Rule of Constructive Notice: Ernest v. Nicholls

Introduction

The case was decided by the Privy Council, which dealt with contracts executed between an outsider and a person of a company, who has gone beyond the powers of a person and constitution of a company. The article primarily deals with how various countries have dealt with the decision made in this case. The analysis part includes how doctrine of constructive notice has been negated and how a new doctrine has been established.

A company has a duty to file its constitution with the Registrar of Companies, which can be made available for inspection by any member of the public by paying a certain fee.[1]Outsiders who contract outside the limits of the constitution have the risk of their contract being declared void even if such contracts were entered with the people of the company itself.[2]This protects the capital and sources of the company from being used in ways which the company members do not accord for.

But, such rules can trap outside innocent parties acting in good faith in their contract with the company. While some cases have accepted that a person dealing with the company has constructive notice,[3] it brought about a lot of confusion. Constructive notice, simply, is a concept under which, it is said that an outsider dealing with a company is aware of the company’s internal affairs, and is therefore, himself liable for damage he incurs by entering into contract with the company.

Scenario and Decision in the Case

In Ernest v. Nicholls[4] the contract was made by one company for the acquisition of another company’s goodwill. It was sealed and attested by two directors. The company had four directors and its deed specified the quorum of directors, for such activities, as three. It was said and inferred at first instance that three of them had authorized the sealing while one of those had an “interest” in the contract (though he did not authenticate the sealing). The Lord Chancellor noted that the transaction was extraordinary, and one which a company could not be presumed to have power to enter into the transaction. Lord Wensleydale laid down that the articles which restrict and regulate authority are to be stipulated in obligatory manner for those who deal with the company. Further, he also laid down that directors can make no contract so as to bind the whole body of shareholders. The case assumed constructive notice and constructive knowledge of the constitution.

It was decided that notwithstanding that the contractor has relied on apparent authority, an outsider can’t make a company perform, based on purported authority of the contractor. Further, Lord Wensleydale decided that law of partnerships is not applicable to the company which comprises of greater numbers. Therefore, to make the whole company to comply to the contracts entered by contributors will lead to utter ruins.

Analysis

Limitation to the contracts of the company were seen in the Irish Companies Act of1856. Expressly or not, it provided for two limitations i.e. ultravires and constructive notice. Later, limitation to the doctrine of constructive notice was seen in other legislations as well.

Ultravires

Earlier, the laws were said to provide a company with unlimited capacity to transact.[5]Ultravires as a concept, was developed in the late 19th century to protect the investors of a company. It provided that transactions of a company are to be limited by the objects mentioned in the memorandum of association.[6]Section-38 of the Companies Act, 2014[7] provides that a company for its transaction outside and inside the nation, shall not be limited, if the transaction doesn’t violate the constitution. Therefore, such limitation does not exist as in the past.

Constructive Notice

The legislatures devised provisions of letting people of the world know about the company through certain documents. If the contractors chose not to acquaint the information about the power of the directors, it’d be their own fault.In the case of Kreditbank Cassel v. Schenker’s Ltd., Wright J. said that memorandum and article of companies are public and people dealing with the company are said to be acquainted with their terms and is bound  by it.[8]Some cases even assumed that the person understood the rules and regulation in the documents.[9]The rule of constructive notice extends to documents registered with the Registrar of Companies, not being limited to memorandum and articles. However, constructive notice doesn’t cover documents filed with the registrar of companies, for the purpose of maintaining record.

Where a transaction was ultravires, the transaction was void and there was no need to look into constructive notice.[10] For a transaction that was not ultravires, the contracting outsider could not argue that there was ostensible authority and that estoppel would come into play.[11]In Kotla Venkataswamy v. Rammurthy,[12]  the Madras High Court discussed the Doctrine of Constructive Notice. The Articles of Association of the company in that case provided that all deeds, certificates and other instruments were to be signed by the secretary, managing director and a working director.  The plaintiff executed a mortgage deed signed by the secretary and a working director only. Even if the plaintiff had acted in good faith, and the deed was put forward in adequacy of approval, the plaintiff could not claim for the deed as it was seen that it was mentioned in the document, the need of signatures.

Criticism of Doctrine of Constructive Notice

The doctrine of constructive notice is unreal as it doesn’t take notice of practical business life. People are accustomed to know a business through its people and not its documents. Such doctrine can allow well-known companies to exploit innocent contractors.The doctrine of constructive notice, was termed by Gower was “wholly unrealistic”.Sargant L.J. in his intervention to Houghton& Co. v. Nothard, Lowe & Wills Ltd. said that the doctrine of constructive notice is not a positive doctrine, but a negative one as it operates against the person who has not inquired.[13] Many other people have agreed to this.[14]The Madras High Court in Official Liquidator, Manasube & Co. (P.) Ltd. v. Commissioner of Police[15] observed that the lenders to a company should avail themselves with articles and memorandums but they cannot be expected to investigate legality and regularity of acts of directors.

The rule of constructivenotice lacks practical relevance. Directors require approval for their action from the shareholder. The approval again comes with sanctions and guidelines. Investors and other outsiders do not dare to ask about the approval to the directors as they want to maintain relation with the company. Therefore, the outsiders are actually not aware about everything.

Overcoming Constructive Notice Doctrine

Section 8(1) of the Companies Act, 1963,[16] provided that acts done by a company, notwithstanding the powers of the company, shall be effective in the favour of the person relying on such act provided that the he was not aware of the company’s power. Further, the section provides that any loss caused by any director or officer contracting outside the power of the company, shall be liable for the loss. Therefore, by this section, a person could enforce the transaction even if it was ultravires. However, the section provided no protection to anyone who had read the constitution and were aware of the limitation of the company.[17]

Communities (Companies) Regulations Act, 1973 also provided for protection of people dealing with a company in good faith. Here, any limitation of powers of the board or person of a company, imposed by memorandum or articles of association, could not be relied upon for defending the company. The acts have made an inroad to the doctrine of constructive notice.

In the case of Freeman and Lockyer v. Buckhurst Park Properties (Mangal) Ltd,[18] Diplock L.J. laid down conditions for ostensible authority to be enforced. (i) Representation must be made to the outsider by the person, claiming authority (ii) representation must be made by person who has actual authority in business or contracts of the company (iii) the outsider must be induced by the representation made, to enter into contract.

In case of TCB Limited v. Gray,[19] it was decided that good faith is to be presumed and the person is not bound to enquire. In Lakshmi Rautan Cotton Mills v. JK Jute Miller Co.,[20] it was decided that, a person contracting with an individual director of a company, knowing that board has power to delegate authority on him, may assume that such delegation has been exercised. A company is estopped from asserting limitation of authority of its persons.[21] In the case of Bigger Staff v. Rowatt’s Wharf, Ltd.[22] person purporting to act as a managing director, made the company bound by his acts as the articles of association conferred power to appoint managing director.

Pearson L.J. said that use of expression “ostensible authority” and “holding out” is vague. We can simply understand the criticisms to constructive notice as estoppel by representation.[23]  The doctrine of estoppel followed rejection of the positive doctrine of constructive notice.In Dehra Dun Mussorie Electric Tramway Co. v. Jagmandardas,[24] the directors could delegate their powers other than their borrowing power. Nevertheless, the court decided that an overdraft incurred by the agent would be binding to the company. Therefore, derogation from the concept can be seen in India as well.

The Present Scenario

The Companies Act, 1963 provided to protect the innocent parties but again a conflict arose. The act, in simple language, provided that unaware parties shall be protected while the aware parties shall not be. The conflict was whether to inspect the constitution and be aware and give up their protection or to not inspect the constitution and have their protection. The Companies Act, 2014 made changes to prevent the constitution from having external effect on the third party’s transaction with the company. The new enactments have provided for protection of the innocent outside contractors acting in good faith but what about innocent companies who are bound to carry on with a transaction that their person made outside his power? Hasn’t protection of outsiders come with harm to the insiders?

(i) Transactions with registered and unregistered person

The 2014 act provides that the board and their registered persons are deemed to have a requisite authority.[25] The act also provides that there is no requirement to deal with whether the person knew the person was registered person or not. Essentially meaning that actions of registered person binds the company. This section makes the limitation of the constitution ineffective when it comes to transaction done by a registered person. Further, Section 40(9)[26]provides that “in determining any question whether a person had ostensible authority to exercise any of a company’s powers in a given case, no reference may be made to the company’s constitution.”

The act provides different rules when it comes to transaction with unregistered persons. The third party is entitled to assume that such persons enjoyed the authority of ostensible or apparent nature. But, where the party knew about the limited authority, the company is not bound to perform the transaction. Apparent authority in the present is seen as maximum authority which may be reasonably apparent, in the circumstances provided.[27]

New Doctrine

In the TurquandCase,[28] it was decided that, the outsider can hold the company liable, by merely showing that in the article of association, the company has a power to confer authority to its person, who has contracted with the outsider. Whether the power to confer authority has been exercised or not, was not necessary to be looked upon as it was an inside matter of the company.

Memorandum and articles of association are public document, which are publicly available.[29] This was also agreed by Lord Hatherley in Royal British Bank v. Turquand but he added that, people dealing with the company, externally are not to be affected by the internal matters of the company.

Doctrine of Indoor Management came as a concept after Doctrine of Constructive Notice. The new doctrine protects the outsider while the old one protected the insider.  Court in Royal British Bank v. Turquand, propounded that, even if it was considered that the documents were made avaialble to the contracting parties, they were not required to satisfy themselves that all internal rules have been complied with. Many cases after this have interpret that if a member represents himself as having authority, the company should comply with his acts as such act is an internal matter, which the outsider is not aware and therefore has no duty to inspect.

Memorandum and articles of association are open to the public but details of internal procedures are not. Therefore, doctrine of indoor management is useful instead of constructive notice.There are exceptions to the doctrine of indoor management as well. Knowledge of irregularity, negligence of the outsider, forgery, etc. are some exceptions. In case of TR Pratt (Bombay) Ltd. v. ED Sassoon & Co. Ltd.,[30] the lender has the knowledge and thus the mortgage entered by him was not binding.

Conclusion

The case of Ernest v. Nicholls provided that the company should be protected from its own people who contract/transact with an outsider. This sentence itself shows the absurdity that the doctrine of constructive notice holds. Now, while summarizing the doctrine of indoor management, it protects an outsider having good faith from a person of a company that transacts beyond his power or beyond the constitution of the company. This protects the interest of innocent outsiders and prevents exploitation of arbitrary power by the persons of the company. There is an important exception to the doctrine of indoor management as well i.e. an outsider who has knowledge of indoor activities of a company and still contracts with the company, can’t claim performance of the contract based on the doctrine, if such contracts are rendered as being beyond the company’s power. The doctrine of constructive notice has been replaced by the doctrine of indoor management in the present and has international recognition as well.

References:

[1] Companies Act §l7,965,1004,1174,1231 (2014).

[2] Companies Act § 41 (2013).

[3] Ridley v. Plymouth, Stonehouse, and Devonport Grinding and Baking Co., 2 Exch. 7II, 7I7.

[4] Ernest v. Nicholls [1857] 6 H.L.C. 401 (Eng.).

[5] Sutton’s Hospital Case [1612] 77 Eng. Rep. 960 (Eng.).

[6] Ashbury Railway Carriage and Iron Company v. Riche [1875] L.R. 7 HL653 (Eng.); Central Transp. Co v. Pullmans Car Co (1891) 139 U.S. 24.

[7] Companies Act § 38 (2013).

[8] Kreditbank Cassel Case [1926] 2 K.B. 450 (Eng.); Schenken’s case [1927] 1 K.B. 826 (Eng.).

[9] Mahony v. East Holyford Mining Co. [1875] LR 7 HL 869 (Eng.); Barton v Bank of Ireland [1939] I.R. 6.

[10] Re Jon Beauforte (London) Ltd [1953] Ch.131. 8. (Eng.).

[11] Re Shannonside Holdings Ltd (unreported); Rama Corporation v.  Proved Tin & General Investments Ltd.,[1952] 1 All E.R. 554 (Eng.).

[12] KotlaVenkataswamy v. Rammurthy,AIR 1934 Mad 579 (India).

[13] Houghton& Co. v. Nothard, Lowe & Wills Ltd.[1927] 1 K.B. 246 (Eng.).

[14] Rama Corporation v.  Proved Tin & General Investments Ltd.,[1952] 1 All E.R. 554 (Eng.).; Freeman and Lockyer v Buckhurst Park Properties (Mangal) Ltd  [1964] 2 Q.B. 480 (Eng.).

[15] Official Liquidator, Manasube& Co. (P.) Ltd. v. Commissioner of Police [1960] 3 All E.R. 482 (Eng.).

[16] Companies Act § 8 (1) (1963).

[17] Northern Bank Finance Corporation v. Quinn and Achates Investment Company [ 1979] I.L.R.M. 221.

[18] Freeman and Lockyer v Buckhurst Park Properties (Mangal) Ltd  [1964] 2 Q.B. 480 (Eng.).

[19] TCB Limited v. Gray[1986] 1 All ER 587 (Eng.).

[20] Lakshmi Rautan Cotton Mills v. JK Jute Miller Co., AIR 1957 All 311 (India).

[21]  Hambro v. Burnand [1904] 2 Q.B. 10 (Eng.).

[22] Bigger Staff v. Rowatt’s Wharf, Ltd.[1896] 2 Ch 93 (Eng.).

[23] Ladbroke v. William Hill [1964] 1 All E.R. (Eng.).

[24] Dehra Dun Mussorie Electric Tramway Co. v. Jagmandardas, AIR 1932 All 141 (India).

[25] Companies Act §39 and 40 (2014).

[26]Companies Act §40 (9) and 40 (2014).

[27]JT Montrose, The Apparent Authority of an Agent of a Company, Malaya Law Review,  December 1965 at 253.

[28]Royal British Bank v. Turquand[1856] 6 E&B 32 (Eng.).

[29]Mahony v. East Holyford Mining Co. [1875] LR 7 HL 869 (Eng.).

[30] TR Pratt (Bombay) Ltd. v. ED Sassoon & Co. Ltd., AIR 1936 Bom 62 (India).