 It's Will and Chao and welcome to Forms of Business Organization, Module 5, Part B. In this part, we will look at the partnership, examine how a partnership is formed, and the key legal aspects of a partnership. We will now look at partnerships. There are three types of partnerships that we will look at. The general partnership, the limited partnership, and the limited liability partnership, or LLP for short. How was a partnership formed? Well, the requirements of a partnership are that there are two or more persons carrying on a business together with a view to profit. That second requirement, carrying on a business together, what exactly does that mean? The courts over the years have identified various factors which indicate that two or more people are carrying on a business together as a partnership. So these factors include whether or not they are sharing profits, are they sharing responsibility for losses including guaranteeing the partnership's debts, do they jointly own property, do they all participate in management which could include having signing authority for contracts and bank accounts and having access to information about the business, and do they hold themselves out to people outside of the partnership as partners. Once we have a partnership with two or more persons carrying on a business together with a view to profit, those are the requirements that we looked at on the previous slide. Once those requirements are met, we automatically have a general partnership. There's no need to satisfy any other formalities like filling out forms or registering anything or paying any fees. None of that is required to form a general partnership. However, there may be some formalities required to actually operate the business of a general partnership which could include getting municipal business licenses and registering the business name. Now for the other types of partnerships for a limited partnership, to get that limited partnership status we have to register the partnership under the Limited Partnerships Act. So there is a specific form that has to be filled out and filed to get the limited partnership status. For the Limited Liability Partnership, it also has to be registered, so the name of the partnership has to be registered with the LLP designation under the Business Names Act. Now this type of partnership, the LLP or Limited Liability Partnership is available only to partnerships of lawyers and accountants. And a requirement to get LLP status in addition to the registration is that the law firm or the accounting firm must have liability insurance. Back to Lucy's lemonade. So instead of paying Marcy 25 cents an hour, Lucy decides to give Marcy a quarter share of the profits of the lemonade business. Marcy helps out by serving lemonade to customers and counting the money at the end of each day. She helps Lucy calculate how much profit they are making. She and Lucy decide together that it would be a good idea to raise their price of 50 cents per cup. Marcy tells her friends that she and her big sister are business partners. So the question here is what facts indicate that Lucy and Marcy have formed a general partnership? Please pause this video to consider this question. The first fact that indicates a partnership is that Lucy and Marcy are sharing the profits 75% to 25%. The second fact is that both Lucy and Marcy are involved in managing the business. So that also indicates that they are in a general partnership. And the last fact that indicates a partnership is that Marcy is holding herself out as a partner to her friends. So when she tells her friends that she and her big sister are business partner, that's what we mean by holding yourself out as a partner. We'll look at five different key legal aspects of partnerships. The first is that a partnership is not a legal entity that is separate from its owners. The second is the key legal aspect of unlimited personal liability on the part of the partners. The third is the liability of partners to outsiders, people outside of the partnership. The fiduciary duty that is owed by partners to each other. And the importance of having a partnership agreement when setting up a partnership. In terms of the key legal aspects, a partnership is not a legal entity separate from the partners. Remember the basic legal concept, just like with a sole proprietorship, is that the business and the owners are one and the same. They are not separate. And another related concept is unlimited personal liability. So it's very similar to a sole proprietorship. So with a partnership, each partner is personally liable for up to 100% of the partnership's debts and obligations. So those debts and obligations can arise from contracts or torts. And these are obligations owed to outsiders, people outside of the partnership. And that would also include employees of the partnership. So the way it would work is that if the business assets of the partnership are insufficient to pay an amount owing by the partnership, anyone or more of the partners may be required to pay the remaining amount owing from their own personal assets. The paying partner can then, if a partner is required to pay to an outsider for a debt owed, that paying partner can claim from other partners their share of the debt paid. And that is considered to be the right of indemnification. So let's say Lucy and Marcy have indeed formed a general partnership with Lucy owning 75% and Marcy owning the remaining 25% of the partnership. And Charlie, the guy who drank the bad lemonade, let's say he sued the partnership for the tainted lemonade instead of Lucy's sole proprietorship. Who is liable to Charlie for that $100,000 judgment? And how would Charlie enforce the judgment? Please pause the video at this point to consider these questions. Every partner is fully liable for the negligence of any one partner committed in conducting the partnership's business. So that's the rule that applies here. Each of Lucy and Marcy is liable for up to 100% of the judgment. And that means that any one of them can be made to pay the full $100,000. Charlie would first seize the partnership assets to satisfy the judgment debt of $100,000. If there's still money that's owing after seizing those partnership assets, the remaining debt could be satisfied by any one of the personal assets owned by either Lucy or Marcy. If Charlie seizes Lucy's personal bank account, Lucy may claim indemnification from Marcy for her fair share of the liability to Charlie. So that refers to a partner's right to indemnification. What is the liability of partners of a general partnership to outsiders? The rule is that each partner is fully liable for contracts entered into by another partner. Another partner in the ordinary course of the business of the partnership. So if you are in a partnership and one of your partners enters into a contract, even without your knowledge, as long as it's in the ordinary course of the business, then that contract is also binding on you as a partner. So the legal concept here is that each partner is considered to be an agent of every other partner. If you had an agreement with your partner that neither of you would enter into any contract for greater than $5,000 without the other partner's approval, then if your partner still went out and entered into a large, let's say $10,000 contract without your knowledge, is that contract binding on you? Now, if it depends, if that outsider did not know about that $5,000 restriction, then that contract is also binding on you, even though you neither knew nor approved of that contract. But if that outsider did know about the $5,000 restriction that you and your partner had agreed to, and that outsider still went ahead and entered into the $10,000 contract, then that contract is not binding on you. Each partner is fully liable also for the torts of any other partner in the partnership, as long as the tort arose while acting in the ordinary course of the partnership. When a new partner is added to an existing partnership, that new partner is not liable for any of the prior liabilities of the partnership. Conversely, when a partner leaves the firm, either departing maybe to take another job or just retiring altogether, that partner remains liable for partnership liabilities that were incurred before that partner retired or left the firm. But they are not liable for any post-departure liabilities unless that ex-partner either holds themselves out as a partner or the ex-partner knows that his or her name is still being associated with the partnership and does nothing about that. Back at Lucy's Lemonade, Marcy decides on her own to order $1,000 worth of lemons from a fruit hole sailor on account. The lemons were on sale at a good price. When Lucy hears about this, she says, are you crazy? We'll never be able to sell enough lemonade to use up all those lemons before they go bad. So who is personally liable to the fruit hole sailor for the lemons? And does it matter if Marcy was only authorized by Lucy to make purchases for the business of up to $50? Please pause this video to consider these questions. Each of the partners is up to 100% liable for this order. So each of them can be made personally liable for the full $1,000. Marcy was acting as Lucy's agent when she entered into the contract to buy the lemons in the ordinary course of the partnership's business. Ordering lemons is a part of the ordinary course of the lemonade business. The second question, does it matter if Marcy was only authorized by Lucy to make purchases for the business of up to $50? If the fruit hole sailor was not aware of the $50 restriction on Marcy's authority, both partners are still fully personally liable for the full amount of the contract, which is the $1,000. However, if the whole sailor was aware of the $50 restriction, only Marcy would be personally liable. The general rule that imposes unlimited personal liability on partners for debts owed by a partnership to outside creditors is modified in the case of limited partnerships and limited liability partnerships. A limited partnership involves two types of partners, general partners and limited partners. There has to be at least one general partner in any limited partnership. The general partner is the partner that controls the management of the business and has unlimited personal liability to outsiders. So if the limited partnership is sued by an unpaid creditor, the partnership assets and all of the personal assets of the general partner can be used to satisfy that debt. The second type of partner is limited partners. Limited partners, just like general partners, can share in the profits and losses of the partnership business. However, the liability of limited partners is limited to the amount invested in the partnership. So if a limited partner has invested $5,000 in a limited partnership, that is the maximum amount that that partner can lose. There is no personal liability on the part of limited partners for debts owed to outsiders. That limited liability protection, however, is lost if either the limited partner participates in controlling that business, but giving advice is fine, but actually making decisions and controlling the management of the business is not allowed. If that happens, the limited partner becomes a general partner in terms of unlimited personal liability. Alternatively, if the limited partner allows their name to be used in the firm name, in the name of the limited partnership, that also takes away that limited liability protection from that limited partner. The rules regarding liability of partners to outsiders and the rule regarding unlimited personal liability of partners is slightly different when we're talking about limited liability partnerships or LLPs. Remember that LLPs are available only to accountants and lawyers. A partner of an LLP is not personally liable for the negligence of another partner. If the client sues the firm for negligence, that partner who committed the negligence is personally liable. In other words, their personal assets are at risk, but the personal assets of other partners of that firm are not at risk. A partner is personally liable if they're the ones who committed the negligence, if they're the ones that made the mistake that the client is suing for. And also, a partner is personally liable for the negligence of other lawyers or accountants in the firm that that partner supervises. A partner owes a fiduciary duty to the partnership. Fiduciary is another word for trust. A duty of trust is owed by the partner to the partnership. What that means is that a partner must act honestly and in good faith in the best interests of the partnership. Specifically, a partner can never put their own personal interests ahead of those of the partnership. A partner cannot take personal advantage of a business opportunity that the partnership may pursue. A partner cannot have a conflict of interest where their own personal interests may conflict with the partnership's interests. And a partner cannot compete with the partnership. In other words, a partner cannot be in a business that competes with the business of the partnership. If a partner is sued for a fiduciary duty and is found to have actually breached their fiduciary duty, a court may order that partner to pay their resulting profits over to the partnership. At Lucy's Lemonade, Lucy is frustrated with Marcy. While still operating Lucy's Lemonade with Marcy, Lucy sets up another Lemonade stand down the street in partnership with Linus. What can Marcy do about this situation? Please pause the video so you can consider this question. Marcy can sue Lucy for breach of fiduciary duty. As a partner, Lucy cannot compete against the business of the partnership Lucy's Lemonade. A court may order Lucy to pay over to the Lucy's Lemonade partnership her share of the profits from the other Lemonade stand. If you are going into business with someone as partners, you need to have some rules regarding the relationship between you and your partner, in particular, what are your legal rights, where are your different rules in the business. The Ontario Partnerships Act sets out a set of default rules on how partners relate to each other. So these are default rules. They apply only if the partners themselves have not set up their own rules and put them into a partnership agreement. The general advice is that it's always preferable to have a partnership agreement. And we'll talk about partnership agreements a little more in a moment. The default rules contained in the Partnerships Act, there are seven of them here. I won't talk about all of them, just point out a few of them. In particular the ones that usually partners will want a change, will want a different rule by putting it into a partnership agreement. The first default rule is that partners share equally in the capital, profits, and losses. So that default rule quite often partners will want to change where they do not want an equal split in the capital, profits, and losses. So there would have to be a specific agreement that's agreed on by all of the partners and put into a partnership agreement. Another rule I'd like to point out is rule number four. It says each partner may take part in management of the partnership. So in many partnerships you may not want every partner to be managing the business. You may want one partner, let's say a managing partner, managing the business. So that is a default rule that is often overridden by a different agreement or a different arrangement put into a partnership agreement. Another rule that quite often people want to change is rule number six which talks about how business decisions are made. So the default rule is that ordinary business matters require the majority consent of the partners and unanimous consent is needed for major decisions like admitting new partners, expelling existing partners, and any change in the nature of business. So quite often for the sake of efficiency you will want a different rule especially with regard to ordinary business matters. These are day-to-day management decisions. You may want to give one or two people or some other arrangement the power to make those day-to-day decisions instead of having the need to have a majority consent of all of the partners. When going into business with others in a partnership it is always a good idea to have a written partnership agreement. By having an agreement it forces the partners to sit down and discuss and negotiate all of the different rules that govern how the partnership will be run, rules setting out each of the partners, legal rights, and what their ownership interests are. Specifically I mentioned earlier that a reason to have a partnership agreement is to override some of the default rules that are contained in the Partnerships Act which we had just looked at. A partnership agreement may contain rules on a number of different things, rules on how the profits and losses will be shared and paid out to partners, what are the capital contributions expected from each partner, what are the rules for admitting and expelling new partners, how will disputes be resolved between partners, how will management decisions be made, for example, how will day-to-day management decisions be made, who will make them, and how will major decisions be made, how many partners need to consent to a major decision. And also rules regarding the consequences on the death, insolvency, or resignation of a partner. We'll talk about a little later on that the default rule on the death, insolvency of a partner is that it terminates the partnership. So obviously most partnerships will want a different rule than the default rule in that situation. Back to Lucy's Lemonade. Lucy's Lemonade general partnership had a net profit of $200 in its first year of operation. Remember that the partners had agreed to give Marcy 25% of the profits and Lucy would get the remaining 75%. To start up the business Lucy had contributed $40 of capital while Marcy contributed $10 of capital. So essentially Lucy contributed 80% of the capital and Marcy contributed 20% of the capital. So the question is how should the $200 net profit be shared between Lucy and Marcy? Please pause the video so you can consider this question. The agreement to split the profits 75-25 overrides the partnership act rule of a 50-50 profit split. So remember the default rule under the partnerships act is that profits have to be split equally. So therefore Lucy is entitled to $150 profit and Marcy gets the rest which is $50. How much capital each partner contributed to the partnership is not relevant in determining each partner's share of the profits.