This article is written by Gurpreet Singh, a student at the Faculty of Law, Delhi University. The article apprises readers of the basics of a company as a medium of conducting business, and the proper purpose rule devised by the United Kingdom Supreme Court to rein in the directors of a company.
Table of Contents
With the Harshad Mehta web series creating a buzz on social media by amassing huge viewership, adding a feather to its hat, it has also managed to create a buzz among people about the working of the share market, but alas! This article will not take you through the share market but will apprise you about the basic functioning of the companies usually listed in the share market and proper purpose rules devised by the United Kingdom Supreme Court to reign in powers of directors.
Definition of company
The word ‘company’ is derived from the Latin word ‘Com’ which means together and the other half panis meaning bread. Combining the both, it referred to the association of persons who took meals together. Now it refers to people coming together to conduct business. Some businesses are carried by a single person that is known as a sole proprietorship, when two or more than two persons carry business together entailing responsibilities for each other’s actions it is known as partnership. A company on the other hand is distinguishable from both, it is a medium of conducting business that has its existence apart from its members.
Features of a company
Independent corporate existence
A company exists independent of its members, once a company is incorporated under the relevant Act, the company has its personality independent from its members. The enterprise is an institution in itself, no one can claim he/she is the owner of the company.
Limited liability of the members
In simple terms, the members of the company are not liable for its debts and liabilities barring certain exceptions.
A company once in existence never dies. The membership might change but the corporation remains, A company is born by the process of law and its death is only possible by the process of law. For example, The Company Tata motors will be in existence after the demise of a visionary Mr. Ratan Tata.
The common seal is considered to be the signature of the company. A company is bound by only those documents which bear a signature of the company i.e common seal. Due to amendments made in the Companies Act, 2005 it is optional for the corporation to possess a common seal.
A company is an artificial person that can buy, hold and dispose of properties by its name. The company is built by the members, and the shareholders fund the company but they are not the joint owners of the property held by the corporation.
Capacity to sue and be sued
A company is a legal entity in itself that can be sued by other companies or individuals and can sue others in case of a breach in its name. A company as a matter of act can sue its members. A company’s right to sue accrues when some loss is caused to the company that includes the property or the personality of the company. A company can sue another for defamation.
Management divorced from the capital
In companies of significant size, ownership of the company is divorced from the management of the company. The management consists of a small number of people, which are partly supervised and advised by the board of directors. The shareholders are limited to providers of capital with no real say in the management.
Types of companies
Classification based on the incorporation
These are created by the Acts of the parliament or state legislatures. The provisions of the Companies Act, 2013 do not apply to them. For example Life Insurance Corporation, Unit Trust of India, etc.
These companies are bound by the provisions of the Companies Act, 2013.
Classification based on liability
Unlimited liability companies
In these types of companies, the members are liable for the number of shares they hold in the company and they hold unlimited liability.
Companies limited by shares
A company that fixes the liability of the members according to the memorandum up to the unpaid amount of shares. For example, a company named “Star” calls 7 rupees from the shareholders for a 10 rupee shareholder. A shareholder liability would be fixed only up to the remaining 3 rupees.
Classification based on registration
A company possessing a minimum paid-up share capital of one lakh rupees or such higher paid-up share capital imposes certain restrictions on the transfer of shares and limits the number of members up to 200 except in exceptional circumstances. It is known as a private company.
A company that is not a private company prescribes a minimum paid-up capital of Rupees Five lakh or above and does not restrict the transfer of shares and number of members.
Board of directors
After having gone through the basics of the company, you must be wondering who runs the company? The company is an artificial person in the eyes of law but it cannot run itself, it requires an element of human intervention. The human intervention or agency is known as the director and when there is more than one director it is known as the board of directors. According to Section 2(34) of the Indian Companies Act, 2013, a director refers to a director appointed to the board of the company, and under Section 2(10) of the Act, a board refers to the collective body of directors in a company. Section 149 of the Act further mandates the board of directors to be present in every company and prescribes the following composition of directors:
- In the case of a public company – The minimum number of directors mandated are 3 and the maximum is 15. There is a further requirement of ⅓ requirement of directors being independent.
- In the case of a private company – The minimum number of directors mandated are 2 and the maximum is 15.
- In the case of one person company – one director is mandated.
- One women director.
- At least one director has stayed in India for 182 in the previous calendar years.
Duties of directors
- A director is bound to operate according to articles of association of the company.
- A director is bound to act in good faith to promote the objectives of the company and a duty of responsibility towards its shareholders.
- A director is expected to perform obligations to the best of their abilities.
- A director should avoid conflict of interest in any assignments directly related to the company.
- A director is expected not to pursue personal interests and favor his close aides.
- A director should act independently without the fervor of influences.
Additional duties of an independent director
An independent director is a director who doesn’t hold any shares of that particular corporation and doesn’t hold any financial relationship with the corporation. The additional duties imposed are as follows :
- Protecting the interests of minority shareholders.
- Donning the cap of a mediator to resolve conflict among the stakeholders of the corporation.
- Passing honest and independent advice to the board of directors.
- Close attention in case of favoritism.
- Impartial reporting of violations if any.
Proper Purpose Rule
You must have heard the famous quote by Tobey Maguire in Spiderman that “with great power comes great responsibility”, the proper purpose rule is just an extension to the content of the quote, by mandating that power must be used only for the purpose for which it is provided. Under Section 171(b) of the U.K Companies Act, directors are supposed to use the powers only for the purpose for which they have been conferred.
Directors are in a fiduciary relationship with the members of the company but hold a high degree of authority to apply their intellect to meet the fast pacing requirements in the working of a company. The decisions of the directors are influenced by a multitude of factors and have a long-lasting effect on a large number of people. For example, a director has the power to issue shares to raise capital for the company and he/she issues new shares for improving the aspects of business and increasing cash flows for the company, but this was done with keeping in mind his/her reputation and a guarantee of better pay to the director. The underlying effect of this decision would affect the rights of the majority shareholders. Would the use of power be considered improper or proper? To clear all this confusion, a decision was passed by the UK Supreme Court in the case Eclairs Group v. JKX Oil.
Facts of the case
- JKX was a company listed on the London stock exchange.
- Eclairs Group Ltd and Glengary Overseas Ltd. owned shares up to a capacity in JKX Oil & Gas plc to block special resolutions.
- JKX was looking to raise capital for upcoming projects but they were blocked by the group.
- Eclairs and Glengarry wrote to JKX about the removal of the present director and called for an annual general meeting.
- Relations were strained between the three groups.
- The Board of directors perceived a threat of corporate raid due to the reputation of Eclairs and Glengarry.
- The Board of JKX issued disclosure notices under Section 793 of the U.K. Companies Act, to disclose the information regarding beneficial owners of the shares they held
- The responses were given by Eclairs and Glengar, but they promptly denied any connivance among themselves.
- The article of association under Article 42 permitted the directors to issue restriction notices (notices that rip the power of voting in respect of shares held) if the board believes that information garnished under disclosure notice is incomplete.
- The board issued the restriction notice and as a result, Eclairs and Glengary could not exert their influence in the annual general meeting. The notice was challenged on the grounds of improper use.
The contention of Glengarry and Eclairs
- The main contention of the petitioners was that the board had the power to issue restriction notices but they were issued for improper purposes i.e. to prevent them from exercising their rights in the Annual General Meeting.
Trial Court outcome
- The trial court held that the directors exercised the power for improper purposes.
The Court of appeal
- The court of appeal held that the powers granted to the board under Article 42 of the articles of association are very wide and once the disclosure notices are issued there are no restrictions on issuing restriction notices. The court of appeal ruled in favor of JKX oil.
The Supreme Court
- The court ruled in the favor of Glengary and Eclairs and held that the directors used their power for improper purposes.
- The court explained it is not enough for directors to act within the confines of power only, the use of power must be for a proper purpose, not for an underlying purpose.
- The court emphasized that proper purpose rule is not meant to cover excess of power, instead, it is meant to cover abuse of power.
Criticism of the decision
- The test applied by the court was highly subjective and could result in variable outcomes in different cases according to the understanding of the court.
The Indian scenario
The Indian courts have not yet examined the scope of proper purpose as the Supreme Court in Dale & Carrington v. Prathapan (2005) 1 SCC 212 observed :
“…Courts in the Commonwealth countries including England and Australia have emphasized that the duty of the Directors does not stop at “to act bonafide” requirement. They have evolved a doctrine called the ‘proper purpose doctrine for directors. In Hogg v. Cramphorn, explicit recognition was given to the proper purpose test over and above the traditional bonafide test…In the present case, we are concerned with the propriety of the issue of additional share capital by the Managing Director in his own favor. The facts of the case do not pose any difficulty particularly for the reason that the Managing Director has neither placed on record anything to justify the issue of further share capital nor it has been shown that proper procedure was followed in allotting the additional share capital. The conclusion is inevitable that neither the allotment of additional shares in favor of Ramanujam was bonafide or it was in the interest of the company nor a proper and legal procedure was followed to make the allotment. The motive for the allotment was malafide, the only motive is to gain control of the company, Therefore, in our view, the entire allotment of shares to Ramanujam has to be set aside…”
The decision rendered by the Indian Supreme Court focuses on the lack of bona fides rather than the application of proper purpose doctrine on the document that conferred such powers and determining the purposes for such power was granted.
Through the course of the article, we have examined the working of a company as a mode of conducting business and the proper purpose rule to prevent directors from going haywire. Though the test is subjective, it would be interesting to observe how the Indian Supreme Court confronts the situation when it arises.
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