Partnerships - When Things go Wrong

Paper delivered at the College of Law Sydney

16^th November 2006

By

Tony McMinn

Introduction

It is often the case of that people engage in commercial enterprises without necessarily realising that they are, at law, partners with all the legal ramifications and consequences which flow from such relationship.

It is also often the case that people conduct their enterprise without a written agreement reflecting the terms of their arrangement.  Whether they know it or not, if they are “carrying on a business in common with a view to profit,” at law they are deemed to be partners and are subject to the Partnership Act;

At law, the major consequences of a partnership include:

1. The personal liability of each member of the firm to creditors is unlimited.
2. The partners are jointly liable for contracts committed by any partner of the partnership. 
3. The estate of the deceased partner is liable severally on such obligations incurred before the Partner's death. 
4. Partners are jointly and severally liable for liabilities arising out of torts committed by the Partners.

Many partners are often uncertain as to what happens when a partnership has problems and the various ways in which those problems may be resolved by litigation or other dispute resolution methods.

I have recently been reading a most interesting book about the Beatles and it occurred to me that their legal arrangement and the ultimate breakup might be an interesting place to start in looking at what happens when partnerships go wrong.  Prior to April 1967, George Harrison, John Lennon, Paul McCartney and Richard Starkey (Ringo) were partners at will in the group known as The Beatles.  This meant the agreement to work together could be terminated by any of them at any time.  However on the 19th of April 1967 a partnership deed was entered into in which the Beatles agreed that their partnership would continue for a period of 10 years, the name of the firm being "the Beatles and Co".

Apple Corporation Ltd (Apple) was also bought into the partnership with an 80% interest in the capital and profits of the partnership, with Apple agreeing to pay the sum of ₤800,000     to be a partner.  In effect, the 4 Beatles were in partnership with their own company.  The partnership agreement gave Apple the right to manage the business of the partnership and exploit the assets of the partnership as profitably as possible.  The agreement further provided that "proper books of accounts should be kept by the partnership" and that on the 31st of each year a balance sheet and profit and loss statement for the year ending was due to each partner.

At the time of entry into the partnership agreement it was contemplated that the Beatles long-time manager, Brian Epstein would be in charge of their affairs.  However Brian Epstein died in August 1967 and the Beatle’s financial affairs became even more complex.  Apple became a fully operational company and proceeded to lose money at an alarming rate.  In early 1969 John Lennon remarked that if things continued with their financial affairs as they had been going, the Beatles would be broke within six months.  This statement caught the eye of one New York lawyer, Allen Klein.  Klein was an American involved in the music publishing and artist management business and had also acted as an agent for the Rolling Stones.  Klein's company was called ABCKO.  On the eighth of May 1969 a contract was entered into between ABCKO and Apple.  John Lennon and George Harrison as director all signed the agreement on behalf of Apple and John Lennon, George Harrison and Ringo Star engaged Klein as their personal manager.  Paul McCartney never signed the contract with Klein.

Klein met with mixed success as the Beatle’s manager.  He was able to renegotiate the existing recording agreement with Capitol Records to the United States, Canada and Mexico.  However he failed to acquire control of the Beatle’s publishing rights in Northern Songs.

By 1970 it became apparent the Beatles were not going to be recording again and the individual partners were engaged in producing their own solo albums.

It became apparent by the end of 1968 that there was a serious problem with regard to the Beatle’s capacity to meet a large provisional tax bill.  Up until that time, the accountants for the Beatles had been unable to produce any accounts for the period subsequent to 31st of March 1968.

Accordingly Paul McCartney and his advisers felt it necessary to issue proceedings in the High Court of Justice, Chancery Division in London.  McCartney had named as Defendants the other partners in his business being John Lennon, George Harrison and Ringo Star although it was clear that his real target was Allen Klein.  McCartney sought two basic remedies.  First he asked that a receiver be appointed to act as a caretaker of properties and interests in which the Beatles were involved.  Second he asked that an accounting of the Beatle’s financial condition be made by someone hired by the receiver.  The aim was to have someone other than the current staff at Apple run the affairs of Apple and get the financial records in order.  It was clearly McCartney's position that the Beatles were no longer a functioning band and a receiver would have the primary duty of collecting payments from various sources based on the work the Beatles had produced up to that time.

McCartney bore the burden of proof that such extreme steps were necessary.  After all, he was asking a judge to intervene in business contracts that had been entered into voluntarily by all involved and wrest control of the company away from the majority of the parties to the contract John Lennon, George Harrison and Ringo Star.  McCartney claimed that without a receiver in charge the assets of the Beatles were in jeopardy. There were seven areas McCartney claimed demonstrated that the partnership assets were being misused or improperly accounted for.

It was also incumbent on McCartney to show that it was likely that a court hearing the case would eventually agree that a dissolution of the partnership was appropriate.  In addition, McCartney claimed that his artistic freedom was being curtailed by his partners to such an extent that it amounted to unfair dealing between the partners.

McCartney's counsel was able to establish that Allen Klein had received excess payment of commissions on royalties from various sources.  They then established that there had been numerous breaches of the partnership agreement.  They then established that the accountants were unable to prepare accounts without the full co-operation of Klein.  Significantly they then turned to the state of the financial affairs of the partnership and it appeared that the Beatles were not be able to meet their tax obligations.

McCartney's motion for a receiver to be appointed was granted. The judge did not have to rule on all the points raised by McCartney to do so, based his decision, which was temporary in nature, on the alleged conduct of Klein.  The judge found that there was a likelihood that the assets of the partnership would be jeopardised if the business continued to operate in the manner in which it had for the prior months and found that the partnership would probably be dissolved due to the conduct of the defendants.

You may recall that McCartney was pilloried for his decision to take legal action however in hindsight he really had no alternative and it is surprising that he did not do so earlier.  Although criticised by John Lennon for breaking up the Beatles, in fact it was John Lennon who had earlier announced that he was leaving the band to pursue a solo career.

A colleague of mine has recently been through a partnership dispute which ended up in court.  It was a bitter and expensive dispute and I asked him to provide some insight to the experience which he had been through and how he might have done things differently.  He made these points and they really apply to most partnerships:

1. Take care with the preparation of the firm's accounts.  Often partners will adopt accounting techniques such as interposing service trusts which may distort the reality.  In this case distributions were made from the trust to the partners which were loaned back to the firm leaving the firm a huge liability to the partners. On dissolution the outgoing partner demanded re payment of his loans causing a cash crisis.
2. Record all major decisions in writing that involve the expenditure or advance of moneys by or to the firm.  The Court placed great weight on contemporaneous diary notes created by a partner.
3. Pay serious attention to the contents of Partnership Agreement.  Treat it as a work in progress that should be subject to constant review as the practice grows or as circumstances change.  Where one or more partners are not really expert in matters such as tax structures, valuation methodology, etc   engage the services of an outside consultant or accountant to advise on the suitability of arrangements that suit everybody.
4. Have the firm's accounts prepared by an independent accountant.
5. Don't leave one partner in charge of everything and rely on him or her to do the right thing in the belief that what he/she does will be good for all the partners.
6. Have very clear exit and valuation provisions set out in the Partnership Agreement for the retirement or removal of a partner.  This can take all the angst away if it is properly covered up front before it becomes a live issue.

Remedies

So what happens when the partnership breaks down and action needs to be taken to dissolve the partnership.  If the partnership is a partnership at will, the partnership can be dissolved by any of the partners giving notice of dissolution to the other partners.  However if the partnership is for a fixed term, the terms of the partnership agreement may provide grounds for   dissolution or alternatively the statutory grounds available under the Partnership Act may provide relief.  These grounds include mental infirmity, permanent incapacity of a partner, prejudicial conduct by a partner, wilful or persistent breach by a partner, the partnership has become a loss-making business and finally if the Court considers it is just and equitable that the partnership be dissolved.

Appointment of a receiver

The first decision is whether to apply for the appointment of a receiver.  In making this decision, the partners will need to give consideration to the high cost of appointing an independent receiver and the fact that they will lose control of the partnership business to the receiver.  Against this will be the desire to protect partnership assets and perhaps the appointment of a third-party accountant is what is required. 

The decision may be governed by the terms of the partnership agreement or alternatively one of the partners may apply to the Supreme Court Equity Division and seek an order for the appointment of a receiver.

The basic purpose of the appointment of a receiver is to protect or preserve property.  The applicant must show a threat of danger or jeopardy to the partnership property.  The mode of preservation, if preservation is to be granted, is in the discretion of the Court and it may be sufficient that preservation be by way of injunction rather than by way of appointment of a receiver.  The general rule is that where the partnership is already dissolved or where it is clear that dissolution of an admitted partnership will be granted on the final hearing, the plaintiff is entitled to the appointment of   an interim receiver.  The appointment may be refused if such appointment would be ruinous to the business or assets of the partnership or if the expenses associated with the appointment would be disproportionate to the nature and value of the partnership business.

The approach of the judges in the Equity Division of the Supreme Court has generally been to try and persuade the parties to reach some agreement with respect to the ongoing conduct of the partnership without the need for the appointment of a receiver.  For example the Court might defer the point of a receiver and instead order that an account be taken and an inquiry be held in relation to the partnership and to this end appoint a referee (usually an accountant) to conduct such an inquiry and report to the court so that the parties are better appraised of their respective positions on the desirability of winding up the partnership by mutual agreement rather than the employment of a receiver.  However, if the plaintiff persists with the application for a receiver, he or she will usually be entitled to one as of right.

Prior to dissolution, a receiver may be appointed where the partnership assets are in danger.  Misconduct by a partner is not of itself a ground for the appointment of a receiver but may be granted where the misconduct jeopardises the partnership assets.

Where the existence of the partnership is in dispute, older authorities suggested a receiver will not be appointed.  However there is no general rule of practice to this effect. Similarly, where there is real doubt that the partnership will be dissolved at the final hearing, the court is reluctant to appoint a receiver.  However a receiver might be appointed pending resolution of the dispute between the partners.

Urgent Relief:

Ex Parte applications

Ex parte applications for the appointment of a receiver are not granted except in the case of emergency.  The applicant must show that there is an immediate and real danger that the defendant is about to commit some act to the material prejudice of the applicant or creditors of the defendant and that there is strong evidence that if time is taken to give notice to the defendant, that act will be committed.  The applicant must make full disclosure of the potential prejudice to the defendant of the appointment of a receiver.  The court will weigh the potential prejudice to the applicant against the potential prejudice to the defendant.  An undertaking as to damages is usually required of the applicant.  And ex parte application should be made by summons together with a notice of motion seeking the relevant interlocutory relief.  In cases where the partnership agreement is not in writing or where there are likely to be disputes of fact or where it is alleged that the partnership agreement has been varied by conduct or orally, proceedings should be instituted by statement of claim and directions sought to provide for the orderly conduct of the dissolution.

The applicant will need to consider what other relief it seeks before deciding in which division of the Supreme Court the relief should be filed.  Usually the application should be made to the registrar or in extreme urgency to the associate of the Chief Judge or the Duty Judge of the relevant division.

The applicant will need to file an affidavit in support of the application deposing to all the relevant facts and the reason that the property is in jeopardy or other reasons why it is just and convenient to appoint a receiver. The proposed receiver should consent to the appointment and this consent should be verified in the affidavit of the applicant and annexed to the affidavit.

Two affidavits of fitness will be required in all cases except where the proposed receiver is an Official Liquidator who has also indicated to the Court that he or she is prepared to act in any liquidation.

The receiver is an officer of the Court and is appointed on behalf of all persons interested in the property.  The order appointing a receiver operates as an injunction restraining other parties to the action from interfering with the receiver getting in the properties and dealing with his appointment.

The partners should be aware that the appointment of a receiver effectively takes the business of the partnership out of their hands and they lose control of the partnership business.  Furthermore, the receiver and/or the court may impose decisions upon the partners which they may not like.  The costs of the receiver will be paid out of the partnership assets and the receiver's costs can be very substantial.  In my colleague' s case which I have mentioned, the receiver's costs were $200,000.

The Court will usually order accounts and inquiries be taken at the time of dissolution.  They will rarely be ordered during the continuation of the partnership.  Section 42 (1) of the Partnership Act provides that where the firm continues to use the assets of the partnership after the date of dissolution, the outgoing partner should be entitled to a share of profits made since the dissolution that are attributable to the use of the outgoing partner's share of the assets or at an interest rate of the rate of 6% per annum on the amount of the partner's share of the partnership assets.  The first alternative of the section is often very difficult to calculate and it would be more usual to seek the statutory interest.

The sale after dissolution

Subject terms the partnership agreement, the partnership assets must be converted into money.  Frequently the partnership agreement will contain a provision whereby an option is granted to members of the partnership to acquire partnership property on certain terms.  This will often involve valuation issues and in the absence of provision in the partnership agreement, a method of valuation will need to be adopted and this can often be a matter of dispute as there are a number of ways of valuing businesses and various types of business often have their own specific method of valuation which is accepted in practice.  If the partnership agreement is silent on the issue, the remaining partners may find themselves having to pay a large amount of money to the outgoing partner for his or her share of the partnership business.

An alternative to an application for an appointment of a receiver is an application for an injunction to preserve particular assets or to restrain a partner from interfering with the business or, where goodwill has been sold, to restrain a former partner from carrying on business under the old firm name.

Other issues

• Outgoing partner’s obligations for contracts of the partnership business and the extent to which insurance may protect an outgoing partner.  An outgoing partner remains liable for debts and liabilities of the partnership incurred prior to his departure.  An outgoing partner should be indemnified by the remaining partners in respect of liabilities incurred loss whilst he was a partner.  However that does not necessarily affect the outgoing partner's liability directly to a creditor.
• Any restraints which may be imposed upon an outgoing partner from setting up a similar business or soliciting the customers of the partnership.  In this regard any covenant restricting the right to carry on a similar business is restrictively interpreted against the then partners as if they were employers extracting such a covenant from a prospective employee.  An attempt to restrain a partner on the basis that it is customary in the practice of a profession is contrary to public policy is likely to be void.
• Defining partnership property particularly where one partner contributes a capital item such as intellectual property or a physical asset and another partner is providing services.
• Consider also the situation where a partner carries on another business or activity and whether such activities might be caught by the terms of the partnership agreement.  For example at the same time as the Beatles were in partnership producing Beatles records, John and Paul were both producing their solo records and an argument arose as to whether the proceeds of sale of their solo work should be considered partnership assets.

Partners are of course in a fiduciary relationship with each other from which flow all the attendant fiduciary obligations.

• Who will get the name of the partnership business, including its trade names and registered or common-law trademarks, after dissolution.  This has been a continuing source of dispute between the founding members of Little River Band.  Ironically, the main members of Little River Band lost control of the name and now go under the name ‘Birtles, Shorrock and Goble, formerly of Little River Band’.  This would be a continuing source of annoyance to them as they were the principal songwriters and stars of the group.

Mr Housden and eventually his company We Two Proprietary Limited acquired legal right to its trademark and trade name "Little River Band".

I quote from an extract from the recent Federal Court proceedings involving the former members of the group (We Two Pty Ltd v Shorrock (No 2) [2005] FCA 934).

"Little River Band is the name of a pop group. The group was established in Australia in the 1970s. The applicants are three of the five original members of the group. Within a short period of its formation the group became very successful with many sell-out concerts and a large volume of record sales. Its success was not confined to Australia. Along with a handful of other Australian groups, Little River Band gained popularity overseas, particularly in the United States where it was the first Australian-based group to sell a "gold" album (that is where sales exceed one million records).

6 Notwithstanding its success the line-up of the group changed from time to time. One by one each of the applicants left the group to pursue his musical interests elsewhere. When any member left he lost the right to perform under the name "Little River Band". That right stayed with the remaining line-up. In due course the proprietorship of the name was transferred to We Two.

7 In 2002 or thereabouts the applicants (Birtles, Shorrock and Goble),began to perform together at live concerts in Australia and in the United States. They performed under the name "Bertels, Shorrock and Goble, The Original Little River Band". They made other use of the name "Little River Band" in promotional material.

8 This led to the institution of two actions. One is the US action to which I have already referred. The other is the action commenced in the Federal Court of Australia. The Australian action was for infringement of trade mark, passing off, and misleading or deceptive conduct contrary to s 52 of the Trade Practices Act 1974 (Cth). The foundation for each cause of action was the use by the applicants in their promotional material and in their performances of the name "The Original Little River Band". We Two sought declarations of unlawful conduct, a permanent injunction, damages and other relief. The applicants filed a defence in which they admitted using the words "The Original Little River Band" but alleged that this use was lawful. A company associated with the applicants counterclaimed for the removal of We Two’s trade mark from the Register of Trade Marks.

The injunction was obtained in an action commenced by We Two, an Australian company, and its director, Mr Housden. The applicants and Mr Wheatley were the defendants in that action. We Two is the proprietor in Australia of the trade mark "Little River Band" which is registered in class 41 in respect of "entertainment services". It seems that We Two and Mr Housden have similar rights in respect of the mark under the Trademark Act of 1946 (Lanham Act). At all events, in the US action the plaintiffs claimed to have the exclusive right to use the name "Little River Band" as a trademark and trade name, that the defendants infringed upon those rights and that, accordingly, the plaintiffs were entitled to a permanent injunction to ensure no future violation. There was no trial of the action. Judgment was obtained pursuant to the Federal Rules of Civil Procedure 1937 (US), rule 55(b), which authorises the court to enter judgment by default.

We Two Pty Ltd v Shorrock (No 2) [2005] FCA 934.”

The case centred on the terms of a deed of settlement which the parties had entered into in 2002 and the undertakings given by Shorock, Birtles and Gobel in relation to the use of the trademarks.

The case is interesting because it demonstrates the problems which can arise when partners come and go.  In this case the last man left in the group ended up with the assets!

With the revival of many formerly famous groups now a common occurrence in the music world, no doubt such issues are live and of value.

For further information please contact Tony McMinn on (02) 9957 4501 or amcminn@rbhm.com.au