[Guest post by Naman Kamdar, a 5th year BA LLB student at National Law University Odisha]
The Companies (Amendment) Bill, 2017 was introduced in Parliament to usher in more changes to the recently amended Companies Act, 2013 (the “Act of 2013”). The Bill seeks to make substantial changes in the pattern of trade and commerce in the country by liberalizing the procedures and requirements for running a company. Among the proposed reforms, one proposal was to do away with the need for an ‘object clause’ in the Memorandum of Association (MOA). This post investigates the reasons behind this proposed amendment and the pros and cons of such an amendment.
Section 4(1)(c) of Act of 2013 lays down a requirement of including an object clause in the MOA which states the objectives behind the incorporation of a company and mandates every MOA to state “the objects for which the company is proposed to be incorporated and any matter considered necessary in furtherance thereof”. This was a departure from section 13(d) of the Companies Act, 1956 (the “Act of 1956”) which provided that every company should separately provide for ‘main’ and ‘other’ objects.[1]
The actions undertaken by any company are required to be within bounds of its object clause and any action beyond its realms is to be considered ultra vires, a principle established in the case of Ashbury Railway Carriage & Iron Company Ltd. v. Riche.[2] However, such ultra vires act is different from an illegal act.
For example, an act performed by a company may be legal and done for the purpose of carrying out an otherwise bona fide transaction, but may be ultra vires its MOA owing to an ill-drafted object clause which does not cover within its ambit the power to carry out such activity. In such cases, the burden is shifted on to the courts to determine whether the action concerned is incidental to or consequential upon the object clause, and thereby leaving the possibility of treating the transaction as intra vires.[3]
Ultra vires acts largely impact the third parties/outsiders dealing with the company who enter into contracts without thoroughly reviewing the objects and determining whether the actions concerned are within the bounds of company’s objectives. Under conditions where the company exceeds its objects, they are neither able to sue the company for breach of contract nor seek specific performance. Such actions undertaken ultra vires the objects were considered void, as laid down in Ashbury Railway Carriage. Thus, the only actions which a company could have undertaken are those within the ambit of objects clause; ones which could be incidental to or consequential upon such clause; the actions essential in the fulfillment of the objects so stated; or the actions otherwise authorized to be done by the Companies Act, in the course of its business.
An argument which attempted to negate the allegation of an ultra vires agreement was that of constructive notice, which states that since outsiders/third parties had access to the MOA which contained the object clause, they would be deemed to have knowledge about extent of company’s ability to enter into transactions. But, the interplay between the ultra vires and constructive notice doctrines has not been an easy one to deal with, especially for courts.
The detrimental impacts of dealings, on third parties, which were otherwise bona fide but ultra vires the object clause, were identified and addressed in section 31(1) of the (English) Companies Act of 2006. The provision states that unless the articles of company specifically restrict the objects of a company, its objects are unrestricted. A similar approach is followed in section 23 of the Singapore Companies Act.
Likewise, the Companies (Amendment) Bill, 2016 in India (as introduced in its original form) sought to do away with the requirement of having a specific object clause. By introducing amendments to section 4(1)(c) of the Act of 2013, it extended an option to the company to either merely mention that it will engage in lawful activities or choose to enumerate specific objects in detail. However, by way of a proviso, it was stated that if a company chose to lay down specific objects, it won’t be permitted to engage in activities ultra vires such ambit.
The amendment sought to grant maximum autonomy to persons controlling the affairs of the company to enter into any transaction unhindered and un-impacted by any ill-drafted clauses in the MOA. But the transactions entered into were subject to laws in force and hence the transactions could still be challenged and be vitiated by applicable laws. Thus, the defence that transactions carried out beyond object clause being void and not binding upon the company was relinquished the moment a company decided not to have an object clause. It was beneficial for third parties since any breach of contract or fraudulent transactions could be brought before the court for redressal, without having the burden to prove the vires of transaction.
However, it was not clear what the drafters tried to achieve through the proviso to section 4(1)© as proposed in the Companies (Amendment) Bill, 2016. It merely allowed the company to proceed with the traditional approach of laying down an exhaustive object clause. It did not in any way unburden the court of the need to decide on basis of factual analysis whether certain action would be incidental or consequential to what has been expressly mentioned in the clause.
Due to the mandate of having a detailed object clause, the practice of drafting the object clause as widely as possible had developed, and which was in direct correlation to obviating the necessity to seek consent of general meeting by special resolution whenever any new venture was contemplated. The proposed clause in the Bill would have given unlimited power in the hands of persons controlling the company to enter into any possible transaction as deemed correct without having the need to amend the clause or to seek consent from other stakeholders from time to time.
But, this had its flip side too. With such unrestrictive clauses, the shareholders would be required to keep adequate check on the exercise of such power by adding appropriate internal control clauses and distributing powers proportionately. One of the reasons which Daphtary Sastri Committee gave for having a detailed object clause was to give all the stakeholders (shareholders and other interested parties) a clear idea of what the objects were. With such liberal position, there was higher possibility of their rights being impaired without the presence of adequate checks and balance.
Further, the concern about establishment of bogus entities was raised by the Parliamentary Standing Committee on Finance in its 37th Report that considered the provisions of the Companies (Amendment) Bill, 2016,[4] and removal of such blanket exemption was suggested. The Committee found that the reduction of object clause to a mere redundant provision in the Memorandum as “too far-fetched.” The Committee argued that a well stated object clause instilled confidence amongst the investors and creditors of the company. The suggestion was accepted in the amendments to the bill circulated on April 5, 2017 and the status quo was restored by removing the proposed amendment in the Companies (Amendment) Bill, 2017 as passed by Lok Sabha on July 27, 2017.
However, it is argued that such practice of detailed clauses would entail an addition of only those objects and powers that the ingenuity of drafters could dream up. In 1945, the Cohen Committee in UK attempted to reform the concept of object clause and ultra vires actions and recommended “a company to have all powers attributed to a natural person.” Though not accepted in statute, a complete removal of the object clause was also recommended in the Prenctice Report[5] in 1986. In 1998, the Company Law Review considered the removal of object clause requirement as a bid to promote “straightforward, cost-effective and fair” corporate law system.[6] Thus, the attempt has always been to provide greater flexibility in carrying out business.
It is indeed an issue that bogus companies might crop up, but having such unrestricted power also empowers the third parties to drag every such company to court for every fraudulent transactions entered into or otherwise to enforce their contractual rights and remedies without having to show the vires of the transaction. Thus, the Parliament could have safely watered down the requirement for an elaborate object clause.
– Naman Kamdar
[1] Section 13(d) was amended through the Companies (Amendment) Act, 1965. The changes were in line with the suggestions of Daphtary Sastri Committee.
[2] (1875) LR 7 HL 653
[3] Gujarat Mining & Manufacturing Co. v. Motilal HS Weaving Co., AIR 1930 Bom 84
[4] Standing Committee on Finance, 16th Lok Sabha, 37th Report, p. 58, pp. 3.31
[5] The Reform of “Ultra Vires Rule: A Consultative Document”.
[6] Modern Company Law for a Competitive Economy: Final Report, 2001.