Partnership Law [2003] SLC 192(8) (Report) (November 2003)

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Scottish Law Commission (Reports)

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URL: http://www.bailii.org/scot/other/SLC/Report/2003/192(8).html
Cite as: [2003] SLC 192(8) (Report)

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PART VIII

CONTINUITY OF PARTNERSHIP AND THE OUTGOING PARTNER

Introduction

In this Part we discuss the proposals to encourage continuity of partnership which we set out in the Joint Consultation Paper, the debate which those proposals generated and our recommendations on continuity and the rights of the outgoing partner.

8.2

Many partners conduct business in partnership on the basis that there is continuity of partnership, notwithstanding the existing rule (at least in English law) that a change in the membership of a partnership gives rise to a new partnership. Many partnership agreements commit partners to continue doing business together when one of the partners dies or retires. In this Part we recommend that there should be a default rule that a change in membership should not terminate a partnership. The default rule should be continuity of partnership on change of membership, provided that at least two partners remain in partnership. This has the consequence that in the default regime the outgoing partner would not have a right to insist on a winding up of the partnership. Instead, the partner wishing to leave the partnership would be able to withdraw and would be entitled to receive the value of his share in the partnership. This would promote continuity of partnership and thus the stability of businesses carried on in partnership.

8.3

At the same time we recognise the need to protect the legitimate interests of the outgoing partner, and recommend the introduction of new measures to enable the outgoing partner to obtain his financial entitlements on withdrawing from a continuing partnership. We also recommend default rules by which the former partner can obtain indemnity from the continuing firm or contribution from the partners who remained in the partnership on his withdrawal.

8.4

The consultation exercise illustrated real uncertainty, particularly in English law, as to the applicability of certain contractual doctrines to the law of partnership. Recent case law appears to have resolved some of this uncertainty. We take the opportunity in this Part to recommend an approach in the draft Bill which will confirm the approach of those cases.

Terminology

8.5

It may be useful at the outset to clarify the meaning of terms which we use in this Part. "Continuity of partnership" refers to the continuation of a partnership on changes of its membership. As a result of the introduction of separate legal personality, so long as a partnership continues, it remains the same legal entity notwithstanding changes in its membership. "Dissolution" under the existing law refers to the termination of the partnership, which can and often does occur before the partnership business has been wound up.

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Continuity of partnership

Existing law

In English law a change in the membership of a partnership, whether an admission or a withdrawal, brings into existence a new partnership. A partnership of A, B and C is a different partnership from that of A, B, C and D and a partnership of B, C and D is again a different partnership.

^[3]

Lindley & Banks

Because the firm name represents no more than a convenient means of describing the partners who for the time being make up the firm, whenever the partners change that name must take on a new meaning.^[4]

In Scots law, in which a partnership has separate legal personality, there is uncertainty as to whether a change in membership terminates the personality of the "old" partnership and brings into being a "new" partnership entity.

^[5]

The partnership at will

In both jurisdictions the default arrangement is the partnership at will. As its name suggests, a partnership at will is dissolved immediately when any partner gives notice to all the other partners.

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The Syers v Syers order

On dissolution of a partnership, a partner has a statutory right to have the partnership wound up so that the property of the partnership may be applied in paying the liabilities of the partnership and in distributing the surplus of the proceeds of sale of its assets to the partners.

^[9]

The courts have on occasion acted to prevent the unnecessary winding up of viable businesses where a partner's legitimate interests can be met by less drastic remedies. Thus the court has refused to grant a salaried partner's application to wind up a partnership on the ground that he lacked any proprietary interest in the partnership's capital, goodwill or clients.

Syers v Syers

Lindley & Banks

Syers v Syers

^[14]

In many cases the partners who wish to continue the business are able to agree with the outgoing partner that it is not necessary to wind up the business. The outgoing partner negotiates and receives a financial settlement in return for the transfer of his share in the partnership to the ongoing partners. This is known as "technical dissolution" as the partnership business is not wound up. But even where the outgoing partner accepts a buy-out in lieu of a winding up, the continuing partnership is a "new" partnership because the membership has changed.

8.12

Assets which were held for the "old" partnership require to be transferred to or held for the "new" partnership. While it appears that this has not created difficulty in practice, the basis by which assets come to be held for the "new" partnership is not clear in either jurisdiction.

Problems of discontinuity: a summary

8.13

The lack of continuity of partnership gives rise to a number of problems. The principal problems include the enforcement of partnership debts against the partnership, the transfer of property from the "old" partnership to the "new" partnership, the right of the "new" partnership to take the benefit of contracts which the "old" partnership has entered into, and the authority as agent conferred on or by an "old" partnership.

^[15]

Our provisional proposals

In the Joint Consultation Paper we proposed that the default rule should be that a change of membership does not dissolve a partnership.

^[16]

We also proposed that as a default rule the outgoing partner should lose the right to insist on a winding up of the partnership. Instead, the outgoing partner's share should be transferred to the remaining partners by operation of law at the moment of departure. As a counterpart of this transfer we proposed that the outgoing partner should become entitled to the value of the share as a debt from the date of departure. We suggested that while the outgoing partner should be entitled to interest at a commercial rate on the value of his share from the date of departure, he should no longer be entitled to a share of the profits attributable to his share in the partnership assets.

^[17]

We recognised and recognise that these proposals are central to our aim to achieve greater stability in partnerships and that the removal of the right to insist in a winding up of a partnership affects the interest of the outgoing partner. We therefore consider measures which may provide appropriate protection to the outgoing partner in detail below.

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Consultation

There was strong support in both jurisdictions for our proposals to introduce continuity of partnership on change of membership as a default rule. In England support came from practising lawyers, professional bodies, representative bodies in industry and finance and from academics.

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^[21]

There was general support for our proposal to replace section 42 of the 1890 Act with an entitlement to interest at a commercial rate. Such opposition as there was to the proposal was based on the view that the right to elect to receive a share of profits was a salutary disincentive to the continuing partnership withholding monies due to the former partner.

^[22]

Reform recommendations

We remain firmly in favour of the policy of encouraging continuity of partnership by removing the rule that a partnership is dissolved on a change of membership and by restricting the right of an outgoing partner to insist on the winding up of the partnership. We have considered carefully the comments of the influential consultees who have concerns about the position of the outgoing partner. We believe that the measures which we recommend below to protect the interests of the outgoing partner are sufficient to meet those concerns.

^[23]

More detailed rules

Although consultees did not suggest that it would be a problem, we recognise that replacing the partnership at will as the basic partnership model will involve the enactment of more rules in the default regime to govern the rights of partners on a change of membership. In formulating the rules, we aim to provide a practical arrangement by which a partnership may deal with the withdrawal of a partner in a way which is fair as between the partners while preserving continuity of partnership. Indeed, the fact that many well-organised partnerships contract out of the default rule of the partnership at will is itself suggestive that more detailed rules are an acceptable price for continuity of partnership. The rules are intended to create a practical mechanism and timetable for a partner to withdraw and for the other partners to respond to the withdrawal. They are default rules and parties are free to agree different arrangements. They do not compromise the flexibility of partnership as a business vehicle.

The inadvertent partnership

8.21

Another possible criticism of our recommendations, which we have considered, is that there will be partnerships in which the partners are unaware that they are in partnership. Such partners may not observe the procedures which we prescribe in the default regime. This may well be the case. But we do not think that this consideration is a sufficient reason for forgoing the benefits of continuity of partnership. We have four principal reasons for this view.

8.22

First, it is likely that partnerships in which partners are not aware of their status as such will often (but by no means exclusively) be informal two-person partnerships. Such partnerships will break up on the withdrawal of a partner

^[24]

Secondly, under the existing law the unaware partner owes fiduciary duties,

Thirdly, we think that where parties are genuinely not aware that they are in partnership and have acted on the understanding that any one of them may terminate the arrangement on giving notice, the courts will be able without too much difficulty to infer the existence of an agreement to allow the break up of the partnership on notice. The default regime would not apply in such circumstances.

8.25

Fourthly, and in any event, in making recommendations to reform the law of partnership we have to address the interests of persons who know that they are in partnership and wish a workable and efficient default regime as well as the interests of partners in an inadvertent partnership. We think that there is a strong case for the default rule of continuity of partnership to assist the commercial interests of advertent partnerships and in the public interest of continuity of business activity. For the reasons given above, we do not think that the problems which the inadvertent partnership may face are sufficiently serious to militate against our recommendation.

The loss of vested contractual rights

8.26

A further possible problem, which appears to have influenced the drafters of RUPA, is that removal of a partner's right to insist on a winding up of the partnership could take away the contractual rights of existing partners without their agreement. We do not consider this to be a problem in relation to our recommendations as our recommended transitional provisions

^[29]

The incoming partner's capital

Another problem which caused some consultees concern was the effect on the incoming partner. We have discussed this issue already.

^[30]

^[31]

Where after the incoming partner joins the partnership, a partner withdraws and the firm gives him an indemnity when buying out his interest in the partnership, the incoming partner will incur secondary liability to the former partner under that indemnity. His personal assets may thus be affected by prior obligations. But again this arises under the existing law when a "new" partnership takes over an "old" partnership's business and grants an indemnity to an outgoing partner.

8.29

We therefore think that the default rule, which partners can reverse or qualify by agreement, should be that a partnership continues on a change of membership whether that change is a partner joining the partnership or a person ceasing to be a partner, provided that there remain at all times at least two partners. We achieve this result in the draft Bill by defining exclusively the grounds on which a partnership breaks up. In a partnership with only two partners the withdrawal of one partner will break up the partnership.

8.30

We therefore recommend that it should be a default rule that a partnership continues when a partner joins a partnership or withdraws from a partnership, provided that there remain at all times at least two partners. This is achieved in the draft Bill by providing a comprehensive list of the circumstances in which a partnership breaks up and by excluding from that list a change in the membership of the firm (unless the partnership agreement otherwise provides). (Draft Bill, cl 38).

8.31

Continuity of partnership where a partnership has separate legal personality means that the same entity will hold the property of the partnership and will be primarily liable for partnership obligations notwithstanding changes in its membership. The secondary liability of partners will be affected by the exits and entrances of partners as discussed in Part VI above.

^[32]

We also recommend the abolition of the outgoing partner's right under section 42 of the 1890 Act to opt to receive a share of the profits made after his withdrawal where the continuing partners have not bought out the outgoing partner's share. It is notoriously difficult to attribute a proportion of the profits of a continuing partnership to the use of the outgoing partner's share of the partnership assets.

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Lindley & Banks

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^[35]

As the partnership will continue on the withdrawal of a partner it is necessary to provide for the buy-out of the outgoing partner's share. We think that there should be a default rule that where a partner withdraws from a partnership

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^[37]

If the outgoing partner holds any partnership property in his own name at the time of his withdrawal from the partnership, he (or his estate) should be bound, on request, to transfer title to the partnership or to trustees for the partnership.

8.35

We therefore recommend that there should be a default rule that where a partner withdraws from a partnership, he is bound on request to transfer to the partnership or to trustees for the partnership title to any partnership property which he held in his own name at the time of his withdrawal from the partnership. (Draft Bill, cl 34(7))

Striking a balance: the rights of the outgoing partner

Our provisional proposals

8.36

In the Joint Consultation Paper we provisionally proposed that the outgoing partner should be entitled to the value of his share as a debt due by the partnership from the date of his withdrawal. We discuss the measure of value and the extent of the indemnity to which the outgoing partner would be entitled in the following section.

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Consultation

Consultees were divided on the protection which we proposed for the outgoing partner. Those who opposed the removal of the partner's right to insist on a winding up suggested that the protection was inadequate and that the right to wind up the business should remain to prevent the remaining partners "driving the [partnership] business into the ground". Others suggested that the outgoing partner should not have a right to wind up but that he should be given further protection. Suggestions included giving the court power to order a winding up not only on the ground proposed but also on the "just and equitable" ground. Another suggestion was to lower the threshold from "substantial likelihood" to "a real possibility" or a similar test. The Chancery Bar Association suggested that the outgoing partner should have an unfettered right to apply to the court which should be empowered to order a winding up if that were "just and equitable".

^[39]

Other consultees thought that the proposal gave the outgoing partner too much protection. They did not favour allowing the outgoing partner to seek a winding up order from the court. They argued that it was not necessary as he could recover his debt by normal means of enforcement and that his best chance of payment and indemnity was if the partnership continued in business.

^[40]

Some consultees also expressed the view that a partnership should have the right to dissolve itself on the death or bankruptcy of a partner whose membership was essential to the viability of the partnership business.

Reform recommendations

8.40

The question is one of balancing the interests of the outgoing partner on the one hand and the remaining partners on the other. There is also the public interest in preserving businesses and facilitating economic activity.

8.41

We adhere to the view that the primary right of the outgoing partner should be to receive the value of his share in the partnership. As that share is valued by reference to the net assets of the partnership, the outgoing partner in the default regime should be entitled to an indemnity from the continuing partnership at least in relation to the liabilities of the partnership which were taken into account in valuing his share. We discuss the valuation of the outgoing partner's share and the indemnity below.

^[41]

At present, parties negotiating the withdrawal of a partner under English law have to consider on the one hand the right of the outgoing partner to seek the winding up of the partnership and on the other the option available to the continuing partners to seek a Syers v Syers order from the court.

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Syers v Syers

We think that it is more appropriate that the default regime presents the balancing factors the other way round. Under our recommendations the outgoing partner's primary right is his financial entitlement. To discourage unscrupulous behaviour by the continuing partners we think that the outgoing partner should have the additional right, both at the time of his withdrawal and thereafter, to apply to the court for the winding up of the partnership.

8.44

A former partner who has not been paid his financial entitlement by the continuing partnership or who has good grounds for apprehending that the partnership could not or would not honour the indemnity that it had given would have the right to seek a court order for the winding up of the partnership.

^[43]

While a court may in many cases be reluctant to order the winding up of a partnership on the application of a former partner long after he has left the partnership, there may be cases where the former partner can demonstrate that a winding up order is appropriate. A former partner may find it difficult to enforce an indemnity in his favour where the financial health of the continuing partnership is precarious: the indemnity is a continuing obligation and is required so long as debts, for which the former partner has a secondary liability, subsist. The right of a former partner to apply for a winding up at the time of withdrawal and thereafter would be a fact which the continuing partners would require to take into account in their negotiations with an outgoing partner.

8.46

We see merit in the suggestion that we should not lay down tests for such applications, for example, by requiring a substantial likelihood that the remaining partners would not meet their financial obligations to the outgoing partner. We think that a former partner should have a statutory right to seek the winding up of the partnership on the ground that the affairs of the partnership are being conducted in a way which prejudices his interests and it is just and equitable that it be wound up. This will provide the continuing partners with a motive to meet the outgoing partner's financial entitlements and will give the court discretion to act justly in the light of all the circumstances.

8.47

In dealing with an application by a former partner the court would be able to give such relief as it thought fit. Where the problem was a failure by the remaining partners to provide accounts which established the outgoing partner's financial entitlement, the court could order that the requisite accounts be drawn up. In addition, the court could order interim payments or require the remaining partners or the partnership to provide security for the outgoing or former partner's claim. Where necessary, the court could order the break up of the partnership and appoint a liquidator to wind up its business. For example, if the continuing partners had stripped assets out of the partnership to the prejudice of the former partner, the court could take account of such action in granting relief to the former partner. The personal representative of a deceased partner and the insolvency practitioner in relation to a bankrupt partner should also have the right to seek relief, for example where their interests are being prejudiced by the incompetent winding up of a partnership.

^[44]

We therefore recommend that a former partner, the personal representative of a deceased former partner and the insolvency practitioner in relation to a former partner should have the right to apply to the court to make an order to give relief on the ground that the partnership affairs are being conducted in a way that is prejudicial to his interests and it is just and equitable to make the order. The court should have a general discretion to make such order as it thinks fit for giving relief, including (without prejudice to the generality of the discretion) (a) requiring accounts to be drawn up, (b) requiring interim payments to be made, (c) requiring security to be provided, (d) breaking up the partnership and (e) giving directions as to the way in which the partnership is to be wound up. (Draft Bill, cl 53).

The financial rights of the outgoing partner

Our provisional proposals

8.49

In the Joint Consultation Paper we sought the views of consultees on different measures of valuation of the outgoing partner's share.

The notional sales measure

8.50

The first, the notional sales measure, would measure the outgoing partner's entitlement by reference to the value of the business as a whole on a hypothetical sale. This would include attributing a value to work in progress and (if appropriate) to goodwill.

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The accounts measure

The second, the accounts measure, would measure the outgoing partner's entitlement by reference to the accounting practice in the last annual accounts. The accounts could be made up on that basis to the date on which the outgoing partner leaves the partnership. Many partnerships adopt this approach in partnership deeds. It has the advantage of being relatively simple, certain and cheap to apply. The principal difficulty with that measure, however, is that in many partnerships the annual accounts are not compiled for the purpose of valuing the partnership's business and the values attributed to assets may be an inappropriate basis for assessing the value of the outgoing partner's share. We also pointed out that annual accounts often ignore goodwill. They may also treat work in progress in a way which would not be appropriate in this context.

^[47]

An indemnity

As on either measure the outgoing partner is being paid a value for his share of the value of the partnership, one looks to the net assets of the partnership after deduction of known liabilities. We therefore proposed as a default rule that the outgoing partner should receive the benefit of an indemnity from the remaining partners. We asked consultees whether the indemnity should be qualified (a) to exclude any liability attributable to the outgoing partner's wrongful acts or omissions; or (b) so that it was without prejudice to any claims which the partners or partnership might have against the outgoing partner for breach of duty to the partnership; or (c) in any other way.

^[48]

Interest on the value of the unpaid share

In place of section 42 of the 1890 Act we proposed that the outgoing partner should have a right to interest at a commercial rate on the value of his share in the partnership which remained outstanding after his withdrawal.

^[49]

Consultation

Most consultees favoured the proposal to introduce a statutory default measure of the value of the partnership to enable partners to value the outgoing partner's share. It was recognised that it was not appropriate to lay down detailed rules of valuation as the circumstances of different partnerships were so varied.

The appropriate measure of value

8.55

The majority of consultees supported the notional sales measure as the fairest default provision. Several consultees pointed out that in many partnerships there was little if any value attached to goodwill because the sellers of a partnership business did not usually give covenants against competition. Nor is it usual for the incoming partner to pay for goodwill. The Institute of Chartered Accountants in England and Wales thought that the notional sales measure was too expensive as a default provision.

^[50]

Many consultees opposed the accounts measure, maintaining that it was unfair. It was argued that the partnership's accounts were compiled for a different purpose and might state assets at inaccurate values. There could be a material difference between the written down value of assets in partnership accounts and their market value. The measure was also not suitable for the partnership where a partner withdrew before the first annual accounts had been finalised.

8.57

Some consultees suggested that an approach based on "fair value", which was used in Financial Reporting Standards for company accounting, should be adopted. Another suggestion was that partnership law should adopt an approach similar to that adopted by the courts in the valuation of a minority shareholder's interest under section 461 of the Companies Act 1985. Our consultant opposed the use of the concept of "fair value" and emphasised that the critical issue was the need to ascertain the market value of the partnership business or its assets. This involved many factors such as whether the business was to be viewed as a going concern or valued on a break up basis, whether the partners were assumed to be in the market and whether and, if so, how value was to be attributed to goodwill. He suggested that detailed valuation rules were unworkable.

An indemnity to the outgoing partner

8.58

Most consultees supported the inclusion in the default regime of an indemnity to the outgoing partner. Several consultees suggested that the proposal reflected the position under the existing law. Roderick Banks, our consultant, considered the indemnity to be essential. Several consultees pointed out that the outgoing partner was also entitled to the indemnity when on completion of the withdrawal accounts it was discovered that he was not due to be paid anything by the partnership and when, if there was a balance due by the outgoing partner, he paid that balance to the partnership. We agree. Whoever is due to pay a balance to the other, that balance is calculated by reference to the value of the net assets of the partnership. Accordingly, known liabilities are already taken into account in determining that balance.

8.59

There was limited opposition to the proposal for an indemnity. One consultee argued that there should be no general indemnity unless expressly provided for in a partnership agreement. It referred to the risk of "long tail" liabilities in the construction industry where liability could arise from latent defects in work completed by an earlier generation of partners. The risk of such liability would, it suggested, encourage partners to insist on a dissolution of the partnership and the formation of a new one in order to avoid a general indemnity. One consultee preferred to leave indemnity to the discretion of the partnership in order to discourage partners in a partnership in financial difficulty from leaving the partnership in order to burden their fellow partners with the obligation to indemnify them. It also expressed concern over giving an indemnity to a partner who had caused loss to the partnership by his behaviour and suggested that the default regime should allow a partnership by a 75% majority to deprive a partner of his indemnity. Another consultee suggested that the indemnity should be limited to known and ascertained debts taken into account when valuing the outgoing partner's share.

Restrictions on the indemnity

8.60

Consultees expressed differing views on the extent to which the indemnity should be qualified to exclude liability attributable to the outgoing partner's wrongful acts or omissions. Some argued that the indemnity should be limited only by express agreement. Differing views were expressed on whether the indemnity should not cover future liabilities for the outgoing partner's negligence rather than dishonesty or deliberate fault. The Scottish Law Commission's Partnership Advisory Group suggested that the indemnity should be qualified so that it was without prejudice to any claims which the partners or the partnership might have against the outgoing partner for breach of duty but that the draft Bill should not attempt to define other exclusions.

Interest on the value of the outgoing partner's share

8.61

In response to our proposal that the outgoing partner should have a right to interest at a commercial rate on the value of his share in the partnership, consultees expressed different views as to the rate of interest which would be appropriate. The Institute of Chartered Accountants of England and Wales suggested rates of interest which escalated over time so as to impose a penal rate if there was serious delay. Other suggestions included the rate of interest on judgments and a fixed percentage over the Bank of England base rate or London Interbank Offered Rate (LIBOR) to provide an incentive for the debt to be paid without being punitive to the continuing partnership.

Reform recommendations

The measure of value

8.62

We recognise that any default measure of value will have its critics. We also agree that it is inappropriate to lay down detailed statutory rules of valuation: not only will the detailed rules be inappropriate for some partnerships but also accounting practice will change over time.

8.63

In our view, the most important consideration in the default regime is to place the outgoing partner and the continuing partners as closely as possible to the financial position in which they would be on a winding up of the business, whether by sale of the business or by the breaking up of its assets. As we recommend that the outgoing partner should lose the right to insist on the winding up of the partnership, it is appropriate to protect his financial position so that he enjoys an equivalent financial right. We agree with Roderick Banks that it is important to ascertain the market value of the partnership business or its assets in the default regime. Partnerships which wish to adopt the accounts measure may contract out of the default regime to do so. But, applying the "think small first" principle, the default regime should address market value.

8.64

We think that this is essentially similar in aim to the "fair value" approach of the Financial Reporting Standards (FRS). FRS 7 ("Fair Values in Acquisition Accounting") defines "fair value" as "the amount at which an asset or liability could be exchanged in an arm's length transaction between informed and willing parties, other than in a forced or liquidation sale". The FRS then sets out detailed principles by which the acquiring company is to value the acquired business in its accounts. In this context the exclusion of a forced or liquidation sale is appropriate. We do not recommend the enactment of detailed valuation rules in a Partnerships Bill or in subordinate legislation. It is not necessary therefore to consider the detailed principles of FRS 7. We also do not think that it is appropriate to use a concept like "fair value" in legislation as that might be a licence for parties to argue that equitable considerations based on the parties' prior conduct should influence the value to be attributed to an outgoing partner's share. What we take from FRS 7 is the pursuit of the market value of the assets of the business.

8.65

In the context of the valuation of an outgoing partner's share, the market value of a business may be its value on a sale as a going concern or it may be the break up value of its assets. Some partnership businesses may be capable of sale as a going concern; many may have value which is realisable only through the sale of assets in a winding up.

8.66

We have looked again at our proposals for valuation in the light of the consultation responses. We have considered the approach of RUPA, which seeks to encourage the norm of the buy-out of the outgoing partner's share. In section 701(b) RUPA defines the buy-out price of a dissociated partner's interest as the amount which would have been distributable to the dissociating partner on a winding up:

… if, on the date of dissociation, the assets of the partnership were sold at a price equal to the greater of the liquidation value or the value based on the sale of the entire business as a going concern without the dissociated partner and the partnership were wound up as of that date.

8.67

We are attracted to this approach as it is an attempt to give the outgoing partner that which he would receive if the partnership were wound up. In some partnerships it may be possible to sell the business as a going concern, particularly where the partnership's economic activity is not dependent on the work of its individual partners so that other persons could manage the business in their place. In others, for example professional partnerships, it may be more difficult to do so, where the client connection is with the individual partners and where those partners are not contractually constrained from leaving the partnership and competing with it. The hypothetical vendors of the partnership would seek to maximise the sale price by a sale as a going concern if that were possible. In many cases it may not be possible. Where it is not possible, on the RUPA approach, the liquidation value will be the appropriate value.

8.68

In many professional partnerships, where the restrictive covenants (if any) in the partnership agreement do not prevent the partners from leaving the partnership and competing with it and where partners are not contractually obliged to remain within the partnership in the long term, it is conventional for valuers to attribute either no value or only very limited value to goodwill. This is because the hypothetical purchaser will not pay the hypothetical vendor a significant sum for the partnership business in addition to the value of its other assets because the purchaser cannot be sure of the continued contribution of the partners.

^[51]

The outgoing partner's indemnity

We consider that an outgoing partner whose share is valued by reference to the net assets of the partnership should be entitled to an indemnity in the default regime. Otherwise he suffers the deduction of known liabilities in the calculation of his share while remaining liable to third parties for those partnership liabilities without the right to be reimbursed by his former partners. The indemnity will not prevent third parties from suing the former partner but so long as the partnership and his former partners are solvent, he can seek reimbursement from them should he be required to pay a partnership debt to a third party.

8.70

We have considered carefully whether to provide for a general indemnity against liabilities or to confine the indemnity to known liabilities which were taken into account in determining the outgoing partner's financial entitlement. We are aware of arguments in favour of the latter. RUPA

^[52]

^[53]

On the other hand, it appears to be the present law that an outgoing partner is entitled to a general indemnity from his former partners who choose to continue in partnership and take over the assets of the partnership. Thus in Gray v Smith

^[54]

The withdrawing partner shall make over to the continuing partners all his interest in the partnership and in the partnership assets, whether there be real or personal estate … Secondly … the continuing partners shall indemnify the retiring partner against all liabilities of the firm from that time forth.

We think that we should preserve this existing rule. It achieves finality. By contrast, an indemnity which is confined to known liabilities may not achieve finality in the calculation of the financial entitlement of the outgoing partner and the continuing partners. In some cases it may expose the outgoing partner to an unforeseen liability. For example, a partnership may enter into a lease at market value while partner A is a partner. When partner A resigns from the partnership the lease may have no value and be ignored in the calculation of the outgoing partner's interest. Some time later the partnership assigns the lease to a third party. In English law, if the assignee of a lease went bankrupt the partnership as assignors would incur liability to the landlord. Partner A would retain secondary liability under the lease. If we were to recommend an indemnity which was limited to known liabilities, the former partner would not have an indemnity against such a claim. That appears to be unjust as the continuing partners have chosen to assign the lease to the third party. In addition, an indemnity confined to known liabilities could create significant problems in relation to disputed liabilities where complaints are intimated to a partnership but it is not clear whether any or how many may develop into claims. In addition, where the firm has an insurance policy which operates on a "claims arising" basis the former partner may benefit from the firm's insurance through the indemnity when otherwise he would not. We therefore favour a general indemnity as the default rule.

^[55]

We also think that an outgoing partner's entitlement to an indemnity on withdrawal should not prevent the partnership or the other partners from pursuing claims against him for breach of duty, breach of contract, fraud or misrepresentation. Under the existing law the implied indemnity does not cover claims which any of the other partners have against the outgoing partner, such as for breach of duty.

^[56]

The right to a commercial rate of interest

We have already recommended that it is not appropriate to preserve the outgoing partner's option under section 42 of the 1890 Act to seek a share of the profits attributable to the continuing partnership's use of his share of the partnership.

^[57]

^[58]

We recommend therefore that there should be a default rule that on withdrawal from the partnership the outgoing partner (or his estate) has the following financial rights as a debt due by the partnership:

(1) To be paid the value of his share in the partnership calculated on the hypothesis that the partnership had broken up and its assets were sold on the date of his withdrawal at a price equal to the greater of (i) the liquidation value and (ii) the value based on a sale of the entire business as a going concern without the outgoing partner. (Draft Bill, cl 32(1), (2)(a) and (3))

(2) To be paid interest at a commercial rate on the value of his share from the date of withdrawal. The prescribed rate of interest should initially be three per cent above the Bank of England base rate. The rate should be alterable by statutory instrument to allow for changes in economic conditions. (Draft Bill, cls 32(2)(b), 76(1))

(3) To be indemnified against partnership liabilities or payments made in reasonable settlement of an alleged personal liability for a partnership obligation but the indemnity is without prejudice to any claim of the partnership or the other partners against the outgoing partner. (Draft Bill, cl 34(1), (2) and (3))

8.76

The right set out in paragraph 8.75(1) above will have the effect that the partnership assets are valued as they are at the date of withdrawal but that the price to be paid for the business is on the basis that the partnership will not have the continuing services of the outgoing partner. Whether in the hypothetical sale the purchaser will pay anything to the vendors for the continued services of the partners who remain will depend on the nature of the partnership business and the terms on which those partners participate in the business. As we have said,

^[59]

It may occur that the valuation exercise set out in paragraph 8.75(1) above results in a sum due by the outgoing partner to the partnership, as the partnership may have a negative value or if it has a positive value, there may in the result be a negative balance on the outgoing partner's account. The default rule should be that the former partner is liable to pay the resulting sum to the partnership.

8.78

We therefore recommend that where the valuation of the outgoing partner's share in terms of paragraph 8.75(1) above results in a sum due by the outgoing partner (or his estate) to the partnership, the outgoing partner (or his estate) should be liable to pay that sum to the partnership. (Draft Bill, cl 32(2) and(3))

Where the partnership does not honour the indemnity

8.79

If the firm does not indemnify the former partner who has withdrawn from the firm before the firm breaks up, he should be entitled, in the default regime, to an indemnity from any person who was a partner when he ceased to be a partner and who continued to be a partner thereafter. This is justified by the consideration that the continuing partners have in substance taken over the former partner's interest in the partnership's net assets and it is they who should be responsible to indemnify him against continuing or future liabilities. If the former partner is not so indemnified he should be entitled to contribution from any person, such as another former partner or a continuing partner, who was liable with him for the partnership obligation. As those obliged to make such contributions may not have been partners at the same time in the partnership,

^[60]

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^[62]

We therefore recommend that if the partnership does not pay all or part of the indemnity the former partner should be entitled to either (a) indemnity from any person who was a partner when he ceased to be a partner and who continued to be a partner thereafter or (b) contribution from any person who was liable with him for the partnership obligation (or, in case of settlement of an alleged liability, would have been liable if the alleged liability had been established) of such amount as is just and equitable. (Draft Bill, cl 34(4) and (5))

8.81

The former partner's rights to indemnity from the firm and to indemnity or contribution from his former partners are default rules. It is open to partners to agree other terms to govern the rights of an outgoing partner. But the rights of the former partner once conferred cannot be removed without his consent. It is not necessary therefore to state in the draft Bill that the continuing partners cannot retrospectively alter the rights of a former partner without that person's consent.

The mechanisms for withdrawal from a partnership and the powers of the court

Introduction

8.82

In this section we consider the mechanisms for withdrawal from a partnership. We consider first voluntary withdrawal, where a partner chooses to retire from a partnership. We then consider involuntary withdrawal, which may occur on the death or bankruptcy of a partner. Thirdly, we consider the circumstances in which the court may order the withdrawal of a partner instead of ordering the winding up of the partnership. We also consider the circumstances in which the court may order the break up of a partnership.

8.83

The decision of the House of Lords in Hurst v Bryk

Mullins v Laughton

(1) The mechanisms for voluntary withdrawal

The mischief

The introduction of continuity of partnership requires us to address the mechanisms by which a partner may withdraw in a manner which protects both his interest and also the interests of the remaining partners. Since the consultation exercise we have benefited from further discussions on this matter with amongst others the APP and have developed our policy as a result.

8.86

The APP and our consultant, Roderick Banks, have emphasised the need for a withdrawal mechanism which protects the reasonable expectations of the outgoing partner and the remaining partners. What is required is a more orderly process of resignation. The outgoing partner requires reasonable certainty as to his entitlement on withdrawing from the partnership. On giving notice of resignation he should be able to know promptly whether he is to be bought out by a continuing partnership or the partnership is to break up. The remaining partners may decide that the withdrawal of a partner compromises the viability of a partnership and that the prudent response to his impending withdrawal is to break up the partnership. They need an opportunity to reach a view on this issue.

8.87

Several consultees urged us to provide that the remaining partners could break up a partnership where a partner wishes to retire and the residual partnership would not be large enough to support its continuing liabilities.

^[68]

The APP have also suggested that in any event it would be reasonable that a partnership of undefined duration should be broken up if at least fifty per cent of the partners wish to break it up (whether or not a partner has decided to resign); but that any partner who has given notice of resignation should be excluded from taking part in such a vote.

Reform recommendations

8.89

We recognise that if we are to meet the concerns of the APP and others we will be creating a more complex default regime than the present simplicity of a dissolution (technical or otherwise) on any change in the membership of a partnership. But that simplicity comes at the price of instability of the partnership.

8.90

It would be possible to provide simply for the resignation of a partner on a period of notice and leave it to the partners to respond to that notice by themselves resigning or deciding to break up the partnership. But that would not have the benefit of a default regime which requires those resigning in response to do so with effect from the same day thus enabling the financial rights of all the partners to be ascertained as at the same date. The regime which we recommend will benefit the partnerships whose partners are well aware that they are in partnership but who have not agreed detailed terms. The proposed default rules offer a mechanism for withdrawal which is fair to both the outgoing partner and the other partners. As we have said, the default rules will not assist the inadvertent partnership; but it should be relatively easy for the courts to infer an agreement to disapply the withdrawal mechanism where the parties have envisaged a right to terminate their business association on notice.

8.91

We think that there should be a default rule that a partner who wishes to withdraw from a continuing partnership should give notice of his withdrawal which will take effect only after the end of the prescribed period. This period of notice will give the other partners the opportunity to consider their position in the light of the intended departure of the withdrawing partner. Some partners may not wish to continue in partnership in the absence of the outgoing partner. During the period of notice the other partners can individually decide whether to withdraw from the partnership or collectively decide to discontinue the partnership.

8.92

This is an innovation in partnership law because the default regime to date has provided the partnership at will as the basic partnership structure. On the other hand many well-drawn partnership agreements provide not only for the continuation of the partnership on the retirement of a partner but also for the other partners to dissolve the partnership in response to notice of a partner's proposed retirement. We aim to provide a practical mechanism for withdrawal which fairly balances the interests of the partners.

8.93

The APP emphasised the need to avoid the danger of some partners ambushing others by choosing a time to intimate withdrawal from the partnership which injures the other partners. In particular, a last minute intimation of withdrawal by a partner or group of partners could impose on the remaining partners the obligation to pay out the shares of the withdrawing partners and leave the remaining partners with sole responsibility for the continuing liabilities of the partnership. Such a burden may be unsustainable. The APP's suggested default regime of a timetable for resignation would give the remaining partners the opportunity to consider the viability of the partnership business in the light of the intended resignations and, if appropriate, to elect to break up the partnership on the expiry of the first partner's period of notice. The result of such an election would be that all of the partners would receive their entitlement on the winding up of the partnership.

8.94

We are persuaded that this is an appropriate regime for the voluntary withdrawal of partners from a continuing partnership and is a sensible reform to avoid unfairness as between partners. The appropriateness of particular periods of notice in the default regime is a matter of judgement. We considered a default notice period of 4 weeks (28 days) but received representations that such a period was too short.

^[69]

We also agree with the APP that, as a default rule, a partnership should be broken up if at least fifty per cent of the partners vote in favour of a break up; and that any partner who has given notice of resignation prior to such a vote should not be entitled to take part in it.

8.96

We have concluded that the following is an appropriate default regime for a partnership of undefined duration:

(1) A partner wishing to resign from the partnership may give 8 weeks notice of his withdrawal;

(2) Each of the other partners has the option of resigning from the partnership at the same time as the partner in (1) above by giving not less than two weeks' notice of his intention to do so; and

(3) The partnership may be broken up at any time by a vote of not less than fifty per cent of the partners (excluding any partner who has given notice of resignation).

8.97

By requiring the partners who wish to withdraw in response to the first partner's notice of withdrawal to give notice within the first 6 weeks of the first partner's notice period, the timetable gives the remaining partners a minimum of 2 weeks to consider their position and, where appropriate, to resolve to break up the partnership. If 50% of the partners vote to break up the partnership with effect on or before the expiry of the notice period, that decision would override the outgoing partners' resignation notices and all partners would receive the financial entitlements which arise in the winding up.

8.98

Diagram 1 below is a flow chart showing the effect of the default timetable and the consequences of withdrawal including the former partner's right to seek a discretionary remedy from the court.

8.99

Where the partnership is of defined duration a partner will not in most circumstances

^[70]

^[71]

We therefore recommend that the following rules should be the default rules for resignation from a partnership of undefined duration:

(1) A partner wishing to resign from a partnership of undefined duration should give each other partner eight weeks' notice of his resignation;

(2) Each of the other partners should then have a right to resign from the partnership by giving not less than two weeks' notice, such notice taking effect on the same date as the expiry of the first partner's notice period;

(3) Partners (excluding any partner who has given notice of any resignation) should be entitled to break up a partnership at any time if not less than half of the partners vote to do so. A vote to break up a partnership at the same time as a resignation notice takes effect would supersede the resignation notice and all partners will be entitled to such sums as were due to them on settlement of accounts in the winding up. (Draft Bill, cls 30, 34(5) and 38(2)–(4)).

(2) Involuntary withdrawal from a partnership

Reform recommendations

Death or bankruptcy

8.101

The existing default regime provides for the dissolution of a partnership on the death or bankruptcy of a partner

^[72]

^[73]

Where a partner who is a natural person dies or a corporate partner ceases to exist his estate or its representative will have the same financial rights as he or it would have on resignation from the partnership.

^[74]

We also recommend for partnerships of defined duration a regime by which the other partners can elect to resign from the partnership in response to the death or bankruptcy and the remaining partners can agree to break up the partnership. Under the present default regime, a partnership, including one of defined duration, is dissolved on the death or insolvency of a partner.

^[75]

We recommend that a partner should have the right to resign from a partnership of defined duration when one or more persons has ceased to be a partner involuntarily, whether by death, insolvency or in terms of another provision in the partnership agreement. The notice regime will be the same as that for resignation in a partnership of undefined duration.

^[76]

^[77]

We are aware of the suggestion that where partners respond to the death of a partner by resolving to break up a partnership, we should backdate the break up of the partnership to the date of death. The suggestion is prompted by a concern that the estate of the deceased partner might receive a going concern value of his share while the remaining partners receive only what is left in a winding up. We doubt if this outcome is likely. If the response of the surviving partners to the death of their colleague is to break up the partnership, it is likely that an informed valuation of the partnership at date of death (which takes account of the absence of the dead partner) would not be on a going concern basis. The valuer ought to foresee the likelihood that the partners would not continue in business where the deceased partner was critical to the success of the business.

8.106

Where a partner is rendered bankrupt he ceases to be a partner under the proposed default rules from the moment of his bankruptcy. If the other partners' response is to break up the partnership, we think that the date of the break up does not need to be back-dated to the date of bankruptcy in order to be fair to the other partners, again for the reasons stated in the previous paragraph. Thus the bankrupt or insolvent partner (like the deceased partner's estate) will be paid out on a valuation on withdrawal, will not take part in the winding up, nor incur secondary liability in relation to expenses incurred in the winding up.

Expulsion

8.107

We do not support the introduction of any general power to expel a partner.

We think that there is force in the suggestion that it is not necessary to give an option to dissolve a partnership where a partner has allowed his share in the partnership to be charged if the other partners are given a power to expel the offending partner. We recommend therefore that the option in section 33(2) of the 1890 Act be replaced by an option to expel the offending partner. As expulsion is a serious step in a contract of the utmost good faith, we recommend that exercise of the option should require the unanimity of the other partners. We also recommend that the option to expel should be available when a partner allows his share in the partnership to be charged and where the partner's share is arrested in execution under Scots common law, in respect of a debt which is not a partnership debt. In order to protect the offending partner from immediate expulsion when such an event occurs we also recommend that the offending partner should have a period of grace of three months to remedy the situation before the expulsion notice can take effect.

8.109

On reflection we now propose that there should not be a power to expel where a partner voluntarily assigns his share in the partnership. In contrast with the partner whose share is charged or, in Scotland, arrested in execution, the partner who voluntarily assigns his share may not be in financial difficulty and may be able to perform his contractual duties as a partner without difficulty. If he is not able to do so, the partners will have a right to apply to the court for his removal, for example, on the ground that his conduct is adversely affecting the carrying on of the partnership business.

^[82]

We recommend that the following rules should be default rules for involuntary withdrawal from a partnership:

(1) If a partner dies (or if a non-natural legal person ceases to exist) or goes bankrupt (or if a non-natural person, an insolvent winding up order or an award of sequestration is made) the partner ceases to be a partner on the date of death or bankruptcy; (Draft Bill, cl 28(1)(c) and 29)

(2) The partner in question (or his estate) has the same financial rights as on voluntary withdrawal; (Draft Bill, cl 32)

(3) Where in a partnership of defined duration one or more persons has involuntarily ceased to be a partner, any other partner may resign from the partnership by giving each other partner not less than eight weeks' notice; (Draft Bill, cl 30)

(4) In response to the notice in (3) above each of the other partners should have a right to resign; (Draft Bill, cl 30(3))

(5) After the death or bankruptcy of a partner, the remaining partners should be entitled to break up the partnership as in paragraph 8.100 above; (Draft Bill, cl 38(2)–(4))

(6) In place of the existing right to dissolve the firm, the partners will have an option to expel a partner by unanimous vote (other than the offending partner) where: (a) (in English law) the partner allows his share in the partnership to be charged and (b) (in Scots law) a partner's share is arrested in execution. In each case the offending partner will have a period of grace of three months before the expulsion notice takes effect. The expulsion notice will be treated as having no effect if during the three-month period the charging order or the arrestment ceases to have effect. (Draft Bill, cl 31).

(3) The intervention of the court: removal of a partner or winding up

The mischief

8.111

The power of the court under section 35 of the 1890 Act to order dissolution of a partnership is not matched by a statutory power to order the withdrawal of a partner while allowing the business of the partnership to continue. Where a partner or partners invoke the jurisdiction of the court under this section the usual result is the dissolution of the partnership.

^[83]

In addition, as mentioned above,

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^[85]

Our provisional proposals

In the Joint Consultation Paper we proposed that in the replacement of section 35 of the 1890 Act the court should have the additional power, where a partnership consists of three or more partners, to dissolve only the relationship between the partner in question and the other partners, while leaving the partnership relationship in being as between the rest.

8.114

We also addressed the controversy surrounding Hurst v Bryk

^[86]

Thirdly, we addressed the application of the doctrine of frustration to partnerships asking whether dissolution could be restricted to terminating the relationship between the party affected by the frustration and the other partners or whether it was sufficient that cases of frustration should fall within the just and equitable ground of dissolution of partnership under section 35 of the 1890 Act.

Consultation

8.116

There was general support for our proposal to give the court the additional power to dissolve the relationship between the partner in question and the other partners on the grounds set out in section 35. One consultee suggested that it amounted to a codification of the Syers v Syers

^[87]

^[88]

Consultees were divided in their views on the correct approach to the application of contract law doctrines to partnerships. While there was a balance in favour of requiring a court order to terminate a partnership in the context of a repudiatory breach of the partnership contract, several consultees objected to the proposal on the basis that it was inconsistent with the underlying contractual basis of partnership in the agreement between the parties.

8.118

Views were also divided on whether there should be exceptions to the proposed requirement of a court order to terminate a partnership, for example where the "innocent" partner is excluded from the management and working of the partnership. Consultees were also divided in their views on whether a partner should be able to rescind the partnership contract for fraud or misrepresentation, with a majority favouring the proposal that a court order should be required to terminate the partnership. A majority of consultees favoured the proposal that cases of frustration of contract should fall within the just and equitable ground for court intervention in section 35 of the 1890 Act.

Reform recommendations

8.119

We think that the court should have power to remove a partner from a partnership in addition to its power to terminate the partnership where there are grounds similar to those in section 35 of the 1890 Act. The introduction of this power, which is consistent with our policy of encouraging continuity of partnership, will enable the court to provide a proportionate remedy in circumstances which do not call for the winding up of the partnership.

8.120

We also see the preparation of the new draft Partnerships Bill as an opportunity to clarify the law by defining comprehensively in the Bill the circumstances in which the court may order the break up of the partnership or the withdrawal of a partner. We recommend that contractual doctrines such as acceptance of repudiatory breach and frustration should not have the effect of terminating a partnership in the absence of either a contractual provision or the intervention of the court.

8.121

This approach involves the acceptance of Lord Millett's opinion in Hurst v Bryk

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^[91]

This approach is also consistent with the American approach in RUPA which provides that a partnership breaks up and its business must be wound up only on the occurrence of specified events.

^[92]

This does not mean that all contractual doctrines will cease to apply to a partnership. In particular a partner may be entitled to withhold performance of an obligation to another partner when the other partner is in breach of his contract. The mutual rights and duties of the partners, and the mutual rights and duties of the partners and the partnership, are subject to overriding duties of good faith.

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^[94]

We recommend therefore that contractual doctrines such as acceptance of repudiatory breach of contract and frustration and rescission for fraud or misrepresentation should be excluded by a provision which sets out exhaustively the grounds upon which a partnership breaks up and the grounds upon which the court may order the break up of a partnership. (Draft Bill, cls 38 and 47)

8.125

We propose to draw on section 35 of the 1890 Act for the grounds on which the court may grant an order. We think that the provision should allow a partner to apply to the court for an order either to remove a partner from the partnership or for the break up of the partnership.

8.126

We recommend that the court should have power:

(a) To order the removal of a partner (other than the applicant partner) on the following grounds:-

(1) The partner is suffering from a mental or physical condition which renders him incapable of performing his duties under the partnership contract and the incapacity is likely to be permanent;

(2) The partner's conduct (which may or may not amount to breach of contract) is such as to affect adversely the carrying on of the partnership business;

(3) The partner is in serious or persistent breach of the partnership agreement or a provision of the draft Bill;

(4) The partnership agreement was entered into or modified as a result of fraud, misrepresentation or non-disclosure by the partner;

(5) An event has occurred which makes it unlawful for the partner to remain a partner;

(6) There is no reasonable prospect of the partnership business being carried on at a profit unless the partner is removed;

(7) It is just and equitable for any other reason to make the order.

(b) To order the removal of the applicant partner where any of grounds (a) (1)–(4) above apply to a partner other than the applicant or where it is just and equitable for any other reason to make the order;

(c) To order the break up of the partnership on the following grounds:

(1) Any of the grounds (a) (1) – (5) above;

(2) An event has occurred making it unlawful for the partnership business to be carried on;

(3) There is no reasonable prospect of the partnership business being carried on at a profit;

(4) It is just and equitable for any other reason to make the order. (Draft Bill, cl 47 and Schedule 3)

8.127

In creating an exhaustive list we have drawn on section 35 of the 1890 Act. Grounds (a)(1) – (3), (6) and (7)

Supplementary matters

The court order under clause 47 of the draft Bill must specify the date on which a person ceases to be a partner or the partnership breaks up. In order to give the court flexibility to do justice where a partner applies for his own removal from the partnership, for example where he has been the victim of fraud or non-disclosure, we consider that the court should have power to back-date the removal of the applicant to the date on which the applicant became a partner or any later date. If the court backdates the removal of the applicant it should also have power to give directions to put the applicant and other persons in the position they would have been in if the partner had in fact ceased to be a partner at that date or so near that position as is just and equitable.

8.129

Where the court orders the removal of a partner, the partner would not have to give notice. The removed partner would have the rights which a partner who had resigned would have on the expiry of his notice of withdrawal to realise his share in the partnership, subject to the power of the court to give directions. The court should have power to issue such directions as it sees fit to facilitate the removal, such as specifying the terms of payment to the outgoing partner. Where the court orders the break up of a partnership it should also have power to give directions to give effect to its order and should have power to appoint a liquidator to wind up the affairs of the partnership or a provisional liquidator to preserve the assets of the partnership. Whether the court orders the removal of a partner or the break up of a partnership, its power to give directions should extend to ordering one partner to make a contribution to another where that is just and equitable.

8.130

In addition we think that on an application to remove a partner the court should have power to make an interim order, on cause shown, that the partner should take no part, or only a limited part, in the partnership business pending the outcome of the application. We do not think it necessary that the default code should include a power to suspend a partner. We have already said

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We therefore recommend:

(1) That, where a partner applies for his own removal from the partnership, the court should have power to backdate the removal and give directions to put the applicant and other persons in the position they would have been in if the partner had ceased to be a partner at that date or so near that position as is just and equitable; (Draft Bill, cl 47(5) and Schedule 3 paras 1(2) and 3(2))

(2) That where the court orders the removal of a partner, that partner will, subject to the directions of the court, have the same rights as he would have had to realise his share in the partnership on resigning from the partnership; (Draft Bill, cls 32, 47(5) and Schedule 3 para 3(1))

(3) That where the court orders the removal of a partner or the break up of a partnership, it should have power to give such directions as it thinks fit for giving effect to its order; (Draft Bill, cl 47(5) and Schedule 3 para 3(1))

(4) That the court may combine an order to break up a partnership with an order to appoint a liquidator to wind up the partnership's affairs or to appoint a provisional liquidator; (Draft Bill, cl 47(5) and Schedule 3 para 2)

(5) That, in an application to remove a partner, the court should have power to make an interim order prohibiting a partner from taking part in, or limiting the extent to which he may take part in the partnership business or affairs, subject to such conditions as it thinks fit and to give such directions as it thinks fit for giving effect to its interim order. (Draft Bill, cl 48)

8.132

Diagram 2 is a flow chart showing the effect of a court order in accordance with our recommendations.

Fraud, misrepresentation and non-disclosure

8.133

Where the ground of removal of a partner is that the partnership agreement has been entered into or modified as a result of his fraud or misrepresentation we think that it is appropriate to adapt section 41 of the 1890 Act (which confers certain rights on rescission of the partnership contract) to our recommended regime. Section 41 confers on the rescinding partner (a) a lien over the surplus of the partnership assets for any sum which he may have paid to purchase a share in the partnership or his capital contribution, (b) a right to stand in the place of creditors of the partnership for any payments he made in respect of partnership liabilities and (c) a right to be indemnified by the guilty partner against all debts and liabilities of the partnership.

8.134

Under the scheme which we recommend, the remedy of rescission will not exist. Fraud or misrepresentation will be a ground on which the court may remove the partner or break up the partnership. In this context we consider that the appropriate remedies for the innocent partners are (a) an indemnity to the partnership in respect of any of its liabilities which are attributable to the fraud or misrepresentation

^[101]

We are persuaded that it would be appropriate to give similar remedies to partners who suffer loss through non-disclosure. We have recommended that a prospective partner should owe a duty of disclosure to other prospective partners.

We therefore recommend that where the order of the court is on the ground of fraud, misrepresentation or non-disclosure, the following parties should, subject to the directions of the court, have the following rights against the partner at fault:

(1) The applicant partner or partners should be entitled to be indemnified by the partner at fault in respect of any liabilities which are attributable to the fraud, misrepresentation or non-disclosure; and

(2) Where the court orders the break up of the partnership, any partner not at fault should be entitled on a distribution of partnership assets to be paid any money paid by him to purchase his share in the partnership and what is due to him from the partnership in respect of loans or capital before any amount is paid to the partner at fault. (Draft Bill, cls 10(6) and 47(5) and Schedule 3 paras 4 and 5).

(4) Illegality and continuity of partnership

Existing law

8.137

Section 34 of the 1890 Act provides that a partnership is dissolved by the happening of any event which makes it unlawful for the business of the partnership to be carried on or for the members of the partnership to carry it on in partnership. A circumstance may arise where one partner may lose or fail to renew a licence or certificate and may be unable to practise lawfully as a partner. Although only one partner was barred from practice, the illegality would dissolve the partnership and threaten the continuance of the partnership business. In one case the court avoided this outcome by holding that where the partners continued in business after and in ignorance of the occurrence of the illegality there was a new partnership which excluded the partner affected by the illegality.

^[106]

Our provisional proposals and consultation response

We proposed that in the case of a partnership where two or more partners would remain after the illegality, the consequence of an illegality affecting only the ability of one partner to carry on the business of the partnership should be to dissolve only the relationship between that partner and the others. Unless the partnership agreement provided otherwise, such illegality would not dissolve the partnership itself.

^[107]

Although there was general support for the proposal in both jurisdictions, the APP argued that the unaffected partners should have the right to treat the illegality as dissolving the partnership. Another consultee suggested that it was appropriate to allow the partners an opportunity to assess their position and to decide whether they could cure the illegality. We have also had the benefit of further advice from our consultant when we were refining our proposals. He pointed out that problems may arise where partners are unaware of the illegality.

Reform recommendations

8.140

We think it is likely that illegality is a problem which occurs only rarely. There is therefore no need for complex provisions in the draft Bill.

8.141

The dissolution of a partnership on the ground of illegality under the existing law reflects the contractual origin of a partnership. It can be argued that the law should not condone an illegal business. There is merit however in having an opportunity to cure an illegality and so to preserve the partnership. RUPA has adopted this approach. Section 801(4) of RUPA provides that a partnership is dissolved and its business must be wound up on the occurrence of specified events including:

An event that makes it unlawful for all or substantially all of the business of the partnership to be continued, but a cure of the illegality within 90 days after notice to the partnership of the event is effective retroactively to the date of the event for the purposes of this section.^[108]

We have considered adopting a similar approach but have decided against it. The partnership might learn of an illegality long after it had occurred and a cure within 90 days of so learning would then have retrospective effect. This creates uncertainty. Nor does the provision in RUPA deal with the circumstance which makes it unlawful for a particular partner to carry on business. We think that it would be simpler and more sensible if illegality did not dissolve a partnership. It is hard to see why a partnership should automatically be wound up when one partner temporarily lacks a practising certificate,

^[109]

Hudgell Yeates & Co

^[110]

The existing rule appears to reflect a contractual analysis of the nature of partnership. One of the problems about the subject of illegality in the law of contract is that it can take many forms and cover a wide range from the gravely criminal to the relatively trivial. Moreover criminal violations may be of a technical nature. The Law Commission consulted on this issue in 1999.

^[111]

We think that a partnership should not automatically break up because of an illegality. Earlier, we have recommended that the court should have power to order (a) the removal of a partner when an event occurs which makes it unlawful for him to remain a partner and (b) the break up of the partnership where an event occurs which makes it unlawful for the business of the partnership to be carried on.

^[112]

We consider that our recommendations to give the court power to remove a partner or break up a partnership and to make interim orders in an application to remove a partner (by which a partner's right to take part in the partnership business and affairs can be suspended) are sufficient in most circumstances. In addition, we think that it is appropriate to allow public authority to take steps to break up an illegal partnership where the public interest so requires. We consider that the Secretary of State should have power in the public interest to apply to court for a order to break up a partnership and where appropriate for an order appointing a liquidator to the partnership.

8.146

We therefore recommend that the Secretary of State should be empowered, if he thinks it expedient in the public interest that a partnership should be broken up, to apply to the court for an order breaking up the partnership and the court may grant that order if it thinks it just and equitable to do so. The court may combine an order breaking up the partnership with an order appointing a liquidator or provisional liquidator. (Draft Bill, cl 49)

Other matters

Dispute resolution, self help and instalments

8.147

In the Joint Consultation Paper

^[113]

^[114]

There was little support for the options in either jurisdiction and many consultees thought that the dispute resolution and self-help procedures were not necessary. Some consultees thought that the timetable of the self-help procedure would be too rigid, being too short for some partnerships and too long for others. Consultees were generally opposed to a statutory regime for instalment payments. Most consultees who addressed the issue suggested that an outgoing partner should be immediately entitled to the full value of the share. On the other hand some consultees supported a regime which allowed for interim payments while the value of a partner's share was being ascertained.

8.149

We see no need for a dispute resolution procedure in a Partnerships Bill. Partners will be able to opt for alternative dispute resolution if they so wish. The Company Law Review envisages that ADR will develop in shareholder disputes.

^[115]

^[116]

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Note 1    See the 1890 Act, s 38 which provides for the authority of the partners to continue after dissolution so far as necessary to wind up the affairs of the partnership.    [Back]

Note 2    See paras 12.13 - 12.23 below.    [Back]

Note 3    See eg Commissioners for General Purposes of Income Tax for City of London v Gibbs [1942] AC 402, Lord Wright at pp 429-430.     [Back]

Note 4    Lindley & Banks, para 3-08.    [Back]

Note 5    See the Joint Consultation Paper, paras 2.34 – 2.35.    [Back]

Note 6    1890 Act, s 26(1).    [Back]

Note 7    1890 Act, s 27(1).    [Back]

Note 8    In Walters v Bingham [1988] 1 FTLR 260 Browne-Wilkinson VC held that an agreement to continue a partnership for an indefinite period ending when a new partnership agreement was executed did not create a partnership at will as an indefinite period is not necessarily an undefined period. This decision achieved a sensible result but the reasoning has been criticised by Twomey (para 8.05) for putting too much emphasis on the duration of a partnership as the criterion for excluding a partner’s right to dissolve by notice. It may be seen as straining the language of the Act.    [Back]

Note 9    1890 Act, s 39.    [Back]

Note 10    Stekel v Ellice [1973] 1 WLR 191.    [Back]

Note 11    Sobell v Boston [1975] 1 WLR 1587.    [Back]

Note 12    After the House of Lords decision in Syers v Syers (1876) 1 App Cas 174. See also the Privy Council case, Latchan v Martin [1984] NLJ 745.    [Back]

Note 13    SeeHammond v Brearley and Burnett, 10 December 1992 (unreported), Hoffmann LJ. On the other hand in Anselm v Anselm June 29, 1999 (NLC 2990610701) Hart J considered ordering that one equal partner should buy out the share of the other in partnership properties.     [Back]

Note 14    SeeLindley & Banks, Preface p vii and paras 23.187 – 23.190.     [Back]

Note 15    See paras 5.11 – 5.23 above in our discussion of the closely related issue of separate legal personality.    [Back]

Note 16    In the Joint Consultation Paper we used the words “dissolve a partnership” in their current sense of the termination of the partnership, often at the start of a winding up.    [Back]

Note 17    The present entitlement is contained in the 1890 Act, s 42. There are considerable practical problems in determining what profits (if any) are attributable to an outgoing partner’s share of partnership assets for the purpose of that section. We suggested that a commercial rate of interest on the value of the partner’s outstanding share was more appropriate. See Joint Consultation Paper, paras 7.18 – 7.26.     [Back]

Note 18    See paras 8.40 – 8.48 below.    [Back]

Note 19    Supporters of our proposals included the APP, the Association of District Judges, Clifford Chance, the City of Westminster Law Society and Holborn Law Society, the Institute of Chartered Accountants in England & Wales, the Association of Consulting Actuaries, the Construction Industry Council, the Architecture and Surveying Institute, the Institute of Directors, the Manchester Chamber of Commerce, the British Bankers Association, Professor Webb and Professor Morse.     [Back]

Note 20    The APP thought the proposed regime was suitable for new partnerships but urged appropriate transitional provisions to protect the expectations of existing partnerships in which people had deliberately adopted the existing default code which allowed the immediate dissolution of a partnership at will. We discuss these concerns in the context of our proposals for transitional provisions in part XIV below.    [Back]

Note 21    See paras 8.40 – 8.48 below.    [Back]

Note 22    The Law Reform Committee of the Bar Council and the Faculty of Advocates.    [Back]

Note 23    See paras 8.40 – 8.48 below.    [Back]

Note 24    On break up the partnership will continue for the purposes of winding up and dissolve on completion of the winding up. See paras 12.13 – 12.23 below.    [Back]

Note 25    1890 Act, ss 29 and 30.    [Back]

Note 26    1890 Act, s 21(1).    [Back]

Note 27    1890 Act, s 32(c).    [Back]

Note 28    See paras 8.91 – 8.95 below.    [Back]

Note 29    See paras 14.18 – 14.21 below.    [Back]

Note 30    See paras 6.66 – 6.80 above.    [Back]

Note 31    See RUPA, s 306(b) which provides: “A person admitted as a partner into an existing partnership is not personally liable for any partnership obligation incurred before the person’s admission as a partner”.    [Back]

Note 32    See paras 6.66 – 6.88 above.    [Back]

Note 33    See Willett v Blanford (1842) 1 Hare 253, 269 and Hugh Stevenson and Sons Ltd v Aktiengesellschaft für Cartonnagen-Industrie [1917] 1 KB 842, 849.    [Back]

Note 34    Lindley & Banks, para 1-05, footnote 8.    [Back]

Note 35    This also removes any problem of an overlap between ss 29 and 42 of the 1890 Act to which Arden LJ referred in John Taylors (a firm) v Masons and Willsons [2001] EWCA Civ 2106, para 38.    [Back]

Note 36    Withdrawal includes voluntary withdrawal, death, bankruptcy, withdrawal on the order of the court and expulsion (where expulsion is competent).    [Back]

Note 37    We had considered postponing the extinction of the outgoing partner’s share until the partner received the value of his share. But as the postponement would not give the outgoing partner any substantive rights, we saw no benefit in doing so. As our consultant said, it would be a lien without teeth. Our policy therefore is that on withdrawal the outgoing partner’s share in the continuing partnership is extinguished and replaced with (a) his right to the value of that share and (b) his (implied) indemnity.    [Back]

Note 38    See paras 8.69 – 8.73 and 8.75(3) below.    [Back]

Note 39    The Law Reform Advisory Committee for Northern Ireland (NILRAC) advocated a similar approach but suggested that the court should have a discretion either to wind up the partnership or to direct a buy-out having regard to a list of specific issues such as the financial position of the partnership and the remaining partners, the time scale for payment and the value of any security offered. The Scottish Chambers of Commerce also referred to the possibility that the outgoing partner should have a right to seek a winding up on the “just and equitable” ground.     [Back]

Note 40    The APP.     [Back]

Note 41    Paras 8.62 – 8.68 and 8.75(1) below.    [Back]

Note 42    See para 8.10 above.    [Back]

Note 43    This right would give the continuing partners a strong incentive to pay the outgoing partner’s financial entitlement. It would also allow the outgoing partner to wind up the partnership where he could demonstrate that it was not able to discharge the debts for which he was liable or to honour the indemnity.    [Back]

Note 44    A partner who has ceased to be a partner on or after the break up of the partnership, through death or insolvency, will be affected by the winding up as, in the default code, he will be entitled to be paid out under Steps 3 – 5 of cl 44 of the draft Bill. See cl 44(2). If the continuing partners were to dissipate the firm’s assets by trading unprofitably during the winding up, the interests of the former partner’s estate could be prejudiced.     [Back]

Note 45    In many professional partnerships where the partners are not prevented by restrictive covenants from leaving and competing with the partnership there may be little value attached to goodwill as a partnership asset since a would-be purchaser could not be sure of a substantial continuing income flow without tying in the partners who generate that income.    [Back]

Note 46    Joint Consultation Paper, para 7.37.    [Back]

Note 47    Joint Consultation Paper, paras 7.40 and 7.41.    [Back]

Note 48    Joint Consultation Paper, para 7.29.    [Back]

Note 49    Joint Consultation Paper, para 7.26.    [Back]

Note 50    The Institute of Chartered Accountants of Scotland on the other hand favoured the notional sales measure.    [Back]

Note 51    The loyalty of the continuing partners is bought by offering them attractive levels of income from the continuing business, not by paying the vendor for their future services. That is a benefit which the vendor usually is not able to offer for sale.    [Back]

Note 52    RUPA, s 701(d).    [Back]

Note 53    Hillman,Vestal and Weidner, The Revised Uniform Partnership Act (2003 ed), p 290-291 state: “Overly-generous indemnification may encourage members of a partnership in an early stage of decline to dissociate and demand indemnification from the partnership for liabilities not fully reflected in the valuation of their interests but later asserted by third parties”.     [Back]

Note 54    (1889) 43 Ch D 208, 213. See alsoLindley & Banks, para 10-247.    [Back]

Note 55    As with the indemnity to which a partner is entitled under cl 12 of the draft Bill, this indemnity covers payments made reasonably and in good faith. See para 10.30 below.     [Back]

Note 56    SeeLindley & Banks, para 10-248.    [Back]

Note 57    See para 8.32 above.    [Back]

Note 58    The Law Commission has consulted on a proposal that the former partner should receive compound interest on his share in the partnership. See Compound Interest, Consultation Paper No 167.     [Back]

Note 59    See paras 8.66 – 8.68 above.    [Back]

Note 60    For example, where a claim is made both in contract and in tort (delict) and the partners with secondary liability in contract (ie the partners at the date of the contract) are not the same as those liable in tort (ie those who were partners when the act or omission occurred).    [Back]

Note 61    See draft Bill, cls 11(2) and 12(7).    [Back]

Note 62    This is consistent with the approach of English law in the Civil Liability (Contribution) Act 1978.    [Back]

Note 63    [2002] 1 AC 185. Textbook writers have responded differently to the case: see Lindley & Banks (para 24-07) and Blackett-Ord in the preface to his 2nd edition.     [Back]

Note 64    In this paragraph and in the next paragraph “dissolve” and “dissolution” are used in the sense of the existing law. See para 8.5 above.    [Back]

Note 65    [2003] Ch 250.    [Back]

Note 66    [2002] 1 AC 185.    [Back]

Note 67    See the draft Bill, cls 38 and 28 respectively.    [Back]

Note 68    See for example Sobell & Others v Hooberman (unreported) 20 December 1993, Court of Appeal.    [Back]

Note 69    For example if a partner is on holiday, he may have only a limited opportunity to take stock of his position on the imminent withdrawal of a co-partner. A case can be made out for a substantially longer period, say 3 months. But the longer the period of notice, the greater the likelihood that partners in an inadvertent partnership will act in ways which breach the implied terms of the partnership agreement of which they are unaware.     [Back]

Note 70    We recommend below that partners in a partnership of defined duration may resign if one or more of their partners dies or otherwise involuntarily withdraws from the partnership. See paras 8.101 – 8.106 and 8.110 (3) and (4) below.     [Back]

Note 71    Our recommendations leave open the possibility that partners may claim damages from each other for breach of contract. What our recommendations exclude is the break up of the partnership by reason of the acceptance of a repudiatory breach of contract, frustration or rescission for fraud or misrepresentation. See para 8.126 below.    [Back]

Note 72    1890 Act, s 33(1).    [Back]

Note 73    1890 Act, s 33(2).    [Back]

Note 74    See para 8.75 above.    [Back]

Note 75    1890 Act, s 33(1).    [Back]

Note 76    In effect the involuntary withdrawal of a partner from a partnership of defined duration allows partners thereafter to resign from the firm as if it were a partnership of undefined duration.    [Back]

Note 77    See the draft Bill, cl 38(3).    [Back]

Note 78    See para 10.40 below.    [Back]

Note 79    Joint Consultation Paper, para 6.53(3).    [Back]

Note 80    Again, we use “dissolve” in this paragraph and the next paragraph in the sense of the existing law. See para 8.5 above.    [Back]

Note 81    Joint Consultation Paper paras 6.49 – 6.53.    [Back]

Note 82    See para 8.126 below.    [Back]

Note 83    In English law, there is the Syers v Syers jurisdiction: see para 8.10 above.    [Back]

Note 84    Paras 8.83 – 8.84 above.    [Back]

Note 85    Lindley & Banks, para 24-12, suggests that the 1890 Act may exclude the doctrine of frustration because it expressly caters for a number of frustrating events.     [Back]

Note 86    [2002] 1 AC 185.    [Back]

Note 87    (1875) 1 App Cas 174.    [Back]

Note 88    See para 8.10 above.    [Back]

Note 89    [2002] 1 AC 185.    [Back]

Note 90    This analysis is not readily adaptable into Scots law as Scotland does not have a tradition of Chancery jurisdiction.    [Back]

Note 91    See para 5.40 above.    [Back]

Note 92    RUPA, s 801.    [Back]

Note 93    See the draft Bill, clause 9(1) and (3).    [Back]

Note 94    We discuss in paras 8.130 – 8.131 below the option of an interim order in an application to remove a partner.    [Back]

Note 95    And also grounds (c)(3) and (4).    [Back]

Note 96    Section 35(a) of the 1890 Act was repealed in relation to England and Wales by the Mental Health Act 1959, Sched 8.    [Back]

Note 97    1890 Act, s 41 sets out the rights of the party entitled to rescind. This provision is not required in the draft Bill as rescission will cease to be an available remedy.    [Back]

Note 98    See paras 8.140 – 8.146 below.    [Back]

Note 99    See para 8.123 above.    [Back]

Note 100    See para 8.123 above.    [Back]

Note 101    We consider it appropriate to confine the indemnity to liabilities attributable to the fraud or misrepresentation as under our recommended regime of continuity of partnership a partnership may exist and incur liabilities without any causal connection with the fraud or misrepresentation.     [Back]

Note 102    See paras 11.35 – 11.40 below and draft Bill, cl 10.    [Back]

Note 103    Draft Bill, cl 9(2)(a).    [Back]

Note 104    Draft Bill, cl 15(2)(b).    [Back]

Note 105    Draft Bill, cl 47(2) – (3) and para 8.126 above.    [Back]

Note 106    See Hudgell Yeates & Co v Watson [1978] QB 451.     [Back]

Note 107    Joint Consultation Paper, paras 6.26 and 6.27.    [Back]

Note 108    This innovated upon s 31(3) of UPA 1914 which was of similar effect to s 34 of the 1890 Act.    [Back]

Note 109    See Hudgell Yeates & Co v Watson [1978] QB 451.    [Back]

Note 110    Ibid at p 464F-H.    [Back]

Note 111    Illegal Transactions: The Effect of Illegality on Contracts and Trusts, Consultation Paper No 154.    [Back]

Note 112    See para 8.126, grounds (a)(5) and (c)(2) above.     [Back]

Note 113    Joint Consultation Paper, paras 7.45 - 7.70.    [Back]

Note 114    Joint Consultation Paper, paras 7.71 - 7.81.    [Back]

Note 115    In “Modern Company Law: Final Report” (Vol 1 para 2.27) the Company Law Review Steering Group recommended that all forms of ADR should be encouraged in shareholder disputes in private companies. The Steering Group recommended that the Government should (a) increase awareness of and accessibility to ADR through publicity and the establishment of referral mechanisms and (b) work with arbitration providers to establish an arbitration scheme designed specifically for shareholder disputes. Many partnership disputes are resolved by arbitration; an arbitration scheme for partnership disputes can be developed alongside a scheme for shareholder disputes.     [Back]

Note 116    See paras 8.40 – 8.48 above.    [Back]

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You are here: BAILII >> Databases >> Scottish Law Commission >> Scottish Law Commission (Reports) >> Partnership Law [2003] SLC 192(8) (Report) (November 2003) URL: http://www.bailii.org/scot/other/SLC/Report/2003/192(8).html Cite as: [2003] SLC 192(8) (Report)