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Do companies have complete freedom to act

Do companies have complete freedom to act? Analyse the doctrine of ultra vires and the proposed reforms in the Companies Bill designed to grant companies full capacity.

The doctrine of ultra vires has been fervently debated for many years since its conception in the 19th century, and has caused widespread confusion within the sphere of company law. It will be necessary, in order to construct a thourough and fluidous argument, to outline the history and development of the ultra vires doctrine and why, some would argue, it has become the bane of company law. It will also be necessary to dicuss the relevance of ultra vires to modern company law and the efforts to curtail its widespread influence. The DTI’s White Paper Modernising Company Law, presented to Parliament in 2002 seeks to afford companies the ability to act with unlimited capacity and therefore remove the problems associated with the ultra vires doctrine which will be discussed shortly.

This essay will adopt the normative approach that companies, in order to fulfil their potential should have the ability to expand by any means possible to achieve the most economically efficient response. The doctrine of ultra vires is widely regarded as a way in which the company law can be responsive to different bodies and constituencies. The doctrine of ultra vires has been subjected to many reforms and has been highly criticised since it was first introduced, this is largely due to the fact that it has been regarded as a hindrance upon the economic efficiency of companies and an inhibitor of a companies ability to expand and respond to the economic climate. Stephen Griffin describes the ultra vires doctrine (pre-reform) as a

"regulatory device which sought to prevent a registered company from entering into any type of transaction which exceeded the scope of the company's contractual capacity; contractual capacity being determined by the contents of a company's object clause."[1]

In order for a company to be considered as having full-capacity to act, the company must be fully unconstrained in its contractual capacity and therefore, in a position to expand any way it sees as economically advantageous and therefore not incarcerated by its own legal structure (objects clause and memorandum of association). The writer will investigate whether undergoing reforms have actually ordained the company with full capacity to act or whether this paradigm has yet to become a reality.

Ultra vires, if described literally, is generally understood to mean "beyond (ultra) legal powers (vires)"[2], this becomes active upon a company’s entering into a contractor dealing with an indiviual in a way not covered by the scope of a company’s contractual capacity. Sealy states that the doctrine "imposed artifical limitations on the acts and things which a company was regarded in law as capable of doing...it (the company) would also be regarded as incapable of doing anything which was not within the scope of its objects clause, or reasonably incidental thereto".[3] A company’s objects clause clearly states what business a company is permitted to undertake, and anything extra mural to that scope was, before reform, considered to be ultra vires the company and therefore voidable. Farrar asserts that the ultra vires doctrine has, throughout history, battled between two spearate theories of incorporation[4], "the legal privilege model and the freedom of contract model"[5]. Farrar states that the legal privilege theory "emphasised responsibility through restriction and the fulfillment of conditions"[6], the freedom of contract theory "emphasises the utility of the right to incorporate and the freedom of choice of the incorporators under a liberal economy state concerned with facilitating rather than restricting business."[7] This supports the belief that a company should have the ability to act with full capacity in order to act in the most economically efficient manner. However, in order to conduct a discussion concerning the future developments of the ultra vires doctrine it is necessary to examine its origins in British company law.

In 1844, the boom in the railway economy gave way to an upsurge in the incorporation of companies, before then the most common form of company was a deed of settlement company[8], which did not benefit from the corporate personality enjoyed by chartered companies and companies directly incorporated by statute.[9] The Joint Stock Companies Act of 1856 saw an overwhelming decrease in the deed of settlement company which faded out and was replaced incrementally by the registered incorporated company.[10] The registered incorporated company contained a memorandum of association obliging the company to specify and highlight its objects, the company was also granted limited liability.[11] However, the drafting of the act did not specify any conceivable way in which the company could alter its objects and therefore broaden the markets in which it could operate. The objects clause was riddled with ambiguities and deficiencies in its lack of specifying a way in which a company could alter its objects clause. The original intent behind the structure of the ultra vires doctrine was two-fold, it was designed to protect the two corporate constituencies, shareholders and creditors and to create greater certainty and stability for investors. This ability to change the objects clause was confirmed by the Companies Act 1862, which provided a company with two means of changing its objects clause, by members’ ratification or by court order. The 1862 Act did not expressly forbid the ability of a company to create a limitless list of any conceivable business so as not to be caught by the ultra vires rule.

The effect of the ultra vires rule was first discovered in the Leading case of Ashbury Railway Carriage & Iron Co. (Ltd) v. Riche[12], in which the House of Lords rendered a contract entered into by the company void as it was beyond the company’s objects clause[13], even though the measure was adopted by the company’s directors. Lord Cairns LC stated that "the question is not as to the legality of the contract; the question is as to the competency and power of the company to make the contract".[14] Lord Cairns leading judgement adhered closely to the stated intent of the company and he delared that the company’s objects clause

"states affirmatively the ambit and extent of vitality and power which by law are given to the corporation....(that) nothing shall be done beyond that ambit, and that no attempt shall be made to use the corporate life for any other purpose than that which is so specified".[15]

The house of Lords decision in Ashbury prioritised the protection of creditor interests when deciding the case as it took the view that any topic not authorised for business, either expressedly or impliedly must duly be taken to be expressly prohibited.[16] The House of Lords believed that a strict judgement would prevent the surge in company registrations, but would afford members and creditors come protection from the detrimental effects that their would inevitably suffer if the company’s risk venture was to be exposes and unsuccessful.[17] This decision demonstrated to company directors that their freedom to contract was being curtailed and this seemed to be wholly discriminatory to their efforts of expansion and venture caplitalist minds.

Companies sought to circumvent this legal blockade and drew up lists in their memoranda of association highlighting a complete list of various objects and powers "reasonably incidental to the specified objects"[18]. This was the conclusion drawn from the case of Att-Gen. v. Great Eastern Railway[19]. This decreed a certain emancipation to companies as it allowed them to conduct a change in direction as long as it can be said to have been related to the original objects of the company. Griffin states that this case entitle a company "to employ any power reasonably incidental to the use of a company's stated objects, irrespective of the fact that the power use was not expressly provided for within the company's object clause."[20] This did widen the scope of a company’s ability to contract and therefore act with full contractual capacity, however this full capacity to contract could only be used in conjunction with objects already stated in the objects clause and ancillary powers directly related to the course of business. This decision was followed by the court’s active search to narrow the scope of ultra vires, separating powers and objects, the esjudem generis rule of construction was incorporated to ensure that interpretation of the decision in Att-Gen. v. Great Eastern Railway[21] was not over-exaggerated. According to this rule, powers were only to be used in relation to objects.[22] The court’s discretion in this case also allowed objects not expressly indicated in the company’s objects clause to be validated although the need for it to be incidental and conducive to the company’s main object was a prerequisite. The ejusdem generis rule was primarily of use to ensure strict interpretation of legthy objects clauses so as to effectuate the substratum (primary purpose) of the company.

The statutory objects clause was, effectively, terminated by a device stating that each power and object should be seen as independent of one another and therefore not ancillary or subsidiary to the other.[23] This was the decision upheld in Cotman v. Broughman[24] and it can be said that this decision narrowed a company’s full capacity to contract as its necessity for interconnected objects and powers did not allow for a complete change in direction of the business. The effect of this case however extinguished the value ultra vires was to have as a protection for shareholders and creditors, it had been consigned to trapping the unwary third party that had not taken full account of the company’s objects clause.[25]

The Companies Act 1948 further weakened the scope of ultra vires in relation to creditors and shareholders by negating the necessity for a court’s consent[26] to apply for any change to the company’s objects clause. Beforehand, petition to the court was vital for any change to be effectuated. Following the 1948 Act, it was only necessary to obtain a special resolution to change the objects clause, although aggreived members were given an open period of 21 days within which to contest the change. The previous rules regarding change were more cumbersome and difficult to circumvent. The writer contends that this Act strengthened the companies’ status and gave companies a wider ambit and greater discretion, along with an ability to act more economically efficient.

The Companies Act 1948 was followed by the case of Bell Houses Ltd. v. City Wall Properties Ltd[27], in which it was asserted that a power clause could be inserted at a later date enabling the company "to carry on any other trade or business whatsoever which can, in the opinion of the board of directors, be advantageously carried on by the company, in connection with or as ancillary to the above businesses or general business of the company".[28] This statement effectively served to destroy the intrinsic value once associated with the ultra vires doctrine as a protector of the rights of shareholders and creditors. Lord Wedderburn opined that

"the Court of Appeal had now decided that this (subjective formula) is not the law. In so doing they may have destroyed altogether the vitality of the ultra vires principle. With a well-drafted clause in subjective terms no company need be bothered by it again. It will have the capacity to do any act which its directors decide to do."[29]

Lord Wedderburn’s opinion was to the effect that the decision in Bell Houses Ltd v. City Wall Properties Ltd[30], had sowed the seeds for the demise of the ultra vires doctrine, and its relevance in modern day law was slowly coming to an end. The ultra vires rule had, as discussed before, become a trap for unwary third parties, but moreover it had become a time-consuming problem for company incorporation and change. The evolving nature of the courts’ interpretation of the ultra vires rule and the distinction between objects and powers, the writer contends, has been of the upmost benefit for companies in their efforts to gain full contractual capacity and a more economically efficient approach to business in their ability to diversify and change.

Cases that have supported this change in interpretation of the ultra vires doctrine are most notable for the contreversial way in which thay have approached the new-found ability to change their objects clause. The defects of the ultra vires doctrine have been brought to the fore by cases such as Re Jon Beauforte[31] and Re Introductions Ltd v. National Provincial Bank[32]. These cases demonstrated the weakness of the ultra vires doctrine by revealing a loophole which was used by companies to their advantage. Companies were able to escape ultra vires liability by altering their objects clause’ at a date after the alleged ultra vires breach had occurred, therefore making the act intra vires. This was criticised by Harman L.J., he contended that "...you cannot have an object to do every mortal thing you want, because that is to have no object at all".[33] Lord Wedderburn also doubted that there was a relevant distinction between objects and powes, he asserted that "the distinction has happily been absent from most modern company law".[34] This position has now been changed and this evidently is possible after the case of Newstead (Inspector of Taxes) v. Frost[35].[36] This was indeed a contreversial state of affairs as companies were overtly stating an intention to claim a status of full contractual capacity. It had become abundantly clear that reform was necessary.

The doctrine of constructive notice strengthened the postition of ultra vires as it deemed all those dealing contractually with a company to have notice of its objects as they were available to all in the form of public documents. These documents contained the articles of association and the company’s memoranda.

The introduction of the European Community (European Union) in 1972 paved the way for reform of the law in the UK as regards a company’s contractual capacity and the relevance of ultra vires as regards third parties. Article 9[37] of the first Company Law Directive 68/151 1968, was introduced into UK law and became section 35 of the Companies Act 1985. This did serve to end the imposing rule of constructive notice. Section 35 was created in an attempt to rid the problems posed against the ultra vires doctrine in relation to companies.[38] Third parties were to be more protected with the provision providing protection for "a person dealing in good faith... deemed to be within the capacity of a company if agreed upon by the directors"[39], there would also "no longer be a need to enquire about these matters".[40] Commentators have criticised it for being too narrow as it covered only "transactions decided on by the directors"[41] and "protected only a third party dealing with the company in good faith"[42]. Simon Deakin opines that "third parties are now largely protected against the highly adverse affacts which the rule formerly had on the validity of transactions entered into outside the company’s stated objects"[43]. Section 35A had the effect of potentially abolishing the ultra vires rule as regards to those outside the sphere of the company, therefore transactions outside a company’s stated objects would no longer be outright nullified for lack of competence. The idea of protection of parties dealing with the company in good faith was ommitted as the term ‘good faith’ caused much confusion between states due to its several and indeterminable meanings. The directive was bereft of a provision which would, in effect, erase the possibility of the other party suing the company for an ultra vires action.[44] Consequently the department of Trade and Industry instructed Professor Dan Prentice to make a full review and suggest recommendations for changes to be made to the ultra vires rule regarding company law.[45]

Prentice drew up a report entitled The Reform of The Ultra Vires Rule. Prentice argued that there should be a

"complete abrogation of the rule by conferring a company with the capacity of a natural person; a recommendation which would have brought the UK in line with other common law jurisdictions".[46]

Prentice also contended that companies should have the option of stating, or not, what their objects are. The recommendation suggested by Prentice were far-reaching and intended to dissolve the ultra vires rule in relation to companies. However, the suggestions posed by Professor Prentice had inherent complications. Prentice’s solution would have afforded companies the right to register objects if they needed to, it was not an outright intention to offend the rights of the relevant authorities power to intervene.[47] Under Article 2 (1) (b) of the 2nd Company Law Directive, public companies were in relation to their instruments of incorporation required to state the objects of their company.[48]

The 1989 Act included a new section 3A which was added to ammend the CA 1985, this has been regarded "as a well-meaning attempt to encourage the draftsmen of company memoranda to abandon the traditional long winded objects clauses".[49] Section 3A atated "that a company’s object is to carry on any business as a ‘general commercial company, and therefore carry on any business or trade whatsoever and affords the company any power to do all such powers as are incidental or conducive to the carrying on of any trade or business by it"[50]. The single objects clause was designed to minimise the need for lengthy and complicated objects clauses. Section 35A was not, according to Simon Deakin, constructed solely to avoid the excessive use of multiple objects clauses but to enable a company to "opt out of the ultra vires rule for internal purposes".[51] De Gay opines that

"the new single objects clause does... contain an inherent flaw and, as a consequence, the government’s intention does not appear to have been achieved... The problem has been tackled by the draftsmen in several ways and the resulting confusion means that, in practice, it may not be advisable for the company to adopt the new clause"[52]

Davies asserts that "there is, however, a school of thought which argues that on the wording of s.3A a company cannot be a "general commercial company" unless that is stated as its sole object... it is not likely to encourage use of the section."[53] De Gay argues that "in practice, draftsmen are unsure as to how the new single ojects clause should be used".[54] Many commentators have questioned how effective the new law is, labelling it ineffective and "confused by the inability of the DTI to take a consistent and clear-headed approach to reform.[55]

The writer contends that, despite the academic criticism, it is clear that the alterations to the 1985 act can be regarded as a sign that the courts have sought to afford companies the right of full contractual capacity and also to rid the company law of the doctrine of ultra vires. The ultra vires doctrine has seen its role narrowed by statute and will witness a further narrowing under the new reforms which will all but extinguish its role in company law. The ultra vires doctrine is now considered as a purely internal mechanism designed to ensure the maximum compliance of directors and minimum fraudulence in adhering to the rules of company law.

The proposed reforms[56] to company law seek to redress modern company law and make it relevant to the changing nature of modern times. The reforms are also aimed at creating an environment in which companies can thrive economically and contract freely so as to create and economically efficient atmosphere. Under the propositions of the Companies Bill, s1(5), "A company formed under this (Companies Bill) has unlimited capacity". This has been designed to clarify the position of third parties and allow them to disassociate themselves of the notice of an objects clause. The Explanatory Notes state that "Subsection 5 is intended to replace section 35 of the 1985 Act and so to remove the last vestiges of the doctrine of ultra vires. Henceforth the company will have unlimited capacity and no challenge can be made to the validity or legality of any of its acts on the basis that the act is beyond the powers of the company"[57]. This clause will substantially change the way the company law is conducted and promote the economicially efficient contractual capacity which is so far lacking in our current system. The Companies Bill should be approved by Parliament at some point in the next year, it will put an end to the reform process started in 1972 and distinguish the ultra vires principle as regards to a company’s freedom to act. It will give companies freedom to act and contract and therefore remove the problems that have blighted company law for over a century.

BIBLIOGRAPHY

Gower’s Modern Company Law, Sweet & Maxwell, 8th ed., 2003 eds Davies and Prentice

Farrar’s Company Law, Butterworths, 5th ed., 2002

Sealy, LS, Cases and Materials in Company Law, Butterworths, 6th ed.1996

Lord Wedderburn, Death of Ultra Vires (1966) 29 MLR 673

Lord Wedderburn, Unreformed Company Law (1969) 32 MLR 563

S De Gay, Problems Surrounding Use of the New Single Objects Clause (1993) 137 SJ 146

S Griffin, The Rise and Fall of the Ultra Vires Rule in Corporate Law (1998) 2 MJLS

P Pettet, Unlimited Objects Clauses? (1981) 97 LQR 15


[1] S Griffin, The Rise and Fall of the Ultra Vires Rule in Corporate Law (1998) 2 MJLS 5

[2] p202, Davies, P.L., Gower’s Company Law, Sweet and Maxwell

[3] p147, Sealy, LS, Cases and Materials in Company Law, Butterworths

[4] p93, Farrar, J.H., Farrar’s Company Law, Butterworths

[5] Ibid

[6] Ibid

[7] Ibid

[8] op cit. n2 at 203

[9] Ibid

[10] Ibid

[11] Ibid

[12] [1875] L.R. 7 H.L. 653

[13] The ultra vires act had allowed the railway co. to finance construction instead of railway carriages, which was not contained within the objects clause of the company.

[14] Ibid at 672

[15] Ibid

[16] op cit. n4 at 100

[17] Ibid

[18] House of Lords in Att-Gen. v. Great Eastern Railway [1880] 5 App.Cas. 473 HL

[19] Ibid

[20] op cit. n1

[21] op cit n18

[22] op cit. n2 at 204

[23] Ibid

[24] [1918] AC 514

[25] op cit n 2 at 204

[26] Ibid

[27] [1966] 2 Q.B. 656 C.A.

[28] Ibid

[29] Lord Wedderburn, Death of Ultra Vires (1966) 29 MLR 673 at 675

[30] op cit. n27

[31] [1953] Ch. 131

[32] [1970] Ch. 199 C.A.

[33] P Pettet, Unlimited Objects Clauses? (1981) 97 LQR 15 at 15

[34] Lord Wedderburn, Unreformed Company Law (1969) 32 MLR 563

[35] [1980] 1 W.L.R. 135

[36] op cit. n 31 at 15

[37] "the limits on the powers of the organs of the company arising under the statutes or from a decision of the competent organs, may never be relied on as against third parties, even if they have been disclosed."

[38] op cit. n2 at 136

[39] Ibid

[40] Ibid

[41] op cit. n2 at 136

[42] Ibid

[43]p10, Deakin, S, Company Formation, ESRC Centre for Business Research, University of Cambridge, August 1999

[44] op cit. n 2 at 136

[45] Ibid

[46] op cit. n1

[47] op cit. n2 at 137

[48] Ibid

[49] op cit. n3 at 177

[50] Ibid

[51] op cit. n40

[52] S De Gay, Problems Surrounding Use of the New Single Objects Clause (1993) 137 SJ 146

[53] op cit. n2 at 210 fn39

[54] op cit. n 49 at 147

[55] op cit. n4 at 114

[56] The Company Law Review, which began in 1998

[57] Companies Bill, Draft Illustrative Clauses and Explanatory Notes



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