Articles of Association
Articles of association is the second document which has, in the case of some companies, to be registered along with the memorandum. Companies which must have articles of association are :
- Unlimited companies.
- Companies limited by guarantee, and
- Private companies limited by shares.
This document contains rules, regulations and bye-laws for the general management of the company. Schedule I of the Companies Act, 1956, contains various model forms of memoranda and articles. The Schedule is divided into several Tables. Each table serves as a model for one kind of company. A company limited by shares may either frame its own set of articles or may adopt all or any of the regulations contained in Table A. But if does not register any articles, Table A applies, in so far as its regulations are not excluded. The chief advantage of adopting Table A is that its provisions are legal beyond all doubt.
Form and signature of articles (Section 30)
If articles are proposed to be registered they must be printed. They should be divided into paragraphs, each consisting generally of one regulation and numbered consecutively. Each subscriber of the memorandum has to sign the document in the presence of one attesting witness, both of them adding their addresses and occupation..
Contents of articles
Articles of association may prescribe such regulations for the company as the subscribers to the memorandum deem expedient. The Act gives the subscribers a free hand. Any stipulations as to the relations between the company and its members, and between members inter se may be inserted in the articles. But everything stated therein is subject to the Companies Act. The document must not conflict with the provisions of the Act. Any clause which is contrary to the provisions of the Act or of any other law for the time being in force, is simply inoperative and void. Section 439 of the Companies Act, for example, confers the right on a shareholder to petition for the winding up of the company in certain circumstances. This cannot be excluded or limited by the articles. Similarly, the articles cannot sanction something which is forbidden by the Act. Section 205, for example, declares that no dividend shall be paid by a company except out of profits. The force of this section cannot be undone by any provision in the articles of association.
Articles in relation to Memorandum
Articles have always been held subordinate to the memorandum. If, therefore, the memorandum and articles are inconsistent, the articles must give way. In other words, articles must not contain anything the effect of which is to alter a condition contained in the memorandum or which is contrary to its provisions. “This is so because the object of the memorandum is to state the purpose for which the company has been established, while the articles provide the manner in which the comp[any is to be carried and its proceedings disposed of.”
That constitutes the difference between the documents.
In the words of LORD CAIRNS, the difference is thus :
The memorandum is, as it were, the area beyond which the action of the company cannot go ; inside that area the shareholders may make such regulations for their own government as they think fit.
In the words of Lord Bowen L.J. :
There is an essential difference between the memorandum and the articles. The memorandum contains the fundamental conditions upon which alone the company is allowed to be incorporate. They are conditions introduced for the benefit of the creditors, and the outside public, as well as of the shareholders. The articles of association are the internal regulation of the company.
Some of the conditions of incorporation contained in the memorandum cannot be altered except with the sanction of the Company Law Board. Articles of association, on the other hand , can be altered simply by a special resolution.
Binding force of Memorandum and Articles
Section 36 declares :
Subject to the provisions of this Act, the memorandum and articles shall, when registered, bind the company and the members thereof to the same extent as if they respectively had been signed by the company and by each member, and contained covenants on its and his part to observe all the provisions of the memorandum and of the articles.
The section aims to impart contractual force to the memorandum and articles. It is only the exact limits of that effect and the persons it is intended to cover that are in controversy. The law may be stated in terms of the following propositions :
- Binding on Members in their relation to the Company
In the first place, the members are bound to the company by the provisions of the articles “just as much as if they had all put their seals to them.” And had thus contracted to0 conform to them. In the words of LORD HERSCHELL : “It is quite true that the articles constitute a contract between each member and the company.”
In Barland’s Trustee Vs. Steel Brothers & Co. Ltd. (1901)
The articles of association of the defendant company contained clauses to the effect that on the bankruptcy of a member his shares would be sold to a person and at a price fixed by the directors. B, a shareholder, was adjudicated bankrupt. His trustee in bankruptcy claimed that he was not bound by these provisions and should be at liberty to sell the shares at their true value. But it was held that “contracts contained in the articles of association is one of the original incidents of the shares. Shares having purchased on those terms and conditions, it is impossible to say that those terms and conditions are not to be observed.
- Binding on Company in its relation to members
Secondly, just as members are bound to the company, so also the company is bound to the members to observe and follow the articles. “Each member is entitled to say that there shall be no breach of the articles and he is entitled to an injunction to prevent the breach. This is clear from the section itself which says that “the memorandum and articles shall bind the company.” In Wood Vs. Odessa Waterworks Co. (1889
The articles of the Waterworks Co., provided that ‘the directors may, withy the sanction of the company at general meeting, declare a dividend to be paid to the members’. Instead of paying the dividend in cash to the shareholders a resolution was passed to give them debenture bonds. In an action by a member to restrain the directors from acting on the resolution, Stirling , J, held : “The question is whether that which is proposed to be done in the present case is in accordance with the articles of association of the company. Those articles that the directors may, with the sanction of a general meeting, declare a dividend to be paid to shareholders. Prima facie that means to be paid in cash. The debenture bonds proposed to be issued are not a payment in cash.” Accordingly the directors were restrained from acting on the resolution.
- But not in relation to Outsiders
Thus, the articles bind the members to the company and the company to the members. But neither of them is bound to an outsider to give effect to articles. “No article can constitute a contract between the company and a third person.” For example, in Browne Vs. La Trinidad (1887) :
The articles of association of a company contained a clause to the effect that B, should be a director and should not be removable till after 1888. He was, however, removed earlier and had brought an action to restrain the company from excluding him. It was held that there was no contract between B, and the company. No outsider can enforce articles against the company even if they purport to give him certain rights
Who is an Outsider. ?
Who is an outsider for this purpose ? The expression naturally means a person who is not a member. But even a member may be an outsider. Section 36 creates an obligation binding on the company in its dealings with the ‘members’, but the word ‘members’ in this section means members in their capacity as members, that is, excluding any relationship which does not flow from the membership itself. Eley Vs. Positive Government Security Life Ass.
The articles of a company contained a clause that the plaintiff (Eley) should be the solicitor to the company and should not be removed from his office unless for misconduct. He was a member also. He acted as a solicitor to the company for some time, but ultimately the company substituted other solicitors for him. He brought an action against the company for breach of the contract in not employing him as a solicitor on the terms of the articles. His action was dismissed. Even a member cannot enforce the provisions of articles for his benefit in some other capacity than that of a member.
“The purpose of the memorandum of association and articles is to define the position of the shareholder as a shareholder, not to bind him in his capacity as individual.”
Articles do not themselves form a contract, but from them you get the terms upon which the director is serving. Following these principles the Lahore High Court held is a case before it that :
Where in pursuance of certain art6icles acted upon by the company, a member was appointed managing director and acted for eleven years in that capacity, the articles constitute an implied contact between the member and the company. If the company removes him from office, he would be entitled to damages for the breach (Sardar Gulab Singh Vs. Punjab Zamindara Bank Ltd., 1942)
4. How far binding between Members
Lastly how far do the articles bind one member to another. Unfortunately, on this point the law has yet to take a final shape. The Companies Act does not purport to settle the rights of members inter se., It leaves these to be determined by the articles. Hence articles define the rights and liabilities of members. But whether these rights and liabilities can be enforced by one member against another is the moot question. LORD HERSCHELL said in Welton Vs. Saffery (1897) : “It is quite true that articles constitute a contract between each member and the company, and that there is no contract in terms between individual members of the company ; but the articles do not any the less regulate their rights inter se. Such rights can only be enforced by or against a member through the company” “Memorandum and articles did not constitute a contract between the members inter se, although they regulated their rights which could be enforced through the company and that they only regulated the rights which could be enforced through the company and that they only regulated the rights of the members qua members for the purposes of the company law.”
Thus in a case before the Calcutta High Court , a member of a company who had a commercial dispute of private nature with another member could not be compelled to refer the dispute to arbitration in terms of the company’s articles. The court said : “Articles do not affect or regulate the rights arising out of a commercial contract with which the members have no concern, rights completely outside the company relationship.”
ALTERATION OF ARTICLES
Every company has a clear power to alter its articles of association by a special resolution. It is a statutory power given by section 31, and therefore, it cannot be negatived by contract. If, for example, there is a clause in the articles providing that the company would not introduce any change in its original articles, it will be invalid on the ground that that it is contrary to the statue.
Similarly, a company cannot deprive itself of the power of alternation by a contract with any one
The altered articles will bind the members just in the same way as did the original articles.
The power of alteration of articles as conferred by section 31 is almost absolute. It is subject only to two restrictions. In the first place, alteration must not be in contravention of the provisions of the Act. It should not be an attempt to do something which the Act forbids. Secondly, the power of alteration of articles is subject to the conditions contained in the memorandum of association.
Alteration against Memorandum
Sometimes a change in the articles seems apparently to influence the memorandum. To take, for example, Hutton Vs. Scarborough Cliff Hotel Co. Ltd. (1865)
A resolution passed at a general meeting of a company altered the articles of association by inserting the power to issue new shares with preferential dividend. No such power existed in the memorandum. The alteration was held to be inoperative. The issuing of new shares with a preference dividend was considered to be a variation of the constitution of the company as fixed by the memorandum. “The question is”, said the Vice-Chancellor, “whether the power given to the general meeting, by special resolution to modify the regulations of the company is unlimited : clearly there must be some limit to the power ; otherwise they might alter not only such articles as relate to the management of the company, but they might alter the very nature and constitution of the company.”
It must be noted that the noted that the memorandum was silent. It neither authorised not prohibited the issue of preference shares. But the court inferred from its silence that it intended equality of status of all the shareholders. But now the courts refuse to draw this inference. The power of alteration of articles is subject only to what is clearly prohibited by the memorandum, expressly or impliedly. This change was marked by Andrews Vs. Gas Metro Co. Ltd. (1897)
By the 5th clause of a company’s memorandum it was stated that the nominal capital of the company was £60,000 divided into 600 shares of £100 each. Neither in the memorandum nor in the original articles was there any provision as to preference shares. A special resolution was passed authorising the directors to issue shares bearing a preferential dividend, which was accordingly done.
It was held that the issue was valid. “If this had been forbidden by the memorandum, it could not have been done : but as ir was not ; it was immaterial that the change quite altered the composition of the company
Alteration in Breach of Contract
Sometimes an alteration of articles may operate as a breach of contract with an outsider. To take, for instance, a
done ? The answer depends upon the nature of the contract. If the contract is wholly dependent upon the provisions of the articles, as it was in this case, the alteration would naturally be operative. Articles are subject to the statutory power of alteration. Any one accepting an appointment purely on the terms of the articles takes the risk of those terms being altered.
But where apart from the articles, the company has entered into an independent agreement, the company may, of course, by altering articles, repudiate that contract but will be answerable in damages for the breach. “A company cannot, by altering articles, justify a breach of contract.” Southern Foundries Ltd. Vs. Shirlaw (1940) is the leading authority :
The plaintiff was a director in the defendant company. In 1933 he was appointed as a managing director for a term of ten years. In 1935 the defendant company was amalgamated with another company and new articles were adopted under which powers were taken to dismiss a director. It was further provided that a managing director’s appointment would be subject to determination, ipso facto, if he ceased to be a director. Under these articles the plaintiff was removed from the office of director. He sued for the wrongful repudiation of the contract. It was held that the agreement was unqualified in regard to the term of ten years. The removal was, therefore, a breach of the agreement for which the employer must answer in damages.
The court may even restrain an alteration where it is likely to cause a damage which cannot be adequately compensated in terms of money.
In a case before the Calcutta Hindustan Ins. Society 1925 ,
The plaintiff had taken out a policy of life insurance in the defendant company. He was entitled under the contract to draw from the company a certain sum on a certain date. The company altered its articles by which sums were made payable out of a special fund. At the time the amount became payable to the assured, the fund was insolvent. The plaintiff sued for his payment under the original contract.
It was held “the effect of the alteration of the articles was that it involved a fundamental breach of contract which the company had previously entered into with the plaintiff and in respect of that contract the (new) article was inapplicable.”
An alteration cannot require a member to purchase more shares or increase his liability in any way except with his consent in writing.
Lastly, the alteration must not constitute a “fraud on the minority.”
CONSTRUCTIVE NOTICE OF MEMORANDUM AND ARTICLES OF ASSOCIATION
The memorandum and articles of association of every company are registered with the registrar of companies. The office of the Registrar is a public office and consequently the memorandum and ar6ticles become public documents. They are open accessible to all. It is, therefore the duty of every person dealing with a company to inspect its public documents and make sure that his contract is in conformity with their provisions. But whether a person actually reads them or not, “he is to be in the same position as if he had read them. ”He will be presumed to know the contents of those documents. This kind of presumed notice is called constructive notice. Kotla Venkata Swami Vs. Ram Murthi (1934) shows the practical effect of this rule.
The articles of association of a company required that all deeds etc., should be signed by the managing director on behalf of the Company. The plaintiff accepted a deed of mortgage executed by the secretary and a working director only. It was held that the plaintiff could not claim under this deed. The court observed : “If the plaintiff had consulted the articles she would have discovered that a deed such as such as she took required execution by three specified officers of the company and she would have refrained from accepting a deed inadequate signed. Notwithstanding, therefore, she may have acted in good faith and her money may have been applied to the purposes of the company, the bond is nevertheless invalid.”
Another effect of this rule is that a person dealing with the company is “taken not only to have read those documents but to have understood them according to their proper meaning.”
He is presumed to have understood not merely the company’s powers but also those of its officers. Further, there is constructive notice not merely of the memorandum and articles, but also of all the documents, such as special resolutions and particulars of charges which are required by the Act to be registered with the Registrar.
Constructive notice is more or less an unreal doctrine. It does not take note of the articles of business life. People know the company through its officers and not through its documents. The courts in India also do not seem to have taken it seriously. For example, in Dehra Dun Mussoorie Electic Tramway Co. Vs. Jagmandardas (1932), the articles of a company expressly provided that the directors could delegate all their powers except the power to borrow. Even so an overdraft taken by the managing agent without approval of the Board was held to be binding, the court saying that such temporary loans must be kept outside the purview of the relevant provisions.
Similarly, the Calcutta High Court enforced a security which was not signed in accordance with the company’s articles.
THE DOCTRINE OF INDOOR MANAGEMENT
The role of the doctrine of indoor management is opposed to9 the principle of constructive notice. The latter seeks to protect the company against the outsiders, the former operates to protect the outsiders against the company. The rule of constructive notice is confined to the external position of the company and, therefore, it follows that there is no notice as to how the company’s internal machinery is handled by its officers. If the contract is consistent with the public documents, the person contracting will not be prejudiced by irregularities that may beset the indoor work of thee company. The rule had its genesis in Royal British Bank Vs. Turquand (1865)
The directors of a company borrowed a sum of money from the plaintiff. The company’s articles provided that the directors might borrow on bonds such sums as may from time to time be authorised by a resolution passed at a general meeting of the company. The shareholders claimed that there had been no such resolution authorising the loan and, therefore, it was taken without their authority. The company was, however, held bound by the loan. Once it was found that the directors could borrow subject to a resolution, the plaintiff had the right to infer that the necessary resolution must have been passed.
In Pacific Coast Coal Mines Ltd. Vs. Arbuthnot (1917), the rule is thus stated “ If the directors have the powers and authority to bind the company, but certain preliminaries are required to be gone through on the part of the company before that power can be duly exercised, then the person contracti8ng w3ith the directors is not bound to see that all preliminaries have been observed. He is entitled to presume that the directors are acting lawfully in what they do.”
The rule is based upon obvious reasons of convenience and justice. Firstly, the memorandum and articles of association are public documents, open to the public inspection. But the details of internal procedure are not thus open to public inspection. Hence an outsider “is presumed to know the constitution of a company ; but not what may or may not have taken place within the doors that are closed to him.” The wheel of commerce would not go round smoothly if persons dealing with companies were compelled ,to investigate thoroughly “the internal machinery of a company to see if something is not wrong.” People in business would be very shy in dealing with such companies.
The rule is of great practical utility. It has been applied in a great variety of cases to9 secure justice. It has been used to cover acts done on behalf of a company by de facto directors who have never been appointed, or whose appointment is defective, or who, having been regularly appointed, have exercised an authority which could have been delegated, or who have exercised an authority without proper quorum. Thus, where the directors of a company having the power to allot shares only with the consent of general meeting allotted them without any such consent ; where the managing director of a company granted a lease of the company’s properties, something which he could do only with the approval of the board ; where the managing agent having the power to borrow with the approval of directors borrowed without any such approval, the company was held liable.
EXCEPTIONS
The rule is now more than a century old. In view of the fact that companies having come to occupy the central position in the social and economic life of the modern communities, it was expected ,that its scope would be widened. But the course of decisions has made it subject to the following exceptions :
1. Knowledge of Irregularity.
The first and the most obvious restrictions is that the rule has no application where the party affected by an irregularity had actual notice of it. “Thus where a transfer of shares was approved by two directors, one of whom within the knowledge of the transferor was disqualified by reason of being transferee himself and the other was never validly appointed, the transfer was held to be ineffective.
Knowledge of an irregularity may arise from the fact that the person contracting was himself a party to the inside procedure. In Howard Vs. Patent Ivory Manufacturing Co. (1888), for example, the directors could not defend the issue of debentures to themselves because they should have known that the extent to which they were lending money to the company required the assent of the general meeting which they had not obtained. Similarly, in Morris Vs. Kansren (1946) a director could not defend an allotment of shares to him as he participated in the meeting which made the allotment. His appointment as a director fell through because none of the directors appointing him was validly in office. The trend of decisions has been slightly altered by Hely Hutchinson
But apart from this, the principle is clear that a person who is himself a part of the internal machinery cannot take advantage of irregularities. Any other rule would “encourage ignorance and condone dereliction from Duty”
2. Suspicion of Irregularity
The protection of “the Turquand rule” is also not available where the circumstances surrounding the contract are suspicious and, therefore, invite inquiry.
Suspicion should arise, for example, from the fact that an officer is purporting to act in a manner which is apparently outside the scope of his authority. Where, for example, the plaintiff accepted a transfer of a company’s property from its accountant, the transfer was held void. The plaintiff could not have supposed, in the absence of a power of attorney, that the accountant had authority to effect transfer of the company’s property.
3. Forgery
Forgery may in circumstances exclude the Turquand rule. The only clear illustration is Ruben Vs. Fingall Consolidated (1906)
The plaintiff was the transferee of a share certificate issued under the seal of the defendant company. The certificate was issued by the company’s secretary, who had affixed the seal of the company and forged the signatures of two directors.
The plaintiff contended that whether the signatures were genuine or forged was a part of the internal management and, therefore, company should be estopped from denying genuineness of the document. But it was held that the rule has never been extended to cover such a complete forgery. LORD LOREBURN said : “ It is quite true that person dealing with limited liability companies are not bound to inquire into indoor management and will not be affected by irregularities of which they have no notice. But this doctrine, which is well established applies to irregularities which otherwise might affect a genuine transaction. It cannot apply to a forgery.”
This statement has been regarded a dictum, as the case was decided on the principle that the secretary did not have actual or implied authority to represent that a forged document was a genuine and, therefore, there was no estoppel against the company. Hence, a general statement that the “turquand rule”. does not apply to forgeries is not exactly warranted by the present authorities.
In a case before the Madras High Court, a document on which a company borrowed a sum of money was executed by the managing director who was the chief functionary of the company and, to comply with the requirements of the articles, the signatures of the two other directors were forged, the company was not allowed to eschew liability under the document. (Official Liquidator Vs. Commr. of Police, 1969 ) The has held “ We hold the company liable as a matter of social and economic policy. The basis of liability is eminently practical view that if authority is conditioned on facts peculiarly within the agent’s knowledge, his representation express or implied should bind the principal.”
4. Knowledge of Articles
This exception deals with the most controversial and highly confusing aspects of the “Turquand rule”. Articles of association generally contain what is called the “power of delegation”. Lakshmi Rattan Lal Cotton Mills Vs. J.K. Jute Mills Co. (1957) explain the meaning and effect of “delegation clause”.
One G was a director of a company. The company had managing agents of which also G was a director. Articles authorised directors to borrow money and also empowered them to delegate this power to any or more of them. G borrowed a sum of money from the plaintiffs. The company refused to be bound by the loan on the ground that there was no resolution of the board delegating the power to borrow to G. Yet the company was held bound by the loan. “Even supposing that there was no actual resolution authorising G to enter into the transaction, the plaintiff could assume that a power which could have been delegated under the articles must have been actually conferred. The actual delegation being a matter of internal management, the plaintiff was not bound to enter into that.
Thus the effect of a “delegation clause”, is “that a person who contracts with an individual director of a company, knowingly that the board has power to delegate its authority to such an individual, may assume that the power of delegation has been exercised.”
But now suppose that the plaintiff when he contracted with an individual director had not consulted the company’s articles and, therefore, had no knowledge of the existence of the power of delegation. Could he assume that the power of which he did not know at the time had been exercised ? This question arose in Houghton & Co. Vs. Nothard, Lowe and Wills Ltd. (1927)
The defendant company and one P & Co. were engaged in fruit trade. One M.L. was a director of both companies. By the articles of the defendant company the directors could “delegate any6 of their powers to committees consisting of such member or members of their body as they think fit”. M.L. acting on behalf of the defendant company, contracted with the plaintiffs, a firm of fruit brokers, that in consideration of the plaintiffs advancing a sum of money to P. & Co., the plaintiff should have the right to sell on commission all the fruit imported by the defendants and P & Co. and to retain the sale proceeds belonging to both companies as security for the advance. The plaintiffs required the confirmation of the agreement by the defendant company itself. The secretary of the defendant co. accordingly wrote a letter a letter confirming the agreement and then the plaintiffs made the advance. The defendants subsequently repudiated the agreement as made without their authority. In an action for the breach of the agreement, the plaintiffs claimed that the M. L. or the secretary had ostensible authority as the board could have delegated their powers to them under the company’s articles.
But it was held that the plaintiffs were not entitled to assume that any authority to make the contract had been delegated to them by the board, and for the following reasons ; Firstly, that “the plaintiff are not entitled to rely on the supposed exercise of a power which was never in fact exercised and of the existence of which they were in ignorance at the date when they contracted, and secondly,
that there was something so unusual in an agreement to apply the money of one company in payment of the debts of another that the plaintiffs were put upon inquiry to ascertain whether the persons making the contract had any authority in fact to make it.”
5. Acts outside apparent authority
Lastly, if the act of an officer of a company is one which would ordinarily be beyond the powers of such an officer, the plaintiff cannot claim the protection of “Tarquand rule” simply because under the articles power to do the act could have been delegated to him. In such a case the plaintiff cannot sue the company unless the power has, in fact, been delegated to the officer with whom he dealt. A clear illustration is Annand Bihiari Lal Vs. Dinshaw & Co. (1942)
The plaintiff accepted a transfer of a company’s property from its accountant. Since such a transaction is apparently beyond the scope of an accountant’s authority, it was void. Not even a ‘delegation clause’ in the articles could have validated it, unless he was, in fact, authorised.
The well known English authority is Kredit Bank Cassel Vs. Schenkers Ltd. (1927) The defendant company, by its memorandum, had power to draw and accept bills of exchange and, by its articles, the directors were empowered “to determine who shall be entitled to sign, draw, accept, etc. bills on company’s behalf.” The defendant’s business was that of forwarding agents. They had a branch at Manchester
It was held that having regard to his position, drawing of bills was not within the ostensible authority of this branch manager and, therefore, the company was not bound, unless it had given actual authority or was otherwise precluded from setting up the want of authority.
Prospectus
Statement in lieu of prospectus [S. 70]
One of the great advantages of promoting a company is that the necessary capital for business can be raised from the general public. This advantage is, however, enjoyed only by a public company. A private company is, by its very constitution, prohibited from inviting monetary participation of the public. Section 3 (3) (c). But even a public company need not necessarily go to the public for money. The promoters may be confident of obtaining the required capital through private contacts. In such case no prospectus need be issued to the public. The promoters are only required to prepare a draft prospectus containing the information required to be disclosed by Schedule III of the Act. This document is known as a statement in lieu of prospectus. A copy of it must be filed with the Registrar at least three days before any allotment of shares is made. This is intended to preserve an authoritative record of the terms and conditions of the capital issue. If the statement contains any misrepresentation the liability, civil and criminal, is the same as in the case of a prospectus.
Most companies have, however, to issue a public appeal for subscription. This involves the issue of prospectus. For no application for shares or debentures of a company can be invited unless the appeal is accompanied with a prospectus. Section 56(3)
Definition of Prospectus
Prospectus is defined by Section 2(36). “A Prospectus means any document described or issued as a prospectus and includes any notice, circular, advertisement or other document inviting deposits from the public or inviting offers from the public for the subscription or purchase of any shares in or debentures of a body corporate.” In essence, it means that a prospectus is an invitation issued to the public to take shares or debentures of the company or to deposit money with the company. Any advertisement offering to the public shares or debentures of the for sale is a prospectus. In a Calcutta
Some shares are still available for sale according to the terms of the prospectus of the company which can be obtained on application. This was held to be a prospectus as it invited the public to purchase shares. The directors were accordingly convicted under section 92(5) [now section 60(5) for not complying with the requirements of the Act.
Public Issue
The provisions of the Act relating to prospectus are not attracted unless the prospectus is issued. “issued” means issued to the public. What does or does not amount to an issue is a question of fact in each case and is not capable of exact definition. In Nash Vs. Lynde (1929) it was held that “the term ‘issue’ is not satisfied by a single private communication.”
The fact were that a document marked “strictly private and confidential.” But in form of a prospectus was prepared by the defendant, the managing director of a company. But the document did not contain all the material fact required by the Act to be disclosed. A copy of it alo9ng with application forms was sent to a solicitor who in turn sent it to the plaintiff.
It was held that this did not amount to an issue and accordingly the plaintiff’s action for compensation for loss sustained by reason of the omissions was dismissed. VISCOUNT SUMNER said :
It is difficult to think of a prospectus being issued without some measure of publicity, however modest …. Though literally it is true that the issue is not expressly said in the section to be an issue to the public, I think it must be so in substance, otherwise any private letter, written by a person engaged in forming a company and advising his correspondent to take shares … would become an issue an issued prospectus. ‘The public’ is of course a general world. No par5ticular numbers are prescribed. Anything from two to infinity may serve : perhaps even one, if he is intended to be the first of a series of subscribers, but makes further proceedings needless by himself subscribing the whole. The point is that the offer is such as to open to any one who brings his money and applies in due form, whether the prospectus was addressed to him on behalf of the company or not. A private communication is not thus open.
Thus the issue need not be made to the public as a whole. An advertisement among a group or a class of persons only would be an issue. Accordingly, where 3,000 copies of a document in form of a prospectus were sent out and distributed among the members of certain gas companies only, it was held to be an offer of shares to the public. Section 67(1) of the Act also provides that the term ‘public’ includes any section of the public, whether selected as members or debenture holders of the company concerned or as clients of the person issuing the prospectus or in any other manner.
In the following case, however, although shares are offered and application form issued, a prospectus containing all the details is not necessary:-
1. Where the offer is made in connection with a bona fide invitation to a person to enter into an underwriting agreement with respect to the shares or debentures.
2. Where the share or debentures are not offered to the public.
3. Where the offer is made only to the existing members or debenture holders of the company.
4. Where the shares or debentures offered are in all respects uniform with shares or debentures already issued and quoted on a recognised stock exchange.
5. Where a prospectus is issued as a newspaper advertisement, it is not necessary to specify the contents of the memorandum. Or the names etc. of the signatories to memorandum or the number of shares subscribed for by them.
Contents of Prospectus
“The investor wants a sound concern.” Prospectus is one of the means by which he is informed of the soundness of the company’s venture. That indeed is the basic function of the prospectus. But this fact also affords an opportunity to directors and promoters to impose a fraud on the public. “The Companies Act accordingly now contains a comprehensive set of regulations intended to protect the investing public from such victimisation.” The chief aim of the legislature in making these regulations, is “to secure the fullest disclosure of all material and essential particulars and lay the same in full view of all the intending purchasers of shares.” The relevant rules and regulations are briefly set out below :
1. Every prospectus to be dated [Section 55) Every prospectus has to be dated. This ensures a prima facie evidence of the date of its publication.
2. Every prospectus to be registered [Section 60] A copy of every prospectus has to be registered with the Registrar of Companies. This preserves an authoritative record of the terms and conditions of the capital issue. Registration must be made on or before the publication of the prospectus. The copy sent for r4egistration must be signed by every person who is named in the prospectus as a director or a proposed director of the company. The copy for registration must be accompanied with ;
(a) If a report of an expert is to be published, consent of the expert ;
(b) a copy of every contract relating to appointment and remuneration of managerial personnel ;
(c) a copy of every material contract, unless it is entered into in the ordinary course of business or two years before the date of the prospectus ;
(d) a written statement relating to the adjustments, if any, “as respects the figures of any profits or losses or assets or liabilities”, dealt with in any report set out in the prospectus in pursuance to part II of Schedule II. The statement should give reasons for the adjustments and should be signed by the expert ;
(e) the comments in writing of the person, if any, named in the prospectus as the auditor, legal advisor, attorney, solicitor, banker or broker of the company to act in that capacity.
The prospectus must be issued within 90 days of its registration. The company and every person who knowingly issues a prospectus without registration is punishable with fine which may extend to five thousand rupees. [section 60 (5) It must be stated on the face of the prospectus that it has been registered and that the requisite documents, giving names, have been filed. [Section 60 (2) (a) and (b)
3. Expert’s Consent [ Section 58]
If the prospectus includes a statement purporting to be made by an expert, a consent in writing of that expert must be obtained and this fact should be stated in the prospectus. The expert should not be one who is himself engaged or interested in the formation or management of the company. “This section enacts a wholesome rule intended to protect an intending investor by making the expert a party to the issue of the prospectus and making him liable for untrue statements.”
4. Disclosures to be made [Section 56]
Section 56 requires every prospectus to disclose the matters specified in Schedule II of the Act. The Schedule is divided into three parts. Part I contains matters to be specified. Part II, the reports to be set out, while Part III is explanatory of Parts I and II.
PART I
The following matters are to be disclosed in a prospects :
1. (a) The main objects of the company including the details about the signatories to the memorandum. This is, however, not necessary when the prospectus is published as a newspaper advertisement.
(b) The number and classes of shares. The interest of the shareholders in the property and profits of the company.
(c) The number of redeemable preference shares specifying the date or notice required for redemption.
2. Qualification shares of directors, if any.
3. a) Names, descriptions and addresses of directors, or proposed directors, managing directors, or manager.
(b) Contents of the articles or of any contract relating to their appointment, remuneration and compensation for loss of office.
4. Where shares are offered to the public, the minimum subscription, which means the minimum amount which in the opinion of the promoters must be raised to provide for the purchase price of any property purchased or to be purchased, preliminary expenses, undertaking commission, repayment of money borrowed for these purpose and working capital.
5. The time of the opening of the subscription list.
6. The amount payable on application and allotment. If any prospectus issued within two years, the details of the shares subscribed and allotted.
7. The particulars about any option or preferential right to be given to any person to subscribe for shares or debentures of the company.
8. The number of shares or debentures which within the two preceding years have been issued for a consideration other than cash.
9. Particular about premium received on shares within the two preceding years or to be received.
10. Where any issue of debentures or shares is underwritten, the names of the underwriters, and the opinion of the directors that the resources of the underwriters are sufficient to discharge their obligations.
11. Particular about vendors from whom any property has been or is to be acquired by the company and the price whereof is to be paid out of the proceeds of the issue.
12. The amount or rate of underwriting commission.
13. Preliminary expenses.
14. The amount paid within the last two years or to be paid to promoters of the company. The statement must include any other benefit given.
15. The date of and parties to any material contract unless it is made in the ordinary course of business or two years before the date of the prospectus.
16. The name and addresses of auditors, if any, of the company.
17. Full particulars about the interest, if any, of every director or promoter in the promotion of the company or in any property acquired by the company within two years of the date of prospectus or proposed to be acquired by the company.
18. Where the shares are of more than one class, the rights of voting and the rights as to capital and dividend attached to several classes of shares.
19. The restrictions, if any, imposed by articles on the right to attend, speak or vote at meetings of the company, on the right to transfer shares and upon the directors of the company in respect of their powers of the management.
20. The length of time during which the company has carried on business. If the company proposes to acquire a business which has been carried on for less than three years, the length of time during which the business has been carried on.
21. If any reserves or profits of the company have been capitalised, particulars of capitalisation and particulars of the surplus arising from any revaluation of the assets of the company.
22. A reasonable time and place at which copies of all accounts on which the report of the auditors is based may be inspected.
P A R T II
Following reports are to be set out in the prospectus :
1. A report by the auditors of the company relating to profits and losses and assets and liabilities of the company. Report must refer to the rates of dividends, if any, paid by the company in respect of each class of shares for each of the five financial years before the issue of the prospectus. The report of the auditors must also state separately the profits and losses of the company’s subsidiaries and also combined profits and losses.
2. If the company proposes to acquire any business, a report should be made by an accountant, whose name should be disclosed, upon the profits and losses of the business for five years before the date of the prospectus and assets and liabilities of the business.
Issuing Houses and Deemed Prospectus [S. 64]
The requirements show that “provisions relating to prospectus are most stringent and the duty of preparing and filing it in accordance with the law is extremely onerous.” But these onerous requirements were often evaded by companies in this way. The whole of the capital was allotted to an intermediary known as an “issuing house”. The “House” then offered the shares to the public by means of an advertisement of its own, which was obviously not a prospectus and then the requirement of the Act relating to prospectus was evaded. But now every such advertisement sponsored by an “issuing House” is known as an “offer for sale” and is deemed to be a prospectus issued by the company. The responsibility of the company, its directors and promoters is, therefore, the same. In addition, the “Issuing House” incurs its own liability.
Now, how it is to be known whether an agreement to allot shares to an “issuing House” is intended for the shares to be offered to the public. Apart from the express provisions of the agreement, the Act provides in Section 64(2) that the intention to offer shares to the public shall be presumed in the following cases :
1. Where the “Issuing House “ offers the shares to the public for sale within six months after they were allotted or agreed to be allotted to the House ; or
2. Where at the date of offer to the public, the whole of the consideration to be received by the company in respect of shares has not been received.
The prospectus issued by an “Issuing House” shall state the following further particulars :
1. The net amount of consideration to be received by the company in respect of those shares, and
2. The place and time at which the relevant contracts may be inspected.
5. Golden rule
Above all the golden rule as to the framing of prospectus must be observed. The rule was laid down by KINDERSELY V C in New Brunswick Co. Vs. Muggeridge (1860) and was described as a “golden legacy” by PAGE V C in Henderson
Those who issue a prospectus hold out to the public great advantages which will accrue to the persons who will take shares in the proposed undertaking. Public is invited to take shares on the faith of representations contained in the prospectus. The public is at the mercy of company promoters. Everything must be stated as a fact which is not so and no fact should be omitted the existence of which might in any degree affect the nature or quality of the privileges and advantages which the prospectus holds out as inducements to take shares. In a word, the true nature of the company’s venture should be disclosed.
This golden legacy has condensed in few words the whole doctrine as to the rule of conduct between shareholders and the directors.
REMEDIES FOR MISREPRESENTATION
These stringent provisions have proved to be very useful. As a result litigation on this subject has already declined. The fear of heavy liability and of criminal sanctions has controlled the directors’ tendency of “using extravagant terms and flattering descriptions.” The law allows the following remedies for misrepresentation in a prospectus.
1. Damages for Deceit
Deceit is a tort. It means fraud. Any one who has been induced to invest money in a company by a fraudulent statement in a prospectus can sue the persons responsible for issuing it. If his action is successful he recovers full compensation for the loss sustained by him directly as a result of the fraud. But the burden of proof lies on him to establish the following main points of the action.
In the first place, the plaintiff must prove that there was a fraudulent misstatement. “To support an action of deceit”, said LORD HERSCHELL, “fraud must be proved and nothing less than fraud will do. Fraud must be proved when it is shown that a false representation has been made –
(a) knowingly, or
(b) without belief in its truth, or
(c) recklessly, carelessly whether it be false or true.”
In other words, if the directors publish a statement with knowledge that it is false or without any knowledge whether it is true or false, it is a fraud. “Fraud may be committed by reckless representations without knowing how the matter stands one way or other.” Section 17 of the Indian Contract Act, defines “fraud” as including, among other things, the suggestion that a fact is true when it is not so and the person making the suggestion does not believe it to be true or active concealment of a fact. These definitions show that if the person making the statement honestly believes it, he is not guilty of fraud, even if the statement is not true. Derry Vs. Peek (1889) involved a situation of this kind.
A special Act incorporating a tramway company provided that carriages might be moved by animal power and, with the consent of the Board of Trade, by steam power. The directors issued a prospectus containing a statement that by their special Act, the company had the right to use steam power instead of horses and that a saving would be effected thereby. No reference was made to the Board of Trade who refused their consent. Consequently, the company had to be wound up. The plaintiff having taken shares on the faith of the statement brought an action of deceit against the directors. But they were held not liable.
The statement was certainly untrue because the power to use steam was stated to be an absolute right, when in truth it was conditional on the approval of the Board of trade. But the directors honestly believed that once the At of Parliament had authorised the use of steam the consent of the Board of Trade was practically concluded.
Secondly, the false representation must relate to some existing facts which are material to the contract of purchasing shares. The purpose for which the new money is going to be used is an important fact. In Edgingtone Vs. Fltzmaurice (1885)., for example—
The directors of a company issued a prospectus inviting subscriptions for debentures and stating that the objects of the issue of debentures were to complete alterations in the buildings of the company, to purchase horses and vans and to develop the trade of the company. The real object of the loan, however, was to enable the directors to pay off pressing liabilities. Relying on the statement the plaintiff advanced money. The company became insolvent and the plaintiff sued the directors for fraud.
The directors argued that the suggestion of possible purposes to which the money might be applied was not a statement of existing facts. But they were held liable. BOWEN L.J., said that the directors had misrepresented their state of mind and “The state of a man’s mind is as much a fact as the state of his digestion.” The statement was also regarded as material to the contract. “A man who lends money reasonably wishes to know for what purpose it is borrowed, and he is more willing to advance it if he knows that it is not wanted to pay off liabilities already incurred.”
Thirdly, the plaintiff should have taken the shares directly from the company by allotment. “Those only who are drawn in by the misrepresentation in the prospectus to become allot tees can have a remedy against the directors.” A purchaser of shares in the open market has no remedy against the company or the promoters though he might have bought on the faith of the representations contained in the prospectus. This rule owes its origin to Peek Vs. Gurney (1873)
A deceitful prospectus was issued by the defendants on behalf of a company. The plaintiff received a copy of it but did not take any shares originally in the company. The allotment was completed and several months afterwards the plaintiff bought 2,000 shares on the stock exchange. His action against the directors for deceit was rejected. “The office of a prospectus”, the court said, “is to invite persons to become allot tees, and, the allotment having been completed, such office is exhausted and the liability to allot tees does not follow the shares into the hands of a subsequent transferees. Directors cannot be made liable ad infinitum for all the subsequent dealings which may take place with regard to those shares upon the stock exchange.
But “where the object with which the prospectus of a company is issued is merely to induce applications for allotment of shares, but also to induce persons to whom it is sent to purchase shares in the market, its function is not exhausted when the company has gone to allotment, and the person issuing the prospectus is responsible for the consequences of false representation contained in it.” In other words, “There must be something to connect the directors making the representation with the party complaining that he has been deceived and injured by it, as, for example, where the fraudulent prospectus is delivered to a person who thereupon becomes a purchaser of shares.”
Liability of the Company
The company may also be sued for damages provided that the fraud was committed by the directors within the scope of their authority. But the action against the company is beset with the limitations laid down by the House of Lords in Houldsworth Vs. City of Glasgow Bank (1880) that the contract of allotment must be first rescinded. One cannot remain in the company as a shareholder and yet sue it for damages. But the English Misrepresentation Act, 1967, now “entitles the court to award damages in lieu of rescission.” Thus rescission is no longer necessary as a pre requisite for liability of the company.
2. Compensation under Section 62
The decision of the House of Lords in Derry Vs. Peek exposed the inadequacy of the tort action of deceit to protect the interest of investors in public companies. The directors in that case had, no doubt, told their falsehood in good faith rather than from corrupt motive. But that would not console the misled investor for he is not concerned with the state of the director’s mind or conscience. His loss is the same whether the misrepresentation is innocent or fraudulent. Accordingly, within a year of the decision in Derry Vs. Peek the Directors’ Liability Act was passed and the directors were made answerable for the false statements although they might have believed their assertions to be substantially true. The provisions of this Act have been re-enacted in Section 43 of the English Companies Act, 1948. Section 62 is the corresponding provision in the Indian Act. Following persons are liable under this section :
1. Every person who is a director of the company at the time of the issue of the prospectus.
2. Every person who has authorised himself to be named as a director in the prospectus.
3. Every promoter who was a party to the preparation of the prospectus.
4. Every person who authorised the issue of the prospectus.
They are liable to compensate the investor for any loss sustained by him by reason of any untrue statement contained in the prospectus. A statement is deemed to be untrue if it is false in the form and context in which it is included. Omissions which are calculated to mislead shall also render the prospectus false. An instance of liability under this section is provided by Greenwood
The prospectus issued by a wheel manufacturing company stated :”Orders have already been received (inter alia), from the House of Commons…… wheels for the trolleys in the House of Commons have been ordered and are now in use.” In fact no single order had been obtained except for trial and by way of experiment. It was held that the prospectus contained untrue statements.
The chief advantage of proceeding under this section is that the plaintiff does not have to prove fraud. If the representation is false, the directors cannot escape liability even if they had made it bona fide and not with intent to deceive. But they have the following defences under the section.
1. Withdrawal of consent :- A director will not be liable if he had withdrawn his consent to become a director before the issue of the prospectus and the same was issued without his authority or consent.
2. Issue without knowledge :- Even where a director’s name appears in the prospectus he can escape liability by proving that it was issued without his knowledge or consent and on becoming aware he forthwith gave a public notice to that effect.
3. Ignorance of untrue statement :- Sometimes a director may be ignorant of the untruth of the statements made in the prospectus. Such a director can defend himself by showing that, on becoming aware of the untrue statement, he withdrew his consent by a reasonable public notice. Obviously, this must be done before allotment.
4. Reasonable ground for belief :- A director will also be protected if he can show that “he had reasonable ground to believe, and did up to the time of allotment believe the statements to be true.” It may be recalled that under the rule of Derry Vs. Peek a director having honest belief in the truth of his statement is protected. But under this section it is not enough for him to say that he was honest. He must go further and show that his honest belief was based upon reasonable grounds. And so in Adams Vs. Thrift (1915) :
An action was brought by the plaintiff to recover compensation from a director of a company in respect of false statements in a prospectus. The director contended that the statements were prepared by the promoters and before issuing he enquired from one of them. “Is everything perfectly alright” and he said, “of course, it is.” It was held that although the director did honestly believe the statement to be true, he had no reasonable ground to do so. “The promoter is the very last person whose uncorroborated statement ought to be relied upon by an intending director as justification for saying that he had reasonable ground for belief. If they had taken the opinion or obtained a report of competent people as to material facts in the prospectus that might have afforded a reasonable ground for belief.”
5. Statement of expert :- If the untrue statement happens to be contained in the report of an expert, the director sued has to show that he had reasonable ground to believe and did up to the time of allotment believe that the expert was competent, and if it is in some public official document, that it was a correct and fair representation of the document.
3. Rescission for Misrepresentation
An allotment of shares can be avoided at the option of the allottee if it was caused by misrepresentation whether innocent or fraudulent. By avoiding the contract he is able to get rid of his shares and claim the money he paid for them. Further under Section 75 of the contract Act, a person who lawfully rescinds a contract is entitled to compensation for any damage which he has sustained through the non-fulfilment of the contract. The action is against the company to have the subscriber’s mane removed from the register of shareholders. The essential requisites of the action are as follows :
1. False Representation
In the first place there must be false representation in the prospectus. False representation means a positive mis-statement, or a concealment of material facts. But, generally speaking, “a mere non-disclosure does not amount to misrepresentation unless the concealment has prevented an adequate appreciation of what was stated”. “Everybody knows that sometimes half a truth is no better than a down right falsehood.” The King Vs. Kylsant [1932] illustrates the point.
Lord Kylsant was prosecuted for issuing a prospectus with untrue statements. A table was set out in the prospectus showing that between 1911-1927, the company had paid dividends varying from five to eight percent, except in 1914, when no dividends was paid and in 1926 when a dividend of 4 percent was paid. This statement created the impression that the company was in a sound financial position ; whereas the truth was the during the seven years preceding the date of the prospectus the company had made substantial trading losses and dividends could be paid by recourse to funds which had been stored up during the war period. The whole prospectus was held to be false, not because of what it stated, but because of what it did not state.
AVORY, J., relied upon the following statement of LORD HALSBURY in Aaron’s Reef Ltd. Vs. Twiss [1896] “…. Taking the whole thing together was there false representation ? I do not care by what means it is conveyed – by what trick or device or ambiguous language : all these are expedients by which fraudulent people seem to think that they can escape from the real substance of the transaction. If by a number of statements you intentionally give a false impression and induce a person to act upon it, it is not the less false, although if one takes each statement by itself there may be a difficulty in showing that any specific statement is untrue.”
Even if those who issued a prospectus were prompted by innocent motives, the subscriber would be entitled to his remedy. Accordingly6, a prospectus stating that “more than half the shares have already been sold,” when in fact, only one promoter of the company had signed documents applying for more than half the shares, but had not paid any money and ultimately he took only 200 ; a prospectus stating that “the directors and their nfriends have subscribed a large portion of the capital and they now offer to the public remaining shares,” the fact being that the directors had subscribed only ten shares each ; a prospectus stating that “B and M, aleading businessmen of repute, have agreed to become directors of the company”, when they had expressed their willingness to help the company, were all held to be misleading, giving the subscribers the right to rescind .
Change of circumstances
There is often an interval of time between the publication of a prospectus and allotment of shares. During this interval a statement which was true when made may cease to be so owing to some change of circumstances. For example, in Rajagopala Iyer Vs. The South Indian Rubber Works [1942]
The plaintiff had applied for shares in a company on the basis of a prospectus containing the names of several persons as directors. But before allotment took place, there were changes in the directorate, some directors having retired. That was held sufficient to entitle the plaintiff to revoke his application as few matters are more important than the names of directors. “Moreover, the persons who applied for shares on the faith of one state of things should have the option of retiring when a totally different state of things came into existence.”
2. Of facts and not of Law
Secondly, the misrepresentation must be of facts and not of law. If, for example, a prospectus represents that a company’s fully paid shares will be issued at half their nominal price, when the companies Act prohibits the issue of shares at so much discount, it is a misrepresentation of law and a person deceived by it will have no remedy. Again, the facts misrepresented must be material to the contract of taking shares. Materiality of misrepresentation is a question of fact in each case. Generally speaking, a fact is said to be material if it is likely to influence the decision of an average purchaser of shares, that is, if it will urge or induce him to purchase or refrain from purchasing shares. This rule enables the directors to include what are commonly known as flourishing or puffing up statements and make the prospectus attractive, as was done, for example, in Mckeown Vs. Boudard Feveril Gear Co. Ltd.
A company was incorporated for working inventions of one Boudard relating to the driving gear of cycles. Its prospectus stated : “Within a few weeks the following exciting, and at the time unheard of, performances took place.” Then the results of various cycle races were set out in all of which the company’s cycle was claimed to have bettered the record and the prospectus concluded with these words : “This is the first occasion that a mile has been done under two minutes in England
It was held that the omission of later performances which cut the records referred to in the prospectus was not material and did not render the prospectus misleading. “It is impossible to suppose that the plaintiff could have been really deceived by such a common quality in the prospectus as puffing or that he was blind to the possibility that the records and the performances set forth might possibly be due not solely to the merits of the gear, but also to the merits and skill of the riders and to the general improvement in cycles.”
3. Reliance and inducement
It is further necessary that the plaintiff should have acted in reliance on the statements contained in the prospectus. Misrepresentation should be at least one of the inducements for his contract of taking shares. It is for this reason that a purchaser of shares in the open market cannot proceed against the company unless the company had done something to induce him to purchase in the market. For the same reason a person cannot complain of misrepresentation if “he had the means of discovering the truth with ordinary diligence.” But a recipient of a prospectus is entitled to rely on it. He is not bound to verify it.
4. By or on behalf of Company
“A company is not responsible for the statements in a prospectus unless it is shown that the prospectus was issued by the company or by some one with the authority of the company – by the board of directors, for instance,” or that the prospectus, having been issued by the promoters was ratified by the company. This becomes particularly important where a representation is made apart from the prospectus. Thus where a person was induced to join a company as a shareholder by representations of the secretary of the company, he could not obtain rescission as the secretary has no general authority to make representations. But where shares were applied for on the basis of fraudulent representations made by a person both before and after he had become a director, rescission was allowed.
Limits of Rescission
A contract induced by misrepresentation is valid until it is rescinded. The option to rescind is not an unlimited one. It is lost in the following circumstances :
1. By affirmation
If the allot tee, with full knowledge of misrepresentation, up-holds the contract, he cannot afterwards rescind. Affirmation may be express or implied. An implied affirmation takes place by shareholder’s conduct, where, for example, after discovering his right to rescind, he endeavours to sell his shares, attends meetings of the company, receives dividends or pay calls.
2. By unreasonable Delay
“Any man whom claims to retire from a company on the ground that he was induced to become a member by misrepresentation, is bound to come at the earliest possible moment after he becomes aware of the misrepresentation.” Accordingly in Re Christineville Rubber Estates Ltd [1911]
An applicant to whom shares were allotted in a company became fully aware of misrepresentation in the prospectus by the end of July, but in December he moved to have his name removed from the register. It was held that the un-explained delay of five months precluded him from obtaining relief.”
3. By commencement of Winding up
The right of rescission is lost on the commencement of winding up of the company. Shareholders cannot be permitted to get rid of their shares after the proceedings for the winding up the company have been initiated. The names of the shareholders are entered in the register of members and the register is prima facie evidence of membership. It is open to public inspection. “The object being that the creditors might form their own opinion as to the persons who constituted the shareholders of the company.” Creditors might have lent money on the faith of so many good names being there on the register. And if the shareholders can get their names removed from the register even after the winding up is on, the creditors would be seriously misled. “But where a shareholder has started active proceedings to be relieved of his shares, the passing of the winding up order during their pendency would not prevent his getting the relief.”
4. Liability under Section 54
Section 56(1) states that a company’s prospectus must contain certain particulars and sub-section (3) imposes penalty for its contravention. But the section is silent as to the subscriber’s remedy in case all the required particulars are not disclosed. “The section in terms gives no remedy or cause of action ; but it is a remedial section for the protection of applicants for shares against wiles of promoters and others.” The provision does contemplate a liability in damages on the part of directors and other persons responsible for prospectus, for sub-section (4) exonerates such persons from liability if they can prove certain matters. This is equivalent to saying that they are liable if they cannot prove those defences. Hence an allot tee can recover damages from the directors for mere failure to comply with Section 56(1). But the plaintiff who has subscribed for shares on the faith of a prospectus which did not disclose the material particulars required to be disclosed by the section must prove that he has sustained damage. The onus lies on him to show that he has acted on the faith of the prospectus, that is to say, if he had known of the undisclosed matter he would not have become a shareholder. It should be noted the section does not entitle a shareholder to get rid of his shares by reason merely of the omission of any of the facts required to be disclosed by the secti8on. Where, however, the omission amounts to fraud or misrepresentation within the meaning of Section 17 and 18 of the Indian Contract Act, an action for rescission will also lie.
A director or other person sued under this section may defend himself by showing [Section 56(4)]
1. That he had no knowledge of the matter not disclosed ;
2. That the contravention arose out of an honest mistake of fact ;
3. If, in the opinion of the Court, the matter not disclosed was immaterial or that the person sued ought to be excused.
Criminal Liability for Misrepresentation
Where a prospectus includes any untrue statement, every person who authorised the issue of the prospectus shall be punishable with imprisonment for a term which may extend to two years, or with fine which may extend to five thousand rupees or with both. A director prosecuted under this section can defend himself by showing that the statement was immaterial or he had reasonable ground to believe and did up to the time of the issue of the prospectus believe that the statement was true.
Invitation for Deposits [S.58A]
The Central Government has taken the power by Section 58A to regulate, in consultation with the Reserve Bank, the acceptance of deposits by companies. Apart from the regulations that may be thus prescribed, the section itself contains certain important provisions. Deposits should be invited in accordance with the deposit rules and by an advertisement accompanied by a statement showing the financial position of the company in such form as may be prescribed by the ru7les. If any deposit is accepted in contravention with such rules, the company shall repay it within thirty days or within further thirty if allowed by the Central Government on sufficient cause.
If it is not so refunded the company shall be liable to a fine twice the amount of the deposit not refunded. Out of this amount, when realised, the court pays back the depositor and then the company’s liability stands discharged. Officers are punishable with fine and imprisonment up to five years.
Deposits in excess of the limits prescribed by rules also involve fine on the company to an amount equal to the deposit ; for mere invitation the fine may go up to one lakh rupees, but not less than Rs. 5000/- Officers are punishable with fine and imprisonment up to five years.
These provisions are not applicable to a banking company, or a company which the Central may, in consultation with the Reserve Bank, exempt ; any other financial company which the Central Government may similarly exempt, but not from the requirement as to advertisement.
Acceptance of Deposits
Of late companies have shown a marked preference for raising funds by inviting fixed deposits from the public generally instead of raising capital by means of a prospectus. There is a greater desire to raise loan capital instead of share capital. The craze began for the reason that no regulations had to be followed in subsequently managing them. People were tempted to invest because higher interest rates were offered as compared with banks. Some investors had, however, to face a very sad experience. Unscrupulous companies failed to pay back and the deposit-holders had no effective remedy. There was a wave of public disappointment with companies. Government intervened. The Companies Act was amended. Section 58 A came into being. It regulates public invitation for deposits, their acceptance and repayment and also provides criminal sanctions for breach of rules. The madras High Court has witnessed a case arising out of a prosecution under the section.(Sujani Textiles (P0 Ltd. Vs. Astt. Reg. of Cos.(1980) The provisions of the section and the rules framed under it by the Reserve Bank of India
Instead of repaying the excess amount, the petitioners have kept the amount and have issued fresh deposits receipts. This renewal amounts to receiving fresh deposits. The word “renew” also means “to acquire again”. Therefore renewal amounts to receiving fresh deposits within the meaning of S. 58A(4) punishable under S.58A(5)(b). since the punishment under the section is for more than three years, and also fine, the prosecution is not barred by reason of the provisions of Section 468C of the Criminal Procedure Code.
PROMOTERS
Definition and importance
In companies matters, the term promoter” is of frequent occurrence. The Companies Act itself uses the word at some places of imposing liability upon promoters. Yet “it has never been clearly defined either judicially or legislatively.” “The difficulties in defining the term led the judges to state that the term ‘promoter’ is not a term of art, nor a term of law, but of business.” The4 emphasis upon business implications is quite apparent from the statement of BOWEN L.J. that the term is used to sum “up in a single word a number of business operations, familiar to the commercial word, by which a company is generally brought into existence.” Most of the definitions are in terms of categories of works that the promoters usually perform. “A promoter is a person who brings about the incorporation and organisation of a corporation. He brings together the persons who become interested in the enterprise, aids in procuring subscriptions, and sets in motion the machinery which leads to the formation itself” Whether a person is a promoter or not is a question of fact in each case. Much depends upon the nature of the role played by him in the promotion of business. In Twycross Vs. Grant (1877)
The court said that “ the defendants were the promoters of the company from the very beginning can admit can admit no doubt. They framed the scheme, they not only provisionally formed the company, but were, in fact, to the end its creators, they found the directors, and qualified them, they prepared the prospectus, they paid for printing and advertising, and the expenses incidental to bringing the undertaking before the world”. The court added that the function of promoters come to an end as soon as they hand over the company to a governing body, like a board of directors.
A person who acts in a professional capacity is not a promoter. Thus a solicitor, who prepares on behalf of the promoters the primary documents of the proposed company, is not a promoter. Similarly an accountant or a valuer who helps the promotion in his professional capacity is not a promoter. The Companies Act, in section 62, while providing for the liability of a promoter for misrepresentation in prospectus, also excludes such persons from the category. But any such person may become a promoter if he helps the formation of the company by doing an act outside the scope of his professional duty. A person may, for example, help in getting a purchaser for the company’s patent, or of shares, or in getting personnel for the company. Any such role may make him a promoter.
DUTY AND LIABILITY
Fiduciary Position
The position of promoters in relation to the company was explained by LORD CAIRNS in Erlanger Vs. New Sombrero Phosphate Co. (1878) in the following words :
They stand, in my opinion, undoubtedly in a fiduciary position. They have in their hands the creation and moulding of the company. They have the power of defining how and when and in what shape and under what supervision the company shall start into existence and begin to act as a trading corporation.
The business of promotion thus gives a very advantageous position to the promoter in relation to the proposed company. The courts have, therefore, fixed him with the responsibility of a fiduciary agent. “The promoter is in the situation akin to that of agent or trustee of the company, and his dealings with it must be open and fair.” Thus the first and foremost duty of a promoter is that if he starts a company for then purpose of buying his property and wants to draw his payment from the money obtained from shareholders, he must faithfully disclose all facts relating to the property. If he conceals any fact in relation to the character or value of the property, or his personal interest in the proposed sale, the company will be entitled to ser aside the transaction or recover compensation for its loss. He is guilty of breach of trust if he sells properety to the company without informing the company that the property belongs to him or he may commit a breach of trust by accepting a bonus or commission from a person who sells property to the company. In short, the chief duty of the promoter as a fiduciary agent is to disclose to the company his position, his profit and his interest in the property which is subject of purchase or sale by the company.
The only difficult question is to whom the disclosure is to be made. It was suggested by the House of Lords in Erlanger Vs. New Sombrero Phosphate Co. that it should be made to an independent and competent board of directors. The facts of the case were as follows :
A group of persons headed by E purchased an island containing phosphate mines for £55,000. a company was then incorporated to take over the island and to work the mines. E named five persons as directors. Two were aboard. Of the three others two were persons entirely under E’s control. These directors purchased the island for the company at a price of £ 1,10, 000. A prospectus was then issued. Many persons took shares. The purchase of the island was adopted by the shareholders at the first meeting ; but the real circumstances were not disclosed to them. The company failed and the liquidator sued the promoter for refund of the profit.
The only material contention urged on behalf of the promoter was that the company’s board of directors had full knowledge of the facts. Rejecting this LORD CAIRNS said :
If they propose to sell their property to the company, it is incumbent upon them to take care that they provide the company with an executive who shall both be aware that the property which they are asked to purchase is the promoters property and who shall be competent and impartial judges as to whether the purchase ought or ought not to be made. They should sell the property to the company through the medium of a board of directors who can and do exercise an independent and intelligent judgement on the transaction.
Subsequent experience, however, showed that it may not always be possible for the promoters to give to the company an independent board of directors. In a case of a private company, or a public company which, like that of Salomon & Co., consists of only family members, it is just nor possible to constitute an independent board of directors. In such a case the promoter should disclose his interest and profit to the shareholders of the company. But it will not be enough to disclose the truth to the first few shareholders. The disclosure should be made to the whole body of persons who are invited to become the shareholders. This was emphasised by the House of Lords in their well-known decision in Gluckstein Vs. Barnes (1900)
A syndicate of persons was formed to raise a fund, buy a property, called “Olympia
It was held that the promoters ought to have disclosed to the company the profit of £ 20,000. The defendant, who was one of the promoters, contended that the fact was known to the parties to the transaction. Rejecting. This, EARL OF HALSBURY L.C. said :
It is too absurd to suggest that a disclosure to the parties to this transaction is a disclosure to the company. They were there by the terms of the agr4eement to do the work of the syndicate, that is to say, to cheat the shareholders ; and this, forsooth, is to be treated as a disclosure to the company, when they were really there to hoodwink the shareholders, and so far from protecting them, were to obtain from them the money, the produce of their nefarious plans.
The duty continues even after incorporation until the profits are fully disclosed and fully accounted for.
Where rescission is not possible, that is, the company is not in a position to return the property, it can recover damages for breach of the duty of good faith, though the measure of damages is the profit which the promoter made from the breach of his duty.
