Companies the time to scrutinise contracts before entering

Topics: BusinessManagement


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Last updated: December 28, 2019

Companies and third parties interact with one another all the time in the current commercial climate. However not too long ago third parties were at somewhat of a disadvantage in these transactions.

With the fast paced nature of contractual interactions, third parties, as Kershaw remarked, will not read their opposing parties constitution unless the contract was unusually large or different in nature. This was ultimately down to lack of time and man power and more often than not contracts would have no issues and so more and more third parties weren’t taking the time to scrutinise contracts before entering into them. This resulted in an involuntary favouring of companies by the law because fundamentally third parties had no protection. This essay considers how third parties deal with companies and visa versa when transacting; whether in relation to this the law is overprotective or not of third parties; and how s39 and s40 of the Companies Act 2006 relate to these issues and whether they have managed to change the law in a good way. Further, the essay will delve into the law prior to the enactment of s39 and s40 of the Companies Act 2006, and look into arguments for and against these provisions in terms of protecting third parties. Section 39 of the Companies Act 2006S39 (1) states, ‘the validity of an act done by a company shall not be called into question on the ground of lack of capacity by reason of anything in the company’s constitution.’ Before assessing whether the law is overprotective of parties dealing with the company, we should look into why S39 was enacted in the first place. An objects clause is found in the companies constitution and describes the  companies objectives and for what it was first formed for.

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If a company acts outside of its objectives then the company is acting ultra vires, which means the contract is void if a company enters into a contract that is outside of its objectives and beyond its capacity. The ultra vires doctrine was established in the case of Ashbury Railway Carriage and Iron v Riche where it was said that the doctrine was there to restrict companies in their choices of business to ensure protection for shareholders that had provided money for certain objectives. It ensured that worries about where investments were actually going were squashed, prima facie, and instead they knew exactly where their money was going and knew that it wasn’t being invested in risky business.

 Although, a few issues with the ultra vires doctrine started to pop up. One of these was found in the case of Ernest v Nicholls where its expected that someone in dealings with a company ought to know about the company’s constitution and ultimately its objects clause, which can all be easily accessed by the public at the Companies House. This is based on constructive notice where a person dealing with a company can be notified about the company by public posting and so the person has been given notice of this, whether they have seen the public posting or not. By merging this with the ultra vires doctrine, it leaves outsiders with unenforceable contracts if the company acts outside its objects and essentially leaves them in different positions, with companies holding all the power. Another issue is the idea that if a company wanted to change its objects clause then they would have to set up a separate company, which could put companies off from expanding their businesses not only because of the effort this would take but also how much it would cost.

It defers companies from going from less profitable business to more profitable business that is less risky for example. Expansion is crucial for companies and only the best show diversity with their objectives.Companies were also reacting to other international jurisdictions elsewhere in the world too, such as the USA who were moving towards giving wider authority to companies and allowed them to participate in practically any legal business they wanted. A more straightforward issue with the ultra vires doctrine is, as explained by Omar, that companies can simply avoid certain contracts by saying they were beyond their capacity, rather than accepting the outcomes. Companies do this especially where there has been a change in the market that would cause there to be unprofitable arrangements.

We reacted to this by giving the broadest objects clauses possible to all companies, including everything and anything that was relevant. This was coined the ‘exhaustive list syndrome’ which was described as a list of objects so wide that it covered every outcome even if there was no scope for the company to even carry it out. This prevented outsiders from ever truly knowing what a companies true objectives were and so it essentially voided the use of the whole doctrine of ultra vires. To limit the effect of this, the courts decided to apply the ejusdem generis rule which is latin for ‘of the same kind’ and means words that follow specific words in a list only refer to the types of things identified by the specific words. So essentially companies could only exercise power in relation to the main objective. However then it became a bit back and forth because the companies then reacted by developing the Cotman clauses from the case of Cotman v Brougham. This allowed companies to introduce clauses at the end of their constitution saying each object in their already broad objects clause, were nothing to do with the main object and were individual in their own right.

 But the end of the doctrine really came about with the case of Bell Houses v City Wall properties. In this case a company was allowed to pursue anything that was wholly beneficial to the company, whether it was a stated company objective or not, with a subjective objects clause.  The courts saw that the doctrine had no real benefit to either companies or third parties and companies specifically would not stop trying to defeat its purpose. Lord Wedderbum called the whole thing ‘the death of ultra vires’. From this, I would say that the aim of the ultra vires doctrine to protect third parties dealing with a company worked to begin with but were shortly after ruined by the innovation of the drafting objects clauses. Outsiders became completely unprotected from the doctrine and put them in an uncertain position from the start, meaning less and less third parties were even entering into contracts. Despite this, the enactment of section 39 of the Companies Act 2006 allowed third parties to enter into these contracts without the risk the company would claim incapacity down the line.

 In this way, the enactment of section 39 improved the state of the law rather than caused the law to become too overprotective. To begin with, there was no protection for third parties at all before the ultra vires doctrine was introduced. Third parties were tiptoeing on egg shells the whole time they were leasing with a company. Before a transaction was even completed a third party would have to investigate what the companies objectives were to avoid the contract being void for incapacity.

And even then, the company, as Omar stated, could still claim incapacity somehow to avoid unprofitable contracts. However, the ultra vires doctrine allowed third parties to relax and to be confident that the company was behind their investment in a positive way. At this point, the law was no more in favour of a third party than it was a company. It’s aim was just to ensure third parties were protected against unfairness from a company. Then, outside of the laws control, the ultra vires doctrine started to completely breakdown. After the issues of constructive notice, the exhaustive list syndrome, cotman clauses and everything in between, the ultra vires doctrine was essentially got rid of. Consequently, the third parties were back in a position where they were disadvantaged against the companies they were transacting with. So, the enactment of S39 was the law attempting to solve this again, as the ultra vires doctrine had tried to before.

It again puts both the third parties and companies on the same level; third parties are protected from companies claiming incapacity and companies are allowed to expand their objective clauses to their heart’s content. For S39 to be seen as overprotective would assume that its acceptable to allow companies to claim they are beyond their capacity to avoid transacting with a third party instead of accepting the consequences. This would be incredible preferential towards the companies, by allowing them practically to walk in and out of transactions as they wish. Section 40 of the Companies Act 2006This section states, ‘In favour of a person dealing with a company in good faith, the power of the directors to bind the company, or authorise others to do so, is deemed to be free of any limitation under the company’s constitution’. Both this and S39 as mentioned earlier make up the requirements of Article 9(2) of the First directive on Company Law, which aimed to protect both outsiders and members of the companies, as well as the beginning of the huge change of impact of the ultra vires doctrine.

But as with S39, we should look into the surrounding context before assessing whether the law is overprotective or not. The basics of the law of agency involves an agent, acting on behalf of the principal, creating legal relations with a third party. The principal has to honour this relationship as long as the agent has acted within their actual or apparent authority. The latter is where the agent hasn’t received actual authority from the principal but it can be inferred from the principals actions or failure to act that the agent does in fact act on behalf of the principal. Actual authority, on the other hand, can be express or implied (written or spoken), and is specific actions permitted by the principal to be done by the agent.

An outsider may be able to force a company to honour a contract that was entered into by an agent, who had no actual authority, on behalf of the company. The conditions that have to be met in order to do this were stated by Lord Diplock in the case of Freeman and Lockyer. They entail a representation that must have been made by an agent, to a third party, who had actual authority, which must have caused the contract to be entered into, by the third party relying on this representation. The final condition is that the company cant be restricted to enter into such contract due to their lack of capacity to do so as stated in their constitution or their capacity to give authority to enter into contracts from an agent. Seemingly if this were the case, there would be no contract entered into at all, it would be ultra vires. However, this is no longer relevant due to S40’s enactment. Another difficulty for outsiders when contracting with companies is the huge burden of constructive notice.

Whilst constructive notice gave everybody the capacity to find out exactly what the company’s objectives were and whether they were acting ultra vires, this is not always practical to do so. In reality, decisions need to be made quickly and contracts need to be signed promptly and so there is no time to be looking into the objectives of a company. The majority of outsiders that companies deal with are of commercial nature. It was also said by Dignam that even if third parties take the time to know all about a company through constructive notice, there may still be internal procedures that aren’t available to the public.

This means, even if the company is within its capacity to act, the agent representing the company may not be within its own powers because an internal procedure wasn’t followed. From this harsh finding, the indoor management rule came about, from the case of Royal British Bank v Turquand, which says third parties aren’t required to know the internal procedures of a company and can instead assume that an agent has authority to represent the company, as well as their main authority. From all this difficulty and uncertainty for outsiders, S40 was enacted and seemed to bring everything together. As mentioned, S40 essentially replaced the last condition in the Freeman and Lockyer case. It also means there is no longer a duty to look into the companies objectives as required by consecutive notice.

S40 mentions the person must be dealing in good faith with the company too. This may seem restrictive and is there to avoid protecting third parties who have bad purposes, but a finding that a third party does have knowledge of the capacity of the company before contracting, doesn’t count as bad faith. Automatically this shows that it may move difficult to even prove a third party was acting in bad faith at all. What S40 has has also done is given confidence back to commercial businesses wishing to contract because they are no longer worried about whether the contract may end up being ultra vires. Less time and money are spent by commercial businesses from reading through companies objects clauses too. Yet, now there is argument that the law has gone from not enough protection for third parties, to too much protection. A big argument as to why the law is now overprotective of third parties is the issue surrounding how hard it is to find bad faith.

Such as, as mentioned, the fact that the outsider is no longer obliged to enquire into the company but if they do enquire and still contract, this is not seen as bad faith. Lord Webberburn describes this as, ‘these sections always take the part of the third party even when he isn’t a nice chap; when he knows everything and has grabbed an opportunity.’ From this we can see that even the law doesn’t necessarily agree with the new protections on third parties, and so maybe the law is too in favour of them now. There are others who also disagree with the lack of bad faith where the outsider has sought knowledge of the company, such as Dr Prentice. The Prentice report was an analysis on the ultra vires doctrine where Dr Prentice suggested a third party should be prevented from contracting if they had knowledge of the companies procedures relating to authority and capacity.

On the issue, Leacock remarks, ‘this seems fair to all parties to the controversy’. However Leacock also gives some ways where having knowledge shouldn’t always mean bad faith on behalf of the outsider. There is the issue of not really understanding the knowledge you have sought about a company. Proof of getting this knowledge doesn’t always mean you know the implications of  doing so and how this could effect you in future transactions. This is where the outsider may have still been acting in good faith. Whilst this may seem ridiculous to allow all outsiders who have gained knowledge to automatically be seen as acting in good faith, there are ways of not letting everyone get away.

For example, if its clear from further investigation that the outsider has experience with company law then its likely they have gained the knowledge in bad faith. Also, if the outsider has sought legal advice this may seem that they have gained the knowledge in bad faith because they are seeing to understand it to use it in the future. But, this legal advice may be wrong and they may have been misled to enter into transactions with a company that they thought wouldn’t be effected by the ultra vires doctrine, but actually it is.

Despite all this, these exceptions only cover specific circumstances and doesn’t really answer the question of why bad faith isn’t equated with knowledge sought after by an outsider, especially where they are totally aware of the implications of this. Another argument that S40 isn’t overprotective of third parties is the preconditions that only allow fairness in terms of benefitting the provision. When looking at the definition of S40, it says third parties must be acting in good faith.

Whilst it’s been discussed that it’s quite easy for a third party to be found acting in good faith, this good faith can also be denied. For example in the case of Wrexham AFC v Crucialmove, where a third party knew the agent was entering into the transaction for an improper purpose but hadn’t enquired about the scope of his authority. The court of appeal stated that third parties, in this case, cant use S40. So, it does show that not all third parties who are assumed to have good faith pass the conditions needed. This clearly shows that the law isn’t overprotective of third parties because they are limited in how they use S40. Another way to show this is again in the wording of S40, where it uses ‘person’ to describe a third party. The case of Henniker-Major addressed whether a director is included in this definition of a person. The court of appeal held that a director cant be included because he would be placed in a position of conflict; a director couldn’t really contract with the company he directs.

As well as this, in the case of EIC Services v Phipps, a shareholder isn’t included as a person able to deal with a company either. This again shows that the law isn’t overprotective because not all third parties can complete transactions with companies. ConclusionThe ultra vires doctrine was developed to give comfort to third parties, who were investing in companies, who were worried about where their investment was going and how risky it was to invest. But it started to restrict companies due to the objects clause that they couldn’t alter and so companies weren’t free to pursue profitable pursuits. This then led to exhaustive lists of objectives, which was then narrowed by the ejusdem generis rule and then changed with the conman clauses and drafting battles because companies were fighting to expand.

After all this, the ultra vires doctrine couldn’t really be used for its purpose anymore and we were back in the same position of third parties and companies not really comfortable with transacting with one another all the time. S39 and 40 were enacted and solved this. They meant third parties no longer had to abide by constructive notice and cost themselves time and money by doing so and no longer had to be fearful of how a company they’d contracted with would react if the transaction turned sour. After the enactment of S39 and 40, it was said that they meant the law was too overprotective of third parties. As stated before, the fact that there are conditions for third parties such as whats included under the definition of ‘person’ shows the law has put in restrictions and means people are only allowed to rely on S40 if its fair. Another condition is they must have acted in good faith which is arguably very straightforward to achieve, but even their good faith can be rebutted as in the case of Wrexham AFC v Crucialmove.

However, both these conditions could also be arguments for why the law IS overprotective because of how difficult it is to eatables bad faith. There must be knowledge of dishonesty for it to be bad faith, even though just knowledge of authority about a company isn’t seen as bad faith. So, in regard to whether the law is too overprotective of third parties when dealing with companies, I would say the law is slightly too overprotective but not unfairly. Whilst the two provisions have benefitted third parties greatly, especially compared to who they used to be treated, and they should definitely still be protected the way they are, I think they should be modified in reaction to the recent commentary.


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