Sometime partnerships come into existence without any conscious decision being made that those involved want to be bound by all of the legal rules that apply to partners. As if that isn’t bad enough, some well established partnerships are often surprised to learn that their failure to document their relationship properly means that a set of inappropriate default provisions govern their rights and entitlements. Andrew Cromby of Weightmans LLP considers how these situations can arise and what to do to avoid being caught out in what can be a disastrous situation.
Two or more friends decide that they will start a business together. They don’t form a company for that business but just decide to see “how it goes”. After all, it’s early days.
At first the business does well. It grows and profitability is good. Then the business hits a rocky patch – perhaps fuelled by a breakdown in relations between the (now “former”) friends. As tensions mount the business begins to slide into the red and an argument breaks out over who owns what in the business – for instance, its name. One of the friends takes advice and learns that not only that he has legally been in partnership with the other since they started the business but that he has unlimited personal liability for all of its debts, in the event that it goes to the wall. How did this state of affairs come about?
Partnership is defined in the Partnership Act 1890 (“the Act”) as being “the relationship which subsists between persons carrying on a business in common with a view of profit”. That means that whenever two or more individuals run a business they may become partners – automatically by operation of the Act. There are other factors that the courts will consider in deciding whether a partnership has arisen, but essentially it can be as easy at that. And there are many consequences that flow from being in partnership. Each partner has joint and a several liability for all of the debts and financial obligations of the partnership. This means that they are each personally responsible for the debts of the business. So if you do not know your partner very well and if he or she subsequently runs amok, incurring huge expenses for the business, you could find yourself liable for them – and not just half of the expenses, but all of them. It will be the decision of the creditor as to which of the partners he wishes to sue for the sum that it is owed. Alternatively, the creditor may decide to sue all of the partners.
The Act also creates a statutory framework for the operation of a partnership, in the absence of any written agreement to the contrary. It is open to the parties to agree the terms on which they are in partnership and, if they wish, they can displace that statutory framework by doing so. Although it is not necessary that the terms should be recorded in writing, if any dispute arises this is naturally much more helpful. In the absence of any agreement (whether written or oral) there are a number of assumptions about ownership of the partnership’s assets. For instance, even though contributions to the partnership’s assets may have been unequal (perhaps with one partner investing more capital and the other spending more time on the business) the court is likely to approach the process of dividing up the assets of a partnership which is to be dissolved on the basis that it should be split between the partners equally. For that reason alone it is essential to record the terms on which you wish to enter into partnership with someone else.
A partnership in which there is no written or other agreement as to the terms of the relationship is known as a partnership “at will” and can be terminated by any of the partners simply by the giving of notice of termination. No notice period is required. Once the partnership has been terminated, all of the partners are under a continuing duty to collect in the business’s assets and realise the highest possible value for them with a view to paying off creditors and then, finally, make a distribution of any surplus to the partners. Conversely, if there is any loss, after all the assets have been realised, then that loss is to be shared between the partners. So bear in mind that even if you want to bring a partnership to an end, immediately, you may need to continue running the partnership for a further period simply to work through business in the pipeline, in order to avoid heavy losses.
There’s another wrinkle. Suppose the landscape is different. Suppose, instead, that you are a partner in a large, well organised partnership. This one is properly regulated by a fully developed partnership deed which sets out the respective duties of the partnership.
A new partner is admitted. As a consequence of an administrative slip-up, the new partner is not given, and does not sign up to, the relevant agreement. The consequence is that the old partnership agreement can cease to apply and the default rules set out in the act apply. The carefully considered and structured arrangements can be swept away, creating a very unhappy situation for the partnership.
So, if you are thinking about starting a new business, consider whether you want to do so in a partnership or whether your business would be better suited to a company which, at the very least, has the potential to confer limited liability on those running it – or perhaps consider a Limited Liability Partnership, a partnership, but with some of the protection afforded by a company. If you do want to go into partnership, or any other form of business, get an agreement in place, at an early stage, to set out the parties’ respective obligations. You will thank yourself later for doing so.
And, if you are admitting a new partner, make sure that they also sign up to your existing partnership agreement. This is one situation where paying attention to the detail of your business will pay off.
Andrew Cromby is a partner at Weightmans and specialist in partnership law.
Tel:+44 (0)20 7822 1900