Partnership dissolution – can it be used to “exit” a partner?

Partnership dissolution is often misunderstood, not only as to what it entails, but also as to what the outcomes may be. When partners seek to “weaponise” the dissolution of a partnership, as a means of taking a business forward, while leaving one of the partners behind/excluding him from participation in a new business, further important considerations arise.

An all too common situation

It is inevitable that some partnerships will not last forever. Sometimes, for whatever reason, a group of partners will want to “exit” one of the other partners, and carry on the profitable business without him. They will be looking for a method that will enable them to be rid of a perhaps under-performing partner, without paying him for the value of his partnership share. But what if there is no power to “exit” the partner concerned, and he refuses to go quietly?

Either:

• there may be no partnership agreement at all, or
• any partnership agreement may not contain an expulsion/involuntary retirement power, or
• if there is an expulsion/involuntary retirement power, the partner concerned may not fall within the grounds permitting expulsion/involuntary retirement.

How can the deadlock be broken?

The purpose of this article

The purpose of this article is to explore:

• what the partners wishing to “exit” their colleague might be able to do, and what the pitfalls are that they may face, and
• from the point of view of the partner whom they wish to “exit”, how he can resist being “exited”, and on what basis he might demand/be entitled to a substantial “exit” payment or other compensation.

The Partnership Act 1890

The 1890 Partnership Act and more than a century of case law authority provide a complex framework of rights and obligations of partners, against the background of which partner disputes are conducted.

Analysis of the situation

The starting point is that many partnership businesses have very valuable goodwill, and (in the absence of any contrary agreement) each of the partners is entitled to a share of that goodwill value.

The next point to consider is that all partners owe their fellow partners a fiduciary duty. That means that:

• they must act in good faith, including disclosing to their partners all matters concerning the partnership (and their own conduct in relation to the partnership, including adverse/unlawful conduct), and
• they are in effect trustees of the assets of the firm, and any breach of that trust is likely to result in the guilty partners having:
• to pay the losses of the wronged partner, and/or
• to share with the wronged partner all of their profits derived from the breach (plus interest), at least up until the point in time at which they may be required (by the court) to pay to the wronged partner the value of his share of the assets (especially goodwill) that they may have taken for themselves.

Unless partners have locked themselves into a partnership for their “joint lives” (in effect “until death us do part”), then the partnership will be a partnership at will, and any partner is likely to have the power to dissolve the partnership by serving a dissolution notice. Very broadly, the effect of such a notice is to change the status of the firm from one that is continuing to trade indefinitely to one that must now be wound up and eventually cease trading.

But a notice of dissolution does not immediately free the partners to do whatever they want, without restriction. Adopting the metaphor of a marriage, a notice of dissolution might be seen as more akin to a divorce petition than to a decree absolute. Subject to some exceptions, following a notice of dissolution of a partnership, most of the duties of the partners to one another continue, until such time as the affairs of the firm have been fully wound up, which in some cases can take years. In the meantime, the partners are still locked together as partners in the dissolution of the firm, for the duration of the winding up. They continue to owe each other a duty of good faith, and they continue to be fiduciaries.

Liability for debts and obligations of the firm

In addition, they each continue to be liable for all of the debts of the firm at dissolution, and for all other liabilities that continue to be incurred (at the very least those incurred for the purposes of winding up the affairs of the firm).

Potential obligation to continue trading

Depending on the circumstances, there may well be an obligation to continue trading, at least for a time, in order to fulfil existing obligations to clients or customers, and arguably an obligation to renew valuable contracts/retainers, if that is for the benefit of the firm, for example in order to maximise the prospects of sale of the firm’s goodwill and the sale price.

The broad overview is that following a notice of dissolution a firm may carry on trading for a considerable period, almost as though nothing has happened.

New and ongoing liabilities

New substantial liabilities may arise or continue or be accelerated. These may include compensation payable to employees who are made redundant, ongoing rent and other obligations in connection with long leases, and a requirement to repay loans immediately. Other issues may also arise.

Notifying clients/customers of dissolution of the partnership

Though in principle any partner may (exercising a statutory right) notify clients/customers that the firm is now in dissolution, there may be three key reasons not to do so:

• Such a notification may drive away the very clients/customers that the partners will wish to retain;
• Partners may hope that the issues between the partners will be resolved by reaching an agreement, so that the dissolution can be presented as a non-contentious retirement of one of the partners, with the result that clients/customers and other third parties will react more favourably (or barely notice); and
• If a partner does more than merely notify clients/customers of the dissolution, for example if there is any hint of solicitation of clients/customers to move their custom to a new proposed business, the partner or partners concerned may expose themselves to substantial claims.

In brief, one way or another, notifying clients/customers may do more harm than good.

So dissolution may not immediately feel like a good route to pursue.

Potential solution

The partners who wish to be rid of their colleague may believe they can get around these difficulties on the following basis:

1. They will serve notice of dissolution.
2. They will assert that there is no value in the goodwill of the firm because all or most of the clients of the firm are loyal to them alone and so will follow them come what may, so that no third party would ever buy the goodwill.
3. They are not obliged to give a non-acting covenant to any such third-party buyer.
4. They will start a new business without the partner they are seeking to “exit”.
5. They will hope (and they believe) that, upon hearing that the “old” business has been dissolved and is ceasing to trade, “their” loyal clients will seek them out and ask them to continue working for them.
6. They will not do anything to encourage those clients to act in that way (but if approached they will gratefully agree to continue working for the clients concerned).
7. To the extent that clients/customers do not follow them, and/or express a wish that their work should be completed by the dissolved firm, they will ensure that the dissolved firm will continue to trade for that purpose, with all partners (including the to-be-exited partner) sharing the profits and expenses of that continuation.
8. Accordingly, they will not (they may assert) be in breach of their obligation not to compete with the firm.

Extent and limits of partner obligations

This potential plan of action relies on the broad legal principle that, if there were to be a sale of the firm’s goodwill to a third party, there is no legal duty that would prevent the partners of the dissolved firm from setting up their own new firm in competition with the firm carried on by the buyer of the goodwill.

That said, there is an important proviso in that the partners of the dissolved firm must not (before or after any sale of goodwill) solicit (for the benefit of their “new” firm) the custom of the clients or customers of the dissolved firm who have been “sold” as part of any sale of the goodwill, or who might become the subjects of any such sale that may yet take place. They would be prohibited from giving the impression that their new firm is a continuation of the old firm.

Professional obligations

Over and above the general law relating to the dissolution of partnerships, in the case of professional partnerships there may well be an overlay of professional obligations to act in the best interests of clients, not to act unlawfully, and to act with integrity. There is good authority to the effect that professional obligations will not override or offer a “free pass” in relation to obligations and duties that a partner has to his co-partners under the general law. Accordingly, a tension may arise between competing duties.

Steps an aggrieved partner can take

A partner who is facing potential “exit” by way of dissolution can draw attention to the obligations of the other partners and the various vulnerabilities, uncertainties and claims that they may face. Merely holding up a mirror that reflects the realities of an opponent’s situation can have a significant effect.

If that were not to produce a “result” for an aggrieved partner, a court may well (if asked to do so) issue an injunction restraining partners from taking steps in pursuit of an ulterior motive, and/or which might otherwise be unlawful, and/or may supervise the winding up and/or preside over a full account and inquiry into the conduct of the partners, and may value the goodwill, and make orders accordingly, including potentially an order requiring a payment to be made by the “new” firm to the “old” firm in respect of goodwill, and in respect of profits made by virtue of the goodwill, which would benefit the “exited” partner. The value of goodwill as assessed by the court may well be higher or lower than the value that a professional valuer might arrive at.

There is a very narrow path of permitted partner conduct, and any wandering off of that path may result in substantial financial consequences for the partners concerned. There is a risk of moving “from the frying pan into the fire”.

Settlement

Against such a backdrop, it is often possible for a partner facing a potential “exit by dissolution” to negotiate a substantial settlement.

The other partners will need to balance the cost of such a settlement with the potential cost of alternative outcomes (in terms not only of additional expense and potential liability, but also their time and attention). In the face of a prolonged partner dispute, it is often much quicker and “cleaner” to agree the terms on which a partner will exit, avoiding the need to wind up the business of the old firm, or setting up a separate new firm, and avoiding giving the impression to the outside world of a major schism between the partners, that might be perceived as affecting the continued viability of the business and/or (given the distractions of litigation) the level of service that clients/customers can expect.

When the full reality of their situation dawns, all of the partners, on both sides of the argument, may prefer a route that avoids both the increasing heat of the “frying pan” and the uncertain consequences of the prospective “fire”.