Partnerships: How to protect yourself

November 6, 2008, 3:05 pm John Sier KBB

What happens if your business partners are in financial trouble?

When an individual or corporation becomes insolvent, their assets are up for grabs by their secured creditors racing to get their piece of pie with any leftovers going to whomever is left standing.
The impact on you, if your business partner goes bankrupt or insolvent, will mainly depend on whether your business partner is an individual or a company.

If your partner is an individual, upon bankruptcy, the bankrupt is required to make all their assets accessible to the Trustee in Bankruptcy ("Trustee") so that his/her debts owing can be realised. On the other hand, if your partner is a body corporate, you could find yourself dealing with an Administrator, Liquidator or Receiver ("External Controller"), depending on the type of insolvency. Whatever the situation, common to both scenarios is the fact that you will no longer be dealing with your business partner in relation to their interest in your business, but with a third party.
Interference by an External Controller/Trustee in your business will no doubt be unwelcome, however that may be the least of your concerns when that third party looks to realise your business partner’s interest in the enterprise to satisfy your business partner's debts.

What happens if I run my business through a Partnership?
If your business is run through a partnership, then you and your partners own all of the assets of the partnership jointly. If a partner becomes insolvent, then their interest in the partnership may be realised by an External Controller/Trustee.

The main difference between a partnership structure and a corporate structure is that:
a.  the liability of the partners for the debts of the business is unlimited; and
b.  such liability is shared jointly and severally as between the partners; that is each partner
     is liable for their own share of the partnership debts as well as being liable for all the
     partnership debts.

In other words, when things go wrong and creditors start to chase an unpaid debt of the partnership, the creditor can sue all the partners jointly. It may be that all partners have to contribute in equal proportions towards the debt. In the worst case scenario, one partner can be made personally liable for the total debt of the partnership and if necessary, be forced to satisfy any debt from their personal assets.

Under legislation, when a partner becomes bankrupt, the partnership is dissolved. This result can be particularly harsh on the remaining partners, particularly where the partner's bankruptcy has little, if anything, to do with the partnership itself. Further, the Court can order that the bankrupt partner's debt be satisfied from the partner's interest in the assets and profits of the partnership. Alternatively, at the option of the solvent partners, the solvent partners can satisfy the bankrupt's debt to protect the partnership.

What happens if I run my business through a company?
A company is a separate legal entity to its shareholders and to its directors. Directors and shareholders are protected from the company's liabilities incurred in the ordinary course of business, particularly where the loans have not been documented and loan monies are repayable on demand. Where a director becomes bankrupt, the director is no longer able to remain as a director.

When a shareholder becomes insolvent, shares held by the shareholder become an asset to be realised by an External Controller/Trustee. Shareholders (in most cases) have the right to appoint directors and it may be that the directors are forced to deal with an unknown person at board level who is appointed by an External Controller/Trustee.

Partner/Shareholder/Director Loans and Guarantees
It is common that a business is financed by way of loans from its shareholders or partners. If the lender becomes insolvent then these loans may be called in by an External Controller/Trustee which may have a disastrous effect on the business. Similarly, if you have provided joint guarantees then you may find yourself in breach of those guarantees as a result of your business partner's insolvency.

Minimising the impact of a business partner going bust
If you are concerned about the financial viability of one of your business partners you should consider the following:
•  Where your business is run through a company, entering into a Shareholders Agreement
   with you business partner. The agreement can place restrictions on using shares in the
   company as collateral for a mortgage. The agreement can also place restrictions on
   transferring shares which would equally apply to an External Controller/Trustee who later
   obtains rights to those shares. You may even provide for the shares to be redeemed by
   the company or subject to pre-emptive rights in favour of the remaining shareholders
   should one shareholder go bankrupt.
•  Where your business is run as a partnership, entering into a partnership agreement
   which provides similar restrictions as above.
•  Where you have provided joint guarantees with your business partners, and then review
   those guarantees to determine what effect your partner's insolvency may have on you and
   your business. Negotiating "several" guarantees with financiers may protect you.
•  In all cases, reviewing existing loans by shareholders to the business and entering into
   written loan agreements which provide a defined payment schedule for these loans is
•  Where appropriate, shareholder loans should be secured by Registered Mortgage
   Debentures to ensure priority over other unsecured creditors.