DOCTRINE OF 'INDOOR MANAGEMENT'

By:
SAAD ULLAH
Advocate High Court

Introduction

The doctrine of Indoor management, popularly known as the Turquand's rule initially arose some 150 years ago in the context of the doctrine of constructive notice. The rule of Doctrine of Indoor Management is conflicting to that of the principle of Constructive Notice. The former operates to protect outsiders against the company, while the latter seeks to protect the company against outsiders. 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 company's 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 in 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 doctrine 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.[1]

Definition of the doctrine

According to this doctrine outsiders dealing with the company are entitled to assume that as far as the internal proceedings of the company are concerned, everything has been regularly done. They are presumed to have read the registered documents and seen to it that the proposed dealing is not inconsistent therewith, but they are not bound to do more, they need not inquire into the regularity of the internal proceedings as required by the memorandum and the articles.[2]

Genesis Of The Doctrine

The rule had its genesis in the case of Royal British Bank v Turquand[3]

Facts

In this case the Directors of the Company were authorized by the articles to borrow on bonds such sums of money as should from time to time by a special resolution of the Company in a general meeting, be authorized to be borrowed. A bond under the seal of the company, signed by two directors and the secretary was given by the Directors to the plaintiff to secure the drawings on current account without the authority of any such resolution. Then Turquand sought to bind the Company on the basis of that bond.

Issue

Thus the question arose whether the company was liable on that bond?

Judgment:

The Court of Exchequer Chamber overruled all objections and held that the bond was binding on the company as Turquand was entitled to assume that the resolution of the Company in general meeting had been passed. The relevant portion of the judgment of Jervis C. J. reads:

"The deed allows the directors to borrow on bond such sum or sums of money as shall from time to time, by a resolution passed at a general meeting of the company, be authorized to be borrowed and the replication shows a resolution passed at a general meeting, authorizing the directors to borrow on bond such sums for such periods and at such rates of interest as they might deem expedient, in accordance with the deed of settlement and Act of Parliament; but the resolution does not define the amount to be borrowed. That seems to me enough……We may now take for granted that the dealings with these companies are not like dealings with other partnerships, and the parties dealing with them are bound to read the statute and the deed of settlement. But they are not bound to do more. And the party here on reading the deed of settlement, would find, not a prohibition from borrowing but a permission to do so on certain conditions. Finding that the authority might be made complete by a resolution, he would have a right to infer the fact of a resolution authorizing that which on the face of the document appear to be legitimately done."

Rational Basis of the Test

The law provides that it is not necessary for third parties to enquire into the corporation's internal authorization requirements. One of the basic rationales is that the flow of commercial transactions, and the economy with it, would be brought to a halt if the third parties, prior to signing any agreement with a corporate entity, were required to complete a thorough due diligence to ensure that such corporation is indeed properly authorized to sign. The legal doctrine known as the indoor management rule was developed to deal with the issue. [4]

Comparative Practices

The Turquand's Rule obtained statutory recognition in Section 40 of the Companies Act, 2006 which embodies the principle articulated in Turquand case. The section provides protection to the outsiders against any internal irregularity of the company. [5]

The Turquand's rule has also obtained statutory recognition in Section 9(1) of the European Communities Act, 1972, which reads;

"9. Companies.--(l) In favour of a person dealing with a company in good faith, any transaction decided on by the directors shall be deemed to be one which it is within the capacity of the company to enter into, and the power of the directors to bind the company shall be deemed to be free of any limitation under the memorandum or articles of association ; and a party to a transaction so decided on shall not be bound to enquire as to the capacity of the company to enter into it or as to any such limitation on the powers of the directors, and shall be presumed to have acted in good faith unless the contrary is proved." [6]

Initial application of the doctrine

The House of Lords further endeavored to explicate the Turquand Rule in the case of Mahony v. East Holy ford Mining Co.[7] The case is an excellent example of Court's drawing out qualifications to the rule. In this case the company's bank made payments based on a formal copy of a resolution of the board authorizing payments of cheques signed by any two of three named "directors" and countersigned by the named "secretary". The copy was itself signed by the secretary. It came out subsequently that neither the directors nor the secretary had ever been formally appointed. According to the articles, the directors were to be nominated by the subscribers to the memorandum and the cheques were to be signed in such manner as the board might determine.

It was held by the House of Lords that since the bank had received formal notice in the ordinary way of the board's decision, it was not bound to enquire further.

CANADA

Indoor Management

The law provides that it is not necessary for third parties to enquire into the corporation's internal authorization requirements. This principle was first formulated in 1856 in England and became known as the "Indoor Management Rule". The Canadian common law adopted the rule which was also codified by state legislation.

The Courts have held that a third party is entitled to rely on actions taken by officers of a corporation on the basis that they were within the authority usually granted to officers. Such authority can either be actual or apparent authority. Actual authority, whether express (such as by a resolution) or implied (by a position held) is binding between a company and others. Apparent authority creates a direct legal relationship between a company and a third party, based on the company's representation to the third party that a certain employee or an officer has the authority to act on the corporation's behalf. In most of the cases considered by the Courts, the actions were found to be in the ordinary course of the corporation's business and therefore within at least the apparent authority of the employee or the officer in question.

The Courts held that a company is bound by the acts of persons who take it upon themselves, with the knowledge of the directors, to act for the company, provided such persons act within the limits of their present authority, and that strangers dealing bona fide with such persons have a right to assume that they have been duly appointed. The Courts also held that it is not appropriate to ascribe an implied authority to a subordinate employees of a company in the way implied authority could be ascribed to a senior officer. [8]

India

Provisions under the Indian Companies Act, 1956

The provision under the Indian Companies 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.[9] Illustrating upon the point the Punjab & Haryana High Court has avowed in the case of Diwan Singh v Minerva Mills[10] 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

The Turquand's rule has been approved and followed by Varadaraja lyengar J., in Varkey Souriar v. Keraleeya Banking Co. Ltd. [11] Thus he articulates in the following words;

"Coming to the alternative ground, it is no doubt true that where a company is regulated by a memorandum and articles registered in some public office, persons dealing with the company are bound to read the registered documents and to see that the proposed dealing is not inconsistent therewith but they are not bound to do more. They need not enquire into the regularity of the internal proceedings what Lord Hatherley called 'indoor management'. So if there is a managing director and authority in the articles for the directors to delegate their powers to him, a person dealing with him may assume that it is within the ordinary duties of a managing director. All he has to see is that the managing director might have power to do what he purports to do. But the rule cannot apply where the question, as here, is not one as to the scope of the power exercised by an apparent agent of the company, but is in regard to the very existence of the agency."

In Lakshmi Ratan Cotton Mills Co. Ltd, v. J. K. Jute Mitts Co. Ltd[12] the plaintiff company sued the defendant company on a loan for
Rs. 150,000. 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[13] 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 rule is based upon obvious reasons of convenience in business relations. Firstly, the memorandum and articles of associations are public documents, open to public inspection. Hence 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." 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 company's 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.

Implications 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[14], 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 In YKM Holdings Private Limited v Prayag T-Pac Industries Limited and Others[15]

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.

PAKISTAN

Companies Ordinance 1984 and Turquand Rule

Section 185 contains the principle of indoor management and states that, "No act of a director, or of a meeting of directors attended by him, shall be invalid merely on the ground of any defect subsequently discovered in his appointment to such office. Provided that, as soon as any such defect has come to notice, the director shall not exercise the right of his office till the defect has been rectified".[16]

In the case of UBL V. Messrs Pak Wheat Products Ltd. (1970), company was sued for obtaining loan on securities signed by one of the three minor directors. The company pleaded that it couldn't be liable because the signing MD was not duly appointed. The Court held that third party could rightly rely on the delegation of powers if apparently the articles provided for such delegation to MD in fact appointed, though not legally.

AGENCY PRINCIPLES

In addition to the Turquand's rule, a third party may be able to rely on general agency principles of actual and ostensible authority;

(a) Actual Authority

It may be express arising from an authority conferred on a director, or implied arising from the position which the individual holds. In case of Hely Hutchinson V. Bray Bead Ltd. (1968) [17], Mr. Richards was chairman of Brayhead and also acted as MD without being formally appointed. He gave guarantees on behalf of defendant for a company which went into insolvent liquidation. The Court held that defendant was liable on guarantees as Mr. Richards had authority to do so.

(b) Ostensible or Apparent Authority

It is authority of the agent as it appears to others, but it doesn't exist. Board of director has this authority but whether an individual director has it or not subject to the following 4 conditions given in case of Free Man & Lockyer V. Buchurst Park Properties (Mangal) Ltd (1964) [18];

(i) A representation that agent had authority to enter on behalf of the company into a contract to be enforced was made to the contractor;

(ii) Such representation was made by a person or persons who had actual authority;

(iii) Contract was induced by such representation;

(iv) Under memorandum and articles, company is not bound to delegate the authority.

Exceptions To The Doctrine

The rule of doctrine of indoor management is however subject to certain exceptions. In other words, relief on the ground of 'indoor management' cannot be claimed by an outsider dealing with the company in the following circumstances:

1. Where the outsider has knowledge of Irregularity

2. Suspicion of Irregularity

3. Forgery

4. Representation through Articles

5. Acts outside apparent authority

1. Knowledge of Irregularity.--The first and the most obvious restriction is that the rule has no application where the party affected by an irregularity had actual notice of it. Knowledge of an irregularity may arise from the fact that the person contracting was himself a party to the inside procedure. As in Devi Ditta Mal v The Standard Bank of India[19], where a transfer of shares was approved by two directors, one of whom within the knowledge of the transferor was disqualified by reason of being the transfer himself and the other was never validly appointed, the transfer was held to be ineffective.

Similarly in Howard v. Patent Ivory Manufacturing Co[20] where the directors could not defend the issue of debentures to themselves because they should have known that the extent to which they were lending money to the company required the assent of the general meeting which they had not obtained. Likewise, in Morris v Kansseen[21], a director could not defend an allotment of shares to him as he participated in the meeting, which made the allotment. His appointment as a director also fell through because none of the directors appointed him was validly in office.

But after the Hely-Hutchinson v Brayhead Ltd[22] according to which the mere fact that a person is a director does not mean that he shall be deemed to have knowledge of the irregularities practiced by other directors. A newly appointed director does not mean that he shall be deemed to have knowledge of the irregularities practiced by the other directors. A newly appointed director entered into contracts of indemnity and guarantee with the company through a director whom the company had knowingly allowed to hold himself out as having the authority to enter into such transaction, although in fact he had no such authority. The company was held liable.

2. Suspicion of Irregularity.--The protection of the "Turquand Rule" is also not available where the circumstances surrounding the contract are suspicious and therefore invite inquiry. Suspicion should arise, for example, from the fact that an officer is purporting to act in matter, which is apparently outside the scope of his authority. Where, for example, as in the case of Anand Bihari Lal v. Dinshaw & co[23] the plaintiff accepted a transfer of a company's property from its accountant, the transfer was held void. The plaintiff could not have supposed, in absence of a power of attorney, that the accountant had authority to effect transfer of the company's property.

Similarly, in the case of Haughton & co v. Nothard, Lowe & Wills Ltd[24] where a person holding directorship in two companies agreed to apply the money of one company in payment of the debt to other, the Court said that it was something so unusual "that the plaintiffs were put upon inquiry to ascertain whether the persons making the contract had any authority in fact to make it." Any other rule would "place limited companies without any sufficient reasons for so doing, at the mercy of any servant or agent who should purport to contract on their behalf."

3. Forgery.--Forgery may in circumstances exclude the 'Turquand Rule'. The only clear illustration is found in the Ruben v Great Fingall Consolidates[25] here in this case the plaintiff was the transferee of a share certificate issued under the seal of the defendant's company. The company's secretary, who had affixed the seal of the company and forged the signature of the two directors, issued the certificate. The plaintiff contended that whether the signature were genuine or forged was apart of the internal management, and therefore, the company should be estopped from denying genuineness of the document. But, it was held, that the rule has never been extended to cover such a complete forgery.

Lord Loreburn said.--"It is quite true 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 have no notice. But, this doctrine which is well established, applies to irregularities, which otherwise might affect a genuine transaction. It cannot apply to Forgery."

4. Representation through Articles.--The exception deals with the most controversial and highly confusing aspect of the "Turquand Rule". Articles of association generally contain what is called 'power of delegation'. Lakshmi Ratan Lai Cotton Mills v J.K. Jute Mills Co[26] explains the meaning and effect of a "delegation clause".

Here one G was director of the company. The company had managing agents of which also G was a director. Articles authorised directors to borrow money and also empowered them to delegate this power to any or more of them. G borrowed a sum of money from the plaintiffs. The company refused to be bound by the loan on the ground that there was no resolution of the board delegating the powers to borrow to G. Yet the company was held bound by the loans. "Even supposing that there was no actual resolution authorizing G to enter into the transaction the plaintiff could assume that a power which could have been delegated under the articles must have been actually conferred. The actual delegation being a matter of internal management, the plaintiff was not bound to enter into that." Thus the effect of a "delegation clause" is "that a person who contracts with an individual director of a company, knowing that the board has power to delegate its authority to such an individual, may assume that the power of delegation has been exercised."

The question of knowledge of Articles came up in the case of Rama Corporation v. Proved Tin and General Investment Co[27] here; one T was the active director of the defendant company. He, purporting to act on behalf of his company, entered into a contract with the plaintiff company under which he took a cheque from the plaintiffs. The company's article contained a clause providing that "the directors may delegate any of their powers, other than the power to borrow and make calls to committees, consisting of such members of their body as they think fit". The board had not in fact delegated any of their powers to T and the plaintiffs had not inspected the defendants' articles and, therefore, did not know of the existence of power to delegate.

It was held that the defendant company was not bound by the agreement. Slade J’, was of the opinion that knowledge of articles was essential. "A person who at the time of entering into a contract with a company has no knowledge of the company's articles of association, cannot rely on those articles as conferring ostensible or apparent authority on the agent of the company with whom he dealt." He could have relied on the power of delegation only if he knew that it existed and had acted on the belief that it must have been duly exercised. Knowledge of articles is considered essential because in the opinion of Slade J; the rule of `indoor management' is based upon the principle of estoppel. Articles of association contain a representation that a particular officer can be invested with certain of the powers of the company. An outsider, with knowledge of articles, finds that an officer is openly exercising an authority of that kind. He, therefore, contracts with the officer. The company is estoppel from alleging that the officer was not in fact authorised.

This view that knowledge of the contents of articles is essential to create an estopped against the company has been subjected to great criticism. One point is that everybody is deemed to have constructive notice of the articles. But Slade J brushed aside this suggestion stating constructive notice to be a negative one. It operates against the outsider who has not inquired. It cannot be used against interests of the company. The principle point of criticism, however, is that even if the directors had the power to delegate their authority. They would not yet be able to know whether the director had actually delegated their authority. Moreover, the company can make a representation of authority even apart from its articles. The company may have held out an officer as possessing an authority. A person believes upon that representation and contract with him. The company shall naturally be estopped from denying that authority of that officer for dealing on its behalf, irrespective of what the articles provide. Articles would be relevant only if they had contained a restriction on the apparent authority of the officer contained.

5. Acts outside apparent authority.--Lastly, if the act of an officer of a company is one which would ordinarily be beyond the power of such an officer, the plaintiff cannot claim the protection of the "Turquand rule" simply because under the articles power to do the act could have been delegated to him. In such a case the plaintiff cannot sue the company unless the power has, in fact, been delegated to the officer with whom he dealt. A clear illustration is Anand Behari Lal v Dinshaw[28] here the plaintiff accepted a transfer of a company's property from its accountant. Since such a transaction is apparently beyond the scope of an accountant's authority' it was void. Not even a 'delegation clause' in the articles could have validated it, unless he was, in fact, authorized.

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 party's 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" or "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 can not 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.

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.

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[1] http://www.legalserviceindia.com (last accessed July 5, 2011).

[4] www.GeorgeNetwork.com, 2010 The Canadian Business Journal.

[5] Section 40 of the companies Act 2006

[6] Section 9(1) of the European Communities Act, 1972

[8] www.GeorgeNetwork.com, 2010 The Canadian Business Journal.

[9] Sections 290 & 81, The Indian Companies Act, 1956

[11] [1957] 27 Comp Cas 591, 594; AIR 1957 Ker 97,

[16] Section 185 of the Companies Ordinance 1984