Doctrine of Constructive Liability and Doctrine of Indoor Management under Companies Act, 2013

Introduction

The doctrine of Constructive Notice is a Legal fiction created and assumed by the court, signifying that a reasonable person or entity should have known of the legal actions that are to be/are taken, even if they have no actual knowledge of it. It is an important principle as serves its purpose of easing business regulations and provides security to the companies while they are dealing with outsiders.

 The term Company is defined under Section 2(20) under the Companies Act, 2013 as a body corporate registered under the Act or any previous law; and shall include all companies (public or private). It is governed by its own constitution and framework in the form of The MOA (Memorandum of Association) and AOA (Article of Association) which lays down the powers, objectives, and functions of the company and the nature of its business. 

They are registered with the Registrar of Companies under the Ministry of Corporate Affairs. Thereby, it becomes imperative that any person who transacts any kind of business with the company is conversant with all the rules and regulations of the company that are available in the public domain. This apparent presumption is called the Doctrine of Constructive Notice.

It was introduced to reduce the liability over a company, assuming that it should have been known by everyone, entering into the contract with the company, of the MOA and AOA, since the company’s information is a public record.

Doctrine of Constructive Notice

The term Constructive Notice is based on the term ‘constructive’ which means something which can be deduced by inference. While notice is an alert or a kind of information which is served either to the public at large or to an individual person. Therefore, a constructive notice shall mean such facts that are expected to be known to a person by virtue of some inference. This inference is drawn by a legal duty that is put on a person to be aware of certain circumstances. In corporate jurisprudence, it means such information which is expected to be known to a person who is transacting with a company because such information is available in the public domain, irrespective of the fact whether it was known to him or not.

Section 398 of the Companies Act,2013 is a specific regulation that requires the registrar to inspect all of the incorporation documents since all documents registered with the registrar are public documents.

According to Section 398(2) of the Act, The Central Govt. may, by notification, frame a scheme to carry out the above provision through electronic forming.  Section 399 of the Act allows any person to inspect, take extracts from or make records of any document of any company which has been registered with the Registrar of Companies. The section lays down that this right shall be provided to the applicant on the payment of specified fees.

The right extends to the inspection of any public document of any company. Hence, the MOA and AOA of the company are available for scrutiny at all times. The doctrine of constructive notice was instituted under this provision whereby a person is expected to be aware of the contents of any document which is available in the public domain. Before a person

plans to transact with a company, he must inspect all the documents related to the company and ensure that the content of his transaction conforms to the rules of the company and should also be aware of the individual powers and conditions of the company. And it is considered to be the responsibility of the party entering into a contract to collect, read and understand the documents

Hence, The Doctrine of Constructive Notice simply means that notice was given, even without an actual notice existing. Another common example of constructive notice is – when a court is unable to directly reach someone and publishes a summons in the public newspaper.

 Case Laws related to the Doctrine of Constructive Notice

1.Kotla Venkaswami v. Ram Kurthi[1]

In this case, all the deeds and other documents were to be signed by the managing director, the secretary and a working director as per the Articles of the company. R accepted a deed from the company which was signed by the secretary and a working director on behalf of the company. It was held by the Court that R could not have accepted such a deed which not signed by all the required persons as was mentioned in the Articles of the Company and hence was invalid. It was observed by the Court,

“If the plaintiff had consulted the articles, she would have discovered that a deed such as she took required execution by three specific officers of the company and she would have refrained from accepting a deed which was inadequately signed. Notwithstanding, therefore she may have acted in good faith and her money may have been applied to the purpose of the company, the bond is nevertheless invalid.”

2.Oakbank Oil Co. v. Crum [2]

In this case, the Court held that anyone who is dealing with the company shall be presumed to have read and understood the MOA and AOA of the company, thus presuming to be a notice to the public.

3.Mahony v. East Holyford Mining Co.[3]

In this case, The Court observed that,

“Every join-stock company has its memorandum and articles of association…open to all who are minded to have any dealings whatsoever with the company, and those who so deal with them must be affected with notice of all that ‘is contained in these documents.’”

If a person enters into a contract that is beyond the power of the company, he cannot acquire any rights under the contract against the company[4].

4.Griffith v. Paget[5]

In this case, the Court held that it is presumed that individuals dealing with the company have not only read the documents but have also understood the proper meaning of each document related to the deal.

5.Ernest v. Nicholas[6]

In this case, it was held, for the very first time that anyperson who is dealing with the company is deemed to be familiar with the contents of all the public documents of the company.

6.Rama Corporation v. Proved Tin and General Investment Co. [7]

The director of the plaintiff company formed an agreement with the director defendant company which would enable them to subscribe to funds which they can use to finance the sale of goods produced by a third company.

As per the AOA of the defendant company only a director to whom the power of the board has been delegated, can collect a cheque on the behalf of the company. Being unaware of such clause the defendant company was given a cheque by the director of the plaintiff company.

In the decision the Court applied the doctrine of Constructive Notice and the defendant company was held not bound by the agreement.

Criticism of the Doctrine of Constructive Notice

The doctrine of constructive notice has been proven to be too inconvenient for business transactions, especially where the directors or other officials of the company were empowered under the articles and memorandums of the company to exercise certain powers in terms of sanctions and prior approvals of the shareholders.

The vendors/dealers/others have no mechanism to verify if the sanctions and approvals are obtained in the manner as prescribed under the articles and memorandums and whether those sanctions and approvals have been obtained or not could be ascertained by them in real situations. An outsider to the company could not be expected to know of what goes on behind close doors of the company unless there is the due conveyance of the events and processes.

In a case where the act is declared to be ultra vires in the company’s AOA or MOA, a person cannot claim any relief on the ground of being unaware of the said provision in the documents. The principle of common law jurisprudence of corporate law provides ample protection to an innocent person who is dealing with the company in good faith, where the act concerned is not ultra vires to the company, however, the protection cannot be extended in a case where the said act goes beyond the authority of the company.

According to Palmer, the doctrine of constructive notice applies to all such documents of the company which affect its powers. But from the practical standpoint, this view appears to be unrealistic as people know about the Company through its workers and not through its documents. The rule as therefore, been abandoned in Europe,[8] also in India, the Court have not deemed it necessary to follow the doctrine rigidly. (N.V.Paranjape, 2020)

However, the persons desirous of dealing with a company should, in their own interest, collect information about the contents of the memorandum and/or articles through the office of the Registrar of Companies so as to have knowledge of the real status of the Company.[9]

The doctrine of Indoor Management as an Exception to Doctrine of Constructive Notice

 As the memorandums and articles of association of a Company are public documents, a person dealing with the Company may have access to these documents and will be deemed to have constructive notice of the contents of the memorandum and/or articles. However, an exception to this doctrine was enunciated in the case of Royal British Bank v. Turquand[10] in the form of the Doctrine of Indoor Management and is also known as the Rule Turquand.  

In the case of Royal British Bank v. Turquand, the directors of the Company had borrowed money by issuing a bond. The Articles of Association of the company authorized them of such an act, provided that a special resolution had to be passed by a resolution of the company in the general meeting, to be authorised to borrow in this regard. The Directors gave a bond to Turquand without the authority of any such resolution.

It was held that Turquand could sue the company on the strength of the bond since he was entitled to assume that the necessary resolution had been passed.

It was observed by Lord Hatherly,

“outsiders are bound to know the external position of the company, but are not bound to know its indoor management.”

While the Doctrine of Constructive notice can be invoked by the Company and does not operate against the company. It operates against the person who fails to inquire and is not in his favour.

While on the other hand, the Doctrine of Indoor Management can be invoked by the person dealing with the company and works in the favour of the outside and against the Company.

Gower justified the doctrine of indoor management by pointing out that; it would be difficult for the creditors and persons dealing with the Company “ if the company could escape the liability by denying the authority of the officials to act on its behalf.”[11]

In the case of Royal British Bank v. Turquand the judiciary saw the gap in the legislation, and this gap was filled through the doctrine of indoor management. The judge in their verdict stated an outsider cannot be expected to know what happens behind the closed doors of the company, in such a case man, irrespective of how prudent he/she is, cannot have knowledge of information which hasn’t been public yet.

An outsider may come to know about the internal proceedings of a company only when the same is delivered to him/her. In the absence of such conveyance, the outsider cannot be made to suffer. The doctrine of indoor management thus provides protection to outsiders from what happens in the internal proceedings of the company.

In general speech, the Doctrine of Indoor Management means that the persons transacting any business with the company are entitled to assume that if there is any internal requirement that is prescribed in the public document; it has been met by the officers. It absolves any liability on the outsider for any internal irregularity of the company as it cannot be reasonably expected from an outsider to inquire about such details.

Case Laws related to the Doctrine of Indoor Management

1. Varkey Souriar v. Keraleeya Banking Co. Ltd[12]

In this case, it was held that a person dealing with a company does not need to enquire about the internal proceedings of the company in furtherance of an obligation put on them through a public document or otherwise. All that is expected from them is to ensure that the person transacting the business has the authority to do so.

2.Lakshmi Ratan Cotton Mills Co. Ltd. v. J.K. Jute Mills Co. Ltd.[13]

In this case, the stance of the court was similar to the Turquand case and it was held that the company cannot be expected to be in knowledge of an internal rule of the debtor company. If the negotiations are happening on behalf of the company, it shall be presumed that all the internal requirements for the same have been met by the officers of the company. The only aspect that a person needs to see is whether the person approaching on behalf of the company is the authorised person or not.

3. Freeman v. Backhurst Park Properties Ltd.[14]

The defendant company dealt with the purchase and sale of land which was founded by X & Y who nominated a director each and together four of them formed the Board of Directors. As per the Articles of Association of the company, the board was to nominate a name from the board itself, for the position of Managing Director. The board failed to do so and A started acting as the Managing Director of the company.

Subsequently, the company hired the plaintiff company for architectural and surveying services. On completion of their services, the plaintiff company asked for their fees but the defendant firm denied it because of its omission to appoint a Managing Director.

The court referred to Royal British Bank v. Turquand and held that the defendant company was liable to pay the plaintiff firm for their services as they cannot be made to suffer because of the irregularity which took place in the management of the company.

Exceptions to the Doctrine of Indoor Management

The Doctrine is subjected to the following exception;

Knowledge of Irregularity

If the party affected knew of the irregularity already then this doctrine shall not come into play. It may happen in a case when the person contracting was himself a party to the inside procedure of the company.

Howard v. Patent Ivory Manufacturing Co[15], In this case, it was held that the directors could not defend the issue of debentures because, being the directors, they should have known the extent to which they were lending the money and for that amount, the assent of the general meeting was necessary which was not obtained in this case.

Suspicion of Irregularity

The protection under this provision shall not be given when the circumstances are such that they invite suspicion of a man of ordinary prudence.

Anand Behari Lal v. Dinshaw[16]

 In this case, the plaintiff accepted a transfer of property of the company concluded by the accountant of the company. In ordinary prudence, no company allows its accountant to transfer properties of the company. Therefore, the plaintiff was asked to have been more cautious and the defence was not provided to him.

Forgery and Fraud

Forgery may, in some cases, be an exception to this rule.

Ruben v. Great Fingall Consolidated[17]

In this case, the company secretary sold the shares to the plaintiff by forging the signatures of two directors. It was held that the company cannot be made liable in cases like this where there has been an apparent forgery and fraud.

Ignorance about the Contents of the Articles

The doctrine does not apply to where the person dealing with the company has not consulted and gone through the articles and memorandum of the company.

Ford Motor Credit Co. Ltd. v. Harmack[18]

Lord Denning MR, in this case, observed,

“Where there was a group of companies all controlled by the same person who was in full control of everything- it had to be supposed that he was the Chairman and MD of each. It seemed that he had not only actual but also ostensible authority”

Conclusion

While Doctrine of Constructive Notice is a fiction of law, created in favour of the company as this allows the process to be smooth and is an important principle as serves its purpose of easing the business regulations. It provides security to the companies while they are dealing with outsiders. Thereby, if an outsider is dealing with the company, he is burdened with the duty to know all the rules of the company that are available in the public domain. 

This doctrine needs to be scrutinised to ensure that it is not being made applicable in infractions of the rule of law and the basic postulates of justice. Additionally, it needs to be assured that the company is not provided with an opportunity to take advantage of its wrong. Since the provision was seen to be doing more wrong than good, its credibility was reduced. For that, the doctrine of indoor management was evolved by the courts to restrict the application of this provision when the rule in dispute is internal. To counter the drawbacks of constructive Notice and favour the persons dealing with the company.

[1] AIR (1934) Madras 579

[2] 1882 8 AC 65

[3] (1857) 6 H.L.C.

[4] More,2020 Doctrine of Constructive Notice, The Fact Factor

[5] (no.2) (1877) 6 Ch. D. 517

[6] (1857) 6 HL Cas 401

[7] [1954] SydLawRw 14; (1954) 1(2) Sydney Law Review 258.

[8] Section 9 of the European Communities Act,1972.

[9] K.L. Engineering Co. v. Arab Malaysia Finance, (1995) 1 SCR 85 (Malaysia).

[10] (1856) 119 ER 886.

[11] Gower: Modern Company Law (3^rd Ed. 1969) p. 153

[12] (1957) 27 Comp Cas 391.

[13] AIR 1957 All. 311

[14] (1964) 1 All ER 630.

[15] (1888) 38 Ch D 156.

[16] AIR 1942 Oudh 417.

[17] (1906) AC 439

[18] (1972) JBL 226

Author Details: Zaki Khan [Student, School of Law, DAVV]