The majority of businesses in the UK are operated by sole traders (more than 3,000,000 at the last count). Of the remainder, one in six are regular, unincorporated partnerships (i.e., two or more people operating a business together with a view to profit).
Notwithstanding the obvious benefits of incorporating (notably, limited liability and creating a jointly held “legal person” that can enter into contracts and own assets in its own right), hundreds of thousands of partnerships continue to contribute to UK business.
One of the other key vulnerabilities of this structure is that, unlike companies and LLPs, partnerships are not governed by modern rules designed to protect stakeholders and provide confidence to third parties.
In fact, whilst the Companies Act has had multiple iterations over the last century (notably in 1948, 1985 and 2006), you may be surprised to hear that the regime applying to partnerships (in the absence of a partnership agreement) is the Partnership Act 1890. This often results in partners finding themselves navigating out of date legislation and case law, fraught with potential conflicts and uncertainties.
The Default Regime: The Partnership Act 1890
While the legislation provides a basic set of rules, the fact that it is over a century old means that it will not (alone) adequately address the nuances and complexities of modern-day partnerships. Without a bespoke partnership agreement, uncertainty can arise, leading to legal challenges that undermine the partnership’s stability and success.
Key Issues Arising from the Absence of a Partnership Agreement
Ambiguity in Decision-Making and Management:
Without a partnership agreement, the inflexibility and lack of detail in the default rules can lead to ambiguity regarding decision-making processes, voting rights, and management responsibilities. This lack of clarity can lead to power struggles, and potential gridlocks, ultimately hindering the partnership’s ability to operate efficiently and make timely decisions.
Unequal Distribution of Profits and Losses:
The Partnership Act 1890 dictates that profits and losses should be shared equally among partners, regardless of their respective contributions or roles within the partnership. This rigid approach may be perceived as unfair, particularly in situations where partners have varying levels of financial investment, expertise, or time commitment.
Lack of Clarity on Partners’ Duties and Obligations:
A well-drafted partnership agreement will outline the specific duties and obligations of each partner, ensuring transparency and accountability. Without such provisions, there may be confusion or disagreements regarding partners’ responsibilities, which can strain relationships and jeopardize the partnership’s success.
Challenges in Admitting New Partners or Exiting the Partnership:
The absence of a partnership agreement can create challenges when it comes to admitting new partners or facilitating the exit of existing partners. Without clear guidelines, disputes may arise regarding the valuation of partnership interests, the transfer of ownership, and the terms and conditions governing such transitions.
This particular issue was addressed in the recent case of Procter v Procter [2024] EWCA Civ 324.
Procter v Procter
In this case, the Court of Appeal was asked to clarify a partner’s entitlement if she retired without agreeing financial terms relating to her departure. The partnership was between members of the same family (a farming business) and one of the partners wished to retire.
It should be noted that, amongst its many inadequacies, the 1890 Act does not contain any provisions or entitlements in relation to voluntary retirement other than it will cause the entire partnership to be automatically dissolved! If the partners are to have a right to retire (and the remaining partners to continue without them), it must be set out in the partnership agreement.
Fortunately, in this case there was a partnership agreement that provided for circumstances in which members would cease to be partners. Less fortunately, none of these included the right to voluntarily retire. Notwithstanding this omission, when the retiring partner did give such notice, the other partners accepted it but, crucially, without any specific agreement as to how her interest would be “bought out”.
The retiring partner claimed that she was entitled to a proportionate share (one quarter) of the assets and income of the partnership. Her argument was that this was either “by default” or because of an implied term to that effect in the partnership agreement. The other partners argued that, without any agreed terms, a retiring partner is entitled to nothing and has given up their share in its assets.
The court was not prepared to imply a term as there were multiple ways to calculate a share and the court would need to unilaterally impose one of the methodologies (which courts are reluctant to do).
However, in the absence of agreement, an assumption that the retiring partner had surrendered her interest was incorrect. The court said there was “all the difference in the world between an agreement that nothing should be paid, and … no agreement as to what, if anything, should be paid”.
Whilst the partnership agreement is the first port of call to identify what should be paid, the court’s judgment was that, if this is silent (as was the case here) and there is no ad hoc agreement when the retirement is accepted, the outgoing partner retains her interest in the net assets of the partnership at the time of retirement.
Using s. 42 of the 1890 Act (for inspiration), the court held that the continuing partners were liable to account to her for her share of the market value of the partnership assets.
The case highlights a key issue. Failing to make provision for a retiring partner and asking the court to rely (somewhat creatively) on 130 year-old legislation can create significant uncertainty. In this case, it also resulted in expensive and unpredictable litigation.
Key Provisions of a Comprehensive Partnership Agreement
To mitigate the potential issues mentioned above and establish a solid foundation for a successful partnership, a comprehensive partnership agreement should typically include the following key provisions:
Partnership Structure and Management:
- Clearly define the roles, responsibilities, and decision-making processes for each partner.
- Establish voting rights, quorum requirements, and mechanisms for resolving disputes.
Financial Arrangements:
- Outline the capital contributions and profit/loss allocation methods, considering each partner’s investment and involvement.
- Specify guidelines for drawings, reinvestment strategies, and financial reporting requirements.
Admission and Exit of Partners:
- Establish procedures for admitting new partners, including eligibility criteria and valuation methods.
- Define the terms and conditions for partners exiting the partnership, such as buy-out provisions, non-compete clauses, and intellectual property rights.
Duties and Obligations:
- Clearly outline the fiduciary duties and obligations of each partner, including confidentiality, non-disclosure, and non-compete provisions.
- Specify consequences for breaches of duties or misconduct.
Dispute Resolution Mechanisms:
- Establish procedures for resolving internal disputes, such as mediation, arbitration, or other alternative dispute resolution methods.
- Define circumstances that may lead to the dissolution of the partnership.
Operational Procedures:
- Outline protocols for decision-making, record-keeping, and reporting.
- Address issues related to insurance, indemnification, and liability limitations.
By proactively drafting a comprehensive partnership agreement, partners can mitigate legal risks, establish clear expectations and create a solid foundation for their partnership.
Consulting with experienced lawyers is crucial to ensure that the partnership agreement is tailored to the specific needs and goals of the partnership, while complying with (and, where necessary, disapplying) relevant laws.
If you would like to get in touch with us about a partnership agreement, please call 01737 907492 or email [email protected] and a member of our expert team will get back to you.