Business Associations Class Notes 6/30/04

More on the dissolution of partnerships

Accounting is crucial. In Cauble, if the original agreement had provided that the payout to the widow of the deceased partner would have been in three or four equal annual installments that it also would have held up. Sometimes the capital accounts are huge and there is no way the remaining partners can have a check written quickly for the capital account. In Cauble, because of the way § 38 of the Uniform Partnership Act of 1914 reads, if the parties had agreed up-front that the widow’s profit interest would have terminated at her husband’s death and that there would have been no interest (or interest at a non-usurious rate) that also would have held up.

Some finance overview

In the mid-1950’s, there were seven or eight dominant Wall Street securities firms. At that time, they were all partnerships. Their capitalization (by today’s standards) was amazingly small: only $25-30 million. It’s still small even when you adjust for inflation. The big firms now have billions in capital. But there were problems: they soon realized that now and again even the best run brokerage goes broke. Also, among your partners, you will have some with very large capital accounts, to the tune of several million. How do you deal with the widows of the partners as they die? If you did nothing and went with the UPA, the widow will get her money in a few months, just as it says in Cauble. First, they switched to limited partnerships and tried to talk the widows into transferring their capital accounts to limited partnership status at a good fixed rate (like 9%). Then they discovered that they had to make the same deal with retired partners. These problems also crop up in close corporations. People fail to consider the possibility that someone will die or retire.

Within limits, you can specific when, how, and how much the payout will be upon dissolution. But if the sections say that something is a dissolution, you can’t specific that thing as a non-dissolving event. For example, you can’t agree that death constitutes dissolution. It’s only half true that you can contract to determine what dissolution is. You can specify that there will be events of dissolution in addition to what the statute deals with.

The fiduciary duty override will sometimes conflict with literal contract or statutory provisions and working out the conflict is not mechanical. The RUPA deletes the provision that there is a fiduciary duty in formation. They still leave the fiduciary duty in operation. In Ohio, about five years ago a statute was passed saying that there is no fiduciary duty in formation, but there is a fiduciary duty in operation.

GAAP accounting is accrual accounting. If you sell something on credit, you take in the income and you increase the capital account immediately. In other words, you accrue immediately. For tax purposes, any business using an inventory must use the accrual method. What does the Internal Revenue Code provide as to professionals? For service professions, regardless of income, you can use the cash method, that is, accounts receivable are neither an asset nor income until they are collected. The capital account will not reflect unrealized receivables. If you are on the accrual method, the capital account will reflect such receivables. Independent CPAs will certify statements on the cash method, but they will put legends on the statements saying that a non-GAAP method is being used. The pure cash method is not a traditional GAAP method.

All lawyers and doctors use the cash method because, from a business standpoint, their cash flow runs far behind the provision of services. This may not always have been true, especially with doctors. They may have taken cash at the time of service. For other businesses, once you reach a certain size, you must use accrual accounting. This is mainly a matter of the political power of lawyers and doctors. New York passed a statute saying that, upon dissolution, unless otherwise agreed, the amount paid out would be book value. There arises a case where a lawyer dies who is a partner. The partnership agreement is silent. Not only did they not use fair market value, but they cut the guy’s widow out of his share of the unrealized receivables completely.

Adams v. Jarvis

In this case, we have a medical partnership on the cash method. The partnership agreement provided for what a rightful or wrongful withdrawing partner would get: if the partner pulls out five months into the year and has a one-fourth profit interest, then he will get his pro-rata income for the year: 5/12 times ¼. He will also get what is in his capital account at book value. Thus, the Cauble result of fair market value (and possibly some goodwill) is precluded. The problem is that they’re using the cash method, and as of May 31^st, there may be up to $500,000 coming in as accounts receivable. The departing partner could be forfeiting $125,000 by leaving early! On a very literal reading, this squares with the first sentence of § 38. But we’re nervous because all the parties are fiduciaries with each other, and the law generally abhors forfeitures. All dissolution and accounting proceedings are equity proceedings! The court says something that Shipman claims is only half true: the partners defined this as a non-dissolution and that’s okay because § 38 allows you to do that. But the court is overreaching, according to Shipman. If you read between the lines, this case says that this penalty is good policy because it tends to make people live up to their contracts. In a later case in California, they make this point explicitly. The book indicates that the situation in New York is just the opposite. New York cases have held that any Adams v. Jarvis clause works a partial forfeiture of property and, as such, is per se against public policy.

Very commonly, whenever a law partner rightfully withdraws, retires or dies, he will get a pro-rata share of that year’s income, the amount in his capital account computed by book value, but no goodwill. The capital account payoff is often over the course of several years. Why is it done this way? Under Internal Revenue Code, if the agreement provides that no part of the continued profit participation is for goodwill, then the recipient includes that payment in income. But the good news is that the other partners get to deduct or exclude that payment. Subchapter K is the only part of the Internal Revenue Code where you can buy out a business with after-tax income. You can’t do it any other way. As to the return of the capital account, if, for example, it goes to a widow, the payment will be tax-free because taxes have already been paid.

There is an old Court of Appeals of New York case from the 1940’s in the corporate context involving the question of whether at-will employees, while on the company payroll, may use company time and resources to entice clients away after they leave. One of the big mid-level ad agencies in New York City was incorporated. It was started by the old man, who, at his best, was superb. But he was getting older and losing it. The top people under him who were all at-will employees, thought they had worked out an arrangement by which they would purchase the old man’s stock and he would retire. But there was a real business problem here: at the last minute, the old man refused to sign. Without informing him or getting his consent, they plotted a walkout day. They set up a new shop on company time while drawing company paychecks and solicited clients. They walked out, taking a lot of clients with them. The old corporation and the old man sued under agency and corporate law saying that these people had violated their duty of loyalty, duty of care, and duty of full and fair disclosure up-front to the company and the old man. The court answered that it was still the majority rule in the corporate world that the at-will employees could not participate in this type of activity.

Meehan v. Shaughnessy

This is an unusual partnership agreement in that it lumps rightful and wrongful dissolution together and provides what is going to happen. The court looks at the agreement and basically ratifies the agreement. It sees no conflict between the agreement and the UPA. In this case, some of the partners went to young associates and solicited business for their new firm. They held that the old per se rule of setting up shop while being employed didn’t apply to a law firm because at a law firm the main parties to be protected are the clients, and the clients can’t get good service unless there is work up front. The court found a violation, holding that the old partners had a right to have their solicitation sent to the clients at the same time that the departing partners sent theirs. Note that you can’t forcibly take clients with you.

8182 Maryland Associates, Limited Partnership v. Sheehan

In Kansas City around 1984, we have a fast-growing mid-sized law firm. One of the lawyers did financial work. They saw growth in the area and decided to sign a long term lease under the “last erection” principle, which comes from the S & L crisis of the early 1980’s. You could tell that an S & L was going out of business when they spent hundreds of millions to build new skyscrapers. So the partnership signed a long term lease. This was a general partnership; the case shows the dangers of not using an LLC or corporation. Acceleration clauses in these documents, at least in non-consumer leases, are fully valid. The lessors will hire good lawyers to put “good” acceleration clauses in. What happened? Legal business was great for a while in the 1980’s, then it turned sour in the late 1980’s for about four years. When that lawyer left, what was the effect on the dissolution of the firm? The UPA tells us that the firm continues until winding up occurs. In a contracts sense, that will mean that all contracts that were on the books are paid for. The court holds that the rising star guy is liable! Don’t use general partnership or LLP? Some states have the broad form LLP that covers contract as well as torts, but most states have LLPs that don’t cover contracts or embezzlement. An action for embezzlement can be pleaded as tort or contract. The lessor failed to ratify or adopt in this case.

What happens when there is a joint judgment against all those partners plus the partnership? In the case of Wayne Smith from the Ohio Supreme Court, it is held that where there is joint liability in contract, you must first try to get satisfaction at the partnership level, meaning that your suit is both against the partnership and all partners, because if you omit one partner you can’t go back later and get ‘em. In tort, you can move “sequentially”. Later, it was held that when you go to the two 50% partners, the creditor should try to get 50% from each, but if one is a turnip, then after trying to divide it 50-50, you can get 100% from the other. We’re into guaranty and surety again. If you are a creditor of a partnership and you let one partner off, some cases will hold that you have released everyone. Furthermore, if the partnership has to pay something by June 1^st and you get that date pass without suing them, then in many states the partner who has ditched is released under surety and guaranty law. If there are former partners you want to reach, then before you extend the due date of the partnership, get all twelve partners to consent. Otherwise, if you extend as to the four that you will try to reach on surety grounds then you will screw up.

Along the same lines, there was a big case from the 1960’s from the California Court of Appeals dealing with tort liability. There was a general partnership for the practice of law. Smith was a general partner. While he was a partner, Jones, another partner, brought a personal injury client in. Smith did not know about it. After he left, Jones mishandled the case and let the statute of limitations run. The client sues the partnership, current partners, and Smith, the retired partner. Smith says he wants out! He argues that the old firm was dissolved and the negligence occurred after he left. The UPA tells us that the old firm continues until winding up, and for a tort client, that’s not until you’ve completely finished a case, which may be 10-12 years later!

How do you protect yourself on torts if you’re a retiring partner? The firm today is usually an LLP. If you didn’t bring the client in and you didn’t supervise or screw up, you’ll have a defense under the LLP statutes. The other thing that you do is in the retirement agreement with the firm you get the firm to agree to have the malpractice policy cover not only current partners and employees but former partners and employees too. If the firm won’t do it and it’s not an LLP, go buy yourself tail coverage. In Ohio, a limited partnership can make an LLP election, in which case the general partner of the limited partnership has some shield against tort liability, though it’s not worth a lot. The job of the general partner of a limited partnership is to supervise and manage. Don’t be an individual general partner of a limited partnership: form an LLC or a corporation.

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