An Outsiders Guide to Deal with a Company
This document contains certain very important concepts with respect to the diligences that any outsider should observe while dealing with a company for any purpose, especially for the purpose of entering into contracts.
When an outsider deals with a company, a question as to whether the director or the representative of the company who is apparently representing the company is properly authorized to enter into a particular transaction often arises. There is a risk that a representative may induce the outsider to enter into the contract with the company, and subsequently state that the company is not bound to honour the contract, on the ground that the representative was not authorized by the company.
In this regard, two concepts, doctrine of constructive notice and doctrine of indoor management must be understood.
Doctrine of constructive notice:
Doctrine of constructive notice states that every person dealing with the company is presumed to have read the memorandum and articles of association of a company (and any other document that must be registered with the ROC) which lays down the rules and regulations supposed to be followed by the company.
The doctrine is based on Section 610 of the Companies Act, 1956/ Section 399 of Companies Act 2013. The section states that the memorandum and articles when registered with Registrar of Companies can be inspected by anyone on payment of a nominal fee- hence they become public documents. Therefore, any person who contemplates entering into a contract with the company has the means of ascertaining what is written in the memorandum and articles, and is thus presumed to know the powers of the company and the extent to which powers can be delegated to the directors.
Hence, if the articles of a company states that any contract entered by the company must be signed by the managing director and should be executed under the stamp of the company, and these procedures are not followed by a director, officer, employee or any representative of the company while entering into a contract with an innocent third party, such contract will not be binding on the company as the third party is presumed by law to have knowledge that such contract will not be binding on the company.
Doctrine of indoor management:
According to this doctrine, persons dealing with the company are entitled to presume that internal requirements prescribed in the memorandum and articles have been properly observed by employees, directors and representative of the company. Hence, if any rules or regulations with respect to how the company should deal with third parties or enter into contract are not specified in the memorandum of association or articles of association, then the third parties dealing with the company can presume that either there are no such rules or regulations or that the representative of the company has complied with all such rules and regulations in their entirety. Similarly, if the company is required under the articles or memorandum to take certain actions or fulfil certain pre-conditions before entering into a contract, unless the third party has any knowledge to the contrary, the third party may presume that such requirements and pre-conditions have been fulfilled by the company.
Thus, the doctrine of indoor management presumes that any management decision or action taken by a company or its board of directors which are not reported to the Registrar of Companies and made available as public record is an internal matter of the company that the general public cannot be expected to know. Hence, failure on part of a company to comply with its own management policies unknown to the public should not affect innocent third parties.
The doctrine (also known as the Turquand rule) was first laid down by courts in England in the case of Royal British Bank v. Turquand. In that case, the directors of a company had issued a bond to Turquand. They had the power under the articles to issue such a bond, provided they were authorised by a resolution passed by the shareholders at a general meeting of the company. Turquand had borrowed from the company, without inquiring whether such a resolution had been passed or not. In reality, no such resolution was passed by the company. Nevertheless, it was held that Turquand could recover the amount of the bond from the company on the ground that he was entitled to assume that the resolution authorising directors to borrow was passed by the shareholders.
Also Note that where the circumstances surrounding the contract are suspicious and therefore invite inquiry, the doctrine of indoor management cannot be invoked. See MRF Ltd. v. Manohar Parrikar,(2010) 11 SCC 374(Supreme Court of India).
What documents must be scrutinized by third parties before dealing with companies
In light of the above, the following documents must be scrutinized by a third party before entering into a contract with the company:
- Memorandum and articles of association of the company
- Shareholder resolutions, if the concerned transaction, as per the articles, cannot be undertaken by the board without shareholder consent
Note: This step is optional and as per the doctrine of indoor management is not necessarily required to be scrutinized. However, it is safer to see the resolution and in practise the resolutions should be insisted upon, to prevent the company from later on taking the argument that the circumstances were suspicious and invited independent inquiry by an outsider.
- Any power of attorney authorizing the concerned director or representative to act for the company
Note: As a matter of practice, in case of high-value investment agreements, loans or mergers & acquisitions (M&A) transactions, third parties dealing with the company (i.e. investors, lenders, etc.) insist on being supplied with a copy of the shareholderâ€™s resolution, board resolution and power of attorney (if applicable) as a condition precedent to the concerned transaction, which is also specified in the legal documentation that they enter into with the company.
Public documents such as memorandum of association, articles of association and various periodic and one time (except resolutions passed by the Board under Section 179 (3) of the Companies Act, 2013) filings with the Registrar of Companies are accessible upon doing search on the Ministry of Corporate Affairs (MCA) website for the documents of the concerned company. Charges are Rs. 50/- per company, and may be paid online. The documents are available for download for a period of three hours after first accessing them. Any person who wishes to conduct such a search needs to create an account on the MCA21 website.
In reality, people often do not carry out these checks in case of low value contracts and often the articles of companies do not specify rules for dealing with third parties and entering into contract.
However, it is strongly advisable to carry out these diligences at least before entering into long term relationships with a company, supplying goods or services on credit, issuing guarantee in favour of a company or entering into high value contracts. Investors and bankers always carry out these checks before investing or providing loans.
It is also important from the perspective of a company to create these rules and incorporate them in the articles of association promptly to avoid liability arising out of negligence or entering of unauthorized contracts by directors and employees of a company. The rules should state who is authorized to deal with a third party. For example, the articles could state that contracts above a minimum value must be signed by at least two directors (including a managing director). A company is free to formulate and specify such rules in its articles based on commercial and practical considerations.