Reconstitution of a Partnership Firm: Basic provisions under Contract

law
 

Synopsis-

1. Introduction
2. Modes of reconstitution recognized under Indian law

(i) Admission of a new partner (Section 31)

(ii) Retirement of a partner (Sections 32, 36 and 37)

– Liability of retiring partner (Sections 32(2) to 32(4))

– Rights of a retiring partner (Sections 36 and 37)

(iii) Expulsion of a partner (Section 33)

– Irregular expulsion

(iv) Death of a partner (Sections 35, 37 and 42(c))

– Rights of heirs of deceased partner (Sections 35 and 37)

(v) Insolvency of a partner (Section 34)

(vi) Transfer of a partner’s share (Section 29)

III. Effect of reconstitution

– Change in mutual rights/duties

– Notice to Registrar

– Revocation of continuing guarantee

1. Introduction
Partnership, in a commercial sense, can be defined as a mutual understanding between two or
more persons for carrying on some business and mutual sharing of profits resulting from that
business.
 The organization formed between those persons as a result of such understanding is called a
partnership firm. In India, the formation and working of partnership firms is governed by the
Indian Partnership Act, 1932 (hereinafter referred to as “Act“).

A change in the structure of a firm is called reconstitution of the firm. Reconstitution includes
changes not only in the firm’s structure, such as by addition of new partners or retirement of
any existing partner, but also other changes such as change in the ratio in which the firm’s
profits are to be shared between the partners.

This article discusses the different modes of reconstitution recognized under the Act, the
rights and liabilities of a retiring partner and effect of reconstitution of a firm.

1. Modes of reconstitution recognized under Indian law

The Act recognizes the following modes of reconstitution of a partnership firm:

(i) Admission of a new partner (Section 31) – Section 31 of the Act states that a new
partner can be admitted to a partnership firm only with prior consent of all partners or in
accordance with a contract entered into by the existing partners.

While the Act makes partners jointly liable for all acts of the firm, Section 31(2) clarifies that
a newly admitted partner is not liable for any act done by the firm before the date on which
he/she became a partner.

The Act does not permit a minor to become a partner in a firm, till he/she attains majority, but
permits him/her to be admitted to the benefits of the partnership. On attaining majority, a
minor has the right to elect whether or not to become a partner in the firm.

While a newly admitted partner is only liable for the firm’s acts which are done after he/she
was admitted to partnership subject to a contract to the contrary, a minor, on becoming
partner after attaining majority, also becomes liable for all of the firm’s acts done after the
date on which the minor got admitted to the benefits of the partnership.

(ii) The retirement of a partner (Sections 32, 36 and 37) – Any partner of a partnership
firm may want to retire, at any time, for any reason such as bad health etc. Section 32(1) of
the Act states that a partner can retire either with prior consent of all other partners or in
accordance with the terms of any agreement existing between the partners.

Naturally, the retirement of a partner leads to a change in capital contribution and profit
sharing ratios between the continuing partners.

Liability of retiring partner (Sections 32(2) to 32(4))

 For the firm’s acts done before retirement  – Section 32(2) allows a retiring partner to escape
his/her liability, in respect of acts done by the firm before the date of retirement, by an
agreement with the continuing partners and the concerned third party having the right to enforce
such liability.

 
 For the firm’s acts done after retirement  – Section 32(3) of the Act provides that a retired
partner is liable to a third party for all acts done by the firm in respect of such third party even
after the date of his/her retirement unless a public notice has been given of the partner’s
retirement. Section 32(4) of the Act requires such notice to be given either by any continuing
partner or the retired partner.

Rights of a retiring partner (Sections 36 and 37)

A retiring partner is given the following rights under the Act:-

 Right to complete – Section 36(1) of the Act permits a retired partner to carry on, post-
retirement, a business competing with that of the firm from which he/she has retired and the
right to advertise such business.

In order to protect the firm’s interest, the aforesaid right to compete is subject to the
following restrictions:

(a) the retired partner does not use the firm’s name;

(b) the retired partner does not represent himself/herself to be still carrying the firm’s
business; and,

(c) the partner must not solicit persons who were the firm’s customers before his/her
retirement.

Further, Section 36(2) permits a firm’s partners to enter into an agreement with any partner to
the effect that on ceasing to become a partner, he/she will not carry on any business, similar
to the firm’s business, for a specified period or within specified local limits. Such agreements
are treated to be valid even though agreements in restraint of trade are void under Section 27
of the Indian Contract Act, 1872.

 Right to share subsequent profit – At the time of retirement, the retiring partner can re-
claim his/her share of capital contributed in the firm through a settlement of accounts with the
continuing partners. Section 37 of the Act clarifies that if no such settlement takes place at the
time of retirement and the firm continues to use the retired partner’s capital for its business, the
retired partner shall be entitled to claim, even after his/her retirement, either:

(a) 6% interest per annum on the amount of his share in the firm’s property or

(b) such share of the firm’s profits which are attributable to his share of capital in the firm.

In the case of M.C. Sharma vs. B.C. Sharma and others, AIR 1986 All 69, the Allahabad High
Court held that benefit of section 37 of the Act is not available to a sole partner who wishes
to continue the firm’s business after dissolution of the firm.
 (iii). Expulsion of a partner (Section 33) – Partners of a firm may want to expel any
particular partner for various reasons such as misconduct, not taking interest in the firm’s
business etc. Under Section 33(1) of the Act, expulsion of a partner is permissible only if:

(a) it is done in the firm’s interest;

(b) approved by majority partners; and

(c) power to expel is provided in the partnership deed or any other contract between the
partners.

By virtue of section 33(2), an expelled partner is subject to the same rights and obligations
which are imposed on a retired partner under sections 32(2) to 32(4) of the Act.

Irregular expulsion

If the expulsion of a partner does not satisfy the aforesaid 3 conditions simultaneously, it will
be considered as an irregular expulsion and shall not be effective against the expelled partner.
In such case, the expelled partner may claim to be reinstated as a partner or claim refund of
his/her share of capital and profits in the firm.

In S. Vel Arvind and Others vs. Radhakrishnan and Others, (2018) 4 MLJ 468, the Madras
High Court has clarified, in paragraph 15, that “in the absence of explicit provisions in the
contract agreed to between the partners regarding expulsion of partners, only remedy
available to the disgruntled partners is taking recourse to Section 44 of the Indian
Partnership Act for dissolution to be ordered by the Court on a suit of the partner and they
cannot dismiss or expel the other partner“.

(iv). Death of a partner (Sections 35, 37 and 42(c)) – Death of any partner of a firm may
occur naturally or due to disease, accident etc. Section 42(c) of the Act provides that death of
any partner will lead to the dissolution of the firm i.e. end of the partnership unless there is an
existing contract between the partners providing for continuation of the partnership.

Rights of heirs of deceased partner (Sections 35 and 37)

 Estate of deceased partner not liable  – Section 35 states that in case a partnership does not
get dissolved (in terms of section 42(c)) after death of any partner, the deceased partner’s estate
is not liable for any act which is done by the firm after the deceased partner’s death.

 Right to share subsequent profit – Section 37 of the Act states that the contributed capital
and other dues are to be paid by the partnership firm to the legal representatives/heirs of a
deceased partner else the heirs can claim either 6% annual interest or share of the firm’s profits,
under section 37, in the same manner as a retiring partner can claim.

(v). Insolvency of a partner (Section 34) – Section 34(1) of the Act states that if any partner
of a partnership firm has been adjudicated as insolvent by the competent authority/court,
he/she ceases to remain partner in the partnership firm from the date of order of adjudication.
 Section 34(2) of the Act clarifies that the insolvent partner’s estate shall not be made liable
for the firm’s acts which are done after the date on which the order of insolvency was passed.
Similarly, the firm also does not remain liable for any act of the insolvent partner which is
done by him/her after being declared insolvent.

(vi). Transfer of a partner’s share (Section 29) – The Act permits any partner of a
partnership firm to transfer his/her interest in the firm to any other person either absolutely
i.e. by sale or conditionally i.e. in form of a mortgage or by creation of a charge on the
interest. Section 29 of the Act clarifies that in case of such transfer of interest, the transferee
has the right to receive the transferor’s share of profits in the firm. However, the transferee
cannot:

(a) interfere in the conduct of the firm’s business,

(b) require accounts of the firm, and

(c) inspect the firm’s books.

III. Effect of reconstitution  

The Act identifies the following implications of reconstitution of a firm-

 Change in mutual rights/duties – Section 17(a) of the Act describes the effects of
reconstitution of a partnership firm. It states that upon occurrence of any change in a firm’s
constitution, the mutual rights and duties of the partners of the reconstituted firm remain the
same as before unless there is a contract to the contrary between the partners.

 Notice to Registrar – Under Section 57 of the Act, each State government appoints a
Registrar of Firms for registering partnership firms working within the concerned State. Section 63
of the Act requires notice of change in constitution of a registered partnership firm to be given by
any incoming, outgoing or continuing partner to the concerned Registrar. The Registrar thereafter
makes note of such change in his/her records. Considering that registration of a partnership firm
is not mandatory under the Act, section 63 applies only to registered partnership firms.

 Revocation of continuing guarantee – A guarantee extending to a series of transactions is

called a continuing guarantee. Section 38 of the Act states that change in constitution of a firm
shall lead to revocation of any continuing guarantee given to that firm or to a third party in
respect of the firm’s transactions in the absence of any agreement to the contrary.