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Need For Incorporation of Business

Written by: Ashwini Chawla
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Hundreds of commercial companies emerged in Britain in the 300-year long era of the charter company that commenced from the end of the 14th century and ended with the bursting of the "South Sea Bubble"in the 18th century. In the age of the statutory corporation that followed in the 18th and 19th centuries, a large number of companies were formed by the Parliament for canalizing private capital for building infrastructure that included the country's railways, canals, roads and utilities . In this period of increasing business activity, registered companies emerged.

The attainment of limited liability for its investors soon followed . By the end of the 19th century, a proliferation of registered companies had taken place, following the decision of the House of Lords in the leading Salomon case.

In this study, the need for incorporation shall be examined by comparing the legal position of an incorporated association with that of an unincorporated one. Incorporation alone confers upon a business concern a separate legal personality, and resultant legal characteristics like limited liability of members, perpetual succession, etc. as shall be observed in this study.

I. The Registered Business Has A Separate Legal Entity

1.1 Historical Origin of Incorporation - As a means to Prevent Emergence of Spurious Companies
Forming a body corporate in England during the 17th and 18th centuries required the passing of a Royal Charter, or a special Act of the Parliament. This process, being expensive and lengthy, soon proved to be completely unsuited to the economic needs of a post-Industrial Revolution England. For this reason, large unincorporated partnerships emerged. Closely resembling the modern-day companies in their functions, they successfully attracted investments from the general public and disappeared due to the absence of adequate regulating legal mechanisms. This prompted the English Parliament to pass an Act that prohibited forming companies as a solution, instead of prohibiting the emergence of spurious companies . However, this ultimately affected business, and the legislators realized that the solution lay not in not in discouraging the formation of companies, but in ensuring that companies do not commit frauds. Only in 1944 with the passing of the Joint Stock Companies Act in England, did incorporation emerge as a solution. This Act facilitated incorporation in considerable measure by granting separate legal entity to incorporated associations . Incorporation has always been incorporated as a legislative measure in India, due to the similarities between Indian and English company law . Unincorporated associations can still exist, and do exist in fact. They resemble incorporated ones quite closely, in some cases with large memberships and substantial financial resources, but differ from them by not enjoying a separate legal personality.

1.2 The Business Concern before and after Incorporation - Principle of Separate Legal Entity

The general understanding of incorporation is that it is the process of forming or uniting into a corporation either by a charter or by a statute, so as to form a single body. Immediately after incorporation, the business concern shall be constituted as a body corporate, legally authorized to act as a single person. In relation to companies, the act or process of forming a company is called "incorporation". An incorporated company is a corporation that has been formed for the purposes of carrying on business for profit.

The principle of independent corporate existence of an incorporated company is perhaps of greatest importance in company law. This alone distinguishes an incorporated company from other forms of business organization. On incorporation, the business shall cease to be an association of those individuals who have established it, and shall be an entity completely distinct from them, capable of carrying on business in its own name.

The company has no physical existence, thereby being no more than a contemplation of the law. Since it is an artificial entity, it does not possess the body of a natural person. Therefore, it has to be manned and operated by natural persons, like directors, officers, shareholders, etc. They are behind the company's operations, and therefore the company shall be liable for the acts done by them within the scope of their authority, in the name of and on behalf of the company .
More than an aggregate of its members, the law has endowed the incorporated company with certain rights and privileges . The new legal personality of an incorporated association emerges at the time of incorporation itself. Its members do not pool together their status or their personality . However, on incorporation, the entity that has been formed enjoys a status that is separate from all of them. The incorporated association is a juristic person, and distinct legal entity both. Since it is a juristic person, it can carry on all those activities that human beings can, subject to those limitations that arise from it not being natural person, and those limitations imposed upon its activities by its Memorandum of Association.

For appreciating the separate legal personality of a company, the leading case of Lee v. Lee's Air Farming shall be referred to. In this case, Lee formed a company in which he held almost the whole of the capital and was the managing director. Being a qualified pilot as well, he (in the capacity of managing director) appointed himself as the chief pilot of this company, under its articles. In the course of piloting the plane, he died in an accident. Since all the workers of this company had been insured, his widow claimed compensation. The Privy Council held that by being the managing director, he did not stand precluded from entering into contracts with himself. Accordingly, the claim for compensation was upheld.

English law has consistently insisted upon the mutual exclusivity of incorporated and unincorporated associations. The courts recognize that incorporated associations enjoy certain rights and duties that are legally enforceable, and that they can sue or be sued in their own name, hold property (the ownership of which shall be protected by an action in the courts), enter into agreements, and be held liable for committing torts and crimes. Unincorporated associations, lack a separate legal personality, and in theory are a non-entity in law. This ensures that they are incapable of the incidents of legal personality .
Not being a natural person does not prevent the company from not performing the activities that a natural person can. In ADPBM Mandal v. Joint Charity Commissioner , the High Court held that a company, being a juristic person, shall be entitled to act as a trustee, so long as it has been permitted to do so by the objects clause in its memorandum and articles. Since it is capable of holding property, it is not precluded from holding property in the capacity of a trustee. But this shall be subject to the requirements that bind natural persons in this respect. This shows that the company shall be free to carry on all human activities, subject to those limitations that arise from its not being a natural person.

On the basis of the aforesaid, it is contended that incorporation alone confers upon the association a separate legal personality, and is therefore needed. Only upon incorporation does an association become a juristic person, an artificial entity having no physical existence, capable of carrying on business independently of the individuals associating with one another to form it.

II. Registered Concerns As Compared To Unregistered Ones -- Consequences of Incorporation

2.1 Can Sue and be Sued in its Own Name
The fundamental attribute of an incorporated company from which all the other attributes emanate is that it enjoys a separate legal personality from its members. Therefore, it is capable of enjoying rights and being subject to duties that are not the same as those being enjoyed or borne by its members. By being an artificial entity, the company stands in complete contradistinction to the members constituting it.

In Rajendra Nath Dutta v. Shibendra Nath Mukherjee, the Calcutta High Court held that if the company contends that a wrong has been committed against it, legal proceedings for redressing the same should be instituted by the company in its own name. In this case, a lease deed had been executed by the Directors of a company but without its seal. Later, they filed a suit on the grounds that the defendants had fraudulently added certain terms to the lease deed. The court held that the Directors shall not be competent to file the suit, until and unless they are doing so on behalf of the company itself.

There is no doubt that this decision would have been different had the same set of facts and circumstances been applied to an unincorporated association like a firm. Legal proceedings, whether civil, criminal or otherwise shall have to be initiated and defended only in the name of the individual members of the unincorporated association. This shall result in the individual members being impleaded as parties to all the proceedings that this association may initiate and proceed with, or is defending.

2.2 Limited Liability of Members

The principle of limited liability saves the shareholders from any liability for the company's debts. This applies to all dues legally recoverable from the company, whether due under a contract, a decree , under a taxing statute , or otherwise. In companies limited by shares, the shareholder's liability shall be limited to the nominal value of shares that he has subscribed to. He cannot be called upon to pay more than the nominal value, along with the premium if agreed on at the time of issuing the shares. In companies limited by guarantee, his liability shall be limited by the amount guaranteed by him. If a company fails to pay off its debts, the creditors can only petition the court to pass orders for its winding up. In the course of winding up, the shareholders shall be liable only for any unpaid amounts on the shares, and nothing more . This principle of limited liability emanates from the company having a separate legal personality, and therefore the debts of the company not being those of its members.

The House of Lords held in JH Rayner (Mincing Lane) Ltd. v. Department of Trade and Industry that the International Tin Council, being a separate legal entity shall alone be liable for its debts, the member states not being liable for the same. This case arose out of the collapse of the International Tin Council in 1985 that left it indebted to a number of metal traders, and banks, by millions of pounds. Since the Council consisted of states as its members, its creditors sought to recover their debts from those member states. The House of Lords held that there are no gradations of legal personality, because if the separate legal personality of an association has been established, there shall be no scope for any further inquiry as to the nature of its legal personality, and the principle of limited liability shall apply. However, had the International Tin Council been an unincorporated association of states, all the member states would have been liable.

In HS Sidana v. Rajesh Enterprises, the High Court held that if a decree has been passed against the company, then the liability for paying the decretal amount is on the company only, not on its managing director. The executing court shall be in a position to proceed against the managing director for recovering the amount only if it comes to the conclusion that he is personally liable, not otherwise. In contrast, in an unincorporated association like a partnership firm, a decree passed against the firm shall impose a personal liability, joint and several, on all the partners to discharge the decretal amount.

The principle of limited liability is however not absolute, and shall not be available to an incorporated company in certain circumstances specified in the Companies Act. If the number of members of a company is less than the statutory minimum , and if in the opinion of the court any business of the company has been carried on with the intent of defrauding its creditors, then the members shall be personally liable, and cannot take the plea of limited liability.

2.3 Separate Property

The Supreme Court has held in Bacha F Guzdar v. CIT that a shareholder only has a right to participate in the company's profits as and when a dividend is declared, and by buying shares, he does not acquire an interest in the company's property. Whether individually or collectively, he cannot claim a share in the property. The shareholders do administer the internal affairs of the company, this including deciding if dividends should be distributed or not , but they have no claim over the company's property.

The rights of the shareholder include participating in the profits as and when a dividend is declared, and in the assets of the company that are left at the time of winding up, but this does not operate to confer on the shareholders a general right to the assets.

Shares cannot be likened to a sum of money settled upon . The shareholder is not a part owner of a company, or its property, because he only has rights to participate in the business in the form of receiving dividends, and voting at meetings. This enables the company to manage its property in the manner it deems fit without having to bother about claims over its property by its members.

In an unincorporated association, the property is under the ownership of its members. They are free to claim the property at any point of time, subject to the broad restrictions that they may collectively impose in this regard. This shall result in the association having to face claims over its property from its members. This shall restrict it in managing the property.

On incorporation, the property belongs to the company and not its members, the latter enjoying no direct proprietary rights to it, but only the right to their shares in the undertaking. The undertaking is something different from the totality of shareholders . Any change in the membership, that causes inevitable dislocation to a partnership firm, leaves the company unconcerned. The shares may be transferred but the company's property shall remain untouched. Moreover, unlike a change in the partnership that requires a splitting up of property or realization of the same, this shall not be necessary as far as a company is concerned.

In the Naga Brahma Trust case , the High Court held that the company's property shall not be the property of its members. The plaintiffs had filed the present suit for obtaining a permanent injunction restraining the defendant from entering into any transaction for subletting the desired premises by transferring majority of the shares. The court held that an attempt on part of the company to induct more shareholders shall not be an attempt on its part to sublet the premises. This shows that the companies enjoy operational autonomy that unincorporated associations in similar circumstances shall not enjoy. The former are free to change the composition of their membership without having to face competing claims from outsiders.

2.4 Perpetual Succession

The company never dies. Due to the attribute of perpetual succession, it shall continue to remain in existence notwithstanding the composition of its members. Only if it is dissolved by liquidation shall it cease to exist. In a firm, the death, insolvency or lunacy of partners shall result in the firm being dissolved, and the business being continued with by the remaining partners being a new partnership. This also enables the members of a company to freely transfer their shares, because changes among the shareholders do not affect the company.

In Gopal Tea Estate Co. Ltd. v. Peshok Tea Co. Ltd. & Others, the Calcutta High Court held that if a company has been constituted under the Companies Act, it shall enjoy an identity independent of the estates it owns. For this reason, even if its estates have been taken over by the Central government (under the Tea (Amendment) Act, 1976), only the takeover of the units shall be deemed to have taken place, in other words the estates owned and possessed by the company, and not the management of the company. This establishes the continuous existence of the company.

2.5 Shares are Freely Transferable

The shares of a public limited company are freely transferable. Section 82 of the Companies Act lays down that the shares/debentures and other interest of a member in a company shall be freely transferable, being moveable property capable of being transferred in the manner as contained in the articles, the only requirements being those contained in the articles.

In the absence of any restrictions being imposed, a shareholder has a right under the statute itself to transfer his shares to anybody, without taking anybody's consent for this. The transaction should be a bona fide transaction, and the shareholder should afterwards retain no interest in the shares transferred. This shows that the statutes do not intend to regulate the composition of members of a company, since doing so shall restrict the member's right to free transferability of his interest. This right is enjoyed not just by shareholders, but also by debenture holders, and by all those possessing an interest in the company.

Free transferability results in the members being free to transfer their interest at any point of time subject to certain broad restrictions, and in the process enjoying the resultant economic gains in the form of profits on the sale of their interest in the company. This undoubtedly operates as a major incentive for people to become members of companies and trade their interest for gains. The restrictions that apply to the transfers of shares are as follows:
"The Board of Directors may refuse to permit a transfer on the grounds of protecting the interests of the company, but their refusal has to proceed from an honest desire to benefit the company, and should not be mala fide.

"Due to an amendment of the Companies Act, the Directors are required to disclose the reasons for declining a transfer. The National Company Law Tribunal can examine the relevancy and adequacy of the reasons.

"The Directors should be guided only by relevant considerations, in other words, those considerations that are relevant on a true construction of the articles.
Sometimes, a member transfers his interest for escaping liability. This shall be valid, as held in Discoverers Finance Corporation Ltd., Re . In this case, the shareholder, being worried about the precarious condition of the company, sold his shares for escaping liability. Escaping liability appeared to be his only concern at that time, since he sold the shares to a person in Germany, at a nominal price that he did not receive. The Board of Directors duly passed the transfers, and the same was upheld by the court as well.

In unincorporated associations, the interest of a member shall not be freely transferable. There are statutory restrictions imposed on the same, apart from those that can be imposed by the members. This discourages people from becoming members of such associations, as they shall not be able to trade their shares freely and derive gains from such transactions in the same manner as the members of a company can.

2.6 Independent and Professional Management

Companies that are performing governmental but commercial functions do not become government departments. In the absence of any statutory provisions to the contrary, a commercial corporation acting independently, even if controlled partially or wholly by a government department, shall be presumed not to be an agent of the state . This ensures autonomy in managerial functioning. This also enables companies to attract the best of managerial talent, because the management executives are assured freedom in forming and implementing their managerial ideas, so long as the same do not conflict with the settled norms of the company. The shareholders as such cannot govern them, since they (the shareholders) exercise only a formative control over the company.

In Madras Labour Union v. Buckingham and Carnatic Mills and Others, a company had been incorporated under the Companies Act, and was running a business in one of the industries appearing in the First Schedule, Industries (Development and Regulation) Act. For this, it had obtained loans from a public financial institution that had placed a Director on the company's board of management. The court held that this did not result in the company becoming an instrumentality or agency of the government within the meaning of Article 12.

2.7 Financial Autonomy (Raising Finances from the General Public)

The company is the only form of business organization that can raise finances from the general public by inviting the general public to subscribe to its shares, debentures, and other securities. Banks and financial institutions lend their resources more willingly to companies because of the facility of floating charge, this being an exclusive characteristic of companies. Easy availability of capital ensures that the business operations of the company are not impeded for want of capital. Unincorporated associations face the disadvantage of not being able to raise finances from the general public.

2.8 Comparative Study of Incorporated Companies and Unincorporated Entities Like Partnership

There is perhaps no doubt that a registered company has many advantages over a partnership firm , other forms of business organization that are unincorporated, like a sole proprietorship. The following points illustrate this :

"Being a separate legal entity, the incorporated company is distinguishable from the members constituting it, unlike a partnership that is no more than an aggregate of its members. The debts and contracts of an incorporated company are those of the company itself, not that of its members. For this reason, the members shall not be liable on such contracts. In contrast, in a firm, every partner shall be jointly and severally liable along with all the other partners for the firm's debts . This shall not apply to partnerships set up under the Limited Partnerships Act, 1907, but there are only a few such firms that have been formed to date in England, this showing the comparatively superior advantages of private limited companies.

"Unless wound up a company shall continue to exist independent of changes in its membership, not being affected by the death bankruptcy, lunacy, or retirement of any of its members. In a firm, such incidents shall result in the dissolution of the existing partnership, subject to any agreement between the partners in this regard. In such circumstances, the share of a retired or deceased partner has to be determined out of the business, or provided for by the other partners.

"The company is the sole owner of its property, with none of the members enjoying any formal charge or title over it. Members of a company are free to transfer their interest in the company. In a partnership, the property belongs to the partners and is vested in them. For this reason, with a change in the partners, there shall be a change in the ownership of the firm's property as well.

"The registered company can contract with its members and sue and be sued on such contracts. But partners cannot contract with the firm. Each partner shall be an agent of the firm for the business purposes of the partnership, but this is not the case in a company.

"In a public limited company, there is no upper limit to the number of members, but in a partnership, there are limits as to the number of members.

"Registered companies enjoy greater ease in borrowing as compared to partnerships, because they can raise funds from the general public by issuing securities. There may also be a floating charge in the case of the former . Floating Charge is a special charge recognized by the Companies Act, and is created by making the assets of the undertaking or company a security for the payment of debts into which a company has entered .

Conclusion
This study submits that the need for incorporation is there because an association of individuals, on incorporation, enjoys a separate legal personality. There are legal consequences arising out of that, enabling the company far greater ease in its daily functioning. This is perhaps evidenced in the popularity of the joint stock company as a form of business organization in recent times. The benefits of incorporation, that establish the need for it, are the capacity to sue and be sued in own name, limited liability of members, perpetual succession, separate property, free transferability of shares, ability to raise finances from the general public and independent and professional management. In comparison with an unincorporated entity like a partnership, the benefits of a company clearly outweigh those of a partnership.

The author can be reached at: ashwinichawla@legalserviceindia.com / Print This Article

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