Legal risks
The legal risks which the present kind of objects clause creates are the consequences of the rules of law which sanction observance of the limits of the company's objects. In the first place, directors and other officers of a company who employ its resources for purposes outside the objects set out in its memorandum are absolutely liable to make good any loss which the company suffers as a result. It is no defence for them to plead that they interpeted the company's objects clause mistakenly but reasonably after exercising proper care and taking legal advice (Cullerne v London and Suburban General Permanent Building Society (1890) 25 QBD 485, 490).
The very complexity of objects clauses increases this risk of absolute liability for misinterpretation, and the absolute liability of directors despite their good faith appears unjust and unbalanced when they are at the same time fully accountable to the company in equity for any profit or gain they realise from the ultra vires employment of the company's resources. Nor is it much consolation to them that there is a statutory power for the court to relieve them from personal liability to compensate the company for any loss it suffers.
To obtain relief from liability, directors must apply to the court at their own expense, and they bear the burden of proving that they 'acted honestly and reasonably, and ... ought fairly to be excused' (Companies Act 1985, s 727(1)); this has been held to oblige them to do everything possible to make good the company's loss *105 short of paying compensation themselves (National Trustee Co of Australasia Ltd v General Finance Co of Australasia Ltd [1905] AC 373; Re Windsor Steam Coal Co Ltd [1929] 1 Ch 151).
Furthermore, at common law the other party to a transaction with a company which proved to be ultra vires was equally exposed to absolute responsibility for his ignorance or mistake. The transaction was simply void, and he acquired no rights under it despite his good faith and his unawareness that the transaction was beyond the company's powers or his understandable ignorance of the limits of the company's legitimate business activities (Re Jon Beauforte (London) Ltd [1953] Ch 131). The position of the other party has now been improved by statute, and he may now enforce a transaction against a company despite it being ultra vires if he acted in good faith and was unaware that the transaction was beyond the capacity of the company or the authority conferred on its directors (Companies Act 1985, s35(1), re-enacting European Communities Act 1972, s9(1)).
Statutory limitations
Dr Prentice shows in his report how limited and uncertain the statutory protection given to a person who enters into an ultra vires transaction with a company may be. The statutory provision does not validate the transaction, but merely enables the other party to enforce it by seeking the usual judicial remedies, and his protection lies in the company's inability to defend the action by relying on its ultra vires nature, but only if certain conditions are fulfilled.
The first of these is that the transaction must have been 'decided on by the directors' of the company. Whether this requires the transaction to have been authorised or approved by a resolution of the board of directors, or whether it is sufficient that it is entered into by any one director or any two or more directors purporting to act on behalf of the company, is uncertain, although there is an obiter dictum in one case that the statutory protection of the other party applies in all of these situations (International Sales and Agencies Ltd v Marcus [1982] 3 All ER 551). However, it cannot be safely assumed that the statutory protection applies when a transaction is entered into by an employee or agent of the company, if only a general authorisation has been given to him by the board of directors to enter into transactions of the kind in question, but the board has not approved the particular transaction.
Secondly, the degree of good faith required of the other party to the transaction is indefinite and uncertain, and although the other party is presumed to have acted in good faith unless the contrary is proved, and although he need not enquire as to the capacity of the company to enter into the transaction or as to any limitation on the power of its directors to do so, it remains uncertain whether the other party would be held to have acted in good faith if he did not make the enquiries and require the production of all the documents, authorisations and statements which it is normal business practice to call for in negotiating transactions of the kind involved (eg the making of a substantial loan to the company).
Ultra Vires Transactions
Having described the unhelpful form which company's objects clauses invariably take and the serious risks which directors and officers of companies and persons who enter into transactions with them run if they engage in transactions which turn out to be ultra vires, Dr Prentice's report goes on to enquire whether the ultra vires in its practical application in fact benefits the persons whom it is designed to protect.
Motives for investing
Primarily such persons are the shareholders of the company concerned. The theory underlying the principle enunciated in the Ashbury Railway Carriage and Iron Co case is that the shareholders of a company invest in it in reliance on the implied assurance that their money will be used only to carry on the kind of business which is specified in the company's memorandum, and that they will therefore be safeguarded against the loss of their money or the fall in the value of their investment caused by the company using its resources to carry on any other kind of business.
Dr Prentice questions whether this has ever been shareholders' motivation for investing. He sees the shareholders' motivation and expectations in investing more realistically as springing from a desire to share in the profits of an enterprise which may change its character or dimensions with changes in economic conditions, but which promises, at least initially, to be commercially successful.
The 19th century judicial concept of a company's assets as a kind of trust fund dedicated to the pursuit of defined and limited objects which would, hopefully, generate fairly stable annual profits for the benefit of the shareholders who supplied the company's capital, never was realistic, simply because it placed too much emphasis on the channelling of the company's resources into specialised areas of business (a 19th century panacea for economic progress) instead of the exploitation of suitable and profitable business opportunities of any kind as and when they presented themselves.
Dr Prentice points out that the original immutability of a company's objects as a safeguard for shareholders has long ceased to serve this purpose since companies were first empowered in 1890 to change their objects, and this has been especially true since 1948 when the Companies Acts have enabled companies to change their objects, nominally for any of seven purposes, without leave of the court, and have made the alteration effective, whatever its purpose, unless the holders of a certain percentage of the company's issued shares appealed to the court successfully within a limited period.
It has been less strongly argued in the past that the ultra vires rule also protects creditors of the company by assuring them that the company's assets will be used only *106 for a limited range of purposes consistent with the company's objects, and because of this creditors can more accurately judge the company's creditworthiness. Dr Prentice sees this reasoning as even more fanciful than that which justifies the ultra vires rule as a safeguard for shareholders. Creditors are interested only in the full and timely payment of the debts owed to them, and the features of a company which concern them in that connection are the volume and rate of its cash flow, the liquidity, value and amount of its assets, and the amount of its other indebtedness; the conformity of the company to its legitimate objects does not necessarily affect any of these features favourably or unfavourably. Moreover, creditors have no legal remedy if the debtor company engages in ultra vires activities, unless the company has expressly contracted not to do so which is rare except in long- term loan agreements, and whether it has contracted in such terms or not, creditors cannot prevent a company from altering its objects.
From his analysis of the present state of the law and the justifications pleaded for the ultra vires rule, Dr Prentice concludes that the rule serves little purpose in practice, that it is the source of considerable confusion, that it makes transactions unenforceable or at least uncertain in many situations, and that it imposes on persons who enter into business transactions with companies a burden of enquiry in respect of matters where the risk of irregularity should be borne by the company and not by the other party to the transaction.
Nevertheless, Dr Prentice also recognises the legitimacy of a claim by shareholders to be entitled to restrict the activities which directors use funds provided by shareholders to finance, and to require the consent of shareholders in general meeting before directors employ the company's resources to pursue activities in defiance of such restrictions. This may be described as the internal application of the ultra vires rule, as distinct from its external application in invalidating transactions between the company and outsiders. However, in its internal context the rule is not really concerned with the legal capacity of the company to enter into transactions, but with the authorisation of its directors to use the funds contributed by its shareholders to pursue whatever business activities the directors think fit. The most significant legal aspect of the ultra vires rule is its effect in making transactions entered into by a company invalid or unenforceable.
Solution and Proposals
The solution which Dr Prentice proposes to remedy the defects and difficulties inherent in the ultra vires rule involves six changes in the existing law.
(1) Conferment of unlimited legal capacity
The first of these is the conferment of unlimited legal capacity on all companies notwithstanding the objects which they are formed to fulfil, and notwithstanding any restrictions imposed on them or the organs which act on their behalf (board of directors, general meeting of shareholders) by their memoranda and articles of association. If this proposal were adopted, companies would have the same capacity to enter into contracts, engage in transactions and do other legal acts as an adult human being who is subject to no disabilities. It would therefore be impossible for a transaction to which a company is a part to be held invalid merely on the ground that the company lacked the ability in law to enter into it. This would not necessarily mean that the transaction is valid in all respects, and it would still be open to challenge on other grounds, and the company's officers or agents would still be liable if they breached their duties in entering into it.
This proposal is not as radical as may at first appear, because it represents the law as it has existed since the 16th century in respect of companies incorporated by charter granted by the Crown (Sutton's Hospital Case (1612) 10 Co Rep 1a, 23a and 30b; British South Africa Co v De Beers Consolidated Mines Ltd [1910] 1 Ch 354). The early common law was unable to conceive of disabilities other than ones which manifest themselves naturally in human beings (eg infancy, insanity) or which are imposed to give effect to public policy (eg alienage, outlawry). Had registered companies existed in the 16th century, it is most unlikely that the rule laid down in the Ashbury Railway Carriage Case would have ever seen the light of day.
Nevertheless, statutory extension of the notion of full legal capacity to registered as well as chartered companies would remove one of the impediments to the validity of companies' transaction, but it would still leave other and probably more serious impediments intact, unless the rules embodying them were modified as well, and Dr Prentice proposes that this shall be done. The justification for his first proposal, therefore, is that the concept of the limited legal capacity of a company serves no useful purpose, and provides no protection for shareholders or others which is not also provided by other rules.
The extension of full legal capacity to registered companies would be of no significance if it were possible for a party to a transaction with a company to escape from it by arguing that the organ which represented the company in negotiating the transaction had an authority to do so which was necessarily limited by the objects set out in the company's memorandum of association, and possibly also by other factors, such as the terms of a board resolution or a resolution of a general meeting defining the authority concerned. It is on the basis of this line of reasoning that until recently French law adopted a rule similar in effect to the English ultra vires rule, namely, that the board of directors or other agents of a company have a mandate to act on the company's behalf which is necessarily limited to transactions which are needed to carry on the kind of business which the company is empowered to carry on by its constitutive documents, corresponding to an English company's memorandum and articles.
Dr Prentice deals with this impediment to the validity *107 and enforceability of contracts or other transactions entered into on behalf of British companies by proposing that registered companies should be bound by all transactions entered into by their respective boards of directors, or by one or more of their directors, even though the transaction is inconsistent with the company's objects, or it infringes some restriction imposed by its memorandum or articles of association, or exceeds an authorisation given by a superior organ of the company.
The justification for such a general validation of transactions entered into by the board or an individual director is that the other party to the transaction should not be required to ascertain the limits of the board's or directors' authority to represent the company, but should be entitled to assume that since the management powers of the board are usually general and unlimited in character, the powers of the board of the particular company he deals with and its individual directors are unlimited. It is less easy to justify such an assumption when the other party deals with an individual director or individual directors, and not the whole board. In theory, at least, a director is merely a member of a collegiate body, the board of directors, which has power to make decisions collectively, but whose members individually are not recognised as organs of the company and authorised by law to represent it. An exception to this is the managing director of a company to whom the board has delegated its general-powers of management, reserving to itself only a supervisory role and a power to decide major policy questions.
Dr Prentice scouts the idea of confining his proposal to the board and managing directors, however, because of the impracticability of defining a managing director in legal terms by reference to the broad or narrow delegation of the board's powers to him. Instead, Dr Prentice prefers to enlarge rather than restrict the protection afforded to third persons by enabling them to deal with individual directors without enquiry as to their particular powers, and to rely simply on the fact that they currently hold office as authorising them to bind the company.
This solution is similar to the one offered as an option by the German law relating to public companies. Normally, the executive board of such a company (Vorstand) can act on the company's behalf only with the concurrence of all its members, unless they agree to divide the functions of management between themselves, but if the statutes of the company so provide, each executive director may represent the company alone, and then if he enters into a contract or transaction with a third party, or does any act in relation to a third party, the company is bound by it whether the transaction or act is consistent with the company's objects or any authorisation given by the executive board to the director or not. Dr Prentice proposes that the German option should be the rule for all registered companies in this country.
(2) Transactions binding on companies
Dr Prentice's second proposal, that a company should be bound by the transactions and acts of its board of directors and its individual directors, is based on the assumption that the third person who deals with the company does so in good faith. Bad faith in this context would be limited to actual knowledge and realisation that the transaction was inconsistent with the company's objects, or beyond the powers or authority vested in the directors of the company with whom the third person deals, and it would not include imputed knowledge of matters of which the third person was ignorant or did not understand to be relevant, even though he could have discovered them and their impact on the transaction by making enquiries.
(3) Imputed or constructive notice
This leads us on to Dr Prentice's third proposal, that the doctrine of imputed or constructive notice should not apply to documents and matters relating to companies which can be inspected or discovered by searching at the Companies Registry, or by relying on a statutory right of inspection of records which the Companies Act 1985, requires companies to keep.
The application of the doctrine of constructive notice originated with the decision of the House of Lords in Ernest v Nicholls (1857) 6 HL Cas 401, where it was held that all persons who deal with a company have deemed or constructive notice of the contents of a company's memorandum and articles of association, because they are filed and available for inspection by the public at the Companies Registry. Whether the doctrine extends to other documents which a company is required to deliver to the Companies Registry (such as particulars of its directors, its annual return and its annual accounts) is uncertain, but Dr Prentice proposes that legislation shall expressly declare that the doctrine does not apply to documents, returns or other matters filed at the Companies Registry or kept by the company, if they relate to the company's objects or the powers or authority of its board or of any of its directors, when the validity or enforceability of a transaction entered into by the company is in question.
On the other hand, Dr Prentice fully accepts that a person should not be able to enforce a transaction against a company if when he enters into it by negotiating with its board or any of its directors, he knows, or from the facts of which he is aware, fully realises, that the transaction is outside the company's objects or inconsistent with them, or is beyond the powers or authority of the board or the director or directors with whom he deals. On the other hand, the company would be free to ratify the transaction and so make it binding on all the parties to it, but if the transaction were outside or inconsistent with the company's objects, ratification would be possible only by a general meeting of the company passing a special resolution.
(4) Knowledge of relevant information
This fourth proposal is consonant with the underlying principle of English commercial law that in commercial transactions the parties shall be affected only by what *108 they know and understand, and not by what they could have discovered if they had made enquiries. Nevertheless, it is implicit that a party who claims to escape the impact of a rule of law because he did not know of the relevant facts, should be able to do so only if he acts in good faith, and he will lack good faith if he suspected that the transaction he entered into was in some way improper, or if he knew facts which would cause a reasonable businessman to be suspicious.
Dr Prentice does not add this qualification, but it should be included in legislation to implement his proposals, and if carefully drafted the legislation would not reintroduce the doctrine of constructive notice which Dr Prentice is anxious to dispense with. A problem arising from relevant knowledge with which Dr Prentice does deal, however, is the extent to which a third person if it is itself a company or corporation, should be treated as knowing or understanding that a transaction which it enters into with another company is outside the objects of that company or beyond the powers or authority of its board or the director or directors who represent it.
The present vague rule is that any knowledge of a relevant matter which a director acquires in the course of carrying out his functions is attributed to his company, unless he acquires the knowledge in perpetrating a fraud on the company, or unless he acquires the knowledge in the course of negotiating a transaction between himself and the company or a transaction with a third person in which he is interested (Houghton & Co v Nothard, Lowe and Wills [1928] AC 1).
Dr Prentice proposes that if a company or corporation enters into a transaction with another company which is outside that company's objects or beyond the powers or authority of that company's board or the director who represents it, the first company or corporation shall be treated as knowing or understanding only those facts or matters of which its own representative acquires knowledge or understanding in connection with the negotiations leading to the transaction. It is questionable whether this is not unduly restrictive, and it is suggested that if the matter was known or realised by any director of the other company or corporation who was in any way concerned with the negotiations, even though he did not conduct them, the other company or corporation should be treated as knowing or understanding the matter in question.
(5) Dealings involving third party
Dr Prentice's first four proposals would provide sound and adequate protection for third persons who deal in good faith with a company, its board of directors or its individual directors. His fifth proposal would qualify this protection when the third person with whom the company deals is himself a director or officer of the company, and this presumably includes its secretary and auditors, but not a shadow director. In this situation Dr Prentice proposes that the doctrine of constructive notice should continue to apply, and that knowledge of any inconsistency between the transaction and the company's objects, or knowledge of a lack of power or authority on the part of the organ which represents the company should be attributed to the director or officer who is a party to the transaction if he has the means of discovering them.
The expression 'constructive notice' is used here in a narrower sense than usual, however, because Dr Prentice would attribute to the director or officer only knowledge of those matters which it is reasonable to expect the director or officer to have had in carrying out the functions of his office. In other words, he will be treated as having knowledge of what he actually knew and also of what he ought to have known in his capacity as an officer of the company. This modified treatment of directors and officers of the company is justified by the fact that they are under fiduciary duties to conduct the company's business in the best interests of its shareholders and to exercise proper skill and care in doing so, and they should not therefore be able to assume that a transaction is within the company's objects and within the powers of the board or of the director or directors with whom they deal when it is part of their duty to the company to ensure that this is so, or at least to warn the board that the deficiency should be remedied before the transaction is entered into. The modification of Dr Prentice's main proposal is therefore less a perpetuation of the doctrine of constructive notice than an application of the principle that a claimant cannot rely on this own breach of duty as giving him rights which he would lack if he had performed his duties properly.
(6) Private companies: omission of objects clause
Dr Prentice's sixth proposal results from his observation that objects clauses in memoranda of association are invariably so wide in terms that they rarely give any clear idea of the limits set to a company's legitimate area of business activity, and they are in any case so malleable that they can effectively be changed in any way by a general meeting passing a special resolution, unless a minority group of shareholders appeals to the court against the alteration, which rarely happens in practice. Dr Prentice considers, but rejects, the idea of listing in the Companies Act the powers which all companies need to carry on any kind of business, and conferring them on all companies by law; this would shorten objects clauses, but would not deal with the problem of objects clauses which make it legitimate for companies to carry on practically any kind of business activity if its directors so wish.
Dr Prentice sees no objection in principle to companies being able to carry on any kind of business they wish, subject to whatever limits and conditions the shareholders see fit to impose by the company's articles, but he sees no sense in requiring all possible businesses to be listed in the objects clause. Instead he proposes that private companies should be permitted to omit a statement of the company's objects in their memoranda of association, and the companies' objects would then be universal and they would be able to carry on any kind of business whatsoever. Any restrictions imposed on its *109 directors' complete liberty of action in this respect would be contained in the company's articles, and would be of concern only to the company's shareholders, who would be able to enforce them by relying on the implied contract between the company and its shareholders to conform to the provisions of its memorandum and articles of association (Companies Act 1985, s14(1)). Such restrictions would have no external effects, however, and third persons dealing with the board of directors or with individual directors, officers or agents of the company would not be concerned with them.
Dr Prentice proposes that new private companies should be able to be incorporated without specifying their objects, and that existing private companies should be able to dispense with a statement of their objects by altering their memoranda of association by special resolution. He sees no objection in principle to enabling public companies likewise to omit a statement of their objects from their memoranda of association, so that they too would be able to carry on any kind of business, subject only to any restrictions or conditions imposed in their articles.
However, this would involve a departure from the requirements of the Second Directive on the harmonisation of the companies legislation of the member states of the European Communities, which was issued by the Council of Ministers of the Communities in 1976 (Official Journal, No 26/1 of 31 January 1977). This directive requires the constitutive documents of a public company (its memorandum and articles of association) to set out its objects, but the directive requires no sanctions to be imposed if a company acts outside its stated objects. Dr Prentice considers that the requirement of the directive may be satisfied by obliging public companies to deliver to the Companies Registry with their memoranda and articles and other papers to lead to incorporation, and also to deliver annually to the Registry thereafter, a statement of their actual and intended business activities, and he would impose the same obligation on private companies. The initial and annual activities and business statements would be filed for the purpose of informing shareholders and other interested persons about the areas of business activity in which the company has been engaged and intends to engage, and it would in no way affect the company's legal capacity or the powers or authority of its directors, officers and agents to enter into transactions or to act on its behalf. It is therefore doubtful whether it would suffice under the Second Directive as a substitute for a statement of the company's objects, a matter which has legal consequences.
Dr Prentice's proposal that private companies at least should be able to dispense with a statement of their objects in their memoranda of association and so impliedly adopt universal objects, would not preclude any company from having a restrictive objects clause in its memorandum if that were wished, but in view of Dr Prentice's other proposals the statement of objects would have only an internal effect within the company. It would therefore still be possible for members of a company to obtain injunctions to restrain the company and its directors from acting inconsistently with its objects, and directors would still be liable to their companies for any loss they caused them by acting in disregard of their objects.
Dr Prentice makes no recommendations about the law governing directors' personal liability for acting or applying their company's resources for ultra vires purposes. It is open for discussion whether their liability in that respect should not be reduced from the present absolute liability to liability only for acting without proper skill and care. This should be adequate and acceptable if legislation adopting Dr Prentice's other proposals resulted in shorter objects clauses in memoranda of association; this would achieve the original intended purpose of such clauses, namely, to state briefly the areas of business in which the company intended to engage, and the desirable absence of complexity should help to avoid misinter-pretation.
Conclusion
The main proposals in Dr Prentice's report have been covered in this article. In the final chapters of the report he deals with the remedies available to shareholders if a company pursues ultra vires activities, the legality of donations made by companies and the law governing charitable companies, but he finds no need to change the existing law in respect of any of these matters. The Prentice Report will be judged on the proposals it contains for altering the existing law on the legal capacity of companies, on the binding effect of transactions entered into by their boards of directors and their directors individually, and on the facility for incorporating companies without express objects and whose objects will consequently be universal. If these proposals are adopted the law in this area will be simpler, more intelligible, more practical and easier to enforce.
FNa1. Professor of Commercial Law, Birmingham University
COMPLAW 1987, 8(3), 103-109
