benefit of the company to recover moneys due to it and the alteration in its terms related to all holders of fully-paid shares.  The fact that Zuccani was the only member of that class at that moment did not invalidate it.

 

VARIATION OF CLASS RIGHTS

 

Although the Companies Act recognizes the existence of class of shareholders, it does not define the term ‘class’ the best definition is found in the case of

 

Sovereign Life Assurance Co. v. Dodd (1892) 2 QB 573

 

In that case Bowen L.J. stated as follows:  “The word Class is vague it must be confined to those persons whose rights are not dissimilar as to make it impossible for them to concert together with a view to their common interest.”

 

Under Article 4 of Table A where the Share Capital is divided into different classes of Shares, the rights attached to any class may be varied only with a consent in writing of the holders of three quarters of the issued share of that class or with assumption of a special resolution passed at a separate meeting of the holders of the shares of that class.

 

However, under Section 25 (2) if the rights are contained in the Memorandum of Association and if the Memorandum prohibits alteration of those rights, then class rights cannot be varied

THE COMPANIES ORGANS & OFFICERS

 

Since a company is an artificial person, it can only act through an agency of a human person.  For this purpose, a company has two primary organs.

 

1.                     The general Meeting;

2.                     The Board of Directors.

 

The authority to exercise a company’s powers is normally delegated neither to the members nor individual directors but only to the directors as a Board.  The directors may however delegate powers to an individual Managing Director.

 

Section 177 of the Companies Act requires every public company to have at least two directors and every private company at least one director.  The Act does not provide for the means of appointing Directors but in practice the Articles of Association provide for initial appointments by subscribers to the Memorandum of Association and thereafter to annual retirement of a certain number of directors and the filling of vacancies at the annual general meeting.

 

Under Section 184 (1) of the Companies Act every appointment must be voted on individually except in the case of private companies or unless the meeting unanimously agrees to include two or more appointments in the same resolution.  The appointment is usually effected by an ordinary resolution. However, no matter how a director is appointed, under Section 185 of the Companies Act he can always be removed from office by an ordinary resolution in addition to any other means of removal which may be embodied in the articles.

 

Unless the Articles so provide Directors need not be members of a company, but if the articles require a share qualification, then the shares must be taken up within two months otherwise the office will be vacated.  Undischarged Bankrupts are not allowed to act as directors without leave of the court.  A director need not be a natural person.  A company may be appointed a director of another.  The disqualifications of directors are set out in article 88 of Table A.  The division of powers between the general meeting and the Board of Directors depends entirely on the construction of the Articles of Association and generally where powers of management are vested in the Board of Directors, the general meeting cannot interfere with the exercise of those powers.

 

Automatic Self-cleaning Filter Syndicate v. Cunningham (1906) A.C. 442

 

The company’s articles provided that subject to such regulations as might be made by extra ordinary resolution, the Management of the company’s affairs should be vested in the Directors who might exercise all the powers of the company which were not by statute or articles expressly required to be exercised by the company in general meeting. In particular the articles gave the directors power to sell and deal with any property of the company on such terms as they must deem fit.  At a general meeting of the company, a Resolution was passed by a simple majority of the members for the sale of the company’s assets on certain terms and instructing the directors to carry the sale into effect.  The Directors were of the opinion that a sale on those terms was not of any benefit to the company and therefore refused to carry it into effect.  The issue was, whether the directors were under an obligation to act in accordance with the directives.

 

The court held that the Articles constituted a contract by which the members had agreed that the Directors alone should manage the affairs of the company unless and until the powers vested in the Directors was taken away by an alteration in the Articles they could ignore the general meeting directives on matters of management.  They were therefore entitled to refuse to execute the sale.

 

 The division of the power to manage the company’s affairs is embodied in Article 80 of Table A which states that the business of the company shall be managed by the directors who may exercise all such powers of a company as are not by the Act or by these regulations required to be exercised by the company in general meeting.  Where this article is adopted as it is invariably done in practice the general meeting cannot interfere with a decision of the directors unless they are acting contrary to the provisions of the Companies Act or the particular company’s articles of association.

 

Shaw & Sons Ltd v. Shaw (1935) 2 KB 113

 

Here the Directors were empowered to manage the company’s affairs.  They commenced an action for and on behalf of the company and in the company’s name, in order to recover some money owed to the company.  The general meeting thereafter passed a resolution disapproving the commencement of the suit and instructing the Directors to withdraw it

 

It was held that the resolution of the general meeting was a nullity Greer L.J. stated

 

“A company is an entity distinct from its shareholders and its directors.  Some of its powers may be according to its articles exercised by the Directors and certain other powers may be reserved for shareholders in general meeting. If powers of management are vested in the Directors, they and they alone can exercise these powers.  The only way in which the general body of the shareholders can control the exercise of the powers vested by the articles in the directors is by altering the articles or if opportunity arises under the articles by refusing to re-elect the directors or whose actions they disapprove.  They cannot themselves reserve the powers which by themselves are vested in the Directors any more than the directors can reserve to themselves the powers vested by the articles in the general body of shareholders.”

 

To this there are two exceptions

1.                     In relation to litigation – here a general meeting can institute proceedings on behalf of the company if the board of directors refuses or neglects to do so.

2.                     When there is a deadlock in the Board of Directors as for instance in the case of

 

Barron v. Porter (1914) 1 Ch. 895

The articles of association vested the power to appoint additional directors in the Board of Directors.  There were only two directors namely, Barron and Porter and the conduct of the company’s business was at a standstill as Barron refused to attend any Board meeting with Porter.

 

The court held that it was competent for the general meeting to appoint additional directors even if the power to do so was by articles vested in the Board of Directors.

                                                     

 

CORPORATES’ LIABILITIES FOR ACTS OF ITS ORGANS & OFFICERS

 

There are certain situations in which the law does not recognize vicarious liability but insists on personal fault as a prelude to liability.  In such cases a company could never be liable if the courts applied rigidly the rule that a company is an artificial person and therefore can only act through the directors.  In practice and for certain purposes the courts have elected to treat the acts of certain officers as those of the company itself.  This is sometimes referred to as THE ORGANIC THEORY OF COMPANY LAW.

 

The theory sprung from the case of:                                                                             

 

Lennard’s Carrying Co. v. Asiatic Petroleum Co. Ltd. (1950) A.C. 705

 

In this case a ship and her cargo were lost owing to unseaworthiness.  The owners of the ship were a limited company.  The managers of the company were another limited company whose managing director a Mr. Lennard managed the ship on behalf of the owners.  He knew or ought to have known of the Ship’s unseaworthiness but took no steps to prevent the ship from going to sea.  Under the relevant shipping Act the owner of a sea going ship was not liable to make good any loss or damage happening without his fault.  The issue was whether Lennard’s knowledge was also the company’s knowledge that the ship was unseaworthy.

The court held that Lennard was the Directing mind and will of the company his knowledge was the knowledge of the company, his fault the fault of the company and since he knew that the ship was unseaworthy, his fault was also the company’s fault and therefore the company was liable.  As per Viscount Haldane

                  “My Lords a corporation is an abstraction.  It has no mind of its own anymore than it has a body of its own. Its active and directing will must consequently be sought in the person of somebody who for some purposes may be called an agent but who is really the directing mind and will of the corporation, the very ego and centre of the personality of the corporation.

 

Bolton Engineering Co. v. Graham

 

 Here the Plaintiffs who were tenants in certain business premises were entitled to a renewal of their tenancy unless the landlords who were a limited company intended to occupy the premises themselves for their business purposes.  The issue was whether the Defendant Company had effectively formed this intention.  There had been no formal general meeting or Board of Directors meeting held to consider the question but the managing director’s clearly manifested the intention to occupy the premises for the company’s business.

 

The court held that the intention manifested by the Directors was the company’s intention and therefore the tenants were not entitled to a renewal of the tenancy. 

 

Denning L.J.  As he then was stated as follows:

“A company may in many ways be likened to a human being.  It has a brain and nerve centre which controls what it does.  It also has hands which hold the tools and act in accordance with the directions from the centre.  Some of the people in the company are mere servants and agents who are nothing more than hands to do the work and cannot be said to represent the mind and will of the company.  Others are directors and managers who represent the directing mind and will of the company and control what it does.  The state of mind of these managers is the state of mind of the company and is treated by the law as such.  Whether their intention is the company’s intention depends on the nature of the matter under consideration, the relative position of the officer or agent and other relevant facts and circumstances of the case”

 

THE RULE IN TURQUAND’S CASE

 

Crossly connected with this aspect is the so called rule in Turquand’s case:

 

This rule deals with a company’s liability for acts of its officers.  The question as to whether or not the company is bound or not depends on the normal agency principles:  If a company’s officer or a company’s organ does an act within the scope of its authority, the company will be bound.  The problem which might arise is that even if the Act in question is within the scope of the organs or officers authority, there might be some irregularity in the action of the organ concerned and consequently in the exercise of authority.  For example, if a particular act can only be valued if done by the Board of Directors or the general meeting, the meeting might have been convened on improper notice or the resolution may not have been properly carried.  In the case of the Directors, they may not have been properly appointed.  In these circumstances can the company disclaim an act which was so done by arguing that the meeting was irregular? Must a third party dealing with the company always ascertain that the company’s internal regulations have been complied with before holding the company liable?

 

The answer to this question was given in the negative in the case of

 

The Royal British Bank v. Turquand (1856) 6 E & B 327

Here under the Company’s constitution the directors were given power to borrow on bond such sums of money as from time to time by a general resolution be authorized to be borrowed.  Without any such resolution having been passed, the directors borrowed a certain sum of money from the Plaintiff’s bank.  Upon the company’s liquidation the bank sought to recover from the liquidator who argued that the Bank was not bound to recover it as it was borrowed without authority from the general meeting.

 

The court held that even though no resolution had been passed, the company was nevertheless bound by the act of the directors and therefore was bound to repay the money.

 

The words of Jarvis C.J. were as follows:

 

“A party dealing with a company is bound to read the company’s deed of settlement (Memorandum of Association) but he is not bound to do more.  In this case a third party reading a company’s documents will find not a prohibition from borrowing but permission to do so on certain conditions.  Finding that the authority might be made complete by resolution, he would have had a right to infer the fact of a resolution authorizing that which on the face of the document appeared to be legitimately done.”

 

This is the rule in Turquand’s Case which is often referred to as the rule as to indoor management.

 

This rule is based not on logic but on business convenience.

 

1.                     A third party dealing with a company has no access to the company’s indoor activities;

2.                     It would be very difficult to run business if everyone who had dealings with the company had first to examine the company’s internal operations before engaging in any business with the company;

3.                     It would be very unfair to the company’s creditors if the company could escape liability on the ground that its officials acted irregularly.

 

But should the company always be held liable for the act of any people purporting to act on the company’s behalf? Suppose these persons are impostors, what happens? 

In order to avoid this some limitations have been imposed on the rule.  Later cases have refined the rule to a point where the position appears to that ordinary agency principles will always apply

 

Anybody dealing with a company is deemed to have notice of the contents of the company’s public documents.  Therefore any act which is contrary to those provisions will not bind the company unless it is subsequently ratified by the company acting through its appropriate organ.  The term public document is not defined in the companies Act but so far as registered companies are concerned, the expression is not restricted to the Memorandum and Articles but it also includes some of those documents filed at the companies’ registry. These include special resolutions, particulars of directors and secretary, charges etc.  provided that everything appears to be regular, so far as can be checked from the public documents, a third party dealing with a company is entitled to assume that all internal regulations of the company have been complied with unless he has knowledge to the contrary or there are suspicious circumstances putting him on inquiry.  Reference is made to the case of

 

Mahoney v. East Hollyford Mining Co. (1875) L.R. 7 HL 869

 

Here a mining company was founded by W and his friends and relatives.  Subscriptions were obtained from applicants for shares.  These monies were paid into the bank which had been described in the prospectus as the company’s bank.  The communication of the letter was sent to the Bank by a person describing himself as the Company’s secretary to the effect that in accordance with a resolution passed on that day, the bank was to pay out cheques signed by either two of the three named directors whose signatures were attached and countersigned by the Secretary.  The bank thereafter honored cheques so signed.  When the company’s funds were almost exhausted, the company was ordered to be wound up.  It was then discovered that no meeting of the Shareholders had been held, and no appointment of Directors and Secretary met but that with his friends and relatives, W had held themselves to be secretary and directors and had appropriated the subscription money.  The issue was whether the Bank was liable to refund the money it had paid back to the borrower.

 

The court held that the bank was not liable to refund any money to the company as it had honored the company’s cheques in reliance on a letter received and in good faith.

 

Lord Hatherly stated

 

“When there are persons conducting the affairs of a company in a manner which appears to be perfectly consonant with the articles of association, then those dealing with them externally are not to be affected by any irregularities which may take place in the internal management of the company.”

 

Directors will not necessarily and for all purposes be insiders.  The test appears to be whether the acts done by them are so closely related to their position as directors as to make it impossible for them not to be treated as knowing the limitations on the powers of the officers of the company with whom they have dealt.  Otherwise a third party dealing with a company through an officer who is or is held out by the company as a particular type of officer e.g. a Managing Director and who purports to exercise a power which that sort of officer will usually have is entitled to hold the company liable for the officer’s acts even though the officer has not been so appointed or is in fact exceeding his authority as long as the third party does not know that the company’s officer has not been so appointed or has no actual authority.

 

A third party however, will not be protected if the circumstances are such as to put him on inquiry.  He will also lose protection if the public documents make it clear that the officer has no actual authority or could not have authority unless a resolution had been passed which requires filing in the Companies Registry and no such resolution had been filed.  These are normal agency principles.

 

Freeman & Lockyer v Buckhurst Park Properties (1964) 2 Q.B. 480

In this case Kapool & Hoon formed a private company which purchased Buckhurst Park Estate.  The Board of Directors consisted of Kapool, Hoon and two others.  The Articles of the company contained a power to appoint a Managing Director but none was appointed.  Though never appointed as such, Kapool acted as Managing Director.  In that capacity he engaged the Plaintiffs who were a firm of Architects to do certain work for the company which was duly done.  When the Plaintiff’s claimed remuneration, according to the agreement, the company replied that it was not liable because Kapool had no authority to engage them.

 

The Court held that the act of engaging Architects was within the ordinary ambit of the authority of a Managing Director of a property company and the Plaintiffs did not have to inquire whether a person with whom they were dealing with was properly appointed.  It was sufficient for them that under the Articles, the Board of Directors had the power to appoint him and had in fact allowed him to act as Managing Director.  Four conditions must however be fulfilled in order to entitle a third party to enforce a contract entered to on behalf of the company by a person who has no actual authority.

 

1.                     It must be shown that there was a representation that the agent had authority to enter into a contract of the kind sought to be enforced;

2.                     Such representation must be made by a person or persons who had actual authority to manage the company’s business either generally or in respect of those matters to which the contract relates;

3.                     It must be shown that the contract was induced by such representation;

4.                     It must be shown that neither in its Memorandum or under its Articles was the company deprived of the capacity either to enter into a contract of the kind sought to be enforced or to delegate authority to do so to the agent.

 

 

 

Emco Plastica International vs. Freeberne (1971) E.A. 432

Here by a resolution of the company at a meeting of the Board of Directors, the Respondent was appointed as the company’s secretary.  Nothing was decided at the meeting as regards his remuneration or other terms of service.  The terms of his appointment were contained in a letter signed on behalf of the company by its Managing Director which provided that the appointment was for a maximum period of 5 years.  The Managing Director dealt with the day to day affairs of the company but had no express authority to appoint a Secretary or to offer such unusually generous terms as contained in the letter.  After two years service the company purported to dismiss the Respondent by five days notice.  The Secretary sued for benefits under the Contract.  The Company contended that the Managing Director had no authority from the Company to offer the terms of the contract.  There being no resolution of the board to support it and nothing in the company’s articles conferring any such powers on a Managing Director.

 

The court held that as a chairman he performed the functions of the Managing Director with a full knowledge of the Board of Directors and that a contract of service as the one entered into with the Secretary was one which a person performing the duties of a Managing Director would have power to enter into on behalf of the company.  Therefore, the contract was genuine, valid and enforceable.  If however, the officer is purporting to exercise some authority which that sort of officer would not normally have, a third party will not be protected if the officer exceeds his actual authority unless the company has held him out as having authority to act in the matter and the third party has relied thereof i.e. unless the company is estopped.  However, a provision in the Memorandum or Articles or other public document cannot create an estoppel unless the third party knew of the provision and has relied on it.  For this purpose, regulations at the Companies Registry do not constitute notice because the doctrine of constructive notice operates negatively and not positive.  If a document purporting to be received by or signed on behalf of the company is proved to be a forgery, it does not bind the company.  However, the company may be estopped from claiming the document as a forgery if it has been put forward as genuine by an officer acting within his usual or ostensible authority[8].

 

PROMOTERS

 

The Companies Act does not define the term promoter but Section 45(5) says

“A promoter is a promoter who was a party to the preparation of the prospectus. Apart from the fact that this definition does not speak much, it nevertheless shows that the definition is only given for the purposes of that section. 

 

At common law the best definition is that by Chief Justice Cockburn in the case of

 

Twyfords – v – Grant (1877) 2C.P.D. 469

 

Cockburn says “a promoter is one who undertakes to form a company with reference to a given project and to set it going and who takes the necessary steps to accomplish that purpose.”

 

The term is also used to cover any individual undertaking to become a director of a company to be formed.  Similarly it covers anyone who negotiates preliminary agreements on behalf of a proposed company.  But those who act in a purely professional capacity e.g. advocates will not qualify as promoters because they are simply performing their normal professional duties.  But they can also become promoters or find others who will.  Whether a person is a promoter or not therefore, is a question of fact.  The reason is that Promoter of is not a term of law but of business summing up in a single word the number of business associations familiar to the commercial world by which a company is born. 

 

It may therefore be said that the promoters of a company are those responsible for its formation.  They decide the scope of its business activities, they negotiate for the purchase of an existing business if necessary, they instruct advocates to prepare the necessary documents, they secure the services of directors, they provide registration fees and they carry out all other duties involved in company formation.  They also take responsibility in case of a company in respect of which a prospectus is to be issued before incorporation and a report of those whose report must accompany the prospectus.

 

DUTIES OF A PROMOTER

 

His duty is to act bona fide towards the company. Though he may not strictly be an agent, or trustee for a company, anyone who can be properly regarded as a promoter stands in a fiduciary relationship vis-à-vis the company.  This carries the duties of disclosure and proper accounting particularly a promoter must not make any profit out of promotion without disclosing to the company the nature and extent of such a Promotion.  Failure to do so may lead to the recovery of the profits by the company.

 

The question which arises is – Since the company is a separate legal entity from members, how is this disclosure effected?

 

Erlanger v New Sombrero Phosphates Co. (1878) 3 A.C. 1218

 

The facts were as follows

 

The promoters of a company sold a lease to the company at twice the price paid for it without disclosing this fact to the company.  It was held that the promoters breached their duties and that they should have disclosed this fact to the company’s board of directors.  As Lord Cairns said

 

“the owner of the property who promotes and forms that company to which he sells his property is bound to take care that he sells it to the company through the medium of a Board of Directors who can exercise an independent judgment on the transaction and who are not left under belief that the property belongs not to the promoters and not to another person.”

 

Since the decision in Salomon’s case it has never been doubted that a disclosure to the members themselves will be equally effective.  It would appear that disclosure must be made to the company either by making it to an independent Board of Directors or to the existing and potential members.  If to the former the promoter’s duty to the company is duly discharged, thereafter, it is upon the directors to disclose to the subscribers and if made to the members, it must appear in the Prospectus and the Articles so that those who become members can have full information regarding it.

 

Since a promoter owes his duty to a company, in the event of any non-disclosure, the primary remedy is for the company to bring proceedings for

 

1.                     Either rescission  of any contract with the promoter or

2.                     Recovery of any profits from the promoter.

 

As regards Rescission, this must be exercised with keeping in normal principles of the contract.

 

1.               The company should not have done anything to ratify the action

2.               There must be restitution in inter-gram (restore the parties to their original position),

 

REMUNERATION OF PROMOTERS

 

A promoter is not entitled to any remuneration for services rendered for the company unless there is a contract so enabling him.  In the absence of such a contract, a promoter has no right to even his preliminary expenses or even the refund of the registration fees for the company. He is therefore under the mercy of the Directors.  But before a company is formed, it cannot enter into any contract and therefore a promoter has to spend his money with no guarantee that he will be reimbursed.

 

But in practice the articles will usually have provision authorizing directors to pay the promoters.  Although such provision does not amount to a contract, it nevertheless constitutes adequate authority for directors to pay the promoter.

 

PRELIMINARY CONTRACTS BY PROMOTERS

 

Until a company is formed, it is legally non-existent and therefore cannot enter into any contract or even do any other acts in law.  Once incorporated, it cannot be liable on any contract nor can it be entitled under any contract purported to have made on its behalf before incorporation.

 

Ratification is not possible when the ostensible principle is non-existent in law when the contract was entered into.

 

Price v. Kelsall (1957) E.A. 752

 

One of the issues in this case was whether or not a company could ratify a contract entered into on its behalf before incorporation.  The alleged contract was that the Respondent had undertaken to sell some property to a company which was proposed to be formed between him and the Appellant.  In holding that a company cannot ratify such an agreement, the Eastern Africa Court of Appeal as then constituted O’Connor President said as follows:

“A company cannot ratify a contract purporting to be made by someone on its behalf before its incorporation but there may be circumstances from which it may be inferred that the company after its incorporation has made a new contract to the effect of the old agreement.  The mere confirmation and adoption by Directors of a contract made before the formation of the company by persons purporting to act on behalf of the company creates no contractual relations whatsoever between the company and the other party to the contract.”

 

However, acts may be done by a company after its formation which gives rise to an inference of a new contract on the same terms as the old one. 

 

The question whether there is a new contract or contracts is always a question of facts which depends on the circumstances of each individual case.

 

Mawagola Farmers & Growers Ltd. V Kanyanja (1971) E.A. 272

 

Here, prior to the incorporation of a company the promoters held public meetings at which members of the public were asked to purchase shares in a proposed company.  The Respondents paid for the shares both before and after incorporation of the company but the company did not allot any shares to them.  Instead after incorporation, it allotted shares to other people.

 

The Respondents filed actions praying for orders that the shares they paid for be allotted to them and the company’s registered members be rectified accordingly.

 

The Company argued that as the Respondents had paid money for the purchase of their shares before incorporation, their claim could only be directed against promoters because no pre incorporation agreement could bind the company and the company could not even after incorporation ratify or adopt any such contract.

 

 

Mustafa J.A. replied as follows:

“In order that the company may be bound by agreements entered into before incorporation, there must be a new contract to the same effect as the old agreements.  This contract may however be inferred from the acts of the company when incorporated.”

 

The allotment of shares to the Respondents after the incorporation was held to be sufficient evidence of a new contract between the company and the Respondents.  Therefore the Respondents were entitled to be allotted the shares agreed upon.

 

If any preliminary arrangements are made, these must therefore be left to mere gentlemen’s agreements or otherwise the promoters might have to undertake personal liability.

 

Although the principle is clear, those engaged in the formation of companies often cause contracts to be entered into on behalf of their proposed companies. 

 

As to whether the promoters will be personally liable on such contracts of naught might depend on the terminology employed.  In the case of

 

Kelner v. Baxter (1886) L.R. 2 C.P. 174

 

In this case, A, B and C entered into a contract with the Plaintiff to purchase goods “on behalf of the proposed Gravesand Royal Alexandra Hotel Company” the goods were duly supplied and consumed.  Shortly after incorporation the company in question collapsed and the Plaintiff sued A B and C for the price of the goods supplied.

 

It was held that A B and C were liable.  Chief Justice Erne stated as follows:

“Where a contract is signed by one who professes to be signing as agent but who has no principal existence at the time, then the contract will hold together the inoperative unless binding against the person who signed it.  He is bound thereby and a stranger cannot by subsequent ratification relieve him from that responsibility.  When the company came afterwards into existence, it had rights and obligations from that time but no rights or obligations by reason of anything which might have been done before.”

 

 

Contrast this case with the case of  Newborn v. Sensolid (G.B Ltd) (1954) 1 Q.B. 45

 

Here a contract was entered into between Leopold Newborn London Ltd and the Defendant for purchase of goods by the latter.  The defendant subsequently refused to take delivery of the goods and an action was commenced by Leopold Newborn Ltd.

 

It was discovered that at the time the contract was entered into, the company had not been incorporated.  Leopold Newborn thereupon sought personally to enforce the contract.

 

It was held that the signature on the document was the company’s signature and as the company was not in existence when the contract was signed, there never was a contract and Mr. Newborn could not come forward and say that it was his contract.  The fact was that he made a contract for a company which did not exist.

                                   

PROSPECTUSES

 

Basically when the public is asked to subscribe for shares or debentures in a company the invitation involves the issue of documents which set out the advantages to accrue from an investment in the company.  This document is called a prospectus and may be issued either by the company itself or by a promoter.  It is only in the case of a public company that a prospectus may be issued.

 

A private company must always raise its capital privately as required by Section 13 of the Companies Act Cap 486.

 

Section 20 of the Statute defines Prospectus as “any prospectus notice circular advertisement or other invitation offering to the public for subscription or purchase of any shares or debentures in the company.”

 

The word invitation and offering in that definition are loosely used because when a company issues a prospectus it does not offer to sell any shares but rather invites offers from members of the public.  A prospectus is therefore not an offer but an invitation to treat.

 

The word prospectus is thus a vague and uncertain term.  Whether an invitation is made to members of the public is always a question of fact.  The question “public” is not restricted to a certain section of the public but includes any members of the general public.  [9]

A newly formed company issued 3000 copies of a document which offered for subscription shares in a company and which was headed “for private circulation only”.  These copies were then circulated to the shareholders of a number of gas companies and the question arose Was this a prospectus?

 

The court held that this was an offer to the public and therefore constituted a prospectus. 

 

CONTENTS OF A PROSPECTUS

 

The object of the Companies Act is to compel a company to disclose in a prospectus all the necessary information which will enable a potential investor in deciding whether or not to subscribe for a company shares or debentures.  Therefore Section 40 requires that every Prospectus shall state the matter specified in Article 1 of the 3^rd Schedule to the Act and that it will also set out the report specified in Part II of that Schedule.  The provisions in that Schedule are designed mainly to provide information about the following matters:

 

1.                     Who the directors are; and What benefits they will get from the Directorship;

2.                     In the case of a new company, what profits are being made by the promoters;

3.                     the amount of capital required by the company to be subscribed, the amount actually received or to be received, the precise nature of the consideration which is not paid in cash;

4.                     In the case of an existing company, what the company’s financial records have been in the past.

5.                     the company’s obligations under any contracts it has entered into;

6.                     the voting and dividend rights of each class of shares;

7.                     If a Prospectus includes any statement by an expert, then the expert must have given his written consent to the inclusion of the statement and the prospectus must state that he has done so as per Section 42 of the Companies Act.

 

Contravention of these requirements renders the company and every person who was knowingly a party to the issue of the prospectus to a fine not exceeding 10,000/-

 

Section 42 defines Expert as including “Engineer, Valuer, Accountant or any other person whose profession gives authority to the statement made by him.”

 

In addition to these requirements the prospectuses must also be dated and the date stated therein is taken to be the date of publication of the prospectus.  However, there are two instances when a prospectus need not contain the matter set out in Schedule III namely

1.                     When the prospectus is issued to existing members or shareholders of the company;

2.                     When the prospectus relates to shares or debentures uniform with previously issued shares or debentures.

 

LIABILITY IN RESPECT OF PROSPECTUS

 

If a prospectus contains untrue statements, the Companies Act prescribes both penalty at Criminal Law and also Civil Liability for payment of damages.  As concerns Criminal Liability, under Section 46 where a prospectus includes any untrue statement, any person who authorized the issue of the prospectus is guilty of an offence and liable to imprisonment of a term not exceeding two years or a fine not exceeding 10,000/- or both such a fine and imprisonment unless he proves either that the statement was immaterial or that he had reasonable grounds to believe and did up to the time of issue of the prospectus that the statement was true.

 

A statement is deemed to be untrue if it is misleading in the form and context in which it is included.

 

R. v. Kylsant (1932) 1 K.B. 442

 

In this case the company had sustained continuous loses for over 6 years from 1921 to 1927.  The company issued a prospectus which in all material facts was correct. It further specified that the dividends being paid were high.  But these dividends were being paid out of abnormal profits made after World War 1.  Therefore the Prospectus was misleading in its context.

 

CIVIL REMEDIES

 

There are two primary remedies for those who subscribe for shares in a company as a result of a misrepresentation in a prospectus

 

(a)                   Damages;

(b)                   Rescission of any resulting contract.

 

 

DAMAGES

 

Section 45 provides for compensation to all persons who subscribe for any shares or debentures on the faith of the Prospectus for loss or damage they may have sustained by reason of untrue statements included therein.  If the statement is false to the knowledge of those who made it, then this amounts to fraud and damages will be recoverable from all those who made the statement intending it to be acted upon.  Refer to the case of

 

Derry v Peek (1889) 14 A.C. 337

 

Herein a company had power to construct tramways to be moved by animal power and with the consent of the British Board of Trade by steam or mechanical power.  The Directors issued a prospectus stating that the company had power to use steam or mechanical power.

 

In reliance on this misrepresentation, the Plaintiff bought shares in the company.  Subsequently the Board of Trade refused to give consent to the use of Steam or mechanical power and as a result the company was wound up.  The Plaintiff brought an action for deceit alleging fraudulent misrepresentation.

 

The Court held that the Defendants were not liable as they had made the incorrect statement in the honest belief that it was true.  Lord Herschell said “the authorities establish two major propositions.

(i)                    In order to sustain an action of Deceit, there must be proof of fraud and nothing short of that will suffice;

(ii)                   Fraud is proved when it is shown that a false representation has been made either;

(a)                   Knowingly or

(b)                   Without belief in its truth; or

(c)                   Recklessly not caring whether it is true or false.

In order to succeed in an action for damages for fraud the plaintiff must show that the Misrepresentation was made to him or that he was one of a class of persons who were intended to act upon it.  The ordinary purpose of a prospectus is to invite members of the public to become allottees of shares in a company.  Once the shares have been allotted therefore the prospectus will have served its purpose and thereafter it cannot be used as a ground for filing an action for fraud in respect of shares bought at a later date from another source.  Reference made to the case of

 

Peek v. Gurney (1873) L.R. 377

 

The allotment of shares in the company began on July 24^th and was completed on 28^th July.  In October, the Plaintiff bought shares on the stock exchange.  He subsequently found that the prospectus issued in July contained some untrue statements and therefore brought an action in respect thereof.

 

The issue was could he sue?

 

The court held that the Plaintiff could not base his action on the prospectus which was intended to be addressed only to the original company subscribers to the company shares.  The Directors of a company are not liable after the full original allotment of shares for all the subsequent dealings which may take place with regard to those shares on the stock exchange. 

 

However, the rule in Peek v. Gurney will not apply where a prospectus is intended to induce not only the original subscribers for the company shares but also to influence the subsequent purchase of those shares

 

Andrews v. Mockford (1896) 1 QB 372

 

Here the Plaintiff alleged that the Defendant sent him a prospectus inviting him to buy shares in the company which they knew would be a sham but the Plaintiff did not subscribe for the shares.  The prospectus eventually produced a very scanty subscription and the Defendant caused a telegram to be published in the local Newspaper to the effect that they had struck a vain of Gold.  And this they alleged had confirmed the statistics in the prospectus. 

 

The Plaintiff immediately bought shares on this basis.  The company was wound up.  The question arose, had the Prospectus served its purpose?

 

The court held that the prospectus was intended to induce the Plaintiff both to subscribe for shares initially and also to buy them in the Market thereafter.  The telegram was part of the prospectus.

 

Lord Justice Smith stated as follows

                  “there was proved against the Defendant a continuous fraud on their part commencing with ascending of the prospectus to the Plaintiff and culminating in the direct lie told in a telegram which was intended by the defendant to operate upon the Plaintiff’s mind and minds of others and did so operate to his prejudice and the advantage of the Defendant.  In this case the function of the prospectus was not exhausted and a false telegram was brought in to play by the Defendant to reflect back upon and countenance the false statements in the prospectus.”

 

The purchaser of shares induced to buy shares by the misstatement in the prospectus has an action for damages in negligence.  He has also an action for negligent misstatement[10]. All these actions are directed to the Directors personally.

 

RESCISSION

 

As against the company a person induced to buy shares by a misrepresentation in the prospectus may rescind the contract.  On buying shares ones contract is with a company itself.  The remedy is available only against the company.  To be entitled to this remedy, it is not necessary for the purchaser of the shares to show that the statement was fraudulent or negligent.  Even if the misrepresentation was innocent, rescission lies.  However, the rights to rescind is subject to two limitations

 

1.                     The allotee loses the right to rescind if he shows any election to affirm the contract; e.g. by attending and voting at the company’s meetings or by accepting dividends or by selling or attempting to sell the shares.

 

2.                     If the allotee does not rescind the contract before the company is wound up, he loses the right to do so as from the moment the winding up proceedings commenced.  The rationale is the protection of the other company’s creditors.

 

DIRECTORS’ DUTIES

 

First, three preliminary observations

 

1.                     Whereas the Directors’ authority to bind the company depends on their acting collectively as a Board, their duties to the company are owed by each Director individually.  These duties are owed to the company and the company alone and not to individual shareholders.

 

Percival v. Wright (1902) 2 Ch. 421

 

Certain Shareholders wrote to the Company’s Secretary asking if he knew anyone willing to buy their shares.  Negotiations took place and eventually the company chairman and two other directors bought the Plaintiff Shares at £12 10s per share.  The Plaintiff subsequently discovered that prior to and during their own negotiations for sale, the Chairman and the Board of Directors had been approached by 3^rd Party with a view to the purchase of the entire company’s assets at more than the price of 12 pounds 10 shillings per share.

 

The Plaintiff brought an action to set aside the share sales on the ground that the directors owed them a duty to disclose the negotiations with the 3^rd Party.

 

It was held that the Directors were not agents for the individual shareholders and did not owe them any duty to disclose.  Therefore the sale was proper and could not be set aside.  However, if the Directors are authorized by the members to negotiate on their behalf e.g. with a potential purchaser then the Directors will be in a position of agents for such members and will owe them a duty accordingly.

 

Allen v Hyatt (1914) 30 T.L.R. 444

These duties except where expressly stipulated in the Companies Act are not restricted to directors alone but apply equally to any officials of the company who are authorized to act as agents of the company and in particular to those acting in a managerial capacity.  This is particularly so as regards fiduciary duties.

 

DIRECTORS’ DUTIES PROPER

 

These fall into two broad categories

 

1.                     duties of care and skill in the conduct of the company’s affairs; and

2.                     Fiduciary duties of loyalty and good faith.

 

DUTIES OF CARE & SKILL

 

Duties of care and skill were summed up by Romer J.  In the case of

 

Re City Equitable Fire Insurance Co. (1925) Ch. D 447

 

Here the Directors of an insurance company left the management of the company’s affairs almost entirely to the Managing Director.  Owing to the managing Director’s fraud, a large amount of the company’s funds disappeared.  Certain items appeared in the balance sheet under the heading “loans at call or short notice and “Cash in Bank or in Hand”.  The Directors did not inquire how these items were made up.  If they had inquired they would have found that the loans were chiefly to the Managing Director himself and to the Company’s General Manager and the cash at Bank or in hand included some £13,000 in the hands of a firm of stockbrokers at which the managing director was a partner.

 

On the company’s winding up, an investigation of its affairs disclosed a shortage in its funds of more than £1.2 million incurred mainly due to the delinquent fraud of the Managing Director for which he was convicted and sentenced. The other Directors had all along acted in good faith and honestly but the liquidator sought to make them liable for the damages.

 

It was held that the Directors were negligent.  Justice Romer reduced the Directors duties of care and skill as follows

“A Director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience.”

 

This proposition prescribes the standard of skill to be exhibited in actions undertaken by directors.  The test is partly objective and also partly subjective because a reasonable man would be expected to have the knowledge of a director with his experience.  Refer to

 

Re Brazilian Rubber & Plantations Estates Ltd. (1911) 1 Ch. 405

 

In this case a company had five directors and one of them confessed that he was absolutely ignorant of business.  A second one was 75 years old and very deaf.  A third one said he only agreed to become a director because he saw one of his friends names on the list of directors.  The other two were fairly able businessmen.  The directors caused a contract to be entered into between the company and a certain syndicate for purchase by that company of some rubber plantation in Brazil.  The prospectus issued by the company contained false statements about the acreage of the Plantation, the types of trees and so forth.  The information given therein was given to the Directors by a person who had an original option to purchase that property.  He had never been to Brazil and the data was based on his own imagination.  The Directors caused the company to purchase the property.  The question arose, were they negligent in so doing?

 

The court held that their conduct did not amount to gross negligence.  Neville J. had the following to say:

“It has been laid down that so long as they act honestly, Directors cannot be made responsible in damages unless they are guilty of gross negligence.  A Director’s duty requires him to act with such care as is reasonably expected from his having regard to his knowledge and experience.  He is not bound to bring any special qualifications to his office.  He may undertake the Management of a Rubber Company in complete ignorance of anything connected with Rubber without incurring responsibility for the mistakes which may result from such ignorance.  While if he is acquainted with the Rubber business, he must give the company the advantage of his knowledge when transacting the company’s business.  He is not bound to take any definite part in the conduct of the company’s business but insofar as he undertakes it he must use reasonable care.  Such reasonable care must be measured by the care an ordinary man might be expected to take in the same circumstances on his own behalf.”

 

3.                     A director is not bound to give continuous attention to the affairs of his company.  His duties are of an intermittent nature to be performed at periodical Board Meetings and at meetings of any committee of the Board on which he is placed.  He is not bound to attend all such meetings though he ought to attend whenever in the circumstances he is reasonably able to do so.

 

Refer to the case of Re Denham & Co. Ltd (1883) 2 Ch. D 752. Here a company was incorporated in 1873.  Under the Articles 3 Directors were appointed namely, Denham, Taylor and Crook.  A fourth Director was appointed later.  The articles conferred on Denham supreme control of the company’s affairs.  He was given power to override decisions of the general meeting and a Board of Directors.  He was responsible for declaring dividends and he managed the company’s affairs entirely alone and without consulting the other directors.  Between 1874 and 1877 a dividend of 15% per annum was recommended and paid and the total amount paid was some £21,600.  In 1880 the company went into liquidation and an investigation revealed that the money paid as dividends had been paid not out of profits but out of capital.  Thereafter Denham became bankrupt, Taylor was dead and his estate was worthless and the third man was a man of straw.  The creditors directed their claims against Crook who had property.  Crooks argued that since the formation of the company, he had never attended Board Meetings and therefore could not be accountable for fraudulent statements in the Company’s Balance Sheets.  He attended one meeting in 1876 where he formally put forth a Resolution for the payment of a dividend for that year.

 

The Court held that a Director is not bound to attend every Board meeting and that he is not liable for misfeasance committed by his co-directors at Board meetings at which he was never present.

 

Marquis of Butes (1892) 2 Ch. 100

 

Here the Director never attended any Board meetings for 38 years.  It was held that he was not liable.

 

3.               In respect of all duties which having regard to all exigencies of business and articles of association may properly be left to some other official.  A Director in the absence of grounds for suspicion will not be liable in trusting that other official to perform that other duty honestly.

 

Dovey v. Cory (1901) A.C. 477

 

A bank sustained heavy losses by advances made improperly to customers.  The irregular nature of advances was concealed by means of fraudulent Balance Sheets which were the work of the General Manager and the Chairman in assenting to the payment of dividends out of capital and those advances on improper security were done on the advice of the general manager and chairman.

 

The court held that the reliance placed by the co-director on the general manager and chairman was reasonable.  He was not negligent and therefore was not liable for not having discovered the fraud as he was not in the absence of circumstances of suspicion bound to examine entries in the Company’s Books to see that the Balance Sheet was correct.

 

It may be said that the duties of care and skill appear to be negative duties.  What about fiduciary duties?

 

FIDUCIARY DUTIES

 

Basically a Director’s fiduciary duties are divisible into 4 sub categories

 

1.                     The Directors must always act bona fide in what they consider and not what the courts may consider to be in the best interest of the company.  In this context, the term company means the present and future members of the company on the basis that the company will be continued as a going concern thereby balancing long-term view against short term interests of existing members.

 

2.                     The directors must always exercise their powers for the particular purpose for which they were conferred and not for extraneous purposes even if the latter are considered being in the best interests of the company.  For example the Directors are invariably empowered to issue capital and this power should be exercised for only raising more funds when the company requires it.  Hence it will be a breach of the Directors’ duties to issue the company shares for the purpose of entrenching themselves in the control of the company’s affairs. 

 

Refer to the case of Punt v. Symons (1903) 2 Ch. 506  in this case the directors issued shares with the object of creating a sufficient majority to enable them to pass a special resolution depriving the other shareholders of some special rights conferred upon them by the company’s articles.  It was held that a power of a kind exercised by the Directors in this case was a power which must be exercised for the benefit of the company.  Primarily this power is given to them for the purpose of enabling them to raise capital for the purposes of the company.  Therefore a limited issue of shares to persons who are obviously meant and intended to secure the necessary statutory majority in a particular interest was not a fair and bona fide exercise of the power.

 

Piercy v. Mills & Co. (1920) 1 Ch. 78

A company had two directors.  They fell out of favor with the majority of the shareholders who were therefore threatened with the election of 3 other directors to the Board.  The directors issued shares with the object of creating a sufficient majority to enable them to resist the election of the 3 additional directors whose election would have put the two directors in the minority on the Board.

 

The Court held that the Directors were not entitled to use their powers of issuing shares merely for the purpose of maintaining their control or the control of themselves and their friends over the affairs of the company or even merely for the purpose of defeating the wishes of the existing majority of shareholders.  The Plaintiff and his friends held the majority of shares in the company and as long as that majority remained, they were entitled to have their wishes prevail in accordance with a company’s regulations.  Therefore it was not open to the directors for the purpose of converting a minority into a majority and purely for the purpose of defeating the wishes of the existing majority to issue the shares in dispute.

 

In those circumstances where the directors have breached their duty to exercise their powers for the proper purpose, the shareholders may forgive them by ratifying their action

 

Hogg v. Cramphorn Ltd. (1967) Ch. 254

 

In this case the company had two classes of shares, ordinary and preference shares.  Each share carried 1 vote.  The power to issue the company shares was vested in the Directors.  They learnt that a takeover bid was to be made to the Shareholders.  In the Bona fide belief that the acquisition of control by the prospective take over bidder will not be the interest of the company or its staff.  The Directors decided to forestall this move.  They therefore attached 10 votes to each of the unissued preference shares and allotted to a trust which was controlled by the Chairman of the Board of Directors and one of his partners in the company’s audit department and an employee of the company.  To enable the trustees to pay for the shares, the directors provided them with an interest free loan out of the company’s reserve fund.

 

An action challenged by the Plaintiff who was an associate of the prospective take-over bidder and registered holder of 50 ordinary shares in the company was started.  After finding that it was improper for the directors to attach such special voting rights, the Court stood over the action in order to enable a general meeting to be held and to debate whether or not to ratify the Director’s actions.  The general meeting ratified the action.

 

Bamford v. Bamford (1969) 1 All ER 969

 

There were similar facts as in the former case but a meeting was held before proceeding to court and that general meeting ratified the Director’s action.  The question also arose in this case, could a decision of the general meeting cure the irregularity?

 

The court held if the allotment was made in bad faith, it was voidable at the instance of the company because it was a wrong done to the company and that being so, the company which has the rights to recall the allotment has also the right to approve it and forgive the breach of duty.

 

3.                     They must not fetter their displeasure to act for the company for example, the directors cannot contract either among themselves or with third parties as to how they will vote at future Board meetings.  However, where they have entered into a contract on behalf of the company they may validly agree to take such further action at Board meetings as maybe necessary to carry out such a contract.

 

FIDUCIARIES CONTINUED

 

4.                     As fiduciaries the Directors must not place themselves without consent of the company in a position in which there is a conflict between their duties to the company and their personal interests.  Good faith must not only be done but it must also manifestly be seen to be done.  The law will not allow the fiduciary to place himself in a position where he will have his judgments to be biased and then argue that he was not biased.  This principle applies particularly when a Director enters into a contract with his company or where he makes any secret profit by being a Director.  As far as contracts are concerned a contract entered into by the Board on behalf of the company and another Director is governed by the equitable principle which ordains that a fiduciary relationship between the Director and his company vitiates such contracts.  Such contract is therefore voidable at the instance of the company.  Reference may be made to the case of

 

Aberdeen Railway v. Blaikie (1854) 1 Macc. 461

 

The Defendant Company entered into a contract to purchase a quantity of chairs from the Plaintiff partnership.  At the time that the contract was entered into a Director of the company was also one of the partners.  The issue was, was the company entitled to avoid the contract?  The court held that the company was entitled to avoid the contract.  The Judge said that as a body corporate can only act by agents and it is the duty of those agents so to act as best to promote the interests of the corporation whose affairs they are conducting.  Such an agent has a duty of a fiduciary nature to discharge towards his principal.  It is a rule of universal application that no one having such duties to discharge shall be allowed to enter into or can have a personal interest conflicting or which may possibly conflict with the interests of those whom he is bound to protect.  This principle is strictly applied no question is entertained as to the fairness or unfairness of the contract so entered into.  However, it is possible for such contract to be given effect by the articles of association.  At their narrowest the Articles might provide that a Director who is interested in a Company contract should disclose his interests and he will not be counted to decide that a quorum is raised and his votes will also not be counted on the issue.  At their widest the articles might allow the director to be counted at Board meeting.

 

In order to create a balance between these two extremes and ensure that a minimum standard prevails, Section 200 was incorporated into the Companies Act.  Under this Section it is the duty of a director who is interested in any contract or proposed contract to disclose the nature and extent of his interest to the Board of Directors when the contract comes up for discussion.  Failure to do so renders the defaulting director liable to a fine not exceeding 2000 shillings. In addition the failure also brings in the equitable doctrine whereby the contract becomes voidable at the option of the company and any profit made by the director is recoverable by the company.

 

The shortcoming of the Section is that the Director has to disclose to the Board of Directors and not to the general meeting.  It is not sufficient for a Director to say that he is interested.  He must specify the nature and extent of his interests.  If the company’s articles take the form of Article 84 of Table ‘A’ then a Director who is so interested is required to abstain from voting at the Board meeting and his vote will not be taken in determining whether or not there is a quorum on the Board.  Once the Director has complied with Section 200 and Article 84 then he can escape liability.

 

In respect of all other profits which a Director may make are out of his position as a Director the equitable principle which requires the Directors to account for any such profits is vigorously enforced.  This is because the Courts have equated Directors to trustees and their duties have also been equated to those of Trustees.  The question is, are they really trustees?[11]

 

Re Forest of Dean Coal Mining Company (1879) 10 Ch. D 450

 

In the latter case, the directors of a company were seen to be trustees only in respect of the company’s funds or property which was either in their hands or which came under their control.  But this does not necessarily make directors trustees.  There are two basic differences between Directors as Trustees and Ordinary Trustees.

(a)                   The function of ordinary trustee is to preserve the Trust Property but the role of a director is to explore possible channels of investment for the benefit of the company and these necessitates some elements of having to take a risk even at the expense of the company’s property.

(b)                   Whereas trust property is vested in the Trustees, a company’s property is held by the company itself and is not vested in the trust.

 

Nevertheless if the directors make any secret profits out of their positions then the effect is identical to that of ordinary trustees.  They must account for all such profits and refund the company.

 

Regal Hastings v. Gulliver (1942) 1 All E.R. 378

 

Herein the company owned a cinema and the directors decided to acquire two other cinemas with a view to the sale of the entire undertaking as a going concern.  Therefore they formed a subsidiary company to invite the capital of 5000 pounds divided into 5000 shares of 1 pound each.  The owners of the two cinemas offered the directors a lease but required personal guarantees from the Directors for the payment of rent unless the capital of the subsidiary company was fully paid up.  The directors did not wish to give personal guarantees.  They made arrangements whereby the holding company subscribed for 2000 shares and the remaining shares were taken up by the directors and their friends.  The holding company was unable to subscribe for more than 2000 shares.  Eventually the company’s undertakings were sold by selling all the shares in the company and subsidiary and on each share the Directors made a profit of slightly more than two pounds.  After ownership had changed the new shareholders brought an action against the directors for the recovery of profits made by them during the sale.

 

The court held that the company as it was then constituted was entitled to recover the profits made by the Directors.  Lord Macmillan had the following to say:

 

                  “The directors will be liable to account if it can be shown that what they did is so related to the affairs of the company that it can properly be said to have been done in the course of their management and in utilization of the opportunities and special knowledge and what they did resulted in a profit to themselves.”

 

Phipps v. Boardman (1966) 3 All E.R. 721

 

In this case Boardman was a solicitor to the trust of the Phipps family.  The trust held some shares in the company.  Boardman and his colleagues were not satisfied with the company’s accounts and therefore decided to attend the company’s general meeting as representatives of the Trust.  At the meeting they received information pertaining to the company’s assets and their value.  Upon receipt of the information, they decided to buy shares in the company with a view to acquiring the controlling interest.  Their takeover bid was successful and they acquired control.  Owing to the fact that Boardman was a man of extraordinary ability, the company made progress and the profits realized by Boardman and his friends on the one hand and the trusts on the other were quite extensive.  One of the beneficiaries of the Trust brought an action to recover the profits which were realized by Boardman and his friends.

 

The court held that in acquiring the shares in the company, Boardman and his friends made use of information obtained on behalf of the trust and since it was the use of that information which prompted them to acquire the shares, then the shares were also acquired on behalf of the trust and thus the solicitors became constructive trustees in respect of those shares and therefore liable to account for the profits derived there from to the trust.

 

Peso Silver mines v. Cropper (1966) 58 D.L.R. 1

 

The Defendant was the company’s Managing Director.  The Board of Directors was approached by a prospector who offered to sell his claims to the company.  The company’s consulting geologists advised that it was in order for the company to acquire the claims.  The directors decided that it was inadvisable for the company to acquire the same mainly because of its strained financial resources.  Subsequently at the suggestion of the geologists, some of the Directors agreed to purchase the claims at the price at which they had been offered to the company.  Thereafter they formed a company which took over the claims and a second company for developing the resources.  After the control of Peso Silver Mines had changed the new directors brought an action against the Defendant to account to the company for the shares held by them in the new companies.  But here the court held that since the company could not have taken over the claims, there was no conflict of interest between the Directors and the Company and therefore the Defendant was not liable to account for the shares.

 

Directors may make use of opportunities originally offered to the company and thereby make profits provided that some 4 conditions are satisfied namely

1.                     The opportunity must have been rejected by the company;

2.                     If the directors acted in connection with that rejection, they must have acted bona fide in the best interests of the company.

3.                     The information about that opportunity should not have been given to them confidentially on behalf of the company.

4.                     Their subsequent use of that information must not relate to them as directors but as any other ordinary person.

 

Industrial Development Consultants v Cooley (1972) 2 All E.R. 162

 

The Defendant who was an architect was appointed the company’s Managing Director.  The company’s business was to offer design and construction services to industrial enterprises.  One of the defendant’s duties was to obtain new business for the company particularly from the gas companies where he had worked before joining the Plaintiff.  While the Defendant was still so employed by the Plaintiff a representative of one Gas Company came to seek his advice on some personal matters.  In the course of their conversation the Defendant learnt that the gas company in question had various projects all requiring design and construction services of the type offered by the Plaintiff.  Upon acquiring this information and without disclosing it to the company, the Defendant feigned illness as a result of which he was relieved by the company from his duties.  Thereafter, he joined the gas company and got the contract to do the work.  Two years previously, the Plaintiff had unsuccessfully tried to obtain that work.  After the Defendant acquiring the contract, the company sued him alleging that he obtained the information as a fiduciary of the company and he should therefore account to the company for all the remuneration fees and all dues obtained.

 

The court held that until the Defendant left the Plaintiff, he stood in a fiduciary relationship to them and by failing to disclose the information to the company, his conduct was such as to put his personal interests as a potential contracting party to the gas company in conflict with the existing and continuing duty as the Plaintiff’s Managing Director.

 

Roskill J.

“It is an overriding principle of equity that a man must not be allowed to put himself in a position where his fiduciary duty and interest conflict.  It was the defendant’s duty to disclose to the plaintiff the information he had obtained from the Gas Board and he had to account to them for the profits he made and will continue to make as a result of allowing his interests and duty to conflict.  It makes no difference that a profit is one which the company itself could not have obtained.  The question being not whether the company could have acquired it but whether the defendant acquired it while acting for the company.”

 

CONTROLLING SHARE HOLDERS

 

By controlling share holders is meant those who hold the majority of the voting rights in the company.  Such share holders can always ensure control of the company’s business by virtue of their voting power to ensure that the controlling shareholders do not use their voting power for exclusively selfish ends; the Law requires that in exercise of their voting power, these shareholders must not defraud a minority.  For example by endeavoring directly or indirectly to appropriate to themselves any money property or advantage which either belong to the company or in which the minority shareholders are entitled to participate.[12]

 

Menier v Hoopers Telegraphy Works (1874) L.R. Ch. A 350

 

In the latter case the company brought action against its former Managing Director for a declaration that the concessions for laying down a telegraph cable from Portugal to Brazil was held by that former Director as a trustee for the company. While this action was still pending, the Defendants who were the majority shareholders in the company approached that former Managing Director with a view to striking a compromise.  It was agreed between the parties that if that director surrendered the concessions to the Defendants then the Defendants would use their voting power to ensure that the action was discontinued.  At a subsequent general meeting of the company, by virtue of the defendant’s voting power, a resolution was passed that the company should be wound up.

 

The court said that the resolution was invalid since the defendants had used their voting power in such a way as to appropriate to themselves the concessions which  if the earlier action had succeeded should have belonged to the whole body of shareholders and not merely to the majority.  Lord Justice Mellish stated as follows:

                  “Although the shareholders of the company may vote as they please and for the purpose of their own interest, yet the majority of the shareholders cannot sell the assets of the company itself and give the consideration but must allow the minority to have their share of any consideration which may come to them.”

 

Cook v. Deeks (1916) 1 A.C. 554

 

The Toronto Construction Company carried on business as Railway Construction contractors.  The Shares in the company were held equally among Cook, G S Deeks and G M Deeks.  And another party called Hinds.  The company carried out several large construction contracts for the Canadian Pacific Railway.  When the two Deeks and Hinds learnt that a new contract was coming up, they obtained this contract in their own names to the exclusion of the company and then formed a new company to carry out the work.  At a general meeting of the shareholders of Toronto Construction Company a resolution was passed owing to the two powers of Deeks and Mr. Hinds declaring that the company was not interested in the new contract of the Canadian Pacific Railway.  Cook brought an action and the court held:  that the benefit of the contract belonged properly to the Company and therefore the Directors could not validly use their voting power as shareholders to vest it in themselves.

 

 

 

 

ENFORCEMENT OF DIRECTORS’ DUTIES

 

As the company is a distinct entity from the members and since directors owed their duties to the company and not to individual shareholders, in the event of breach of those duties any action for remedies should be brought by the company itself and not by any individual shareholder.  The company and the company alone is the proper Plaintiff.  This is generally referred to as the rule in:

 

 Foss V. Harbottle (1843) 2 Hare 461

 

In this case the directors who were also the company’s promoters sold the company’s property at an undisclosed profit.  Two shareholders brought action against them alleging that in so doing, that the directors had breached their duties to the company.  It was held that if there was any breach of duty, it was a breach of duty owed to the company and therefore the Plaintiffs had no locus standi for the company was the proper plaintiff.  This rule has two practical advantages namely:

1.                     Insistence on an action by the company avoids multiplicity of actions;

2.                     If the irregularity complained of is one which could have been effectively ratified by the company in general meeting, then it is pointless to commence any litigation except with the consent of the general meeting. 

 

However there are four exceptions to this rule in which an individual member may bring action against the directors namely:

(a)                   Where it is complained that the company through the directors is acting or proposing to act ultra vires;

(b)                   Where the act complained of even though not ultra vires, the company can effectively be done by a special resolution;

(c)                   Where it is alleged that the personal rights of the Plaintiff have been infringed and/or are about to be infringed;

(d)                   Where those who control the company are perpetuating the fraud on the minority;

The problem likely to arise is that if the directors themselves are also controlling shareholders, the rule in Foss v. Harbottle if strictly applied in exercise of their voting powers, the Directors may easily block any attempt to bring an action against themselves.  In such cases a shareholder will be allowed to bring an action in his own name against the directors even if the wrong complained of has been done to the company.  Such an action is called a derivative action.

 

In order to be entitled to commence a Derivative Action, it must be shown that

 

1.                     The wrong complained of was such as to involve a fraud on the minority which is not ratifiable by the company in general meeting;

2.                     It must be shown that the wrong doers hold the controlling interests

3.                     The company must be joined as a nominal defendant;

4.                     The action must be brought in a representative capacity on behalf of the plaintiff and all other shareholders except the Defendant.

 

The question is, are these exceptions effective?

There are situations where the rule does not apply. 

Another remedy against directors for breach is found in Section 324 of the statute which provides as follows:

“If in the course of the winding up of the company it appears that any person who has taken part in the formation or promotion of the company or any past or present director has misapplied or retained any money or property of the company, or been guilty of any breach of trust in relation to the company on the application of the liquidator, a creditor or member or a court may compel such person to restore the money or property to the company or to pay damages instead.”

 

This section is designed to deal with actual breaches of trust which come to light in the winding up proceedings or during the winding up proceedings but winding up itself may be used as a means of ending a course of oppression by those formally in control.  Among the grounds for the winding up is one which is particularly appropriate for such circumstances.

 

Under Section 219 (f) of the Companies Act the court may order a company to be wound up if it is of the opinion that it is “just inequitable” the courts have so ordered when satisfied that it is essential to protect the members or any of them from oppression in particular they have done so when the conduct of those in control suggests that they are trying to make intolerable the position of the minority so as to be able to acquire the shares held by the minority on terms favorable only to the majority.  But a member cannot petition under this section if the company is insolvent.  If the company is solvent to wind it up, contrary to the majority wishes will only be granted where a very strong case against the majority is established.

 

Winding up a company merely to end oppression appears rather awkward as it may not be of any benefit to the petitioners themselves.  Owing to these shortcomings, Section 211 was incorporated into the Companies Act as an alternative remedy for the minority of the shareholders.  Section 211 provides that any member who complains that the affairs of a company are being conducted in a manner oppressive to some part of the members including himself may petition the court which if satisfied that the facts will justify a winding up order but that this will unduly prejudice that part of the members, may make such order as it thinks fit.  Such an order may regulate the conduct of the company’s affairs in the future or may order the purchase of member shares by others or by the Company itself.  This remedy is available only to the members.  An oppressed director or creditor cannot obtain any remedy under Section 211 of the Companies Act for this is expressly restricted to oppression of the members even if a director or creditor also happens to be a member.

 

Elder V. Elder & Watson (1952) AC 49

 

The two Plaintiffs were the company director and secretary and factory manager respectfully.  As this was a small family concern, serious differences arose between the plaintiffs and the beneficial owners of the undertaking.  Consequently the Plaintiff brought action under Section 211 alleging oppression.  It was held that if there was any oppression of the Plaintiffs, it related to them as directors and the remedy under Section 211 is only available to members.  The suit was dismissed.

 

WHAT IS OPPRESSION?

 

This term has been defined to mean something burdensome, harsh or wrongful.

 

Scottish Cooperative Wholesale Society v. Meyer (1959) AC 324

 

Here the Society wished to enter into the retail business.  For this purpose a subsidiary company was formed in which the two Respondents and 3 Nominees of the Society were the directors.  The society had majority shareholders and the Respondents were the minority.  The Company required 3 things namely;

1.                     Sources of supplies of raw material;

2.                     A license from a regulatory organization called cotton control

3.                     Weaving Mills.

 

The Respondents provided the first two but weaving Mills belonged to the society.  For several years, the business prospered because of mainly the knowhow provided by the Respondent.  The company paid large dividends and accumulated substantial results.  Due to the prosperity, the society decided to acquire more shares and through its nominee directors offered to buy some of the shares of the Respondent at their nominal value which was one pound per share but their worth was actually 6 pounds per share.  When the Respondents declined to sell their shares to the society, the society threatened to cause the liquidation of the company.  About 5 years later, Cotton control was abolished which meant that the society would obtain the raw materials and weave cloth without a license.  It accordingly started to do the same and also started starving the subsidiary by refusing to manufacture for it except for an economic crisis. As all the other Mills were fully occupied, the subsidiary company was being starved to death and when it was nearly dead the Respondent brought the petition claiming that the affairs of the company were being conducted in an oppressive manner.

 

It was held that by subordinating the interests of the company to those of the society, the nominee directors of the society had thereby conducted the affairs of the company in a manner oppressive to the other shareholders.  The fact that they were perhaps guilty of inaction was irrelevant.  The affairs of the company can be conducted oppressively by the Directors doing nothing to protect its interests when they ought to do so.

 

Re Hammer (1959) 1 WL.R 6

 

In this case Mr. Hammer senior was a Philatelist (stamp collector) dealer and incorporated business in 1947 forming a company with two types of ordinary shares class A shares which were entitled to a residue of profit and Class B Shares carrying all the votes.  He gave out the shares to his two sons and at the time of the petition each son held 4000 Class A shares and the father owned 1000 shares.  Of the Class B Shares, the father and his wife held nearly 800 to the 100 held by each son.  Under the Company’s articles of association, the father and two sons were appointed directors for life and the father was further appointed chairman of the Board with a casting vote.  The father assumed powers he did not possess ignored decisions of the Board and even in court, during the hearing asserted that he had full power to do as he pleased while he had voting control.  He dismissed employees using his casting vote to co-opt self directors; he prohibited board meetings, engaged detectives to watch the staff and secured payment of his wife’s expenses out of the company’s funds.  He negotiated sales and vetoed leases all contrary to the decisions and wishes of the other directors.

 

The sons filed an action claiming that the father had run the affairs of the company in a manner oppressive to them.  The father was 88 years.

 

The court held that by assuming powers which he did not possess and exercising them against the wishes of those who had the major beneficial interests, Mr. Hammer senior had conducted the company’s affairs in an oppressive manner.

 

These two cases are among the few where an application under Section 211 has succeeded.  This is because section 211 has been subjected to a very restrictive meaning.  To succeed under Section 211, one must establish a case of oppression.

 

There is no clear definition of the term and therefore it is not easy to tell when a company’s affairs are being conducted oppressively.  For example in the case of:

 

 Re Five Minute Car Wash Ltd (1966) 1 W.L.R. 745

 

The petitioner alleged oppression on grounds that the company’s Managing Director was extremely incompetent.  The court ruled that even though the allegation suggested that the Managing Director was unwise inefficient and careless in the performance of his duties, this did not mean that he had at any time acted unscrupulously, unfairly or with any lack of probity towards the petitioner or to other members of the company.  Therefore his conduct was not oppressive.

1.                     The conduct which is complained of must relate to the affairs of the company and must also relate to the petitioner in his capacity as a member.  Personal representatives cannot petition nor can trustees in bankruptcy petition.

 

2.                     The wording of the section suggests that there must be a continuous cause of conduct and not merely isolated acts of impropriety.

 

3.                     The conduct must be such as to make it just and equitable to wind up the company.  In other words, the members must be entitled to a winding up order.

 

 

Re Bella Dor Sick Ltd (1965) 1 All E.R. 667

 

In a small family concern, there developed two factions among shareholders.  Owing to these personal differences the petitioner filed a petition under Section 211 complaining inter alia that the distribution of profits had not been fairly made.  That he had been excluded from the Board of Directors and that the affairs of the company were being conducted irregularly. In particular, he alleged that the company had failed to repay its debts to another company in which he had some interests.

 

It was held that the petitioner had not made a case of oppression and the petition must be dismissed.

 

Three reasons were given:

(a)                   This petition had been brought for the collateral purpose of enforcing repayment of debts to some third party;

(b)                   The conduct complained of and particularly the removal of the petitioner from the Board related to him as a director not as a member;

(c)                   That the circumstances were not such as to justify a winding up order at the instance of the petitioner because the company was insolvent and therefore the shareholders had no tangible interests.

 

It is an unfortunate mistake to link up Section 211 with winding up.  The courts are construing the Section very restrictively.  Section 211 has therefore failed to live up to expectations.  It is no real remedy.

 

RAISING AND MAINTENANCE OF CAPITAL

 

The basis of the whole concept or a company’s capital was explained by Jessel M.R. in the Flitcrafts Case 1882 21 Ch. D 519  in this case for several years the directors had been in the habit of laying before the meeting of shareholders reports and balance sheets which were substantially untrue inasmuch as they included among other assets as good debts a number of debts which they knew to be bad.  They thus made it appear that the business had produced profits whereas in fact it had produced none.  Acting on these reports, the meetings declared dividends which the directors paid.  It was held here that since the directors knew that the business had not made any profit, they were liable to refund to the company the monies paid by way of dividends.

 

Jessel M.R said as follows “when a person advances money to a company, his debtor is that artificial entity called the corporation which has no property except the assets of the business.  The creditor therefore gives credit to that capital or those assets.  He gives credit to the company on the faith of the implied representation that the capital shall be applied only for the purposes of the business and he has therefore a right to say that the corporation shall keep its capital and shall not return it to the shareholders.”

 

The capital fund is therefore seen as a substitute for unlimited liability of the members.  Courts have developed 3 basic principles for ensuring that the company’s represented capital is actually what it is and for the distribution of that capital.

1.                     Once the value of the company’s shares has been stated it cannot subsequently be changed the problem which arises in this respect is that shares may be issued for non-monetary consideration.  For instance for services or property in such cases the company’s valuation of the consideration is generally accepted as conclusive.  If the property has been over valued, provided the valuation has been arrived at bona fide, the courts will not question the adequacy of the consideration but if it appears on the face of the transaction that the value of the property is less than that of the shares, then the court will set aside that transaction.  For this reason the shares in a company must be given a definite value.  The law tries to ensure that the company initially receives assets at least equivalent to the nominal value of the paper capital.  Refer to Section 5 of the Companies Act.  Unfortunately if in the insistence that shares do have a definite fixed value is not an adequate safeguard because there is no legal minimum as to what the nominal value of the shares should be.

 

2.                     The Rule in Trevor v. Whitworth [1887] 12 A.C 449 under this rule a company is not allowed to purchase its own shares even if there is an express power to do so in its Memorandum of Association as this would amount in a reduction of its capital.  This principle is now supplemented by Section 56 of the Companies Act which prohibits any direct or indirect provision of any form of assistance in the purchase of the company shares.  However, there are 3 exceptions to this broad prohibition.

 

a.                     where the lending of money is part of the ordinary business of the company;

b.                     Where the company sets a trust fund for enabling the trustees to purchase or subscribe for the company shares to be held or for the benefit of the employees of the company until where the company gives a loan to its employee other than directors to enable them to purchase shares in the company.

 

3.               Payment of Dividends:   In order to ensure that the company’s capital is not refunded to the shareholders under the guise of dividends, the basic principle is that dividends should not be paid otherwise than out of profits.  Refer to Article 116 of Table A of the Companies Act.  The legal problem in this respect has been the lack of an adequate definition of what constitutes profits.  To avoid the problem of definition the courts have formulated certain rules for the payment of dividends.  These are as follows

(i)               Before a company can declare dividends, it must be solvent.  Dividends will not be paid if this will result in the company’s inability to pay its debts as and when they fall due;

 

(ii)                   If the value of the company’s fixed assets has fallen thereby causing a loss in the value of those assets, the company does not need to make good that loss before treating revenue profits as available for dividends.  It is not legally essential to make provision for depreciation in the fixed assets.  However Losses of circulating assets in the current accounting period must be made good before a dividend can be declared.  The realized profits on the sale of fixed assets may be treated as profit available for distribution as a dividend. Unrealized profits on evaluation of the company’s assets may also be distributed by way of dividends.  Refer to Dimbula Valley (Ceylon) Tea Co. V. Laurie [1961] Ch. D 353  Losses on circulating assets made in previous accounting periods need not be made good.  The dividend can be declared provided that there is a profit on the current year’s trading.  Each accounting period is treated in isolation and once a loss has been sustained in one trading year, then it need not be made good from the profits over subsequent trading periods.  Undistributed profits of past years still remain profit which can be distributed in future years until they are capitalized by using them to pay a bonus issue.

 

CORPORATE SECURITIES

 

Basically securities are a collective description of the various forms of investment which one can buy for sale at the stock exchange.  A company can issue two primary classes of securities.  These are shares and debentures.  The basic distinction between a share and a debenture is that a share constitutes the holder.  A member of the company whereas a debenture holder is a creditor of a company and not a member of it

 

The best definition of the term share is that given by Farwell J. in the case of Borland’s Trustee v. Steel [1901] Ch. D 279 stated “a share is the interest of a member in a company measured by a sum of money for the purpose of liability in the first place and of interest in the second and also consisting of a series of mutual covenants entered into by all the shareholders among themselves in accordance with Section 22 of the Companies Act.”

 

The contract contained in the Articles of Association is one of the original incidents of a share.  A share is therefore not a sum of money but an abstract interest measured by a sum of money and made up of various rights contained in a contract of membership.

 

In contrast a debenture means a document which either creates or acknowledges a debt and any document which fulfils either of these conditions is called a debenture.  A debenture may take any of 3 forms

 

1.                     It may take the form of a single acknowledgment under seal or the debts;

2.                     It may take the form of an instrument acknowledging the debt and charging the company’s property with repayment; or

3.                     It may take the form of an instrument acknowledging the debt charging the company’s property with repayment and further restricting the company from creating any other charge in priority over the charge created by the debenture. 

 

The indebtedness acknowledged by a debenture is normally but not necessarily secured by charge over the company’s property.  Such charge could either be a specific charge or a floating charge.   Both were defined by Lord McNaughton in the case of Illingworth v. Houlsworth [1904] A.C. 355 AT 358 He stated:

“A specific charge is one that without more fastens on ascertained and definite property or property capable of being ascertained and defined.  A floating charge on the other hand is ambulatory and shifting in its nature, hovering over and so to speak floating with the property which it is intended to affect until some event occurs or some act is done which causes it to settle and fasten on the subject of the charge within its reach or grasp.”

 

A floating charge has 3 basic characteristics.

 

1.                     It must be a charge on a class of a company’s assets both present  and future;

2.                     That class must be one which in the ordinary cause of business of the company keeps changing from time to time;

3.                     By the charge it must be contemplated that until future step is taken by or on behalf of those interested, the company may carry on its business in the ordinary way as far as concerns the particular class of the assets charged.

 

CRYSTALISATION

A floating charge will crystallize under the following

(a)                   Where the company defaults in the payment of any portion of the principal or interest thereon, when such portion or interest is due and payable.  In that event however, the debenture holders’ rights will not crystallize automatically.  After the expiry of the agreed period for repayment, the debenture still remained a floating security until the holders take some step to enforce that security and thereby prevent the company from dealing with its property;

(b)                   Upon the appointment of a receiver in the course of a company’s winding up;

(c)                   Upon commencement of recovery proceedings against the company;

(d)                   If an event occurs upon which by the terms for the debenture the lender’s security is to attach specifically to the company’s assets

 

Section 96 of the Companies Act requires every Charge created by a company and conferring security on the company’s property to be registered within 42 days. Under this Section what must be registered are the particulars of the charge and the instrument creating it.  Failure to register renders the charge void as against the liquidator or any creditor of the company.  [13]

 

Under Section 99 of the Companies Act the registrar is under a duty to issue a certificate of the registration of a charge and once issued, that certificate is conclusive evidence that all the requirements as to registration have been complied with.[14]

 

 

 

 

SHARES

In a company with a share capital it is obvious that the company must issue some shares and the initial presumption of the law is that all the shares so issued confer equal rights and impose equal liabilities.  Normally a shareholder’s right in a company will fall under 3 heads.

1.                     Payment of dividends;

2.                     Refund of Capital on winding up;

3.                     Attendance and voting at company’s general meetings.

 

Unless there is indication to the contract all the shares will confer the same rights under those heads.  In practice companies issue shares which confer on the holders some preference over the others in respect of either payment of dividends or capital or both.  This is the method by which classes of shares are created i.e. by giving some of the shareholders preference over others.

 

In practice therefore most companies with classes of shares will have ordinary shares and preference shares.  The preference shares being those that enjoy some preference with reference to voting rights refund of capital or payment of dividends.

 

There are certain rules that courts use to interpret or construe on shares.

 

(a)                   Basically all shares rank equally and therefore if some shares are to have any priority over the others; there must be provision to this effect in the regulations under which these shares were issued.  Refer to the case of Birch V. Cropper (1889) 14 AC 525 here the company was in voluntary winding up.  The company discharged all its liabilities and some money remained for distribution to the members.  The Articles being silent on the issue, the question was on what principle should the surplus be distributed among the preference and ordinary shareholders?  The ordinary shareholders argued that they were entitled to the entire surplus.  Alternatively the division ought to be made according to the capital subscribed and not the amount paid on the shares.  It was held that once the capital has been returned to the shareholders, they thereafter become equal and therefore the distribution of the surplus assets should be made equally between the ordinary and preference shareholders.

 

(b)                   However if the shares are expressly divided into separate classes thereby rebutting the presumed equality, it is a question of construction in each case what the rights of each class are.  Hence if nothing is expressly said about the rights of one class in respect of either dividend, return of capital or attendance and voting at meetings, then that class has the same rights in that respect as the other shareholders.  The fact that a preference is given in respect of any of these matters does not imply that any right to preference in some other respect is given e.g. a preference as to dividends will not apply a preference as to capital i.e. the shares enjoy only such preference as may be expressly conferred upon them.

 

(c)                   If however, any rights in respect of any of these matters are expressly stated, the statement is presumed to be exhaustive so far as that matter is concerned.  For instance the preference dividend is presumed to be non-participating in regard to other dividends.  Refer to Re Isle of Thanet Electricity Supply Co. (1950) Ch. 1951 where Justice Wynn Parry stated;

 

“The effect of the authorities as now in force is to establish two principles.  First that in construing an article which deals with the rights to share all profits, that is dividend rights and rights to shares in the company’s property in liquidation, the same principle is applicable and secondly that principle is that where the articles sets out the rights attached to a class of shares to participate in profits while the company is a going concern or to share in the property of a company in liquidation, prima facie the rights so set out are in each case exhaustive.”

 

(d)                   Where a preferential dividend is provided for it is presumed to be cumulative for instance if no preferential dividend is declared the arrears of dividend are carried forward and must be paid before any dividend is paid on the other shares.  But these presumptions may be rebutted by words tending to show that the shares are not intended to be cumulative or words indicating that the preferential dividend is only to be paid out of the profits of each year i.e. if the company sustains any financial loss during any year, there will be no dividend for that year.  Even then preferential dividends are payable only if and when declared.  Therefore arrears of cumulative dividends are not payable on winding up unless the dividend has been declared.  This presumption could be rebutted by any indication to the contrary.

WINDING UP

 

Section 212 of the Companies Act provides that a company may be wound up as follows

1.                     Voluntarily;

2.                     Order of the Court;

3.                     By supervision of the Court.

 

The circumstances under which the company may be voluntarily wound up are outlined in Section 217 of the Companies Act.  Here a company may be wound up

 

a.                     When the period fixed for its duration by the articles expires or the event occurs on the occurrence of which the articles provide that the company is to be dissolved and thus a company passes a resolution in general meeting that it should be wound up voluntarily;

b.                     If it resolves by special resolution that it should be wound up voluntarily;

c.                     If the company resolves by special resolution that it cannot by reason of its liabilities continue its business and that it be advisable that it be wound up.

 

Basically the second circumstance is the most important because in practice at least the first circumstance does not arise and in the 3^rd circumstance the creditors themselves will resolve that the company be wound up.

 

In any winding up those in need of protection are the creditors and the minority shareholders.  Where it is proposed to wind up a company voluntarily Section 276 of the Companies Act requires the directors to make a declaration to the effect that they have made a full inquiry in to the affairs of the company and having so done have found the company will be able to pay its debts in full within such period not exceeding one year after the commencement of the winding up as may be specified in the declaration.  Such declaration suffices as a guarantee for the repayment of the creditors.  If the directors are unable to make the declaration, then the creditors will take charge or the winding up proceedings in which case they may appoint a liquidator.

 

WINDING UP BY THE COURT

 

Winding up after an order to that effect by the court is the most common method of winding up companies.

 

Section 218 of the Companies Act gives the High Court jurisdiction to wind up any company registered in Kenya.  The circumstances under which a company may be wound up by a court order are spelt out in Section 219 of the Companies Act.

 

These cover situations in which

1.                     the company has by special resolution resolved that it be wound up by court;

2.                     Where default is made by the company in delivering to the registrar the statutory report or on holding the statutory meeting;

3.                     When the company does not commence business within one year of incorporation or suspends its business for more than one year;

4.                     Where the number of members is reduced in the case of a private company below 2 or in the case of a public company below 7;

5.                     Where the company is unable to pay its debts;

6.                     Where the court is of the opinion that it is just and equitable to wind up the company;

7.                     In the case of a company registered outside Kenya and carrying on business, the court will order the company to be wound up if winding up proceedings have been instituted against the company in the country where it is incorporated or in any other country where it has established business.

 

Under Section 221 of the Companies Act an Application for winding up by an order of the court may be presented either by a creditor or a contributory.  However a contributory cannot make the application unless his name has appeared on the register of members at least 6 months before the date of the application and in any event he can only petition where the number of members has fallen below the statutory minimum. 

 

In practice the creditors will petition for a compulsory winding up where the company is unable to pay its debts.  The company’s inability to pay its debts under Section 220 is deemed in the following circumstances

 

1.                     If a creditor to whom the company is indebted in a sum exceeding 1000 shillings demands payment from the company and 3 weeks elapse before the company has paid that sum or secured it to the reasonable satisfaction of a creditor;

 

2.                     If execution issued on a judgment against the company is returned unsatisfied;

 

3.                     If it is proved by any other method that a company is unable to pay its debts.

 

Before a creditor can petition it must be shown as a preliminary issue that he is in fact a creditor or a company creditor.  This is a condition precedent to petitioning and the insolvency of the company is a condition precedent to a winding up order.

 

PETITION BY A CONTRIBUTOR

 

Section 221 of the Companies Act speaks not of members but of contributories.

 

Section 214 defines the term contributory as follows “every person liable to contribute to the assets of the company in the event of its being wound up”.  The persons falling under this category are defined in section 213 of the Companies Act and include both present and past members.  A past member however, is not liable to contribute if he ceased to be a member one year or more before the commencement of the winding up and he is not liable to contribute for any debt or liability contracted after he ceased to be a member.  Even then he is not liable to contribute unless it appears to the court that the existing members are unable to satisfy the contributions required.

 

The most important limitation on liability of contributories is found in Section 213 (1) (d) of the Companies Act.  Under that clause no contribution shall be required from any member exceeding the amount unpaid on their shares in respect of which he is liable as a present or past member.

 

The petitioning contributor must establish that on winding up there will be prima facie a surplus for distribution among the members i.e. he must establish a tangible interest.  If therefore the company’s affairs have been so managed that there would be no assets available for distribution among the members then a shareholder has no locus standi and will not be allowed to petition for winding up.

 

Another possible limitation is that stated under Section 22(2) of the Act.  Here the court has a discretion not to grant the winding up order where it is of the opinion that an alternative remedy is available to the petitioners and that they are acting unreasonably in seeking to have the company wound up instead of pursuing that other remedy.

 

WINDING UP ON JUST AND EQUITABLE GROUNDS

 

It is now established that the just and equitable clause in Section 219 of the Act confers upon the court an independent ground of jurisdiction to make an order for the compulsory winding up of the company.  The courts have exercised their powers under this clause in the following circumstances:

 

1.                     In order to bring to an end a cause of conduct by the majority of the members which constitutes operation on the minority;

2.                     The courts have also exercised this power where the substratum of the company has disappeared;

3.                     The courts have applied the partnership analogy to the small private companies particularly those of a kind which makes an analogy with partnerships appropriate. 

 

In case of domestic private companies, there is normally an understanding between the members that if not all of them, then the majority of them will participate in the management of the company’s affairs.  Such members impose mutual trust and confidence in one another just as in the case of partnerships. 

 

Also usual in such companies is the restriction of the transfer of a member’s shares without the consent of all the other members.

 

If any of these principles were violated in a partnership, the courts will readily order the partnership to be dissolved.  In the case of a small private company, the courts have also held that such companies are run on the same principles as partnerships and therefore if the company was run on such principles it is just and equitable to wind it up where a partnership would have been dissolved in similar circumstances.

 

RE YENIDGE TOBACCO CO. LTD [1916] 2 Ch. 426

Here W and R who traded separately as Tobacco and Cigarette manufacturers agreed to amalgamate their business.  In order to do so, they formed a private company in which they were the only shareholders and the only directors.  Under the Articles, both W and R had equal voting powers. Differences arose between them resulting in a complete deadlock in the management of the company.  The issue was whether it was just and equitable to wind up the company.  Lord Justice Warrington stated as follows

“It is true that these two people are carrying on business by means of the machinery of the limited company but in substance they are partners. The litigation in substance is an action for dissolution of the partnership and we should be unduly bound by matters of form if we treated the relations between them as other than that of partners or the litigation as other than an action brought by one for the dissolution of the partnership against the other.”

 

The Model Retreading Co. [1962] E.A. 57

 

Here the petitioner who was a shareholder in a small private company petitioned for winding up mainly on the ground that this was just and equitable.  The Affidavits sworn by the petitioner and his co-shareholders disclosed that there had been bitter and unresolved quarrelling between the parties going to the root of the companies business but none of these stated that the company’s affairs had reached a deadlock.  It was however conceded by all the parties that as a result of the quarrelling the petitioner had been prevented from participating in the management of the company’s affairs.

 

The issue was it just and equitable to wind up the company?  Sir Ralph Windham C.J. said as follows:

“in these circumstances the principle which must be applied is that laid down in Re-Yenidge Tobacco namely that in the case of a small private company which is in fact more in the nature of a partnership a winding up on the just and equitable clause will be ordered in such circumstances as those in which an order for dissolution of the partnership would be made.  In that case the shareholders were two and they had quarreled irretrievably.  In the present case, if this were a partnership an order for its dissolution ought to be made at the instance of one of the quarrelling partners.  The material point is not which party is in the right but the very existence of the quarrel which has made it impossible for the company to be ran in the manner in which it was designed to be ran or for the parties disputes to be resolved in any other way than by winding up.”

 

Mitha Mohamed V. Mitha Ibrahim [1967] EA 575

4.                     Finally the just and equitable clause will also be applied where there is justifiable loss of confidence in the manner in which the company’s affairs are being conducted Continuous Cause of Conduct.

 

CONSEQUENCES OF A WINDING UP ORDER

Once a company goes into liquidation, all that remains to be done is to collect the company’s assets, pay its debts and distribute the balance to the members.

Under Section 224 of the Companies Act, in a winding up by the Court, any dealing with the company’s property after the commencement of the winding up is void except with the permission of the court.

The purpose is to freeze the corporate business in order to ensure that the company’s assets are not wasted.  Once the company has gone into liquidation, the directors become functus officio. 

Thereafter a liquidator is appointed whose duty is to collect the assets, pay the debts and distribute the surplus if any.  In so doing, he must always have regard to the interests of the creditors. 

The powers of the liquidator are set out in Section 241 of the companies Act.

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[1] (1910) 26 LQR 259 in his Article Law Quarterly review

 

[2] governed joint stock companies

[3] Andrews v Mockford

[4] Peek v Gurney

[5] In Erlanger v New Sombrero phosphate

 

[6] Kelner v Baxter

 

[7] Bowman v secular society limited

 

[8] Rama Corp v Proved Tin & General Investment (1952) 2 Q.B. 147

 

[9] Re South of England Natural Gas Co. (1911) 1 Ch. 573

 

[10] Hedley Byrne & Co. v. Heller & Partners (1974) A.C. 465 

[11] Selanger United Rubber Estates v. Craddock (1968) 1 All E.R. 567

 

 

[12] Brown v. British Abrasive Wheel Co. (1919) 1 Ch. 290

 

 

[13] National Provincial & Union Bank V. Charmley [1824] 1 KB 431

[14] Re C.L. Nye [1970] 3 AER 1061