26 October 2012

Ask the Expert Q&A – a Partner acting in bad faith

Question:

I am a partner in a partnership business operating in the construction sector. There are 3 partners in the business and we have been operating for some 10 years. We do not have a partnership agreement as we have never previously felt that this was necessary as we are old personal friends.

Recently one partner (“A”) has been displaying strange behaviour and myself and the other remaining partner (“B”) are becoming suspicious that A is diverting customers away from the business. We are aware that A has incorporated a separate business of which we have had no involvement and he appears to be spending more and more time ‘setting up’ this business, which often involves him being away from the office. A is reluctant to talk about the new company and claims the new company is “for his wife”.

I recently had a conversation with a long established client who informed me that he had been contacted by A to tell him that the partnership business was in the process of being wound up, however, A would be able to offer the same service through an alternative firm. Neither B, nor myself, have any plans to wind the business up and A has not mentioned any intention of leaving the partnership to us. We strongly suspect that A plans to use this new company to offer competing services to that of the partnership. What can we do to stop A?

Answer:

Firstly, as there is no partnership agreement in place you have been operating a partnership ‘at will’ governed by the Partnership Act 1890 (the “Act”).

The good news is that partners have an implied duty to each other of honesty and good faith. There is also a statutory duty under s30 of the Act not to compete with the business of the partnership and in the event that partner does make a profit from a competing business, s30 states that such profits are to be paid to the partnership.

However, the bad news is that without a partnership agreement, the only remedy available to you is dissolution of the partnership which means the business would be wound up and the assets divided up. This I suspect is not your desired outcome. If A has set up in competition to the business, he would almost certainly at some point in the near future issue yourself and B with a retirement notice under s26 of the Act, or with a dissolution notice as he is entitled to do so under s32 of the Act. A dissolution notice will automatically have the effect of winding up the business. The court retains the discretion to award what is known as a ‘Syers v Syers’ order – i.e. that the remaining partners can ‘buy out’ the partner threatening dissolution and carry on the business. However, this has not been applied for some time and would involve taking the matter to court, incurring substantial costs.

If yourself and B are satisfied that you have enough evidence to suggest A is setting up in competition with the partnership business, it is important to act fast. Without proceeding towards litigation, there are two options available to you as I see it:

  •  Ask if A would be amenable to exiting the partnership peacefully through entering into a deed of retirement and offering him payment for his share of the partnership. Although A may have behaved in an unscrupulous manner thus far, he may be willing to leave peacefully if he can get his share of the partnership and avoid costly litigation. Again, it is important to seek legal advice here as an agreement would need to be drawn up to state that A has received his share, otherwise there is a risk that A may claim a share of the profits after dissolution. There may also be other implications to consider, such as equality legislation, if applicable in the circumstances.
  •  Dissolve the partnership and divide the assets – issue the dissolution notice before A does. Once the partnership has been dissolved, yourself and B can continue to run a partnership business, however, this will need to be handled with caution. As mentioned above, you need to be wary of A claiming a share of the profits if you continue to operate the business. In order to prevent this, the ‘old’ partnership business firstly needs to be wound up and profits distributed. If you wish to continue using the same business name, you will need to seek further advice as this will form part of the goodwill of the business, which B may argue holds some monetary value. This option is less attractive than the first given that the original partnership business has to effectively ‘shut down’.

In both of the above scenarios we would strongly recommend seeking legal advice as soon as possible. Trying to negotiate either of the above without the correct advice is unadvisable and runs the risk of prejudicing your position if the matter ever proceeded towards litigation.

Prior to approaching A with either of the above options we would also recommend considering the following:

  • Has A been ordering products in the name of the partnership business that relate to his new venture? If so, the costs of such products should be deducted from his share of the partnership assets on dissolution;
  • Speak to your existing suppliers (and follow up with notice in writing) to inform them that A does not have the requisite authority to order supplies on behalf of the partnership business. State that if products are supplied which are ordered by A, that the partnership business is not liable for payment of invoices relating to such orders;
  • Conduct an inventory of stock and assets. Ensure that all equipment is accounted for such as laptops, mobile phones etc which will assist when dividing the assets;
  • Review existing contracts with customers and suppliers right down to mobile phone contracts, broadband supply etc – check how such contracts can be assigned or terminated (possibly dividing up the costs of termination across the three partners). Also consider any contracts with customers, are any of the partners named as ‘key personnel’? In such cases you may need to address how to manage the continuation of the contract.

Lessons to be learned:

The existence of a partnership agreement provides all partners with further options in this type of situation. The most compelling reason for entering into an agreement is that if any partner breaches the agreement, this invariably gives the remaining partners the right to make a claim for breach of contract, or if appropriate, seek an injunction to prevent a partner from taking some form of action (e.g. approaching customers of the business). A well drafted partnership agreement would usually contain provisions including a power to expel a partner (usually by majority vote), non-compete provisions, post termination restrictive covenants and will be tailored to address concerns relevant to that particular partnership.

Additionally, entering into a partnership agreement does not necessarily mean that you will always be fully protected. As the partnership changes, the partnership agreement may also need to change to reflect the new structure and/or incoming partners may need to sign a deed of adherence so that they are also bound by the provisions of the partnership agreement.

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About the Author
Robert Capper, Partner, Head of Commercial Team and Sectors
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