Partnership is a familiar structure to many lawyers, not only because of the important legal concepts that it embodies but also because many lawyers practise in this form.
Perhaps the most important aspect of partnership law is the nature of the liability that partners bear to third parties. We considered this issue in a previous article (see China Business Law Journal volume 4 issue 4, page 93: Joint and several), where it was noted that in both common law jurisdictions and China, the law governing general partnerships provides that each partner’s liability to third parties is unlimited. In other words, if the partnership incurs a debt and the assets of the partnership are insufficient to repay the debt in full, each partner is personally liable to pay the debt. This can be contrasted with the concept of limited liability as it applies to shareholders in a company (see China Business Law Journal volume 3 issue 9, page 89: Company or enterprise).
This article considers the origins of the term for “partnership” in English and Chinese. It then examines the concept of a limited partnership and a limited liability partnership, or as it is referred to in China, “special general partnerships”. In particular, it highlights the impact of limited liability partnerships on professional firms such as law firms and accounting firms.
Origins of the term ‘partnership’
The English term “partnership” traces its roots to the Latin verb partiri, meaning “to share” or “to divide up”. It subsequently found its way into the English word “partner”, meaning somebody who is united or associated with another person, either in the context of a business or a personal relationship. In this sense, it has the same meaning as the Chinese word hehuo [合伙], which is formed from the character he [合], meaning “to combine” or “to unite”, and the word huo [伙], meaning “companion”.
In both England and China, the concept of a partnership has a long history. In England, its origins can be traced back to the 16th century, when banking and commercial partnerships were introduced by merchants from Italy. The concept claims an even older heritage in China. Although the Chinese term hehuo is a relatively modern one, scholars have traced the origins of partnership back to the warring states period [475-221 BC] and its mature development to the Song dynasty [AD960-1279].
It is important to distinguish between limited partnerships and limited liability partnerships.
Limited partnerships involve an arrangement under which capital is provided by an investor – known as the limited partner – who shares in the profits of the partnership but is not liable for the debts or liabilities of the partnership, except to the extent of any unpaid capital that the limited partner has agreed to contribute. In return for limited liability protection, the limited partner agrees not to participate in the management of the partnership. Instead, the partnership is managed by the general partner, who bears unlimited liability in the same way as an ordinary partnership.
The concept of a limited partnership was established to make it easier for partnerships to raise capital from passive investors and is a common vehicle for use in private equity and venture capital transactions.
In China, limited partnerships are governed by chapter 3 of the 2006 Partnership Enterprise Law, which provides in article 61 that a limited partnership must have at least one general partner. Many foreign-invested partnerships established under the 2009 Administrative Measures for the Establishment of Partnerships in China by Foreign Enterprises and Individuals take the form of limited partnerships, under which the foreign investors acts as the general partner and Chinese investors act as the limited partners.
Limited liability partnerships in the US and UK
In essence, the objective behind a limited liability partnership (LLP) is to protect all partners against any personal liability that they might incur solely by reason of being a partner.
In the US, legislation on LLPs was first introduced in the state of Texas, in response to bank failures that occurred in the 1980s. When creditors were unable to recover all of their money from the banks, they sued the professional advisers who had advised the banks – such as lawyers and accountants. As a result, many law firms and accounting firms faced huge claims and the risk that their partners would become personally bankrupt. The legislation was introduced to protect innocent partners from this risk.
In common law jurisdictions, there are essentially two models that have been adopted to extend limited liability protection to partners. The first model is the US model. Under this model, there is no change to the nature of the partnership. The firm remains a partnership as that term is traditionally understood. However, the law provides a protective shield that insulates innocent partners against liability for the negligent or fraudulent acts of another partner.
There are some differences between states in the US in terms of the ways in which limited liability protection works. In some states, protection is only extended to negligence claims, with the result that partners of an LLP can be personally liable for contract and other claims that are made against the LLP. In other states, including New York, innocent partners are protected against all claims that are made against the LLP. It is important to note that limited liability protection in the US does not protect partners against liability for their own faults or negligent acts. Nor does it protect partners against liability that arises in relation to matters that fall under their “direct supervision and control”. The phrase “direct supervision and control” has proven to be a difficult one to define and has generated quite a bit of case law in the US.
Another benefit of an LLP is that it maintains the flexibility of the traditional partnership structure without imposing the onerous requirements that apply in the case of a company. This is particularly relevant in relation to taxation. In most jurisdictions, a partnership is tax-transparent; in other words, it is not taxed in its own right. Instead, the partners pay tax on the income or profit that they receive through the partnership.
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A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at law.asia.