Opinion: Indoor management rule overlooked in Necta and John Ndyabagye vs Crane Bank Limited case

By Mwesigwa Onesmus

 The court of Appeal, Uganda’s second highest court has held that financial institutions such as banks or any person lending money to a company are required to scrutinize the Memorandum & Articles of the borrowing company and sufficiently acquaint itself with its demands in Necta (U) Ltd & John Ndyabagye Vs Crane Bank Limited- Court of Appeal Civil Appeal No. 219 of 2013.

The decision of the court overlooks the application of a settled common law principle; the “indoor management rule” thereby raising an interesting point that an apparent illegality on the part of the borrower is decided in the borrower’s favour.

Background

The Respondent advanced to the second Appellant (John Ndyabagye) an overdraft facility of UGX 70,000,000. The first Appellant company (Necta (U) Ltd) bound itself surety in regard to the overdraft facility advanced to John Ndyabagye who was a shareholder and director of the company. The board resolution pledging the company property as security to the overdraft was signed by John Ndyabagye and his wife, as director and secretary of Necta (U) Ltd respectively.

The Respondent later advanced an additional overdraft facility which it later froze, demanded payment from the second appellant, went ahead to advertise the said mortgaged property and eventually sold it.

The Appellants instituted a suit against the Respondent challenging the legality of the mortgage and validity of the subsequent sale of the property. The Trial Court ruled in favour of the Respondent holding that the sale of the mortgaged property to have been valid.

Dissatisfied with the Trial Courts’ decision, the Appellants lodged an appeal to the Court of Appeal.

Litigants’ Arguments

The gist of the appeal was founded on the first ground of appeal; that the learned trial judge erred in law and fact in holding that a resolution in the hands of the Directors’ was a valid resolution of the appellant.

The Appellants’ argument was that the company’s memorandum and articles of association (MEMARTS) required a board resolution to be evidenced in writing under the hands of all directors. They argued that the board resolution relied upon by the Respondent to issue the credit facility was only signed by the second Appellant as chairman and his wife Elizabeth Ndyabagye as secretary contrary to the company’s MEMARTS and thus invalid.

The Respondent in response argued that the company’s MEMARTS empowered the board of directors to borrow and mortgage its property as security and that since the said board resolution was drawn on the first Appellant’s letter head, signed by its Chairman and Secretary, it was thus valid.

Court of Appeal Judgement

The Court of Appeal found that whereas the MEMARTS of the company allowed the company to mortgage its property as security, and whereas there was a special resolution pledging the company’s property as security, the resolution was invalid on the basis that it was not signed by all directors as required by the company’s MEMARTS.

 

The court further held that the Respondent had not showed proof of due diligence to sufficiently acquaint itself with the demands of the Appellant’s MEMARTS. The court found that the Appellants had successfully proved that the special resolution submitted by themselves was invalid.

Analysis of the decision 

The decision on the Court of Appeal in principle is a departure from a settled common law principle; ‘the indoor management rule’  that was long settled in the case of Mahony v East Holyford Mining Co(1875) LR 7 HL 869 by the House of Lords.

In Mahony case, the court held that; “when there are persons conducting the affairs of the company in a manner which appears to be perfectly consonant with the articles of association, those so dealing with them externally are not to be affected by irregularities which may take place in the internal management of the company”.

The rule has been adopted by many commonwealth jurisdictions and in particular codified in Uganda’s Companies Act, 2012. Section 53 of the Act provides that; a party to a transaction with a company is not bound to enquire whether it is permitted by the company’s memorandum or as to any limitation on the powers of the board of directors to bind the company or authorize others to do so.

 In CTM Uganda Limited v Allmuss Properties Uganda Ltd, Italtile Ceramic Limited, Italtile Limited Misc. Application No.  806 of 2015 (Arising from HCCS No. 467 Of 2013), the High Court held that; people transacting business with companies are entitled to assume that internal rules are complied with even if they are not. Under the Indoor Management rule, the Company’s indoor affairs are the Company’s problems.

In this case, two of the company’s officials, it’s director and secretary prepared a board resolution pledging its property as security to secure an overdraft facility. Upon the Respondent bank advancing the overdraft facility and the second Appellant failing to make payment, the same Appellants argued that the company resolution was invalid.

It is for such circumstances that the indoor management rule becomes very useful by protecting persons dealing with companies from irregularities perpetuated by the company itself through its management.

The Court of Appeal in the instant case did not make reference to section 53 of the Companies Act because it came into force after the enactment of the current Companies Act of 2012 which was not in force at the time of filing this suit. This notwithstanding, the Court having acknowledged that the second Appellant’s gerrymandering with corporate authority contributed to the defects in the mortgage transaction ought to have upheld the application of the indoor management rule at common law.

A further consideration by the Court of article 126(e) of the Constitution of Uganda which provides that substantive justice shall be administered without undue regard to technicalities should have sufficed. In Horizon Coaches V Edward Rurangaranga & Mbarara Municipal Council SCCA No. 18/2009 (unreported), the court held that; where the effect of adherence to technicalities may have the effect of denying a party substantive justice, the Court should endeavor to invoke that provision of the Constitution. The Respondent in this case was demonstrably prejudiced by the Court’s strict adherence to a technicality moreover orchestrated by the Appellants themselves.

Had Court considered the indoor management rule at common law, reflected on section 53 of the Companies Act, 2012 and article 126(e) of the Constitution of Uganda, the learned Justices of the Court of Appeal could have perhaps come to a different conclusion.

Conclusion

I fault the Court for delving into technicalities rather than dispensing justice. This decision therefore creates ambiguity on the application of the indoor management rule now codified under section 53 of the Companies Act, 2012.

Financial institutions such as banks and other credit institutions if bound by this decision shall be required to perform sufficient due diligence of company articles and memorandum of association and not merely relying on companies’ board resolutions before advancing them credit and ensure that all demands are met.

 Mwesigwa Onesmus  is an Advocate at Birungyi, Barata & Associates