Norm Emblem Ara Basmadjian April 1 2014 The 'indoor management rule' explained Dentons | Litigation - Canada Norm Emblem, Ara Basmadjian Litigation IntroductionIndoor management ruleCodificationApplicationCommentIntroductionAt common law, a person dealing with a corporation – assuming that he or she is acting in good faith and without knowledge of any irregularity – need not inquire about the formality of the internal proceedings of the corporation, but is entitled to assume that there has been compliance with the articles and bylaws.(1)This principle, known as the 'indoor management rule', was authoritatively laid down in the 19th century case of Royal British Bank v Turquand(2) and eventually codified in Section 19 of the Ontario Business Corporations Act(3) and Section 18 of the Canada Business Corporations Act.(4)This update provides a survey of the law in respect of the indoor management rule. It begins by reviewing the common law origins of the indoor management rule (or the "rule in Turquand's case") and then examines the codified version of the indoor management rule under the Ontario Business Corporations Act and the Canada Business Corporations Act. The update also provides examples of the court's application of the rule.Indoor management ruleIt is a fundamental tenet of the law of agency that the actions of an agent bind the principal only where those actions are within the actual, apparent or deemed authority of the agent.(5)In the context of business corporations, the indoor management rule provides that:"a person dealing with a corporation has no obligation to ensure that a corporation has gone through any procedures required by its articles, by-laws, resolutions, contracts, or policies to authorize a transaction or to give authority to a person purporting to act on behalf of the corporation."(6)Indeed, "[c]ompliance with such procedures", according to Professor J Anthony VanDuzer, "is a matter of internal or 'indoor' management with which outsiders do not have to concern themselves".(7)This general principle was first articulated in the seminal decision in Turquand.(8) In that case, the company's registered deed of settlement authorised its directors to borrow such funds as might from time to time be authorised by a general resolution of the company. The directors borrowed money from the plaintiff bank and issued a bond under the seal of the company. However, no resolution was adopted by the company authorising the loan or the bond.The issue before the Court of Exchequer Chamber was whether the bank was required to determine whether the general resolution of the company had actually been adopted. Chief Justice Jervis held as follows:"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."(9)Turquand served to qualify the harsh implications of the 'constructive notice' doctrine, under which all persons conducting business with a corporation were deemed (or construed) to have knowledge of any restriction on the authority of an agent contained in the corporation's articles and by-laws.(10)The rule in Turquand's case was endorsed by the House of Lords in Mahony v East Holyford Mining Co(11) and subsequently became known as the 'indoor management rule'. According to Lord Hatherley:"[The articles and by-laws of a corporation] are open to all who are minded to have any dealings whatsoever with the company, and those who do so deal with them must be affected with notice of all that is contained in those two documents.After that… all that the directors do with reference to what I may call the indoor management of their own concern, is a thing known to them and known to them only; subject to this observation, that no person dealing with them has a right to suppose that anything has been or can be done that is not permitted by the [articles or by-laws]…[W]hen there are persons conducting the affairs of the company in a manner which appears to be perfectly consonant with the articles of association, then those so dealing with them, externally, are not to be affected by any irregularities which may take place in the internal management of the company. They are entitled to presume that that of which only they can have knowledge, namely, the external acts, are rightly done, when those external acts purport to be performed in the mode in which they ought to be performed."(12)After the decision in Mahony, the indoor management rule was applied throughout the common law world.(13)The Supreme Court of Canada adopted the indoor management rule in JH McKnight Construction Co v Vansickler.(14) In McKnight, the plaintiff sued for specific performance of a contract under which the defendant company agreed to sell its business premises to the plaintiff. It was admitted that the premises were being sold in order to enable the defendant to acquire a more suitable work site. The defendant, however, resisted specific performance on the basis that the company's secretary-treasurer had no authority to enter into the contract.A majority of the court determined that the secretary-treasurer had sufficient authority to enter into the contract at issue. In any event, there was ample evidence that the secretary-treasurer was the apparent agent of the company. The court referred to Palmer's Company Law for a summary of the indoor management rule:"This rule is that where a company is regulated by an Act of Parliament, general or special, or by a deed of settlement or memorandum and articles registered in some public office, persons dealing with the company are bound to read the Act and registered documents, and to see that the proposed dealing is not inconsistent therewith; but they are not bound to do more; they need not inquire into the regularity of the internal proceedings—what Lord Hatherley called 'the indoor management.' They are entitled to assume that all is being done regularly."(15)There are two policy reasons in support of the indoor management rule. First, it would be an unfair imposition on the outsider, who has no right to demand proof by the directors that the requirements of the articles of incorporation or by-laws have been fulfilled. Second, and perhaps more importantly, the constant duty of verification would impose an impractical burden on business.(16)There are, however, exceptions to the application of the indoor management rule.(17) Unsurprisingly, the rule will not apply where a person dealing with a corporation has actual knowledge of the deficiency in the authority of a director or officer.(18)The rule will also not apply in suspicious circumstances that put an outsider on notice to inquire into the actual authority of a corporate officer. As Justice Wright stated in B Liggett (Liverpool), Limited v Barclays Bank, Limited:(19)"[t]he rule proceeds on a presumption that certain acts have been regularly done, and if the circumstances are such that the person claiming the benefit of the rule is really put on inquiry, if there are circumstances which debar that person from relying on the prima facie presumption, then it is clear, I think, that he cannot claim the benefit of the rule."(20)In Brooks Ltd v Claude Neon General Advertising Ltd,(21) Justice Garrow held that:"I am inclined to agree with the argument of counsel for the defendant company… that there was something so out of the ordinary in one company undertaking to purchase the entire outstanding stock of another as to put the plaintiffs 'upon inquiry to ascertain whether the person or persons making the contract had any authority in fact to make it.'"(22)Codification The indoor management rule is codified in both the Ontario Business Corporations Act and the Canada Business Corporations Act. The statutes buttress rather than replace the common law.(23)Section 19 of the Ontario Business Corporations Act provides as follows:"Indoor management rule19. A corporation or a guarantor of an obligation of a corporation may not assert against a person dealing with the corporation or with any person who has acquired rights from the corporation that,(a) the articles, by-laws or any unanimous shareholder agreement have not been complied with;(b) the persons named in the most recent notice filed under the Corporations Information Act, or named in the articles, whichever is more current, are not the directors of the corporation;(c) the location named in the most recent notice filed under subsection 14 (3) or named in the articles, whichever is more current, is not the registered office of the corporation;Note: On a day to be named by proclamation of the Lieutenant Governor, clause (c) is amended by striking out 'subsection 14 (3)' and substituting 'the Corporations Information Act'. See: 2011, c. 1, Sched. 2, ss. 1 (4), 9 (2).(d) a person held out by a corporation as a director, an officer or an agent of the corporation has not been duly appointed or does not have authority to exercise the powers and perform the duties that are customary in the business of the corporation or usual for such director, officer or agent;(e) a document issued by any director, officer or agent of a corporation with actual or usual authority to issue the document is not valid or not genuine; or(f) a sale, lease or exchange of property referred to in subsection 184 (3) was not authorized,except where the person has or ought to have, by virtue of the person's position with or relationship to the corporation, knowledge to that effect."(24)Similarly, Section 18 of the Canada Business Corporations Act provides as follows:"Authority of directors, officers and agents18. (1) No corporation and no guarantor of an obligation of a corporation may assert against a person dealing with the corporation or against a person who acquired rights from the corporation that(a) the articles, by-laws and any unanimous shareholder agreement have not been complied with;(b) the persons named in the most recent notice sent to the Director under section 106 or 113 are not the directors of the corporation;(c) the place named in the most recent notice sent to the Director under section 19 is not the registered office of the corporation;(d) a person held out by a corporation as a director, officer, agent or mandatary of the corporation has not been duly appointed or has no authority to exercise the powers and perform the duties that are customary in the business of the corporation or usual for a director, officer, agent or mandatary;(e) a document issued by any director, officer, agent or mandatary of a corporation with actual or usual authority to issue the document is not valid or genuine; or(f) a sale, lease or exchange of property referred to in subsection 189(3) was not authorized.Exception(2) Subsection (1) does not apply in respect of a person who has, or ought to have, knowledge of a situation described in that subsection by virtue of their relationship to the corporation."(25)Section 19(a) of the Ontario Business Corporations Act states that neither a corporation nor a guarantor of a corporation may assert against a person dealing with the corporation or with any person who has acquired rights from a corporation that the "articles, by-laws or any unanimous shareholder agreement may have not been complied with". Section 18(1)(a) of the Canada Business Corporations Act is identical. These sections simply eliminate the doctrine of constructive notice.Section 19(b) of the Ontario Business Corporations Act and Section 18(1)(b) of the Canada Business Corporations Act provide that a person will have the usual authority of a director if his or her name appears on the public file.Section 19(c) of the Ontario Business Corporations Act and Section 18(1)(c) of the Canada Business Corporations Act seek to ensure that a third party can rely on the address in the public file in order to communicate with the corporation.Section 19(d) of the Ontario Business Corporations Act and Section 18(1)(d) of the Canada Business Corporations Act provide that where a corporation makes a representation to a third party by holding a person out as a director, officer or agent, the corporation is not permitted to deny that the person is duly appointed or that he or she has the authority customary or usual for such a director, officer or agent.Section 19(e) of the Ontario Business Corporations Act and Section 18(1)(e) of the Canada Business Corporations Act deal with the situation in which a person who is authorised to issue an executed document is not the person with authority to execute the document. The effect of these sections is to permit a third party to rely on a document issued by a person who has actual or usual authority to issue it. In other words, the corporation is not allowed to argue later that the right person did not sign the document.Section 19(f) of the Ontario Business Corporations Act and Section 18(1)(f) of the Canada Business Corporations Act protect third parties against claims by corporations that a particular transaction – that is, the sale, lease or exchange of "all or substantially all the property of a corporation other than in the ordinary course of business" – was entered into in a manner contrary to the applicable corporate statute.These provisions are subject to an important qualification. Third parties conducting business with a corporation are not entitled to benefit from these protections if they had knowledge of the defect in the authority of the person with whom they were dealing, or if they ought to have known of the defect in the authority of the person due to their position or relationship to the corporation.Application The courts have generally adopted a robust application of the indoor management rule.In Bank of Montreal v Vola,(26) an account manager of a local branch retained lawyers to commence an action on behalf of the bank to collect amounts loaned to the defendants. The defendants brought an application for a stay of proceedings on the grounds that the plaintiff had not given the proper authority to commence the actions. The master granted the application and concluded that for a corporation to commence an action, there must be a resolution of its directors. The plaintiff appealed to the Ontario Supreme Court.The Ontario Supreme Court reviewed the authorities and observed that:"[c]learly the act of an apparent agent binds the corporation… The cases clearly show that as a basic principle where an agent is acting for a company within the apparent scope of his authority the 'indoor management' rule applies and the internal workings of the company cannot be raised as a defence by the company."(27)The court determined that the indoor management rule applied and that the plaintiff did not have to show what, if any, express authority was given by the board of directors. On the facts, the account manager was holding himself out to be an agent of the bank in its normal course of business.(28)In Martin v Artyork Investments Ltd,(29) the plaintiff, Heinrich Martin, was contacted by his solicitor, Hans-Dieter Bernhardt, about an opportunity to invest in property owned by the defendant corporation, Artyork Investments Ltd. Bernhardt was also a director of Artyork Investments. On the advice of his solicitor, the plaintiff transferred C$120,000 to an account in Bernhardt's name. The plaintiff received no further information about the investment, so he contacted Bernhardt and eventually received a copy of what was purported to be a debenture that secured the money advanced by Bernhardt to Artyork Investments. Bernhardt committed suicide. There was no record that the plaintiff's money was advanced to Artyork Investments under the debenture. As a result, the plaintiff sued Artyork Investments for recovery of his investment.At trial, the plaintiff argued that Artyork Investments was responsible for the debenture issued by its director, Bernhardt. The defendant claimed that Bernhardt, or whoever signed the debenture, did not have proper authority to borrow on behalf of Artyork Investments.The court referred to Section 19 of the Ontario Business Corporations Act, which:"in effect, codifies the indoor management rule laid down… in Royal British Bank v Turquand… which held that bona fide outside persons dealing with a corporation are entitled to assume that its internal procedures have been properly complied with."(30)In the circumstances, the court was of the view that Sections 19(d) and (e) were applicable and held that the defendant was liable for the sum of the debenture.The defendant appealed the decision to the Court of Appeal for Ontario which overturned the decision of the trial judge and concluded that Bernhardt had defrauded both Martin and Artyork Investments, and that each party should bear its own loss.On further appeal to the Supreme Court of Canada, the judgment of the Court of Appeal for Ontario was set aside and the trial judgment was restored. In a short decision, Justice Iacobucci held that:"the appellant was entitled to the protection afforded by s. 19 of the Ontario Business Corporations Act in his dealings with the director of the Respondent. Accordingly, the Respondent is bound by its [director's] representations."(31)CommentThe indoor management rule protects third parties in their dealings with corporations. If a third party acts in good faith with a person whom they trust represents a corporation, then the corporation is bound by the transaction whether or not the person did not actually have the power to bind the corporation.(32)As Kevin Patrick McGuinness states in Canadian Business Corporations Law, the indoor management rule serves:"to protect those who act in innocent ignorance, and not those who act with blind disregard or in wilful contravention or whose position allowed ample opportunity to determine whether the agent possessed the required authority."(33)The rule is firmly based on principles of fairness and business practicality.For further information on this topic please contact Norm Emblem or Ara Basmadjian at Dentons Canada LLP by telephone (+1 416 863 4511), fax (+1 416 863 4592) or email ([email protected] or [email protected]). The Dentons website can be accessed at www.dentons.com.Endnotes(1) Wayne D Gray, Ontario Corporate Law & Practice, vol 1, loose-leaf (Toronto: Carswell, 2012) at 184.108.40.206.(2) Royal British Bank v Turquand (1856), 6 EL & BL 327.(3) Business Corporations Act, RSO 1990, c B16.(4) Canada Business Corporations Act, RSC 1985, c C-44.(5) See generally Gerald Fridman, Canadian Agency Law, 2d ed (Markham, Ontario: LexisNexis Canada Inc, 2012).(6) J Anthony VanDuzer, The Law of Partnerships and Corporations, 3d ed (Toronto: Irwin Law Inc, 2009) at 214-215. But see Pacific National Investments Ltd v Victoria (City), 2000 SCC 64,  2 SCR 919, 2000 CarswellBC 2441at para 68: the indoor management rule does not apply to municipal corporations.(7) VanDuzer, ibid at 215.(8) Turquand, supra note 2.(9) Ibid at 332.(10) VanDuzer, supra note 6 at 214.(11) Mahony v East Holyford Mining Co (1874-75), LR 7 HL 869.(12) Ibid at 893-894.(13) Kevin Patrick McGuinness, Canadian Business Corporations Law, 2d ed (Markham, Ontario: LexisNexis Canada Inc, 2007) at 316.(14) JH McKnight Construction Co v Vansickler (1915), 51 SCR 374, 24 DLR 298, 1915 CarswellOnt 19.(15) Ibid at para 38.(16) McGuinness, supra note 13 at 316.(17) Ibid at 330. See also Gray, supra note 1 at 220.127.116.11.(18) Dickson Co v Graham (1913), 23 OWR 749, 9 DLR 813, 1913 CarswellOnt 19 at para 19.(19) B Liggett (Liverpool), Limited v Barclays Bank, Limited,  1 KB 48.(20) Ibid at 56-57.(21) Brooks Ltd v Claude Neon General Advertising Ltd,  2 DLR 743, 1931 CarswellOnt 126.(22) Ibid at 10.(23) McGuinness, supra note 13 at 317.(24) Ontario Business Corporations Act, supra note 3, s 19.(25) Canada Business Corporations Act, supra note 4, s 18.(26) Bank of Montreal v Vola (1980), 31 OR (2d) 60, 18 CPC 315, 1980 CarswellOnt 115 .(27) Ibid at paras 8 and 10.(28) Ibid at paras 11-12.(29) Martin v Artyork Investments Ltd, 1991 CarswellOnt 2024 (OCJ), rev'd (1995), 25 OR (3d) 705, 85 OAC 221, 1995 CarswellOnt 1774 (Ont CA), rev'd,  2 SCR 290, 33 OR (3d) 64, 1997 CarswellOnt 2359 (SCC).(30) Ibid (OCJ) at para 16.(31) Ibid (SCC) at para 2.(32) Paul Martel, Business Corporations in Canada: Legal and Practical Aspects, vol 2, loose-leaf (Toronto: Carswell, 2004) at 26-7.(33) McGuinness, supra note 13 at 331.