Consequences of Not Having a Partnership Agreement
Legal Documents & ContractsPartnership Firm Registration

Consequences of Not Having a Partnership Agreement

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Partnership registration become a common business structure for small and medium enterprises in India as this formation is very simple. However, few partners pay much attention to writing a legal partnership agreement. A partnership agreement is a contract stipulating the rights and duties, and in particular, the duties of the parties involved in partnership business.

In the absence of such an agreement, many issues and possibilities of conflicts arise subsequently causing loss of money and sometimes causing the shutdown of the partnership business. This blog takes an overview of running a business without such an agreement in the context of the Indian legal system.

Introduction

The Partnership form of business is one of the most favoured business structures in India due to the freedom that partners enjoy and the sharing of risks. It enables the introduction and execution of large projects by combining personal and other resources while sharing risks. While it may be possible for partners to run the business based on trust and word of mouth, it is crucial to draft a partnership agreement when the business expands or when situations arise that lead to confusion and conflict among partners.

A partnership agreement is an important aspect for running business, but in the rush of the excitement of starting a fresh venture, most partners often ignore it.

What is Partnership and its legal framework in India

Now, before moving any further forward with a discussion of the consequences of business in case it does not have a Partnership Agreement, let us discuss what this “Partnership Agreement” and its legal setup in India are.

Partnership refers to the association of two or more persons who have come together to carry on any business with a view to a share in the profits and losses. The Indian Partnership Act, 1932, governs the formation and the working of partnerships firms in India. Though the law requires a basic structure, some specificities of the partnership need to be agreed on, in writing between partners.

Partnership Deed

In fact, a partnership agreement actually is defined as a written, legal document that among other things specifies profit and loss sharing, partners’ responsibilities and duties, the method of making decisions, and the procedure for settling any sort of disagreement. This agreement, commonly known as a partnership deed, is signed and agreed upon by firm partners.

This deed is an important document to the firm. It is just as a memorandum of association is to the company. It gives legality to the partnership firm when they get it registered with the registrar of the firm.

Legal Framework

The basic enactment to govern partnership in India is the Indian Partnership Act, 1932. The second very important feature of this Act is that it does not make a requirement of any written agreement for creating a partnership. Which consequently means that a partnership could be orally created, or even implied through conduct. However, when there is no writing agreement, then by default a certain provision of the Act comes into effect.

For example, if no written agreement exists, all the profits will go directly to the partners equitably without considering capital contribution and effort. Of course, each partner would have equal authority in decision-making, but again, the conflict would be recognized when opinions vary.

Consequences of not having a Partnership Deed

A firm that operates without a partnership agreement may face the following consequences:

  1. Inability to define Roles and Responsibilities

This is very important in the business since major tasks should be divided evenly for the smooth running of the business in any partnership. This means that the use of a written partnership agreement allows partners to set some activities in relation to their abilities.

This leads to lack of clarity on some of the issues because the business does not have a well laid down partnership agreement that defines the roles of each partner in the business.

The absence will therefore cause confusion in making decisions and utilization of the resources, as well as in the smooth running of day-to-day activities.

  1. Admission and Exit of Partners

Even in the absence of a formal agreement, the addition or removal of new partners may be very problematic. Lack of these terms may lead to conflict on issues to do with admission of new partners or procedure for the exit of a partner from the business.

Such ambiguity causes problems in the relationship, and the partners argue over the rights or even the value of the partner’s stake in the business or their right to exit the partnership.

  1. Distribution of Profit and Loss

Indeed, one of the biggest problems that a firm which has no partnership agreement is that the profit splitting can be undefined.

According to the Indian Partnership Act of 1932, if the partners do not have a written Partnership Deed that states the sharing pattern of the profits and losses, then these shall be shared equally among partners without reference to the capital subscribed by the partners or the work done by them. Where there is such a default provision it will not be well received by the partners because there was no thought given to avoiding unfair treatment in distribution of it.

Thus, in an agreement for a partnership business, it can be provided that another ratio of profit distribution is different in accordance with the contribution and expectation of the partners.

  1. Dispute Resolution and Decision-making

Decision-making is part of any business. Conflicts between partners would really impact the success or failure of any partnership. There is no method of prior determination that conflicts will be resolved and that key decisions will be made since there is no agreement over collaboration.  It may lead to situations in which the decisions about certain matters cannot be agreed on, thus bringing business to a standstill. A partnership agreement may outline how decisions will be made and provide a vehicle with which to settle disputes so that businesses may run uncongested.

For Instance, in a restaurant business, decisions to change menus, pricing, or expansion plans would not move forward if partners disagreed. Such deadlocks may delay many vital business moves and result in a loss of competitive edge.

  1. Litigation against the Third Party

In civil law as is seen any person can go to the court cooping the other and start a case and even ask the court to do something. Nevertheless, the partnership firm in the absence of the partnership deed or has not registered with the Registrar of Companies is subject to restrictions. This restriction is due to the reason that according to the law the Partnership firm can be taken as legal persons only if it is registered.

It means a partnership deed first needs to be prepared before it can be registered. As a result, partners cannot turn to any legal action against such third parties if they have a conflict with the outsiders at some point.

  1. Effects on Dissolution and Winding up of Firm

The dissolution of a partnership with no written agreement also presents a number of challenges. The Act provides for a provision on the dissolution, but the lack of a prescribed formal method of dissolution is most likely to cause a dispute over the distribution of the property and that of the liabilities.

For instance, partners may differ as to how the business assets should be divided or how the business liabilities should be paid.

Partnership may also specify in the partnership agreement how wind up of the partnership business will take place, reference to the details of dissolution and how the properties and liabilities will be divided.

  1. Legal and Financial Risk

If no partnership agreement was made in writing, partners will have to deal with third party risks much more often. For example, if there are no limit laid down, partners may be held legally responsible for the business debts or other commitments.

For instance, when one partner borrows a loan on behalf of the business, all partners may be held accountable to pay it off although they have nothing to do with that decision. A lack of partnership agreement may provide a way for legal disputes and litigation.

However, In the absence of written partnership agreements, the Indian Partnership Act of 1932 makes provisions for many aspects.

Like, Section 12 provides for rights and duties of partners, Section 13 of the Act provides that all profits and losses should be shared equally; as is the default position unless a different agreement has been arrived at. When there is no written contract then the courts also held that it is only reasonable that the profits are shared equally.

Conclusion

If a partnership firm is run without a partnership agreement it means it is like sailing in unknown waters with no map or compass. In the long run, taking time to write a good comprehensive partnership agreement that spells out the details of partnerships would benefits partners by saving them money by avoiding legal battles over the partnership and loss of investment.

The roles, the responsibilities and rights of partners given for in a well drafted partnership agreement are in relation to proper profitability and losses distribution which also provides a general structure for the proper management of the partnership.

A partnership agreement is a more than just a legal document. It is a shield that ensures that all the partners are safeguarded, and that Operations run efficiently.

Related Service

Bibliography

The Indian Partnership Act, 1932 (Act No. 09 of 1932)

Law of Partnership Authored by Avtar Singh

https://www.icsi.edu/home/

https://www.mca.gov.in/

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About author
Advocate by profession, currently pursuing an LL.M. from the University of Delhi, and an experienced legal writer. I have contributed to the publication of books, magazines, and online platforms, delivering high-quality, well-researched legal content. My expertise lies in simplifying complex legal concepts and crafting clear, engaging content for diverse audiences.
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