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Law for Business

Knowhow - guidance - precedents

07 MAR 2016

Did you know ... that provisions in the articles restricting directors’ powers have limited effect?

Did you know ... that provisions in the articles restricting directors’ powers have limited effect?

Many companies include in their articles a provision restricting directors’ powers in some way. Such a provision might provide, for example, that the board must not, without prior shareholder approval, borrow sums in excess of a specified amount or enter into transactions above a certain value. Provisions of this nature certainly serve the useful purpose of indicating to the directors the proper scope of their responsibilities. It may be thought that they also ensure that the company is not bound by any agreement with a third party which the directors enter into in contravention of the restriction. However, this is not the case. The law in this area is biased in favour of ensuring the validity of contracts, and in practice many agreements entered into by directors acting outside the scope of their authority have full effect, and so bind the company.

Directors’ authority

The standard provision for dividing responsibility for the company’s affairs between the shareholders and the directors is article 3 of the Companies Act 2006 model articles for private companies and public companies:

“Subject to the articles, the directors are responsible for the management of the company’s business, for which purpose they may exercise all the powers of the company.”

This constitutes a very broad delegation of power by the shareholders to the board, giving the latter control not only over the day-to-day affairs of the business, but also over such matters as the acquisition and disposal of assets, staffing levels, litigation decisions, changes to the company’s business model and, indeed, the company’s long-term strategy.

Some shareholders are not comfortable with the idea of giving the directors such extensive powers, not least since it is a basic principle of company law that they are not permitted to overrule board decisions on delegated matters by means of an ordinary resolution (that is, a resolution passed by a bare majority). One way of retaining a degree of direct control over the company’s affairs is to restrict the scope of article 3 by carving certain matters out of it. Thus, the revised article might specify that the broad delegation is subject to the proviso that the directors may not borrow a sum of more than, say, £100,000 without first obtaining the shareholders’ approval in the form of an ordinary resolution, or that the directors may not acquire an asset worth more than, say, £100,000 without such approval.

In most cases, no doubt, directors comply with such restrictions. What, though, is the position where the board – or, more typically, one of its members - enters into a contract with a third party in breach of a restriction?

Contracts entered into in breach of a restriction

Common sense might suggest that a contract entered into in breach of an express restriction on the board’s powers is invalid, for after all the directors were acting beyond the scope of their authority. Unfortunately, the law in this area is not quite as simple as that.

Consider the case of a managing director of a multinational who signs a £200,000 contract with a supplier without first obtaining shareholder approval, despite the fact that the articles require prior approval of any transaction worth more than £100,000.

In order to ascertain whether the company is bound by the contract, two questions need to be addressed:

  • Does the company have “capacity” to enter into the contract?

This is an easy question to answer. Historically, a company’s capacity to act was determined by its objects, which had to be specified in its memorandum. Nowadays, most companies choose not to confine themselves to the pursuit of specified objects (see section 31 of the Companies Act 2006, which allows companies to have unrestricted objects), and, what is more, even if a company’s objects are restricted, a contract is not rendered invalid on the ground that the company was acting outside those objects (see section 39 of the Companies Act 2006, which provides, in effect, that a contract will not be rendered invalid on the ground of the company’s lack of capacity). In short, the company in our example will be treated as having capacity to enter into the contract even if it happens to have an objects clause and the contract happens to fall outside the scope of its objects.

  • Does the managing director have authority to enter into the contract?

Clearly, the managing director does not have authority in the normal sense of the word, since he has failed to comply with the requirement in the articles that any transaction worth more than £100,000 must be approved in advance. In company law terms, he is said not to possess “actual authority” to enter into the contract.

The company law regime has long taken the view, however, that a company will be bound by a contract purportedly entered into on its behalf by someone who, even if he does not have actual authority to bind he company, has what is known as “ostensible authority” or “apparent authority” to do so. As the name suggests, ostensible authority refers to authority which a person appears to have. Essentially, a person occupying a particular role within a company – such as the role of managing director, commercial director or company secretary – will normally have ostensible authority to enter into such contracts as a person occupying such a role would normally have actual authority to enter into. Returning to our example, assuming a court would take the view that a managing director of a multinational would normally have actual authority to enter into a £200,000 contract, the managing director would be considered to have ostensible authority to enter into the contract in question, and the contract would, therefore, be valid, notwithstanding his failure to secure the necessary shareholder approval.

There is a potential problem with this analysis, in that the articles are a public document, which means that the third party had every opportunity to find out about the restriction on the managing director’s authority. In the circumstances, can the company not argue that the third party should have known of the managing director’s lack of actual authority, and should therefore not be permitted to rely on the assumption that, as the managing director, he was authorised to enter into the contract? English law does, indeed, start from the proposition that the third party must be taken to have read the articles (the so-called doctrine of constructive notice), but the Companies Act 2006 has intervened to prevent the company’s argument from succeeding. Section 40(1) provides as follows:

“In favour of a person dealing with a company in good faith, the power of the directors to bind the company, or authorise others to do so, is deemed to be free of any limitation under the company’s constitution.”

The effect of this provision is that the restriction on the managing director’s freedom to enter into transactions worth more than £100,000 must, for present purposes, be ignored, with the result that his ostensible authority is preserved and the contract is binding on the company. (Indeed, the effect of section 40 taken as a whole is that a director’s ostensible authority will normally be preserved even if the third party has actually read the articles and is aware of the restriction.)

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Some aspects of the law governing the circumstances in which a company is bound by a contract purportedly entered into on its behalf are exceedingly difficult. However, one thing, at least, will be clear from the brief outline above: the rules seek to ensure that, within reason, such contracts are binding on the company.

This approach undoubtedly promotes certainty in the field of commerce, in that a third party can normally be confident that when he signs a contract with someone who appears to be acting on the company’s behalf, the contract will, indeed, bind the company. Equally, however, it creates a problem for companies, in that they may find themselves bound by contracts entered into by directors who are acting outside the specified scope of their authority. From the shareholders’ perspective, provisions in the articles restricting directors’ powers may, in this sense at least, seem to be worthless.

Companies cannot opt out of the law on ostensible authority or section 40, so they have no choice but to accept that in this area the company law regime favours third parties. They can, however, take steps to ameliorate the problem. Most obviously, they can ensure that all members of the board are fully aware of the existence of any restrictions. Furthermore, they are not, in fact, entirely helpless in the event that a restriction is breached, for in committing the breach the director in question will have left himself open to a claim that he failed to comply with his statutory duties as a director. Section 171(a) of the Companies Act 2006 specifically requires directors to act in accordance with the articles, and a director who did not comply with a restriction will find it difficult to argue that he exercised reasonable care and skill pursuant to section 174. The company may be bound by the unauthorised contract, then, but if it suffers any losses in connection with the contract it may be able to recover them from the director.