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Friday, September 20, 2013

Partnership Firm: Basics That a Banker Should Know

A partnership, as it is commonly perceived in the mercantile circles, is basically a business concern that comes into existence with an objective to earn profits and share the same among the partners. Besides business, it could also include any trade, occupation, and profession. And here, the word “business” does not necessarily mean an undertaking of an industrial or commercial nature. For example, it could be the case of two doctors coming together to form a partnership to render service to patients, or a group of construction engineers coming together as a partnership to construct flats for sale.

The Partnership Act, 1932 that came into effect on 1st October, 1932 defines “partnership” as the relation between persons who have agreed to share the profits of the business carried by all or any of them acting for all (Section 4). Persons who have entered into a partnership with one another are known as “Partners” and the business carried out by them is known by “Firm Name”. To satisfy the contents of Section 4 of the Partnership Act, each business concern should basically exhibit certain attributes such as:
  • Agreement between the parties;
  • Agreement to share the profits of the business; and
  • Business carried out by all or by one on behalf of the rest.
1. Partnership Provisions and the Banker
Day in day out, a banker entertains business transactions with partnership firms. It could be by way of accepting deposits, maintaining deposit accounts of partnership firms, or extending credit support in the form of cash credit, overdraft, bill negotiation, etc. In all such transactions, the banker enters into a contractual relationship with the partnership firms and similarly, the firms undertake certain contractual obligations towards the banks, either as its depositors or borrowers. In view of these relationships, it becomes imperative for a banker to know whether the firm is duly constituted as per the provisions of law, the different types of partners and their rights and liabilities, their powers to undertake contractual obligations on behalf of the firm, etc., so that he could be sure of his ability to enforce his rights in the event of a firm defaulting on its contractual obligations to the bank. It is in this context that a banker needs to be familiar with the relevant provisions of the Partnership Act.

2. Essential Elements of a Partnership
No formal procedure has been prescribed by the Act for constituting a partnership firm. However, as per Section 4 of the Act, there should be an agreement to the effect that a partnership firm has been constituted.

2.1. By Agreement
An agreement to be enforceable should obviously encapsulate all the requisites of a contract as spelt out under the Indian Contract Act:
  • The agreement should be drawn with the free consent of all the persons involved. Here “persons” refer to natural or artificial/ legal persons, for example, companies formed under the Companies Act. It means that a company can become a partner in a partnership firm, but a partnership firm cannot be a partner in another partnership firm because, a partnership firm is only group of persons coming together for carrying out business and sharing of profits, and it is not a legal person. However, nothing prevents the partners of one firm from floating another partnership firm.
  • The partners to an agreement must be competent to enter into a contract. Alien enemy, minors, persons of unsound mind, and persons disqualified from contracting by any law are not competent to become partners.
  • The agreement should be for a lawful object and consideration.
The document containing the agreement is called the “Partnership Deed”. It contains provisions relating to:
  • Nature and principal place of business
  • Name of the firm
  • Names and addresses of all partners
  • Duration of the firm
  • Profit sharing ratio
  • Interest on capital and drawings
  • Valuation of goodwill on death/retirement of a partner
  • Management, accounts and arbitration, etc.
The deed must be stamped in accordance with the Indian Stamp Act.

2.2. Sharing Profits of a Business
There should be an agreement to share profits. Here “profits” mean excess of what is obtained over the cost of obtaining it. Sharing of losses does not constitute an essential attribute of the partnership firm. Nevertheless, loss being intrinsically incidental to a business activity, the partnership deed may also prescribe a mode of sharing the losses among the partners. However, sharing of profits alone constitutes an essential attribute for identifying a partnership, for no business is constituted for earning losses.

In the absence of any prescription for capital contribution in Section 4 of the Act, joint capital is not an essential requisite.

Though the right to share the profits of business is the basic test of a partnership, it cannot, by itself, determine the existence of a partnership, as much depends on the real intention and the contract of the parties, i.e., whether the relationship satisfies the concept of principal and agent between the parties taking the profits and the parties working for it.
The following example illustrates this principle:

Ram, Sham, and Mohan own a residential property in Mumbai. It is rented out for Rs.10,000/- a month, and the rent is divided by them in proportion to their interest in the property. This relationship does not make them partners. For, they do not have mutual agency under this arrangement except for dividing the income between them. In other words, partnership and co-ownership are two distinct entities.

A co-owner can transfer his share in the property without the consent of the others, whereas, a partner cannot do so. In a partnership, each partner acts as an agent of the other impliedly or really.

2.3. Mutual Agency
The other test of a partnership is that there must be a mutual agency between partners. It is perhaps rather a conclusive element of partnership. This does not prevent a partnership from delegating powers of control and management to one or two partners while others remain dormant.

Since partnership is an outcome of a contract, it is open to the partners to predetermine the duration of their partnership. The duration could be explicit or implicit.

If no provision has been made about the duration of a partnership in the contract, the partnership is considered a “Partnership at Will”, which means the partnership can be dissolved by giving notice by any one partner (Section 43).

3. Illegal Partnership
A partnership which works for an objective contrary to or prohibited by law, or which employs means forbidden by law for pursuing its objective is termed illegal. Similarly, a partnership having partners in excess of the number stipulated in Section 11 (2) of the Companies Act, 1956 – i.e., 20 persons in a trade and 10 persons in a banking business – is also considered illegal.

4. Different Types of Partners
An outsider dealing with a particular firm would always wish to know as to who are the partners and to what extent they are liable, for different types of partners have got different types of liabilities.

4.1. Actual or Ostensible Partner
  • An actual or ostensible partner is a person who became a partner by an agreement and is actively engaged in the conduct of the business of the firm.
  • In the ordinary course of business, he is an agent for other partners.
  • With regard to third parties, he binds himself as also other partners for any act, which is done in the ordinary course of business and in the name of the firm, subject to the restrictions under Section 9 of the Partnership Act.
4.2. Sleeping or Dormant Partner
  • A sleeping or dormant partner does not take active part in the conduct of the business of the firm.
  • However, his liability is similar to that of the other partners.
  • Like other partners, he ceases to be liable for acts of other partners after he ceases to be a partner of the firm.
4.3. Nominal Partner
  • A nominal partner has no real interest in the firm.
  • He does not share the profits of the firm.
  • He does not contribute to the capital.
  • However, he is liable to outsiders for all the debts of the firm.
4.4. Partner in Profits Only
  • As the name indicates, this partner gets a share in profits only.
  • However, he is liable to outsiders for all the acts of the firm on the basis of the principle that liability of partners is joint and several and at the same time unlimited.
4.5. Sub Partner
  • A sub partner is the one with whom one of the partners of the firm agrees to share his profits.
  • He has no rights or liabilities.
4.6. Managing Partner
  • By virtue of special qualifications, a firm may assign the management and control of business to one of the partners and he is called managing partner.
  • Besides share in profits, such partners get additional remuneration.
4.7. Partner by Holding Out or by Estoppel [Section 28 (I)]
  • Anyone who by words spoken or written or by conduct represents himself to be a partner, or knowingly allows others to represent him as a partner, becomes liable to a third person, who, on the faith thereof, gives credit to the firm. The person so representing himself as a partner is called a partner by holding out or by estoppel.
  • He can be held liable if he has represented himself to be a partner by word, spoken or written, or by his conduct (active representation), or knowingly allowed himself to be represented as a partner (tacit representation); and if a third person acting on the belief of such representation has given credit to the firm.
4.8. Minor Partner
A minor is incompetent to enter into a contract. So he cannot become a partner in a firm. Even the guardian of a minor cannot enter into a partnership agreement on behalf of a minor.

However, Section 30 makes a provision for a minor to be admitted to the benefits of a partnership, though not as a partner. This section contemplates:
  • That there is a partnership firm in existence.
  • Such admission of a minor is with the consent of all the existing partners for the time being.
  • There is an exhibition of definite act of allotting a share or distribution of profits to such a minor partner.
4.8.1. Rights and Liability of a Minor
  • A minor partner has a right to a share of the property and of the profits of the firm as agreed upon.
  • He has got a right to access the accounts of the firm and to inspect and copy them.
  • But he has no personal liability for any act of the firm except his share in the firm, i.e., for realisation of a partnership debt his personal property cannot be proceeded against.
  • He has no right to sue the partners for account or payment of his share. However, he can avail of such a right when severing his relations with the firm.
4.8.2. Consequences Upon Becoming a Major
  • Upon becoming a major, a minor partner has the right to elect to become or not to become a partner in the firm.
  • If he elects to become a partner, he has to give a public notice of such election within six months of his attaining majority or of his obtaining knowledge that he has been admitted to the benefits of partnership, whichever date is later.
  • Non-issuance of such notice automatically makes him a partner in the firm after the expiry of the six-month period.
  • Once he becomes a partner, he becomes personally liable to third parties for all the acts of the firm, starting from the day he was admitted to the benefits of partnership.
  • If he decides not to become a partner and gives a public notice to that effect, his share is no more liable for any acts of the firm from the date of the notice. Further, he is entitled to sue the partners for his share of the property and profits.
Box 1: Minor as Partner – Implications to a Lending Bank
If the minor elects to continue as a partner, the banks usually obtain a fresh set of documents signed by all the partners along with the minor (now a major). In the event of a minor opting out of the firm, a lender has to appraise the impact of payouts, if any, to be made to the outgoing partner on the subsequent functioning of the firm. The assessment of credit facilities under such changed circumstances obviously calls for a fresh look.

5. Inter-se Relations of Partners
The relations among the partners imply certain duties, rights, and liabilities (Sections 9-17).

5.1. Duties
Section 9 states that partners of a firm have to:
  • Carry on the business of the firm to the greatest common advantage;
  • Be just and faithful to each other; and
  • Render true accounts and full conditions of all things affecting the firm to all partners or their legal representatives.
Section 10 states that every partner shall indemnify the firm for any loss caused to it by his fraud in the conduct of the business of the firm.

Box 2: Lending Banker – Why Look at Partnership Deed
A lending banker should take a look at the document through which a partnership firm is created and be sure of the rights and liabilities of each partner before entertaining contractual relationships—particularly, of the nature of debt.
According to Section 11, the rights and duties of the partners of a firm may be determined by the contract between the partners and such contract may be express or implied.

5.2. Rights and Liabilities (Section 13)
  • A partner is not entitled to receive remuneration for taking part in the conduct of the business.
  • He has to diligently attend to the conduct of the business.
  • The profits are divisible and losses are apportionable in equal shares.
  • The sharing of profits is governed by the provisions in the contract between the partners.
  • If the contract says that profits are to be shared in a particular ratio, the losses are also to be apportioned in the same ratio.
  • Unequal contribution to the share capital has no bearing on the extent of sharing the losses.
  • A partner’s entitlement for interest on the capital subscribed by him can only be paid out of profits.
  • On monies lent to the firm, a partner is entitled for interest payment.
Box 3: Lending Banker – Must Read Balance Sheet
Many a time, the balance sheet of a partnership firm exhibits borrowed capital in the names of partners. In such situations, it is desirable to estimate the likely outflow in terms of interest payment on the borrowed capital and its impact on the borrowers’ ability to service bank’s debt. Secondly, the probability for sudden withdrawal of capital from the firm also needs to be looked into, for such capital may alter not only the net worth but also the very functioning of the firm.

6. Properties of the Firm (Section 14)
The properties of a firm include all the properties, rights, and interest in property originally brought into the stock of the firm or acquired by purchase or otherwise by or for the firm, including the goodwill of the business.

At the time of the constitution of a firm, the partners may bring in assets by way of their capital contribution. Once the property is brought into the partnership as capital, “it would cease to be the exclusive property of the person, who brought it in. It would become trading asset of a Partnership in which all the partners would have interest in proportion to their share in the business of Partnership.” (Addanki Narayanappa AIR 1966 SC 1300)

The property of an individual partner, which is used for the purposes of partnership business, does not constitute the property of the partnership firm unless it is transferred in the name of the firm.

Every partner has an undefined ownership, along with other partners, over all the assets of the firm. No partner can claim or exercise any exclusive right on any of the properties of the firm. A
partner may, however, assign his share, under which the assignee gets only a right to receive the share of profits of the assignor but no interest in the property of the firm.

The property of the firm can only be used for furthering the business of the partnership but not otherwise. Section 16 states that any profit made by any partner out of the property of the firm shall account for it in the firm’s books.
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