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Chapter 8: Formation of a Company

A company does not come into existence merely because a few people decide to start one. A sole proprietor can begin trading the day the shop opens, but a joint stock company is created by law, and it can be brought into being only by following the procedure laid down in the Companies Act, 2013. Someone must first conceive the business idea, examine whether it is workable, arrange the funds and professional help it will need, and then place a set of prescribed documents before the Registrar of Companies. Only when the Registrar is satisfied does the company acquire a legal identity of its own. The procedure is not mere formality. It protects everyone who will later deal with the company — investors who buy its shares, banks that lend to it, suppliers who sell to it on credit. They need a public record of what the company is permitted to do, who controls it and how it is to be governed. This chapter explains the stages through which a company is formed, the role of the promoter, and the basic documents on which the entire process rests.

Figure

Fig. 8.0-1 — Filing Documents With The Registrar Of Companies Photograph of an office counter where company incorporation documents are submitted and verified.

8.1 Stages In The Formation Of A Company

A sole proprietor or a partnership firm can begin trading as soon as the owners agree to do so. A company cannot. A company is an artificial person created by law, and something that is created by law can come into existence only in the manner the law prescribes. In India that manner is laid down in the Companies Act, 2013, and until its requirements are met there is no company — only a group of individuals planning one.

Because the law is protecting outsiders as much as the founders, it does not leave the order of events to the founders’ convenience. The business idea has to be examined before large sums are committed to it. The company must exist in law before it can lawfully invite the public to buy its shares, since the public is being asked to invest in a legal person, not in a proposal. And a public company must have collected the capital it announced it needed before it begins trading, so that it does not start business under-funded with other people’s money already spent.

The Four Stages

The formation of a public company therefore moves through four stages, in the order shown in FC 8.1.

Flowchart

FC 8.1 — Stages In The Formation Of A Company Promotion → Incorporation → Capital subscription → Commencement of business

  1. Promotion — the idea for the business is conceived, investigated for its commercial soundness, and given a workable shape by assembling the money, people and permissions it will require.
  2. Incorporation — the prescribed documents are filed with the Registrar of Companies and the company is registered, at which point it becomes a legal person distinct from its members.
  3. Capital subscription — the company invites the public to subscribe to its shares or debentures, receives applications, and allots the securities once the minimum subscription has been received.
  4. Commencement of business — the company satisfies the Registrar that the capital promised has actually been received, and becomes entitled to begin trading and to exercise its borrowing powers.
How Far A Private Company Goes

A private company does not raise capital from the public, so the third and fourth stages have no application to it. It is formed by completing the first two stages only, and may begin business as soon as it receives its certificate of incorporation. The same is true of a public company that has no share capital.

Incorporation And Commencement Of Business Incorporation gives the company its legal existence; commencement of business gives a public company the entitlement to start trading. A public company is fully born at incorporation but must still complete the later stage before it operates.

8.2 Promotion Of A Company

Every company begins as somebody’s idea. Before the law is approached at all, that idea has to be tested, priced and given a workable shape, because the Registrar registers a proposal that is already complete on paper. The first stage of formation is therefore a business stage rather than a legal one, and it is called promotion.

8.2.1 Meaning Of Promotion

Promotion is the process of discovering a business opportunity, investigating whether it can be run profitably, and organising the money, property, people and permissions needed to turn it into a going concern under corporate ownership. It covers everything from the moment the idea is conceived to the moment the company is ready to be registered.

The word carries a narrower meaning here than in everyday speech. Promotion in this chapter has nothing to do with advertising or with sales; it means bringing a business unit into existence. The person who does this work is the promoter, whose position is examined in the next section.

NoteDefinition

Promotion Promotion may be defined as the discovery of business opportunities and the subsequent organisation of funds, property and managerial ability into a business concern for the purpose of making profits therefrom. — C. W. Gerstenberg

Two points follow from this. First, promotion involves risk that no one else will bear: the promoter spends time and money on investigation before there is any company to reimburse the expense, and if the idea proves unsound that expenditure is lost. Second, promotion is preparatory. Nothing done at this stage binds a company, because at this stage the company does not yet exist.

8.2.2 Steps In Promotion

The steps follow a strict logic. An opportunity is worth investigating before it is worth financing, and worth financing before it is worth registering; reversing the order means committing money to a proposition that has not been tested. The sequence is summarised in FC 8.2.

Flowchart

FC 8.2 — Steps In The Promotion Of A Company Discovery of a business opportunity → detailed investigation → assembling the proposition → financing the proposition → incorporation

  1. Discovery of a business opportunity — the promoter identifies an unmet demand, a new product or process, or a gap in an existing market. This is the creative step, and everything that follows depends on the quality of the idea chosen.
  2. Detailed investigation — the idea is examined for technical feasibility, availability of raw material and labour, likely demand, expected cost and expected return. Specialists such as engineers, accountants and market researchers are usually consulted, because the promoter’s own optimism is not a reliable test.
  3. Assembling the proposition — once the idea survives scrutiny, the promoter secures what the business will actually need: a site, plant and machinery, licences and approvals, key personnel, and preliminary agreements with suppliers or vendors.
  4. Financing the proposition — the promoter estimates how much capital is required and decides where it will come from, arranging for bankers, brokers and underwriters where the money is to be raised from the public.
  5. Incorporation — the necessary documents are prepared and filed with the Registrar of Companies, which carries the proposition into the second stage of formation.

Testing An Idea Before Funding It A group planning a cold storage unit for a fruit-growing district first commissions a study of local output, existing storage capacity and expected rentals. The study shows that capacity already exceeds demand in that district, and the promoters shift the site rather than build. The investigation cost a little; ignoring it would have cost the whole investment.

8.3 The Promoter

Promotion is work, and somebody must do it. The person who conceives the idea of a company, tests it, assembles the resources it needs and takes it through registration is the promoter. A promoter need not be an individual; a firm, an association or an existing company may act as one, because what makes a person a promoter is the function performed, not the description used.

8.3.2 Functions Of A Promoter

The functions below are not a list of chores. Each one removes an obstacle that would otherwise prevent registration or prevent the company from working on the day it is registered.

  1. To conceive the business idea and conduct a feasibility study, so that capital is committed only to a proposition that has been tested.
  2. To select the name of the company and settle its objects, since both must be stated in the documents filed for registration.
  3. To arrange the money required to meet the preliminary expenses of investigation, drafting and filing.
  4. To acquire the assets the business will need, or to negotiate the purchase of a running concern, entering into preliminary contracts for the purpose.
  5. To have the memorandum, the articles and the other documents prepared and filed with the Registrar of Companies.
  6. To appoint the first directors, bankers, brokers, auditors and legal advisers, because a registered company must have people authorised to act for it from the outset.
  7. To prepare and issue the prospectus and arrange for the raising of capital from the public, where the company intends to approach it.
  8. To make arrangements for the company’s registered office and its records.

Promoter And Director A promoter works before the company exists and has no legal authority to bind it. A director is an officer of a company already in existence and acts on its behalf. A promoter may later become a director, but the two positions are not the same.

8.3.3 Types Of Promoters

Promoters differ in why they take up the work, and this affects how long they stay with the company.

  1. Professional promoters — they specialise in forming companies and hand over control and management to the Board of Directors once promotion is complete. Promotion is their business activity, so they move on to the next venture.
  2. Occasional promoters — they promote a company rarely, often only once, and return to their usual occupation after the task is done. They do not carry out promotional work regularly.
  3. Entrepreneur promoters — they conceive the idea, carry out the promotion and then join the management of the company they created, because their interest lies in running the business and not merely in launching it.
  4. Financier promoters — financial institutions sometimes undertake promotion themselves, since their experience in financial affairs lets them judge a proposition and fund it at the same time.

8.4 Incorporation Of A Company

Incorporation is the stage at which the promoters’ proposal is placed before the Registrar of Companies and, if it satisfies the law, is registered. Registration is what converts a plan into a person: from this point the business has a name of its own, property of its own and liabilities of its own, separate from the people who created it. Everything the Registrar asks for at this stage is asked for so that outsiders can later find out, from a public record, what the company is and who stands behind it.

8.4.1 Preliminary Activities

Certain decisions must be taken before the application is even drafted, because the application cannot be completed without them.

  1. Deciding the location of the registered office — the promoters must fix the state in which the company’s registered office will be situated, since the application goes to the Registrar of Companies of that state and the courts of that state will have jurisdiction over the company.
  2. Obtaining approval of the name — the proposed name must not be identical to, or closely resemble, the name of an existing company or a registered trade mark, must not be undesirable or offensive to any section of society, and must not use words whose use is restricted without the required approval. The name of a public company ends with ‘Limited’ and that of a private company with ‘Private Limited’. Application for the name is made to the Registrar through the prescribed online process, and it is usual to propose alternatives so that one may be approved.
  3. Obtaining identification for the proposed directors — every individual who is to be appointed a director must hold a Director Identification Number, and the persons signing the electronic forms must hold a digital signature certificate, because the documents are filed in electronic form.
  4. Obtaining any special approval the business requires — a company proposing to carry on an activity that is separately regulated, such as banking or insurance, must obtain the approval of the concerned regulator before it can begin that activity.
  5. Getting the documents prepared — the memorandum and the articles are drafted, checked, signed by the subscribers and attested by a witness.
  6. Making the necessary appointments — the promoters arrange for the first directors, and for the bankers, auditors and legal advisers the company will need on the day it is registered.

8.4.2 Documents To Be Filed With The Registrar

The application is accompanied by the documents listed below. The sequence in which they are read matters less than the fact that together they answer three questions: what the company may do, how it will be run, and who is answerable for it.

  1. Memorandum of association — the charter of the company, stating its name, the state of its registered office, its objects, the liability of its members and its capital, signed by each subscriber.
  2. Articles of association — the rules governing the company’s internal management. A company may frame its own articles or adopt the model articles set out in the schedules to the Companies Act, 2013.
  3. Declaration of compliance — a declaration that all the requirements of the Act relating to registration have been complied with, made by a professional engaged in the formation of the company, such as an advocate, a chartered accountant, a cost accountant or a company secretary in practice, and by a person named in the articles as a director, manager or secretary.
  4. Declaration by subscribers and first directors — a declaration that they have not been convicted of any offence connected with the promotion, formation or management of a company and are not otherwise disqualified.
  5. Address of the registered office — the address at which the company’s records will be kept and communications served. It may be furnished at the time of incorporation or within thirty days of registration.
  6. Particulars and consent of the first directors — the name, address, occupation and identification number of each proposed director, together with a written consent from each to act in that capacity, so that no person is shown as a director without agreement.
  7. Payment of the prescribed fee — the filing fee and stamp duty at the prescribed rates must be paid through the prescribed electronic mode when the documents are filed.

The Corporate Identity Number On registering a company the Registrar allots it a Corporate Identity Number, a unique code that stays with the company for life. Indian companies are required to print it on their letterheads, invoices and other official publications, which is how a supplier or investor can trace a company’s records in the public register before dealing with it.

8.4.3 Certificate Of Incorporation

The Registrar examines the documents. If satisfied that the requirements of the Act have been complied with, the Registrar registers the memorandum and the articles and issues a certificate of incorporation, which is the company’s birth certificate. The date printed on it is the date from which the company legally exists.

NoteDefinition

Certificate of Incorporation The certificate of incorporation is the document issued by the Registrar of Companies certifying that a company has been registered under the Companies Act, 2013, and stating the date from which the company exists as a body corporate.

Figure

Fig. 8.4-1 — A Certificate Of Incorporation Photograph of a certificate of incorporation issued by the Registrar of Companies, with the company name and identity number visible.

Effects Of Incorporation

Each of the consequences below flows from a single fact: the company is now a person in law.

  1. The company becomes a body corporate with a legal personality separate from that of its members, and its property is its own and not theirs.
  2. It acquires perpetual succession, so that its existence is unaffected by the death, insolvency or retirement of any member.
  3. It may enter into contracts, own and dispose of property in its own name, and sue and be sued in its own name.
  4. The memorandum and the articles become binding on the company and on every member as though each of them had personally signed the documents.
  5. Any amount remaining due from a member under the memorandum or articles becomes a debt payable to the company.
  6. A private company may commence business at once; a public company having share capital must still complete the stages that follow.
The Standing Of The Certificate

The certificate is the accepted proof that the company has been duly registered and that the legal formalities preceding registration were complied with, and the regularity of the incorporation is not ordinarily open to challenge afterwards. The protection is not absolute, however. Where registration has been obtained by furnishing false or incorrect information, the Act allows the Tribunal to pass such orders as it thinks fit, including action against the persons responsible.

Find the Corporate Identity Number printed on the website footer or letterhead of any Indian company and note the year of incorporation it shows.

8.5 Capital Subscription

A registered company has a legal existence but not necessarily any money. A private company solves this privately, from the resources of its own small group of members, and a public company without share capital does not face the problem at all. A public company that intends to raise its funds from the general public must go through a further stage, in which it invites investors to subscribe to its shares or debentures and collects what they subscribe.

This stage is the most closely regulated part of the whole formation process, and for an obvious reason. The money being collected belongs to thousands of people who know nothing about the business except what the company chooses to tell them. The law therefore controls what the company must disclose, where the money must be kept while applications are being processed, and what must happen if the issue fails.

The Procedure

The steps are summarised in FC 8.3 and explained below.

Flowchart

FC 8.3 — Steps In Capital Subscription Approval and compliance with SEBI requirements → appointment of merchant bankers, underwriters and brokers → issue of prospectus and filing of a copy with the Registrar → application for listing on a stock exchange → receipt of applications from the public → allotment of securities and filing of the return of allotment

  1. Compliance with the requirements of the Securities and Exchange Board of India — a company approaching the public must satisfy the disclosure and eligibility requirements laid down by SEBI, whose function is investor protection.
  2. Appointment of intermediaries — merchant bankers manage the issue, underwriters agree to take up shares that the public does not subscribe to, and brokers procure subscriptions. Underwriting matters because an issue that falls short may have to be cancelled altogether.
  3. Issue of the prospectus — the company issues a prospectus inviting the public to invest and files a copy with the Registrar of Companies, so that the statements made to investors are on the public record.
  4. Application for listing — a company making a public offer must apply to a recognised stock exchange for its securities to be listed, since investors will not readily subscribe to shares they cannot afterwards sell.
  5. Receipt of applications — applications and application money are received through the company’s bankers to the issue, and not by the company itself, so that the money is not at the company’s disposal until allotment is properly made.
  6. Allotment — where the issue has been subscribed to the extent required, the Board passes a formal resolution of allotment, the securities are credited to the successful applicants and a return of allotment is filed with the Registrar.
If The Issue Falls Short

An issue that is under-subscribed cannot simply be allowed to proceed at a reduced size, because a business funded at a fraction of its stated requirement is a business that will fail with the subscribers’ money in it.

NoteDefinition

Minimum Subscription Minimum subscription is the least amount which, in the opinion of the directors, must be raised by an issue of shares and stated in the prospectus, and below which the company may not proceed to allot the shares offered.

If the minimum subscription is not received within the period prescribed, no allotment may be made and the whole of the application money must be refunded to the applicants. Where the refund is delayed beyond the permitted period, the company becomes liable to repay it with interest, and the officers in default are liable as well.

Where The Application Money Sits In public issues in India, retail applications are made through the ASBA facility, under which the amount applied for is blocked in the investor’s own bank account instead of being paid over to the company. It is debited only if shares are allotted, so an unsuccessful applicant never parts with the money at all.

8.6 Commencement Of Business

Registration proves that a company exists. It does not prove that anyone has actually paid for the shares they promised to take, or that the company can be found at the address it gave. A company could therefore be incorporated, borrow money on the strength of its registration, and begin trading without a rupee of its own capital having been received. The final stage of formation exists to close that gap.

The Declaration Required

A company having share capital may not commence business, and may not exercise its borrowing powers, until it has filed with the Registrar of Companies a declaration to the following effect.

  1. That every subscriber to the memorandum has paid the value of the shares agreed to be taken by him. This is the substance of the requirement — the promoters must have put in their own money before the company operates on anyone else’s.
  2. That the company has filed verification of its registered office, so that the company has a fixed address at which notices can be served and records inspected.

The declaration is made by a director within the period prescribed after incorporation, and it is filed in the prescribed electronic form.

NoteDefinition

Commencement of Business Commencement of business is the stage at which a company having share capital becomes entitled to begin its operations and to exercise its borrowing powers, on filing with the Registrar a declaration that the subscription money has been received and the registered office verified.

Consequences Of Failure

Two consequences follow from not filing the declaration, and both are severe because the requirement protects lenders and creditors rather than the company itself.

  1. The company and every officer in default become liable to penalty under the Act.
  2. Where the declaration is not filed within the prescribed period and the Registrar has reasonable cause to believe that the company is not carrying on any business, action may be initiated to remove the company’s name from the register.
The Two Routes Compared

The stages a company passes through depend on how it proposes to raise its capital, as set out in Table 8.1.

Table 8.1 — Formation Of A Private Company And A Public Company | Basis | Private company | Public company raising capital from the public | |—|—|—| | Stages involved | Promotion and incorporation | Promotion, incorporation, capital subscription and commencement of business | | Source of capital | Members, their relatives and private arrangement | The investing public, through a public offer | | Prospectus | Cannot invite the public and so issues none | Must issue a prospectus and file a copy with the Registrar | | Listing of securities | Not applicable | Must apply to a recognised stock exchange for listing | | Regulatory oversight of the issue | Not applicable | Issue subject to the requirements of SEBI | | Start of operations | May begin once the declaration of commencement is filed | May begin only after allotment is completed and the declaration is filed |

8.7 Memorandum Of Association

Of all the documents filed at incorporation, one stands above the rest. A company registered without articles can borrow the model articles from the Act; a company cannot be registered at all without a memorandum, because the memorandum is what tells the world which company has been created and what it is permitted to do.

8.7.1 Meaning And Importance

The memorandum of association is the charter of a company. It states the company’s name, the state in which its registered office is situated, the objects for which it is formed, the liability of its members and the capital with which it is registered, and it is signed by every subscriber.

NoteDefinition

Memorandum of Association Memorandum means the memorandum of association of a company as originally framed, or as altered from time to time in pursuance of any previous company law or of the Companies Act, 2013.

Why The Memorandum Matters

The memorandum governs the company’s relationship with the outside world, and each of the points below is a consequence of that.

  1. It is the basis of incorporation — a company cannot be registered without filing it, since the Registrar has nothing to register until the promoters have stated what the company is to be.
  2. It defines the limits of the company’s powers — the company may do what its objects permit and what is reasonably incidental to them, and nothing else.
  3. It informs outsiders — an investor, a banker or a supplier can read the memorandum on the public record and see for himself whether the company is authorised to enter into the transaction proposed.
  4. It is difficult to alter — its provisions can be changed only by a special resolution of the members, and certain changes require the approval of the Central Government or the Tribunal in addition. The difficulty is deliberate, because people deal with the company on the faith of what the memorandum says.
The Doctrine Of Ultra Vires

An act outside the scope of the objects stated in the memorandum is described as ultra vires the company. Such an act is void, and it cannot be made valid afterwards even by the unanimous consent of all the members, because the members are not free to give the company a capacity that the law never gave it. The doctrine protects shareholders, whose money may be applied only to the purposes they were told about, and creditors, who lend on the strength of the stated objects.

8.7.2 Clauses Of The Memorandum

The memorandum is divided into the clauses shown in FC 8.4. Each answers a question that an outsider is entitled to have answered before dealing with the company.

Flowchart

FC 8.4 — Clauses Of The Memorandum Of Association Memorandum of Association → Name clause, Situation clause, Objects clause, Liability clause, Capital clause, Subscription clause

  1. Name clause — states the name by which the company is to be known. The name must not be identical to or closely resemble that of an existing company, must not be undesirable or such as to hurt the feelings of any section of society, and must not suggest government patronage or contravene the Emblems and Names (Prevention of Improper Use) Act, 1950. The name of a public company ends with ‘Limited’ and that of a private company with ‘Private Limited’, so that anyone dealing with it is warned that the members’ liability is limited.
  2. Situation clause — states the name of the state in which the registered office of the company is to be situated. It fixes the jurisdiction of the courts and identifies the Registrar with whom the company’s records are kept; the full address is furnished separately.
  3. Objects clause — states the objects for which the company is proposed to be incorporated, together with any matter considered necessary in furtherance of those objects. It is the most important clause, since it settles the company’s capacity. The objects must not be illegal or opposed to public policy.
  4. Liability clause — states whether the liability of the members is limited, and if so whether it is limited by shares or by guarantee. Where liability is limited by shares, a member can be called upon to pay only the amount remaining unpaid on the shares held, and nothing at all if they are fully paid. Where it is limited by guarantee, the clause states the amount each member undertakes to contribute if the company is wound up.
  5. Capital clause — states the authorised capital with which the company is registered and the number and fixed nominal value of the shares into which it is divided. This amount is the ceiling: the company cannot issue shares beyond it without first altering the memorandum.
  6. Subscription clause — contains the declaration by the subscribers that they are desirous of being formed into a company and agree to take the number of shares written against their names. A public company requires at least seven subscribers, a private company at least two, and a One Person Company one. Their names, addresses, occupations and signatures follow, attested by a witness.

8.8 Articles Of Association

The memorandum says what a company is for. It says nothing about how the company is to be run — who may call a meeting, how many members must be present for it to be valid, how a share is transferred, how a dividend is declared. These questions arise every week in the life of a company, and if they were left unsettled every one of them would have to be argued afresh. The articles of association settle them in advance.

NoteDefinition

Articles of Association Articles means the articles of association of a company as originally framed, or as altered from time to time, or as applied in pursuance of any previous company law or of the Companies Act, 2013.

The articles contain the rules and regulations for the internal management of the company. They fix the rights, powers and duties of the directors and of the members, the manner in which the business is to be carried on, and the procedure by which the internal rules may themselves be changed. They regulate the relationship between the company and its members, and among the members themselves.

Position Relative To The Memorandum

The articles are subordinate to the memorandum and to the Act. A provision in the articles that goes beyond the objects stated in the memorandum, or that conflicts with the Act, is of no effect, because rules for carrying out a purpose cannot enlarge the purpose itself. Both documents are public documents, filed with the Registrar and open to inspection, and once registered both bind the company and its members as though each member had signed them.

Framing Or Adopting The Articles

A company is not obliged to draft its own articles. The Companies Act, 2013 sets out model articles in a schedule, of which Table F applies to a company limited by shares, and a company may adopt them wholly or in part instead of framing its own. Small companies commonly do so, since the model set already covers the ordinary situations; a company with unusual arrangements between its members will draft its own.

The articles must be printed, divided into paragraphs, numbered consecutively and signed by each subscriber to the memorandum. They may afterwards be altered by a special resolution of the members, without any confirmation by the Tribunal — which is why the articles are described as easier to change than the memorandum.

Contents Of The Articles

The matters usually dealt with fall into a few groups, each corresponding to a recurring decision the company must take.

  1. Share capital and classes of shares — the types and denominations of shares and the rights attached to each class, so that a shareholder knows what has been bought.
  2. Dealings in shares — the procedure for allotment, for making calls, for issuing share certificates, and for forfeiture, surrender, lien and the transfer and transmission of shares.
  3. Directors — their appointment, qualification, powers, duties, remuneration, retirement and removal, and the conduct of Board meetings.
  4. General meetings — the calling of meetings, the notice to be given, the quorum required and the business to be transacted.
  5. Voting — the method of voting, the taking of a poll, the appointment of proxies and the counting of votes.
  6. Dividends and reserves — the declaration and payment of dividends and the transfer of profits to reserves.
  7. Accounts and audit — the keeping of books of account, their inspection, and the appointment and remuneration of auditors.
  8. Other powers and procedures — the borrowing powers of the company, the use and custody of the common seal, and the procedure on winding up.

When The Articles Decide A member of a private company agrees to sell his shares to an outsider, but the company’s articles require that shares first be offered to the existing members at a valuation. The sale cannot go through until that right of first refusal is exhausted. The buyer’s willingness is irrelevant; the articles bind the member as if he had signed them personally.

8.9 Memorandum And Articles Distinguished

The memorandum and the articles are often confused, because both are filed at incorporation, both are public documents, and both bind the company and its members as though each member had signed them. The distinction between them turns on a single idea: the memorandum settles what the company may do, while the articles settle how it will do it. The points of difference set out in Table 8.2 all follow from that.

Table 8.2 — Memorandum And Articles Of Association | Basis | Memorandum of association | Articles of association | |—|—|—| | Contents | States the objects and powers of the company | States the rules for the internal management of the company | | Scope | Governs the relationship between the company and outsiders | Governs the relationship between the company and its members, and among the members | | Status | The charter of the company and its fundamental document | Subsidiary to the charter, framed to carry it out | | Necessity | Must be prepared and filed by every company | A company may adopt the model articles instead of framing its own | | Alteration | Requires a special resolution, and in certain cases the approval of the Central Government or the Tribunal | Requires only a special resolution of the members | | Subordination | Subject only to the Companies Act, 2013 | Subject both to the Act and to the memorandum | | Acts beyond the document | An act beyond the memorandum is void and cannot be ratified even by all the members | An act beyond the articles is irregular and may be ratified by the members if it is within the memorandum |

Q. Can a company’s articles authorise an activity that its memorandum does not cover?

A. No. The articles are subordinate to the memorandum, and a rule for conducting business cannot enlarge the business the company is permitted to conduct.

Where the two documents conflict, the memorandum prevails and the offending provision of the articles is of no effect. The articles may, however, be read to explain an ambiguity in the memorandum, since the two are meant to be read together as one scheme.

Choose any activity you would like a company to carry on and write one line for the objects clause and one rule for the articles that would be needed to run it.

8.10 Prospectus And Its Substitutes

A company that wants money from the public must ask for it, and the document in which it asks is the prospectus. Everything about the way the law treats that document follows from one imbalance: the company knows what its business is worth and the investor does not. The prospectus is the law’s answer to that imbalance, and it is why the document is regulated far more strictly than any ordinary advertisement.

8.10.1 Meaning And Contents Of A Prospectus

A prospectus is a document by which a company invites the public to subscribe to or purchase its securities. It is not confined to a document bearing that title; a notice, circular or advertisement making the same invitation is a prospectus in law, whatever it is called, so that a company cannot escape the rules by changing the heading.

NoteDefinition

Prospectus A prospectus means any document described or issued as a prospectus, and includes a red-herring prospectus or a shelf prospectus, or any notice, circular, advertisement or other document inviting offers from the public for the subscription or purchase of any securities of a body corporate.

What Makes A Document A Prospectus

Four elements must be present together.

  1. There must be an invitation to the public, and not a private approach to a few identified persons.
  2. The invitation must be made by or on behalf of the company, or in relation to a company intended to be formed.
  3. The invitation must be to subscribe for or to purchase securities.
  4. The invitation must relate to shares, debentures or other securities of a body corporate.

Because a private company is prohibited from inviting the public to subscribe to its securities, a private company does not issue a prospectus at all.

Contents Of A Prospectus

A prospectus must state the matters and set out the reports prescribed under the Companies Act, 2013, and where the issue is made to the public it must also meet the disclosure requirements of SEBI. The contents fall into the following groups, each of which answers a question the investor would otherwise be unable to answer.

  1. Identity of the company — its name, the address of its registered office and the main objects for which it was formed.
  2. The people behind it — the names, addresses and occupations of the promoters, directors and other key persons, their remuneration, and the extent of their interest in the company and in any property it proposes to acquire.
  3. The issue itself — the number and classes of securities offered, the rights attached to each class, the amount payable on application and on allotment, the minimum subscription, and the dates on which the subscription list opens and closes.
  4. Use of the money — the objects of the issue and the manner in which the proceeds are proposed to be applied, so that subscribers know what their money is being raised for.
  5. Underwriting and intermediaries — the names of the underwriters and of the bankers and managers to the issue, with a statement about the underwriters’ capacity to meet their obligations.
  6. Financial and legal position — the auditor’s report and financial information, the particulars of material contracts, and details of pending litigation and other liabilities.
  7. Risk factors — the specific risks attaching to the company and to the issue, stated plainly, since a disclosure document that lists only advantages would mislead by omission.

Where an application form for securities is issued to the public, it must be accompanied by an abridged prospectus, a shortened version containing the salient features, because a full prospectus running into hundreds of pages would in practice be read by nobody.

Consequence Of A Misstatement

A prospectus that contains an untrue statement is not merely a bad advertisement. Every person who authorised its issue may be made liable to compensate investors who suffered loss by relying on it, and where the misstatement was made fraudulently the persons responsible attract criminal liability as well. This is the real force behind the disclosure requirements.

8.10.2 Shelf And Red-Herring Prospectus

A company that raises money repeatedly, or one that does not yet know the price at which its securities will sell, would be badly served by a rule requiring a complete prospectus for every offer. The Act therefore recognises two variants, shown alongside the ordinary prospectus in FC 8.5.

Flowchart

FC 8.5 — Kinds Of Prospectus Prospectus → Ordinary prospectus, Shelf prospectus, Red-herring prospectus; Every public issue → accompanied by an abridged prospectus with the application form

Shelf Prospectus

A shelf prospectus is filed by the classes of companies permitted to do so at the stage of the first offer of securities, and it indicates a period of validity not exceeding one year, running from the opening of that first offer. During that period the company may make further offers of the same securities without issuing a fresh prospectus each time; it files only an information memorandum stating the changes since the previous offer. The document sits ‘on the shelf’ and is taken down as required, which saves cost and time for a company that borrows from the public regularly.

Red-Herring Prospectus

A red-herring prospectus is a prospectus that does not contain complete particulars of the quantum or the price of the securities offered. It is used where the price is to be discovered from the market rather than fixed in advance. It must be filed with the Registrar at least three days before the opening of the subscription list, and it carries the same obligations as a prospectus, so the absence of a price is no excuse for any other omission. When the offer closes, the company files the prospectus stating the total capital raised and the final price.

Shelf And Red-Herring Prospectus A shelf prospectus is complete but is used for several offers over a period. A red-herring prospectus is used for a single offer but is incomplete, since the price or quantum is settled only after the offer closes.

8.11 Summary

  1. A company is created by law and can come into existence only in the manner prescribed by the Companies Act, 2013, so its formation follows a fixed order of stages: promotion, incorporation, capital subscription and commencement of business.
  2. A private company, and a public company without share capital, complete the first two stages only; the last two apply to a public company raising capital from the public.
  3. Promotion is the discovery of a business opportunity and the organisation of funds, property and managerial ability into a business concern, and it proceeds through discovery of the opportunity, detailed investigation, assembling the proposition, financing it and incorporation.
  4. The promoter is the person who conceives the idea and carries it to registration, and may be an individual, a firm, an association or a company.
  5. The promoter is neither an agent nor a trustee of the company, since the company does not yet exist, but stands in a fiduciary relationship towards it:
  1. No secret profit may be made out of the promotion, and any profit earned must be disclosed.
  2. All material facts and interests must be disclosed to the company.
  3. Pre-incorporation contracts do not bind the company automatically, and the promoter remains personally liable unless the company adopts them after incorporation.
  1. Promoters are classified as professional, occasional, entrepreneur and financier promoters, according to why they undertake the work and whether they remain with the company afterwards.
  2. Incorporation requires certain preliminary decisions — the state of the registered office, approval of the name, identification of the proposed directors and any special approval the business needs — followed by the filing of the memorandum, the articles, declarations of compliance and eligibility, the address of the registered office, the particulars and consent of the first directors, and the prescribed fee.
  3. On registration the Registrar issues a certificate of incorporation, from the date of which the company exists as a body corporate with perpetual succession, capable of owning property, contracting and suing in its own name, with the memorandum and articles binding on it and on its members.
  4. Capital subscription involves compliance with SEBI requirements, appointment of merchant bankers, underwriters and brokers, issue of the prospectus, application for listing, receipt of applications and allotment; if the minimum subscription stated in the prospectus is not received within the prescribed period, no allotment may be made and the application money must be refunded.
  5. A company having share capital may not commence business or exercise its borrowing powers until it files a declaration that the subscribers have paid for their shares and that the registered office has been verified; failure attracts penalty and may lead to removal of the company’s name from the register.
  6. The memorandum of association is the charter of the company, governing its relationship with the outside world, and it contains the name, situation, objects, liability, capital and subscription clauses.
  7. An act outside the objects stated in the memorandum is ultra vires the company and is void, and cannot be validated even by the unanimous consent of all the members.
  8. The articles of association contain the rules for the internal management of the company, covering share capital and transfers, directors, meetings, voting, dividends, accounts, borrowing powers and winding up; a company may frame its own or adopt the model articles.
  9. The memorandum and the articles differ chiefly in that the memorandum states what the company may do and governs its relations with outsiders, while the articles state how it will do it and govern its relations with members; the articles are subordinate, and the memorandum prevails in the event of conflict.
  10. A prospectus is any document inviting the public to subscribe for or purchase the securities of a body corporate; it must disclose the company’s identity, its promoters and directors, the terms and objects of the issue, financial and legal information and the risk factors, and a misstatement attracts civil and criminal liability.
  11. Two variants exist for particular situations:
  1. A shelf prospectus, valid for a period not exceeding one year, permits several offers without a fresh prospectus for each.
  2. A red-herring prospectus omits the quantum or price of the securities, which is settled after the offer closes.

8.12 Key Terms

  1. Abridged prospectus A shortened version of the prospectus containing its salient features, which must accompany an application form issued to the public.
  2. Allotment The formal act by which the Board of a company accepts applications and appropriates securities to the applicants.
  3. Articles of Association The document containing the rules and regulations for the internal management of a company, as originally framed or as altered from time to time.
  4. Authorised capital The amount of capital stated in the capital clause of the memorandum, beyond which the company cannot issue shares without altering the memorandum.
  5. Capital subscription The stage at which a public company invites the public to subscribe to its securities and collects the capital so raised.
  6. Certificate of Incorporation The document issued by the Registrar of Companies certifying that a company has been registered, and stating the date from which it exists as a body corporate.
  7. Commencement of business The stage at which a company having share capital becomes entitled to begin operations and exercise its borrowing powers, on filing the prescribed declaration with the Registrar.
  8. Fiduciary relationship A relationship of utmost good faith, under which the person occupying it must not make a secret profit and must disclose all material facts.
  9. Incorporation The registration of a company with the Registrar of Companies, by which it becomes a legal person distinct from its members.
  10. Memorandum of Association The charter of a company, stating its name, situation, objects, liability, capital and subscription, as originally framed or as altered from time to time.
  11. Minimum subscription The least amount stated in the prospectus which must be raised by an issue of shares, below which the company may not proceed to allot.
  12. Perpetual succession The continued existence of a company irrespective of the death, insolvency or retirement of any of its members.
  13. Pre-incorporation contract A contract entered into by a promoter before the company is registered, which does not bind the company unless it is adopted after incorporation.
  14. Promoter A person named as such in the prospectus or annual return, or who controls the company’s affairs, or on whose advice the Board is accustomed to act.
  15. Promotion The discovery of a business opportunity and the subsequent organisation of funds, property and managerial ability into a business concern for the purpose of making profits.
  16. Prospectus Any document described or issued as a prospectus, or any notice, circular or advertisement inviting offers from the public for the subscription or purchase of securities of a body corporate.
  17. Red-herring prospectus A prospectus that does not contain complete particulars of the quantum or price of the securities offered, which are settled after the offer closes.
  18. Shelf prospectus A prospectus valid for a period not exceeding one year, permitting a company to make more than one offer of securities without issuing a fresh prospectus for each.

8.13 Points To Ponder

  1. The memorandum is deliberately hard to alter, which gives outsiders certainty but can leave a growing company tied to objects it has outgrown. Where should the balance between stability and flexibility lie?
  2. A promoter who signs a contract before incorporation remains personally liable on it even though the work was done for the company’s benefit. Is it fair that the risk of the promotion falls on one person, and what would be lost if the company were bound automatically instead?
  3. A prospectus is required to disclose a great deal, yet most retail investors read only the abridged version, if that. Does longer disclosure actually protect investors, or does it mainly protect the company from later claims?
  4. If an issue falls a little short of the minimum subscription, the whole of the application money must be returned and a workable venture may never start. Consider whether this rule protects investors at too high a cost, or whether any relaxation would defeat its purpose.
  5. A private company with two members must complete much of the same formation procedure as a company intending to raise capital from thousands of investors. Should the formalities be scaled to the size of the company, and what would be the risk of doing so?
  6. Once the certificate of incorporation is issued, the regularity of the incorporation is not ordinarily open to challenge. Weigh the certainty this gives to people dealing with the company against the possibility that a company was registered on information that was not true.

8.14 Objective Questions

  1. Which of the following documents states the objects for which a company is formed? [1]
  1. Articles of association
  2. Memorandum of association
  3. Prospectus
  4. Certificate of incorporation
  1. Assertion (A): A promoter is not an agent of the company he promotes. Reason (R): A company cannot have an agent before it comes into existence. [1]
  1. Both (A) and (R) are true, and (R) is the correct explanation of (A).
  2. Both (A) and (R) are true, but (R) is not the correct explanation of (A).
    1. is true, but (R) is false.
    1. is false, but (R) is true.
  1. Match the stage in Column A with its description in Column B. [1]
Column A Column B
a. Promotion i. The business idea is discovered, investigated and given shape
b. Incorporation ii. The company is registered and receives its certificate
c. Capital subscription iii. The public is invited to subscribe and securities are allotted
d. Commencement of business iv. The declaration regarding subscription money and registered office is filed
  1. Fill in the blank: The least amount which must be raised by an issue of shares, and which is stated in the prospectus, is called the ______. [1]
  2. State whether the following statement is true or false: The articles of association may authorise a company to carry on an activity that is not covered by its memorandum. [1]

8.15 Check Your Concepts

  1. What is meant by minimum subscription, and what must a company do if it is not received within the prescribed period? [2]
  2. Distinguish between a shelf prospectus and a red-herring prospectus. [3]
  3. Why is a promoter said to stand in a fiduciary relationship towards the company being formed? Explain with an example. [3]
  4. Explain any four clauses contained in the memorandum of association of a company. [4]
  5. ‘A company may begin trading the moment it receives its certificate of incorporation.’ Evaluate this claim with reference to the stages in the formation of a company. [6]

8.16 Case-Based Questions

  1. Nandini and two associates decide to form a company to manufacture packaging material. Nandini commissions a market study, negotiates a lease for a factory site in her own name, appoints an auditor and a legal adviser, and files the required documents with the Registrar of Companies. The company, Vaayu Packaging Ltd., is registered and later refuses to take over the lease she negotiated, saying it was not a party to it.
  1. Identify the position Nandini occupies in the formation of the company and state any two functions she has performed in that capacity. [2]
  2. Explain why the company is not automatically bound by the lease, and state who remains liable on it. [2]