Fahri Ecvet, Commercial team
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When people enter into business partnerships, they do so with ambition, drive and a single minded focus on success. They rarely conceive of the possibility of business failure or bankruptcy. But it often happens, particularly in the current economic climate. A little foresight and planning, usually in the form of a written partnership agreement, can go a long way to making things much less painful than they might otherwise be when bankruptcy looms for a partner or partnership.
How well do you know your potential partner?
When considering partnership, partners should think carefully about the solvency of their partners, before they start trading, and ask some pertinent questions. They should not be afraid to ask their potential business partners for evidence of their solvency and assets, even if this may appear improper or impolite. Partners owe each other a duty of utmost trust and good faith so it is wise to get used to an increased degree of personal association. But even if it is genuinely difficult to broach the subject, there are ways to conduct your own checks.
The Partnership Act 1890
Even after careful enquiry, bankruptcy can be unforeseen and can happen suddenly. Without clear agreement about the terms of a partnership, it will be governed by the vagaries of a piece of legislation written 129 years ago – The Partnership Act 1890 (“the Act “). One good thing about the Act is that bankruptcy will at least mean that the bankrupt partner ceases to have any right to the future profi ts (or losses) of the partnership after bankruptcy. But the Act generally contains provisions you will want to change rather than adopt.
Perhaps the biggest single problem with the Act is that it states that if any one of the partners becomes bankrupt, the whole partnership automatically dissolves. The bankrupt’s trustee in bankruptcy will take control of the bankrupt’s share of the business, and the partnership has to cease trading. Assets and liabilities must be ascertained and realised. The remaining partners can form a new partnership and take control of what’s left, and will have to try and find some way to pay the bankrupt’s share in any profits and capital, and then find some way to revive the business.
This may not seem like an insurmountable problem, but it won’t always be as easy as it sounds. The trustee in bankruptcy is unlikely to be concerned with or accommodate any effort to save the business. Their primary concern is to maximise assets for the bankrupt’s creditors. If the partnership has been successful and increased in value, the partners could find themselves with a capital gains tax liability payable on the dissolution of the partnership. The unexpected tax bill will inevitably come at the most inconvenient time.
How a Partnership Agreement can help
If a majority of other partners want to remove a partner from the partnership, they cannot do so at all under the provisions of the Act.
A simple provision in a Partnership Agreement, automatically removing a partner from a partnership if they are bankrupt, will allow the business to continue without dissolving the partnership, avoiding some of the problems this may otherwise cause. It is normal to have an Agreement which specifies that this can be done for other reasons, as well as bankruptcy. Removal of a bankrupt partner rather than dissolution does not solve all the issues the partnership will face. The partnership may still have to deal with the bankrupt’s trustee, but a written Agreement can include clear provisions outlining how to deal with the financial consequences of a partner’s bankruptcy. The Agreement can explain how and when a bankrupt’s trustee will be able to deal with undrawn profits, and residual capital.
What if you are a partner in a partnership that becomes insolvent?
There are ways to try and trade through it – for example, a Partnership Voluntary Arrangement can be considered, and specialist assistance should be sought with this.
But assuming that the business must be wound up, the basic rule remains that, as well as benefiting from profits, partners will be liable for the partnership debts and losses. They can be expected to pay for these from their own pockets, and potentially far beyond what they might have contributed to the partnership initially. This is the obvious reason people choose to set up limited companies – i.e. to avoid personal liability for the debts of the business.
If the Partnership Act is left to apply without alteration, partners will share these liabilities equally. This is rarely what partners intend and so it is almost always normal to agree the extent to partners will share in profits and losses as whatever proportion they may choose to agree between themselves.This is best done in a written agreement.
When someone takes a 10% share in the business and profits, and signs a document to this effect with their partners, they may be forgiven for thinking that their potential liability ends with 10% of the debts on business failure. But in fact their potential liability for the losses may be much greater than this. This is because partners cannot limit the extent of their liability for the commercial debts of the partnership and the acts of other partners to the outside world.
If a partnership fails leaving debts or claims, a creditor can, and usually will, pursue all of the partners as individuals for the entire amount of the debt. If the creditor gets a court judgement against all of the individuals, they can be quite selective about whom they actually choose to enforce it against. They will obviously look to pursue the partners they believe it will be easiest to recover the debt from – that is the partners who appear to have the biggest, mortgage free, house that they can attach a charge to and apply to court for the power to sell. So the partner who agreed a 10% share of profits (and grudgingly expects to be liable for 10% of the losses, should that happen) will in theory face potential personal liability for 100% of the business losses.
Partners often fail to realise the potential extent of their liability. A written Partnership Agreement cannot override or change this potential liability to creditors, but it can be worded in a way which helps to lower the chances of a partner actually having to pay for the whole of a debt. The partners can at least agree that some of their number will provide an indemnity to others if they are pursued for the whole of a debt beyond agreed shares.
Expert advice is essential when considering an indemnity. An indemnity is only as good as good as the person giving it. A paper indemnity from partners who have flown to Venezuela on a one way ticket shortly after withdrawing the entire partnership bank account is not going to give you much comfort.
The agreement can also be invaluable in dealing with perhaps more mundane matters – who can sign cheques, and for how much, how many partners need to approve and bank borrowing? What is or isn’t an allowable expense? If you have clarity on these things from an early stage, the partnership will run much more smoothly and is much more likely to be successful.
Conclusion
Bankruptcy will always be messy and unpleasant, not just for the bankrupt but for those caught up in the fall that follows. But you can go a long way to protecting yourself if you are willing to apply a little thought and consideration to the possibility of future bankruptcy and the steps that can be taken to minimise your liability as a partner.
Fahri Ecvet is a trainee solicitor in Anthony Gold's commercial team. For further information email Monika Byrska or call 020 7940 4000.
