Business Associations Class Notes 6/29/04

Let us run through the cases. The early ones are straightforward.

Bane v. Ferguson

Here we have non-qualified, unfunded pension plans for partners of law firms. They are becoming less common because they tend to create a strain between the younger partners and the older, retired partners. Most law firms today just set up the H.R. 10 plan for the self-employed and encourage partners to contribute to it. This plan is not nearly as liberal as the provisions under § 404 for a qualified pension plan. A partnership cannot have a qualified pension plan, but a corporation can. If you want the other fringe benefits like Blue Cross/Blue Shield, disability, or long term care, you must go to a Sub C corporation. There are a few law firms that do it, but it is more common physicians for some reason. The question in the case was the non-qualified plan provided that it ended when the firm ended. The plaintiff was a retired who had moved to Florida and was getting $27,000 a year out of the pension plan. The firm entered into a disastrous amalgamation with another partnership, became insolvent, and went out of business. The plaintiff sued, claiming that somehow, either in tort or contract law, he had the right to keep the firm going. But the plan itself provided that it terminated if the firm went out of existence. There was no fraud or bad faith. There is also no wrongful, intentional interference with a contract. The court holds that the partnership will not be kept open.

Partnership management

We dealt with National Biscuit and Smith before.

Rouse v. Pollard

Here we had a very prestigious New Jersey firm. A partner decided he wasn’t making enough from the firm alone. He started confidential conferences with rich old ladies and told them he was running his own private investment operation on the side. He wanted the checks made payable to him alone. This did not appear on the law firm time records. No one else at the firm knew or had reason to know of his activities. Note that for purposes of the securities laws he was selling an investment contract. Most law firms absolutely prohibit anything approaching this. If he had taken the money and made a profit for the clients, probably no one would have sued. But people who do this kind of thing are probably more or less perpetrating a fraud, and this fellow was no exception. He embezzled his clients’ money. He got caught and went to state prison. The old ladies were out a lot of money. They had an action again him, of course, for the breach of his fiduciary duty, but he had spent all their money already. Then they sued the law firm. They latched onto §§ 9-18 of the Uniform Partnership Act of 1914, which impose a respondeat superior regime upon acts in the ordinary course of business. Since the dealings never got on the firm records, the checks were made out to the individual attorney, and there was no evidence that the other partners knew or had reason to know of his dealings, the court holds that the law firm is off the hook.

Roach v. Mead

Here we have different facts. This case cites an earlier case of the Oregon Supreme Court, Croisant. The partnership here was an accounting partnership. One of the partnership’s clients was a wealthy businesswoman who planned to go to Europe for three months. She went to the partner that she usually dealt with and told him that she would put his signature on her bank account. She wanted him to pay her bills while she was out of the country. This conference was entered on the time records of the firm. The firm billed her for the work that the partner did. She came back from Europe and, at first, everything seemed okay. He had paid all of her legitimate bills. Later, however, she found out that the partner had paid the expenses of her husband’s lover while she was gone. She was very mad! The partner died, either by suicide or an accident. She clearly had a cause of action against his estate, but the CPA firm itself was much more inviting. The CPA firm would have had a general liability policy and a malpractice policy. Both of these policies probably excluded anything dishonest, criminal, malicious, or intentional. But the firm was big enough that the assets of the firm plus the personal assets of all the partners were large enough to support a judgment. Note that this came years before the LLP. The court held that the partner’s actions were in the normal course of business. What should the lady have done? She should have required the signature of both her CPA firm and her lawyer for checks while she was gone.

The facts of Roach itself are as follows: there was a two person general partnership long before there were LLPs. One of the partners did some real estate speculation on his own and lost his shirt. One of his clients who he serviced was rich and the lawyer hit him up for a personal loan. The check was made out to the partner in his personal name. The loan was never repaid, and that partner is judgment-proof. The client gets a different lawyer, of course. Could the client sue the one lawyer alone and get his partnership interest? No, because §§ 15-38 of the Uniform Partnership Act of 1914 state that an individual creditor of a partner can levy upon the partnership interest, which allows a kind of weird remedy: a charging order on his earnings from the partnership. Shipman thinks this would include both a guaranteed salary and a share of profits. He’s pretty sure that the restrictions on wage garnishment would not apply because a partner’s earnings or salary are not wages. This is different than a share of stock: you can’t cause the interest to be paid over and cause a dissolution. Furthermore, the other partner or partners can redeem the partner’s interest. Shipman says that it’s not a great remedy. Partnership or LLC interest is basically not good collateral.

The lawyer sued the partnership under §§ 1-18 and 40 saying that there was negligence in what the partner did, and that the negligence led to the client’s loss. He served both partners individually as well as the law firm. He claimed that the partnership itself was liable as was the innocent partner. Negligence was used to dig into the malpractice policy of the law firm. He claimed that what the lawyer did was negligence only. What rules of professional ethics were violated? Canon 5 and the rules thereunder tell us that one of the stupidest things a lawyer can do is enter into personal or financial relationships with clients. It is clear that a lawyer must give all kinds of warnings of the dangers of a personal loan to the client. Here, the lawyer did not inform the client that he ought to insist on a first mortgage on the lawyer’s house. The rule is even stricter with trustees. The court holds that the partnership and the other partner are on the hook.

Fiduciary duties of partners to each other – Meinhard v. Salmon

This is a partnership opportunity case. There was a capitalist and sweat equity who get together around 1900. Sweat Equity is a real estate expert. Sweat Equity wants Capitalist to advance some money. They plan to go 50-50 on earnings. All the assets were put in Sweat Equity’s name. Capitalist was a “secret partner” of the general partnership. Most people think that secret partners are just as liable as regular partners. Sub-partnership leads to the same result: Smith is a general partner in a construction firm. He goes to his brother and he and the brother enter into a sub-partnership in Smith’s share of the partnership. It is generally held that Smith’s brother will be held liable just like any other general partner. Many lawyers in Ohio will tell the bank if it wants to levy on a general partnership interest that it may well have the same liability for the partnership debts and obligations as their debtor has. The law is not clear on this. Was there any tax impact upon the formation of this partnership? It was before the federal income tax was enacted, but let’s presume this happened in the present. The Internal Revenue Code says that if the person contributing property has his capital account credited for the fair market value of the property and if Sweat Equity doesn’t receive an addition to his capital account because of services, then the transaction will be tax-free.

Over 12-15 years there were rocky times, but Sweat Equity generally did well. The only problem was that Sweat Equity didn’t have a lot of money. People who he’s dealt with in real estate believe that he is the sole owner of the property. The partnership with the capitalist may have been a handshake deal, and it wasn’t known by many people. Just before the end of the term of the partnership, a third party proposed a massive redevelopment project for New York City to Sweat Equity. Most of the money was going to be borrowed. Sweat Equity formed a corporation, of which he owned 100% of the stock, to run his end of the development. After the end of the partnership, the capitalist finds out about this and gets really mad. Cardozo holds that Sweat Equity had a duty to inform Capitalist of the opportunity. Cardozo said that Capitalist can have 49% of the stock of the property for what Sweat Equity paid per share. Sweat Equity will run the business, and Capitalist must sign the guarantee with Sweat Equity.

Dissolution of the partnership

Read §§ 14-38 carefully to understand dissolution. Two of the key sections are §§ 31-32. When you read them, you find a big split between two kinds of dissolution: (1) rightful and (2) wrongful dissolution. Fiduciary duties are very important in either case and can cause some odd results. The first question is: can you, by contract, create a partnership for a term that cannot be dissolved during that term? In other words, can you create a true agency coupled with an interest that is irrevocable? No, you definitely cannot. Another way to put it is that you can’t go into court and get a mandatory injunction forcing people to stay with the partnership if they want to leave.

Wrongful dissolution – Collins v. Lewis

This case illustrates that there is such a thing as wrongful dissolution. If there is a wrongful dissolution, two bad things happen to the wrongdoer: (1) the bad guy loses all of his interest in the goodwill of the business and (2) he is subject to an action for breach of contract by the other partners. In this case, Sweat Equity met with Capitalist with the idea of building a big new cafeteria. Sweat Equity didn’t have any money, but he had ideas and experience. Capitalist had a lot of money. A deal like this today would be set up in the LLC form and it would be malpractice per se for a lawyer not to force the actors into this form. The deal was that there was a partner’s salary for Sweat Equity because Sweat Equity needed money to live on. The partnership agreement said that during phase one, the building, no loss of the partnership would be allocated to Sweat Equity. That’s clearly legal and this type of agreement is a typical way to do it. In phase two, when the cafeteria starts running, Sweat Equity’s salary continues, while all profits are allocated to Capitalist until he has recovered all the losses that were allocated to him in phase one. In phase three, the partnership salary continues, but both profits and losses are equally distributed. At that point, Sweat Equity is bearing, indirectly, one-half of the salary to him.

Capitalist had good lawyers and a mortgage on Sweat Equity’s partnership interest as well as many other legal protections. Capitalist got mad and wanted to dissolve the partnership. When you read §§ 31-32, you find that if no term is specified for a partnership, either party can get rightful dissolution at any time. But that “out” is not available to Capitalist. According to several California cases, where a definite term isn’t specified but a project is specified, there is an implied term of years for the time needed to do the project. Another case held that where one party theoretically can rightfully dissolve at will, fiduciary duty override applies if dissolution would be unfair to the other partner. According to §§ 31-32, another “out” is when the business can no longer be carried out at a profit. Under Texas law, dissolution itself is in equity, but Capitalist joined claimed for money damages. In Texas and federal courts, there will usually be a jury and the jury findings on the damage claims (at law) will be collateral estoppel (issue preclusion) on the judge when he sits in equity.

The special issues submitted to the jury were the following: (1) Can this business be successfully carried on at a profit? (2) If not, whose fault is it? The jury found that the business could not be carried on at a profit and that it was Capitalist’s fault. The trial judge, based on these special issues, entered an order that there was no ground for rightful dissolution. The case goes to the Texas Court of Civil Appeals, which affirms. Capitalist claims that there is no such thing as a partnership that cannot be dissolved. But the Court of Civil Appeals says that all the trial judge held was that there were no grounds for rightful dissolution. He could still take a stab at wrongful dissolution, but the jury findings in the case will be collateral estoppel and place all fault on the Capitalist. Capitalist would lose his interest in the goodwill of the business and would be liable in damages to Sweat Equity!

Cauble v. Handler

This is also a Texas Court of Civil Appeals case. We have a 50-50 partnership between two partners in a profitable business. There is no partnership agreement except for the agreement on the 50-50 split on profits and losses. One partner dies. He left all of his property to his widow. The living partner loved the business and wanted to keep it operating. The bank signature cards allowed either partner to sign and thus there was no practical problem with continuing the business. What are the widow’s options at this point given the lack of a formal partnership agreement except for the 50-50 split? Either the widow or the living partner could force an immediate auction block sale of the partnership’s assets. However, such sales sacrifice value, so they are rarely used. If the widow and living partner wanted to negotiate with the widow in the place of the dead partner, they could do so, but the widow didn’t want to. The business could simply be continued, and if the living partner treats the widow as a substitute for the dead partner and vice versa, then under Blumer Brewing, they will be considered 50-50 partners, with the widow taking the position of her husband.

The possibility that comes out here is that the living partner continues the business, but the widow forces him to send out letters to everybody saying that the dead partner is dead and that the living partner is continuing the business. This is done because you don’t want the widow getting sued as an apparent partner. § 31-38 contemplates this possibility. The Act says that she will not be liable as a partner. She has a creditor’s claim on the assets, but that claim is subordinated to the regular old creditors of the partnership. This is true even if the old name is continued (as is often the case with law firms). Within a reasonable time, the partnership must pay off the widow with the value of the capital account. There are two big issues: (1) do we use book value GAAP figures based on historical costs, or (2) do we use fair market value figures? The court holds that in the absence of an agreement (which would be binding under the Act), it was held that fair market value would be used. The ruling implies that goodwill will be computed and included in the equation because a store that has been around for a long time creates goodwill. It may be different for lawyers.

The case is troublesome in a way. The Texas Supreme Court had a case called Mattie Carruth Bird. She was the general partner in a real estate limited partnership. Her capital account had a negative balance. How could this be? If you’re using GAAP historical cost figures and you take out a second mortgage on real estate and then distribute the proceeds to the partners, you’ll have negative capital account balances. That doesn’t mean the business is in trouble. The limited partner sued to force her executor to pay into the capital account. The court interpreted the Uniform Partnership Act of 1914 and Uniform Limited Partnership Act literally and agreed with the limited partner. The second big holding was that the executor of the deceased partner has the option to take interest from the date of death until payoff, or if they elect to do so in a timely matter they can get their share of profits for that period. Early on, the lawyer made the correct election, because this was a very profitable partnership. Note that under § 38, a partnership agreement providing for book value over two, three or four years would prevail over §§ 31-38. The provisions of the Uniform Partnership Act of 1914 are default provisions that can be trumped by an agreement to the contrary.

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