Analysis of Objects Clause and Doctrine of Ultra Vires – Companies Ordinance, 1984 vis-a-vis Companies Act, 2017

The recently introduced, Companies Act, 2017 has brought substantial changes in Pakistani company law. In particular, as far as a company constitution is concerned, the new legislation has turned the tables in favour of the articles of association against the memorandum of association. It can now be safely stated that the articles of association should be considered as the constitution of the company and not the memorandum of association.
However, the memorandum is still required for registration of companies under the Companies Act, 2017, but its role, complexity and length have been significantly reduced. This article deals with the central role played by the objects clause of memorandum of association under the Companies Ordinance, 1984 and the consequences of doing away with it under the Companies Act, 2017. The future role and operation of the ultra vires principle will also be analyzed.

Objects clause under Companies Ordinance, 1984:

Under Companies Ordinance, 1984,ss. 16, 17 and 18, it was the third clause of the memorandum of association which had to state the objects for which the proposed company was being established. The objects clause represented the activities which a company could do (i.e. the capacity of the company). If the company entered into a transaction which was not included in the clause that transaction had to be considered ultra vires and, therefore, void.

Why objects clause?

There are many solid reasons behind the requirement of an objects clause to be inserted in the memorandum of association. In the first place, although the ownership of corporate capital is vested in the company itself, in reality that capital has been contributed by the shareholders and is held by the company as though in trust for them. Such a fund must obviously be dedicated to some defined objects so that the contributors may know the purpose to which it can be lawfully applied. The statement of objects, therefore, gives a very important protection to the shareholders by ensuring that the funds raised for one undertaking are not going to be risked in another.

The objects clause, in the second place, affords a certain degree of protection to creditors also. The creditors of a company trust the corporation and not the shareholders and they have to seek their repayment only out of the company’s assets. The fact that the corporate capital cannot be spent on any project not directly within the terms of company’s objects gives the creditors the legal guarantee that the company will operate only within its specific domain. Even public financial institutions providing loans to companies have to go objects wise in deciding which company receives the loan, because they have their own list of priorities. The objects clause is their only guidance in this respect.

Finally, by confining the corporate activities within a defined field, the statement of objects serves the public interest also. It prevents diversification of a company’s activities in directions not closely connected with the business for which the company may have been established: this will protect the public from undesirable market monopoly situations that may arise from excessive diversification of a single company’s activities. Although this legal limitation can be overcome, as it is witnessed by the increasingly diversified fields of activity of many national and multinational companies, it remains an important safeguard for the public.

Doctrine of ultra vires and consequences of ultra vires transactions:

The legal requirements  mentioned under the previous headings require a company to devote itself only to the objects set out in the memorandum and to no others. So, after the identification of objects, it is the function of the courts to see that a company does not move away from its identified field. An action outside the memorandum is ultra vires, that is beyond the scope of a company’s legitimate activities. Its first application was in Ashbury Railway Carriage and Iron Co v Riche (1875):

The company bought a concession for the construction of a railway system in Belgium, and entered into an agreement to finance Riche to construct a railway line. Riche commenced the work, and the company paid over certain sums of money in connection with the contract. The company later ran into difficulties, and the shareholders wished the directors to take over the contract in a personal capacity, and indemnify the shareholders. The directors thereupon repudiated the contract on behalf of the company, and Riche sued for breach of contract. The case turned on whether the company was engaged in an  activity beyond the scope of the company objects in financing the building of a complete railway system: if so, the contract made with Riche would be ultra vires and void, and the claim against the company would fail. The objects clause of the company’s memorandum stated that it was established: ‘to make or sell or lend on hire railway carriages, wagons and all kinds of railway plant, fittings, machinery and rolling stock; to carry on the business of mechanical engineers and general contractors, to purchase and sell as merchants timber, coal, metal and other materials, and to buy and sell such materials on commission or as agents’

The House of Lords held that the financing of the concession to build a complete railway system from Antwerp to Tournai was ultra vires and void because it was not within the objects of the company. The words empowering the company to carry on the business of general contracting must be construed ejusdem generis with the preceding words, and must therefore be restricted to contracting in the field of plant, fittings and machinery only. In other words, the company could use its funds to make things for railways, but not make railways as such. The contract with Riche was therefore void, and the directors were entitled to repudiate it.

In the next leading case of Attorney General v. Great Eastern Railway Company (1880), the House of Lords observed that the doctrine of ultra vires, as it was explained in the Ashbury case, should be maintained, but it ought to be reasonably and not unreasonably understood and applied so that  : ‘whatever may fairly be regarded as incidental to, or consequential upon, those things which the legislature has authorised, ought not (unless expressly prohibited) to be held, by judicial construction, to be ultra vires’. (Lord Selborne LC) Thus, a company may do an act which is: (a) necessary for, or (b) incidental to, the attainment of its objects.

It may be said that the ultra vires rule of common law was brought in by the courts to protect shareholders. It was thought that if a shareholder bought shares in a company which had as its main object publishing and cognate activities he would not want the directors of that company to start up a different kind of business because he wanted to put money in publishing. However, the people most affected by the ultra vires rule of common law in more recent times were creditors who had supplied goods or services to a company for a purpose not contained in its objects clause. If the company was solvent, no doubt such creditors would be paid, but if it went into insolvent liquidation, they would not even be able to put in a claim. The liquidator would reject it as being based on a void transaction. Other creditors might get paid some part of their debts if the company had some funds but the ultra vires creditors would get nothing.

For this reason, it had very quickly become usual to put in the objects clause a large number of objects and powers so that the company could do a wide variety of things apart from its main business, if at any time it wished to do so. It had also become common to insert a paragraph in the objects clause in which each clause contains a separate and independent main object which can be carried on separately from the others. In Cotman v Brougham [1918], Lord Cozens Hardy MR had said: ‘Now we are familiar with an enumeration of objects which extends the full length of the alphabet, and sometimes beyond it, so that you get sub- clauses (aa) and (bb) after you have exhausted all the other letters’.

In the South Asian context, the Indian Companies Act of 1956 (now repealed) and 2013, both required incidental objects also to be stated in the memorandum, however no such requirement was mandatory under Pakistani Companies Ordinance of 1984. But even if incidental objects are not stated, they would be allowed by the principles of reasonable and liberal   construction as in UK.

Legal consequences of ultra vires transactions:

When a company enters into an ultra vires transaction, the following consequences may ensue:

1. Injunction:

A company may be restrained from doing something which is outside the scope of its objects clause. Thus, in Simpson v Westminster Palace Hotel Co (1860), a shareholder sought to restrain the hotel company from letting out rooms as office space. In the event, it was held that this was not ultra vires or beyond the company’s objects but it was held that had it been so an injunction could have been issued.

In Stephens v Mysore Reefs (Kangundy) Mining Co Ltd [1902], a gold- mining company that was set up to mine in India was restrained from mining for gold in West Africa as this was beyond its objects clause.

2. Personal liability of directors:

It is one of the duties of directors to see that the corporate capital is used only for the legitimate business of the company. If any part of it has been diverted to objects foreign to the company’s memorandum, the directors will be personally liable.

3. Ultra vires contracts are void ab initio, therefore, they are unenforceable:

An important area in relation to a company’s objects clause is the extent to which a contract beyond the capacity of the company is enforceable, either against the company or by the company. At common law the position is that such contracts are void. This sometimes results in manifest injustice. For example, a company purchased and operated a rice mill beyond its powers. The rice was consigned to certain persons who had paid the price. The consignees had to sell rice, owing to its inferior quality, at considerable loss. The company gave them drafts promising to pay for the loss. The company went into liquidation and the question about enforceability of the drafts arose.

The court held that trading in rice was an ultra vires transaction ; the directors, therefore, could not bind the company, and the consignees could not recover. The outcome of Ashbury Railway Carriage and Iron Co v Riche (1875) may be considered another case in which injustice may be said to have resulted from a strict application of the principle that ultra vires transactions are void, as the contractor had already began constructing the railway. In another case, Re Introductions Ltd [1970], where the company went into the ultra vires business of pig breeding, the lender of money, knowing that the purpose of the loan was for pig breeding, was unable to have the loan repaid (nor could the lender rely upon a substantive provision permitting the company to borrow contained in the objects clause, as the court held that borrowing of itself could not stand as a substantive separate object of a company).

Situation under Companies Act, 2017:

But the situation has changed in Pakistan after the promulgation and entering into force of the Companies Act, 2017. A company henceforth will have unrestricted objects. Section 26 states that a company may carry on or undertake any lawful business or activity and do any act or enter into any transaction being incidental and ancillary thereto which is necessary in attaining its business activities. Consequently, for companies formed under the new Act, they are not required to have an objects clause and the doctrine of ultra vires should be irrelevant to their operation. However, for a company that decides to adopt an objects clause so as to limit the capacity of the company, then the doctrine of ultra vires will still remain relevant internally (i.e. with respect to deciding whether its directors have exceeded their powers and entered into a transaction that is ultra vires the company’s objects clause).

Now the memorandum of the company shall state— (i) the name of the company; (ii) the part of Pakistan in which the registered office of the company is to be situated; (iii) the principal line of business (iv) an undertaking as may be specified; (v) that the liability of the members is limited; and (vi) the amount of share capital with which the company proposes to be registered and the division thereof into shares of a fixed amount.

For companies incorporated under previous legislation, provisions are that- (a) the existing companies shall continue with their existing memorandum of association and the object stated at serial number 1 of the object clause shall be treated as the principal line of business; and (b) if the object stated at serial number 1 of the object clause is not the principal line of business of the company, the company is required to intimate to the registrar their principal line of business. A revised copy of the memorandum of association indicating therein its principal business at serial number 1 of the objects clause shall also be furnished to the registrar.

What is principal line of business?

Principal line of business means the business in which substantial assets are held or likely to be held or substantial revenue is earned or likely to be earned by a company, whichever is higher.It should be noted that he principal line of business of the company shall be mentioned in the memorandum of association of the company which shall always match the name of the company. For example, if a company is involved in three areas of business i.e., cement making, real estate, and shoe making, and it holds 55% assets in cement making then its name must  contain a reference to cement.

Conclusion

The history of objects clauses and their interpretation is largely a history of conflict between two conflicting principles: protection of shareholders on one hand and of the persons entering into transactions with the company on the other. Clearly narrowly constructed object clauses would provide more shelter to shareholders, whereas more widely drafted ones would be favourable to those who enter into commercial deals with the company. The role of the judiciary had been to progressively expand, by way of interpretation, the scope of activities that object clauses could allow. But their attempts fell short of what entrepreneurs needed  that is providing companies with as much freedom as possible in their activities. Certainly, the recent reform of ultra vires rule under the Companies Act, 2017 is a welcome sign after somewhat confused and arbitrary decisions of the courts in relation to which contracts were enforceable and which were not. Now 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 and where a person deals with a company in good faith, the power of the directors to bind the company shall be deemed to be free of any limitation under the company’s constitution.