Companies have to borrow funds from time to time for various projects they are engaged with and one cannot imagine running a company without borrowing, as it is an indispensable part of day-to-day transactions. However, there are certain restrictions to these borrowings and if a company goes beyond these restrictions it is deemed as ultra vires.
The Doctrine of ultra vires1 may be a fundamental rule of Company Law. It states that the objects of a corporation, as laid out in its Memorandum of Association, are often departed from only to the extent permitted by the Act. Hence, if the company does an act, or enters into a contract beyond the powers of the administrators and/or the corporate itself, then the said act/contract is void and not legally binding on the company.
The term Ultra Vires means ‘Beyond Powers’. In legal terms, it’s applicable only to the acts performed in excess than the legal powers of the doer. This works on an assumption that the powers are limited in nature. Since the Doctrine of ultra vires limits the corporate to the objects laid out in the memorandum, the corporate can be:
- Restrained from using the funds for other purposes other than those specified in the memorandum
- Restrained from carrying out any other trade work other than that specified.
A company cannot sue an ultra vires transaction and it cannot be sued too. If it offers or supplies any goods or services or lends money on an ultra vires contract, then the company cannot obtain any payment. Although if a lender lends some money to a company which has not been extended, the lender can stop the company from parting with it via an injunction. The lender has this right because the company does not own the money as it is ultra vires to the company and the lender is till the owner of the money. Also, if a company borrows money in an ultra vires contract to repay a legal loan; the lender is entitled to recover the loan from the company. Sometimes an act which is ultra vires can be normalised by the shareowners of the company, for example
- If an act is ultra vires the power of directors, then the shareowners can ratify it.
- If an act is ultra vires the Articles of the corporation, then the company can alter the Articles.
One cannot bind a company through an ultra vires contract. Estoppel, acquiescence, lapse of time, delay, or ratification cannot make it ‘Intravires’.
Origin of the Doctrine of Ultra Vires
The doctrine of ultra-vires was first time seen in the classic case of Ashbury Railway Carriage and Iron Co. Ltd. v. Riche, (1878) L.R. 7 H.L. 653, which was decided by the House of Lords. In this case the company and M/s. Riche entered into a contract in which the company agreed for the financial construction of railway line. Later on the directors abandoned the contract on the grounds of it being ultra-vires of the memorandum of the company. Riche filed a suit for recovering its damages from the company. According to Riche, the words “general contacts”2 in the objects clause of the company meant any kind of contract. Thus, according to Riche, the company had all the powers and authority to enter and perform such kind of contracts. Later, the majority of the shareholders of the company ratified the contract. However, directors of the company still refused to perform the contract as according to them the act was ultra-vires and the shareholders of the company cannot ratify any ultra-vires act.
When the matter went to the House of Lords, it was held that the contract was ultra-vires the memorandum of the company, and, thus, null and void. Term “general contracts” was interpreted in connection with preceding words mechanical engineers, and it was held that here this term only meant any such contracts as related to mechanical engineers and not to include every kind of contract. They also stated that even if every shareholder of the company would have ratified this act, then also it had been null and void as it was ultravires the memorandum of the company. Memorandum of the company cannot be amended retrospectively, and any ultra-vires act cannot be ratified.
What is need for doctrine of ultra vires?
The main objective of it is that it assures the creditors and the shareowners of the company that the funds of the company will be utilized for the objectives mentioned in the company’s memorandum and not for any other purpose. If the assets of the company are wrongfully applied and used then it may result in the insolvency of the company, which in turn means that the shareowners of the company won’t be paid. Thus it prevents a company from such a situation and draws a clear line beyond which the directors of the company are not authorised to act.
Difference between ultra vires and an illegal act:
An ultra vires act is completely different from an illegal act. People often mistakenly use them as synonyms, which they aren’t. An act which is beyond the objectives of the company and not mentioned in the memorandum of the company is termed as an ultra vire act; whereas an act which is an offence in itself and draws civil liabilities or is prohibited by law is termed as an illegal act. Anything which is ultra-vires may or may not be illegal, but both of such acts are void-ab-initio.
The doctrine of ultra-vires in Companies Act, 2013:
Section 4 (1)(c) of the Companies Act, 2013, states that all the objects for which incorporation of the company is proposed any other matter which is considered necessary in its furtherance should be stated in the memorandum of the company. Whereas Section 245 (1) (b) of the Act provides to the members and depositors a right to file a application before the tribunal if they have reason to believe that the conduct of the affairs of the company is conducted in a manner which is prejudicial to the interest of the company or its members or depositors, to restrain the company from committing anything which can be considered as a breach of the provisions of the company’s memorandum or articles.
Basic principles of Doctrine of Ultra Vires:
- Shareowners cannot sanction an ultra vires act or contract even if they wish to do so.
- Where one party has entirely performed his part of the contract, reliance on the defense of the ultra-vires was usually precluded in the doctrine of estoppel.
- When both the parties have entirely performed the contract, the contract cannot be attacked on the basis of this doctrine.
- Any of the parties to the contract can raise the defense of ultra vires.
- If a contract has been partially performed but the performance was insufficient to bring the doctrine of estoppel into action, a suit can be brought for the recovery of the benefits conferred.
Development of the Doctrine of Ultra Vires
Eley v The Positive Government Security Life Assurance Company, Limited, (1875-76) L.R. 1 Ex. D. 88:
It was held that the articles are not a matter between the company and the plaintiff and that they may either bind to the directors, but they do not create any contract between the plaintiff and the company.
The Directors, &C., of the Ashbury Railway Carriage and Iron Company (Limited) v Hector Riche, (1874-75) L.R. 7 H.L. 653.
The objectives of the company as per the memorandum was to supply and sell some material which was to be required for the construction of railways. Here the contract was for construction of the railways, which was contrary to them. As the contract was ultra-vires, it was held that it cannot not be sanctioned even by the assent of all the shareowners. If the sanction had been granted by passing a resolution before entering into the contract that would have been sufficient to make the contract intra-vires. However, in this situation, a sanction cannot be granted with a retrospective effect as the contract was ultra-vires the memorandum.
In Shuttleworth v Cox Brothers and Company (Maidenhead), Limited, and Others,  2 K.B. 9:
It was held that if a contract is subject to the legal powers of alteration contained in the articles and such alteration was made in good faith and for the benefit of the company then it would not be considered as a breach of the contract and will be held valid.
In Re New British Iron Company,  1 Ch. 324:
It was held that in this particular case the directors will be ranked as ordinary creditors in respect of their remuneration at the time of the winding-up of the company. This was stated because generally articles are not considered as a contract between the company and the directors but only between shareowners. However, in this particular case, the directors were employed, and they had accepted the office on the footing of the articles of association. So at the time of winding-up of the company they were considered as the creditors.
Rayfield v Hands and Others, [1957 R. No. 603.]:
Field-Davis Ltd. was a private company carrying on business as builders and contractors, The plaintiff, Frank Leslie Rayfield, was the registered holder of 725 of those shares, and the defendants, Gordon Wyndham Hands, Alfred William Scales and Donald Davies were at all material times the sole directors of the company. There was a provision in the Articles of association of the company where it was required that if he wants to sell his shares, he will inform the directors, who will buy them equally at a fair valuation. However, when he informed the directors, they refused to buy them by saying that there is no such liability imposed by the articles upon them.
The plaintiff claimed that fair value of the shares must be determined and directors must be ordered to purchase them at a fair value. It was held that articles of the company required the directors to buy the shares at a fair price, but the relationship between them was not as a member and director but as a member and a member.
Case Laws relating to Doctrine of Ultra Vires
In India the first concept of ultra vires was noticed in the case of Jahangir R. Modi vs Shamji Ladha , where the plaintiff had purchased 600shares in a company and the defendant(directors of the company) had also purchased some shares in the same company. The memorandum of the company did not allow the members to sell or purchase any shares of the company. The plaintiff sued the directors of the company and asked for the compensation for the purchase of the shares from the court. The Bombay High Court held that “a shareowner can maintain an action against the directors of the company to compel them to restore to the company the funds to it that have been employed by them in a transaction that they have no authority to enter into, without making the company a party to the suit”.
The other important case that can be cited is A. Lakshmanswamy Mudaliar vs Life Insurance Company. In this case the memorandum of the company stated that the directors can donate a part of the company’s profit to a charitable organisation that would help the public or any benevolent object. In accordance with this, the directors donated Rs.2lacs to a charitable organisation for promoting technical and business knowledge. The court eventually held that the directors cannot donate the money to any charitable trust of their choice. They could only spend such amount on the charitable trust that enables them to promote the company’s own business, i.e., the money could be donated to a charitable trust which enables them for the attainment of the company’s own objects. However, the company’s business having been taken over by the life insurance corporation, it had no business left to promote. The court held that the payment made by the directors towards the charitable trust was, therefore, unauthorised and the trustees acquired no right to the amount paid by the directors. Further, the court made the directors of the company personally liable for the payment made by them. The appeal was, therefore, dismissed.
Thus, we can say that no company can function without borrowings, but it is also necessary to protect the interests of the creditors and the shareowners. Any irresponsible act can result in the insolvency or winding up of the company. This may cause considerable losses to them. So to protect the interest of the investors and the creditors, specific provisions are made in the memorandum of the company which defines the objectives of the company.
Directors of the company can act only within the purview of the authority provided to them under these objectives. If any borrowing is made beyond the authority provided by these objectives mentioned in the memorandum, it will be considered as ultra-vires. Any borrowing which is made through an ultra-vires act is void-ab-initio, and hence, directors are personally responsible for these acts. However, if such borrowings are ultra-vires only to the articles of the company or ultra-vires directors, then they can be ratified by the shareholders. Then after such ratification, they will be considered valid.
Thus, directors must be very cautious while borrowing funds, as it may not only make them personally liable for the consequences of such acts but also may result in considerable losses to investors and creditors.
Author Details: Anshika Sharma