Article of Association: Legislative and Judicial Interpretation

    The Article of Association (hereinafter referred to as AoA) is a document of a company, which regulates the internal management, and conduct of the business of a company. It deals with the rights of a member of the company. The AoA is signed by the subscriber of the memorandum and prescribes the regulation of the company.Article of association also gives rise to contractual obligations between the members and between members and the company inter se. This contract governs the ordinary rights and obligations incidental to membership in the company. Articles of Association deals with matters like forfeiture of shares, director’s qualifications, appointment, powers and duties of auditors; procedure for the transfer and transmission of shares and debentures.

    “The memorandum of association, which constitutes the general constitution of the company. Therefore, the Articles going beyond the Memorandum are ultra vires. One thing that should be kept in mind is that those articles in no way can surpass the memorandum. For better understanding”, the “Duncan Gilmour & Co. Ltd., Reis a classic example, where the memorandum had exhaustively defined the rights of preference shareholders, and the articles provided that at the time of winding up, the company’s surplus assets, after paying all its debts and repaying share capital, should be distributed among all its shareholders. It was held that preference shareholders were not entitled to share any surplus assets, because their rights were to be determined from the memorandum alone as it did not confer the right to participate in them and not in respect of the articles.”

    Binding Effects of AOA

    The article when registered along with the memorandum binds the company and the member to the same extent as if they have been signed by the company and by each member. The article after being registered as a contract not only between the company and members but also between members and members. In C.I Joseph v. Jos Son of Attokoram Antony it was led down that the provision of the article cannot be waived off on the bare majority of shareholders. In case of conflict between Article and Prospectuses, the article will prevail.The discussion on the legal effect of Article can be made through the following heads-

    Member bound to the Company

    The members are bound to the company by implied covenants of the article as originally framed or as altered from time to time in accordance with provisions of companies act. It was held in Hickman vs. Kent that where the articles provided for reference of a dispute between the company and the member to arbitration, the member was bound by it. In Borlands Trust Vs. Steel Bros. Corp Ltd. “The articles of the company contained a clause that on the bankruptcy of a member, his shares should be sold to another 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 the true value. The court held that the trustee was bound by the articles, as a share was purchased by ‘B’ in terms of the articles”.

    Again, in “Bradford Banking Co. vs. Briggs Son & Co. the company memorandum provided that it shall have a first and paramount lien upon each share for debts due to the company by members of the company.” One of the members owed some amount to the company. He pledged his share with a bank to secure an overdraft and the bank gave notice of pledge to the company. The company claimed priority over the pledge of the bank and contended that the shares pledged with the bank are bound by the company’s lien as given by AoA. The court upheld the contention of the bank in respect of debts incurred by members before the notice of pledge was given to the bank.

    Company bound to Members

    Acompany is bound to its members in accordance with the memorandum and the article. A company is bound not only to the “members as a body” but also to the individual member as against their rights.A member can restrain a company from investing in an ultra vires transaction and also compel the company to fulfill its obligation towards that individual. In Wood v. Odessa Waterworks  The directors decided to pay dividends in kind of debentures. Here it was held that payment should be done in cash and therefore the company could be compelled to pay the dividends in cash as according to the article. In another case of World Phone India Ltd. V. WPI Group Inc. “The respondent shareholder asserted an affirmative vote in meeting in terms of JVA entered into between parties but AoA had not been amended to incorporate affirmative vote provided to the respondent. It was held that JVA was not binding on the company and the respondent could not insist on exercise of the affirmative vote”.

    Member bound to Members

    It is well settled that the article will have contractual obligations between members and the company and also between the members themselves concerning their certain rights. In Rayfield v. Hand “the articles of the company provided that whenever any member wishes to transfer his shares, he was under obligation to inform the directors of his intention and the directors who were under an obligation to take the said share equally between them at a fair value. The directors refuse to take a share of a particular member on the ground that the articles did not impose an enforceable liability upon them. It was held that the directors were under obligation to purchase the share as members of the company according to articles.” There was a personal liability of members inter se. It is to be noted that a shareholder may, however, sue in his name to restrain another from doing fraudulent ultra vires acts.

    Whether Company or the Members are bound to Outsiders

    A third person is not entitled to enforce the article against the Companies for any breach of right is conferred on him by the article. In Major-General Shanta Shamsher Jung Bahadur Rana v. KamaniBros.Ltd it was observed that even between a member and the company the articles of association constitutes a contract only in respect of his right and liability as a shareholder, but not in respect of rights and liability which he has in a capacity other than that of a member but as between the company and outsiders, i.e., persons who are not shareholders, the articles do not constitute a contract which that person can take advantage of. In other cases, “Hickman v. Kent or Ramney Marsh Sheep Breeders’ Association that no article can constitute a contract between a company and a third party that no right merely proposing to be given by article to a person, whether a member not, in a capacity other than that of a member, for instance, solicitor, promoter, director, can be enforced against the company.”

    Critical Analysis of Companies Act of 1956 and Companies Act 2013 in regard to amendment of Article of Association

    According to section 26 of companies act 1956 it is mandatory for the following companies to have their articles i.e., Unlimited companies limited, companies limited by guarantee, and public companies limited by share. Further in the proceeding sections 27 and 28 states about the rules which should be followed by aforesaid companies. But 2013 gave a wider interpretation of u/s 5 which gives the scope of entrenchment. “Articles of Association of the Company may contain a provision with respect to entrenchment whereby the specific provisions of the Articles can be altered only if the more restrictive conditions or procedures as compared to those applicable in case of Special Resolution have been met with. These provisions may either be made at the time of formation on by way of amendment in Articles. Where Articles contain provisions for entrenchment, specific notice of such provisions is to be given to the Registrar. Also, the Central Government is empowered to prescribe Model Articles for different types of companies, in addition to the forms given under the Act”.

    Provisions for Entrenchment

    For the first time companies’ act of 2013 in section 5(3) provides that the article may contain the provision of entrenchment. This means that the article may provide certain provisions of the Article “which will not be altered, MOA merely passing a special resolution; they will require the more prescribed and elaborate procedure. The provisions for entrenchment referred to above shall only be made either on the formation of the company or by an amendment in the articles agreed to by all the members of the company in the case of a private company and by a special resolution in case of a public company.”

    Why the Entrenchment Provision was added in the 2013 Act?

    Entrenchment arrangements are incorporated into AoA at the discretion of the company however once it is incorporated they must have consented. Sometimes, it is legitimized as it shields the privileges and rights of the minority from the greater part of concentrated ownership of the majority.  Entrenchment can be utilized as a system of corporate administration as it ensures the enthusiasm of the minority investor. By and large, articles are by-laws or tenets which oversee the administration with a specific end goal to accomplish the destinations which are enshrined in the memorandum. If in the clause of entrenchment, it is there that a decision cannot be taken without the consent of the majority, it becomes a mandate on part of the majority to see the interest and assent of the minority also. This implies it gives a unique benefit to minority assent and interest. Now the minority can compel the majority to reprise or to restrain from taking any particular decision.

    [1] It can be seen that the Government by incorporating the provision of entrenchment gave new birth to minority opinion and say in a company. Being a vulnerable group, minority shareholders were forced to accept the decision of the majority shareholder although they don’t have their consent. But now the minority will have their own opinion and value in the decision-making process of the company. Now the majority cannot do work according to their whims and fancies. Although the entrenchment clause is at the discretion of the company once a company has incorporated it in their AoA they are bound to act accordingly. It will finally create a “Fiduciary Duty” of the majority to the minority.

    [2] “The legal dictatorship that was previously available under the former Companies Act has been restricted by this section and now minority members can insist on the majority to consider their grievances and not make decisions unless minority views are put on board.”

    “Where the articles contain provisions for entrenchment, whether made on the formation of the company or by amendment, the company shall give the notice to the registrar of such provisions in such form and manner as may be prescribed.”

    Analyzing the Doctrines

     “To enable the shareholders, creditors, and those who deal with the company to know what is the permitted range of enterprise”. -Lord Macmillan

    The Doctrine of Constructive Notice

    “Under the doctrine of ‘constructive notice’, every person dealing or proposing to enter into a contract with the company is deemed to have constructive notice of the contents of its Memorandum and Articles. Whether he reads them or not, it is presumed that he has read these documents and has ascertained the exact powers of the company to enter into a contract, the extent to which these powers have been delegated to the directors, and the limitations to such powers. He is presumed not only to have read them but to have understood them properly. Consequently, if a person enters into a contract which is ultra vires the Memorandum, or beyond the authority of the directors conferred by the Articles, then the contract becomes invalid and he cannot enforce it, not-withstanding the fact that he acted in good faith and money was applied for the company.”

    The Doctrine of Indoor Management

    “According to this doctrine, after satisfying themselves that the proposed transaction is intra vires the memorandum and articles, persons dealing with the company are not bound to enquire whether the internal proceedings were correctly followed.” They are entitled to assume that the internal proceedings relating to the contract are regular as per the memorandum and articles. When an outsider enters into a contract with the company, he is presumed to know the provisions of memorandum and articles as per the doctrine of constructive notice. “But he is not required to go beyond that and to enquire whether the internal proceedings required by these documents have been regularly followed by the company. They need not enquire whether the necessary meeting was convened and held properly or whether the necessary resolution was passed properly. They are entitled to take it for granted that the company had gone through all these proceedings in a regular manner. This is known as the Doctrine of Indoor Management.”

    The doctrine of indoor management was first propounded by Lord Hatherlyin the celebrated case “Royal British Bank vs. Turquand. The directors of the Bank had issued a bond to Turquand. The company was empowered by its Articles to issue such bonds provided it was authorized by a resolution of the company in general meeting. In this case, no such resolution had been passed. It was held that Turquand could recover the amount of bond from the company on the ground that he was entitled to assume that the necessary resolution had been passed by the company.”

    https://legalreadings.com/presumption-under-evidence-act/

    Judicial Interpretation

    “There have been large debates and doubts concerning whether an alteration of the articles of association resulting in a breach of contract would be permissible or not. It is observed that various judicial authorities could not come up with a clear position.” The discussion over this mainly rests on the following considerations:

    1.     Retrospective alteration.
    2.       Contractual rights of the injured party.
    3.       Personal right of action.

    “The bottom line in this regard is that bonafide for the benefit of the company as a whole must be established; else the granting of the injunction would become a regular affair. Here it must be stated that an appeal on the ground of breach of contract is secondary and not primary. It has been held that alteration could be done retrospectively also.” This issue was very well settled in a landmark case “Greenhalgh v. Arderne Cinemas Ltd.where the articles of the company provided, inter alia, that no shares were to be transferred to a person not a member of the company so long as a member of the company was willing to purchase them at a fair value. Certain majority of shareholders wanted to sell their shares to an outsider.” A special resolution was passed altering the articles to permit a member to transfer his shares to non-members with the sanction of the company in general meeting, without first offering them to the other members. “The resolution was challenged on the ground that the interests of the minority of the shareholders had been sacrificed to those of the majority. The Court of Appeal held valid the resolution. In the case of a company comprising two equally balanced groups of shareholders, in the event of disagreement, or on failure to resolve the deadlock the company would be wound up by a special resolution for which every member was to vote.”

    The next point of consideration was that an amendment to articles, though irregular, has been operative and acted upon for a long time. The Court on this point has lay down in “Joseph Michael v. Travancore Rubber & Tea Co. Ltd. that the courts may not after a long time interfere to declare it void. In another latest judgment in Sunil Dang v. Indian newspaper Society, where there was no provision in the articles of the company to that effect, the company was not allowed to deprive a person of his membership just only because he had defaulted in paying his subscription money particularly when the member claimed that he had made the payment and that if there was the default, he was ready and willing to make it good.”

    In Crompton “Greaves Ltd. v. Sky Cell Communication Ltd. where a joint venture agreement provided restrictions on the rights of the members of the company created by the joint ventures on transferability of their shares.” But the restriction as to transferability was not carried into the articles of the company. The Court said that restriction had not acquired its binding force on the members of the company though it was binding on the parties to the joint venture. The transfer was therefore valid and it was validly registered.

    In another recent case, “Citco Banking Corp. NY v. Pusser Ltd. where an alteration of articles, about voting rights attached to shares, vested voting control in the chairman of the company, thus giving him unqualified control of the company.” “The reason for doing so was that the company needed more working capital. The company’s bank agreed to provide more loans provided that the chairman took over control of the company and personally guaranteed repayments. The court held that in these circumstances that the alteration was in the best interest of the company. The court said that the proper test is whether in the opinion of the shareholders the alteration is for the benefit of the company and whether there were grounds on which reasonable man would come to the same conclusion.”

    Conclusion

    It is a well-established fact that the Article of association plays an important role in a company that acts as a guiding factor in the functioning of the company. Hence it becomes very important to understand all its elements as functionality because it sometimes reflects the interest of various stakeholders. The government of India assimilated the provision of entrenchment in the Companies Act, 2013 which somehow protects the interest of minority shareholders. Being a vulnerable class of shareholders, their interest sometimes gets ignored by the majority shareholders of the company but now due to an amendment in new company law, it became a fiduciary duty of majority shareholder to take care of the consent of the minority. But under amendments in the article, the law cannot allow granting special privileges to the promoters in terms of the voting power. “But with the entrenchment provision in the article certain conditions can be laid down which provides exercise of power by majority shareholders only. In this case, it is concluded that with entrenchment provision the amendments of articles can be made with an objective so that it allows the majority to expropriate the rights of the minority shareholders and which adversely impacts the corporate governance of the company. It is recommended that these provisions need to be effectively implemented by both minority and majority shareholders in the interest of the company and for all the stakeholders.” “The new act refers to “the Amendment of specified clauses of Articles of Association” as the entrenchment Clause. The entrenchment clause, nevertheless, needs to be in agreement with the Memorandum of Association of the Company and the Companies Act, 2013. Any entrenchment Clause which is against the provision of Companies Act, 2013, or Memorandum of Association is void and unenforceable.”

     Further, the evolving principle of corporate jurisprudence tends more towards the balanced interest of the entire stakeholder in a company. It further may result in the smooth functioning of the organization which may ultimately result in a flourishing economy with ease of business.


    BY ASTHA KESHARWANI | INSTITUTE OF LAW, NIRMA UNIVERSITY

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