Directors’ authority – Michael Todd QC and Philip Gillyon of Erskine Chambers consider limits to directors’ ostensible or apparent authority following the Privy Council decision in East Asia Company Ltd v PT Satria Tirtatama Energindo.
The protection afforded by the law to innocent third parties is not without limits; and those limits were recently considered by the Privy Council in East Asia Company Ltd v PT Satria Tirtatama Energindo (Bermuda) [2019] UKPC 30 (Satria). In particular, the Privy Council was concerned with the extent to which a third party can rely on those protections having been ‘put on enquiry’.
Background
The law has always sought to protect the interests of an innocent third party. A bona fide purchaser for value without notice in real and personal property transactions has always taken free of any equity affecting the property or title to it.
In favour of an innocent third party, a transaction may be upheld, notwithstanding the absence of actual authority on the part of an agent (commonly, a company’s director or directors), where that agent had ostensible authority to enter into the transaction in question: Freeman & Lockyer v Buckhurst Park Properties (Mangal) Ltd [1964] 2 QB 480 at p505 per Diplock LJ. That authority derives from a representation made by the principal giving rise to an estoppel in favour of the innocent third party acting in reliance on it.
Similarly, an innocent third party is entitled to assume that acts within a company’s constitution and powers have been properly and duly performed: Royal British Bank v Turquand [1843-60] All ER Rep 435; (1856) 6 E & B 327 and Morris v Kanssen [1946] AC 459. This principle is generally referred to as the ‘indoor management rule’ or ‘the rule in Turquand’s case’.
What were the issues before the Privy Council in Satria?
In Satria the Privy Council was concerned with the validity, or otherwise, of an agreement for the sale by East Asia Company Ltd (EACL) of its only asset, being the whole of the issued share capital in Bali Energy Ltd (BEL), and of a share transfer implementing that agreement. The question of validity depended on whether the directors of EACL who effected the transaction on its behalf did so with the ostensible or apparent authority of EACL (it being accepted that those directors lacked actual authority to do so). The purchaser (PT Satria) sought, unsuccessfully, an order for the rectification of the register of members of BEL to show PT Satria as the holder of all of the issued shares in BEL, following the sale by EACL.
At first instance in the Supreme Court of Bermuda, Hellman J held that the directors had ostensible authority, but the Court of Appeal for Bermuda reversed that decision. The Privy Council decided, principally as a matter of fact, that the directors of EACL lacked ostensible authority; and that the share sale agreement and transfer were, therefore, not valid and binding on EACL.
The judgment of the Privy Council is of particular interest on two points:
(a) as a matter of law, what knowledge is required of, and what enquiry is required to be undertaken by, a third party who seeks to rely on (i) the ostensible authority of the agent of its counterparty so as to bind that counterparty to a contract or (ii) the indoor management rule in relation to the conduct of the affairs of that counterparty; and
(b) as a matter of fact, the extent to which PT Satria was entitled to rely on the indoor management rule to assume that the share sale had been validly agreed on EACL’s behalf in accordance with EACL’s bye laws.
The facts
EACL owned the entire issued share capital of BEL. BEL was EACL’s sole asset, and operated a geothermal energy production facility in Bali, Indonesia. Both EACL and BEL were incorporated in Bermuda as exempted companies. EACL had three directors: Edwin Joenoes (J), Ira Hata (H) and Kiyoshi Yamaura (Y). Y was a representative of EACL’s ultimate beneficial owner, Affluent Ocean Ltd (AOL). Y took no active part in the management of EACL. EACL’s constitution provided that (i) its business was to be managed by its directors, and (ii) decisions of its directors could be taken by resolutions of a simple majority of them.
BEL’s directors were J, H, Y and two others. The latter three were appointees of AOL. J and H were longstanding directors of BEL and its executive directors; the other three took no active part in BEL’s management. There was a series of attempts to alter the composition of the boards of directors of EACL and BEL, which reflected a power struggle between J and H on the one hand and AOL on the other.
In addition, BEL was insolvent. There was also evidence that EACL had outstanding liabilities which had to be met, and for which EACL had no funds. For some time, J and H on behalf of EACL had been trying to sell BEL, without success.
There had been earlier negotiations with PT Satria as a potential purchaser of BEL in 2011 and 2012, in the course of which PT Satria had conducted detailed due diligence, including considering EACL’s bye laws. Thereafter, there had been negotiations with another potential purchaser of BEL (PBS) in 2013 and 2014, with whom EACL had entered into Memoranda of Understanding (MoU). But, by early 2015 those MoU had lapsed and the need for funding was acute. Cash calls by BEL to EACL and by EACL to AOL went unanswered.
Negotiations with PT Satria resumed, conducted by J and H on behalf of EACL, and resulted in an agreement for the purchase by PT Satria of the entire issued share capital of BEL from EACL. The terms of the agreement were contained in Heads of Agreement (HoA), which were executed on behalf of EACL by J and witnessed by H as the chief executive officer of BEL. The share transfer was executed on behalf of EACL by J. In addition to providing for the sale of the shares in BEL, the HoA provided for payments to be made to J and H in respect of arrears of salary and rent. The HoA and share transfer were not formally approved at a quorate board meeting of EACL of which Y was given notice and were not executed on behalf of EACL with actual authority. However, they were approved by J and H who (to PT Satria’s knowledge from its earlier negotiations with EACL) were the two executive directors of EACL. None of the other directors of either EACL or BEL were aware of what was going on.
No ostensible authority
The Privy Council, applying the test in Freeman & Lockyer, held (at para 69) that J did not have ostensible authority to enter into the HoA on behalf of EACL, because (at paras 55-68):
(a) on the facts, EACL had not represented to PT Satria, either expressly or by conduct, that J or H had authority to act on its behalf in connection with the sale of the shares in BEL. This was not a case where the court should depart from the established general principle that an agent cannot by his own actions clothe himself with apparent authority (an argument which had not in any event been advanced by PT Satria before the Privy Council);
(b) it is well established that the indoor management rule does not permit a third party to circumvent the normal rules of agency. It cannot be used to create authority where none otherwise exists; it merely entitles an outsider, in the absence of anything putting him on enquiry, to presume regularity in the internal affairs of a company when confronted by a person apparently acting with the authority of the company (JC Houghton & Co v Nothard, Lowe & Wills Ltd [1927] 1 KB 246, at p266 and Akai Holdings Ltd v Thanakharn Kasikorn Thai Chamkat (Mahachon) also known as Kasikornbank Public Co Ltd [2010] HKCFA 64);
(c) it followed that, in the absence of any independently established apparent authority, the indoor management rule did not permit PT Satria to assume that EACL had exercised its power of delegation of authority to J; and
(d) in any event, PT Satria had not been able to establish that it had in fact relied upon any representation by EACL that J had authority to execute the HoA on its behalf; rather it had relied on the representations and assurances given by J himself.
Limitations on reliance on ostensible authority or the indoor management rule
EACL had also argued that PT Satria was put on enquiry as to whether J had authority to contract on EACL’s behalf and, having failed to make any adequate enquiries, could not rely upon the indoor management rule or upon J’s ostensible authority. The Privy Council noted that EACL’s contention in relation to ostensible authority gave rise to two questions:
(a) what the correct test was as regards the state of mind of the person alleging apparent authority. Was it, as EACL contended, sufficient that the person was put on enquiry or, as PT Satria contended, a person could rely on the apparent authority of an agent unless it knew of the agent’s lack of authority, was dishonest or irrational, or was reckless as to its belief or turned a blind eye; and
(b) whether, upon the application of the correct test, PT Satria was entitled to rely on any apparent authority of J.
The Court of Appeal had not considered it necessary to answer the first question, having found that J did not have ostensible authority. However, it had answered the second question. It found that if the correct test was that for which EACL contended then PT Satria could not rely upon any ostensible authority of J because it was put on enquiry. However, if the correct test was that contended for by PT Satria, it could rely upon any ostensible authority of J.
Although having reached the same conclusion as the Court of Appeal that J lacked ostensible authority, and therefore it was likewise not necessary for the Privy Council to decide the proper test, the Board nevertheless, thought it might be helpful to state its view.
Turquand
In Turquand, the deed of settlement allowed the directors to borrow on bond such sum or sums of money as shall from time to time, by a resolution passed at a general meeting of the Company, be authorised to be borrowed. A resolution, passed at a general meeting, authorised the directors to borrow on bond such sums for such periods and at such rates of interest as they might deem expedient. That resolution did not otherwise define the amount to be borrowed. The directors did not resolve on the amount to be borrowed, but authorised the execution of a loan agreement. Jervis CJ, giving the judgment of the court, said:
“We may now take for granted that the dealings with these companies are not like dealings with other partnerships, and that the parties dealing with them are bound to read the statute and the deed of settlement. But they are not bound to do more. And the party here, on reading the deed of settlement, would find, not a prohibition from borrowing, but a permission to do so on certain conditions. Finding that the authority might be made complete by a resolution, he would have a right to infer the fact of a resolution authorizing that which on the face of the document appeared to be legitimately done.” (emphasis added)
A third party may not rely on an agent’s ostensible authority where the third party is “put on enquiry” as to the agent’s lack of actual authority. Similarly, a person contracting with a company may not rely on Turquand if it is “put on enquiry” as to the internal irregularity in the company’s management: see Morris v Kanssen, p475-476. This raises the question as to: (a) what degree of knowledge constitutes the third party being “put on enquiry”; and (b) what enquiries must the third party undertake in order to be able to rely on agent’s ostensible authority.
The orthodox view, established by cases such as AL Underwood Ltd v Bank of Liverpool [1924] 1 KB 775, Houghton, Armagas Ltd v Mundogas SA [1985] UKHL 11, Criterion Properties Plc v Stratford UK Properties LLC [2004] UKHL 28, Wrexham Association Football Club Ltd v Crucialmove Ltd [2006] EWCA Civ 237 (see paras 76-82), is that a third party may rely on the ostensible authority of an agent provided that the third party makes the enquiries a reasonable person would have made in all the circumstances (in other words, if he is put on enquiry) to verify the agent’s authority.
A similar test for reliance on the indoor management rule is suggested in Morris v Kanssen, at p475 per Lord Simonds, and Rolled Steel Products (Holdings) Ltd v British Steel Corp [1986] Ch 246, at pp284-285 per Slade LJ.
However, a different test in respect of ostensible authority was accepted by a strong Hong Kong Court of Final Appeal in Akai, with the lead judgment given by Lord Neuberger. The test approved in Akai was that the third party could rely on the ostensible authority of the agent or the indoor management rule unless the third party knew of the agent’s lack of authority, was dishonest or irrational in his belief or turned a blind eye.
The Bank had contended that, unless it had actual knowledge of the agent’s lack of authority or its belief that the agent had authority was dishonest or irrational, or if it was reckless in its belief, or if it was guilty of turning a blind eye (on the basis that recklessness and blind eye ignorance amount to irrationality or dishonesty in this context), then its state of mind would suffice for the purpose of establishing apparent authority.
Akai had argued that approach set too low a standard on a third party seeking to establish apparent authority; and that apparent authority could not be relied on if the third party had failed to make the enquiries that a reasonable person would have made in the circumstances to verify the authority of the agent.
Whilst observing that he had some doubts as to the extent to which there would, in practice, be much difference in outcome between the application of the rival tests, Lord Neuberger said that “in a commercial context, absent dishonesty or irrationality, a person should be entitled to rely on what he is told: this may occasionally produce harsh results, but it enables people engaged in business to know where they stand”.
The test in Akai has been followed in a number of English authorities, including in the Court of Appeal (Quinn v CC Automotive Group Ltd (trading as Carcraft) [2010] EWCA Civ 1412). The Privy Council in Satria noted that Akai had been the subject of academic criticism and considered (obiter) that much of that criticism had considerable force (see Satria at para 85).
Although, as stated above, it was not necessary for the Privy Council in Satria to decide the proper test, it stated its view and rejected the more stringent test approved by the Hong Kong Court of Final Appeal in Akai in respect of ostensible authority. Thus, the same test of being ‘put on enquiry’ applied equally to both a third party who relied on ostensible authority and to one who relied on the indoor management rule (see Satria at paras 92 and 93).
On the facts, the Privy Council upheld the decision of the Court of Appeal that PT Satria was put on enquiry as to J and H’s lack of actual authority and the internal irregularities as to due authorisation and could not therefore rely on any ostensible authority of J or on the indoor management rule (at paras 94, 103 and 104).
Application of the indoor management rule to the facts in Satria
The judgment of the Privy Council in Satria appears to leave unanswered one question as to the application of the indoor management rule.
Having noted that the indoor management rule cannot be used to create authority where none otherwise exists, and having found as a matter of fact that EACL had not made any representation as to J’s authority to sell its only asset (namely, the shares in BEL), the Board held that the indoor management rule did not entitle PT Satria to assume that EACL had exercised its power of delegation under its bye law 46 to J (at paras 39 and 65).
However, leaving aside the power of delegation, the bye laws of EACL also provided that:
(a) the business of EACL was to be managed and conducted by the board of directors or by the directors present at a quorate board meeting;
(b) the quorum for a meeting of directors was two; and
(c) a resolution was carried by the affirmative votes of the majority of the votes cast by those present at a meeting of directors.
It follows that decisions of the directors of EACL could be taken by a simple majority of its directors. J and H were therefore able to resolve on behalf of EACL to sell the shares in BEL to PT Satria without requiring the agreement of Y, EACL’s third director. It is not entirely clear from the judgment of the Privy Council why PT Satria was unable to rely on the indoor management rule to assume that (a) J and H were duly authorised to approve, and (b) J was duly authorised to execute, the HoA and share transfer on EACL’s behalf as the majority of EACL’s directors.
After all:
(a) PT Satria knew from its earlier due diligence that EACL’s bye laws provided that resolutions at a board meeting could be determined by a majority (ie two out three) of its directors; and
(b) PT Satria was a third-party purchaser without knowledge of J and H’s lack of actual authority (ie without knowledge that the sale of the shares in BEL had not formally been approved by all the directors of EACL, including Y).
As to the first point, the Privy Council’s approach is of interest as it did not seem to consider it relevant that (as accepted by the Board and as set out above):
(a) BEL was insolvent, and there was also evidence that EACL had outstanding liabilities which had to be met, and for which EACL had no funds;
(b) for some time J and H, on behalf of EACL, had been trying to sell BEL, without success;
(c) there had been earlier negotiations with PT Satria as a potential purchaser of BEL in 2011 and 2012;
(d) thereafter, there had been negotiations with PBS in 2013 and 2014, with whom EACL had entered into MoUs, which subsequently lapsed;
(e) by early 2015 the need for funding was acute; cash calls by BEL to EACL and by EACL to AOL went unanswered; and
(f) EACL had no other means of raising funds, other than by realising its assets.
The Board, nevertheless, thought that the sale of the shares in BEL was a transaction of an exceptional nature, even though, as the Board accepted, the interests of creditors would almost certainly have intruded. The intervention of creditors’ interests was analysed in BTI 2014 LLC v Sequana SA [2019] EWCA Civ 112, at para 222 (see FC Case Feature 22 March 2019) (although that decision was not cited to, or expressly referred to by, the Board in Satria).
As to the second point, the Privy Council found that J and H were under an obligation to make full disclosure to EACL and BEL of all the material circumstances relating to the HoA; and their failure to do so meant that they were in breach of the duties which they owed to both companies and were thereby disqualified from voting at the meetings which purported to ratify the HoA and approve the share transfer, meaning that those meetings were inquorate (at para 101). It is not entirely clear why declarations of interest are not matters of internal management, in respect of which a third party would be protected by the indoor management rule.
Comment
The decision of the Privy Council in Satria is not binding in cases before the courts of England and Wales, but it will clearly be persuasive.
As regards the knowledge of a third party who seeks to rely on the ostensible authority of an agent to bind its principal to a contract and the extent of the enquiries expected of the third party who seeks to rely on ostensible authority, Satria rejects the narrower formulation of the test set out in Akai in favour of the orthodox test: ie the third party will need to show that it made the enquiries that a reasonable person would have made in all the circumstances to verify the agent’s authority.
Similarly, as regards the indoor management rule, Satria illustrates a restricted application of the rule: a third party who contracts with a company will only be able to avoid the consequences of irregularities in internal management of the company provided that it is not ‘put on enquiry’ as to those irregularities, meaning that the third party must have made the enquiries that a reasonable person would have made in the circumstances.
It is worth noting that, in a case governed by English law, the indoor management rule is likely to be of less significance as a third party dealing with a company would rely on s 40 CA 2006, under which the power of the directors to bind the company, or authorise others to do so, is deemed to be free of any limitation under the company’s constitution.
Further, the approach of the Privy Council as to what transactions are exceptional and outside the scope of directors’ ordinary management powers is of interest.
This case feature was first published in FromCounsel‘s Corporate Briefing on 25 September 2019.
