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The consequences of forming an illegal association under companies law : an insight

June 29, 2021
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This article is written by Sharanya Ramakrishnan pursuing a Diploma in Companies Act, Corporate Governance, and SEBI Regulations from LawSikho.

Introduction

Having a highly progressive economy, India is bound to have all types of business entities doing businesses in a range of sectors of its economy. This raises an important question as to how many of these entities are actually registered? Although it’s not mandatory for entities like partnerships to register themselves, registration certainly provides a range of benefits including but not limited to, limited liability protection, easy availability of credit facilities, public confidence, and settlement of claims. Unfortunately, India still remains a host to several unregistered businesses. This may be due to a myriad of reasons, whether it being too costly or the procedure being too cumbersome. 

It’s however important to keep in mind that the objective of most of these entities is to make profits or acquire certain gains. It would hence be problematic if certain associations or partnerships consisting of several persons continue to run their businesses for profits without being registered under any law in force in India. It would not only cause uncertainty as to the rights of the members inter se but also as to their accountability to third parties such as creditors.

This calls into question the legality of the existence of these associations. The Indian company law right from the Indian Companies Act, 1913 to the present Companies Act, 2013 has contained a provision prohibiting certain associations, companies, or partnerships to run a business with the objective to acquire profits unless such entities register themselves under the Companies Act or are formed under any other law. The entities failing to do so are termed “illegal associations”. This article aims to explain the meaning of illegal association, the exceptions to it, and the consequences of forming such an association.

Meaning of illegal association under Companies Act, 2013

Section 464(1) of Companies Act, 2013 (hereinafter referred to as “the Act”) read with Rule 10 of the Companies (Miscellaneous) Rules, 2014 provides that an association or partnership consisting of more than 50 persons cannot be formed-

It is to be noted that the maximum number of persons who may be prescribed under this section shall not exceed 100. [Proviso to Section 464(1)]

Here, the term “person” includes both a natural as well as an artificial person. In the case of Murugan Oil Industries (Pvt) Ltd. vs Athi V. Suryanarayana Chettiar the question was whether a registered incorporated company as such, which enters into a partnership with two other individuals will function in the partnership agreement only as a single person, or whether the company is only a compendious name for its shareholders. The court held that a registered company is to be treated as a single person.

Therefore, any association or partnership formed in contravention of the above provision may be considered to be an illegal association.

Exceptions to Section 464(1) of the Act [Section 464(2)]

An association or partnership shall not be deemed to be illegal if it is:

However, where a business is carried on by two or more HUFs and their combined number of members exceeds the prescribed number (currently 50 members), the registration will be mandatory. In Shyamlal Roy vs Madhusudan Roy And Ors, it was contended that when two or more joint families represented by their kartas enter into a partnership, the number of members for the purpose of Section 4 of the Indian Companies Act, 1913 (corresponding provision to Section 464 of the Act) would be decided by counting the ‘kartas’ and not the other ‘members of the joint family’ represented by their kartas.  The court rejected this argument and held that all the adult members of the family shall be included while counting the members under the Companies Act.

In V. Juia vs S. Dalmia, an action was brought for the determination of the validity of an arbitration agreement. The petitioner being a stockbroker, was a member of the Bombay Stock Exchange (BSE) and the respondents employed the petitioner to effect transactions in shares and other securities. Subsequently, disputes arose between them and the petitioner sought the disputes to be resolved by arbitration as provided by the rules, bye-laws, and regulations of the stock exchange. On notice of appointment of arbitrator by the petitioner, the stock exchange called upon the respondents to appoint their own arbitrator, which was refuted by them stating that the arbitration agreement is not valid as per law due to the fact that BSE was an illegal association. 

According to them, BSE being an illegal body, its rules, regulations, and bye-laws would also be illegal and hence an arbitration agreement stemming from such rules would be invalid. The question which arose was whether BSE was formed for the purpose of carrying on business with an objective to acquire gain to itself or its members. The court held that the stock exchange cannot be said to be formed for the purpose of carrying on any business. It can also not be stated that the motive of BSE was to acquire profits. As per the court, the activities of the stock exchange are only for effectively regulating and controlling transactions in shares and securities. Although profits may arise due to fees charged by it, it is important to take notice of the fact that these activities are not intended for the stock exchange to make a profit or gain. Thus, the arbitration agreement was held to be valid and effective.

Consequences of forming an illegal association

Forming an illegal association would naturally have several consequences ensuing from it. While the Act explicitly provides for certain consequences, it is found that several of them came into existence by rulings of the courts in India. This is explained in detail hereunder:

Every member of an illegal association or partnership shall be punishable with fine which may extend to one lakh rupees. [Section 464(3)]

Every member shall be personally liable for all liabilities incurred in such business. [Section 464(3)]

An illegal association cannot sue any of its members or any third parties to recover any debt due to it.  Likewise, no suit can be filed against an illegal association by its members to recover money lent to it. In addition to this, no suit can be filed by any member for partition, dissolution, or even for a rendition of accounts. This bar continues to exist even if it is subsequently registered as a company or formed under any other law in force. This position has been substantiated by several court rulings. Some of them are stated below.

In Union of India vs Commercial Association Amritsar, it was held that an association consisting of more than 20 members formed for the purpose of purchasing cloth and selling the same for-profit was hit by Section 4 of the Indian Companies Act, 1913 and that without registration thereunder it was an illegal entity. It was also laid down that incorporating a statutory provision in the Act itself barring a suit by such an illegal entity would be needless as it was a fundamental provision that an illegal entity could not maintain a suit.

In Tan Waing v. Bo He’in, there was an unregistered society of 124 members formed with the primary objective to aiding the Chinese who were poor or in temporary financial difficulties. Every earning member was to pay Rs 1 as a monthly subscription and thereafter by a resolution the society required that its members should pay one or more annas per day, and form a fund out of which any Chinese person could get a loan at ‘2 percent per mensem in his difficulty; that such contribution was to continue for three years after which period the amount contributed was to be returned to the members and the interest accrued thereon by lending was to be spent in charity. It was held that the society was formed inter alia for the purpose of carrying on a money lending business that had for its object the acquisition of gain by individual members of the society. On this finding, it was held that a suit brought by a member of that society for recovery of money lent to it was not maintainable and he is not entitled to payments due to him.

In the case of Seth Badri Prasad and Ors vs Seth Nagarmal and Ors, on cloth controlled being introduced in Rewa State, the appellants herein formed themselves into an association to collect the quota of cloth to be allotted to them and sell it on profit. Once the cloth had been decontrolled, the appellants filed a suit against the respondents for the rendition of accounts for a certain period and for the realization of the amount found with interest thereon. The suit was decreed by the trial court but was, on appeal, dismissed by the Judicial Commissioner. 

In appeal before the Supreme Court, the respondents contended that the suit was not maintainable as the association was illegal and that consequently, the members of the association had no remedy against each other in respect of its dealings and transactions. The court held that the suit was not maintainable as the association was found to be illegal under law and that reliefs claimed for a rendition of accounts in the enforcement of an illegal contract of partnership would insinuate recognition of the existence of such association by the court.

In the case of In re. Padstow Total Loss and Collision Assurance Association, a creditor who has obtained a decree against an unregistered company being an illegal body, sought the winding up of it as the only means available to him for the realization of his debt. It was held that, if the formation of the company itself is prohibited, it would be impossible to presume that the legislature could have intended that such a company can be wound up.

Similarly, in In re South West Atlantic Steamship Company, a petition for winding up presented by solicitors, who had themselves helped in establishing an illegal association, was refused. 

In Mewa Ram vs Ram Gopal And Orsthere was a dispute involving two ginning factories. The respondent claimed that the partnership was formed in violation of Section 4 of the Indian Companies Act, 1913 and sought a refund of his subscription money or in the alternative, a division of the properties of the factories and, if proper, an auction sale of the property and an award of 1/8th share in their sale proceeds. The case was first heard by a Division Bench wherein there was a difference of opinion upon a point of law, namely, whether having regard to the fact that the Association to which the respondent belonged was an illegal one, the court cannot grant any relief, or, on the other hand, could grant some form of relief in the nature of restitution by a decree. On being referred to a third judge, he found that in order to give the respondent the 1/8th share, it is necessary to sell the said factories and to turn them into liquid assets. It was observed that if partition were to be granted, it would in substance amount to an order of winding-up of the association and hence a suit for partition of existing assets cannot lie.

Seeing as a suit cannot be maintained for all the reasons above, it brings us to the question as to under what circumstances a suit can be filed against such an association. In Appa Dada Patil vs Ramkrishna Vasudev Joshi, the question was whether the plaintiff (third party) would be entitled to recover the goods he entrusted or the price of those goods, or alternatively the money that he deposited with the defendant company, an illegal association. 

As this is a case dealing with the rights of a third party, the court observed that a third party is not necessarily defeated by illegality in the constitution of the body with which he is dealing.  As per the court, although a suit cannot be maintained by a person who, being aware of all the facts, seeks to enforce a demand arising out of a transaction tainted with the illegality which affects the association, a person acting in good faith and not being implicated in any illegal act himself, cannot be prejudiced by the fact that the person with whom he has been dealing is an illegal body. Therefore, the plaintiff, who entered into transactions with the defendant company in ignorance of the circumstances which resulted in the illegality of the defendant company, can maintain a suit to recover the balance due on an account of the transactions with the said company.

An illegal association or its members cannot enter into binding contracts in the name of the association. This position is illustrated in the case of Bapulal vs Laxmi Bharat Trading Co. And Ors, wherein the appellant Bapulal Soni Saraogi being the President of an association called ‘Naj Vitran Committee’, filed a suit on behalf of himself and the other members of the Committee alleging failure of repayment of the loan by the respondents. This suit was resisted by the respondents contending that the said Committee was an illegal body not registered under Section 4 of Indian Companies Act, 2013, and hence the suit was not maintainable. The trial Court having accepted the said contention dismissed the then plaintiff’s suit and being aggrieved by the same, the present appeal was preferred. 

It was an admitted fact that the Committee was an association of as many as 115 persons and carried on the business of purchasing food grains from the State and made itself responsible for their distribution in the city of Udaipur at the same rates at which the Committee received them from the latter. The bone of contention, however, is whether this Committee undertook this business with the object of acquisition of gain as the respondents put it, or as a mere matter of social service as the appellant would have it believed. The appellant not only failed to produce any evidence such as the memorandum of the committee or association which would have given an unmistakable insight as to the aims and objects with which it was formed, it was also found that the Committee had realized a sum of about Rs. 10,000/- to 15,000/- as the commission received by it from the Government, and further that a sum of Rs. 100/- was distributed as profits to each of the members. 

The court came to the conclusion that the committee in question had been formed with the object of acquiring monetary gain. The court ultimately held that “having regard to the provisions contained in Section 4 of the Companies Act the Committee with which we are concerned had no legal capacity to act whatever and in fact was an illegal association, and, that being so, to give effect to a contract entered into by such an association in a court of law would be a clear violation of that law and no court of law can countenance such a claim.”

In Mohamed Abdul Kareem and Co. v. Commissioner of Income-tax, the question was whether an illegal association can be recognized as an assessable unit under the taxing statute and is thus liable to pay income tax on its profits. The court held that, so long as it is an association that produces income, profits, or gains, it is accessible to tax and cannot escape from its liability.

How Section 464 of the Act differs from the erstwhile Companies Acts?

The following table points out the salient differences:

Basis 

Section 4 of Indian Companies Act, 1913

Section 11 of Companies Act, 1956

Section 464 of Companies Act, 2013

Prohibition for the formation of an association for carrying on a banking business 

More than 10 persons 

More than 10 persons 

No such provision exists 

Prohibition for the formation of an association for carrying on any other business

More than 20 persons

More than 20 persons

More than 50 persons

Exception to HUFs

No such provision exists 

Contains a provision for the same [Section11(3)]

Contains a provision for the same [Section 464 (3)]

An exception to an association formed by professionals governed by special Acts.

No such provision exists 

No such provision exists 

Contains a provision for the same [Section 464 (3)]

Imposition of fine on members

No such provision exists 

Fine may extend to Rs 1000

Fine may extend to Rs 1 lakh

Personal liability of members

No such provision exists 

Personal liability exists [Section 11(4)]

Personal liability exists [Section 464(3)]

Conclusion 

Considering the fact that a provision for prohibiting the formation of illegal associations unless they are mandatorily registered has been included in the statutes governing company law right from 1913, the importance of this provision cannot be understated or ignored.  It can be gathered that the legislative intent for doing so, is to restrain such associations and their members from taking undue advantages by ensuring to provide not only a bar for filing of suits but also making the members personally liable for defaults. It also serves as a warning to those who knowingly enter into transactions with such associations. Thus, registering one’s association becomes vital to avoid harsh consequences under the law.

References

  1. https://www.icsi.edu/media/portals/86/The%20Company%20Act,%201913.pdf
  2. https://swarb.co.uk/in-re-padstow-total-loss-and-collision-assurance-association-ca-1882/
  3. http://ebook.mca.gov.in/default.aspx

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