Soapbox

Can Equity trump the abolition of Turquand’s Case

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Before 1997, company law in Hong Kong, applied the “indoor management rule”. This rule was explained in Royal British Bank v Turquand (1856). It provided that, in considering contracts effected by or on behalf of a company, so that persons contracting with a company and dealing in good faith may assume that acts within the constitution and powers have been properly and duly performed and are not bound to inquire whether acts of internal management have been regular. [Morris v Kanssen [1946, HL]        

Threads of the rule include questions of

i.               the validity of the contract under the general law, and in line with the constitutional documents of the company;

ii.              the manner of execution of the contract; this is now a matter for sections 127 and 128 of the Companies Ordinance ((Cap 622) which provide that a seal is voluntary, and that compliance with either of these sections will enable the company to effect a deed without a seal;

iii.            the authority of the party representing the company, that is the purported ‘agent’ and his authority, or lack of authority; and

iv.             the equitable consequences of having constructive notice.  

By and large, Turquand’s case concerned (a) the objects and purposes of the company, and (b) agency. But there have been swings in court identifying the dominant focus of the rule: from the law of principal and agent – through estoppel – to protection for innocent outsiders from having to investigate internal management to ascertain the authority of the company representative.

Until 1997, Turquand’s case acted as a good defence to the outsider, who had acted in good faith and who was not “put on inquiry”, or was not suspicious about the validity of the transaction.  Freed from necessary investigation of documents filed in the Companies registry, the outsider was not held bound by constructive notice in Equity and thus he could retain the asset or property received under the contract. The defence eliminated possible equitable intervention. 

Where the transaction was improper, the company had to take action against the purported agent. Alternatively, a member could pursue a statutory derivative action on behalf of the company.

Amendment to the then current Companies Ordinance (Cap 32) in 1997 resulted in the insertion of sections 5A to 5C. Section 5A altered traditional law by providing that a company could now do anything a natural person could do, and so there was no need for objects and purposes of the company to be noted in the constitutional documents, up till then more usually in the Memorandum of Association. The memorandum itself was also considered unnecessary.  Although listing powers of the company became irrelevant, yet still the question of constructive notice lingered even though section 5C repealed the traditional principle that constructive notice came from the failure to search the Companies registry:. Section 5C abolished constructive notice.  Section 5B provided that anything done contrary to the existing powers in the constitutional documents would not, of itself, invalidate a transaction. It looked as if that was the end of Turquand.

But Equity and constructive notice hovered around company transactions. An outsider who knew the transactions was not valid, for example because the party representing the company was not its agent, would be unable in Equity to rely on the transaction and was to be treated as a constructive trustee for the company. A suspicion that something was “not quite right” was equivalent to constructive notice if no inquiry was made; the concept of ‘wilful blindness’, or ‘turing a blind eye’, is equitable “language” for failure to investigate when required to do so. It is used in other areas of the law, such as land contracts. Wilful blindness is not peculiar to any specific area of the law. in the Turquand’s situation, it would mean the outsider was acting unconscionable in taking an interest adverse to a prior interest holder known to the later party at the time that party contracted: Tulk v Moxhay (1842). The consequences of willful blindness vary with the type of situation: for example in Akai Holdings Ltd (In Liq) v Kasikornbank PCL [2011] the Court of Final Appeal referred to irrationality in failure to do due diligence on the facts of that case; illustrating thereby the concept of ‘knowing receipt of trust property” (Royal Brunei Airlines v Tan [1995], PC) relied through equitable compensation.

The Companies Ordinance (Cap 622), with effect from 03 March 2014, has now totally abandoned Turquand’s case, introducing in lieu thereof “statutory assumptions”. Section 117 introduces these:  namely         

i.               the outsider is presumed to have acted in good faith unless this is rebutted on proof to the contrary; and

ii.              the outsider is not regarded as acting in bad faith only because he knew the act was ultra vires the powers of the company. This means the outsider does not have to inquire into any possible limitations on the powers of the company, nor on the power of the Directors to bind the compan or to authorize others to do so.

The outsider is thus able to enforce the transaction unless

(a) there is proof of his failure to act in good faith; or

(b) he clearly acts fraudulently within the definition of fraud under the common law.

“Good faith”, a difficult concept to define, in effect means that if the outsider was not at fault, morally or legally, and had acted ‘honestly”, in dealing with the purported representative of the company, then he is entitled to treat the representative as the agent of the company empowered to enter into the transaction so that Equity had no role to play in the transaction strengthened further by the abolition of ‘bad faith’ of a party with notice or knowledge of defects in the transaction. To rebut the presumption of good faith would probably require the company to clearly show that the outsider dealt fraudulently, or perhaps that he recklessly ignored the possibility that the representative was not in fact an agent of the company: on which see the Kasikornbank case.

Members (and creditors) of the company – acting with knowledge and speed – may bring proceedings to restrain by injunctive relief the director or representative from carrying out an ultra vires act; members may also take subsequent action against the director on behalf of the company under a statutory derivative action: see generally sections 723 to 738 of Cap 622.

Further section 120 re-iterates the earlier abolition of constructive notice of anything disclosed in the Articles or in a return or resolution kept by the Registrar of Companies.

So the result is: the outsider acts in good faith, or more correctly, the company cannot prove that he does not. He was suspicious of the transactions. He did not make inquiries. Yet he may retain the property obtained in the transaction. The Companies Ordinance considers his knowledge irrelevant because of his statutory immunity from the usual consequences of taking with notice.

As company law principles that is the end of the story. The outsider is protected.

But should it be the end of the story?

Should the outsider retain the assets obtained under the transaction? Equity considers he should not. His behaviour because of his failure to investigate suspicions is unconscionable; this is akin to, or even amounts to, equitable fraud. So what can happen?

The skill of Equity comes to the fore. By ignoring the embargo on action under company law produced by the statutory assumptions, and re-classifying the behaviour of the outside party, a court of equity can see its way clear to assisting the victim of the unconscionable behaviour, namely, the beneficiary of a constructive trust, that is the company. There are several and varied possibilities for relief. The language becomes that of trust law and ‘knowing receipt’ of trust property. Since the expansion of equitable relief and the operation of the concept of the ‘trustee de son tort’, re-classification from company to trust law expands relief possibilities.

Why should a member or members of the company have to resort to the artificial statutory derivative action against the defaulting director or ’agent’? Recovery of the assets is a more equitable remedy for the company. Other choices of relief include the constructive trust, equitable compensation, account of profits and tracing.

Restitution could also be available but for one prevailing rule which would seem to exclude restitution

Where allowing restitution would subvert a contractual (or statutory) regime whereby risks have been allocated in a particular manner, restitution will be excluded as a matter of principle. [Yew Sang Hong Lid v Hong Kong Housing Authority [2008] CA, per Reyes J at paragraph 32].

Even without restitution there is abundant relief in Equity for the trustee de son tort receiving and retaining property knowing it belongs to the company.

Time will tell whether Equity will trump section 117.

© Sihombing Law Mentors 2014