Scottish Law Commission (Reports)

PART XVII

THE LIABILITY OF THE LIMITED PARTNER

Introduction

17.1     In this Part we discuss some of the principal concerns about the defects in the 1907 Act. The essential feature of a limited partnership is that the liability of the limited partners is limited to the amount of their contributions. There is real uncertainty as to what a limited partner may do in relation to the limited partnership without "taking part in the management of the partnership business" and thus losing his limited liability. Resolving this uncertainty is one of our principal reform recommendations in relation to limited partnerships.
17.2     In addition we look at the scope of the protection afforded to limited partners and suggest some clarification. Recognising that other jurisdictions have adopted different rules in their statutory reforms of limited partnerships, we also look at capital withdrawal by limited partners and the duration of the liability of a limited partner after his withdrawal from the limited partnership.

What constitutes "management"?

The need for further guidance

17.3     Section 6(1) of the 1907 Act provides:

A limited partner shall not take part in the management of the partnership business, and shall not have power to bind the firm:

Provided that a limited partner may by himself or his agent at any time inspect the books of the firm and examine into the state and prospects of the partnership business, and may advise with the partners thereon.

If a limited partner takes part in the management of the partnership business he shall be liable for all debts and obligations of the firm incurred while he so takes part in the management as though he were a general partner.

17.4     This provision is deficient because it gives little guidance as to what activities short of management are permissible for limited partners. By contrast, as we stated in the Joint Consultation Paper (LP),^[1] several other jurisdictions have provided statutory lists of activities which are not to be regarded as amounting to participation in management. We therefore invited views on whether legislation should provide further guidance on this issue and, if so, whether it should take the form of a list of permitted activities or a list of prohibitions.^[2]
17.5     A considerable majority of consultees thought that there was a need for further guidance to allow a limited partner to know what he could and could not do. One consultee suggested that the term "management" had a clear meaning and needed no further definition. Another suggested that it would be difficult to provide guidance in practice with sufficient definition. But there was strong support for guidance, in particular from consultees with extensive practical experience of the use of limited partnerships as investment vehicles. Consultees also expressed a clear preference for that guidance to be in the form of a list of permitted activities.
17.6     We also observed that some jurisdictions, such as Jersey and Delaware, provide that a limited partner loses his limited liability only in relation to a person who transacts with the partnership with knowledge of the limited partner's participation in management and in the belief that he was a general partner. We provisionally suggested that the loss of protection for a limited partner who takes part in management should not be contingent upon knowledge of a third party dealing with the partnership. Almost all consultees agreed with our provisional view.
17.7     We therefore recommend that there should be a list of permitted activities in which limited partners may engage without loss of their limited liability and that the loss of limited liability should not be contingent upon knowledge of a third party dealing with the partnership.

The list of permitted activities

17.8     In the Joint Consultation Paper (LP),^[3] we provisionally proposed that there should be statutory provision that doing specified acts did not mean that a limited partner was taking part in the management of the firm.^[4]
17.9     Most consultees supported the proposed list in full. Two consultees^[5] agreed with all the activities in the list but thought that the list was too restrictive. Another suggested that the draft Bill should make it clear that the list was not intended to be exhaustive.
17.10     On the other hand, one consultee^[6] opposed as undesirable any attempt to vary or clarify the law, suggesting that "management" had a clear meaning. There was a clear distinction, they suggested, between business decisions and non-business decisions. They also expressed concern over the proposal that a limited partner could be a contractor, agent or employee of the firm as there was a danger that the agent could be the managing executive. Another emphasised that a limited partner as a shareholder in or director of the general partner should not have de facto control.
17.11     We recognise the need to exclude management functions from the scope of the permitted activity, but observe that other consultees supported this proposal as a necessary clarification of the law.
17.12     Some consultees argued for a more extensive list. One sought a provision that participation in an advisory group or similar organ did not constitute management. Others^[7] argued that the law should allow limited partners such management powers as a general partner, who alone had unlimited liability, was prepared to allow.^[8] They argued that third parties would not be prejudiced as they enter into dealings with a limited partnership with full knowledge that all limited partners have limited liability. On the other hand, the Inland Revenue noted that there was a distinction between general and limited partners for tax purposes and suggested that the tax distinction reflected their different roles and obligations. We are not persuaded that the distinction between the roles of a general partner and a limited partner should be left to the agreement of the partners.
17.13     Another consultee^[9] suggested that activities excluded from management should encompass the fixing of remuneration of professional advisers and the approval of borrowing transactions. Other activities which consultees suggested should be excluded were deciding to terminate the partnership, voting for the appointment of a partnership liquidator, and appointing an agent to remedy a default by a general partner.
17.14     The APP suggested that we should exclude from participation in management any activity which a limited partner carried out in another capacity, for example as an officer, representative, agent or employee of a general partner. They pointed out that it is common for limited partners also to be employees of the general partner and in that capacity to arrange the investment of the limited partnership's funds. They urged us to allow limited partners to carry out such functions not only for a general partner which is a limited company but also where the general partner was a natural person, an LLP or a partnership. They suggested that a limited partner should be allowed to take an active part in the management of a limited partnership in the capacity of a partner in a partnership, as a member of an LLP or as an employee of a natural person, where the partnership, LLP or natural person was the general partner.
17.15     We think that it is appropriate and helpful to those using or advising limited partnerships that there should be a list of permitted activities and that the list should not be exhaustive. There will be other high level decisions which relate to the strategic direction of the partnership which do not involve management of the partnership. An activity will not amount to management simply because it is not included in the list.^[10] We do not favour an extensive list which might blur the different roles of the limited partner and the general partner. In order to preserve flexibility to deal with changing business practice we also think that the Secretary of State should have power by subordinate legislation to amend the list of permitted activities.
17.16     Nevertheless, there should be a clear distinction between the role of a limited partner and that of a general partner. We recognise that it is possible for a limited partner to act in a different capacity, for example as a director or shareholder in a corporate general partner. Similarly, a limited partner may also be an employee of a general partner, whether the general partner is a limited company or another legal or natural person. In each case it may be possible to provide objective evidence that the limited partner was acting in a capacity other than that of limited partner. For example, if the limited partner asserts that he acted in his capacity as employee, he would have to demonstrate an employer/employee relationship and that he acted as employee.^[11] But we are not persuaded that it is advantageous to exclude more nebulous capacities such as "representative", "officer" or "agent" from the prohibition against taking part in management as that could be a recipe for uncertainty and potential abuse.
17.17     We therefore recommend that a limited partner should be prohibited from taking part in the management of partnership business but that it should be provided that that prohibition does not prevent a limited partner from doing the following things:

(1) Taking part in a decision about the variation of the partnership agreement;

(2) Taking part in a decision about whether to approve, or veto, a class of investment by the limited partnership;

(3) Taking part in a decision about whether the general nature of the partnership business should change;

(4) Taking part in a decision about whether to dispose of the partnership business or to acquire another business;

(5) Taking part in a decision about whether a person should become or cease to be a partner;

(6) Taking part in a decision about whether the partnership should end;

(7) Taking part in a decision about how the partnership should be wound up;

(8) Enforcing his rights under the partnership agreement (unless those rights are to carry out management functions);

(9) Approving the accounts of the limited partnership;^[12]

(10) Being engaged under a contract by the limited partnership or by a general partner in the limited partnership (unless the contract is to carry out management functions);

(11) Acting in his capacity as a director or employee of, or a shareholder in, a corporate general partner;

(12) Taking part in a decision which involves an actual or potential conflict of interest between a limited partner (or limited partners) and a general partner (or general partners);

(13) Discussing the prospects of the partnership business;

(14) Consulting or advising a general partner, or general partners, about the activities of the limited partnership or about its accounts (including doing so as a member of an advisory committee of a limited partnership). (Draft Bill, cl 55(1) and (2) and Schedule 6)

We also recommend that the Secretary of State should have power by subordinate legislation to amend this list (by adding, modifying or omitting a permitted activity). (Draft Bill, cl 55(3))

Scope of protection of a limited partner

Clarifying section 4(2) of the 1907 Act

17.18     The 1907 Act generally limits the liability of a limited partner to the amount of his contribution. Section 4(2) achieves this by providing that the limited partners:

… shall not be liable for the debts or obligations of the firm beyond the amount so contributed.

17.19     In the Joint Consultation Paper (LP) we referred to the concern which Michael Twomey had expressed as to the scope of the protection which the provision gave to a limited partner. We suggested that it was the clear intention of the 1907 Act that except when protection is lost under the Act, a creditor of the firm can only obtain a personal judgment against a limited partner to the extent of his contribution. Nonetheless, we asked consultees if there was a need to clarify the effect of section 4(2) by stating that it excludes any form of liability, direct or indirect, beyond the amount of the limited partner's contribution.^[13] This question generated a considerable response and the majority of consultees favoured some clarification.
17.20     Similarly, there was support for a provision to ensure that the position of a limited partner is protected in any court order against the firm,^[14] although some consultees thought that the provision would be unnecessary.
17.21     We also asked whether, where a limited partner loses his status as such by participation in management or otherwise, he should nonetheless enjoy protection except in the event of insolvency.^[15] Consultees generally saw no need to change the law. We agree. We see no strong policy reason for depriving a partnership creditor of recourse against a limited partner's general assets while the limited partnership remains in business, if the limited partner has by his actions lost the limitation on his liability. We think that to give this additional protection would blur the distinction between the two categories of partner. The limited partner's participation in management may involve a one-off decision or may continue over time. If it is continuing, the limited partner's liability will replicate that of a general partner as he will be liable for all partnership obligations incurred during the period of his non-compliance with the prohibition. If it is a single decision or action that constitutes taking part in management, the limited partner will be liable for the partnership obligations arising from that decision or action.
17.22     The limited partner also loses in part the limitation of his liability where he receives back all or part of his agreed capital contribution while he remains a partner. We discuss this below.^[16]
17.23     We therefore recommend that the protection available to a limited partner should be clarified by providing:

(1) That a limited partner is not personally liable (whether to third parties or by contribution to the liability of the general partner) for any partnership obligation incurred while he is a limited partner, unless he receives back all or part of his capital contribution; (Draft Bill, cl 56)

(2) Where a limited partner takes part in the management of the partnership business he is personally liable for any partnership obligation incurred as a result of his taking part in management and for any other partnership obligation during the period when he takes part in management. (Draft Bill, cl 57)

Capital withdrawal and the liability of a limited partner after leaving the firm

17.24     In the Joint Consultation Paper (LP),^[17] we observed that there were doubts as to the right of limited partners to withdraw their capital contributions and the consequences for their liabilities, whether before or after they leave the partnership.^[18] We identified four issues:

(1) Is there, or should there be, any obligation to restore capital out of profits?

(2) When can capital be withdrawn?

(3) Liability following assignment or, in Scotland, assignation; and

(4) Should there be any time-limit to the limited partner's liability?

17.25     We deal with liability following assignment in the next Part and address the other three issues below.

Restoration of lost capital

17.26     We asked consultees if there should be any restriction on the payments which a limited partnership could make to limited partners (whether out of profits or otherwise) where capital contributions have been lost in the course of business.^[19]
17.27     Most consultees appeared to share our view that the issue was not of practical importance and did not support any restriction. Some, who opposed a restriction, agreed with our view that third parties are more likely to see their protection as resting on the unlimited liability of the general partners. One suggestion was that it would be preferable to require in such a case that the capital shown in the registered particulars be amended, if necessary to zero. This would give a third party the means to discover how much capital there was in the partnership. Another suggestion was that liability should be imposed where a limited partner withdraws assets in the knowledge of the firm's potential insolvency.^[20]
17.28     As we do not think that this is a significant practical problem and as consultees expressed no real enthusiasm for change we do not recommend any restriction on payments to limited partners where contributions have been lost in the course of business.
17.29     In response to our question whether any other change should be made to the rules relating to the contributions of limited partners,^[21] consultees made several suggestions. One consultee adverted to the practice of making advances as well as capital contributions and suggested that it should be made clear that the restriction on withdrawal of contribution related only to the capital contribution.^[22] Another commented on the widespread practice of making loans instead of capital contributions and suggested that one could avoid the need for loans if the law allowed the withdrawal of capital, subject to registration of the withdrawal. Another consultee urged the adoption of the approach of the Delaware legislation, which dispenses with the requirement of a capital contribution.^[23] They argued that third parties do not rely on the capital base of a firm but on the unlimited liability of the general partners.
17.30     While we recognise that the practical utility of the prohibition against withdrawal of capital is limited, particularly in limited partnerships which are funded by loans and which have only minimal capital contributions, we see no pressing need for change. We therefore do not recommend any change, beyond clarifying that the contribution which may not be withdrawn is the capital contribution and not an advance. The capital contribution in this context is, in the default regime,^[24] the amount of capital which the limited partner has agreed with the partners to contribute to the limited partnership and which therefore comprises his agreed capital account. It is the agreed sum of capital that the partner is putting at risk in the partnership business and is a matter of agreement between the partners. It may comprise money or property. If the capital contribution is property the partners must agree the value of that property which is then stated in the partner's capital account. The amount of the capital contribution and any variation of that contribution must be registered.^[25] This registered capital contribution differs from an agreed advance to the limited partnership, which is not registered and may be repaid to the limited partner without compromising his limited liability.
17.31     We therefore recommend that:

(1) While a person remains a limited partner he is not entitled either directly or indirectly to withdraw or receive back any part of his agreed capital contribution ("the relevant capital contribution") to the partnership; (Draft Bill, cl 56(2))

(2) A partner's "relevant capital contribution" should mean a capital contribution consisting of either or both of a sum or sums of money and property which has an agreed capital value. (Draft Bill, cl 56(4))

17.32     The sanction which we think appropriate for such withdrawal of capital is that the limited partner should remain liable for partnership debts and obligations to the extent of the capital contribution. Thus if a limited partner has withdrawn his capital, he will be liable to creditors of the partnership to the extent of his capital contribution and creditors will be entitled to enforce their claims against his assets to that extent. For example, a limited partner may make a capital contribution of £100,000 and subsequently receive back £60,000 while he remains a limited partner. In this case a partnership creditor who is owed £80,000 by the limited partnership would be able to seek payment of his debt in full from the partnership and from the general partner and may seek payment of up to £60,000 from the limited partner who has incurred secondary liability to that extent.^[26]
17.33     We therefore recommend that if a limited partner withdraws or receives back all or part of his agreed capital contribution he should be personally liable for partnership obligations incurred while he is a limited partner, but that his liability should not exceed the amount of his capital contribution drawn out or received back. (Draft Bill, cl 56(3))
17.34     Our discussions with interested parties have caused us to question the utility of a requirement on a limited partner to contribute capital. The 1907 Act does not specify the amount of a limited partner's contribution.^[27] It is common practice for limited partners to make a nominal contribution and to finance the limited partnership by making advances to it. Some other jurisdictions do not require the making of a contribution.^[28] For example, the Delaware legislation allows a person to be admitted as a limited partner and receive an interest in the limited partnership:

Without making a contribution or being obligated to make a contribution to the limited partnership.^[29]

17.35     We see no reason to compel a limited partner to make a capital contribution. Instead, we think that the appropriate rule is to give him an option to make such a contribution and to provide that the capital contribution may be in the form of a cash sum or sums or property valued at an agreed amount.^[30]
17.36     We therefore recommend that the requirement that a limited partner make a contribution should be replaced by an option to make a capital contribution. (Draft Bill, cl 56(2))

When may capital be withdrawn?

17.37     We expressed the view that the correct interpretation of section 4(3) of the 1907 Act, which prohibits withdrawal of contribution "during the continuance of the partnership", was that the words referred to the continuance of the firm of which the limited partner was a member. We do not think the 1907 Act restricts the withdrawal of a limited partner's capital when he leaves the partnership. We seek to make it clear that there is no such prohibition in our recommendation in paragraph 17.31 above through the words "while a person remains a limited partner", and the use of those words in the draft Bill.

Duration of liability

17.38     In the United Kingdom, a former limited partner, who has received his contribution back on ceasing to be a member, remains liable up to the amount withdrawn for any debts and obligations incurred by the partnership before his departure.^[31] Several jurisdictions impose time limits on the liability of a limited partner.^[32] We asked consultees if there should be a time limit to the liability of the limited partner following withdrawal of his contribution, and, if so, how long and subject to what qualifications.^[33]
17.39     Consultees in England and Wales were equally divided in their views on the desirability of a time limit. There was more support for the idea in Scotland but without any consensus on the period, some consultees suggesting that it should be five years so as to equate with the short negative prescription. Those who argued against a time limit pointed out that a partner in a general partnership does not enjoy a special time limit on his liability and that the limited partner's liability was limited to his contribution.
17.40     Under our recommendations the limited partner incurs no liability when he withdraws his capital contribution on ceasing to be a limited partner in the limited partnership.^[34] The issue therefore is whether there should be a special time limit on his liability arising from withdrawal of his agreed capital contribution while he remains a limited partner. On reflection, we do not support the introduction of a time limit other than those arising in English law through limitation and in Scotland through prescription. We have recommended that there be a special time limit for the secondary liability of partners.^[35] This should apply equally to a limited partner who incurs secondary liability by the withdrawal of all or part of his capital contribution. Thus, where a limited partner has received back all or part of his capital contribution while he remains a limited partner, he will retain secondary liability for partnership obligations to the extent of that withdrawal until that liability is extinguished by limitation or prescription.

Note 1    Joint Consultation Paper (LP), paras 4.9 – 4.10 and Appendix B.    [Back]

Note 2    Joint Consultation Paper (LP), para 4.16.    [Back]

Note 3    Joint Consultation Paper (LP), paras 4.20 – 4.33.    [Back]

Note 4    The acts which we provisionally proposed were the following: (a) consulting and advising the general partner, (b) reviewing or approving the firm’s accounts, (c) being a contractor, agent or employee of the firm or of the general partner, or being a director of or shareholder in a corporate general partner and (d) voting on or approving or disapproving: (i) the winding up of the limited partnership, (ii) an amendment to the partnership agreement, (iii) a change in the nature of the firm’s activities, (iv) the admission, removal or withdrawal of a partner and the continuation of the firm thereafter and (v) a transaction involving an actual or potential conflict of interest between a general and a limited partner.     [Back]

Note 5    The APP and BVCA.    [Back]

Note 6    The Chancery Bar Association.    [Back]

Note 7    The APP and BVCA.    [Back]

Note 8    The Delaware Revised Uniform Limited Partnership Act (Title 6, Chapter 17 of the Delaware Code), s 17-303(b)(8)(n) is a precedent for such an approach.    [Back]

Note 9    Nabarro Nathanson.    [Back]

Note 10    Because a limited partner may be involved in certain decisions without breaching the prohibition against involvement in management we have not replicated s 6(2) of the 1907 Act by excluding the incapacity of a limited partner from the grounds (in cl 47 of the draft Bill) on which the court may remove a partner or break up a partnership. In many cases where a limited partner is a passive investor, his incapacity will not affect the running of the partnership business. There will therefore normally be no grounds under cl 47 of the draft Bill for removing the partner or breaking up the partnership.    [Back]

Note 11    The limited partner might also have to demonstrate to the Inland Revenue that his share of the profits of the limited partnership was received in his capacity as a limited partner and was not remuneration arising from his employment.    [Back]

Note 12    In the Joint Consultation Paper (LP), para 4.33(1)(b) we referred to “investigating, reviewing or approving” the firm’s accounts. We think that approving the accounts encompasses both investigating and reviewing them.    [Back]

Note 13    Joint Consultation Paper (LP), paras 4.2 – 4.7. Mr Twomey’s concern was that under the 1890 Act a partner is personally liable for the debts and obligations of the firm and that under s 7 of the 1907 Act the ordinary rules of partnership law apply to limited partnerships. The 1907 Act contains no express provision to protect the limited partner from proceedings to enforce a partnership debt. SeeTwomey, para 28.95.     [Back]

Note 14    Joint Consultation Paper (LP), para 4.7(2).    [Back]

Note 15    This is the position in Jersey. See Limited Partnerships (Jersey) Law 1994, Art 19(3) and (4).    [Back]

Note 16    See paras 17.32 – 17.33 below.    [Back]

Note 17    Joint Consultation Paper (LP), paras 4.34 – 4.37.    [Back]

Note 18    1907 Act, s 4(3) provides: A limited partner shall not during the continuance of the partnership, either directly or indirectly, draw out or receive back any part of his contribution, and if he does so draw out or receive back any such part shall be liable for the debts and obligations of the firm up to the amount so drawn out or received back.    [Back]

Note 19    Joint Consultation Paper (LP), para 4.40.    [Back]

Note 20    See by way of analogy the liability of a partner in a limited liability partnership to contribute to the assets of the LLP where he has withdrawn property from the LLP within two years before its insolvency and in the knowledge of its potential insolvency: Insolvency Act 1986, s 214A.    [Back]

Note 21    Joint Consultation Paper (LP), para 4.40(3).    [Back]

Note 22    In cl 13 of the draft Bill we distinguish between a partner’s capital contribution, which (in the default regime) requires the agreement of all the partners, and advances made by a partner beyond the amount of the agreed capital contribution. In the context of the limited partnership the restriction on withdrawal of capital applies only to the agreed capital contribution, if any.    [Back]

Note 23    See para 17.34 below.    [Back]

Note 24    See the draft Bill, cl 13(2).    [Back]

Note 25    Draft Bill, cl 66(3) and Sched 7, para 5.    [Back]

Note 26    Usually, the creditor’s primary remedy will be against the limited partnership itself but the creditor will have recourse against the general partner’s assets by virtue of his secondary liability and also the limited partner’s assets to the extent of any capital withdrawal.    [Back]

Note 27    1907 Act, s 4(2) merely provides that the limited partners “shall at the time of entering [the] partnership contribute thereto a sum or sums as capital or property valued at a stated amount…”.    [Back]

Note 28    See the Limited Partnerships (Jersey) Law 1994, Art 10 and the Ontario Limited Partnership Act 1990, s 7(1).    [Back]

Note 29    Delaware Revised Uniform Limited Partnership Act (Title 6, Chapter 17 of the Delaware Code), ( 17-301(d).    [Back]

Note 30    Where the limited partner makes, or varies the amount of, an agreed capital contribution, that capital contribution must be registered. See draft Bill, cls 66, 68 and Sched 7, para 5 and also paras 15.38 and 15.51 above.    [Back]

Note 31    SeeLindley & Banks, para 30-20.     [Back]

Note 32    In Jersey the time limit is six months after the date of receipt of the contribution. Guernsey sets a twelve-month period and Delaware sets three years.    [Back]

Note 33    Joint Consultation Paper (LP), para 4.49.    [Back]

Note 34    Clause 56(2) of the draft Bill limits the prohibition against withdrawal to the period “while a person remains a limited partner”.    [Back]

Note 35    See the draft Bill, cl 25 and Sched 2.    [Back]