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Wednesday, October 9, 2013

Partnership Firm & Its Relations With the External World

Partnership is created on the principle of agency. Section 18 pronounces a partner as the agent of the firm for the purposes of the firm’s business.
It means when two or more persons agree to carry on a business and share the profits of it, each becomes a principal, and each becomes an agent for the other, and hence, each is bound by the other’s contract in carrying on the business.

To bind the firm, a partner should undertake to act under the firm’s name or in any other manner, expressing or implying an intention to bind the firm (Section 22). Secondly, to bind a firm for the act done by the partner, it is necessary that the said act falls within the scope of the partner’s authority. Such an authority may be conferred expressly or implicitly through the acts of the partner in the course of carrying on such business.

Suppose a firm borrows money from a bank. Presume John, a partner has borrowed the said amount from Hopes Bank. Now, if this is to be binding on the firm, the lending bank must ascertain if, in the kind of business carried on by the firm, borrowing is authorised. Say, if the firm is carrying on a professional activity, like treating patients, this obviously does not constitute an integral feature of the business. Therefore, John cannot have implied authority to borrow and, hence, cannot bind the firm.

On the other hand, if the firm is carrying on trading activity, borrowing usually constitutes an integral part of it and, therefore, John enjoys implied authority and it would have a binding on the firm.

The essentials of an implied authority can be summarized (Section 19) as:
  • The act must have been done in the capacity as a partner (borrowing on behalf of a proposed partnership does not constitute a binding on the other partners after the partnership is constituted, although the funds have been used for the partnership business).
  • The act must be on behalf of the firm.

Box 4: Firm – Execution of Documents
While getting documents executed by a partner on behalf of the firm, a lending banker ensures that the documents are executed in such a fashion that it binds the firm. For example:
  • Mohsin Bhai, Partner M.M. Abbas & Bros.
The Madras High Court held that this sort of description does not bind the firm and other partners as it merely states a fact and the signatures are not on behalf of the firm.
It should be as under:
  • For M.M. Abbas & Bros.
Mohsin Bhai
This style of observation is held to be a right answer to the question “whether the instrument is so drawn that in form it binds the firm”.

  • The act must be for the purpose of business of the firm.
  • The act must be in the firm’s name.
  • The act must be done to carry on the business in the usual way.

Box 5: SBI vs. SIMCO ENGG Works – Punjab and Haryana High Court – 11 (2005) BC 199
 Facts of the Case
The State Bank of India had advanced various credit facilities to M/s. SIMCO ENGG Works, a partnership firm. Loan documents were executed by Defendants 2 to 5 as partners on behalf of the firm, and Defendant 6 stood as a guarantor for repayment of the loan. The firm defaulted on repayment of credit facilities. The plaintiff, State Bank of India, filed a suit for the recovery of the loan amount with interest, against the partnership firm (Defendant 1), partners and guarantor.

Defendants 3 and 4 just put up their appearance and contested the suit by filing a joint written statement which inter alia pleaded that they had never requested for any loan facilities and no amount had been received by them. It was alleged that Defendant 5—Kusum Malik had applied for the loan facilities from the bank and got signatures on unfilled documents from Defendants 3 and 4. It was further argued that she had authorized R Kathuria as manager to operate the account without the knowledge of the other partners in violation of Clause 7 and 11 of the partnership deed. Clause 7 and 11 of the partnership deed permit the authorization to operate the bank account by any of the partners or manager as mutually decided by all the partners. Hence, Defendant 1—the partnership firm and (other than Defendant 5—Kusum Malik) Defendants 2 to 4 could not be made liable.

The Trial Court decreed the suit filed by the bank for the recovery of the loan amount against Defendant 5 (Kusum Malik) and Defendant 6 (Vallab Das Malik) who guaranteed the loan amount. Accepting the contention of the defendants, the suit against Defendants 1 to 4 was dismissed.

The plaintiff appealed against the judgment and decree of the trial court to the First Appellate Court, seeking the enforcement of liability against the partnership firm and other defendants excluded by the trial court. The Appellate Court relied on Clauses 7 and 11 of the partnership deed and dismissed the appeal.

Not convinced with the judgment, the bank filed a second appeal in the High Court.

  • Can the inter se relationship among partners as contained in Clauses 7 and 11 of partnership deed bind a stranger?
  • Are all the partners of the partnership firm acting as agents of the firm under Section 18 of Partnership Act bound to honor commitments made by any partner of the firm?
  • Would the implied authority available to any partner under Section 19 read with Section 22 of Partnership Act bind the firm?
  • Is the power to restrict the implied authority of partners under Section 20 of Partnership Act an internal arrangement or would it obligate a stranger to take notice of it?
The appeal was allowed on the following grounds:
  • There was no evidence to prove any restriction on implied authority of partner – Defendant 5;
  • Section 20 of the Partnership Act would not be applicable to the detriment of the plaintiff. Any act done by a partner on behalf of the firm which fell within his implied authority was binding on the firm, as the bank was not aware of any restriction;
  • Defendants 1 to 4 were not entitled in law to be excluded from the liability of the firm or any one of its partners;
  • All defendants including the guarantor were liable with costs.
Case Notes
  • The implied authority of a partner is inherent in partnership and the onus to prove restriction on the authority of any partner lies on the party who claims such restriction.
  • The bank, as a stranger, could not be expected to have any knowledge of the inter se relationship or any restriction created by partners.
  • However, when any partner individually authorizes an outsider to operate the bank accounts, the bank should exercise due caution in obtaining the authorization signed by all the partners.
  • Whenever any extension or restriction is imposed on the implied authority of a partner under Section 20 of Partnership Act, by a contract among partners, it is necessary that the firm should inform the bank.
Source: The Icfai Journal of Banking Law, Vol. III, No. 3, 2005.

7.1. Authority to Acknowledge Debts
As per the provisions under Section 20(2) of the Limitation Act, partners are not chargeable by reason only of an acknowledgment of a debt or part payment thereunder by a partner. It would mean that, unless the partner possesses an express authority to acknowledge a debt incurred by the firm, acknowledgment or part-payment of debt by him would not operate against other partners.

However, while interpreting Section 19 of the Limitation Act, the Delhi High Court observed that the acknowledgment made in the course of a partnership business would have a binding on other partners (AIR 1992 Delhi 174).

7.2. Authority to Draw Negotiable Instruments
A partner of a trading concern enjoys the power of drawing, accepting, or endorsing bills or promissory notes for the purpose of the firm in the ordinary course of business. In other instances, a partner would only be enjoying an implied authority for carrying out such acts. This obviously necessitates that a third party, dealing with a partner, should know about his implied authority, or else it may pose a threat with regard to binding of the firm.

Sub-Section (2) of Section 19 of the Limitation Act excludes certain powers from a partner’s implied authority such as:

  • Authority to submit a dispute relating to the business of the firm to arbitration;
  • Power to open a banking account on behalf of the firm in his own name;
  • Power to compromise or relinquish any claim or portion of a claim by the firm;
  • Power to withdraw a suit or litigation or to admit any liability on behalf of the firm in a suit or proceedings against the firm;
  • Power to acquire or alienate property on behalf of the firm, e.g., sale mortgage; and
  • Power to enter into partnership with another firm.
Obviously, a partner who undertakes acts of foregoing nature cannot bind the firm, unless he is expressly authorised to do so, or such acts are ratified subsequently, or they are sustainable on the strength of custom in the trade/practices.

Section 20 of the Act states that partners may extend or restrict the partner’s implied authority by a contract between them.

It also states that, notwithstanding any restrictions, an act done by a partner on behalf of the firm, which falls within his implied authority, binds the firm. However, such an act could not so bind the firm, if the third party knows of the existence of the restriction mentioned above.

In other words, the emphasis of Section 20 is that no third party should suffer on account of his ignorance of the existence of a restriction on the partner’s implied authority.

However, under emergent conditions, Section 22 empowers a partner to do all such acts which are essential for the purpose of protecting the firm from loss, as a person of ordinary prudence would be doing under similar circumstances, irrespective of having implied authority or not.

Further, a partner being an agent of the firm, any admission or representation concerning the firm made by him, creates valid evidence against the firm (Section 23). Similarly, notice to a partner,of any matter relating to the affairs of the firm, operates as a notice to the firm. However, for creation of the mortgage by deposit of the title deeds, all partners shall have to deposit the title deeds with an intention to secure the debt.

Box 6: Bank Accounts of Firm – Operating Instructions
To ease itself from the onerous responsibility of establishing implied authority and other related details, banks often prefer to get the documents such as account opening forms and loan documents, signed by all the partners. Secondly, they also prefer to get the delegation/empowerment of any one partner to operate the bank accounts explicitly recorded and authorised by all the partners concerned.


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