Statutory Indoor Management Rule for the Protection of Third Parties Contracting with Company after Hong Kong Limited Company Registration

Protection of third parties against any corporal abuse is mandatory so as to secure the investment to set up Hong Kong limited company and to assure investor that they will be protected if someone they contract with, do any abuse, provided investor is fair and true in his/her intentions or transactions. This is mandatory to set up Hong Kong limited company and to provide feasible and level playing grounds to the investment prospect of country and corporate sector. Statutory Indoor Management Rule is one of those security establishment to protect the outsider or third party against any corporate abuse or damage.

Section 117 to 119 of Cap. 622 sets out the provisions related to the Statutory Indoor Management Rule applicable after create a company in Hong Kong and is derived largely from the subsection 40 to 42 of UK Companies Act 2006. As per the script of Section 117 (1) of Cap. 622:

The power of the company’s director to bind company and other officials to abide by the terms of contract or transactions, in favour of a person who is dealing with the company in good faith and in a true manner, is said to be free from any restrictions by any relevant document of the company.

Now there is the need to define who shall be person dealing with company and to facilitate this definition, Section 117 (2) (a) of Cap. 622 steps in. Under the Section 117 (2) (a) of Cap. 622; A person is to be considered as the person dealing with company, if that person is a party to any contract or transaction or any act, to which company is a party. This definition can also be supported with the English remarks in the case of Phipps, which says that; to create a company in Hong Kong this section contemplates the bilateral relationship between the company and the person dealing with the company, but the issue of bonus shares does not entitle the members of the company to be called as “dealing with company”. This is because of the scenario as there exist no bilateral transaction between the company and its members and issue of bonus shares is the matter of internal management of the company and such actions require no consent of the members, receiving the bonus shares.

As we talked of an equivalent provision related to the Statutory Indoor Management Rule in the UK’s legislative framework. So, UK’s replica of Section 117 (2) (a) of Cap. 622 is the Section 40 of UK Companies Act 2006, which states that:

For the situation where Section 40 (1) of UK Companies Act 2006 is to be enforced, it can only be enforced if third party contracting with the company, is the party to the contract.

This provision gives rise to the Circularity and thus to avoid circularity, it is necessary to read Section 117 (2) (a) of Cap. 622 with the requirement to make the subjected person, party to the transactions or any act to which company is party, whether usually or purportedly.

Definition of “Good Faith”

It is necessary to define the word “good faith” so that no misconception occurs, and the term is understood rightly. A person shall continue to be acting or being intended to be in “Good Faith” as long as there exist no evidence of him/her to act in “Bad Faith”. So, prima facie it seems as if person not with good faith, cannot enquire company’s constitution on account of restrictions on the part of director’s powers but it must be noted that, failure to make up to such enquiries does not gives proper evidence of person with “bad faith”. The same way, it shall not be legitimate to say person not acting in good faith, if it is in the knowledge of person that, this act is beyond the power of the director. Let’s clear this out with the help of an example; consider the situation where after Hong Kong limited company registration director is properly exercising his/her designated duties and powers but there were some procedural irregularities in the board meeting and the person who is transacting with company knows about this irregularity, even then this person would not be objected about such concealment of truth and shall considered to be acting in good faith. But, there needs to be some check and balances on the extent of concealment so that no probability of misappropriation would arise. For instance, consider the situation where person transacting with the company knew about any irregularity such as breach of fiduciary duties on the part of director and such breach causes company to enter into transaction, even still person does not reveal about this breach of fiduciary duty on the part of the director then such person would no longer be considered to acting in good faith.

It may still sound absurd to you and situation may still not be clear. To cope up with this uncertainty, English legal constituencies emphasis on need of test to assess “Good Faith” on the same ground, test was adopted in the case of Akai Holdings to prevent the third party to rely on the apparent authority of the person acting purportedly for the company. Prima facie it looks that; there shall be good faith where there is a firm belief on the validity of the transaction, which was neither dishonest nor irrational.

After establishing business in Hong Kong and paying Hong Kong business registration fees Section 117 of Cap. 622 shall only be applied in the situation where the alleged transaction was entered by the company’s board of directors or by the agent of the company, through the authority of the board of directors. There are certain irregularities covered by this section and irregularities such as lack of quorum in the board meetings, shall fall within the scope of the Section 117 of Cap. 622. It must be noted that scope of Section 117 of Cap. 622 is not extended to the decision taken or made by any person who does not even holds the substantial basis to claiming to be the board. Section 117 of Cap. 622 says that only director’s powers are those which are free from any constitutional restrictions thus it conveys the message that such authority cannot be conferred to any person who does neither have apparent nor actual authority, given by the board of directors under agency law. The contrary view from this communicates that; provision could otherwise be applied in the circumstances where there is no objection on the authenticity of the document and where neither exist any reason to doubt the authenticity of the presented documents. So, on account of this alternative view it can be said that, subjected to some exceptions, Section 117 of Cap. 622 can be applied to the situation where person acting purportedly for the company, does not even hold apparent or actual authority. However, only difficulty in absorbing this hard fact is the apparent view of the Section 117 of Cap. 622 which says that only director’s powers are immune of any constitutional restriction as well as any other relevant document which limits director’s abilities to bind the company to the transactions. Referring to the examples makes situation much clearer and communicates well so let’s better understand this with the help of the example which refers towards such restriction and deems to restrict the powers of the directors to borrow above certain amount and if to do so, approval of members in the general meeting is required. As it is very clear from this example that this provision deems to limit the powers of the director so here comes Section 117 of Cap. 622 to the rescue and allows directors to obtain loans and bind company to this loan transaction, even if approval of members in the general meeting is not obtained. It must be noted that although Section 117 of Cap. 622 operates so as to limit the restrictions on the powers of the director, but it does not in any sense, operates to confer some extra authority or powers to the director, so this provision should only be taken just as the provision, which limits the restrictions on the powers of the director. Not only directors but this provision does not even confer any authority to any other person and the only subject of it is the removal of restriction on the part of director’s power.

Any document such as the constitution of the company, any resolution of the members or any agreement between the members of the company, is known as “relevant documents” of the company. Section 117 of Cap. 622 is also applicable on any restriction on the powers of the directors, under agreement of the shareholder.

For the situation where the transaction in question, is between the director and the company then Section 118 of Cap. 622 shall apply there. Let’s make it more interactive, basically Section 117 of Cap. 622 deems to enforce the transaction or contract against the company, however Section 118 of Cap. 622 tends to overturn this transaction. So, it’s better to call them repelling provisions of each other, where one tends to enforce transaction and other one repels the enforcement of transaction. The overturning of transaction by the company is not so easy as it seems, there are a lot of things to consider while overturning such transactions. Section 118 (3) of Cap. 622 tends to restrict rescission where company has itself endorsed or affirmed the transaction or where there is intervention of third party in the transaction and that third party is acting in good faith and for substantial and fair value.

There is the restriction to invoke Section 117 of Cap. 622 against the charitable companies and this restriction is in compliance and as per the script of Section 119 of Cap. 622. As per the script of Section 119 of Cap. 622, a person dealing with the charitable company shall be entitled to invoke Section 117 of Cap. 622 if and only if:

  • The person transacting with the company did not knew that; the company he or she is being transacting with, is a charitable company.
  • The person transacting with the company gave full consideration and was not aware of transaction, to be beyond the powers of the director.

In this way one can say that, there is greater protection to the funds of the charity company and such provisions makes sense too, as charitable companies are not made for some profitable business instead they are driven by the emotions of humanity and compassion.

Contrast with the Common Law

Now let’s conclude our discussion on the Statutory Indoor Management Rule by getting into comparative analysis. It is said that Statutory Indoor Management rule contrasts with the provisions of Common Law. This argument is supported by many sub-arguments, the important one of which is the one which is the basis of the Statutory Indoor Management Rule i.e. the protection to the third parties, transacting with the company. It is said that; exception of statutory indoor management rule related to the absence of good faith is much narrower than the notice of exception in the common law, hence statutory indoor management rule gives greater protection to the outsiders than the common law. But this does not mean that common law provides no room for the area of operation, instead it do provide area of operation specially in the situation where outsiders deals with the company through members of the company in the general meeting and not through company’s directors, and also where there is no restriction on the powers of the director either by company’s articles or any relevant document although chances of occurrence of these circumstances are very minimal. For the situation where Section 117 of Cap. 622 is not held to be applicable due to the enforcement of Section 119 of Cap. 622, even there, provisions of Common Law stand applicable for the charitable companies. So, in this way it can be legitimately said that; Statutory Indoor Management Rule overlaps largely with the Common Law.