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An Introduction to Partnerships

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About The Author

Jade Rigby (Writer)

Jade is a third year Law student at Newcastle University. She is currently completely an Erasmus year abroad at Universitat Pompeu Fabra in Barcelona, Spain, and will return to Newcastle in 2015. Jade is predominantly interested in commercial law, but also writes on criminal and private law topics.

As deadlines for winter and spring vacation schemes loom into view, it is time for all potential applicants to start thinking about their understanding of the legal sector and brush up on their commercial awareness.

For those aspiring to train in a commercial law firm, an understanding of the problems and challenges faced by corporate clients is essential. Company and partnership law governs all of our major economic players, and many smaller businesses are also regulated, although often to a lesser extent. Moreover, companies and partnerships are artificial creations of law. Some have separate legal identities to those that own them (companies and limited liability partnerships), others do not (traditional partnerships).

Moreover, this is an important topic if you are stuck on questions revolving around LLPs, ABSs, and other issues concerning the structure of whichever law firm you are applying to. The decision regarding what business structure to adopt has been important to law firms over the past decade or so. Indeed, the only firm in the UK top 50 law firms that is not an LLP is Slaughter and May, which demonstrates how influential partnership law, and the subsequent creation of the LLP, has been.

There are three main legal structures for businesses in the UK; the sole trader, partnerships and companies. This article is going to evaluate the advantages and disadvantages of partnerships, because it is important to have an idea how these important structures could affect a potential client.

So, firstly, what is a partnership?

Partnership law is relatively old. Indeed, we have to go back to 1890 to find the definition of a partnership. The Partnership Act 1890, section 1 (1) defines a partnership as "the relation which subsists between persons carrying on a business with a view of profit.”

For a partnership, there must be a minimum of two partners. These can be either natural persons or artificial legal persons, such as a company.

Partners, collectively known as a firm, do not, individually, have separate legal personality to the firm. This is because a partnership is a relationship between individuals, not an organisation in its own right with its own separate legal personality. For Geoffrey Morse, in his book ‘Partnership Law’ (2010), we should consider a partnership like a marriage because “unlike a company… a partnership cannot of itself make contracts, employ people, commit wrongs, or even be sued, any more than a marriage can.”

Section 1(2) of the Act expressly provides that the relationship between the members (shareholders) of a registered company does not constitute a partnership, and therefore maintains the distinction between partnerships and incorporated companies as distinct legal structures.

So why would you choose to set up your business as a partnership?

Partnerships provide some important commercial and legal advantages as a business structure, which may explain why the partnership is very popular. The Department for Business, Innovation and Skills (DBIS) estimated that 460,000 businesses were partnerships at the beginning of 2014.

1. Formalities and Regulation

In order to incorporate a company, lengthy documents and a full, detailed application has to be submitted, most of which becomes publically available. For partnerships, however, there are very few formalities. Indeed, if the statutory definition of a partnership is met, then a partnership has been formed, unless some other legal structure such as a company has been put in place. Hence, setting up a partnership is relatively easy to do, although if done ‘properly’ will involve drawing up a partnership agreement.

Additionally, there are few regulations once the partnership is set up. Most partnerships actually regulate themselves with their own partnership agreements. The Partnership Act 1890 S.24 lists some default rules if partnerships fail to enter into their own agreement, or if their own agreements leave gaps.

The lack of regulation when a partnership forms also means that partners benefit from greater privacy than directors or shareholders of a company. The arrangements between partners do not have to be a matter of public record.

However, you may consider that smaller businesses might be at risk from this lack of regulation. A client could legally be a part of a partnership even if they do not fully understand or appreciate this. A huge problem, as will be explored further below, is that this means they could incur unlimited liability in a situation where they do not want to.

2. Shared involvement in and responsibility for management

Partnerships allow entrepreneurs and business people to expand their own internal resources such as expertise. By entering into a partnership, businesses can grow by adding new partners, who may bring with them skills, contacts or experience which can benefit the firm, facilitating further growth.

As in all commercial situations, however, it is important to consider what the client wants. A small, family-run business, for instance, may not want to grow exponentially, or may want to retain a large amount of control over the business itself. As always, the client comes first.

3. Capital and Tax

Further, raising capital is typically easier in a partnership than if someone is operating as a sole trader. As there are more partners, and more people liable for debts incurred by the partnership, this makes taking a risk much safer for creditors.

Depending on which jurisdiction they operate in, partnerships may also have tax advantages over other forms of legal structures. This is one reason why companies often form partnerships with other companies, so that they can take advantage of tax efficiency.

However, there are also important disadvantages to setting up a partnership.

4. Confusion

As we know, partnerships are easy to set up because they have few formalities. However, this can cause problems, as partners do not always know that they have become partners. For instance, the House of Lords in Khan v Miah [2000] 1 WLR 2123 found that a partnership existed before actual trading activity began. If there was a more formal process of formation or registration, such confusion would not arise.

Additionally, the language of partnerships can be confusing. The fact that partners are collectively called the firm seems to suggest that the firm is itself a separate entity. As we know from above, this is not the case.

5. Lack of Legal Personality

The former point leads us directly to the problem of liability and lack of legal personality. There are several sub-points which follow from the nature of a lack of legal personality:

Continuity

As we have seen, partnerships are a relationship. This means that there are significant practical difficulties in relation to continuing to operate if one partner leaves or dies. The Law Commission have recommended that there should be a default rule that in such cases the partnership should continue as long as at least two partners remain, but this remains only a recommendation.

Practical Management

As the partnership is essentially a collective of partners, day-to-day management can be extremely complex with many partners. There is no formal legal limit as to how many partners you have, but it is important to consider that the more people that have to be consulted, the longer decisions are likely to take.

Admittedly, professional firms have made use of ways around this; investing management in committees, appointing trustees and the like. However, as has already been pointed out, mutual trust and confidence is vital to the efficiency of a partnership. With growing numbers of partners and parties who have been vested with management duties, you start to lose the benefits of having a partnership by creating a separation between ownership and control.

6. Mutual Agency

This is one of the most important aspects of a partnership, and will rank highly on the list of things to consider in relation to advising clients in interviews or assessment days.

Mutual agency means that each partner is an agent of his fellow partners simply by virtue of the partnership relationship. This has been considered many time in court and is dealt with in S.5 to S.8 in the 1890 Act. If a partner has apparent, implied or actual authority then himself/herself and the other partners will be bound by his/her acts. The main disadvantage of mutual agency is the greater risk individual partners take on, as their liability to third parties is unlimited (in so much as the other partners can bind them).

Actual Authority

This is where a partner expressly or impliedly has authority to bind and act for the other partners. This will bind the other partner(s) in accordance with the terms of their partnership agreement and any other express arrangements that the partners have made among themselves. If there are no agreements, then S.5 of the 1890 Act applies:

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

This may seem protective of partners, because of course the detail of their internal agreements are not subject to public record, so it may be very difficult for a third party to prove that the particular partner had actual authority to act as they did.

The final two forms of authority are related as they are both concerned with the external appearance of the transaction.

Implied Authority

The doctrine of implied authority determines that the agent binds his principal if it seems reasonable, from an external perspective, that he/she had authority to act for and bind the partnership.

Apparent Authority

The other partners are bound if they or another person has held out that the agent has the authority to do a particular thing, and the third party relies on that representation.

Implied and apparent authority makes it much easier for third parties to hold a partnership to account. As this is based on the external appearance of relations, it is much easier for a third party to prove.

More importantly, this means that, even if a partner does not have actual authority to act in a particular way, apparent or implied authority can supersede this. Hence, it is easy for partners to be held liable even if they were not actually involved in a particular deal.

However, mutual agency is mitigated by the Partnership Act 1890 and subsequent jurisprudence. In order for the other partners to be bound, the act of the agent in question has to be actually done for the purpose of the business of the firm, or relate to the kind of business carried on by the firm and if so, in the usual way of carrying on that business.

7. Unlimited Liability

So what happens if something goes wrong, and suddenly the firm owes creditors more money than it can afford? Well, thanks to mutual agency, the general rule is that all of the partners are liable. And just how liable are we talking here?

Again, the general rule seems to be motivated by the principle of shared responsibility. It was decided in Dubai Aluminium v Salaam [2002] UKHL 48, [2003] 2 AC 366 that partners are subject to unlimited liability for all debts, torts and obligations committed by the firm. This is an extensive net of liability.

However, the liability principle has been the catalyst for the creation of other business structures. The distinction between partnerships and companies in relation to limiting liability, and the appetite for partnership law reform, has since been blurred by the creation of the Limited Partnership (LP) and the Limited Liability Partnership (LLP).

This article will not analyse the LP extensively as this vehicle has largely fallen by the wayside in terms of general business use, although they are still used in certain circles, for instance in venture capital. LPs were brought in to existence by the Limited Partnerships Act 1907 in order to account for those ‘limited’ partners who simply wanted to invest in a business with the protection of limited liability (up to the amount they have invested) for the debts of the firm. This protection would not be available for those ‘general partners’ who run and manage the business, of which there must be at least one. Hence, the advantage of an LP really begins and ends with the sleeping partners.

The LLP is an entirely different kettle of fish. Created by the Limited Liability Partnerships Act 2000, the LLP has undergone several changes in various areas due to subsequent regulations. Indeed, one criticism of the LLP by G Morse expressed in his book ‘Partnership Law’ (2010) is that this has produced a “pot pourri of legislation”, despite his concern that “39,000 LLPs deserve rather better than this in a developed society.”

Another problem arising from the LLP is that no one is one hundred percent sure where the LLP sits between partnership and company law. It has been described as a “hybrid” by Finch and Freedman in ‘The Limited Liability Partnership: Pick and Mix or Mix-Up?’ Journal of Business Law (2002), and a “novel concept” by Morse. In fact, the LLP allows all partners to limit their liability in exchange for greater formalities and constraints than those required for a General Partnership or an LP, almost to the extent of a limited company.

Is this compromise worth it? Many of us will recognise the LLP from the names of prominent law or accountancy firms, which suggests that, at least for big business, this is a fair trade off. A major reason for this is that the LLP has a separate legal personality, which means that liability is a completely different issue here than for other types of partnership. Members of the LLP may still have personal liability if they themselves are parties to a contract, but the separate legal personality means that LLP members are more protected when commencing deals for the business. Hence, this greater protection provides an incentive for firms to take advantage of the LLP structure.

Ultimately, partnership law remains an important structure for modern businesses. There are significant advantages of partnerships over other business structures, and the flexibility of forming a partnership means that it may be a wide market for them. However, a general partnership may not provide enough protection or be sophisticated enough to deal with the complexities that come with modern financial or legal businesses, but the development of the LLP shows the pragmatism of English and Welsh law. Admittedly, the aforementioned “pot pourri” of legislation concerning the LLP undermines the distinction between partnership and company law, so it is hopeful that future Law Commissions and jurisprudence will further refine and clarify the position of the LLP.

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Tagged: Legal Careers

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