We have a case where there is a company BCL and it has its Subsidary Company as SCL. BCL has 100% shareholding in SCL and three of the directors of BCL sit on the board of SCL (Amy, Ben and Carrie). One of the directors of SCL(Amy) engaged in a contract with Eddie who was the manager of FCD for trading in fake cds considering the fact that it was more profitable to trade in fake cds then to trade in genuine. This was against the constitution of SCL and General Law. When FCD invoiced SCL for the 1000 Cds SCL refused to pay the account. On further inquiry it as learnt that SCL was insolvent.
Question 1: Whether the contract that Amy entered into with FCD would bind SCL?
Under s126(1) of Corporations Law, an individual acting with the company’s express or implied authority can make, vary, ratify or discharge a contract on behalf of company.
[Ref Case: Hely- Hutchinson v Brayhead Ltd. 919680 1 QB 549)1
In our case, Amy had the authority to enter in to the contract on behalf of the company i.e. SCL but nothing has been mentioned in the case about the authority given to Eddie about entering in to a contract. So I assume that Eddie who entered in to the contract on behalf of FCD had an authority to enter into the contract under s198A of Corporations Law.
The contract entered into by Amy was against the Object clause of the Company’s Constitution where it was stated that the company deals only in genuine products. It was also against clause 6 which states that no director should engage in an activity that breaches the company’s constitution and /or are prejudicial to the reputation and interests of the company. Initially under s125 (2) of Corporations Law such contracts which are against the company’s object clause restricts the business activities.
The original purpose of Doctrine of Ultra Vires was to protect the shareholders and creditors. But under this section the other party who engaged in a contract with the company who was breaching its constitution would be penalized for not knowing the constitution of other company as the contract would be considered as ultra vires contract.
1 Lipton & Hezberg: Understanding Company Law (page 120)
2 Lipton & Hezberg: Understanding Company Law (page 94)
Thus to protect the other party Doctrine of Ultra Vires has been abolished and under s125(2) of Corporations law an act is not invalid merely because it is in contrary to or beyond any of its objects. Further while a company’s constitution may contain an express restriction or prohibition on the exercise of any of its powers, s125 (1) of Corporations Law states that the exercise of power is not invalid merely because it is in contrary to express restriction or prohibition. Hence where a company acts outside its object or contrary to a restriction or prohibition in its constitution, this is not a contravention of Corporations Act. This would mean that the other party to contract can assume that the internal proceedings of a company had been properly carried out.
HELD OUT: Contract is bound to Bank because the passing of resolution is matter internal to the company and an outsider need not inquire whether such a resolution has been passed.
Amy entered into a contract with FCD which was against SCL’s constitution. In general circumstances the law would consider this contract to be valid and bind SCL which can be justified by above stated theory and referred case. But in this case Dennis who is an employee of FCD had the knowledge about company’s constitution and reputation of SCL dealing in genuine software products.
Thus this case would act as an exception to Turquand’s case where the outsider i.e. the other party looses the protection considering s128(4) of Corporations Law
(Ref case: Northside Developments Pty Ltd v Registrar- General (1990) 170 CLR 146)
HELD OUT: Northside Development was not bound by the mortgage as Barclays was ought to suspect an irregularity
Even according to general law this contract would become null and void as it is of illegal nature i.e. dealing in fake Cd’s.
Thus from the above stated facts it can be derived that the contract would not bind SCL as it becomes null and void.
3 Lipton & Hezberg: Understanding Company Law (page 121)
4 Lipton & Hezberg: Understanding Company Law (page 126)
Question 2: Assuming that a court finds there is a contract that binds SCL, what can FCD do to recover the debt? Under what circumstances, if any, could BCL become responsible for the financial obligations of SCL? What could BCL do to minimize the risk?
Amy was approached by Dennis for selling Fake Cd’s and tempted her by stating that the profits to be made by selling fake Cd’s are much better than selling genuine ones. Dennis is aware of SCL’s reputation for only purchasing and selling genuine software and was aware of the company constitution on a prior occasion.
Amy after few days approached FCD and entered into the contract with Eddie, manager of FCD. Amy entered into a contract which was against the object clause of the company and also at that point of time when the company was near to insolvency under s588G of Corporations Law.
Amy entered in a contract with FCD when SCL was near to insolvency and FCD was unaware of this circumstance and engaged in the contract. According to s129 of corporations law which states the concept of indoor management and says that “persons dealing with a company in good faith may assume that acts within its constitution and powers have been properly and duly performed and are not bound to inquire whether acts of internal management have been regular”.
In case where court finds that there is a contract that binds SCL, then FCD is entitled to compensation. We see that when FCD invoiced SCL for 1000 Cd’s, only to learn that SCL had no assets to repay the debt. Now BCL is a holding company of SCL and has 100% share holding on SCL and also the directors who sit on the board of BCL also sits on the board of SCL. Hence FCD can ask for compensation from BCL. It is mentioned in clause 9 of SCL’s constitution that any dispute arising out of and/or in connection with the purchase or sale contract between the company and any third party shall be resolved by arbitration and only if arbitration fails to resolve such dispute then the parties are entitled to litigation.
Thus FCD should try to resolve the problem by the means of arbitration and recover the debt.
Looking at the circumstances it does not seem that BCL would take the liability of SCL’s debts. Hence to recover the debt FCD would proceed to litigation and sue BCL.
5 Lipton & Hezberg: Understanding Company Law (page 379)
Now considering the fact that the matter goes to litigation, for FCD to recover the debts from BCL it needs to prove that BCL has a major hold on SCL business activities.
As a matter of fact that BCL has a 100% shareholding in SCL and three directors of BCL (Amy, Ben, Carrie) also sits on the board of SCL which would help FCD to prove that BCL has a major hold over SCL’s business activities.
Yet the above mentioned fact would not be sufficient to prove that BCL would be responsible for any financial obligations of SCL.
Thus following six requirements must be established to support a finding that SCL carried on a business as an agent for BCL.
* BCL must be in effectual and constant control of SCL.
* BCL must be head and brain of trading venture of SCL.
* The profits of SCL must be treated as the profits of BCL.
* The profits of SCL must be made by BCL’s skills and direction.
* The persons conducting the business of SCL must be appointed by BCL.
* BCL must govern the venture of and decide what should be done and what capital should be embarked on SCL.
HELD OUT : The court was prepared to disregard the corporate veil that the companies in group operated in partnership but there wasn’t sufficient evidence to indicate a partnership between holding company and subsidiary company.
In our case three directors of BCL are also directors of SCL and BCL also has 100% shareholding in SCL. So FCD has an opportunity to prove that BCL is in effectual and constant control of SCL, BCL is a head and brain of trading venture of SCL reason being Amy the director of BCL as well as a board member of SCL ventured the contract and the other above mentioned points.
Further under s588V of Corporations Law a holding company can be held liable for the debts of a subsidiary incurred in circumstances where the holding company knew or ought to have known that the subsidiary was insolvent. In our case Amy was the director of BCL and also the board member of SCL. This shows that Amy knew the fact about SCL nearing to insolvency and which inturn means that BCL the holding company was aware about the same.
Thus if above stated circumstances prevail, then BCL would be responsible for the financial obligations of SCL.
6 Lipton & Hezberg: Understanding Company Law Page 46)
The company would argue that the director has knowingly breached the company’s constitution and also had traded at a time when the company was near to insolvency. Hence in such cases where a company has been trading while being insolvent or near to insolvency the corporation’s law itself has the effect of removing the corporate veil separating the company from certain of its participants making those participants liable for the debts incurred by the company in these circumstances.
In this case Amy, the director of SCL had breached the object clause and clause 6 of company’s constitution which states that no director should engage in contract which spoils the reputation. Amy entered into a contract of Fake Cd’s which is against the general law and also the public policy and also entered into a contract at a point of time where SCL had been near to insolvency. Hence BCL would consider Amy personally liable for SCL’s debt.