… By the time creditors are negotiating terms with partners the firm may have ceased to trade, and the partners may have gone their separate ways …
(This article was first published in the Law Society Gazette on 21 June 2007)
When a firm fails, major creditors are often prepared to agree to limit each partner’s liability to the amount that each is likely to be able to afford. Great care needs to be taken by creditors when entering into individual compromises, as it is surprisingly easy to release other partners, and guarantors, from all liability, without intending to do so.
Compromises
Partnership debts are normally joint (section 9 Partnership Act 1890), otherwise they will be joint and several. Either way, the release (without more) of one co-debtor may well be construed as a release of the debt itself, thus releasing other co-debtors automatically: Deanplan Ltd v Mahmoud [1993] Ch 151. The current approach of the courts is to focus on whether the true intention of the parties was to release the co-obligor “having regard to the surrounding circumstances and taking into account not only the express words used in the document but also any terms which can properly be implied”: Watts v Aldington, The Times, 16 December 1993; Johnson v Davies [1999] Ch. 117.
Court proceedings
The same rule applies to compromises of ongoing proceedings as against one or more but not all partners: Morris v Wentworth-Stanley [1999] QB 1004. Proceedings should always be issued against all partners, otherwise subsequent proceedings against other partners may be struck out as an abuse of process: Morris v Wentworth-Stanley, supra; Henderson v Henderson 3 Hare 100. Obtaining judgment against one partner alone for the full amount claimed or recoverable will not operate to discharge the indebtedness of the other partners: section 3 Civil Liability (Contribution) Act 1978. But compromising an existing judgment debt may release co-debtors (whether or not subject to the same or another judgment or a bankruptcy order): Watts v Aldington, supra.
Guarantors
Once a debt is released, a guarantor will no longer be liable to discharge it (Commercial Bank of Tasmania v Jones [1893] AC 313), subject to any specific reservations in the guarantee instrument: Perry v National Provincial Bank [1910] 1 Ch 464.
Though “consistent neither with justice nor common sense”, it is well-established that the giving of even a very short period of time to pay prejudices a surety and will thus discharge him (Swire v Redman (1875-76) LR 1 QBD 536 at 541), unless the surety consents to the giving of time, or all of the surety’s rights are expressly reserved.
Outgoing partners
When a firm is in difficulty, its bank may well wish to maintain rights against outgoing (including deceased) partners.
In the case of a current account overdraft, if the bank does not rule off the account then post-retirement credits to the account will reduce the indebtedness of the outgoing partner, eventually discharging him completely: Clayton’s Case [1814-23] All ER Rep 1.
There is a further trap for banks or other creditors. Very often when a firm is in difficulty its creditors will give it time to pay. Outgoing partners (or their estates), are usually entitled to be indemnified by the continuing partners. By operation of law this constitutes the continuing partners as principals and the outgoing partner (or his estate) as a surety. Creditors who are aware of the indemnity, and who deal with the continuing partners in such a way as to prejudice the interests of the outgoing partner (such as by giving the continuing partners time to pay), will discharge the outgoing partner: Rouse v Bradford Banking Co [1894] AC 586.
Voluntary arrangements
A voluntary arrangement will automatically discharge co-debtors and guarantors, unless there is an express or implied reservation of rights: Johnson v Davies, supra. Many first drafts of voluntary arrangement proposals do not contain any such reservation, so it is up to affected creditors to negotiate the inclusion of such terms. But the debts owed to such creditors may not be large enough to enable them to block the 75% by value majority required to approve a proposal, and they will be bound even though they vote against it.
In the recent case of Prudential Insurance Company Limited v PRG Powerhouse Limited [2007] EWHC 1002 (Ch) the proposal was for the tenant of numerous commercial premises to pay 28p in the £ to landlords in settlement of numerous long lease liabilities, to release completely the liability of guarantors of the tenant (who were the holding company of the tenant and who were otherwise liable for 100% of the indebtedness), and to pay most other creditors in full. Not surprisingly, the landlords objected to that, but they were outvoted by other creditors.
The landlords applied for an order overturning the arrangement on the grounds that it was unfairly prejudicial, pursuant to sections 6 and 262 Insolvency Act 1986. The court had little hesitation on the particular facts of the case in finding that there had been unfair prejudice. But it should be noted that a term in an approved voluntary arrangement that releases guarantors is effective, placing the onus on affected creditors to apply to the court to set aside the arrangement. There might well be circumstances in which a term releasing a guarantor would not be found to be unfairly prejudicial.
Third party reliance on agreement to limit liabilities
In the recent case of Prudential Assurance Company Limited v Ayres [2007] EWHC 775 (Ch), former long lease tenants who were the guarantors of their assignee, an insolvent US law firm, were found to be entitled, under the Contracts (Rights of Third Parties) Act 1999, to the benefit of an agreement between the landlord and the US firm limiting the liability of the US firm under the lease to the extent of the partnership assets (as opposed to the partners’ personal assets). The net effect was that the former tenants had no liability to the landlord under their guarantee.
Drafting of compromises
Ideally, creditors should try to deal with all partners, former partners and guarantors as a group, but this is not always possible. By the time creditors are negotiating terms with partners the firm may have ceased to trade, and the partners may have gone their separate ways, and thus may no longer be willing or able to negotiate as though they were one single entity.
In order to preserve the liability of co-debtors and guarantors, any compromises with individuals or smaller groups should include the following features:
