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Introduction
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.
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The
author can be reached at: ashwinichawla@legalserviceindia.com /
