The Wally Effect: The doctrine of Ultra Vires

In the nineteenth century it was impossible to change a company’s object clauses. This was modified somewhat in the twentieth century, but until 1989 the object clause could only be changed in very limited circumstances.

Historically, the doctrine of constructive notice could combine with the ultra vires doctrine to leave outsiders with unenforceable contracts.

There are various changes brought by the Companies Act 1985, Companies Act 1989 and Companies Act 2006.

You can download Companies Act 1985 here: https://www.legislation.gov.uk/ukpga/1985/6/pdfs/ukpga_19850006_en.pdf

You can download Companies Act 1989 here: http://www.legislation.gov.uk/ukpga/1989/40/pdfs/ukpga_19890040_en.pdf

You can download Companies Act 2006 here: http://www.legislation.gov.uk/ukpga/2006/46/pdfs/ukpga_20060046_en.pdf

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The ultra vires doctrine

Historically, a registered company is required to specify its objects in the memorandum of association. An object clause, which sets out the activities for which the company was formed, must be part of the MA. Any activity outside the objects was treated as ultra vires (outside the capacity of the company). The ultra vires was absolute, even if there is ratification, or the third party has acted in good faith. The contract would be null and void (Ashbury Rly Carriage v Riche (1875), HOL).

The ultra vires rule was further strengthened by the doctrine of constructive notice.

Under the doctrine of constructive notice, because the memorandum is a public document, any person dealing with the company was deemed to know its contents, including its object clause. Every outsider who wish to contract with the company, are presumed to know the capacity of the company. Hence, an argument that the third party has acted bona fide in contracting with the company and does not aware of its objects clause, is not justifiable.

Over the years, there have been attempts for the court in adopting creative interpretation of companies’ object clauses, in order to circumvent the harshness of the ultra vires doctrine.

For example, in AG v Great Eastern Railway (1880), the HOL outlined a very important broad interpretation of the powers that could be exercised in the pursuit of its objects. They considered a company could enter into transactions which were fairly regarded as incidental or consequential to its object clause.

Despite the great efforts by the courts, the issue is still left problem where the object could not strictly be achieved. This can be seen in the case of Re German Date Coffee Co (1882). Hence, it was generally accepted that only legislation could solve the problem in the long term.

In relation to the doctrine of constructive notice, the courts also have attempted to establish the indoor management rule in the case of Royal British Bank v Turquand (1856). Under the indoor management rule, the outsiders are entitled to assume that the internal procedures have been complied with. For instance, the question of authorization of the company’s staff to enter into a transaction in the name of the company is not question to be worried by the outsiders under the indoor management rule.

Companies Act 1985

Section 35 states that the ‘validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the company’s memorandum’.

In addition, section 8 has reduced the memorandum of association to a more limited function.

Companies Act 1989

Section 35A(1) states that ‘in favour of a person dealing with a company in good faith, the power of the board of directors to bind the company, or authorize others to do so, shall be deemed to be free of any limitation under the issue of internal authority’.

Section 35A(2) states that, for this purpose –

(a) A person ‘deals with’ a company if he is a party to any transaction or other act to which the company is a party;

(b) A person shall not be regarded as acting in good faith by reason only of his knowing that an act is beyond the powers of directors of the directors under the company’s constitution.

(c) A person shall be presumed to have acted in good faith unless the contrary is proved.

Section 35B states that ‘party to a transaction with the company is not bound to enquire as to whether it is permitted by the company’s memorandum or as to any limitation on the powers of the board directors to bind the company or authorize others to do so’.

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Companies Act 2006

Section 31(1) provides that all companies will have unlimited objects, unless a clause which expressly restricts a company’s objects is included in the AA.

The object clause exists before the commencement of CA 2006 will forms part of the company’s article (section 28(1)), unless the company choose to remove the objects clause under section 31(2).

Section 39(1) provides that ‘the validity of an act done by a company shall not be called into question on ground of lack of capacity by reason of anything in the company’s constitution’.

Section 40(1) states that ‘in favour of a person dealing with a company in good faith, the power of the directors to bind the company, or authorize others to do so, shall be deemed to be free of any limitation under the issue of internal authority’.

Section 40(2) states that, for this purpose –

(a) A person ‘deals with’ a company if he is a party to any transaction or other act to which the company is a party;

(b) A person dealing with a company –

(i) Is not bound to enquire as to any limitation on the powers of the directors to bind the company or authorize others to do so,

(ii) Is presumed to have acted in good faith unless the contrary is proved.

(iii) Is not to be regarded as acting in good faith by reason only of his knowing that an act is beyond the powers of directors of the directors under the company’s constitution.

The current law

Following section 31(1) of the Companies Act 2006, a company now need not have its object clause. The existing object clause will continue to take effect as the company’s article until the company chooses to remove it.

Section 35 of the Companies Act 1985, as well as section 39 and section 40 of the Companies Act 2006, became the saving provisions for outsiders in a situation where they have entered into a transaction with a company that is beyond the capacity of the company.

At this point, a question of internal authority has arises, namely who is entitled to enter into transaction on behalf of the company, and as a consequence, the outsiders are then entitled to relied on section 39(1) of the Companies Act 2006.

Following section 35B of the Companies Act 1989, as well as section 40(2)(b)(i) of the Companies Act 2006, the doctrine of constructive trust no longer stand. An outsider is now no longer to be presumed to have constructive notice of whether the company has the capacity to enter into the contract.

Section 35A(2) of the Companies Act 1989, as well as section 40(2) of the Companies Act 2006, have states several condition for an outsider who wishes to enforce the classical ultra vires type of contract.

It must be proved that:

(a) The outsider has acted in good faith

(b) There was dealing between the company and the outsider

A person is presumed to have acted in good faith unless the contrary is proved (section 40(2)(b)(ii)).

If he had actual knowledge that the director is acting ultra vires in dealing with him, he would not be regarded as acting in good faith (section 40(2)(b)(iii)).

Directors of the company to bind the company, or authorize others to do so, shall be deemed to be free from any limitation under the issue of internal authority (section 40(1)).

A person is deem to ‘deal with’ a company if he is a party to any transaction or other act to which the company is a party (section 40(2)).

Internal authority

Internal authority is not defined in Companies Act 2006. However common law considers director as the agent of the company, hence internal authority may rely on common law rule of agency.

According to the law of agency, a principal will be bound by a contract entered into by its agent if the agent acted within either:

(a) The actual scope of the authority given by the principal before the contract, or

(b) The apparent or ostensible scope of his authority.

The principal may also ratify a contract entered into without authority.

Apparent or ostensible authority arises where, rather than any actual authority being given, the board of directors or the general meeting allows someone to hold themselves out as having as such authority or allowing someone to hold themselves out as having a position in the company that would have such authority.

In Freeman & Lockyer v Buckhurst Park Properties Ltd (1964), a person who had never been appointed as managing director, was held to have ostensible authority to bind the company because the board had held out him as the managing director.

In Hely-Hutchinson v Brayhead Ltd and Richards (1968), the court found that a person who had acted as managing director but had never been formally appointed had implied actual authority to bind the company rather than ostensible authority.

The outsiders can also rely on the indoor management rule as established in the case of Royal British Bank v Turquand (1856). Under the indoor management rule, the outsiders are entitled to assume that the internal procedures have been complied with. For instance, the question of authorization of the company’s staff to enter into a transaction in the name of the company is not question to be worried by the outsiders under the indoor management rule. Outsiders are not expected to inquire into the internal proceedings of a company but can simply assume that these have been properly complied with.

The Turquand rule is subject to several exceptions:

(a) Where the article expressly states that the directors had no authority to enter into the transaction on behalf of the company in question.

(b) Where the transaction entered into by the directors in question required special resolution by the article, and there was in fact no special resolution (Irvine v Union Bank of Australia).

(c) Insiders, which are persons who by virtue of their position in the company, cannot rely on the rule (Howard v Patent Ivory Manufacturing). However a director of the company, was be treated as an outsider and therefore could rely on the rule, if he was acting as an individual rather than his capacity as director of the company (Hely-Hutchison v Brayhead Ltd and Richards).

(d) Where the outsider has made an enquiry as to whether the transaction was ultra vires, he cannot rely on the rule (Liggett (Liverpool) Ltd v Barclays Bank).

(e) Where the person acting on behalf of the company, is authorized by a document which is a forgery, for instance the company secretary has forged the directors’ signatures and had affixed the company’s seal without authority (Ruben v Great Fingall Consolidated).

Effect of the rule

The contract contradicting an existing object clause can be enforced by the outsider if the conditions are met.

An existing object clause forms part of the company’s article (section 28(1)). As such, it may give rise to an action between the members inter se.

Vicarious liability in tort

A company can be vicariously liable in tort for the acts of its employees, even though they may not be specifically authorized to carry out the act that leads to the tort but are nevertheless acting within the scope of their employment (Campbell v Paddington).

The company is vicariously liable even though there was no fault on the part of the company. The company is simply legally responsible for the acts of its employee.

You can read the majority rule and overview of shareholder's remedies here: http://thewallyeffect.blogspot.my/2017/10/the-majority-rule-and-shareholders.html

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Please read the disclaimer (at the top of the page) before proceeding.

Please do not take this note as the sole and only sources to study. It is only a guidance which may assist you in drawing out the full picture of the particular area of law. It is never meant to be a comprehensive text.

Feel free to comment if you find any mistakes, or if you have anything to share.

The Wally Effect

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The doctrine of Ultra Vires

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