Company law revision question and answer

“When there are persons conducting the affairs of the company in a manner which appears to be perfectly consonant with the Articles of Association, then those dealing with them externally are not to be affected any irregularities which may take place in the internal management of the company.”

As per Lord Hatherin Mahony v. East Holyford Mining Company (1875) L.R. 7
H.L. 869

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We are listening.

ANSWER
The indoor management rule which is also called the rule in Turquands case, is concerned with the liability of a company for acts of its officers.

This rule answers two questions:

(i) Can a company escape liability of pleading an internal irregularity?
(ii) Are third parties who deal with the company bound to satisfy themselves that the rules of internal management have been complied with.

These questions are answered in the negative in Royal British Bank V. Turquand (1856). The articles of the company provided that the directors could borrow on board such monies as were authorized an ordinary resolution of member in general meeting. Directors of the company borrowed from the plaintiff bank without any resolution. In liquidation, the bank sought to recover the amount from the liquidator who denied liability on the ground that the borrowing was irregular. However, it was held that the company was liable. The court formulated the so called indoor management rule that a person who contracts and deals with a company in good faith is entitled to assume that it is acting within its constitutional powers. He is entitled to assume that officers of the company who are held out the company as particular sort of officers, are the officers of the company concerned.

In Mahony V. East Holyford Mining Company LordHathersays, “when there are persons conducting the affairs of the company in a manner which appears to be perfectly in consonance with the articles of association, then those dealing with them externally are not to be affected any irregularities which may take place in the internal management of the company”.

In Freeman and Lockyear V. Backhurst Park Properties (Freemans case), the company‟s articles created the position of managing director. At the material time, none had been appointed. However, one director with knowledge of the others purported to act as managing director. He engage the plaintiff, a firm of architects to work for the company. The plaintiff was not paid for the services rendered and sued the company. The company denied liability on the ground that the director was not its managing director and hence had no authority to bind. It was held that the company was liable since it represented this director as its managing director who therefore had apparent authority to bind it.

The indoor management rule protects third parties against the company in case of internal irregularities. It is justified on two grounds:

(i) It is fair to third parties to prevent the company from denying liability relying on an internal irregularity.

(ii) It facilitates commercial transactions in that third parties are not bound to inquire whether the rules of internal management have been complied with.

However, the indoor management rule does not protect the third party in certain circumstances and the company may escape liability. These are:

The exceptions to the rule in Turquands case:

1. Public documents of the company:
If the defect or irregularity would have been ascertained an inspection, of the company‟s public documents which the third party did not do, he is not protected the rule. It was so held in Irvine V. Union Bank of Australia. This is because, the public documents are registerable and open for inspection e.g. special resolutions.

2. Knowledge of the irregularity:
If the third party is aware of the irregularity or lack of authority, on the part of the officer dealt with, he is not deemed to be acting in good faith and cannot rely on the indoor management rule. It was so held in B. Liggets (Liverpool) Ltd. V.Barclays Bank Ltd. where the defendant was aware of the irregularity.

3. Suspicion:
If circumstances are such that, they put the third party on inquiry, but the party does not inquire to ascertain the true position, he is not protected the rule as a reasonable third party would have inquired. It was so held in B. Liggets (Liverpool) Ltd. V Barclays Bank Ltd.

4. Abuse of power an officer:
If the officer dealt with the third party purports to exercise powers not ordinarily exercised that sort of officer, and the third party does not inquire, it cannot rely on the indoor management rule.

5. Forged Documents
The indoor management rule cannot protect a third party or hold the company if the document relied upon is a forgery. As such a document is a legal nullity as was held in Ruben V. Great Fingall Consolidated.

6. Insiders
As a general rule, the indoor management rule cannot be relied upon an insider. These are persons who virtue of their position in the company, are in a position to know whether the internal regulations have been complied with e.g. directors. It was so held in Howard V. Patent Ivory Manufacturing Co. Ltd where the 3rd parties in question were directors. It was held that they were deemed to know of the irregularities and would not rely on the indoor management rule.
Question has arisen as to whether directors are insiders in all cases for purposes of the indoor management rule.

It has been observed that they are not always insiders. It all depends on the nature or character of the transaction.
If it is so closely interwoven with the position of the director as a director of the company, he is deemed to know the circumstances affecting it and therefore deemed to be an insider. If it is not closely intertwined with his position as director, he may rely on the indoor management rule.

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