Farming partnerships and financial distress: issues for lenders

Pressures on pricing in supermarket supply chains as they aggressively compete to keep their own prices low, combined with rising costs, have left many farmers over-leveraged and unable to meet their creditors' demands over recent years. With uncertainty as to how EU subsidies will be replaced post-Brexit, and no sign of the 'supermarket wars' ending, it appears likely that the agricultural sector will continue to struggle in the near future.

Many farming businesses are structured as farming partnerships. These are predominantly unincorporated general partnerships made up of a number of generations of the same family. Ignoring potential reputational issues, the legal framework of general partnerships poses a number of issues for lenders and their advisers, both at the point of offering new lending and as they seek a strategy to either rescue a customer's business, or to exit their relationship with the customer by way of a refinance or, in extreme cases, enforcement.

Two of the more common issues that arise when general farming partnerships get into financial difficulties are:

• the ownership of an asset – whether it is a partnership or individual asset and why this is important; and
• the implications that the death of a partner has for the partnership.

These issues are applicable to any general partnership, not just those operating in the agricultural sector.

General governance issues

In the absence of a written partnership agreement, general partnerships are governed by the somewhat archaic Partnership Act of 1890 ('the Act'). No formal agreement or filing of paperwork is required to create a general partnership: you simply need two or more persons "carrying on a business in common with a view to profit". As such, a general partnership can be created without the partners explicitly agreeing to do so.

Each of the partners acts as an agent of the partnership, who can bind the partnership in any acts carried out in the ordinary course of business. The partners are jointly and severally, meaning individually, liable for all of the debts of the partnership. However, in England and Wales, a partnership is not a recognised legal entity in itself and is therefore unable to hold property in its own right.

Partnerships are free to govern themselves by virtue of a partnership agreement that can contract out of the terms of the Act in some circumstances. However, partnership agreements are not common in farming partnerships.

Partnership property: who owns what?

As a partnership cannot hold property, one or more of the partners will generally hold the legal title to the partnership's assets for the benefit of the rest of the partners.

In many cases, it is clear whether an asset is a partnership or individual asset, and this may well be detailed in a formal partnership agreement. However, complications can arise when partners dispute whether an asset is individually owned or owned by the partnership.

The Act describes partnership property as:

• all property originally brought into the partnership stock; and
• all property acquired, whether by purchase or otherwise, on account of the partnership, or for the purposes and in the course of the partnership business.

The Act also contains a presumption that "unless the contrary intention appears, property bought with money belonging to the firm is deemed to have been bought on account of the firm".

Notwithstanding the presumption of ownership, in the absence of an explicit agreement the matter of ownership can be a contentious one and will ultimately be decided by the intention of the partners and the evidence available to support each partner's contention. This has to be considered on a case by case basis as no one piece of evidence is likely to be conclusive in the absence of explicit agreement.

The courts have considered the following evidence.

Accounts

The inclusion or exclusion of an asset in the partnership's accounts is persuasive but not conclusive as to whether an asset is or isn't a partnership asset. The partnership's accountants may have included or excluded certain assets in error, or even for tax reasons, without considering the ownership implications.

Trading premises

The fact that a partnership trades from a property registered in the name of one or more partners does not in itself make the property a partnership asset, even where rent is not being paid by the partnership to the partner. The partnership could simply be trading from the property rent free.

Similarly, a partnership paying rent on a lease held in a certain partner's name does not mean that the lease is a partnership asset. The partners could simply have agreed that the partner should be indemnified against the rent due under the lease while the partnership trades from the property.

Money spent by a partner or the partnership to improve an asset or property does not make the asset a partnership asset. The asset could be being loaned to the partnership, and the improvements simply necessary for the partnership to continue to trade. However, a court is likely to make an allocation for a partner who has funded the improvement of an asset owned by an individual partner to prevent an injustice.

Where a partner seeks to separate an asset from their interest in a partnership, or from partnership assets, in their will and leaves it to someone who is not a partner in the partnership, this may support an argument that it had been the intention of the partners that that particular asset was individually owned.

Why does ownership matter?

On insolvency, there are two sets of assets: partnership assets that are available to meet partnership liabilities; and individual assets that are available to meet the individual partner's liabilities. Similarly, there are two sets of creditors.

To the extent that a partnership creditor is not repaid in full from the partnership assets, it will be entitled to pursue the individual partners who are jointly and severally liable for the partnership's debts. However, if you are only the creditor of an individual partner, the ownership of the property may have a significant impact on the amount you can recover. If all the value in the relevant asset is used to repay partnership creditors, nothing will be left for the creditors of the individual partners.

To avoid any ambiguity on the point, lenders should consider ownership before lending to a new customer as this may impact on the security that needs to be put in place. For example, if a property is registered in the name of two members of a larger partnership, but it is agreed between the partners that the property is their personal asset rather than a partnership asset, the lender should really be taking third party security to secure the partnership's liabilities.

The ownership of assets is also an important point in the event that the partnership is placed into administration or liquidation as it will dictate what the insolvency practitioner is able to control and realise. Negotiations may need to take place with the individual partners or, more likely, their trustee in bankruptcy, to facilitate the sale of individually-owned assets alongside partnership assets. Such assets, such as land adjacent to the partnership's land or plant and machinery, may be crucial to the business or may make the sale generally more attractive to a buyer. This could result in assets being 'held to ransom' unless the bank has taken security, and detailed consideration would need to be given to the apportionment of value.

Death and dissolution

Unless there is a partnership agreement in place which adequately deals with the situation, the Act provides that a general partnership will automatically dissolve on the death or bankruptcy of a partner. The partnership should then, in theory, be liquidated so that all of the partnership's creditors can be repaid, with any remaining money or assets being distributed to the partners.

Practically, this is not going to be a viable proposition for a farming partnership and rarely happens, especially where the business is being passed down the family and there is no intention to cease trading. However, the problem for lenders is that the estate of a dead  partner is not liable for any partnership debts contracted after the date of death . Concerns here include:

• the deceased partner's estate will not be liable for any new loans granted or monies advanced on an overdraft after the relevant date. Lenders may find that the entirety of an overdraft will be considered as 'new monies' if sufficient time passes between the date of death and action being taken by the lender; and
• the lender's security may become susceptible to challenge in respect of any new monies advanced, particularly if the secured liabilities are referred to as those of the now-dissolved partnership rather than the new partnership.

In order to address these concerns, and provided that the lender is prepared to continue to support the new partnership, the ideal position is for all of the old partnership's assets to be transferred to the new partnership – assuming that the deceased's will provides for everything to be left to the continuing partners. The old partnership loans should be repaid using new loans which are granted to the new partnership, and new security should be taken from the new partnership with the existing security remaining in place.

Unfortunately, the likelihood of such a restructure taking place quickly and efficiently is very low, not least because probate can often be complicated and lengthy therefore delaying the transfer of the legal interest in assets to the new partnership. In addition, it is common for lenders to be kept in the dark about the death of a partner until the partnership is seeking a renewal or extension of its facilities, or is in financial difficulties. As such, years can pass and thousands of pounds can be advanced before the lender has the opportunity to protect its position.

Further complications can arise if the deceased has left their interest in the partnership, or any of the partnership assets, to someone outside of the new partnership. In these circumstances, there is a real risk that the third party beneficiary would seek to challenge any attempts by the lender to rely on its security over the particular asset in respect of new monies. Moving forward, the lender would also need to be comfortable that the new partnership's assets provide sufficient security for the purposes of its lending.

How can lenders protect their position?

In the event that refinancing cannot be achieved quickly, lenders may be able to mitigate their position by requiring the partners of the new partnership, any third party beneficiaries of the deceased partner and, potentially, the trustees of the deceased's estate to enter into a short 'side letter' agreement to confirm that the lender's security remains in place to secure all liabilities of the old and new partnerships. The signatories will need to seek appropriate independent legal advice.

Side letters may not be viable in every circumstance and each case needs to be considered on its own facts. The issues are very rarely identical and some are much more complicated than others, particularly if there have been any family disputes or divorces. It is also worth noting that the dissolution of a partnership will not automatically render a lender's security invalid in respect of any new monies advanced - instead, it creates a risk that should be mitigated as far as possible.

The existence of a partnership deed that properly deals with the death of a partner will make the reorganisation process somewhat easier. However, ultimately a lender will want to ensure that all monies already advanced, and any moneys to be advanced, are to the correct partnership and secured properly. Therefore, side letters may still be appropriate even in a scenario where a partnership agreement is in place.

Richard Tripp and Laurie Murphy are restructuring law experts at Pinsent Masons, the law firm behind Out-Law.com.