CHAPTER 29 Formation of a C

There are four broad stages involved in the formation of a comp

Learning Objectives

Promotion

Process OfFormation of a
Company
The whole process of formation of a
joint stock company (in India) can be
divided into three broad stages,
namely:
1. Promotion
2. Incorporation
3. Capital formation
4. Management

PROMOTIONSTAGE Promoter -Sec-2(69)

Promotion refers to the entire backing process by which a company is
brought into life. It begins with the conceptualization of the birth of a
company, and sets out the purpose for which it is to be formed. The
persons who conceive the idea to form a company and invest the initial
funds are known as promoters of the company. The promoters enter into
preliminary contracts with vendors and make arrangements for the
preparation, advertisement and the circulation of the prospectus, and
arrangement of necessary capital.
Promoters occupy fiduciary position (a position based on trust and
confidence) in the company. Accordingly, they have some basic duties
towards the company listed as follows:
They should not make any profits secretly at the expense of the
company, they promote. Promoters may, however, make profits in their
dealings with the company provided they disclose them to the company.
They should make full disclosure to the independent Board of directors,
or in the prospectus of all material facts relating to the formation of the
company including, of course, any profits made by them in transaction
with the company.

Promoters Remuneration
A promoter besides being reimbursed for his preliminary expenses
or registration fees may be rewarded by the company for the
efforts undertaken by him in forming the company in several ways
under a valid contract. The more common ones are:
1. The company may pay him a lump sum for the services rendered.
2. The promoter may make profits on transactions entered by him
with the company after making full disclosure to an independent
Board of directors or to the intended members.
3. The promoter may sell his own property to the company for cash
or against fully paid shares in the company at an overvaluation
after making full disclosures.
4. The promoter may be given an option to under right issue of the
company and earn commission thereon.
5. The articles of the company may provide for a fixed sum to be
paid by the company to the promoters. However, such a provision
has no legal effect, and the promoters cannot sue to enforce it.

Promoters Liability.
In case of default by a promoter in fulfilling his/her duties, the company
may rescind the contract, and if the former has made some profits on any
related transaction, s/he may be compelled to account for it. If it is not
possible to cancel the contract or where the promoter has already
encashed the secret profits, the company can sue him/her for breach of
trust. Damages up to the difference between the market value of the
property and the contract price can be recovered from the promoter
where s/he had sold his/her own property to the company.
The promoter is also liable for mis-statements made in the prospectus, if
any. A person who subscribes for any shares or debenture (i.e., original
allottee only) in the company relying on the mis-statement in the
prospectus can sue the promoter for the loss or damages sustained by
the former as the result of such untrue statement leading to FRAUD. As
per Section 34 of the Companies Act he may be punishable u/s 447
which states imprisonment for a term not less than 6 months which
may extend to Ten years or with fine which may not be less than the
amount involved in the fraud which may extend to three times the
amount involved in the fraud , or with both, unless the promoter proves
either that the statement was immaterial or that s/he had reasonable
ground to believe that the statement was true.

INCORPORATION
Incorporation is the foremost obligation to be fulfilled to form any
type of company under the Companies Act. For a company to be
incorporated, it must be registered with the Registrar of
Companies (ROC). Registration or incorporation of a company is a
procedure which is filled with documentary compliance formalities.
An application in FORM INC-1 needs to be filed with the ROC of the
state, in which the Registered Office of the proposed company is to
be located to obtain a name.
Within 60 days of the name made available by the ROC the
promoters shall file the following documents with the ROC
INC-7 (INC-2 for OPC)
MoA & AoA
INC-8Declaration
by
the
Practicing
CS/CA/Director/Advocate
INC-9-Affidavit by the subscribers to the Memorandum
INC-22 Verification of the regd. Office within 30 days of
incorporation
INC-7 Particulars of subscribers
DIR-12- Particulars of Directors
A power of Attorney in favour of the professional to carry out

.INCORPORATION

The ROC on registration of the

company will issue a Corporate
Identification Number(CIN) in favour
of the company along with the
certificate of incorporation.
Certificate
of
Incorporation
or
Registration is the conclusive evidence
of the fact that the company has been
incorporated fulfilling all the formalities
under the Act, after which the company
becomes a legal entity.

Memorandum of Association{Sec-2(56)}

The Memorandum of Association is the most important

document to be filed by any proposed company. It sets out the
constitution of the company and specifies its relationship with
the outside world. It also states the authorized share capital of
the proposed company and the names of its first/permanent
directors. The Sec-4 of the Act specify the contents of the
Memorandum .
It defines the scope and limitations of the projected company.
It is considered as an unalterable charter of the company. It is
very difficult to change or amend the Memorandum of the
company because it defines certain powers, the company
cannot go beyond.
The Memorandum becomes a public document as soon as the
company gets registered.
Memorandum forms the outer framework within which the
company operates. ( Laxman Rekha )
Contd.

.Memorandum of Association: Contents

The Memorandum of a limited company can be divided into six distinct
clauses:
1. The nameclause.The name clause contains the name of the company
which is of considerable importance as it establishes a companys identity.
A public company limited by shares or by guarantee must end with the
word 'Limited' and a private limited company must end with the words
'Private Limited'. The company cannot have a name, which in the opinion of
the Central Government is undesirable [Section 20(1)]. A name which is
identical with or nearly resembles the name of another company in
existence will not be allowed [Section 20(2)]. Moreover, a company cannot
use a name which is prohibited under the Names and Emblems (Prevention
of Misuse) Act, 1950 or use a name reflective of connection to government
or state patronage. A company can , however, change its name by passing
a special resolution.
2. Registeredofficeclause/Situation Clause.The state in which the
registered office of a company will be situated is mentioned in this clause.
The registered office of the company is the official address of the company
where the statutory books and records must normally be kept. The notice of
exact location (address) in INC-22 must be given to the ROC within 30 days
from the date of incorporation of the company. Similarly, any change in the
name of the state in which registered office was situated earlier must also
be intimated in Form INC-23 to the Regional Director within 30 days of
incorporation. A special resolution is required for this and MGT-14 has to be
filed for this with the RoC
Contd.

.Memorandum of Association: Contents

3. Objectsclause. This is the most important clause of a company. It

defines the activities which a company can carry on and those, it cannot.
This clause must state:
Main object(s) of the company to be pursued by the company
upon
its incorporation and other objects required for furtherance of the same.
It is the Laxmana Rekha for the company beyond which it cannot ordinarily
traverse. For alteration by way of addition or deletion of any clause a
Special resolution is required. Form MGT-14 is to be filed with RoC
4. Liability clause.
This contains the nature of the liability of the
members. A declaration that the liability of the members is limited, in case
the company is limited by shares or guarantee, must be given under this
clause. The memorandum of a company limited by guarantee must also
state the amount that each member undertakes to contribute to the assets
of the company in the event of its being wound-up.
Contd.

.Memorandum of Association: Contents

5. Capital clause. This clause states the amount of

share capital with which the company is to be
registered is divided into numbers of shares of a
fixed amount. A company cannot issue share
capital greater than the maximum amount of share
capital stated in this clause called the Authorised
Capital without altering the memorandum.
For altering this clause by way of increasing or
reducing the authorised capital would require an
Ordinary or Special resolution respectively. For
reduction , approval of the High Court is also
necessary beside the special resolution.

Articles of Association{sec-2(5)}

The Articles of Association is the main instrument which contains the rules
and regulations for the internaladministrationofthecompany. Articles
govern the conduct of a companys business by specifying the rights and
duties of its members and directors.
Contents. As per Sec 5(1) The items usually covered by the articles of
association include:
1.
Powers, duties, rights and liabilities of directors
2.
Powers, duties, rights and liabilities of members
3.
Board of Directors
4.
Rules for meetings (AGM, EGM, Board )of the company;
5.
Dividends and reserves;
6.
Borrowing powers of the company;
7.
Various matters on issue, Calls , transfer, buy-back ,forfeiture of Shares;
8.
Alteration of capital; Capitalisation of Profits
9.
Dematerialisation of shares, conversion to stock etc;
10. Transfer & transmission of shares;
11. Forfeiture of shares ;
12. Surrender of shares;
13. Voting powers of members;
14. Key Managerial Persons
15. Accounts and audit , and Audit Committee;
16. Winding-up, etc.

.Articles of Association
Model form of articles. Normally, every company drafts its own
articles. However, a company may adopt any one of the model forms of
articles, with or without modifications, specified in Tables F, I, J of
Schedule I to the Act, as applicable. If a company limited by shares
does not have its own articles, the model set of 30 articles given in Table
F can be adopted. Whereas Table I is applicable to unlimited companies
having a share capital and Table J for an unlimited liability company not
having a share capital .
Alteration of Articles. Sec-14 : A company can alter or amend any of
the provisions of its articles subject to provisions of the Act and subject to
the conditions contained in its Memorandum. A company by a special
resolution can alter its articles provided the said resolution is passed
bona fide for the benefit of the company. An alteration of articles can be
effected by a 3/4th majority of the shareholders but can be challenged on
the ground that the alteration was not in the interest of the company.
Furthermore, such alteration should not have the effect of converting a
public co. into a private co. without the approval of the Tribunal. The
amendment cannot exceed the powers given by the MoA. It is always
subordinate to the MoA as well as the Companies Act. It also cannot
insert a clause that no amendment of the AoA can be effected

Doctrine of Ultra-Vires

1.
2.
3.
4.

The word ultra means beyond, and vires means the powers. The Latin term
ultra-vires therefore means to describe an act which is beyond the powers.
Any transaction, which is not set out in the object clause of the companys
memorandum, and is not necessarily or reasonably incidental to the
attainment of the object(s), is ultra-vires the company and therefore void
(i.e., of no legal effect).
Consequences of an ultra-vires Act
As stated earlier since an ultra-vires act is devoid of any legal effect:
The company cannot sue any person for enforcement of any of its rights
and vice versa.
The directors of the company may be held personally liable to outsiders for
an ultra-vires act.
Exceptions. However, the doctrine of ultra-vires does not apply in the
following cases:
If an act is ultra-vires of directors powers but intra-vires of company, the
company can ratify the same and make it valid.
If an act is ultra-vires the articles of the company but it is intra-vires of
the memorandum, the articles can be altered to rectify the error.
If an act is within the powers of the company but is irregularly done,
consent of the shareholders will validate it.
Where there is ultra-vires borrowing by the company or it obtains delivery
of the property under an ultra-vires contract then the third party has no
claim against the company on the basis of the loan but it has a right to

Doctrine of Constructive Notice

Under Section 399 of the Act-2013, both memorandum of association
and the articles of association are public documents. Once these
documents are registered with the registrar of companies, these are
accessible by any member of the public by paying the requisite fees.
Therefore, notice about the contents of memorandum and articles is
said to be within the knowledge of both members and non-members
of the company. Such notice is a deemed notice in case of members
and a constructive notice in case of non-members.
Thus, every person dealing with the company is deemed to have
knowledge of the contents of the memorandum and articles of the
company. An outsider dealing with the company is presumed to have
read the contents of the registered documents of the company. The
further presumption is that he has not only read the documents but
has also understood them fully in proper sense. This is known as
the rule of constructive notice. So, the doctrine or rule of
constructive notice is a presumption operating in favour of the
company against the outsider. It prevents the outsider from alleging
that he did not know that the constitution of the company rendered a
particular act or a particular delegation of authority ultra-vires.

Doctrine of Indoor Management

The doctrine of indoor management or internal management of companys affairs is an
exception to the rule of constructive notice and imposes an important limitation on it.
According to this doctrine persons dealing with the company are entitled to presume that
internal requirements prescribed in the Memorandum and Articles have been properly
observed. The Doctrine is partly dictated by practical necessity - persons contracting with a
company are not expected to spend their time checking that any required resolution has
properly been passed, that meetings have been duly convened by directors whose
appointments have been duly made. They can presume that all that is being done regularly and
in keeping with the memorandum and articles.

The Indian courts have been

applying the doctrine of indoor management quite frequently and interpreting it
according to cases in hand.The object being the same i.e., to protect the third
party transacting with the company in good faith and being unaware of the
complex internal management of the company.
In Monark Enterprises vs Kishan Tulpule and Ors, the Company Law Board (now
NCLT) held :- That the validity of the impugned transaction was not affected
even if no resolution for entering into it was actually passed by the board of the
company as the company had entered into and adopted the transaction
throughout and implemented it after receiving consideration thereof. The
doctrine of indoor management protected the transferee and the transferor.
The Royal British Bank v Turquand : Directors of a banking company were
authorised by the Articles to issue Bonds for borrowing money by passing
resolution of the company. But the Directors issued Bonds to Turquand without
the resolution of the company. It was held that Turquand has right to sue for
money and will succeed as he is not supposed to know about the internal
resolution.
Implications of the Doctrine of Indoor Management: .

.Exceptions to the Doctrine of Indoor

Management
The doctrine of indoor management is subject to the following exceptions:
1.Knowledge of irregularity If a person dealing with a company has actual or
constructive notice of the irregularity as regards internal management, he cannot seek
benefit under the doctrine. He may in some cases be himself a part of the internal
procedure.
2. Negligence
The protection under the doctrine is also not available when the
circumstances surrounding the contract are so suspicious as to warrant inquiry, and the
outsider dealing with the company does not make proper inquiry.
3.Forgery The doctrine does not apply where a person relies upon a document that turns
out to be forged since nothing can validate forgery. A company can never be held bound
for forgeries committed by its officers.
4. Acts outside the scope of apparent authority If an officer of a company enters into
a contractwith a third party and if the act of the officer is beyond the scope of his
authority, the company is not bound. The plaintiff can sue the company only if the power
to act has in fact been delegated to the officer with whom he entered into the contract.
Thus, the doctrine of indoor management seeks to protect the interest of the shareholders
who are in a minority, or who remain in dark about whether the working of the internal
affairs of the company are being carried out in accordance with the memorandum and
articles.It is important to note that the doctrine of constructive notice can be invoked by
the company and it does not operate against the company. It operates against the person
who has failed to inquire but does not operate in his favour. Similarly, the doctrine of
indoor management can be invoked by the person dealing with the company and cannot
be invoked by the company.

Certificate of Incorporation
Once all the required documents have been filed along with
the registration fee, filing fee, stamp duty, as specified and
they are found to be in order, the ROC will issue, under his
seal and signature, the Certificate of Incorporation of the
company. The certificate of incorporation is the conclusive
evidence that the requirements of the Companies Act have
been complied with and the company bearing a specific
name with a specific number called the Corporate
Identification Number(CIN) is duly registered.
This document is the birth certificate of the company and is
the proof of the existence of the company. Once this
certificate is issued, the company cannot cease its
existence unless it is dissolved by order of the Court or
otherwise.
On obtaining the incorporation certificate a company is
eligible to carry out its business immediately..

RAISING/FLOTATION OF CAPITAL
Public companies generally wish to transact business by
raising capital from the public. The process of raising
capital from the public is carried out in this stage.
For the purpose of raising capital from the public, the
company needs to prepare and issue a document known
as Prospectus Sec-25 of the Act 2013. Sec-26
stipulates matters to be stated in the prospectus. It
includes a report from an Expert inter-alia other
stipulations.
Dematerialisation of shares is a must- sec-29
Shelf Prospectus sec-31 :- It is issued in respect of
securities that will be raised in one or in more
installments without further Issue of Prospectus
Red-Herring Prospectus Sec-32 :- Which does not
include complete particulars of the quantum or the
price of thee securities included therein.

Prospectus
Sec-23 to 42 of the Act 2013 deals with it.
Part I deals with Public Issue
Part-II deals with Private Placements; Subrat
Ray case in the Sahara Issue
It has to reveal the names of the Directors,
objects of the company, purpose of the funds,
names of CFO, CS, Legal Advisors, Bankers,
Auditors and the Risk factors for the company.
The prospectus must be submitted to the RoC
for registration before the same is published in
the media. This must be specified in the front
page of the advertisement that the prospectus
has been filed with the RoC.

Other Formalities Before or After Incorporation

Besides categorically meeting the terms of the above discussed

procedure to form a company, there are some other formalities
which must be fulfilled by every company before or after obtaining
the certificate of incorporation to carry out its operations smoothly.
These include the following:
1.
2.
3.
4.
5.

Obtaining a Permanent Account Number (PAN) from the Income

Tax Department.
Complying provisions of Shop and Establishments Act, if
required.
Registration for Import Export code from Director General of
Foreign Trade, if required.
Software Technologies Parks of India registration (STPI) if
required.
RBI approvals, if required.

Share Capital

Two types : Equity & Debt

Owners capital- Equity shares
Borrowed Capital which is called the
Debt
Kinds of Share Capital: sec 60
Authorised Capital
Issued Capital
Subscribed Capital
Paid up capital

Debt Capital

Preference Shares: Un secured

Creditors
Debentures : Bond Holders creditors
Loans and Borrowings : Creditors
( secured or un-secured)

Types of Preference Shares

Based on redeemability Redeemable
Pref shares and Irredeemable pref
shares not allowed . It has to be
redeemed by 20 years max
Based on Cumulative dividends; The
dividend which is fixed in the preference
shares may accumulate for more than
one year. If it is not paid for three
consecutive years they get the right to
attend the meetings of the shareholders
which they are usually not entitiled.

Types of Issue of Equity Shares

Initial Public Offers: IPO
Further Public Offers : FPO
Rights Issue: Sec-62- Option to existing share
holders to subscribe to new shares.
Bonus Issue :Sec-63- Fully paid up shares issued to
the existing share holders
Sweat
Equity:
Sec
2(88)
Issued
to
the
Directors/Employees at a
discount
or for
consideration other than cash- for their contribution
in technology, know-how, value addition to the
company by Intellectual property etc
Employee Stock Option Scheme :ESOP: sec62(1)(b)

Types of Debentures
On convertibility basis : Non
convertible , Partly convertible, Fully
convertible, Optionally convertible
On security basis : Secured and Nonsecured debentures
On redeemabilty basis : Redeemable
and Perpetual or Non-redeemable
Debentures (not allowed)
On Registration basis : Registered and
Bearer debentures

Alteration of share capital

It can be both way : Increase or decrease
and sub divided or consolidated.
Increase of authorised Capital : Requires
BoD approval and an ordinary resolution of
the members
Reduction of the Authorised Capital: Sec-66
requires BoD approval, Special Resolution of
the members and approval of the Tribunal
Diminution
of
capital;
Sec-61(1)(e):
Company may cancel the unsubscribed part
of the capital by an ordinary resolution

Shares and Stocks

Stocks are fully paid up shares and
consolidated into a stock for which it
does not have a nominal value.
Stocks held by different persons may
have different denominations.
Stocks can be broken /split into any
value unlike a share