PLC - Chapter 9 - Partnership capital and partners' capital

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Chapter 9 - Partnership capital and partners' capital

Partnership Law, 4th Edition
Resource type: Chapter Status: Published on 01-Nov-2011 Jurisdiction: United Kingdom

This is a chapter from the Bloomsbury Professional book Partnership Law, 4th Edition, which is a comprehensive guide to the modern law of partnerships, Limited Partnerships and LLPs in England and Wales. Dealing fully with the modern practical issues inherent in setting up, running and dissolving a partnership, this authoritative text will provide you with a definitive statement of the law using modern terminology relevant to current business practice. This is essential reading for solicitors and barristers practising in all of the following fields: Partnership; Employment law; Venture capital; Corporate law; Private client work; Insolvency; and Commercial law. This chapter is FREE to view, as a sample of the book's contents. To view the other chapters, please subscribe to Books online Mark Blackett-Ord and Sarah Haren

9 Partnership capital and partners' capital

Table of Contents 1 Background 2 The meaning of 'partnership capital' 3 Partners' capital 4 Accounting for capital 5 Current accounts 6 Variation, and blending partners' capital and current accounts 7 Interest on capital accounts 8 Contributions of capital 9 The ownership and repayment of partnership capital

1 Background
9.1 The principles embodied in the Partnership Act 1890 were evolved at a time when most important commercial activity in Britain was conducted through partnerships rather than through joint-stock companies[1]. A firm did not just give employment to a partner, but was where he employed money in pursuit of commercial enterprise. His remuneration was based more on the amount of capital that he had invested than on the amount

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of work he did for the firm. As a result the authors of the Partnership Act 1890 were at pains to treat with considerable respect his 'capital' in the firm. On it his profit share was usually calculated; it was distinguished from his 'advances to the firm' on which he was entitled to five per cent[2], the likelihood being that from such 'advances' he would get no other return.

2 The meaning of 'partnership capital'

9.2 The partnership capital is the amount of money or other property that all the partners have contributed, with the agreement of the others, to the permanent endowment of the firm. It is akin to the share capital of a company. The total of the capital of the partners will equate to the total net assets of the firm on the first day of trading. Thereafter it will not; money will be used up in the business, property will rise or fall in value, and if the firm is successful then its net assets may increase in value. As Nourse J observed in Reed v Young[3]: The capital of a partnership is the aggregate of the contributions made by the partners It is important to distinguish between the capital of a partnership, a fixed sum, on the one hand and its assets, which may vary from day to day and include everything belonging to the firm having any money value, on the other. Confusion arises because the word 'capital' has many meanings in common parlance, and is often used in different senses even by reference to partnership finance[4]. But in partnership law it means the amounts contributed to the firm by the partners[5] and credited in their favour in its books. Capital is the money, lands, goods or other property with which the company or partnership commences business. Anything acquired or earned over and above this in the course of business is not capital but profit[6]. It is a misconception that 'the capital accounts show the value of each partner's share in the partnership'[7], or that the firm's capital is the total of its net assets, or is the same as the firm's property, or is a loan to the firm from the partners[8]. In McClelland v Hyde[9] Lord Andrews LCJ pointed out that 'the capital of a partnership is something different from its property or its assets'.

3 Partners' capital
9.3 A partner's capital is his contribution to the partnership capital. It will remain as a book-keeping entry, and will be irrelevant to the annual profit share unless (unusually today) profit share is computed by reference to it or interest upon the capital account has been agreed between the partners[10]. He may not withdraw his capital without his partners' consent. Its amount remains of little significance until the net assets or liabilities of the firm are distributed or shared on dissolution, when it becomes very important indeed[11]. To speak at all of a partner's share in a partnership's 'assets' (as opposed to its capital) is inaccurate[12] because the size of this share is unascertainable until dissolution. He merely has a share in capital and a share in 'ultimate residue' on winding up[13]. For instance, before a farming partnership is commenced, one partner may own the farm. He may either: (a) keep it himself, and allow the firm the use of it, with or without payment of rent, but in any case it will not affect the balance sheet or the partners' capital accounts because the farm remains his; (b) agree that it is to be a partnership asset, and that he be credited with its value as part of his capital account in the firm; his capital account is then fixed accordingly, and the farm appears in the balance sheet

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as an asset of the firm; (c) perhaps take the unsatisfactory course of agreeing that it should in its unsold state represent his capital in the partnership[14]. This will mean that it is represented both in the firm's balance sheet and in his own capital account, which will accordingly fluctuate in value from year to year, which is not envisaged by the Partnership Act 1890; or (d) sell it for cash to the partners to be an asset of the firm, in which case it will appear as such an asset but he will not be credited with its value in a capital account because he will have been paid for it already.

4 Accounting for capital

9.4 The 1890 Act drew the distinction, now sometimes lost, between a partner's capital which is his permanent endowment in the firm, and upon which he is not (without agreement to the contrary) entitled to interest[15], and his advances to the firm which are a temporary loan to the firm. It envisages that his capital (in his 'capital account') should not be altered without the agreement of the other members. In the accounts it will not fluctuate, but be his original, permanent investment in the firm, contrasted with his current account. Accounting for capital is further discussed at para 12.22 below.

5 Current accounts
9.5 Separate from his capital account, a partner should have a current account with the firm, reflecting his day-to-day balance created by his periodic entitlement to a profit share and his drawings, non-drawings and advances. This is discussed at para 12.22 below.

6 Variation, and blending partners' capital and current accounts

9.6 The capital accounts of the partnership cannot be varied by a mere majority unless agreement provides for this. Lord Bramwell said in Bouch v Sproule[16]: The undivided profits of any period, a year, or shorter or longer time, continue to be undivided profits unless something in the articles of partnership or some agreement by all the partners makes them capital. They do not become capital by effluxion of time or by their being used in the trading. This statement was quoted by Lindley LJ[17]as authority for the proposition as follows: When capital and profits belong to different persons, or to the same persons in different proportions, the effect of capitalising profits is to change their ownership, and an intention to do this must be shown before conversion of profits into capital can properly be inferred. Moreover, this is a matter on which a majority cannot bind a minority unless expressly empowered to do so Where (unusually) a single partner or (more commonly) a majority or management committee has power to call for an increase in capital, the power must be exercised in good faith[18].

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It is too common an accountancy practice to blend the partner's current account and capital account into one. Then his share of annual profit is added to whatever sum his capital reached at the beginning of the year; then his drawings are subtracted to give a new balancing figure at the end of the year, called his 'capital'. The result of this is that without the consent of the other members he can increase his 'capital' by not drawing his full share of profit, or can reduce it to nothing by drawing too much[19]. Where it is the agreed practice of the partners to do this and to add their undrawn profit to their capital accounts at the end of each year, the capital thus established is the partner's capital for the purpose of distribution of surplus assets on winding up[20].

7 Interest on capital accounts

9.7 If the capital accounts of the partners differ markedly from their profit sharing ratio they sometimes agree that interest is payable on their capital accounts before net profit is ascertained[21]. The rate of interest, whether simple or compound[22], how often it is to be paid, and upon what capital account, must then all be agreed as well. Agreement to pay interest will be inferred[23] from the adopted accounting practice of the firm or its predecessor firm[24], but not merely because only one partner has advanced capital whereas the other ought to have done[25] nor because the partner contributing the capital has had to borrow it at interest[26]. Without express or inferred agreement, no interest on capital is payable[27]. After dissolution no interest is payable notwithstanding that agreement may have provided for interest before dissolution[28], unless there is specific further agreement[29]. Section 24(4) of the Partnership Act 1890 provides: subject to any agreement express or implied between the partners (4) A partner is not entitled, before the ascertainment of profits, to interest on the capital subscribed by him.

8 Contributions of capital
9.8 No partner need contribute any capital unless he has agreed to do so or has submitted to a management regime that requires him to do so[30]. If he does contribute, it may be by instalments. If he fails, his obligation to do so may be enforced against him by action by his partners[31], but the mere fact that a lack of finance will be disastrous to the firm will not impose upon him an obligation to contribute which otherwise does not exist. He may agree that his entitlement to profit will be subject to the condition precedent that he contribute his capital[32], and capital is implicitly owned in the proportions it is contributed[33]. His contributions should be made in cash or in the form of some other asset whose value is agreed. It can be a bank loan or other assignable debt owed to himself[34], or a whole business[35] but what is important is that it should then be recorded as having a certain cash value, and it will be his capital. This sum will have to be known on dissolution in order to wind up the affairs of the firm[36]. Then what will usually[37] have to be ascertained is the then value of the capital contribution in the state in which it originally reached the firm[38]. So an initial failure to quantify the value of his capital will lead to difficulties later.

9 The ownership and repayment of partnership capital

9.9 A partner 'owns' his capital, meaning his share of the partnership capital, only in the limited sense that he may reclaim it on dissolution. If the size of the partners' shares in capital cannot be agreed either expressly or by implication, then they may be treated as equal. Section 24(1) of the Partnership Act 1890 provides:

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subject to any agreement express or implied between the partners (1) All the partners are entitled to share equally in the capital and profits of the business The word 'capital' here means capital properly so called[39] and does not mean partnership property[40]. But the statement that partners 'share equally in the capital' is misleading because the partnership capital that they have contributed will often not have been contributed equally[41]. Nourse LJ suggested in Popat v Schonchhatra[42] that an implication was easily made that unequal contributions to capital resulted in correspondingly unequal entitlements to capital. Perhaps the phrase in section 24(1) 'to share equally in the capital' does not mean to share the ownership equally, but means to share in their use and benefit while the business is a going concern, and the section does not apply to the position on dissolution at all. This was suggested by Neuberger LJ in Sandhu v Gill[43]; Mummery LJ agreed the consequence[44]: the shares of Mr Sandhu and Mr Gill in the assets and the profits of the partnership were equal, but the respective contributions by them to the capital of the partnership were not equal. On a dissolution of the partnership the capital would fall to be shared in proportions corresponding to their respective contributions of capital, but the partnership assets would be shared equally between them. Similarly, in his Supplement on the Partnership Act 1890, Sir Nathaniel Lindley said[45] 'If it be proved that the partners contributed the capital of the partnership in unequal shares what is due to each partner will, subject to all proper deductions, be divided amongst the partners in the proportions in which they contributed it and not equally'. In other words, the parties receive back their partnership capital in the proportions in which they contribute it[46].

[1]

It is notable that the first edition of Lindley on Partnerships was entitled, 'A Treatise on the Law of

Partnership, including its application to Companies' (1860).

[2] [3]

See the Partnership Act 1890, s 24(3), discussed at para 12.23 below. [1984] STC 38, 5758, a passage approved in the House of Lords by Lord Oliver [1986] 1 WLR 649 at 654

and amounting to a close paraphrase of the view of Sir Nathaniel Lindley in the 5th edn of his Treatise on the Law of Partnership (1888), the last edition edited by himself, p 320. In Popat v Shonchhatra [1997] 3 All ER 800, CA, the capital was the amount paid to buy the partnership business.
[4]

Thus in Sykes v Land [1984] 2 EGLR 8 the issue was as to the meaning of the right of a partner to purchase

another's share in the 'capital and profits' of the firm.

[5] [6] [7] [8]

Bennett v Wallace 1998 SC 457 (Scotland). Per Babington LJ in McClelland v Hyde [1942] NI 1. I shall not reveal from which accountancy handbook I quote this. In Teacher v Calder [1899] AC 451 Lord Davey at 467 describes a partner taking money out of the business

as 'withdrawing his capital', which is to confuse matters.

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[9]

[1942] NI 1 at 7; see also Nourse LJ in Popat v Shonchhatra [1997] 3 All ER 800, CA. Without agreement, no interest is payable on the capital account: see the Partnership Act 1890, s 24(4),

[10]

discussed at para 12.24below.

[11] [12] [13] [14]

See para 18.54 below. See Nourse LJ in Popat v Shonchhatra [1997] 1 WLR 1367 at 1372B. See the Partnership Act 1890, s 44, discussed at para 18.54 below. This was assumed to be the case by Parke J at first instance in Re White [1999] 1 WLR 2079 (reversed

[2001] Ch 393) where the capital of the partnership was defined as 'including the freehold premises and land'; see also Sykes v Lund [1984] 2 EGLR 8.
[15]

Without agreement, no interest is payable on the capital account: see the Partnership Act 1890, s 24(4),

discussed at para 12.24 below.

[16]

(1887) 12 App Cas 385 at 405, perhaps obiter, but adopted as reasoning by Lindley and Lopes LJJ in Re

Bridgewater Navigation Co (1891) 2 Ch 317 at 3278.

[17] [18]

In Re Bridgewater Navigation Co (1891) 2 Ch 317 at 327: Lopes LJ agreed. Heslin v Fay (1884) 15 Ir 431, a reference for which I am grateful to my friend Michael Twomey,

Partnership Law (2000).

[19]

The wrongful transfer of the partners' current accounts to their capital accounts led to the auditor's

certificate successfully being challenged before Goulding J in Smith v Gale [1974] 1 All ER 401.
[20]

Binney v Mutri (1886) 12 App Cas 160, PC; Brensell v Brensell (1995) 3 NZLR 320, affirmed 1998 NZFLR

28, and see the Partnership Act 1890, s 44 which is printed in Appendix A.
[21]

Then interest will become payable upon capital but not upon accumulations of undrawn profits unless there

is agreement to this effect: Dinham v Bradford (1869) 5 Ch App 519; compare Browning v Browning (1862) 31 Beav 316.
[22] [23] [24] [25] [26] [27]

Compound interest will not be inferred easily: Foster v Mitchell (1912) 22 OWR 571 (Canada). Spartali v Constantinidi (1872) 20 WR 823. Millar v Craig (1843) 6 Beav 433. Hill v King (1863) 3 De GJ & Sm 418. Rishton v Grissell (1868) LR 5 Eq 326. Cooke v Benbow (1865) 3 De GJ & Sm 1; Jardine v Hope (1872) 19 Gr 76 (Canada); but the law in New

Zealand may be different: Klaus v N Z Guardian Trust Co Ltd (1989) 3 BCR 307.
[28]

See para 18.7 below, and Barfield v Loughborough (1872) 8 Ch App 1; Watney v Wells (1867) 2 Ch App

250; Parsons v Hayward (1862) 4 De GF & J 474 at 484; Wood v Scoles (1866) 1 Ch App 369 at 378.
[29] [30] [31]

Smith v Donaldson (1864) Session 3rd Series, 86. Eslin v Hay (1884) 15 LR Ir 431; Re Bridgewater Navigation Co (1891) 2 Ch 317. Kemble v Mills (1840) 9 Dowl 446; Teacher v Calder [1899] AC 451 at 467. As to claims between partners

for contribution see para 14.54 below.

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[32] [33] [34] [35] [36] [37]

Kemble v Mills (1840) 9 Dowl 446; Popat v Shonchhatra [1995] 1 WLR 908; revsd [1997] 1 WLR 1367. Popat v Shonchhatra [1997] 1 WLR 1367 at 1373B. Toulmin v Copland (1834) 2 Cl & Fin 681. Binney v Mutrie (1886) 12 App Cas 160, PC. Winding up the firm after dissolution is considered in Chapter 18 below. In the unsatisfactory case where a partner's capital is contributed unvalued and in kind, it can only be valued

at dissolution. This was assumed to be the case by Parke J at first instance in Re White [1999] 1 WLR 2079 (reversed [2001] Ch 393) where the capital of the partnership was defined as 'including the freehold premises and land'.
[38] [39] [40] [41] [42] [43] [44] [45] [46]

Cooke v Benbow (1865) 3 De GJ & Sm 1; Bennett v Wallace 1998 SC 457 (Scotland). Per Nourse LJ in Popat v Schonchhatra [1997] 1 WLR 1367 at 1373. [1997] 1 WLR 1367 at 1372. See para 9.4 above. Per Nourse LJ in Popat v Schonchhatra [1997] 1 WLR 1367 at 1373. Sandhu v Gill [2006] Ch 456, CA, para 62. Ibid at para 102(7). (1891) p 62. This is the last work on partnership published by Lord Lindley (as he was soon to be). See the Partnership Act 1890, s 44, discussed in para 18.54 below.

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