Dissolution of a Firm | Law of Contracts - CLAT PG PDF Download

Dissolution of Firm [Sections 39 to 47] 

 Meaning of Dissolution 

•  Dissolution  refers to the discontinuation of a partnership or a firm under the Indian Partnership Act, 1932.

 Dissolution of Partnership 

• Dissolution of partnership signifies the end of the relationship between partners while the firm continues its business.
• This can occur due to the admission, retirement, or death of a partner.
•  Example:  If partners X, Y, and Z are in a firm and X retires, the partnership among X, Y, and Z ends, and a new partnership between Y and Z begins. This new partnership is called a "reconstituted firm." Therefore, when a partner retires, the old partnership is dissolved, but the firm continues its business with the remaining partners.

 Dissolution of Firm 

• Dissolution of a firm, as per Section 39, refers to the termination of the partnership among all partners in a firm.
• In this case, the firm's business is ceased, its assets are liquidated, liabilities are settled, and any surplus is distributed among partners according to their rights.
•  Example:  If partners A, B, and C all cease to be partners with one another, it signifies the dissolution of the firm.

Differentiating Dissolution of Partnership and Dissolution of Firm 

• Dissolution of partnership involves a change in the relationship among partners, while dissolution of a firm signifies the complete closure of the business.
• For instance, if a partner dies, retires, or becomes insolvent, and the remaining partners decide to continue the business, it is a dissolution of partnership, not a dissolution of the firm.
• Dissolution of partnership alters the mutual relations of the partners, whereas dissolution of firm ends all relations and the business itself.
• When a firm is dissolved, its business ceases to exist as its affairs are wound up by selling assets, paying liabilities, and settling partners' claims.
• The dissolution of partnership among all partners in a firm is termed as dissolution of the firm.

Modes of Dissolution (Section 40-41)

There are five modes of dissolution:

1. By Agreement
2. Compulsory dissolution
3. On happening of certain events
4. By Notice
5. By the court

 1) Dissolution by Mutual Agreement [Section 40]: 

• A firm can be dissolved if all partners mutually agree to it.
• Even a partnership for a fixed duration can be dissolved through mutual consent.

 2) Compulsory Dissolution [Section 41]: 

A firm is forced to dissolve in two situations:

•  Insolvency of Partners:  If all partners or all but one partner are declared insolvent. This is necessary because there must be at least two competent individuals to continue the firm.
•  Illegality:  If an event occurs that makes it illegal to carry on the firm's business.

 Example:  If partner A from India and partner Y from Pakistan are in a firm together, and war breaks out between the two countries, the business becomes illegal, leading to compulsory dissolution.

 3) Dissolution on the Happening of Contingent Event (Section 42): 

A firm may be dissolved upon the occurrence of specific contingent events:

 (i) Expiry of Fixed Period:  A firm established for a specific term is not exempt from dissolution by other causes before the term expires. Unless otherwise agreed upon by the partners, a firm constituted for a fixed term will be dissolved upon the expiration of that term.

 (ii) On Achievement of Specific Task:  A partnership formed to complete contracts with specific individuals during a particular season will be dissolved once the contracts are fulfilled. For instance, in the case of Basantlal Jalan v. Chiranjilal, where a firm was set up to supply a specific quantity of grain, the partnership continued until all assets were realized, despite the premature termination of the contract.

 (iii) Death of Partner:  If the partnership agreement does not stipulate that the death of a partner does not dissolve the partnership, the firm is dissolved upon the death of a partner. The partnership does not continue with the deceased partner's death, and any continuation of business after their death does not imply the continuation of the original partnership.

 (iv) Insolvency of Partner:  Unless otherwise agreed, the insolvency of any partner can lead to the dissolution of the firm. This applies even if the partnership was formed for a fixed term or a specific venture that has not yet been completed.

 (v) Resignation of Partner:  The resignation of any partner can dissolve the partnership. If all partners or all but one partner die or become insolvent, the firm is compulsorily dissolved, even if the partnership agreement states otherwise. This is because a firm requires at least two partners to continue.

 4) Dissolution by Notice (Section 43): 

• In a partnership at will, any partner can dissolve the partnership by giving written notice of dissolution to the other partners.
• The notice must be clear and certain, and once given, it cannot be withdrawn without the consent of the other partners.
• In cases where a partner gives notice of dissolution to gain an advantage over the other partners, they may be required to remain in the firm until pending transactions are completed.

Dissolution by Court (S 44)

The court may order the dissolution of a firm on various grounds, including:

 Insanity of Partner 

• If a partner becomes of unsound mind, the court may dissolve the firm at the request of any partner. Lunacy alone does not dissolve the partnership but can be a reason for dissolution.
• It is not necessary for the lunacy to be permanent. In the case of a dormant partner, the court may not order dissolution due to permanent insanity, except in special circumstances.

 Incapacity of Partner 

• If a partner is permanently incapable of fulfilling their duties and obligations, the court may dissolve the firm at the request of any partner.
• For example, if a partner is imprisoned for a long period, the court may dissolve the partnership, as seen in the case of Whitwell v. Arthur.

 Misconduct of Partner 

• If a partner, other than the one initiating the lawsuit, causes significant loss to the firm through misconduct that negatively impacts the business, the court may order the dissolution of the firm.
• For instance, in Carmichael v. Evans, a partner was convicted of traveling without a ticket, leading to the court ordering the dissolution of the firm at the request of the other partners due to the detrimental impact on the firm's interests.
• Similarly, in Abbot v. Crump, the court dissolved the firm due to adultery committed by one partner against the spouse of another partner, as it undermined mutual trust and confidence among partners.

 Constant Breach of Agreement by Partner 

• If a partner, other than the suing partner, is found guilty of repeatedly breaching the agreement regarding business conduct or management, the court may order the dissolution of the firm.
• Such breaches may make it impossible to continue the business with that partner.

 Transfer of Interest 

• If a partner, other than the suing partner, transfers their entire share to a third party permanently, the court may order dissolution.

 Continuous Losses 

• The court may order dissolution if the firm is continuously suffering losses and lacks the capital for future growth.

 Just and Equitable Grounds 

• The court may dissolve the firm on any grounds it considers just, fair, and equitable.
• For example, the loss of total confidence between partners, as seen in Abbot v. Crump, where the adulterous act by one partner with another partner's wife was deemed a valid reason for dissolution.

Rights and Liabilities of a Partner on Dissolution 

 Rights of a Partner on Dissolution 

 Partner's General Right (Section 46):  Every partner or their representative has the right to:

• Have the firm’s property used to pay off the firm’s debts.
• Receive any surplus distributed among partners or their representatives according to their respective rights.

 Right to Claim Return of Premium on Premature Winding Up (Section 51):  If a partner who joined the firm for a fixed term and paid a premium is entitled to a return of the premium if the firm dissolves before the fixed term. The premium amount depends on:

• The terms of the partnership agreement.
• The duration of the partner’s involvement in the firm.

However, the partner cannot claim a return of the premium in the following situations:

• If the dissolution is due to the partner's death.
• If the dissolution is primarily caused by the misconduct of the partner who paid the premium.
• If the dissolution is according to an agreement that does not provide for the return of the premium or any part of it.

 Rights of a Partner in Case of Dissolution Due to Fraud or Misrepresentation (Section 52):  If a partnership is dissolved due to fraud or misrepresentation, the aggrieved partner has the following rights in addition to other provisions:

• Right of lien on surplus assets after paying the firm’s debts for any amount paid by him for purchasing a share in the firm or for any capital contributed by him.
• Entitlement to rank as a creditor of the firm for any payments made towards the firm’s debts.
• Right to be indemnified by the partners guilty of fraud or misrepresentation against all the firm’s debts.

 Right to Prevent Use of Firm Name or Property (Section 53):  Unless agreed otherwise, any partner or their representative can prevent another partner from conducting a similar business using the firm’s name or property for personal benefit until the firm’s affairs are fully settled.

 Agreements Restricting Trade (Section 54):  Partners can agree, upon or in anticipation of the firm’s dissolution, that some or all of them will not engage in a similar business within a specified period or local limits. Such agreements are valid if the restrictions are reasonable, despite Section 27 of the Indian Contract Act, 1872.

 Case Example: Curt Brothers Ltd. V. Webster 

• In this case, A sells the goodwill of his business to B and starts a new business.
• X, a customer of the old firm, chooses to deal with A’s new firm voluntarily.
• A is not allowed to solicit X, although if X continues to deal with A on his own accord, A is entitled to this business.