THE DEVELOPMENT OF THE ULTRA VIRES

DOCTRINE IN COMPANY LAW

- A CASE STUDY ANALYSIS

K DHARMARATNE

University of the Witswatersrand, Johannesburg

I. INTRODUCTION

The ultra vires doctrine has been a topic in company law that has had considerate attention though out its history. With recent changes in the form of the new Companies Act of 2008 new light has been brought to the continued evaluation of this doctrine. In this article I will analyse the direction South Africa has taken in the development and application of the ultra vires doctrine and whether the legislature has provided certainty on this topic.

II. COMMON LAW POSITION

The crux of the ultra vires doctrine under common law was that any contract entered into by a company which was not in line with the objects in its Memorandum of Incorporation (hereafter memorandum) was beyond the company’s capacity and therefore void ab initio.¹
       Under common law the authority of a company to enter into a contract was relevant in an external and an internal context. Externally with a third party contracting with a company, if the authority of the company to enter into such a contract was not included in the objects of the company then the contract was ultra vires and void. Internally between the company and the director entering into an ultra vires contract, the company may either select to restrain the act of the director or if the contract had already been entered into then the company may claim damages against the director who entered into the contract outside of the company’s capacity ² – and therefore breaching his fiduciary duties. If the main object of the company in its memorandum was impossible to fulfil in the first place then the company would have to be wound up on the basis of ‘just and equitable’ for ‘failure of substratum’.³

       In principle this doctrine was adopted to protect third parties and shareholders from exploitation by a company, by protecting creditors of the company in that they were able to keep track of the companies funds and by protecting shareholders so that they knew that their money was being used for the objects as decided in the memorandum, however it had the reverse effect as the company could declare that the contract was void due to lack of capacity and the prejudiced party had no further protection. It also resulted in companies drafting very broad objects in its memorandum and parties contracting with the company had trouble knowing what the exact objects of the company were and the limitations of such. This problem was first eradicated to some extent by the s36 of the Companies Act 61 of 1973 and thereafter to a greater extent by the new Companies Act 71 of 2008, both as discussed below.

¹ See Ashbury Railway Carriage & Iron Company v Riche1875 LR 7HL 653

² Eales v Turner (1928) WLD 173; and seeSorenson v Executive Committee Tramway and Omnibus Workers Union 1974 (2) SA 545 (C)

³ JT Pretorius, PA Delport et al Hahlo’s South African Company Law through the cases 6 ed (1999) 60

III. POSITION IN TERMS OF THE COMPANIES ACT 61 OF 1973

The common law regarding the ultra vires doctrine was dramatically changed with this Act as now a contract between a third party and a company will not be void solely for the reason that the contract was ultra vires, in stead such a contract will be binding and enforceable between the parties. However on an internal level common law is still in effect, as a director acting outside the objects of a company acts unlawfully and can be held liable for any damages suffered by internal parties of the company such as its directors, shareholders and other members.

(a) Section 33 - Capacity, main objects and ancillary objects of company

The effect of this section was that a company incorporated under the provisions of the Act has the capacity as determined by its main objects in its memorandum and also by any other act which was ancillary to the main objects, as long as it is not specifically excluded. This section also provides that the main objects of the company could be determined by its main activities and therefore there is no duty to change the memorandum of the company to adapt to every activity the company participates in, however this caused difficulty for third parties as they were not notified of all these changes and all such changes would also deter the shareholders from restraining the company.

For the purpose of establishing whether a

contract entered into by a company was ultra vires or not depended on the interpretation of the memorandum and the basic rules of interpretation in law are applicable in this situation.

(b) Section 34 - Powers of Company

The object of this section is to allow companies to have plenary

powers and common powers

as set out in the schedule in order that the company may realise its objects. The powers as set out in the schedule are a list of transactions which seems to lean more towards capacity than to authority,

which serves the purpose of categorising legal transactions.It can be seen that

this section tends to limit a companies authority to act and the intention is that a company may do anything that is in pursuance of its objects.

(c) Section 36- Act ultra vires the company not void

S36 is the most relevant in determining the development of the ultra vires doctrine, it states that:

‘No act of a company shall be void by reason only of the fact that the company was without capacity or power so to act or because the directors had no authority to perform that act on behalf of the company by reason only of the said fact and, except as between the company and its members or directors, or as between its members and its directors, neither the company nor any other person may in any legal proceeding assert or rely upon any such lack of capacity or power or authority’.

This section has the result that an ultra vires act (i.e.an act which is beyond a company’s legal capacity as set out in its memorandum) will no longer be void. Even though not expressly stated the section operated regardless of whether the parties concerned knew the act was ultra vires or not at the time the act was concluded.

A vital aspect of this section is that it applies only to contracts between the company and

third parties and has no internal application as between the company and its members or directors, or as between its members and directors. Shareholders still have the right to restrain the ultra vires act, however it would be hard to put into practice because of the fact that a company’s objects could change without an amendment to the memorandum.

Directors

could as always be held liable for breach of their fiduciary duties as discussed by Blackman who states this breach could be used as a ground to void the contract.

The doctrine of

constructive notice was not abolished under this section as the company’s contracting party could approach the court to argue that the third person was aware of the company’s lack of authority to enter into such contract.

Finally the outcome of the 1973 Act was that a director could escape liability for entering

into an ultra vires act if either the company was simply passive regarding the matter or if the shareholders decided to ratify the act. Therefore it can be said that the objects in the memorandum does not determine the capacity of the company but instead it can be seen to impose a duty on a director to protect the interests of internal parties within the company.

N Locke Laws 7011 Lecture 5 2011

MarrokPlase (Pty) Ltd v advance Seed Co (Pty) Ltd 1975 (3) SA 403 (AD) 414

‘Plenary’ means ‘of full scope or extent; complete or absolute in force or effect.’: Shorter Oxford Dictionary 3 ed 1523

N Locke Laws 7011 Lecture 5 2011

See supra atparagraph III.(a)

Blackman ‘Director’s duty to exercise their powers for an authorised business purpose’(1990) SA MercLJ at 9

JS McLennan ‘Time for the final abolition of the ultra vires an constructive notice doctrines in company law’ (1997) 9 SA MercLJat 335

Blackman ‘Director’s duty to exercise their powers for an authorised business purpose’(1990) SA MercLJ

IV. POSITION IN TERMS OF THE COMPANIES ACT 71 OF 2008

The new Companies Act which is supposed to come into operation in May 2011 addresses the shortfalls which were found in the previous Act regarding the position of ultra vires doctrine.

(a) Section 19 - Legal status of companies

This provision greatly extends the capacity of a company by giving it all the capacities a natural person would have in so far as those capacities may be applicable to a juristic person, and the company’s memorandum serves to restrict such liability. Thus the fundamental shift that this section brings about is the idea that society now gives a company the recognition and responsibilities of a natural person. Considering that this Act is yet to come into operation companies existing before this time may choose to either disregard their objects in the memorandum of incorporation or to keep their limitations in the memorandum.

The doctrine of constructive notice has been abolished in this Act except in two

situations as discussed in s19 (5):

‘… (5) a person must be regarded as having received notice and knowledge of –
(a) any provision of a company’s memorandum of incorporation contemplated in section
15(2)(b) if the company’s notice of incorporation or a notice of amendment has drawn attention to the provision, as contemplated in section 13(3); or
(b) the effect of subsection (3) on a personal liability company...’

(b) Section 20 - Validity of company actions

This section has extended and confirmed the rights, of third parties and internal parties, against persons representing the company and who might cause damage due to an action which is prohibited in terms of any limitation present in the company’s memorandum.

In

essence a company or its representatives may not raise the defence in any legal proceedings against another party that the contract entered into was void either because the contract was prohibited by limitation, restriction or qualification or because of such limitation, restriction or qualification the directors of the company lacked authority to enter into such contract.

In other words the company would have to find another basis to declare the contract void

other than the fact that it was an ultra vires contract; however the contract may be ratified by the shareholders to make the act valid- with the exception that acts contra the Act may not be ratified.

The Act did also provide a method for the company to protect its interests by

allowing a shareholder who is aware that the company intends on entering into an ultra vires contract to prohibit the company from doing so.

Third party rights are still protected and an

innocent third party may claim damages on the basis that they obtained their rights in good faith and that they did not have actual knowledge of the limit, restriction or qualification.

As stated in the Act each shareholder will have a claim for damages against the party who presented to the third party that they had the necessary authority and capacity to act on behalf of the company.

This is further supported by s76(3)(a) which states that the

director must always act in good faith and for a proper purpose , s77(3)(a) which makes a director liable for breach of his fiduciary duties and s218(2) which states that a director would be liable to any party who suffered loss due to the directors lack of authority to act.

An innocent third party may presume that the contracting company has complied with

all of the formal and procedural requirements in terms of the Act, its memorandum or any other rules relevant to the company, and this presumption exists unless it can be said that the third party knew or reasonably should have known that there was a failure on the company to comply with such requirements.

N Locke Laws 7011 Lecture 5 2011

T Kamdar& J Feris ‘Dispute resolution matters’ available at http://www.cliffedekkerhofmeyr.com/news/files/CDH-Dispute-Resolution-Matters-Spring-2010.pdf , accessed on 28 March 2011

S20(1) of Act 71 of 2008

S20(2) of Act 71 of 2008

S20(4) of Act 71 of 2008

S20(5) of Act 71 of 2008

However all persons dealing with a ‘RF’ company are deemed to have knowledge of the conditions set out in the memorandum, see M Burger ‘Capacity, ultra vires and turquand rules’ available at http://www.wwb.co.za/wwb/view/wwb/en/page15135?oid=23552&sn=Detail, accessed on 20 march 2011

S20(6) of Act 71 of 2008

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S20(7) of Act 71 of 2008

IV. CONCLUSION

It is my opinion that the new Companies Act does indeed provide a satisfactory solution to the question of validity of a contract entered into by a company which is contrary to its memorandum. The development of the ultra vires doctrine over the years can be clearly followed and it is evident that the legislature has now provided a coherent framework from which to work from. In the case study that was put before me where Design-a-Company Pty Ltd invests in Scribe Ltd contrary to the restrictions in its memorandum there are clear solutions available to Scribe Ltd as the third party, the shareholders and the directors of the company. First the contract would not be void and the rights of the third party will be protected as per the contract, secondly the shareholders may either prevent the directors from entering into such a contract or if the contract is already entered into they may claim damages from the directors for their losses and finally for the directors, their actions could be ratified by the shareholders and they would escape liability –if not ratified they can still be held liable to the shareholders for the shareholders’ losses. In summary it is clear that the rights of the third party are not affected and the contract between Design-a-Company Pty Ltd and Scribe Ltd is valid and enforceable.

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