Partner Leaving the Firm: Liability and Settlement

When One Partner Wants Out

Three friends opened a small accountancy practice in Karol Bagh fifteen years ago. They split profits 40-30-30. Last month, the senior partner — the one whose name was on the door — told the others he was retiring. He wanted his share of the capital, his share of the goodwill, and a clean break by the end of the financial year. The other two said yes, drew up a one-page letter, and shook hands.

Eight months later, a supplier filed a recovery suit against all three of them — including the retired senior — for an unpaid bill that became due after he had left. He was livid. He had retired. He had a letter. He had handed over the keys. How could he still be liable?

The answer lies in a part of the law most small firms never read until it is too late: the rules on what an exiting partner owes to the firm and to the outside world, and what the firm owes him in return.

The Five Ways a Partner Can Leave

The Indian Partnership Act, 1932 recognises that a partnership is a living arrangement — people come in, people go out, and the firm itself need not die when one person walks away. Sections 31 to 38 of the Act deal with this. The chapter heading in the law book is plain: "Incoming and Outgoing Partners."

A partner can become an outgoing partner in five distinct ways:

• Retirement — voluntary withdrawal under Section 32.
• Expulsion — forced exit by other partners under Section 33.
• Insolvency — adjudication as insolvent under Section 34.
• Death — under Section 35.
• Transfer of interest — though this does not always end partnership status.

In every case, the firm itself is not necessarily dissolved. Where there are at least two remaining partners and a contract that allows continuation, the firm carries on with the survivors. What needs careful handling is the transition: who pays what to whom, and who answers to outside creditors for what.

Retirement: The Cleanest Exit

Section 32(1) of the Partnership Act sets out three lawful ways for a partner to retire — with the consent of all other partners; in accordance with an express agreement among the partners; or, if the partnership is at will, by giving written notice to all the other partners of his intention to retire.

Why such formality? Because the retirement of a partner can throw the whole business into disarray. Section 32 strikes a deliberate balance — it recognises the right to walk away, but it does not allow a partner to do so on a whim that could ruin his colleagues. Where the deed sets a procedure (say, six months' notice, or majority consent), that procedure binds.

The remaining partners can continue the firm so long as at least two partners remain. In Abbasbhai v R.G. Shah (AIR 1988 Bom 187), the Bombay High Court considered a clause that allowed all but one of the partners to retire and the last remaining partner to continue the firm with new partners — a useful template for family firms passing through generations.

Expulsion: Only With Good Faith

Section 33 says no partner can be expelled by a majority unless the partnership deed specifically gives that power. And even then, the expulsion must be in good faith and in the interest of the firm. The courts read this strictly. A power of expulsion is a power of extreme nature.

The leading caution here is Bissett v Daniel (1853) 10 Hare 493, where two-thirds of the partners served an expulsion notice on a colleague — but the real reason had nothing to do with business. It was personal. The court struck down the expulsion. The court said majority powers must not be used "for base or unworthy purposes or merely to injure a co-partner." The expelled partner must, ordinarily, be given an opportunity to state his case.

Expulsion has been upheld where the offending partner has done something serious. In Carmichael v Evans (1904) 1 Ch 486, a partner in a drapery firm was convicted of travelling without a ticket. The senior partner expelled him. The court held the expulsion valid — honesty is a fundamental duty of every partner. Misappropriation of client money, professional misconduct, and fraud have all been treated as good grounds.

The expelled partner is treated, for purposes of liability and settlement of accounts, exactly like a retired partner under Section 32(2), (3) and (4).

Insolvency and Death

Section 34 deals with insolvency. The day a partner is adjudicated insolvent, he ceases to be a partner — automatically. The firm may or may not dissolve, depending on what the deed says. If the deed allows the firm to continue, the insolvent partner's estate is no longer liable for any act of the firm done after the date of adjudication, and the firm is not liable for his post-adjudication acts. No public notice is needed because the insolvency order itself is on public record.

Section 35 handles death. If the partnership deed says the firm shall continue notwithstanding the death of a partner, the deceased partner's estate is not liable for any act done after his death. Again, no public notice is required because death is its own notice. But the estate remains liable for everything the firm did up to the date of death.

One important warning: the death of a partner does not automatically make his legal heir a partner. The heir steps in only if all surviving partners consent or if the deed expressly says so. In a two-partner firm, where one dies, there is no firm left for a third party to be introduced — the firm is dissolved by operation of law.

What He Owes for the Past

Section 32(2) starts with a sentence every retiring partner should memorise: "A retiring partner may be discharged from any liability to any third party for acts of the firm done before his retirement by an agreement made by him with such third party and the partners of the reconstituted firm."

Read carefully, that means: liability for past acts survives retirement. The default is continued liability. The release happens only by a tripartite agreement among the retiring partner, the continuing partners, and the third-party creditor. That agreement is called novation — substitution, with the creditor's consent, of a new debtor for an old.

Novation can also be implied. In Evans v Drummond (1801) 4 Esp 89, the firm originally had two partners A and B who jointly executed a bill of exchange. A retired. On the due date, only B signed a fresh bill, which the creditor accepted. The court held that by accepting the new bill signed only by B, the creditor had relied on B alone — A was discharged.

The blunt practical takeaway: until the creditor agrees to release the retiring partner, the retiring partner stays personally on the hook. Internal indemnities from the continuing partners are useful but they cannot bind outsiders. And there is no retirement at all from liability for wrongful acts — even paying co-partners for a release does not buy peace from a tort or fraud committed during the partnership.

What He Can Be Pulled Into After Leaving

This is where the senior partner from our opening story got blindsided. Section 32(3) says: notwithstanding retirement, the retired partner and the continuing partners remain liable to third parties for acts done after retirement which would have been firm acts if done before retirement — until public notice of the retirement is given.

The doctrine behind this is "holding out." So long as the world believes the man is still a partner, the world can continue to extend credit to the firm on his name. That belief must be broken by a formal public notice. Section 72 of the Act lays down what counts: notice to the Registrar of Firms (for a registered firm), notice in the Official Gazette, and notice in at least one vernacular newspaper circulating in the district where the firm carries on business.

There is a saving proviso. A retired partner is not liable to any third party who deals with the firm without knowing that he was a partner. This was the rule applied in Tower Cabinet Co. v Ingram (1949) 2 KB 397. After Ingram retired, the firm continued and a supplier received an order on old letterhead bearing his name. The supplier had not known Ingram before the dissolution. The court held Ingram not liable — the operative date for Section 32(3) liability is the date of retirement, and a creditor who learnt of his existence only afterwards cannot use that learning to drag him back in.

Three categories of partners do not need to give public notice on leaving:

• Insolvent partners — the insolvency order is itself a public record.
• Deceased partners — death is its own notice.
• Dormant partners — partners not known to the public to be partners. But if a dormant partner becomes known, public notice is needed.

Settling the Money — Section 48

The cash side of a partner's exit is governed by Section 48. The rules apply in the absence of a contrary agreement in the partnership deed — so a well-drafted deed is the first line of defence.

The order of settlement under Section 48:

1. Losses, including deficiencies of capital, are paid first out of profits, next out of capital, and lastly by the partners individually in their profit-sharing ratio.
2. The assets of the firm — including any sums brought in by partners to make up capital deficiencies — are then applied as follows:
   • First, in paying outside debts of the firm to third parties.
   • Second, in paying each partner rateably what is due to him on account of advances (loans he gave the firm), as distinguished from capital.
   • Third, in paying each partner rateably what is due to him on account of capital.
   • Fourth, the residue, if any, is divided among the partners in their profit-sharing proportion.

If a partner is insolvent and cannot pay his share of the loss, the rule in Garner v Murray (1904) 1 Ch 57 applies — the solvent partners do not have to make up the insolvent partner's share of losses.

A separate but related rule is in Section 49: where there are joint debts of the firm and separate debts of individual partners, firm property is applied first to firm debts; the separate property of any partner is applied first to his separate debts. The two pots are kept apart so that firm creditors are not crowded out by personal creditors of an individual partner.

If His Share Is Not Paid Immediately

Often, the firm cannot — or does not — settle the outgoing partner's account on the day he leaves. The accounts have to be drawn up, the property valued, the debtors realised. Meanwhile, the firm continues to use his money. Section 37 protects him. The outgoing partner (or the heir of a deceased partner) has a clear option:

• To claim such share of the profits made since he ceased to be a partner as may be attributable to the use of his share of the firm's property; or
• To claim interest at 6% per annum on the amount of his share in the firm's property.

The choice is the outgoing partner's — not the firm's. He picks the option that gives him more. This is one of the most useful provisions for a retiring partner whose erstwhile colleagues are dragging their feet on the settlement, because it gives him a measurable financial cost to point to.

This option is lost if the surviving or continuing partners actually buy out his share under a contract for sale of the share. But if they fail to comply with the buyout terms in any material respect, the option under Section 37 revives.

Can He Start a Competing Business?

Section 36(1) says yes — an outgoing partner may carry on a business competing with the firm and may advertise it. But three boundary lines apply:

• He may not use the firm name.
• He may not represent that he is carrying on the business of the firm.
• He may not solicit the customers who were dealing with the firm before he ceased to be a partner.

He may, however, accept the old customers if they freely come to him. The case Hookham v Pottage (1873) 8 Ch A 91 explained the line. Where the firm was named "H and P" and the outgoing partner P set up a business styled "P from H & P," the court held this was calculated to mislead the public into thinking the new business was the old firm. He was restrained.

The partners can also expressly contract for a non-compete clause when one of them leaves. Section 36(2) is the only place in Indian law where a non-compete agreement is given express statutory blessing — it overrides Section 27 of the Indian Contract Act, 1872, provided the restriction is reasonable in time and area. Many small business owners find this surprising; even an oral promise to stay out of the trade for a year may be wholly unenforceable, while a written, reasonable post-retirement non-compete in a partnership deed is binding.

What Should I Actually Do Now?

1. Read the deed first. What does it say about retirement? Notice period? Mode of valuation of share? Restraint of trade? If there is no deed, the default rules of the Partnership Act govern.
2. Sign a written deed of retirement. All partners — outgoing and continuing — should sign. Mention the date of retirement, the agreed share value, and that the firm shall continue.
3. Settle accounts under Section 48 order. Get a chartered accountant to prepare a formal closing statement. Apply outside debts first, then partner advances, then capital, then profit-sharing residue.
4. Get a written indemnity from the continuing partners. This protects the retiring partner internally. It does not bind outside creditors but it gives him a recovery right against his ex-partners if they let him down.
5. Demand novation from large creditors. For any major outstanding loan or supplier credit, get a tripartite letter — outgoing partner, continuing partners, creditor — releasing the outgoing partner from past obligations.
6. Publish public notice the same week. Section 72 form: notice to the Registrar of Firms (if registered), publication in the Official Gazette, and publication in at least one vernacular newspaper of the district. Keep the original cuttings and gazette copy on file.
7. Notify the bank, the GST department, the income-tax department. Update the firm's PAN records, the GST registration, and the bank account signatories. The retiring partner's name should not continue on any operative document.
8. Pursue Section 37 if the firm delays payment. If the share is not paid, demand 6% interest or the share of post-exit profits — whichever is higher.
9. Decide the non-compete question. If you are the continuing partner, insist on a reasonable post-retirement non-compete. If you are the retiring partner, get clarity on what you can and cannot do — your livelihood depends on it.
10. Talk to a contracts lawyer before, not after, you sign. A well-thought-out exit deed is among the cheapest legal documents you will ever buy. A botched one can cost the price of the firm itself, often through downstream breach-of-contract disputes that surface years later.

Walk Out Cleanly, Not Quickly

The ugliest partnership disputes are not about money sitting in the bank. They are about money that turns up months after one partner has left — a tax demand, a supplier suit, a customer claim — that the retired partner thought he had escaped. He had not. The Partnership Act sets a clear standard: liability survives departure unless three things are done — accounts are settled honestly under Section 48, third parties are released by novation where possible, and public notice is given to break the chain of holding out. Skip any of the three, and you are still a partner in the eyes of the law, no matter what your inner peace tells you.

If you are the partner leaving, give your departure the same care you gave your entry. If you are the one staying, make sure the deed of retirement protects the firm's continuity and the new constitution is on the public record. Quick exits make for slow lawsuits.

Frequently Asked Questions

Does a partner stop being liable the moment he retires from the firm?

No. A retiring partner remains liable for everything the firm did up to the date of his retirement under Section 32(2) of the Indian Partnership Act, 1932. He can be released from those past liabilities only if the third party (the creditor) and the continuing partners enter into a substitution agreement called novation. For acts done after retirement, he continues to be presumed a partner in the eyes of third parties until a public notice of retirement is given under Section 32(3) read with Section 72.

Why is public notice of retirement so important?

Because without it, the law treats the retired partner as if he is still part of the firm for any new dealings the continuing partners do. Section 32(3) says the firm and the retired partner remain liable to third parties for acts done after retirement until public notice is given. Section 72 explains the form: notice to the Registrar of Firms, in the Official Gazette and in at least one local newspaper. Skip this step and a retired partner can find himself being sued for debts run up by his ex-partners months after he left.

How is the outgoing partner's share calculated?

Section 48 of the Partnership Act sets the order. Losses are paid first from profits, then capital, then by the partners individually in their profit-sharing ratio. Then assets are applied to: (a) outside debts, (b) advances each partner gave the firm, (c) capital contributions, and (d) the residue is split in profit-sharing ratio. Section 37 gives the outgoing partner an option to either claim 6% interest on his unpaid share, or claim the share of profits attributable to his money used in the business after he left, until his account is finally settled.

Can a majority of partners simply expel a partner they don't like?

No. Under Section 33, no partner can be expelled by a majority unless the partnership agreement specifically gives that power, and even then it must be exercised in good faith. The Bissett v Daniel case held that an expulsion done to settle a personal grudge or to benefit individual partners — and without giving the partner a chance to be heard — is void. Expulsion is allowed where the partner has been guilty of misconduct, fraud, or has damaged the business — for example, the conviction-for-fare-evasion case Carmichael v Evans.

What happens to liability when a partner dies?

Section 35 of the Partnership Act answers this. If the partnership deed says the firm shall continue despite a partner's death, the deceased partner's estate is not liable for any act of the firm done after his death. No public notice is required because death itself is treated as enough notice to the world. The estate, however, remains liable for everything the firm did up to the date of death. The legal heir does not automatically become a partner — that needs the consent of all surviving partners or a specific clause in the deed.

Can a retiring partner start a competing business?

Yes, subject to limits. Section 36(1) allows an outgoing partner to carry on a business competing with the firm and even to advertise it. But three things he cannot do: use the firm name, represent that he is still carrying on the firm's business, or solicit the customers who were dealing with the firm before he left. He may still serve old customers who voluntarily come to him. Section 36(2) allows the partners to agree, by written contract, on a reasonable restraint of trade for a specific period and area — and that contract overrides the general rule in Section 27 of the Contract Act.

What is novation and why does it matter at retirement?

Novation is the substitution, with the creditor's consent, of a new debtor for an old one. Section 32(2) allows a retiring partner to be discharged from past firm liabilities by an agreement among him, the continuing partners, and the third party. Novation can be express or implied — implied where the creditor, knowing of the retirement, continues to deal with the reconstituted firm. Until novation happens, the retiring partner stays personally on the hook to creditors no matter what private deal he has struck with his co-partners.

Is public notice needed for an insolvent partner or a deceased partner?

No. Section 34 says insolvency itself is treated as public notice — the fact of insolvency adjudication is on the public record. Section 35 says no public notice is required on death because death is its own notice. Public notice is mandatory only for living, solvent retiring or expelled partners under Section 32 and Section 33. A dormant partner who retires also does not need to give public notice, because third parties never knew him to be a partner in the first place.

What if the retiring partner's share is not paid out immediately?

Section 37 protects him. If the firm continues using his share of capital and assets without settling his account, he has a choice: claim interest at 6% per annum on the amount of his share, or claim the share of profits attributable to the use of his share since he left. The choice is his, not the firm's. This option is lost only if the continuing partners actually buy out his share under a contract — and even then, if they fail to comply with the buyout terms, the option revives.

Can a retiring partner be sued for the firm's contracts signed before he retired?

Yes. The rule from Section 32 is plain: every partner is liable for all acts of the firm done while he was a partner. Retirement does not erase that. A liability that arose during the period he was a partner survives his retirement. Even agreements with co-partners to release him from past debts do not bind outside creditors, unless the creditor has agreed (novation). The clean way out is to take the third party's written consent at the time of retirement, in a tripartite document with the continuing partners.

What about wrongful acts — can a retiring partner buy his way out of those?

No. The rule is clear from Chapter 4 commentary on Section 32 — there cannot be any retirement from liability for wrongful acts, even if the retiring partner has paid the other partners to release him. A tort of the firm or fraud committed during his time as a partner sticks with him personally regardless of internal arrangements. Civil settlements between partners cannot defeat a third-party claim arising out of a wrong. This is why retirement should always be advised by a lawyer who reviews any pending disputes before drafting the deed.

What documents should a retiring partner insist on?

At a minimum: a written deed of retirement signed by all partners; a settlement statement showing capital, advances, and share of profits up to the date of retirement; an indemnity from the continuing partners against future firm liabilities; proof of public notice in the Official Gazette and a local newspaper; and notice to the Registrar of Firms under Section 63 read with Section 72 if the firm is registered. Where any large creditor exists, a tripartite novation letter with that creditor is the gold standard.

For more articles on Indian law, visit the Pinaka Legal Blog. Written by the Pinaka Legal Editorial Team. For queries, call +91 8595704798 or email info@pinakalegal.com.