Introduction to constructive notice

Memorandum of Association and articles of association are two most important documents needed for the incorporation of a company. The memorandum of a company is the constitution of that company. It sets out the (a) object clause, (b) name clause, (c) registered office clause, (d) liability clause and (e) capital clause; whereas the articles of association enumerate the internal rules of the company under which it will be governed.

Undoubtedly, both memorandum of association and the articles of association are public documents in the sense that any person under section 610 of Indian company act, 1956 may inspect any document which will include the memorandum and articles of the company kept by the registrar of companies in accordance with the rules made under the destruction of records act, 1917 being documents filed and registered in pursuance of the act.

As a consequence, the knowledge about the contents of the memorandum and articles of a company is not necessarily restricted to the members of the company alone. Once these documents are registered with the registrar of companies, these become public documents and are accessible by any members of the public by paying the requisite fees.

Therefore, notice about the contents of memorandum and articles is said to be within the knowledge of both members and non-members of the company. Such notice is a deemed notice in case of a members and a constructive notice in case of non-members. Thus every person dealing with the company is deemed to have a constructive notice of the contents of the memorandum and articles of

the company. An outsider dealing with the company is presumed to have read the contents of the registered documents of the company.

The further presumption is that he has not only read and perused the documents but has also understood them fully in the proper sense. This is known as the rule of constructive notice. So, the doctrine or rule of constructive notice is a presumption operating in favour of the company against the outsider. It prevents the outsider from alleging that he did not know that the constitution of the company rendered a particular act or a particular delegation of authority ultra vires. The doctrine of constructive notice' is more or less an unreal doctrine. It does not take notice of the realities of business life. People know a company through its officers and not through its documents. The courts in India do not seem to have taken it seriously though. For example, in Dehra Dun Mussorie Electric Tramway Co. v. Jagmandardas, the Allahabad high court allowed an overdraft incurred by the managing agent of a company when under the articles the directors had no power to delegate their borrowing power. Statutory reform of constructive notice The doctrine of constructive notice is more or less an unreal doctrine. It does not take notice of the realities of business life. People know a company through its officers and not through its documents. Section 9 of the European Communities Act, 1972 has abrogated this doctrine. These provisions are now incorporated in sec 35 of the (English) Companies Act, 1985.

Position in India

The

courts in

India do

not seem to

have taken

the doctrine seriously. For exa mpl e, the Calcutta High Court in Charnock Collieries Co Ltd. v. Bholanath enforced a security which was not signed in accordance with the companys articles.

Also, in DehraDun Mussorie Electric Tramway Co. v. Jagmandardas, the Allahabad High Court allowed an overdraft incurred by the managing agent of a company when under the articles the directors had no power to delegate their borrowing power.

Conclusion Thus, the doctrine of constructive notice seeks to protect the company against the outsider by dee ming that such an outsider had the notice of the public documents of the compan y. However, in India the courts with a view to protect the innocent third parties acting in good faith have not relied upon the doctrine seriously.

Introduction to doctrine of indoor management

The role of Doctrine of Indoor Management is opposed to that of the principle of Constructive Notice. The latter seeks to protect the company against outsiders; the former operates to protect outsiders against the company. The rule of constructive notice is confined to the external position of the company and, therefore, it follows that there is no notice as to how the companys internal machinery is handled by its officers.

If the contract is consistent with the public document, the person contracting will not be prejudiced by irregularities that may beset the indoor work of the company.

The Doctrine of Indoor Management lays down that persons dealing with a company having satisfied themselves that the proposed transaction is not in its nature inconsistent with the memorandum and articles, are not bound to inquire the regularity of any internal proceeding.

In other words, while persons contracting with a company are presumed to know the provisions of the contents of the memorandum and articles, they are entitled to assume that the provisions of the articles, they are entitled to assume that the officers of the company have observed the provisions of the articles. It is no part of duty of any outsider to see that the company carries out its own internal regulations.

It is important to note that the notice of constructive notice can be invoked by the company and it does not operate against the company. It operates against the person who has failed to inquire but does not operate in his favour. But the

doctrine of indoor management can be invoked by the person dealing with the company and cannot be invoked by the company.

Genesis of the Doctrine: - The rule had its genesis in the case of Royal Bank v Turquand. In this case, the directors of a banking company were authorised by the articles to borrow on bonds such sums of money as should from time to time, by resolution of the company in the general meeting, be authorised to borrow. 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, as he was entitled to assume that the necessary resolution had been passed. Lord Hatherly observed: Outsiders are bound to know the external position of the company, but are not bound to know its indoor management.

According to this doctrine, a person dealing with a company is bound to read only the public documents. He will not be affected by any irregularity in the internal management of the company. The rule of indoor management had its genesis in Royal British Bank v. Turquand.

The directors of the company borrowed a sum of money from the plaintiff. The companys articles provided that the directors might borrow on bonds such sums as ma y fro m ti me to time be authorized by a resolution passed at a general meeting of a company. The shareholders claimed that there was no such resolution authorizing the loan and, therefore, it was taken without their authority.

The company was however held bound for the loan. Once it was found that the directors could borrow subject to a resolution, the plaintiff had the right to assume that the necessary resolution must have been passed.

The rule is based on public convenience and justice and the following obvious reasons: 1. the internal procedure is not a matter of public knowledge. An outsider is presumed to know the constitution of a company, but not what may or may not have taken place within the doors that are closed to him.

2. The lot of creditors of a limite d co mpany is not a particularly happy one; it would be unhappier still if the company could escape liability by denying the authority of officials to act on its behalf. The rule/doctrine is applied to protect persons contracting with companies from all kinds of internal irregularities.

It has been applied to cover the acts of de facto directors, who have not been appointed but have only assumed office at the acquiescence of the shareholders or whose appointment is defective, or have

exercised authority which could have been delegated to themunder the Act but actually not delegated, or who has acted without quorum.

Exceptions to the rule

1) Knowledge of irregularity

A person who has actual knowledge of the internal irregularity cannot claim the protection of this rule, because he could have taken steps for self- protection. A person who himself is a party to the inside procedure, such as a director is deemed to know the irregularities, if any.

T.R Pratt (Bombay) Ltd. V. E.D. Sassoon & Co. Ltd Company A lent money to Company on a mortgage of its assets. The procedure laid down in the articles for such transactions was not complied with. The directors of the two companies were the same. Held, the lender had notice of the irregularity and hence the mortgage was not binding. 2) Negligence and suspicion of irregularity where a person dealing with a company could discover the irregularity if he had made proper inquiries, he cannot claim the benefit of the rule of indoor management. The protection of the rule is also not available where the circumstances surrounding the contract are so suspicious as to invite inquiry, and the outsider dealing with the company does not make proper inquiry.

3) Forgery The rule in Turquands case does not apply where a person relies upon document that turns out to be forged since nothing can validate forgery. In Ruben v. Great Fingall Ltd, a co was not held bound by a certificate issued by tit secretary by forging the signature of two directions. However, in Official Liquidator v. Commr of Police, the Madras High Court held the company liable where the Managing Director had forged the signature of two other directors.

4) Representation through articles: A person who does not have actual knowledge of the companys articles cannot claim as against the company that he was entitled to

assume that a power which could have been delegated to the directors was in fact so delegated.

In Rama

Corporation v. Proved Tin and

General

Investment

Co,

the plaintiffs contracted with the defendant co and gave a cheque under the contract. The director could have been authorized but in fact, was not. The plaintiffs had not read the articles. The director misappropriated the cheques and plaintiff sued. Held, director not liable as it was outside his authority.

5) Acts outside the scope of apparent authority:

If an officer of a company enters into a contract with a third party and if the act of the officer is beyond the scope of his authority, the company is not bound. In such a case, the plaintiff cannot claim the protection of the rule of indoor management simply because under the articles the power to do the act could have been delegated to him. The plaintiff can sue the company only if the power to act has in fact been delegated to the officer with whom he entered into the contract.

Kreditbank Cassel v. Schenkers Ltd,a branch manager of a company drew and endorsed bills of exchange on behalf of the company in favour of a payee to whom he was personally indebted. He had no authority from the company to do so. Held, the company was not bound. But if an officer of a company acts fraudulently under his ostensible authority on behalf of the company, the company is liable for his fraudulent act.

Provisions under the Indian Companies Act, 1956

The provision under the Indian Act which directly imbibes the Turquand rule is section 290, which reads as under:

Section 290:- Validity of acts of directors:Acts done by a person as a director shall be valid, notwithstanding that it may afterwards be discovered that his appointment was invalid by reason of any defect or disqualification or had terminated by virtue of any provision contained in this Act or in the articles: Provided that nothing in this section shall be deemed to give validity to acts done by a director after his appointment has been shown to the company to be invalid or to have terminated.

Another Provision which directly follows the above stated rule is section 81 of the Indian Companies Act, 1956 which bears the heading further issue of shares. Bona fide allottees of shares are protected by the Doctrine of Indoor Management under s-81.

Illustrating upon the point the Punjab & Haryana High Court has avowed in the case of Diwan Singh v Minerva Mills that The allottees of the shares were contracting in good faith with the Company and they were entitled to assume that the acts of the Directors in making allotments of the shares to them are within the scope of their powers conferred upon them by the shareholders of the Company.

They were not bound to enquire whether the acts of the Directors which as in this case related to internal management had been properly and regularly performed. Even when the Directors exceed their powers or infringe the restrictions imposed upon them, the company may be bound for the outsider dealing with the company is only required to see that the transactions are

consistent with the article. Strangers are justified in assuming that all matters of Indoor management have been done regularly.

Application of the Rule by the Indian Courts

In Lakshmi Ratan Cotton Mills Co. Ltd, v. J. K. Jute Mitts Co. Ltd, the plaintiff company sued the defendant company on a loan for Rs. 1, 50,000. Among other things the defendant company raised the plea that the transaction was not binding as no resolution sanctioning the loan was passed by the board of directors. The court, after referring to Turquand's case and other Indian cases, held: If it is found that the transaction of loan into which the creditor is entering is not barred by the charter of the company or its articles of association, and could be entered into on behalf of the company by the person negotiating it, then he is entitled to presume that all the formalities required in connection therewith have been complied with.

If the transaction in question could be authorised by the passing of a resolution, such an act is a mere formality. A bona fide creditor, in the absence of any suspicious circumstances, is entitled to presume its existence. A transaction entered into by the borrowing company under such circumstances cannot be defeated merely on the ground that no such resolution was in fact passed. The passing of such a resolution is a mere matter of indoor or internal management and its absence, under such circumstances, cannot be used to defeat the just claim of a bona fide creditor.

A creditor being an outsider or a third party and an innocent stranger is entitled to proceed on the assumption of its existence ; and is not expected to know what

happens within the doors that are closed to him. Where the act is not ultra vires the statute or the company such a creditor would be entitled to assume the apparent or ostensible authority of the agent to be a real or genuine one. He could assume that such a person had the power to represent the company, and if he in fact advanced the money on such assumption, he would be protected by the doctrine of internal management."

In case of Official Liquidator, Manasube & Co. (P.) Ltd. V. Commissioner of police the learned judge observed that the lenders to a company should acquaint themselves with memorandum and articles but they cannot be expected to embark upon an investigation as to legality, propriety and regularity of acts of directors.

The wheels of commerce would not go round smoothly if persons dealing with the company were compelled to investigate thoroughly the internal machinery of a company to see if something is not wrong. People in business would be very shy in dealing with such companies.

The rule is of great practical utility. It has been applied in a great variety of cases involving rights and liabilities. It has been used to cover acts done on behalf of a company by de facto directors who have never been appointed, or whose appointment is defective, or who, having been regularly appointed, have exercised an authority which could have been delegated to them under the companys articles, but never has been so delegated, or who have exercised an authority without proper quorum.

Thus, where the directors of company having the power to allot shares only with the consent, something which he could do only with the approval of the board;

where the managing agents having the power to borrow with the approval of directors borrowed without any such approval, the company was held bound. Consequence of the Rule: Recent Decisions

The Indian Courts in certain recent judgments have further broadened the scope of the Doctrine of indoor management. The object being the same i.e. to protect the third party transacting with the Company in good faith and being unaware of the complex internal management of the Company.

In Monark Enterprises v Kishan Tulpule and Ors, the Company Board held :That the validity of the impugned transaction was not affected even if no resolution for entering into it was actually passed by the board of the company as the company had entered into and adopted the transaction throughout and implemented it after receiving consideration thereof

InYKM Holdings Private Limited v Prayag T-Pac Industries Limited and Others Even amalgamation of two companies is one limb of indoor management. Therefore, notice contemplated under Section 394A of the Act is required to be given only at the stage when application under Section 394, of the Act is made to the Court for sanctioning the scheme and not any time prior thereto.

Conclusion
The case of Royal British Bank v Turquand, refined the basic Common law of Agency to articulate the Doctrine of Indoor Management. The rule was enunciated by the Court to mitigate the rigors of the Constructive Notice Doctrine. Its importance arises in situations in which the third partys dealings are with some officer or agent other than the Board. The rule protects the interest of the third party who transacts with the Company in good faith and to whom the Company is indebted. The rule enunciated in the decision is often referred to as "Turquand's rule" and "indoor management rule". The gist of the rule is that persons dealing with limited liability companies are not bound to enquire into their indoor management and will not be affected by irregularities of which they had no notice. The rule enunciated in Turquand has been applied in many cases subsequently and generally in order to protect the interests of the party transacting with the Directors of the Company. Applying the rule, now it cannot be argued that a person having dealings with a Company is deemed to have notice of who the true Directors are, and this being shown by public documents i.e. the registers of the directors required to be maintained by the Company and the and the notices of changes.

With the due course of time several exceptions have also emerged out of the rule like Forgery, negligence, third party having knowledge of irregularity etc. If we analyze the cases it is revealed that the Turquand rule did not operate in a completely unrestricted manner. Firstly, it is inherent in the rule that if the transaction in question could not in the circumstances have been validly entered into by the company, then the third party could not enforce it. Secondly, the rule only protected 'outsiders', that is

persons dealing 'externally' with the company; directors, obviously, were the very people who would be expected to know if internal procedures had been duly followed. Thirdly, actual notice of the failure to comply fully with internal procedures precluded reliance upon the rule. Fourthly, an outsider could not rely upon Turquand's Case where the nature of the transaction was suspicious; for example, where the company's borrowing powers were exercised for purposes which were wholly unconnected with the company's business and of no benefit to the company. The Doctrine of Indoor Management lays down that persons dealing with a company having satisfied themselves that the proposed transaction is not in its nature inconsistent with the memorandum and articles, are not bound to inquire the regularity of any internal proceeding

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