Novation of Contract

‘P’ Co. Ltd. is a company registered under the Companies Act, 1956. It intends to take over the business of a ‘Partnership Firm’, including its liabilities. The partners of the firm are positive to the idea. The liabilities of the firm also include a loan from Bank.

In this connection, the following Issues arise for consideration:

1. Must the Bank’s consent be obtained to effectuate the transfer of the firm’s business to ‘P’ Co. Ltd.?

2. Whether the Bank is required to enter into a fresh agreement with ‘P’ Co. Ltd.?

3. Is the transfer liable to stamp duty?

“Novation” is defined by the Black’s Law Dictionary, 8th Edn., 2004 as “The act of substituting for an old obligation a new one that either replaces an existing obligation with a new obligation or replaces an original party with a new party.”

In Wharton’s Law Lexicon, 15th Edition, 2009 at p.1174, the meaning of the term ‘Novation’ is stated as “the substitution, with the creditor’s consent, of a new debtor for an old one.”

Section 62 of The Indian Contract Act, 1872 sets out the general parameters for novation. The Section reads in pertinent part as follows:

“Effect of novation, rescission and alteration of contract – If the parties to a contract agree to substitute a new contract for it, or to rescind or alter it, the original contract need not be performed.

Illustration:- (a) A owes money to B under a contract. It is agreed between A, B and C that B shall thenceforth accept C as his debtor, instead of A. The old debt of A to B is at an end, and a new debt from C to B has been contracted.”

It is to be noted that Section 62 speaks of substitution of a new debtor, creditor, contract, etc. in place of an old one. The essential feature of novation of contract is that when a contract is substituted the rights under the original contract are relinquished or replaced by the new contract. Illustration (a) to Section 62 indicates that one of the requisites of such novation is the agreement of all the parties to the new contract.

In every novation there are four essential requisites:

“(1) A previous valid obligation;

(2) the agreement of all the parties to the new contract;

(3) the extinguishment of old contract; and

(4) the validity of the new one.

A novation is new contractual relation. It is based upon a new contract by all the parties interested. See Advanced Law Lexicon, P. Ramanatha Aiyar, 3rd Edition, 2005 at pp. 3253-54.

State Bank of India v. T.R. Seethavarma, AIR 1995 Ker 31 at p. 34. is illustrative:

There, on dissolution of a firm its assets and liabilities were taken over by a third person. He paid part of the debt owed by the firm to a Bank and hypothecated assets with the bank. On filing of the suit by the bank against the firm and the third person for recovery of loan, it was held that in the absence of tripartite agreement between the parties, there was no novation of contract. The liability of the firm continued to exist.

In P.S. Atiyah’s An Introduction to the Law of Contract, 3rd Edition, 1981, at p. 283, it is stated as follows:

“The only way in which it is possible to transfer contractual duties to a third party is by the process of novation, which requires the consent of the other party to the contract. In fact novation really amounts to the extinction of the old obligation, and the creation of a new one, rather than to the transfer of the obligation from one person to another. Thus if B owes A $100, and C owes B the same amount, B cannot transfer to C the legal duty of paying his debt to A without A’s consent. But if A agrees to accept C as a debtor in place of B, and if C agrees to accept A as his creditor in place of B, the three parties may make a tripartite agreement to this effect, known as novation. The effect of this is to extinguish B’s liability to A and create a new liability on the part of C.”

The legal maxim that ‘novatio non praesumitur’ enunciates whether a novation needs to be in writing. The maxim means that “A Novation is not presumed”. See Trayner’s Latin Maxims 4th Edition at p. 403.

In Appukuta Panicker v. Anantha Chettiar, AIR 1996 Ker 303, the Kerala High Court held that it is essential for the principle of novation to apply that there must be mutual consent of all parties concerned.

In T.M. & Co. v. H.I. Trust, AIR 1969 Cal 238, the High Court of Calcutta observed that the liability can be transferred only by a tripartite agreement which will amount to novation.

In view of the above legal position, the consent of the Bank as also the execution of a tripartite agreement, between ‘P’ Co. Ltd., the partnership firm(its partners) and the Bank, is sine qua non in order for it to be a novation of contract.

Accordingly, Issue No.1 and Issue No.2 are addressed.

As regards the levy of stamp duty in respect of the aforesaid transfer of liability from partnership firm to ‘P’ Company Ltd., the law on the subject is as follows:

Sub-section (14) of Section 2 of the Indian Stamp Act, 1899, defines the term “Instrument” as under:

“Instrument” includes every document by which any right or liability is, or purports to be, created, transferred, limited, extended, extinguished or recorded.

A novation arises when a new individual assumes an obligation to pay that was incurred by the original party to the contract. As the same is given effect to by the substitution of a new contract for an old one and the new agreement extinguishes the rights and obligations that were in effect under the old agreement, it falls under the definition of the term “instrument” as defined under the Indian Stamp Act, 1899. A novation agreement is an ‘instrument’ under the Indian Stamp Act, 1899.  Whether such instrument is chargeable to stamp duty needs further analysis.

Section 3 of the Indian Stamp Act, 1899 sets out the instruments chargeable with duty. It provides in relevant part as follows:

“Subject to the provisions of this Act and the exemptions contained in Schedule I, the following instruments shall be chargeable with duty of the amount indicated in that Schedule as the proper duty therefor, respectively, that is to say— (a) every instrument mentioned in that Schedule which, not having been previously executed by any person, is executed in India on or after the first day of July, 1899."

Since in the above case, the novation agreement is being executed for the first time not having been executed previously, it squarely attracts the provisions as contained in Section 3 of the Indian Stamp Act, 1899. Substitution of a new contract is the core of novation. If the new contract suffers from legal flaw such as want of registration, stamps etc., on account of which it becomes unenforceable, the original contract will not be extinguished and there would be no novation. See Vishram Arjun v. Irukulla Shankaraiah, AIR 1957 AP 784 : 1958 (2) An.W.R. 259.

In view of the above stated legal position, it must be said that a novation agreement is an instrument liable to stamp duty under the Indian Stamp Act, 1899.

Accordingly, Issue No. 3 is addressed.

Quorum for the Board Meeting When All the Directors are Interested

Can the quorum for the board meeting be achieved for the purpose of passing a resolution when all or all but one of the directors are interested in an item of business to be transacted therein in the event that the board members are not interested to take the matter in general meeting?

Section 287 of the Companies Act, 1956 reads as follows:

(1) In this section- (a) "total strength" means the total strength of the Board of directors of a company as determined in pursuance of this Act, after deducting there from the number of the directors, if any, whose places may be vacant at the time; and (b) "Interested director" means any director whose presence cannot, by reason of section 300, count for the purpose of forming a quorum at a meeting of the Board, at the time of the discussion or vote on any matter.

(2) The quorum for a meeting of the Board of directors of a company shall be one-third of its total strength (any fraction contained in that one-third being rounded off as one), or two directors, whichever is higher :

Provided that where at any time the number of interested directors exceeds or is equal to two-thirds of the total strength, the number of the remaining directors, that is to say, the number of the directors who are not interested present at the meeting being not less than two, shall be the quorum during such time.

As provided in sub-section (2), at least two dis-interested directors or one-third of the total strength, whichever is higher, must be present at the meeting in order to constitute the quoru. If all or all but one of the directors are interested there can be no quorum and, therefore, no meeting.

Quorum means a minimum number of directors required for transacting business. The directors cannot proceed with a meeting unless the required quorum of directors is present. Provision for quorum for meeting of directors is not directory but it is mandatory. Any decision taken by a lesser number than the quorum is void. See: Alma Spinning Co., In re. [(1880) 16 Ch. 681] ; Re, North Eastern Insurance Co. Ltd., [(1919) 1 Ch. 198] . Also see: Needle Industries (India) Ltd. v. Needle Industries Neway (India) Holding Lid., [(1981) 51 Comp. Cases 743 (SC)].

Regulation 75 of Table A of Schedule I to the Companies Act, 1956 reads as follows:

"The continuing directors may act notwithstanding any vacancy in the Board; but, if and so long as their number is reduced below the quorum fixed by the Act for a meeting of the Board, the continuing directors or director may act for the purpose of increasing the number of directors to that fixed for the quorum, or of summoning a general meeting of the company, but for no other purpose."

Where all or all but one of the directors are interested, and there is no quorum, the proper way out of the difficulty will be to have the matter decided by the company in general meeting by an ordinary resolution, or, if the articles so require by a special resolution. This is so because all residual matters are supposed to vest in the general body. Regualtion 75 of Table A, if it is adopted by a company, would authorise the directors to continue to act in such cases for the purpose of increasing the number of directors so as to bring the number upto the quorum requirement or to call a general meeting for the purpose.

The directors cannot act unless the munimum number is first made up. See: Sly, Spink & Co., [Re, (1911) 2 Ch. 430] ; Owen & Ashworth Chaim, [(1901) 1 Ch. 115]. Also that, the Department of Company Affairs has issued a clarification in this regard. The DCA had advised to increase the board strength either by way of co-option or appointment of additional directors, if so authorised by the articles, and to transact the business and if this way out is not possible to call a general meeting. See: Taxmann's Circulars & Clarifications, 1992 Edition at p. 294.

However, in Trayner's Latin Maxims, 4th Edition, 2008 at p. 502, the meaning of the maxim "Quando aliquid prohibetur, prohibetur et omne quod devenitur ad illud" is provided as follows: "When anything is forbidden, everything which amounts to the forbidden thing is forbidden also. This maxim means that when the law has forbidden the doing of anything directly, it equally forbids the doing of it indirectly, and that mere device or colourable evasion will not protect the doer from the consequences of his act."

"... and a transaction will not be upheld which is "a mere device for carrying into effect that which the legislature has said shall not be done." See: Per Martin, B., in Morris v. Blackman, [2 H. & C. 912, at p. 918] ; See also: Minty v. Sylvester, [84 L. J. K. B. 1982] as cited in Broom's Legal Maxims, 10th Edition, 2006 at p. 315. The above clarification is partly erroneous because, the very act of appointment of additional directors is to pass the transaction in which all the existing directors are interested. Thus, as all the directors are even interested in the appointment of additional directors how can they, in the spirit and principle of Section 287, appoint additional directors? Again, even to co-opt a director to make up the quorum there should be at least one disinterested director. It is a well settled legal principle that 'what the law prohibits cannot, in some other way, be legally accomplished'. In view of the above, the directors may, in accordance to the law laid down in the above case laws as also the DCA clarification, first increase the strength of the board and put the item in issue to vote in board meeting if it wants to avoid the item to be put to vote in general meeting. However, it is a moot question whether the transaction would be able to stand against the well laid and followed principle of law, if and when challenged.