Law of Partnership

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The Law Commission in its Consultation Paper No. 159 on reform of the Law of Partnership recommended, inter alia, that a new form of partnership be created that would constitute a legal entity distinct from its members. Critically consider the advantages and disadvantages this form of business organisation would have over the present form of partnership regulated under the Partnership Act 1890. According legal personality to partnerships would produce an overall positive effect. It is not, however, entirely without disadvantages. Legal personality cannot be properly analysed without an understanding of its historical and social consequences. It would simplify the ownership of property, the continuation of contractual obligations and liabilities and would protect partners from litigation as private individuals. It would, however, make winding up firms more difficult. Legal personality has a natural link with limited liability. The concept of legal personality cannot be analysed outside of its historical and social context. The Partnership Act 1890 is out of date. While there is an academic consensus that it has served its purpose well, it is not up to the challenges of modern business. Roger Toulson, Chairman of the Law Commission expresses the point well, ‘Law is also much more than an instrument by which government can aim to deliver its policies. Our laws provide an essential part of the fabric of society and need to be capable of adaptation as society changes…The Partnership Act 1890 was generally considered to be good legislation. But it was passed at a time when the typical partnership was of the kind described in the novels of Charles Dickens. Now we have partnerships ranging in size from the two-person firm to firms with hundreds of partners and thousands of employees. Yet under English law (in contrast with Scots law) a partnership cannot own property or enter into a contract in its own name. Any change in the membership of the firm involves the dissolution of the ‘old’ firm and the creation of a ‘new’ firm.’[1] The lack of legal personality is the cause of two of the problems outlined by Toulson. A partnership cannot own property or enter into a contract in its own name. A third problem, dissolution on change of membership is conceptually consistent with the ‘aggregate’ as opposed to ‘legal entity’ concept of partnership. This shows how the conceptual underpinnings of business law have a direct effect on its substance and by consequence on the structure of society. It is vital for the economy of the United Kingdom that there is sound regulation of business. This is spelt out in the Law Commission’s 2000 Report on partnership law. ‘The impact of partnerships on the economy is significant. There are in fact almost as many partnerships in the United Kingdom as there are trading companies. The business carried on by these partnerships is also significant. Their combined turnover is more than that of sole traders, who outnumber partnerships by more than three to one. Nor are they restricted to micro-businesses: 852,000 of the 2.77 million persons employed by partnerships are in firms with at least ten employees.’[2] The introduction of legal personality for partnerships is not, therefore, a question of mere black-letter law. Rather, it is an issue that impinges on the day to days lives of millions of people. Conversely, the argument can be put forward that the current system has been proved to work effectively and it would be advantageous to leave the current system in place. This is a ‘weight of inertia’ argument. It is submitted, however, that the well-settled principles of the Partnership Act 1890 could be easily adapted to accommodate legal personality without undermining the merits of the law. It is important to maintain a workable business model separate from company law. The Law Commission writes, ‘The existence of the [company] structure requires rules for the protection of shareholders and the existence of limited liability requires rules designed to protect creditors and other third parties. The result is that company law is complex and incorporation as a company involves incurring many obligations which a small firm may see as excessively bureaucratic and burdensome.[3]’ The partnership is a flexible, non-bureaucratic model, based upon contract and automatically occurring through statutory authority. The introduction of legal personality is only advantageous if it adds to these qualities. It is central to the concept of a partnership that parties can ‘contract out’ of element of the statutory code. This does not, however, make the statutory code unimportant. The Law Commission writes, ‘A workable default code is important: 52% of the partnerships surveyed by the Forum of Private Business in November 1991 did not have a written partnership agreement. 57% of those surveyed on behalf of the Association of Chartered Certified Accountants in 1995 did not have a formal agreement.15 This means that for a large number of partnerships, usually small businesses, the statutory rules are the sole basis upon which their affairs are regulated.’[4] It is clear that the statutory code is of very great importance indeed. If the ‘default’ code had legal personality as an element, it would be relevant to a great many businesses. It should also be noted that a great many small firms do not have ready access to legal advice. They have not created their partnership according to choice, rather they have relied on the statutory provisions. It is for this reason that the default code should be as simple as possible. There is also an argument that the code should also conform to public expectations as closely as possible. The accordance of legal personality signifies a major shift in the conceptualization of the English firm. There are two ways of formulating a partnership, it can either be, ‘characterized on a conceptual level… as an “aggregate” - that is, a relationship among the partners - or as an “entity” - that is, a personality existing separately from its partners.’[5] The accordance of legal personality would mean shift away from the ‘aggregate’ and towards the ‘entity’ concept. It is worth noting that Scottish law already employs the ‘entity’ concept. The 1890 Act was a codification of the English common law alone. The law commission considers that such a shift would have a positive effect for continuity of business. It is the smooth continuation of business that perhaps best represents the economic advantages changing the current system. Having set the proposed reform in historical and social context, it is necessary to consider the substantive changes that have been proposed – and whether they would be advantageous. The Law commission has identified three major problems that arise as a result of the lack of legal personality in the current law. These will be analyzed in turn. ‘1) Difficulties arise for partners holding property, particularly land. Title often needs to be transferred from the old group of partners to the new or from an outgoing partner to remaining partners.’[6] Legal personality would prevent this from being an issue. Title could be transferred not to the partners, but to the partnership as a whole. This has positive implications for continuity and would minimize bureaucracy. It would be necessary to undertake substantive law reform, s 20 of the 1890 Act provides, ‘(1) All property and rights and interests in property originally brought into the partnership stock or acquired, whether by purchase or otherwise, on account of the firm, or for the purposes and in the course of the partnership business, are called in this Act partnership property, and must be held and applied by the partners exclusively for the purposes of the partnership and in accordance with the partnership agreement.’ This concept of ‘partnership property’ would obviously have to change. The Law Commission suggest that the concept should be scrapped entirely for partnerships with legal personality. A partnership with legal personality could hold property in its own right. Where partnership money has been used to buy property, that property would be belong to the partnership. If property is bought by a private individual for the benefit of the partnership, then it will be held on trust.[7] It is submitted that this will inevitably create complications. On the one hand there will be partnership property in which the partnership enjoys full legal rights and on the other, there will be property which is merely held on trust for the benefit of the partnership. This will lead to conceptual complications, as the partners are unlikely to be aware of this dual structure of ownership. In a partnership with legal personality, partners, ‘do not own a share in the partnership property directly. The partners own a share in the partnership and that share will, of its nature, be personal or incorporeal moveable property.’[8] Unfortunately according legal personality to firms may cause problems in relation to security of title. The current rules protect the purchaser by insuring that, ‘at least two but not more than four of the partners are registered as proprietors and they hold it on trust for all the partners as tenants in common. The interests of the partners are protected by the entry on the register of certain common-form restrictions. Any purchaser is entitled to assume that the registered proprietor has full dispositionary powers in the absence of any entry to the contrary on the register.’[9] It might not be the case that a purchaser would be able to assume such dispositionary powers in where the firm and not trustees was registered. The Law Commission writes, ‘If a partnership wished to sell land acquired many years earlier when the composition of the firm was different, how, for example, would a purchaser know that the partnership selling the land was the same legal person as the partnership on the records as the owner?’[10] There is no obvious answer to this problem. The Law Commission note that frauds as to security of title are both rare and difficult to put into effect. It is submitted that the benefits of allowing partnerships to avoid the bureaucracy of transferring title every time there is a change of composition outweigh the disadvantages of a reduction in security of title for purchasers. The law society highlights a second advantage to the accordance of legal personality and the transfer of property, ‘2) Where property is transferred, third parties who had claims against the old group of partners may have no claim against the assets of the new group.’[11] Legal personality would prevent a change in partnership composition from automatically creating a new partnership. For this reason, creditors claims would not be broken by the legalistic creation of ‘new’ firms. This has clear and positive implications for lenders. It is not just property that would survive changes in composition; contractual rights would also be left in tact, ‘3) Difficulties may arise in transferring contractual rights and obligations from the old group to the new group, particularly where the contracts cannot be freely assigned or where the partners are unaware of the need to take any steps.’[12] A partnership with legal personality would be able to enter into contracts. The obligations created by those contracts would persist regardless of any change in composition. Another major advantage of reform is that it would simplify the rule that partnerships are dissolved upon change of membership. While partnerships are able to ‘contract out’ of the default rules, they currently provide that a change of membership results in dissolution of the partnership. Under S. 32 (c), this can happen for a variety of reasons,
  1. Reduction of the number of partners to below two;
  1. Expiry of fixed term, subject to any agreement between the partners;
(c) Termination of the single adventure or undertaking for which the partnership was entered into, subject to any agreement between the partners; (d) Notice by one partner of intention to dissolve the partnership where the partnership was entered into for an undefined time, subject to any agreement between the partners. As has been noted, a great many businesses rely on the default rules. This means that following the death or retirement of a partner, the partnership may have to be wound up. This directly contradicts the principle of continuity of business. The Law Commission write consider that, ‘unnecessary legal difficulties, following the death or retirement of a partner, may on occasion cause the winding up of businesses that might otherwise have continued.’[13] Legal personality would mean that the partnership could continue despite changes in composition of the membership. In the view of the economic importance of the business model, it is submitted that this would be a very positive outcome indeed. The accordance of legal personality has far reaching implications for the winding up of a firm. S. 38 of The 1890 Act currently states, ‘After the dissolution of a partnership the authority of each partner to bind the firm, and the other rights and obligations of the partners, continue notwithstanding the dissolution so far as may be necessary to wind up the affairs of the partnership, and to complete transactions begun but unfinished at the time of the dissolution, but not otherwise.’ Partners’ rights and obligations continue insofar as it is necessary to wind up the firm. The Law Commission detail the problem, ‘The difficulty is that rights and property may be vested in the firm as a legal person. Once the firm is dissolved there is no longer any person to hold the rights and property. When an individual dies, rights and property pass to an executor. There is no provision in the 1890 Act for any similar transfer to the former partners by operation of law.’ That is to say that all the rights and obligations vest not in the partners, but in the separate legal personality of the firm. The consequence of this is that on winding up, there is nobody with a duty to oversee the process and settle debts. It is interesting to consider the Scottish situation. As has been noted, partnerships in Scotland have legal personality. In Inland Revenue v Graham’s Trustees [1971][14], Lord Reid said, ‘In my opinion, section 38 does not make the surviving partners parties to the firm’s contracts and so keep those contracts alive. That would involve a radical change in Scots law. But I see no difficulty in holding that this section does require unfinished operations to be completed under the conditions that would have applied if the contract had still existed.’ It is submitted that Lord Reid has clearly avoided giving s. 38 a literal interpretation. His opinion is that s. 38 only serves to compel former partners to complete ‘unfinished operations.’ This is vague and conceptually incoherent. It is not immediately clear what ‘unfinished operations’ might entail, or on what legal basis the court has the power to compel parties to complete them. It is not, however, a problem without a remedy. The first approach concords with the old Scottish rule that the partnerships continues ‘in a sense.’[15] The partnerships are, ‘gone but, not yet gone.’ The advantage of this approach is that the rights and obligations of the partnership continue to attach to the partnership during the process of winding up. This means that the rights and obligations do not have to be passed over to the individual partners in order for unfinished operations to be completed. There are clear conceptual problems, however, the Law Commission writes, ‘There are theoretical difficulties with this option. There is the logical difficulty of regarding the partnership as gone and yet not gone at the same time. There is the difficulty that there may be only one partner, or no partners, left during the winding up process. It may be odd to say that a partnership continues in such circumstances. There is the difficulty of knowing when the partnership does come to an end. The winding up process may drift on indefinitely. In some cases there will be closing accounts and a recognizable end to the winding up period. In other cases there may be no recognizable end at all. The partnership may continue forever.’[16] This is a clearly unacceptable catalogue of woe. The Law Commission do not consider that in practice it is likely to cause much difficulty, however. Rights could be enforceable only for a limited period of time. It is submitted, however, that the concept of a partnership being, ‘gone, but not yet gone,’ lacks legal clarity. What then of the second option? The Law Commission details this as transferring, by operation of law, rights to the former partners as trustees for the purpose of winding up. Unfortunately this solution causes problems in relation to real and heritable property as, ‘title to such property can only pass through registration. If the partnership ceases to exist on dissolution, it will be unable to execute the documents necessary to effect the transfer. The property would become ownerless and ultimately revert to the Crown.’ This is clearly not an acceptable state of affairs. The Law Commission is, therefore, right to recommend option one. It is submitted, however, that partnerships without legal personality have a clear conceptual advantage in this regard. Creditors will not pursue a partnership only when it is being wound up. It is a logical consequence of the accordance of separate legal personality that creditors will be able to pursue the partnership to enforce rights and obligations as well as the individual partners. This is a clear advantage over the current system, as actions against private individuals are stressful and effect family members outside of the business world. The Law Commission debates, however, whether or not partner’s liability should be subsidiary, that it to say, the primary liability would be of the partnership and the individual partners would only be liable when the property of the partnership is not substantial enough to cover the debt. The Law Commission opposes the alternative concept that the partnership and the individual partners should be both jointly and severally liable in the initial action on the basis that it would create a misleading impression, ‘It would, however, give the wrong impression of the nature of the respective liabilities of the firm and the partners. It would give the impression that in a four-partner firm there were five obligants, each being liable, as between themselves, only for a one-fifth share. This solution would also give the misleading impression that if a partner paid the whole of a partnership debt the partner’s right of relief against the partnership would only be for part of the debt. In fact the partner should have a right of relief against the partnership for the whole amount of the debt. It would also be rather misleading to give the impression that if the partnership paid, it would have a right of relief against the partners.’[17] It is submitted that it is wrong to be unduly concerned in this regard. While the Law Commission is absolutely right to emphasise clarity and simplicity in the ‘default code’, it should be remembered that creditors commencing legal action against a firm are very likely to have sought legal advice. The Law Commission is weary of stipulating that creditors must proceed against the firm before the partners on the basis that creditors should not be obliged to take unnecessary steps. If it is clear from the outset that settlement of liability will only come from a direct action against individual partners, the law should reflect this reality. On the other hand there is a more important consideration to take into account. Partners should be protected from actions against themselves as private individuals, when the firm with legal personality would be able to settle the liability. The Law Commission has written, ‘On balance, our provisional view is that a creditor should not have to exhaust enforcement remedies against the assets of the partnership before enforcing the judgment against the assets of a partner.’[18] It is submitted that it is clear advantage of the introduction of legal personality that it will be possible to bring actions against the partnership. An advantage of the current system is that the default rules come into operation without any action being taken by the parties. The system is simple and comprehensible. The introduction of legal personality threatens this to some extent. If the law were to state that legal personality is only accorded for firms that have registered, firms would be divided into three categories; those with their own partnership contracts, unregistered firms without legal personality and registered firms with legal personality. This regime may well be confusing for small firms who do not have ready access to legal advice and who are unlikely to understand the difference between a registered firm with legal personality and one without. It is submitted, therefore, that the Law Commission is correct to suggest that legal personality should arise automatically as a result of the default rules. This would maintain the advantageous simplicity of the current system. There is one possible major advantage of legal personality that the law commission has neglected to consider. Separate legal personality could result in automatic unlimited limited liability for all firms. The current division between conventional firms and limited liability partnerships is confusing. Again, it is unlikely that small firms will have access to legal advice and will not understand the advantages of limited liability. Separate legal personality is conceptually consistent with limited liability. It creates a separate entity from the partners, an entity which takes all the risks. The Economist eloquently records its support of limited liability ‘The economic historian of the future may assign to nameless inventor of the principle of limited liability… a place of honour with Watt and Stephenson, and other pioneers of the Industrial Revolution. The genius of these men produces the means by which man’s command of natural resources was multiplied many times over; the limited liability company the means by which huge aggregations of capital required to give effect to their discoveries were collected, organized and efficiently administered.’[19] It is submitted, therefore, that a natural consequence of separate legal personality is automatic limited liability. This approach would iron the current inequalities in the law, where large professional partnerships with access to legal advice are likely to constitute themselves as LLPs. Of course the major advantage on unlimited liability is that financial affairs are accorded a higher degree of privacy. It is questionable, however, how far small firms value such privacy. It is submitted that given a choice between privacy and limited liability, most small businesses would choose limited liability. While it was perhaps outside the Law Commission’s term’s of reference to address this issue, it is, perhaps, a wasted a opportunity. There is no reason why large firms with access to legal advice should not be allowed to ‘contract out’ of unlimited liability if they wish to protect their privacy. The introduction of legal personality for partnerships would benefit the law, so long as it was part of the default code and not subject to registration. Registration would only complicate an admirably simple system. The introduction of legal personality would iron out difficulties of property ownership and the bureaucratic legal necessity of transferring property each time there is a change in partnership membership and a ‘new’ partnership is created. It would also allow contracts made with the partnership to survive a change in membership and rights and obligations of the partnership would persist. It would allow for actions for liability to be brought directly against the firm rather than against the partners as private individuals. This is highly desirable as the law should try and limit actions against private individuals on policy grounds. Conversely, it would complicate the currently transparent system in operation for the winding up of a partnership, introducing an intellectually vague concept that the partnership is ‘gone, but not yet gone.’ There is also the inevitable argument that as the system is working relatively successfully, alterations may be bureaucratic and time consuming for only minor benefit. The Law Commission failed to consider the advantages of making the ‘default’ partnership limited liability. This is a great shame. Limited liability is a natural extension of separate legal personality.
  • Commercial Law And Practice, The College of Law, 2006
  • Halpbern, An Analysis Of Limited Liability In Corporation Law, University of Toronto Law Journal, 1980
  • Inland Revenue v Graham’s Trustees [1971] SC (HL) 1
  • Law Commission, Consultation Paper 159, Partnership Law, 2000
  • Law Commission, Consultation Paper 159, Partnership Law, Summary, 2000

ï‚· Partnership Act 1890

  • Toulson, Law Reform In The Twenty First Century, Legal Studies, Vol 26, No. 3, 2006
1

Footnotes

[1] Toulson, 2006, p 321 [2] Law Commission Report 159, at 1.4 [3] As above at 1.8 [4] As above at 1.17 [5] As above at 2.7 [6] As above at 4.11 [7] As above at 11.19 [8] As above [9] As above at 4.38 [10] As above [11] As above at 4.11 [12] As above [13] As above at 4.13 [14] Inland Revenue v Graham’s Trustees [1971] SC (HL) 1. [15] Law Commission Report at 8.11 [16] As above at 8.20 [17] As above at 10.15 [18] As above at 10.19 [19] Cited in, Halpern, 1980, p 1
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