Director’s Personal Guarantee - A Void Agreement -27.11.14

Index to Parawise Contents

1. Evolution of concept of legal entity

2. Effect of Incorporation: Company as a separate legal person

3. Limited Liability

4. General Powers of Board   

5. Borrowing

6. Finances

7. Directors as agents

8. A member of an association registered as a company shall not be personally liable for any liabilities incurred in such business

9. A director shall not be personally responsible for any debts of the company unless the business of the company has been carried on for any fraudulent purpose and declared as such by the Tribunal under Section 339

10. Directors, etc., with unlimited liability in limited company

11. Registration of charges

12. Director’s personal guarantee

13. What agreements are contracts

13.1 “Free consent” defined

13.2 Object is lawful

14. “Undue Influence”

14.1 Position of dominance necessary for presumption to arise

14.2 Inequality of bargaining power

14.3 Judicial intervention for rescuing parties from unreasonable terms

14.4 Agreement should be reasonable for the contract to be upheld legal

14.5 Serious terms of a contract must be specifically brought to the notice of the parties 

 

1. Evolution of concept of legal entity

 

A division bench of Delhi High Court in J B Exports Ltd and another vs. BSES Rajdhani Power Ltd  (2006 134 Comp cas 106 Del. decided on 3.3.2006) observed that “the concept that a company is a distinct legal entity apart from its shareholders, vide Salomon  vs. Salomon & Co. (1897 AC 22 HL) had a historical purpose. Its main purpose was to encourage entrepreneurs to start new business ventures and, thus, help in the process of industrialisation.” This background is so important that it merits consideration in detail as follows.

 

1.1 Delhi High Court further observed that “In every business there is a risk that the business may fail due to recession, competition, etc. Hence,  businessmen were reluctant to set up new industrial ventures out of fear that if it failed, recovery would be issued in respect of the loans they had taken and thereupon even their household and personal effects may be sold in connection with the recovery. Hence, businessmen were reluctant to take risks and start new industrial ventures. To get over this hurdle and to encourage industrialisation the legal principle was created that if a company is incorporated under the Act, the liability of the shareholders becomes limited because the shareholders, directors, etc., are legally treated as being different from the company. A company was held to be a distinct legal entity separate from its shareholders and directors. This legal principle gave protection to businessmen who were otherwise reluctant to start new industrial ventures due to the risk involved. Thus, this legal principle was of great help to industrialisation in Eurpoe (where industrialisation first began during the Industrial Revolution) and there after all over the world. “

 

 

2. Effect of Incorporation : Company as separate legal person

 

As per Section 9 of the Companies Act, 2013 (Section 34 of the Companies Act, 1956) one of the characteristics of  a company is that it is an incorporated body of persons. It is constituted into a distinct and independent person in law and is endowed with special rights and privileges.   Hon’ble Supreme Court in TELCO Vs. State of Bihar (1964) 34 Com Cases 458 : AIR 1965 SC 40  observed as follows :-

 

 “ …..The Corporation in law is equal to a natural person and has a legal entity of its own.  The entity of the corporation is entirely separate from that of its share holders;  it bears its own name and has a seal of its own; its assets are separate and distinct from those of its members;  it can sue and be sued exclusively for its own purpose; its creditors cannot obtain satisfaction from the assets of its members;  the liability of the members or shareholders is limited to the capital invested by them; similarly the creditors or the members  have no right to the assets of the corporation. This position is well established ever since the decision in case of Salomon V. Salomon & Co. 1897 AC 22 was pronounced in 1897 and indeed, it has always been the well recognized principle of common law…....” 

 

3. Limited Liability

 

Section 4(1)(d)(i) the Companies Act, 2013 provides that “the memorandum of a company shall state, in the case of a company limited by shares, that liability of its members is limited to the amount unpaid, if any, on the shares held by them”. This means that no member can be called upon to pay anything more than the nominal value of the shares held by him, or so much thereof as remains unpaid; and if his shares be fully paid up his liability for business debts of the company is nil.

 

3.1  “The privilege of limited liability for business debts is one of the principal advantages of doing business under the corporate form of organization {Cadman, THE CORPORATION IN NEW JERSEY , 327 (1949)}. ” The company, being a separate person, is the owner of its assets and bound by its liabilities. Members, even as a whole, are neither the owners of the company’s undertaking, nor liable for its debts. Where the subscribers exercise the choice of registering the company with limited liability, the members’ liability becomes limited or restricted to the nominal values of the shares taken by them or the amount guaranteed by them. No member is bound to contribute anything more than the nominal value of the shares held by him {J.H. Rayner (Mincing Lane) Ltd V. Deptt. of Trade and Industry, (1989) 3 WLR 969 HL}. In a partnership, on the other hand, the liability of the partners for the debts of the business is unlimited. They are bound to meet, without any limit, all the business obligations of the firm. The whole fortune of a partner is at stake, as the creditors can levy execution even on his private property. Speaking of the advantage of trading with limited liability, BUCKLEY J observed {London & Globe Finance Corpn, Re (1903) 1 Ch 728, 731}:

 

“The statutes relating to limited liability have probably done more than any legislation of the last fifty years to further the commercial prosperity of the country. They have, to the advantage of the investor as well as of the public, allowed and encouraged aggregation of small sums into large capitals which have been employed in undertakings of great public utility largely increasing the wealth of the country.”

 

4. General Powers of Board   

 

Sub Section (1) of Section 179 of the Companies Act, 2013 provides as follows:-

 

“The Board of Directors of a Company shall be entitled to exercise all such powers, and to do all such acts and things, as the Company is authorized to exercise and do ….”

 

5. Borrowing

 

Section 179 (3) (d) of the Companies Act, 2013 provides that “(3) The Board of directors of a company shall exercise the following powers on behalf of the company by means of resolutions passed at meetings of the Board namely:-

(a)……………………… …………………… (b)……………………….

(c)………………………….. (d) to borrow moneys;

A company cannot borrow money unless it is so authorized by its memorandum. In the case of a trading company, it is not, however, necessary that the objects clause of its memorandum should expressly authorise it to borrow. As borrowing is incidental to trading, such a company has implied power to borrow. Other companies must have a borrowing power clearly specified in the memorandum.

 

6. Finances

The company  is the only medium of organising business which is given the privilege of raising capital by public subscriptions either by way of shares or debentures. Further, public financial institutions lend their resources more willingly to companies than to other forms of business organisation. The facility of borrowing and giving security by way of a floating charge is also an exclusive privilege of companies. In New Horizons Ltd. v Union of India, (1997) 89 Comp Cas 785 at 802 (Delhi) the hon’ble Delhi high court has observed that “Capital in many cases is the life-blood of a concern, and it is always a great misfortune where the development of a business is arrested or restricted by want of capital.”

 

7. Directors as agents

It was clearly recognized as early as 1866 in Ferguson v Wilson (1866) LR 2 Ch LR 77: 36 LJ Ch 67 : 15 LT 230. that directors are in the eyes of law, agents of the company. The Court said:

“The company has no person; it can act only through directors and the case is, as regards those directors, merely the ordinary case of principal and agent.”

The general principles of agency, therefore, govern the relations of directors with the company and of persons dealing with the company through its directors. Where the directors contract in the name, and on behalf of the company, it is the company which is liable on it and not the directors.

 

          8. A member of an association registered as a company shall not be personally liable for any liabilities incurred in such business

Section 464 of the Companies Act, 2013 provides as follows

“(1) No association or partnership consisting of more than such number of persons as may be prescribed shall be formed for the purpose of carrying on any business that has for its object the acquisition of gain by the association or partnership or by the individual members thereof, unless it is registered as a company under this Act or is formed under any other law for the time being in force: Provided that the number of persons which may be prescribed under this sub-section shall not exceed one hundred.

 

(2) …….xxx…….xxx….

 

(3) Every member of an association or partnership carrying on business in contravention of sub-section (1) shall be punishable with fine which may extend to one lakh rupees and shall also be personally liable for all liabilities incurred in such business. “

                               

By necessary implication it follows that a member of an association registered as a company under the Companies Act shall not be personally liable for any liabilities incurred in such business by the company.

 

9. A director shall not be personally responsible for any debts of the company unless the business of the company has been carried on for any fraudulent purpose and declared as such by the Tribunal under Section 339

Section 339 of the Companies Act, 2013 provides as follows

 

“(1) If in the course of the winding up of a company, it appears that any business of the company has been carried on with intent to defraud creditors of the company or any other persons or for any fraudulent purpose, the Tribunal, on the application of the Official Liquidator, or the Company Liquidator or any creditor or contributory of the company, may, if it thinks it proper so to do, declare that any person, who is or has been a director, manager, or officer of the company or any persons who were knowingly parties to the carrying on of the business in the manner aforesaid shall be personally responsible, without any limitation of liability, for all or any of the debts or other liabilities of the company as the Tribunal may direct:”

 

     By necessary implication it follows that a director, manager, or officer of the company shall not be personally responsible for any of the debts or other liabilities of the company incurred in such business by the company unless the business of the company has been carried on with intent to defraud creditors of the company or any other persons or for any fraudulent purpose and declared as such by the Tribunal under Section 339 of the Companies Act, 2013.

 

10. Registration of charges

Section 77(1) of the Companies Act, 2013 (hereinafter referred to as ‘the Act’) is reproduced below for ready reference:

 

77. (1) It shall be the duty of every company creating a charge within or outside India, on its property or assets or any of its undertakings, whether tangible or otherwise, and situated in or outside India, to register the particulars of the charge signed by the company and the charge-holder together with the instruments, if any, creating such charge in such form, on payment of such fees and in such manner as may be prescribed, with the Registrar within thirty days of its creation:

 

 

10.1 The lenders always insist on some security and the only security that a company can give is to charge its assets. Any charge or mortgage created on certain specified assets of a company must be registered with the Registrar of Companies under Section 77 of the Act.

 

10.2 Section 83 of the Act is reproduced below for ready reference:

 

83. Power of Registrar to make entries of satisfaction and release in absence of intimation from company. The Registrar may, on evidence being given to his satisfaction with respect to any registered charge, -

(a) that the debt for which the charge was given has been paid or satisfied in whole or in part; or

(b) that part of the property or undertaking charged has been released from the charge or has ceased to form part of the company's property or undertaking;

enter in the register of charges a memorandum of satisfaction in whole or in part, or of the fact that part of the property or undertaking has been released from the charge or has ceased to form part of the company's property or undertaking, as the case may be, notwithstanding the fact that no intimation has been received by him from the company.

By necessary implication it follows that any charge / mortgage created by the Banks on the  Director's personal property / property of a third party, even if unconsciously registered by ROC, is illegal being without the authority of the Act, and therefore unenforceable at law.

 

11. Director’s personal guarantee

Since long the banks and public financial institutions (hereinafter collectively referred to as ‘the Banks’) have unilaterally and arbitrarily developed a practice, without the authority of law, to execute personal guarantee agreements with the directors of a company to secure the debts of the company. This view is supported by the following latest judgment of the Supreme Court.

Recently, the Supreme Court in the case of Karnataka State Financial Corporation vs N. Narasimahaiah & Ors. (2008 AIOL 348 Civil Appeal No. 610-612 of 2004 Decided on 13/03/2008) has observed as follows (in para 18):

“18. Banking practice may enable a financial corporation to ask for a collateral security. Such security, we would assume, may be furnished by the Directors of a Company but furnishing of such security or guarantee is not confined to the Directors or employees or their close relatives. They may be outsiders also. The rights and liabilities of a surety and the principal borrower are different and distinct.” (emphasis supplied)

Therefore, it stands concluded, without any doubt, that the banks have developed the practice to execute personal guarantee agreements with the directors of a company to secure the debts of the company without the authority of law. This practice is against the principle of limited liability of the shareholders as well as directors of the company as provided in the Companies Act, 2013. Accordingly, it is clearly against the letter and spirit of the Companies Act and therefore unlawful.

12. What agreements are contracts

Section 10 of the Indian Contract Act, 1872 provides that - An agreement between two or more parties becomes a contract when the following conditions are satisfied:

            (1) ……………………….

            (2) ……………………….

            (3) The parties’ consent is free.

            (4) The parties’ object is lawful.

 

12.1 “Free consent” defined

            “Consent is said to be free when it is not caused by:

            (1) ……………………

            (2) undue influence, as defined in Section 16, or

            (3) …………………...

            (4) …………………...

            (5) ……………………

Consent is said to be so caused when it would not have been given but for the existence of such coercion, undue influence, fraud, misrepresentation or mistake.”

 

12.2 Object is lawful         

            In P Ramanatha Aiyar’s The Law Lexicon 2nd Edition 2007 the term “Object” is defined “As a noun, the end aimed at; the thing sought to be accomplished (as) object aimed at; the aim or purpose (as) object not authorized by law; the thing sought to be attained (as) object of the law.”

 

The Hon’ble  Supreme Court in the case of Gurmukh Singh v. Amar Singh       (1991) 3 SCC  79  has held that the word “object” would mean the purpose and design which is the object of the contract. If it is opposed to public policy which tends to defeat any provision of law or purpose of law, it becomes unlawful and thereby it is void under Section  23 of the Contract Act.

 

Further, in P Ramanatha Aiyar’s The Law Lexicon 2nd Edition 2007 the term “lawful”  is defined  as “By lawful, it means not contrary to law, public policy or void ab-initio, or unlawful. (Order 23, Rule 3 C.P.C. S.G. Thimmappa v. T. Anantha, AIR 1986 Kant 1, 4)

 

13. “Undue Influence”

            Section 16 of the Contract Act provides that-

            “(1) A contract is said to be induced by “undue influence” where the relations subsisting between the parties are such that one of the parties is in a position to dominate the will of the other and uses that position to obtain an unfair advantage over the other.

            (2) …………………………….

            (3) Where a person who is in a position to dominate the will of another, enters into a contract with him, and the transaction appears, on the face of it or on evidence adduced, to be unconscionable, the burden of proving that such contract was not induced by undue influence shall lie upon the person in a position to dominate the will of other.” (Italics supplied)

 

13.1 Position of dominance necessary for presumption to arise

            The Privy Council in Raghunath Prasad v Sarju Prasad AIR 1924 PC 60 pointed out the conditions for presumption to arise. Referring to sub-section (3) of Section 16, which provides for presumption of undue influence, Lord SHAW observed as follows:

            “By this sub-section three matters are dealt with. In the first place, the relations between the parities to each other must be such that one is in a position to dominate the will of the other. Once that position is substantiated the second stage has been reached, viz., the issue whether the contract has been induced by undue influence. Upon the determination of this issue a third point emerges, which is that of onus probandi. The burden of proving that the contract was not induced by the undue influence is to lie upon the person who was in a position to dominate the will of the other.

            Error is almost sure to arise if the order of these propositions be changed. The unconscionableness of the bargain is not the first thing to be considered. The first thing to be considered  is the relations of these parties. Were they such as to put one in a position to dominate the will of the other?” (Italics supplied)

           

13.2 Inequality of bargaining power

            The presumption of undue influence may also arise from the fact that there is such an inequality of bargaining power between the parties that one can cause economic duress to the other. The decision of the Court of Appeal in Lloyds Bank v. Bundy (1975) 1 QB 326. is a remarkable illustration of the concept of inequality of bargaining power.

A  contractor borrowed a sum of money from a bank. He could not pay back in time. The banker pressed for payment or for security. He suggested that his father might mortgage the family’s only residential house. The bank officer visited the father and obtained his signatures upon readymade papers. The contractor still could not pay and the banker sought to enforce the mortgage which might have meant throwing out of the family from its only residence. Accordingly, Mr Bundy relied upon the unfair character of the mortgage. He was allowed to set aside the mortgage.

 

13.3 Judicial intervention for rescuing parties from unreasonable terms

In Central Inland Water Transport Corpn vs. Brojo Nath Ganguly (1986 3 SCC 156, 206)  the Supreme Court has noted that the word “unconscionable” means something as shows no regard for conscience and which is irreconcilable with what is right or reasonable. The matter before the court was a service contract. A clause in the contract empowered the employer (a Govt. undertaking) to remove an employee by three months’ notice or pay in lieu. The employee, who contested the validity of this clause, was removed by handing him over a three months’ pay packet. The Supreme Court regarded the clause to be constitutionally as well as contractually void. The court added that any term which is so unfair and unreasonable as to shock the conscience of the court would be opposed to public policy therefore also void under section 23 of the Contract Act. The contract was not based upon a real consent. It was rather an imposition upon a needy person. The term was unconstitutional because it was so absolute that any officer could be made a target irrespective of his conduct, good or bad.  (Italics supplied)

 

13.4    Commenting upon this expanding power of the court to relieve a party from the consequences of his own contract, a learned writer J H Baker says that “freedom of contract turns out to be a misleading guide when so many contracts are not free in the economic sense. The notion of contract as private legislation appears less attractive when legislation is always drawn up one-sidedly. Judges are empowered to read in terms which are not there, or read out terms which are there. They are to impose reasonableness. Whatever is not reasonable is not law. If the parties have agreed to something unreasonable, they should be treated as if they have not agreed at all and released”. (Emphasis supplied) (J. H. Baker, From Sanctity of Contract to Reasonable Expectation, Current Legal Problems 1979).

 

 

 

13.5    Serious terms of a contract must be specifically brought to the notice of the parties

 

The Bombay High Court in Road Transport Corpn Vs. Kirloskar Bros Ltd ( AIR 1981 Bom 299 ) said that it is for the carrier to plead and prove that the print on the receipt was brought to the notice of the consignor and that he had agreed to and accepted the same. The Court held that it is necessary that serious terms of a contract must be specifically brought to the notice of the parties whose rights are sought to be curtailed. In Oriental Fire and General Ins Co Vs. New Suraj Transport Co (AIR 1985 All 136) the consignment note was not even signed by the booking party or his agent, the Allahabad High Court held that the consignor was not bound by a printed term about the exclusive jurisdiction. The Court said that something more must be done than merely printing the terms on consignment documents. (Italics supplied)

 

13.6    In Road Transport Organisation of India vs. Barunai Powerloom Weaver’s Coop Society Ltd ( 1994 84 Cal LT 174 ) the Calcutta High Court held that the law requires that before making a person bound by any such term ( a clause in a consignment note as to exclusive jurisdiction ) it must be proved that the same was brought to the knowledge of the consignor in such a way that it should seem to be the result of a mutual assent. In Grandhi Pitchaiah Venkatraju & Co vs. Palukuri Jagannadham & Co ( AIR 1975 AP 32 ) where a consignment way bill contained the words “subject to Calcutta jurisdiction”,  the Andhra Pradesh High Court ignored it since it was not one to which the plaintiff assented.  Following these principles in East India Transport Agency vs. National Insurance Co ( AIR 1991 AP 53 FB ) the Andhra Pradesh High Court came to the conclusion that a term as to the place of suit was not binding on the insurer who had paid out the consignee and who was  then suing the carrier for the negligent loss of the goods unless it could be proved that the insurer too was made or was otherwise aware of the terms. 

 

13.7    The law plays in this respect the role of a parent. It has been opined by the learned author Anthony T Kronman, in Paternalism and the Law of Contracts, (1988) 32 Yale Law Journal 763 “A person who would give away too much of his own liberty must be protected from himself, no matter how rational his decision or compelling the circumstances.” Therefore, it is expected that the DRT / Courts shall take suo motu cognizance of the legal gimmick being played by the Banks in drafting their documents regarding Director’s personal guarantee agreement and if the borrower / director has agreed to something unreasonable, he should be treated as if he has not agreed at all and released (J. H. Baker, From Sanctity of Contract to Reasonable Expectation, Current Legal Problems 1979).

 

14. What considerations and objects are lawful, and what not

            Section 23 of Contract Act provides as follows-

“The consideration or object of an agreement is lawful, unless-

            it is forbidden by law; or

            is of such a nature that, if permitted, it would defeat the provisions of any law; or

            ……………………………………….”

14.1 Defeat any Law

            Sometimes the object of, or the consideration for, an agreement is such that though not directly forbidden by law, it would, if permitted, defeat the provisions of any law. Such an agreement is also void.

 

14.2 Undercutting of Statutory Privileges

            A term in a contract of carriage requiring that notice of loss must be given within 30 days of the arrival of the goods has been held by the Supreme Court to be contrary to and defeating Section 10 of the Carriers Act, 1865, which prescribes a period of six months for the purpose. {(M. G. Bras v Prasad Textiles, (1983) 3 SCC 61.}

            In V. Raghunadha Rao v State of A. P., (1988) 1 Andh. LT 461. It was held that - the clauses in question were an attempt to relieve the State of its liability and the court said that a State is not free to impose arbitrary or unjust clauses in a public contract. (Italics supplied)

 

Conclusion

            In view of above discussion the following inferences may be drawn.

            (1) The Companies Act provides that the directors of a company are not liable for the debts of the company. This view has been upheld by Delhi High Court in Indian Overseas Bank v. R. M. Marketing and Services Pvt Ltd (2001 107 Comp Cas 606) and subsequently by a Division Bench of Delhi High Court in J B Exports Ltd and another vs. BSES Rajdhani Power Ltd (2006 134 Comp cas 106 Del. decided on 3.3.2006).

            (2) It stands concluded that the agreement of personal guarantee of a director being executed by the banks as a prerequisite, amounts to making the liability of a director unlimited towards the debts of a company, which is absolutely prohibited by the provisions of Companies Act, 2013.

            (3) Further, the consent of a director is not free being obtained by the banks by undue influence, because the company is in need of funds for its working capital requirements and the banks have made the execution of agreement of personal guarantee by a director a prerequisite for obtaining the working capital limits from the banks.

(4) Section 23 of the Contract Act provides that every agreement of which the object or consideration is unlawful, is void. Therefore, the agreement of personal guarantee executed by a director is a void agreement, because its object is unlawful as it defeats the provisions of the Companies Act, 2013. (END)

 

Note: the views expressed are my personal and a view point only.