Business Structuring: a look at partnerships.

An insight into Partnerships as a business structure and analysis of the Partnership Act 1890, with some helpful advice on what to consider for people considering setting up with a partner or partners to commence trading.

Our Adam Dickinson looks at the law on partnerships and whether a traditional partnership as a business trading structure can be suitable for organisations today.

The Importance of Having a Bespoke Partnership Agreement

Of those who choose to run their business as a partnership, very few will consider in depth how the rights and responsibilities will be shared between each partner. Indeed, most aspiring business partners are so eager to penetrate the market with their new and unique ideas that they fail to consider the (very real) possibility that their business venture may not succeed as planned. This article seeks to emphasise the importance of having a sound and structured partnership agreement in place before choosing to embark on this (somewhat risky) business venture.

Contents:

1. -What is a partnership?
2. -Decision-Making in Partnerships and potential pitfalls.
3. -Default Rules under Partnership Act 1890 and the need to have a partnership agreement.
4. -Continuity and Succession Planning
5. -Alternative Business Structures to a Partnership

What is a Partnership?

Section 1(1) of the Partnership Act 1890 defines a partnership as “the relationship which subsists between persons carrying on a business in common with a view of profit”.

If the above definition is met, the law will view the relationship as a partnership with all that this entails (even if the parties did not intend for this to be the case!).

Section 9(1) is arguably the most significant Section of the Partnership Act 1890 and is perhaps the biggest disincentive for trading as a partnership. Section 9(1) states: “Every partner in a firm is liable jointly with the other partners… for all debts and obligations of the firm incurred while he is a partner…”.

What this means in practice is that if one partner makes a series of poor business decisions resulting in a loss for the partnership, the other “innocent” partner will be expected to help repay any debts incurred. It is also important to remember that, unlike companies, traditional partnerships do not enjoy the benefit of limited liability meaning a partner’s personal assets and belongings may be at risk in the event of the partnership becoming insolvent.  It is, however, possible to have a Limited Liability Partnership (commonly referred to as LLPs). LLPs are beyond the scope of this article.

The Ability of Partners to Bind the Firm

Section 6 states “An act or instrument relating to the business of the firm done or executed in the firm-name, or in any other manner showing an intention to bind the firm, by any person thereto authorised, whether a partner or not, is binding on the firm and all the partners”.

This is straightforward and uncontroversial. In simple terms, a partner who is authorised to act in a certain way will bind the whole firm. Take the example of a car dealership being ran by A and B in partnership with one another. It is agreed that both A and B can buy and sell any car that they wish. If A buys a Lamborghini for £100,000, the partnership will be bound by the contract and B will be liable to honour the contract along with A.

Section 5 is more problematic from a partner’s perspective. Section 5 states “Every partner is an agent of the firm and his other partners for the purpose of the business of the partnership; and the acts of every partner who does any act for carrying on in the usual way business of the kind carried on by the firm of which he is a member may bind the firm and his partners, unless the partner so acting has in fact no authority to act for the firm in the particular matter, and the person with whom he is dealing either knows that he has no authority, or does not know or believe him to be a partner.”

In essence, Section 5 is a very long-winded and old-fashioned way of explaining the doctrine of apparent authority. Section 5 encapsulates the idea that a partner can still bind the firm even if acting outside his/her authority as long as the transaction appeared to be normal in the eyes of the third party and they were unaware that the partner in question was acting outside of their authority. The reasoning behind Section 5 (and the doctrine of apparent authority generally) is that the third party who has approached the transaction in good faith should not have to suffer as a result of poor business practice.

Consider our above car dealership example again. This time, it is agreed between A and B that if one of them wishes to purchase a car for more than £20,000, they must first seek the consent of the other. Suppose that A agrees to purchase a Ferrari for £100,000 from C without first seeking permission from B. B will be bound by the contract even though A was acting outside of his authority as long as C approached the contract in good faith and was not aware that B was exceeding his authority.

Unfortunately, there is no way to “contract out” of Section 5 as this is a dealing with the outside world. Therefore, it is vitally important for a partnership agreement to include indemnity clauses requiring partners who have exceeded their authority to indemnify the other “innocent” partners for any losses suffered as a result. Note that the Partnership Act 1890 implies no such indemnity clause into the partnership agreement, so it is important to make sure this is included!

The “Default Rules”

So far, we have looked at how the Partnership Act 1890 governs the relationship between the partnership and the outside world. Now we shall explore how the Act governs the internal relationship between the partners themselves.

The eagle-eyed readers amongst you will have noticed that the Partnership Act 1890 is an archaic piece of legislation. Consequently, the drafters of the Act back in 1890 failed to envisage the potential that some partnerships could grow to become household names (such as The John Lewis Partnership). The way in which the legislation governs the internal relationship of partners amplifies just how out-dated the law is.

Section 24 of the Act provides a set of “default rules” that are implied into a partnership (in the absence of contrary agreement).

Section 24(1) states “All the partners are entitled to share equally in the capital and profits of the business and must contribute equally towards the losses whether of capital or otherwise sustained by the firm.”

Whereas Section 24(1) may be appropriate for a small partnership consisting of two or three partners, it seems almost nonsensical to apply this in the larger context. Section 24(1) takes the stance that a partner who has contributed £6m into the partnership is only entitled to the same return as a partner who has contributed 6p. A thorough partnership agreement will detail exactly how profits and losses are to be distributed (which will often be proportionate to the amount of capital employed by each partner).

Section 24(5) states “Every partner may take part in the management of the partnership business.”

In modern times, it is very common for larger firms to have in excess of 250 partners. Many partners are appointed to oversee and supervise different aspects (or “arms”) of a business but the right to take part in the firm’s structural management will often be reserved to a small handful of those partners. A structured partnership agreement will include an in-depth explanation of the role each partner is expected to play within the organisation and will afford the right to take part in management to the more senior partners.

Section 24(7) states “No person may be introduced as a partner without the consent of all existing partners.”

In the context of larger modern partnerships such as John Lewis. It is hard to imagine having to obtain the consent of 80,000 partners before a new partner can be introduced. A modern partnership agreement will often substitute Section 24(7) with a more “workable” appointment process, thereby giving power to appoint new partners to those more senior partners who are entitled to take part in the firm’s management.

Trading Continuity of Partnerships

Unlike incorporated companies, partnerships do not naturally enjoy the benefit of perpetual succession. That is to say, the starting point is that a partnership will only last as long as the partners running it.

Under the Partnership Act 1890, Section 26(1) states “Where no fixed term has been agreed upon for the duration of the partnership, any partner may determine the partnership at any time on giving notice of his intention so to do to all the other partners.”

In practice, this means if a partner wishes to leave a partnership, the entire partnership will be brought to an end. Any goodwill and reputation that has been built up will be lost and the remaining partners will have to start again “from scratch”.

It is commonplace for a partnership agreement to include a “continuation clause” stating that the partnership will continue as long as there are at least two partners in existence who wish to continue the business. Without a clause to this effect, the partnership is vulnerable to being brought to an abrupt end following the slightest of disagreements between the partners.

Alternative Business Structures to a Partnership

Whilst a Partnership may be a convenient way to transact business due to its simplicity and lack of formality, larger organisations view the prospect of unlimited liability as a significant disincentive.

Since 6^th April 2001, it has been possible to have what is known as a “Limited Liability Partnership”. In essence, an LLP is exactly what it says on the tin – A partnership which enjoys the benefit of limited liability. Although there are stricter legal requirements for the creation of LLPs, the increased protection offered by limited liability makes this an attractive medium through which to conduct business.

A limited company is another alternative to a partnership. The biggest difference between a limited company and an LLP is the way in which the business is owned by its members. In an LLP, the division of ownership is based upon the provisions of the partnership agreement. However, in a company, the extent of ownership depends on the size of a particular member’s shareholding. Like an LLP, a company enjoys the benefit of limited liability which makes it an attractive tool for investors and business people alike.

Summary

This article has sought to demonstrate that the Partnership Act 1890 has failed to keep up with modern times. The default rules implied by the act may even act as a hinderance to ambitious business partners who regard expansion and growth as two main priorities.

If you are going to embark on your business venture via a partnership, it is important that you have a structured agreement in place outlining, in detail, how the partnership will be run internally and the protections that will be in place when dealing with the outside world.

How can AI Law help you and your partnership?

At Ai Law, we understand that no two partnerships are the same. Effective drafting specific to each partnership’s set-up and objectives is essential. We have specialists who appreciate the importance of having a bespoke partnership agreement tailored to meet the needs of your business.

If you require assistance with your partnership agreement, please get in touch today.