The Articles and the Memorandum Form a Contract between the Company and Its Members - Essay Example

? THE ARTICLES AND THE MEMORANDUM FORM A CONTRACT BETWEEN THE COMPANY AND ITS MEMBERS Introduction All companies incorporated and registered with theRegistrar of Companies are required to contain a memorandum and the articles of association.1 Collectively, the memorandum and articles have always formed the constitution of the company and as such were deemed to form a contract between the company and its members. However, recent reforms have reduced the constitutional and thus the contractual role of the memorandum.2 Even so, companies formed under the previous Companies Act 1985 which consolidated previous Companies Acts, remain bound by the substantive constitutional form, much of which were previously contained in the company’s memorandum of association. In this regard, the law relative to the memorandum of association prior to the enactment of the Companies Act 2006 is relevant to this study. Suffice it to say for present purposes that the extent to which the articles and memorandum forms a contract between the members and the company are reflected by the functions of each document. The memorandum’s functions have been altered, but its historical significance continue to be applicable as it has been resurrected and placed within the articles of association. Prior to the implementation of the Companies Act 2006, the memorandum defined the company’s external charter while the articles define the company’s internal charter. Ultimately, the memorandum and articles of association functioned together to determine the member’s commitment to the company’s goals and objectives and how the members will and can facilitate those goals and objectives. It has been argued that by subscribing to the memorandum of association, the subscribing members are binding not only themselves, but all future members to a contractual obligation to comply with the company’s by-laws (articles of association) and the company’s objects.3 All companies formed under the Companies Act 1985 were essentially subject to Section 14 of the 1985 Act which provides that the articles and memorandum binds both the company and its members to what is essentially a contract between them.4 The Companies Act 2006 essentially upholds this provision with one significant modification. Instead of referring to the memorandum and articles of association, it merely attributes the contractual basis to the company’s constitution. Elsewhere in the 2006 Act, the company’s constitution is described as the articles of association. This essay analyses the contractual role of the articles and memorandum association in binding the members to company. I. The Memorandum of Association A. The Contractual Nature of the Memorandum of Association Prior to the Companies Act 2006 All UK companies are required to have a memorandum of association.5 Under the Companies Act 1985, the memorandum of association was required to specifically state the company’s objects and constitution.6 Recent reforms promulgated by the Companies Act 2006 have effectively reduced the memorandum of association to a mere shell of its former contractual significance. The current memorandum of association is no more than a simple instrument reflecting basic information such as the company’s name, its registered office in the UK, share capital and shareholder liability. Even so, the memorandum of association has historical significance in that its main contractual basis has been transferred to the articles of association. Therefore the common law relative to the members’ commitment to the company’s objects under the memorandum of association are now relevant to the same commitment under the articles of association. Moreover, the share capital and limitation of liability as stated in the memorandum of association are also important parts of the members’ contractual relationship with the company that they form. Under the Companies Act 1985, the Memorandum of Association set out the objects of the company and the purposes for which it was formed.7 Section 2 also provides that the memorandum of association must contain the name of the company, its registered office and must state where relevant if the company’s shares are characterized by limited liability.8 A company’s memorandum of association was previously regarded as forming a part of the incorporated company’s constitution in that it provided the basic terms and conditions for which the company is incorporated.9 At common law, the function and purpose of the memorandum of association are captured in the words of Bowen LJ: The memorandum contains the fundamental conditions upon which alone the company is allowed to be incorporated. They are conditions introduced for the benefit of the creditors, and the outside public, as well as of the shareholders.10 What this means is that the memorandum of association binds its subscribers or initial members and all future members to the purpose for which the company was incorporated. The memorandum of association was previously designed to set forth the conditions and purposes for which the company was incorporated. The House of Lords confirmed that the memorandum of association: …states affirmatively the ambit and extent of vitality and power which by law are given to the corporation, and it states, if is necessary so to state, negatively, 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.11 Ultimately what this means is that any activities conducted outside of or ultra vires to the company’s objects would be deemed void ab initio.12 The company’s objects as stated in the Memorandum of association therefore set the parameters of the contractual relationship between the company and its members. The members are bound by the objects in the context of what they can and cannot do as agents of the company. For example, Simpson v Westminster Palace Hotel Co. [1860] a shareholder attempted to prevent the company which operated a hotel, renting hotel rooms for offices. Although it was held that the renting of hotel rooms as offices were not ultra vires the objects of the company, an injunction would have been issued had the court found that it had been ultra vires the objects.13 However, in Stephens v Mysore Reefs (Kangundy) Mining Co. Ltd. [1902] a company established to conduct mining in India was not permitted to take its mining to West Africa as it was deemed to be ultra vires the company’s objects.14 The significance of binding nature of the memorandum of association as between the members of the company and the company led to a wide number of companies drafting long and comprehensive objects clauses. The idea was to ensure that members could conduct a wide range of business activities so as not to compromise their obligations and commitments to the company’s objects as expressed in the memorandum.15 Other techniques used were designed to render the objects open to wide interpretation so that the company’s members could bind the company to a wider range of activities. For instance in Re New Finance and Mortgage Company Limited (in liquidation)[1975] the company’s objects permitted the company to carry on business as capitalists, financiers, bankers, mortgage brokers, financial agents, exporters/importers of “goods and merchandise of all kinds and merchants generally”.16 It was held that the phrase “merchants generally” were broad enough to include virtually any kind of commercial activities and the act complained of (purchasing of motor oil) was therefore not ultra vires.17 Despite the creativity with which objects may be drafted and the ease with which they may be interpreted to bind the company to business activities conducted by its members, the law protects third parties acting in good faith. The result is, members acting ultra vires the company’s object will nonetheless bind the company to these acts, despite the contract between the company and the members limiting the contractual obligations to the objects as stated in the memorandum. EEC Directive 151 of 1968, the first EC Directive on Company Law provides that: Acts done by the organs of the company shall be binding upon it even if those acts are not within the objects of the company, unless such acts exceed the powers that the law confers or allows to be conferred on those organs.18 Member States are permitted to exempt the company if there is evidence that the third party was aware that the transaction was ultra vires the company’s objects or ought to have been aware that the transaction was ultra vires.19 The UK’s European Community Act 1972 responded by providing protection for a third party acting in good faith. The result was that any person acting in good faith can enforce a contract that was ultra vires the company’s objects and will not be constrained by the contractual obligation created between the company and its members in the memorandum of association.20 This provision was later incorporated by the Companies Act 1985.21 Obviously, the contractual nature of the memorandum of association’s objects between the company and its members was unsatisfactory. It created an atmosphere in which the members tended to draft broad objects that could conceivably bind the company to virtually all types of commercial activities. Moreover, the members could bind the company to ultra vires activities as against innocent third parties. In order to address these problems, Section 3A was inserted in the Companies Act 1985 by the Companies Act 1989. Section 3A provides that a company’s memorandum can include an object clause that permits the company “to carry on business as a general commercial company.”22 Cumulatively, the company’s contractual relationship with its member under the memorandum is such that the validity of any transaction carried out by the company will not be scrutinized on the basis that it lacked the capacity under its memorandum of association. Therefore the company’s members will bind it to a transaction as against innocent third parties. A company’s member may take action to prevent a company engaging in ultra vires activities. Nothing in the ensuing legislation modified this position. The only other significant contractual element in the memorandum of association is the requirement that the initial members declare whether or not the company is a limited liability company. In the event the company is a limited liability entity, the members are therefore pledging or agreeing that they will make contributions with respect to discharging the company’s debts and liabilities in the amount stipulated in the memorandum.23 The company’s memorandum of association with respect to all companies in existence prior to the implementation of the Companies Act 2006 forms a statutory contract between the members and the company that they incorporated. The members undertake to conduct the business for which the company is formed and to contribute to the company’s assets and liabilities. Even where the members breach these obligations by acting outside of the committed purpose for which the company is formed, they may nevertheless bind the company to unauthorised acts conducted with innocent third parties. B. The Companies Act 2006 The Companies Act 2006 significantly changed the company’s constitution changing the contractual nature of the memorandum of association as between the company and its members.24 The idea that the company’s constitution was comprised of both the memorandum and articles of association has now been replaced by the concept of a single document. Section 17 of the 2006 Act provides that the company’s constitution will consist of its articles of association and any other resolution and agreements concluded by specific members.25 Section 8(1) of the 2006 Act provides that a memorandum of association commits the subscribers to two undertakings. First they commit themselves to incorporating a company under the Companies Act 2006.26 Secondly, the subscribers commit themselves to becoming the company’s members and in the event the company has share capital they agree to take no less than one share each.27 Presumably, this means that the subscribers agree to become shareholders in the company and this will commit them to the obligation to contribute to the company’s assets and liabilities in the event the company is a limited liability company.28 According to Sheikh, aside from these two aspects reflected in the memorandum of association, the document “serves no other purpose.”29 The memorandum is therefore best described as a “snapshot of part of the company’s constitution at the time of registration”.30 Although companies formed prior to the enactment of the 2006 Act will essentially reflect a memorandum with object clauses that essentially define the nature of the contractual relationship between the company and its members, companies formed after 2006 will have no such contractual obligations under the memorandum. The idea was to place the main constitutional and contractual obligations of the company and its members in one document; namely the articles of association.31 To this end, the requirement that a company’s objects be stated in the memorandum has now been changed to require that this information be included in the articles.32 Even so, the requirement of stating objects is no longer mandatory under the Companies Act 2006. This is so despite the fact that the EC’s second Company Law Directive instructs that: The statutes or the instruments of incorporation of the company shall always give at least the following information: (b) the objects of the company.33 Cahn and Donald express the view that the UK’s government interpreted the Second Directive as requiring companies to state their objects only if they had objects, and not requiring that companies have objects.34 In this regard, the objects, if there are any, now appear in the articles of association. Moreover, for all existing companies that have the pre-existing memorandums, those parts of the memorandum which are mandated to form a part of the articles will now be treated as forming a part of the company’s articles of association.35 II. The Articles of Association The contractual basis of the articles of association has been fortified by recent company law reforms in the UK. The fundamental contractual principles reside in the fact that the articles of association form a statutory contract that creates rights and duties not only between the company and its members but also between “the members inter se”.36 Unlike a standard contract however, the articles of association binds both current and future members to the duties and rights contained in the articles of association.37 Prior to the implementation of the Companies Act 2006, the memorandum and articles of association functioned together to form the contractual basis of the relationship between the company and its members. The contract was formed on the basis that the memorandum and articles of association established the rights, powers and duties of the company and its members. Although both documents provided different rights and duties and powers, neither were permitted to vacate or vary the rights, duties and powers conferred by statute and exemplified by common law.38 Although the Companies Act 2006 changed the significance of the memorandum of association so that most of its constitutional premise is now situation in the articles of association, the contractual basis of the memorandum of association has not been eradicated. Instead most of its contractual significance have now been transferred to the articles of association. The effect of transferring the entire constitutional framework from the memorandum to the articles of association is explained by Sheikh. To start with, for the most part, it places the contractual nature of the relationship between the company and its members in one place. Moreover, it is no longer necessary to be concerned with provisions in one document that may conflict with provisions in the other.39 Ultimately: The articles of association will contain all provisions that are necessary for the proper functioning of the company. The articles are intended to give flexibility to both directors and shareholders in the effective governance of the company, and to provide some degree of transparency in the relationship between directors and shareholders.40 As the main constitutional document of the company, the articles form a statutory contract between the members of the company and the company. This is because by definition, a constitution sets out a regulatory framework for what can be done and how permissible acts can be carried out.41 This is obviously, the main thrust of the objects of the company. As Talbot explains, the articles set out the rules governing the company’s internal functioning and as such set out the statutory contract between the members of the company and between the members and the company.42 Section 33 of the Companies Act 2006 provides that the constitution of the company: Bind the company and its members to the same extent as if there were covenants on the part of the company and of each member to observe those provisions.43 Previously, the corporate structure was such that the company’s constitution was divided among the memorandum and the articles of association with the latter being subordinate to the former. The articles set out the internal regulatory system of the company inclusive of meetings, the process for declaring dividends, directors’ duties and other activities of this nature. Companies were at liberty to divide the regulatory framework between the articles and the memorandum so that they contained different rules relative to if and how those rules may be modified.44 As previously noted, the 2006 Act changed this constitutional framework for the company to such an extent that the memorandum merely functions as evidence that the members intend to form a company and that they intend to be shareholders or members of that company. The articles therefore emerge as the main constitutional document of the company and the pre-existing memorandum will be treated as the articles of association to the extent that they contain those areas that are now required to be a part of the articles of association. Historically however, the memorandum and articles of association have always been deemed to be contractual in nature.45 In fact Section 14 of the Companies Act 1985 stated as much.46 All that has changed now, is that this contract has now been transferred to the articles and no longer divides the statutory contract between the memorandum and articles of association. The consequences of the transfer of the entire constitutional framework of the company to the articles are that the previous contractual obligation of the objects are now defined and followed in the articles. The members of the company continue to have the same contractual relationship with the company, only now, it is described in the articles instead of in the memorandum. Breach of these constitutional and therefore contractual obligations can have two consequences. By virtue of ultra vires activities, the members (directors and shareholders voting to approve the activities) committing the breach have contravened their obligations with respect to the company and the company likewise contravenes its duties to the members (shareholders). In other words, a breach of the contractual duties set out in the articles of association, the company’s main constitutional instrument can both be committed by and against the company at the same time.47 The possibility of this twofold liability is a manifestation of the mutual contractual obligation binding the members to the company and vice versa. The contractual nature of the articles however does not necessarily mean that the members of the company are at liberty to enforce each and every aspect of the company’s constitution. There are two constraints on the members’ ability to hold the company and other members to the company’s constitution. First, the principle that the constitution merely provides insider rights limits actionable contractual obligations under the company’s constitution. In other words, the shareholder may only enforce his or her rights or the company’s rights under as a shareholder and not in any outside capacity such as a lawyer or a director.48 The second restraint arises out of the rule in Foss v Harbottle [1843]. According to the rule in Foss establishes the majority rule principle in that any wrong allegedly committed by the company must be pursued by the company itself which is necessarily the majority shareholders. The rule essentially establishes that internal irregularities cannot justify shareholder actions.49 It was further held by Mellish LJ in MacDougall v Gardiner[1874] that in the event the company’s internal matters were mismanaged, the company was the proper party for lodging the complaint. Even so: The ultimate end of which is only that a meeting has to be called and then ultimately the majority gets it wishes.50 Ultimately, what this means is that although the Companies Act 2006 and the Companies Act 1985 both define the contractual nature of the company’s constitution, that contract is subject to the provisions contained in the Companies Act and the judicial control. Case law and company legislation past and present instruct that the members of the company are bound to company and company is bound to its members by its articles. Be that as it may, members are only able to enforce their obligations qua members.51 Although the articles represent a contractual relationship between the members and the company, it is only enforceable via the company,52 provided of course, the member does not have a personal entitlement to enforce that right.53 Conclusion What can be gleaned from the nature of the statutory contract created by the memorandum and articles of association in the long history of UK company law is that the contractual relationship seeks to regulate three significant issues. First, there is the company’s best interest to be taken account of. Secondly, the rights and obligations of both majority and minority shareholders must be taken account of in the statutory contract. Finally, the difficulties involved in proprietary rights must also be factored in. The primary difficulty however, is that a share confers upon the shareholder a proprietary right and as such the vote that accompanies it also carries with it a proprietary right.54 Therefore a shareholder is at liberty to use his vote as he/she pleases regardless of any conflict of interest between the shareholder’s personal preferences and the company’s interest.55 The statutory contract which is guided by legislation and case law is designed to safeguard against the potential for these kinds of conflicts. Although the statutory contract previously contained in both the memorandum and articles of association and now contained in the articles are designed to ensure that the company remains in business as far as it is possible to. At the same time the statutory contractual framework is intended to safeguard and protect the interests of the company and its members collectively. The idea is to prevent frivolous suits and the tearing apart of the company in the process. 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