Preliminary and Incorporation of Companies
Weightage: Chapters 1 and 2 of ICAI's Paper 2 syllabus, together roughly 12 marks. The definitions chapter is deceptively important, because the classification of a company decides which provisions apply to it throughout the rest of the paper.
Why the definitions chapter matters more than it looks
A great many provisions in the Companies Act, 2013 apply to some companies and not others. A private company is exempt from provisions a public company must follow. A small company files an abridged return. A one-person company need not hold an annual general meeting. A government company has its auditor appointed by the Comptroller and Auditor General.
So when a later question asks whether a particular company must do something, the first step is always classification — and the classification tests are here, in Chapter 1.
The central idea: separate legal personality
On incorporation a company becomes a body corporate — a legal person distinct from the members who compose it.
The consequences are the foundation of company law and each is examinable:
The company owns its property. A member, even a member holding every share, has no insurable interest in and no proprietary claim to the company's assets. The company can sue and be sued in its own name.
Limited liability. A member's liability is limited to the amount unpaid on their shares, or in a company limited by guarantee to the amount they have undertaken to contribute.
Perpetual succession. The company's existence is unaffected by the death, insolvency or departure of members. Members may change entirely; the company continues.
The company can contract with its members, including employing them.
Lifting the corporate veil
Separate personality is a rule, not an absolute. Courts and statute disregard it — lift the corporate veil — where it is being used to defeat the law or perpetrate a fraud.
Statutory instances include liability for misstatements in a prospectus, failure to return application money, misdescription of the company's name on a negotiable instrument, and fraudulent conduct of business.
Judicial instances cluster around identifiable purposes: where the company is a mere sham or cloak; where it is used to evade a legal obligation or a contractual duty; where it is used to commit fraud or improper conduct; to determine the enemy character of a company in wartime; and to protect revenue where the company is a device for tax evasion.
Classes of company
By liability
Company limited by shares — the liability of members is limited to the amount unpaid on their shares.
Company limited by guarantee — liability is limited to the amount members undertake to contribute to the assets in the event of winding up. Common for clubs, trade associations and non-profit bodies. It may or may not have share capital.
Unlimited company — members have unlimited liability, though members are still not directly liable to creditors; the liquidator calls on them.
By number of members
Private company — one which by its articles restricts the right to transfer its shares, limits the number of members to two hundred (excluding present and former employees who are members), and prohibits any invitation to the public to subscribe for securities. Minimum two members; minimum two directors.
Joint holders of shares are counted as a single member for the two-hundred limit.
Public company — a company which is not a private company, and a private company which is a subsidiary of a public company is deemed public even where its articles say otherwise. Minimum seven members; minimum three directors.
One Person Company — a private company with one person as a member. Only a natural person who is an Indian citizen, whether resident in India or otherwise, may incorporate an OPC or be its nominee. A person can incorporate only one OPC and be the nominee of only one. An OPC cannot be incorporated as, or converted into, a company under section 8, and cannot carry out non-banking financial investment activities including investment in securities of a body corporate. The memorandum must name a nominee who becomes the member on the subscriber's death or incapacity.
Small company
A company, other than a public company, whose paid-up share capital does not exceed four crore rupees and whose turnover does not exceed forty crore rupees as per the profit and loss account for the immediately preceding financial year.
The four categories that can never be a small company, whatever their size: a holding company; a subsidiary company; a company registered under section 8; and a company or body corporate governed by any special Act.
Small company status brings real relief — an abridged annual return, a signature by the company secretary or a director, exemption from the cash flow statement, fewer board meetings, and relaxed auditor rotation — which is why the classification is examined.
Other classes
Holding and subsidiary. A company is a subsidiary of another if that other controls the composition of its board, or exercises or controls more than one half of the total voting power, either on its own or together with one or more of its subsidiaries.
Associate company — one in which another company has significant influence, meaning control of at least twenty per cent of the total voting power or control of or participation in business decisions under an agreement. It includes a joint venture company and excludes a subsidiary.
Government company — one in which not less than fifty-one per cent of the paid-up share capital is held by the Central Government, by any State Government or Governments, or partly by the Central Government and partly by one or more State Governments, and includes a subsidiary of a government company.
Foreign company — a company or body corporate incorporated outside India which has a place of business in India whether by itself or through an agent, physically or through electronic mode, and conducts any business activity in India in any other manner.
Listed company — one which has any of its securities listed on any recognised stock exchange.
Section 8 company — formed for promoting commerce, art, science, sports, education, research, social welfare, religion, charity, protection of the environment or any such object, which intends to apply its profits or other income in promoting its objects and prohibits the payment of any dividend to its members. It is licensed by the Central Government and may be registered with limited liability without using "Limited" or "Private Limited" in its name.
Dormant company. Where a company is formed for a future project or to hold an asset or intellectual property and has no significant accounting transaction, or is an inactive company, it may apply to the Registrar for the status of a dormant company. An inactive company is one which has not been carrying on any business or operation, or has not made any significant accounting transaction during the last two financial years, or has not filed financial statements and annual returns during the last two financial years.
Incorporation
Formation
A company may be formed for any lawful purpose by seven or more persons for a public company, two or more for a private company, and one person for a One Person Company, by subscribing their names to a memorandum and complying with the registration requirements.
The memorandum of association
The memorandum states the company's constitution and its relationship with the outside world, and section 4 prescribes its clauses.
Name clause. The name must not be identical with or too nearly resemble the name of an existing company, and must not be undesirable in the opinion of the Central Government or constitute an offence under any law. A public company's name ends with "Limited" and a private company's with "Private Limited", except a section 8 company. Reservation of a name is applied for and, where reserved, is valid for twenty days from the date of approval.
Registered office clause. States the State in which the registered office is to be situated. The company must have a registered office within thirty days of incorporation and at all times thereafter, capable of receiving and acknowledging communications.
Objects clause. States the objects for which the company is proposed to be incorporated and any matter considered necessary in furtherance of those objects.
Liability clause. States the liability of members, whether limited or unlimited, and in the case of a company limited by guarantee the amount undertaken.
Capital clause. States the amount of authorised share capital and the division into shares of a fixed amount.
Subscription clause. The subscribers declare their intention to form the company and agree to take the shares stated against their names — a minimum of one share each.
The articles of association
The articles contain the regulations for the management of the company — its internal constitution. Model articles are given in Schedule I, in tables applicable to different kinds of company, and a company may adopt them wholly or partly.
Entrenchment. The articles may contain provisions for entrenchment, requiring that specified provisions be altered only on conditions or by a procedure more restrictive than a special resolution. Entrenchment may be made only on formation, or by amendment agreed to by all the members in a private company and by a special resolution in a public company.
The relationship between memorandum and articles
The memorandum is the dominant document. Where the two conflict, the memorandum prevails. The memorandum defines what the company may do; the articles regulate how it does it.
Both documents, when registered, bind the company and its members as if signed by each of them, and contain covenants to observe all their provisions.
The doctrine of constructive notice and the indoor management rule
Constructive notice. The memorandum and articles are public documents, registered with the Registrar and open to inspection. Every person dealing with the company is deemed to have read them and to have understood their contents.
Indoor management — the rule in Turquand's case. Constructive notice would be intolerably harsh if it required outsiders to verify that internal procedures had actually been followed, since those are not on the public record. So a person dealing with the company in good faith is entitled to assume that the internal proceedings have been regularly carried out.
Exceptions to indoor management: where the outsider has actual knowledge of the irregularity; where the circumstances are suspicious and the outsider fails to make inquiry; where the act is void or forged, since a forgery is a nullity and no assumption can cure it; and where the outsider has not in fact read the memorandum and articles at all and so cannot claim to have relied on them.
Incorporation and its effect
On registration the Registrar issues a certificate of incorporation, from which date the company is a body corporate by the name contained in the memorandum, capable of exercising all the functions of an incorporated company, having perpetual succession and the power to acquire, hold and dispose of property, to contract, and to sue and be sued.
The certificate also allots the company its Corporate Identity Number.
Furnishing false information. Where a company has been incorporated by furnishing false or incorrect information or by suppressing material facts, the promoters, the persons named as first directors and the persons making the declaration are liable for fraud under section 447. The Tribunal has wide powers on application, including regulating the management, directing liability of members to be unlimited, or ordering removal of the name from the register or winding up.
Commencement of business
A company having a share capital may not commence business or exercise borrowing powers unless a declaration is filed by a director within one hundred and eighty days of incorporation, stating that every subscriber has paid the value of the shares agreed to be taken; and the company has filed verification of its registered office with the Registrar.
Doctrine of ultra vires
An act beyond the objects stated in the memorandum is ultra vires the company and is void. It cannot be ratified even by the unanimous consent of all the members, because the limitation is not for the members' benefit alone but defines the company's capacity.
The consequences follow from voidness. The company cannot sue on an ultra vires contract and cannot be sued on it. Directors who apply the company's funds to an ultra vires purpose are personally liable to restore them. Property acquired with ultra vires expenditure belongs to the company and may be traced.
Promoters and pre-incorporation contracts
A promoter is a person named as such in a prospectus or in the annual return, or who has control over the affairs of the company directly or indirectly as a shareholder, director or otherwise, or in accordance with whose advice, directions or instructions the board is accustomed to act — excluding a person acting merely in a professional capacity.
A promoter stands in a fiduciary relationship with the company and must not make a secret profit, must disclose any interest in transactions with the company, and must account for profits made in that capacity.
A pre-incorporation contract presents a structural problem: the company did not exist when the contract was made, so it was not a party and cannot ratify it, ratification requiring a principal in existence at the time of the act. Such a contract binds the company only where it is warranted by the terms of incorporation and the company accepts it after incorporation and communicates that acceptance to the other party. Until then the promoter remains personally liable.
