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Transaction avoidance

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Laura R. Hall

Partner

New York

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22 April 2022

Laura R. Hall and Annabelle Wang (South Square) reflect on ultra vires, abuse of power and illegality in transactions in England, Wales and the U.S.

In England and Wales, the core transaction avoidance toolkit consists of provisions in the Insolvency Act 1986 which render certain transactions voidable at the instance of officeholders or victims of the transaction. 

These provisions primarily focus on whether the transaction was at an undervalue and whether the purpose of the transaction was to defraud the transferor’s creditors. However, English law also provides that transactions may be void or voidable in other circumstances, such as where the company or directors lack the capacity to enter into the transactions or where the transactions involve some form of illegality.

Ultra vires

Under English law, there has historically been confusion between acts which are ‘ultra vires’ and those which amount to an abuse of the directors’ powers. The misunderstanding largely stems from the judgment of Buckley LJ in Re David Payne in which he stated: “A corporation cannot do anything except for the purposes of its business borrowing or anything else; everything else is beyond its power and ultra vires.”

The foregoing passage was interpreted in later cases as referring to the capacity of the company, such that any act which was not for the purpose of the company would be ultra vires the company. The court therefore held that where a company exercised a power it possessed for an improper purpose, the contract would be ultra vires and void.

However, Slade LJ later clarified the meaning of ‘ultra vires’ in the context of transaction avoidance in Rolled Steel Products Ltd v British Steel Corporation. The judge stated that Buckley LJ’s use of the phrase ‘ultra vires’ should be read as ‘ultra vires the directors’, and therefore concerned acts which would amount to an abuse of the directors’ powers. The phrase ‘ultra vires’ was to be confined to describing acts which are beyond the corporate capacity of the company.

A company is treated as having implied powers to do any act which is reasonably incidental to the attainment or pursuit of any of its express objects, unless expressly prohibited by the memorandum. Accordingly, whether an act is ultra vires falls to be determined by reference to the true construction of the company’s memorandum which, under the predecessor to the Companies Act 2006, had to state the company’s objects. A transaction falling within a company’s objects clause will therefore normally be ‘intra vires’, except where a provision in the objects clause is not capable as existing as an object.

Transactions which are ultra vires are void and incapable of conferring rights onto third parties. ‘Ultra vires’ acts cannot be ratified or become ‘intra vires’ by virtue of estoppel, lapse of time, acquiescence or delay. The usual remedy is restitution, and the courts would not necessarily refrain from granting relief in circumstances where the precise technical basis for restitution remained unclear.

However, the utility of the ‘ultra vires’ doctrine in a commercial context has been largely curtailed. The objects of companies incorporated under the most recent legislation will be unrestricted unless they are specifically restricted by the company’s articles. There is therefore considerably less scope to claim that a transaction is ‘ultra vires’ as it falls outside the company’s objects than under the preceding legislation.

Further, Article 9 of the First EEC Directive on Company Law required member states to abrogate the doctrine of ‘ultra vires’ to ensure security between companies and their contractual counterparties. The validity of a transaction now cannot be called into question on the grounds of the company’s lack of corporate capacity. Accordingly, a transaction can be enforced by or against the company even though it is not authorised by the company’s constitution.

Abuse of power

Transactions may be voidable on the basis that they amount to an abuse of the powers of the directors of the company. For example, a transaction may be ‘intra vires’, but amount to an abuse of the director’s powers on the basis that it was entered into for an improper purpose. Transactions which amount to an abuse of the directors’ powers will be voidable at the election of the company, provided that the conditions for rescission are met. Upon rescission, the parties are obliged to restore the position to what it would have been if the transaction had not been entered into, which will usually entail re-vesting any property transferred to the transferor.

However, voidable transactions will bind the company if entered into with the unanimous consent of its shareholders or if subsequently ratified, although acts which are a fraud on the company’s creditors cannot be authorised by its shareholders. Accordingly, transaction avoidance may be barred by shareholder consent or ratification. A company may also be estopped from objecting to the validity of a transaction by reason of the shareholders’ acquiescence, provided that those shareholders had notice of the transaction and did not oppose it.

A third party wishing to rely on a transaction impugned as an abuse of powers must rely on the directors’ ostensible authority. A company incorporated under the Companies Acts holds its directors as having ostensible authority to do on its behalf anything which its memorandum expressly or impliedly gives the company the capacity to do. The directors are deemed to be free from any limitation to act under the company’s constitution where parties transact with the company in good faith, and those parties are not bound to inquire as to any limits on the directors’ powers.

However, there may lie a claim against the counterparty to the transaction if he has notice that the transaction was entered into in breach of the directors’ duty. Further, the directors are not protected in respect of transactions entered into beyond their capacity to which they are a party on the basis that they did not have the authority to bind the company.

Illegality

A transaction may involve illegality because it involves the commission of a legal wrong, or where no unlawful act is involved, for reasons of public policy or for breaching a statutory provision. The illegality may be found in the terms of the relevant agreement, or its object, purpose, or performance. For example, a contract for insider dealing will be illegal because insider dealing is independently illegal. A legal contract which has been achieved by illegal means may also be voidable at the election of the innocent party.

The English courts have a “long-standing repugnance” for claims which are founded on the claimant’s own illegal or immoral acts. Lord Sumption, giving the leading judgment of the Supreme Court in Les Laboratoires Servier v Apotex Inc, expressed the view that the court’s refusal to enforce illegal contracts was not a matter of discretionary power but was a rule of English law. In his view, courts should not determine whether a transaction involved illegality based on subjective judgments as to the moral culpability of the parties to the contract and how much that behaviour mattered in the particular context.

In Bilta (UK) Ltd v Nazir the court remained divided as to whether the proper approach to the illegality defence was rule-based, or a more flexible approach which permitted consideration of the underlying policies of the doctrine, and the point was not decided in that case. However, the point was settled by a majority of the Supreme Court in Patel v Mirza. The court held that the discretionary approach was correct and that, when considering whether to enforce a contract which involves a legal wrong, the court must consider the underlying purpose of the prohibition which has been breached, any other relevant public policy, and the proportionality of denying enforcement.

An illegal contract may be void or otherwise unenforceable, and the court may make a restitutionary order in appropriate cases. Further, it is important to note that the illegality defence will not be available to directors who conspire against the company or otherwise act as accessories to the directors’ breach of duty, and there is no basis for attributing knowledge of such behaviour to the company to found an estoppel.

U.S. Law of Transaction Avoidance

In addition to the transaction avoidance provisions of the U.S. Bankruptcy Code, state voidable transaction and fraudulent conveyance statutes are frequently invoked to recover property transferred by a debtor in certain circumstances. Less commonly, the principles of ‘ultra vires’, breach of debtor duty and illegal contract may be applied to void contracts.

Ultra vires

The concept of ‘ultra vires’ transactions— those that exceed the authority of a corporation to act—was incorporated into U.S. law from its English antecedents, but has been eroded by the adoption of statutes that limit its application and permit broad purpose provisions in corporate charters. Most U.S. corporations are formed under Delaware’s General Corporation law, which provides that:

“No act of a corporation and no conveyance or transfer of real or personal property to or by a corporation shall be invalid by reason of the fact that the corporation was without capacity or power to do such act or to make or receive such conveyance or transfer, but such lack of capacity or power may be asserted:

  1. In a proceeding by a stockholder against the corporation to enjoin the doing of any act or acts or the transfer of real or personal property by or to the corporation...
  2. In a proceeding by the corporation, whether acting directly or through a receiver, trustee or other legal representative, or through stockholders in a representative suit, against an incumbent or former officer or director of the corporation, for loss or damage due to such incumbent or former officer’s or director’s unauthorized act;
  3. In a proceeding by the Attorney General to dissolve the corporation, or to enjoin the corporation from the transaction of unauthorized business.”

Prior to 2013 legislation, however, Delaware state courts had held that failure to comply with statutory requirements in carrying out certain corporate acts (principally the issuance of stock) rendered a transaction void or voidable. Following the 2013 amendments to the General Corporation Law, such transactions can now be ratified by the board of directors or the Delaware Court of Chancery. Although the legislative text suggests that the Court of Chancery could equally hold that a transaction can declared voided in appropriate circumstances, the court has consistently held that the remedial purpose of the legislation precludes it being invoked in that way.

In the context of failure to comply with corporate bylaw requirements, where the lack of capacity is that of the individual corporate actors and not the corporation itself, it may be ratified by the appropriate actor or the shareholders.

In the context of limited liability companies (LLCs), the concept of ‘ultra vires’ retains some application, as the parties to the LLC member agreement may specify that acts in contravention of the agreement will be void, although third parties may be protected from rescission by the company’s expressor implied ratification of the act.

Note that the limitations on the ‘ultra vires’ principle discussed above apply only to private companies. Government entities, whether or not organized as corporations, are limited by their statutory purposes and the concepts of apparent authority, quantum meruit and estoppel may not be available to enforce contracts against them.

Breach of duty

Corporate directors and officers owe fiduciary duties of loyalty and due care to the corporation. Conduct that breaches these duties (e.g., self-dealing or negligence) generally does not render a corporate act void or voidable under Delaware corporate law, but rather may give rise to a claim for damages incurred by the corporation and its shareholders. Delaware’s General Corporation Law permits corporations to indemnify directors and officers for damages from breaches of the duty of care, so long as they have acted in good faith and not derived an improper personal benefit, so the duty of loyalty is the primary focus of shareholder suits attacking corporate transactions.

The Delaware General Corporation Law further restricts the scope of duty of loyalty challenges by providing that a transaction is not void or voidable solely on the basis that a director or officer with a pecuniary interest in the transaction participates in the approval of the transaction, so long as the material facts of their interest are disclosed and it is approved or ratified by the majority of disinterested directors or the stockholders. In the absence of such informed approval, the transaction must be “entirely fair” to the corporation to avoid attracting liability. While rescission is in principle available, most commonly the Court of Chancery will award rescissory or compensatory damages to the corporation or shareholders.

Illegality

As with English law, illegality could be considered a subset of ‘ultra vires’ because no corporation has the authority to do an illegal act, but the treatment of illegal transactions is not constrained by the statutory limitations placed on the ‘ultra vires’ doctrine. The treatment of illegal contracts is governed by state contract law, rather than state corporate law, though federal courts may refuse to enforce contracts involving federally illegal conduct even if not illegal under the law governing the contract.

A contract may be labelled illegal where its purpose is the commission of a crime or tort, where it fails to comply with applicable statutory law or regulation (e.g., licensing and usury law) or where enforcement would violate public policy. Whether an illegal contract is void, voidable or simply unenforceable depends on the nature of the illegality and the positions of the parties. Illegality ancillary to the contract may not render it voidable.

A contract to commit a crime or tort is unenforceable and the court will generally leave the parties as it finds them—i.e., it will not rescind the contract or award quantum meruit. Where one party to the contract is innocent, however, because it did not know the other party would engage in illegal conduct or because it is the protected party under the relevant statutory scheme, the illegal contract will typically be voidable at the innocent party’s election. The defence of estoppel is not available on a claim to void an illegal contract. A company may also have a cause of action against directors and officers who cause the company to commit an illegal act.

The unenforceability of illegal contracts can be an obstacle in the context of disputes in the cannabis industry, which has been legalized in a number of states, but not under federal law. Thus federal courts, including bankruptcy courts, have held they cannot enforce contracts directed at federally illegal conduct, even where such contracts are legal under applicable state law.

This article first appeared in the April 2022 edition of the South Square Digest