PURCHASER OF UNDERTAKING OR GREATER PART OF ASSETS OF COMPANY MUST ENSURE THAT RESOLUTION OF SHAREHOLDERS IS PASSED – BY FEMIDA CASSIM

Friday, July 09, 2004
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Introduction
In Farren v Sun Service SA Photo Trip Management (Pty) Ltd [2003] 2 All SA 406 (C) the High Court held, for the first time, that an agreement of sale of the sole asset of a company was unenforceable because the director of the company had not obtained the approval of the members of the company as required by section 228 of the Companies Act 61 of 1973.  The purchaser’s application to compel performance of the contract was accordingly dismissed.  This case followed much debate on the consequences of non-compliance with section 228 of the Companies Act.  The court chose not to follow the contrary views expressed obiter in Levy and Others v Zalrut Investments (Pty) Ltd 1986 (4) SA 479 (W) at 487.  Perhaps surprisingly, the court also refrained from continuing what appears to be the current trend of broadening the scope of the Turquand rule, which was extended to apply to transactions between trusts and third parties in MAN Truck & Bus (SA) Ltd v Victor en Andere 2001 (2) SA 562 (NC) and in the more recent case of Vrystaat Mielies (Edms) Bpk v Nieuwoudt en ’n Ander NNO 2003 (2) SA 262 (O). 
 
Farren’s case serves to emphasise that even bona fide purchasers of the company’s undertaking or greater part of the assets of a company must ensure that the shareholders of the selling company have passed an ordinary resolution approving the sale, failing which the agreement of sale will be unenforceable, to the obvious detriment of the innocent purchaser.  It is submitted that although Farren’s case was in my view correctly decided, the outcome is somewhat unsatisfactory, and calls for legislative amendment.
 
Section 228 of the Companies Act
Section 228 provides that “[n]otwithstanding anything contained in its memorandum or articles, the directors of a company shall not have the power, save with the approval of a general meeting of the company, to dispose of - (a) the whole or substantially the whole of the undertaking of the company; or (b) the whole or the greater part of the assets of the company” and that “[n]o resolution of the company approving any such disposal shall have effect unless it authorizes or ratifies in terms the specific transaction.”  The judicial interpretation of the phrase the “greater part of the assets of the company” is that it is a question of fact, and a test of value or market value, in the sense of the price of the relevant assets in a bona fide sale between willing parties who are both reasonably well informed about the transaction, neither of whom is under extraordinary pressure to conclude the transaction. 
 
Thus section 228 is quite clear in its requirements but the section is silent on the consequences of non-compliance - in other words, if the directors of a company for example, enter into an agreement to dispose of all the assets of the company without the requisite approval of a general meeting of the company, what are the consequences for the innocent purchaser who is unaware of non-compliance with section 228, and for the shareholders of the company?  There are two possibilities in this regard.  Either the view in Farren’s case is adopted, namely that the agreement is unenforceable and that the Turquand rule is inapplicable to section 228, or alternatively, the view supported by Levy’s case, that, due to the application of the Turquand rule, the agreement remains enforceable by the innocent third party purchaser. 
 
The Turquand Rule
The Turquand rule or the “indoor management” rule is a rule of our common law.  It was developed to temper the application of constructive notice.  Constructive notice is a doctrine in terms of which a person dealing with a company is deemed to have knowledge of the contents of the memorandum and articles of association of the company and of special resolutions, as these are documents which are registered at the office of the Registrar of Companies and Close Corporations, and are open for inspection by members of the public.  Accordingly a purchaser dealing with a company is assumed to have knowledge of the procedures and formalities laid down in the company’s memorandum and articles.  However such a person is not deemed to have knowledge of whether these procedures and formalities were in fact complied with by the company, as a matter of internal management (since no publicity is given to their compliance or non-compliance).  The Turquand rule thus states that a person dealing with a company in good faith may assume that internal formalities within its constitution have been properly performed, and is not bound to enquire whether acts of internal management have been regular.  The rule therefore limits the enquiries that a person dealing with a company is obliged to make, and the justification behind it appears to be business convenience.   
 
The question which arises in the context of section 228 (and which arose in Farren’s case) is whether the Turquand rule applies to section 228.  In other words, is the passing of a resolution in terms of section 228 (which is an ordinary and not a special resolution and therefore not registered at the Companies Office) an internal formality or act of management of a company, which a purchaser is entitled to assume has been properly passed? 
 
Farren’s case
Briefly, the facts of Farren’s case were as follows.  Farren entered into an agreement of sale with a company, in terms of which the company sold its sole asset to Farren.  The agreement was signed of behalf of the company by its sole director, Klages, who held a very small interest in the company.  Klages then refused to perform the agreement on the ground that no resolution in terms of section 228 had been passed by the shareholders of the company, prompting Farren to apply to court for an order of specific performance.  The High Court held that the fact that the agreement had not been approved by the shareholders did not make it void or invalid, but made it unenforceable.  The court consequently refused to order the company to transfer the property to Farren.       
 
The issue turned crisply on the interpretation of section 228 and the intention of the legislature (which is a key approach to statutory interpretation).  It is generally accepted that the intention behind section 228 is to protect the shareholders of a company by limiting the powers of the directors of the company in respect of the disposal of the whole or greater part of its undertaking or assets.  The court stated that if the Turquand rule were to apply to section 228, implying that an innocent purchaser could assume that a resolution in terms of section 228 had been passed, this would nullify the protection of the shareholders, since the assets of the company could then be sold without their approval.  Accordingly the court ruled that this could not have been the intention of the legislature in enacting section 228, and therefore that the Turquand rule was inapplicable to section 228.  The court further ruled that the fact that the provisions in question were embodied in a statute gave them far more weight than if they were to be embodied in the constitution of the company. 
 
The court in Farren’s case declined to follow the strong view advocated in passing in Levy’s case that an innocent purchaser would “undoubtedly be able to enforce such [a] transaction” (based on the reason that there was no indication that public interest or policy played any part in the legislature’s intention in drafting section 228;) and that this would be in accordance with the Turquand rule. 
 
Evaluation of the legal position
Were Levy’s case to be followed, the innocent third party would be protected and the interests of business convenience would be served.  The shareholders of the company would not be left without a remedy in that scenario, as they would have an action against the directors for breach of fiduciary duty in exceeding the limits of their authority.  It must, of course, be borne in mind that the decision in Farren’s case was a decision of the Cape Provincial Division and that the matter has not yet been finally settled by the Supreme Court of Appeal. 
 
Nevertheless, it is respectfully submitted that the reasoning of the court in Farren’s case was correct.  The fact that the approval of a general meeting of the company is required not by the articles of association of a company but by statute, is a sound reason for affording it greater weight.  A reasonable purchaser of the whole or major portion of the undertaking or assets of a company would as a matter of course be aware of the requirement for a section 228 resolution, and the application of the doctrine of constructive notice to create deemed knowledge is unnecessary.  In any event, it is arguable that the Turquand rule, according to its original formulation in Royal British Bank v Turquand (1856) E&B 248 (119 ER 474), applies to acts of internal management “within [the company’s] constitution.”  Since a resolution in terms of section 228 is not within (or solely within) a company’s constitution, but is instead embodied in statute, the Turquand rule should not apply to it.    
 
Although it is my view that Farren’s case was correctly decided, the outcome is not ideal, hardship being imposed on innocent purchasers.  It is arguable that the innocent purchaser has a remedy against the responsible directors, on the basis of breach of implied warranty of authority or misrepresentation.  The lesson to be learned from Farren’s case is that a purchaser of the undertaking or assets of a company must enquire whether the subject matter of a disposal constitutes the whole or substantially the whole of the undertaking or the whole or greater part of the assets of the company, and if it does, whether a resolution in terms of section 228 has been passed, on pain of finding the agreement to be unenforceable. 
 
It appears that the legislature may not have realised the full implications of section 228 for the innocent purchaser or the shareholders of a company, as pointed out by the Van Wyk de Vries Commission of Enquiry into the Companies Act.  Section 228 appears to be another aspect in which the Companies Act, 1973, is flawed, and it is to be hoped that this will be addressed in the new draft of the Companies Act.           
 
Femida Cassim