ADW Draft 9/25/11
AP edits 9/29/11
Chapter 6. Organizational Choices
Sources Used in this Chapter:
RUPA (1997) §§ 101(6), 202(a), 301, 305, 306, 401, 405, 502, 601, 801, 802, 807
RULPA (1976/1985) §§ 101(7), 201, 302, 303, 403, 503, 504, 702, 801
RULPA (2001) § 303
ULLCA (1996) §§ 403, 404, 405, 501
RULLCA (2006) §§ 501, 601, 701
MBCA §§ 2.02, 6.22, 6.27, 6.40, 7.21, 7.28, 8.01
DGCL §§ 102, 141
Covalt v. High
Dreifuerst v. Dreifuerst
Holzman v. de Escamilla
Kovacik v. Reed
Lupien v. Malsbenden
Owen v. Cohen
Richert v. Handly
Water, Waste & Land, Inc., DEPA Westec v. Lanham
Concepts for this Chapter:
 Basic choices for form of business association: partnerships, corporation, LLC
 Essential aspects of each form:
– Formation
– Liability
– Management and control
– Financial rights
– Continuity
– Liquidity of ownership
– Combinations
 Planning considerations
– Economics of choice
– Tax consequences
A.
Alphabet Soup
Chapter 6 is the beginning of the third module of the book, which covers the mechanics of
forming a corporation and taking corporate action. Chapter 6 compares the corporation to other
business organization forms.
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This chapter introduces a good deal of vocabulary. It explores the choice of organizational
form and its implications for people forming a business firm. The choice is important in
allocating risks, and may determine the future of the business.
In teaching this chapter, we hope to accomplish four goals:
(1) identify the basic business organizational choices: partnerships, corporations and hybrids
such as LLCs;
(2) describe the basic characteristics (and distinguishing features) of each organizational form;
(3) introduce the considerations a business lawyer must take into account in choosing one form
over another in the planning stages of counsel; and
(4) introduce the tax attributes of each basic form.
Above all, we want students in this introductory course to see that organizational forms are not
rigid and unique, but fluid and largely customizable. Firms can choose an organizational form
and then alter that form to closely resemble a different form, or they can reorganize and adopt a
different form. A corporation, for example, is not necessarily subject to double taxation if it
chooses S-corporation status, thus achieving the “flow-through” tax treatment of a partnership
and LLCs.
Note: We also point out that other courses in the curriculum -- such as Business Planning or
Transactional Clinic – give students a chance to apply their learning about organizational
choices presented in this chapter.
Question: What are the concerns or interests that cause people to choose one kind of business
organization over another?
Answer: Parties are likely to be thinking about
o The duration of their undertaking
o Financial rights
o Oversight powers
o Management structure
o Withdrawal (exit) rights
o Allocation of liability, and even
o Tax attributes
Hypothetical 6.1 (p.142)
Brandon, Anita and Charles are three individuals planning to start a business. [AP: the book
hypo at page 142 does not include Charles – we should probably finesse this here]

Brandon is a manager. He brings to the table time, management skills and business
experience, but has little money to invest in the company.
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
Charles is an investor, or a classic capitalist. He has at his disposal a great deal of
money, but little time or experience in the business. [AP: hypo 6.1 has no “Charles” –
the slides do because we had three characters in the prior edition with Jeff Bauman]

Anita offers something in between Brandon and Charles. She has limited managerial
skill, as a CPA, and limited capital, with some money available, to pledge to the firm.
[AP: this is not the Anita of our hypo // my thought is we should simplify things here
(and in the slides) and keep this chapter focused on straight-forward capitalist and
straight-forward manager]
Question: What organizational form should they choose for “Your Green Home”?
Answer: It is too early to answer this question. Our three entrepreneurs would
probably choose either an LLC or an S corporation, but first students should walk
through the characteristics of each form and what groups of people they best suit.
Question: What does each individual expect to give to the business, and, in turn, receive from
it? What organizational issues could arise based on these expectations?
Answer: The parties’ expected contributions and compensation are, of course, based
largely on their resources.
Brandon expects to devote to the business his resources of time, management skills and
business experience. In return, he expects a steady salary and sufficient discretionary
power to perform his job effectively. His salary is guaranteed compensation for his
time, and therefore entails little risk as long as the company is solvent. His less risky
investment also provides less upside.
Charles expects to contribute capital. In the event his contributed capital assists in
making profit, he expects to receive some of it. He has much money, but little time (or
no desire to contribute time) or business experience to put his sizeable financial
resources to efficient use. He expects to receive no guaranteed income from the
venture, only a portion of its profits in the event it is profitable. He also plays no
management role, and therefore has no direct control over how his investment is used.
His risk is considerable—he has put money on the line and will only benefit from it in
the event that management performs profitably. [AP: again notice that there is no
“Charles” in hypo 6.1 in the book]
Anita expects to offer a cross of the resources provided by Brandon and Charles. She
brings to the business limited managerial skill, as a CPA, and limited capital, with some
money available, to pledge to the firm. She therefore assumes a risk greater than
Brandon’s but less than Paul’s. [who is Paul?] If the company is successful, she will
expect a payoff between the two as well. [AP: revert Anita to her role in hypo 6.1??]
Question: What organizational issues will arise?
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Answer: The answer to this corresponds to the issues that will be used to describe the
different organizational forms.
1. Formation of business - When does the investment begin and end?
• Formalities?
• Filing with state?
2. Liability for business obligations - Who is liable for the company’s actions?
• Non-recourse structure?
• Respondeat superior?
3. Management / Control - Who manages the investment?
• Voting rights?
• Ability to bind business?
4. Financial rights - What is the return on investment?
• Profits / losses shared?
• Taxation of entity / individuals?
5. Continuity - How can investors get out?
• Duration?
• Effect of withdrawal?
6. Liquidity (transferability) - What are investors’ responsibilities to others?
• Transfer only financial interests?
• Permission of others?
7. Combinations - How can the firm combine with other firms?
• Process of approval
• Protection of stakeholders
And where should the business be incorporated or organized?
Note: We point out that the issues presented in organizing a business parallel the structure of
the book – and thus the course. We find that regularly pointing out to students the book’s
structure helps them fit things into a bigger picture: Module III (business form - forming the
business and corporate action); Module IV (financial rights – money in and out); Module V
(corporate externalities - liability for business obligations); Module VI (corporate governance –
management and control); Module VII (fiduciary duties); Module VIII (stock trading –
liquidity and transferability of shares); Module IX (corporate deals – combinations); Module X
(close corporations – continuity, along with all the other issues).
Partnerships
There are several types of partnerships, summarized in the table at the top of p. 144
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



General partnerships
Limited partnerships
Limited liability partnerships
Limited liability limited partnerships
Of these, general partnerships (GPs) and limited partnerships (LPs) are the most important.
Limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs) enable
the partners in a general partnership or the general partners in a limited partnership,
respectively, to limit their liability to the amount of their investment (although liability for
tortious conduct for which they are directly or indirectly responsible may remain).
Question: What is a general partnership?
Answer: A partnership is a voluntary association of two or more persons that runs a
business for profit. Unless otherwise agreed, all partners participate fully in
management and share equally in the profits and losses (although the partners’
monetary contributions may vary). The most basic type of partnership, the general
partnership, does not shield partners from personal liability.
Question: What is a limited partnership?
Answer: A partnership composed of one or more persons who control the business and
are personally liable for the partnership’s debts (general partners) and one or more
persons who contribute capital and share profits but who cannot manage the business
and are liable only for the amount of their contribution (limited partners).
Question: Where does partnership law come from?
Answer: Partnership law is state law. As explained in the breakout box on p. 143,
National Conference of Commissioners on Uniform State Laws (NCCUSL) has
promulgated a series of uniform laws in order to promote uniform rules for
unincorporated businesses. General partnerships are the subject of the:


Uniform Partnership Act (1914), and the
Revised Uniform Partnership Act (1997) (“RUPA”)
o
Adopted (frequently with changes, e.g. New York) by 2/3 states
o
Remaining 1/3 states use UPA 1914 (except Louisiana)
I thought that the 1914 version was “UPA” and the 1997 version is “RUPA,” but I think that
you all are using “UPA” for the 1997 version. I have “RUPA” in this text but if I am right
about what you all have already done, should I change the references in this text to “UPA”
Shall we call them “UPA (1914)” – not mentioned much – and “UPA (1997)”? [AP: My
impression is that we should generally go with “UPA”, unless we need to distinguish between
the 1914 version and the 1997 version. This is how the National Conference of
Commissioners on Uniform Laws now does it. And most states, about 34, have adopted UPA
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(1997), UPA (1914) should be mostly an afterthought.
http://en.wikipedia.org/wiki/Uniform_Partnership_Act ]
Question: How does the Revised Uniform Partnership Act define a partnership?
Answer: In §101, the RUPA provides:
Revised Uniform Partnership Act § 101- Definitions
(6)
“Partnership” means an association of two or more persons to carry on as co-owners a
business for profit formed under Section 202, predecessor law, or comparable law of
another jurisdiction
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no&sv=Split&vr=2%2E0
Question: What is an association?
Answer: An association is an organized body of persons who have some purpose in
common.
Question: How is a general partnership created?
Answer: By agreement among the partners to carry on as co-owners a business for
profit. Note that forming a general partnership does not require a filing with the state.
Revised Uniform Partnership Act § 202 Formation of Partnership
(a)
the association of two or more persons to carry on as co-owners a business for profit
forms a partnership, whether or not the persons intend to form a partnership
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Question: What is a “person” for these purposes?
Answer: “Persons” may include:
 individuals,
 corporations, or
 other partnerships
with the capacity to contract (because the partnership agreement is a contract)
Question: What does it mean “to carry on as co-owners a business”?
Answer: According to RUPA § 202, Comment 1, “ownership” involves the power of
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ultimate control. To state that partners are co-owners of a business is to state that they
each have the power of ultimate control. A “business” is defined in RUPA 202,
Comment 1, as “a series of acts directed toward an end.”
Example 6.1 on p. 146 illustrates this principle. Jane has hired Keith as a receptionist,
but controls the business and contributed almost everything to the shop. Even though
Keith was given a share of the profits as a wage increase, they are not co-owners. Jane
is the employer and Keith is the employee. Calling themselves “partners” does not
make them “partners.”
Question: Why does it have to be for profit?
Answer: Because this is about ownership. Partners are owners, and ownership is
defined in terms of profit (and liability), and therefore control. Not-for-profits, by
definition, have no owners. Consider the difference between unincorporated
associations or trusts in which the charitable purpose is the beneficial “owner,” and
corporations which have shareholders. “To carry on as owners a business” not for
profit would be a contradiction in terms.
RUPA § 202, Comment 2, explains that an unincorporated nonprofit organization is
not a partnership under RUPA, even if it qualifies as a business, because it is not a “for
profit” organization.
Question: Can a general partnership be formed unintentionally?
Answer: Yes. RUPA § 202, Comment 1, explains that a partnership is created by the
association of persons whose intent is to carry on as co-owners a business for profit,
regardless of their subjective intention to be “partners.” Indeed, they may inadvertently
create a partnership despite their expressed subjective intention not to do so.
Question: How is a general partnership governed?
Answer: Each partner has an equal voice in the management (regardless of capital
contribution). Ordinary decisions are made by majority vote, although certain decisions
such as adding a new partner or amending the partnership agreement must be
unanimous. Of course, this is the default rule, and many partnership agreements
provide that a partner’s voice will be in proportion to his capital contribution, or some
other formula.
Revised Uniform Partnership Act §401 Partner’s Rights and Duties
(f)
(j)
Each partner has equal rights in the management and conduct of the partnership business
***
A difference arising as to a matter in the ordinary course of business of a partnership may
be decided by a majority of the partners. An act outside the ordinary course of business
of a partnership and an amendment to the partnership agreement may be undertaken only
with the consent of all of the partners.
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Example 6.5 on p. 149 illustrates this principle. In a general partnership, the decision of the
majority governs, and if there is an impasse, and the partnership cannot function, the ultimate
remedy is to dissolve the partnership. A good partnership agreement will include dispute
settlement mechanisms.
Example 6.5 draws on the Covalt v. High case.
Covalt v. High (675 P.2d 999 (N.M. Ct. App. 1983))
Facts: One partner, Louis Covalt, brought action against his co-partner (William High),
seeking damages for High’s failure or refusal to negotiate and obtain an increase in the amount
of the rental of the partnership’s property. The tenant in the property was a corporation in
which originally both Covalt and High had an interest, but later only High. Covalt alleged that
High had breached his fiduciary duty as a partner resulting in a loss of potentially increased
rental income. The District Court entered judgment for Covalt, and High appealed.
Issue: Did the trial court err by ruling that High breached a fiduciary duty of fairness to his
[AP: is this right?] partner Covalt by failing to negotiate and obtain an increase in the amount
of rental for the partnership realty? Can a partner (Covalt) recover damages against his copartner (High) for High’s failure or refusal to negotiate and obtain an increase in the amount of
rental of partnership property?
Holding: No. The Court of Appeals reversed the district court ruling, holding that in the
absence of an agreement between the partners to increase the rent of the partnership realty, one
partner could not recover damages for the failure of the copartner to acquiesce in a demand that
he negotiate and execute an increase in the monthly rentals of partnership property. The
remedy in such a case is dissolution.
Reasoning:
 “The status resulting from the formation of a partnership creates a fiduciary relationship
between partners. The status of partnership requires of each member an obligation of
good faith and fairness in their dealings with one another, and a duty to act in
furtherance of the common benefit of all partners in transactions conducted within the
ambit of partnership affairs.”

“Except where the partners expressly agree to the contrary, it is a fundamental principle
of the law of partnership that all partners have equal rights in the management and
conduct of the business of the partnership. As specified in the Uniform Partnership Act
adopted by New Mexico, where there is a difference of opinion between the partners as
to the management or conduct of the partnership business, the decision of the majority
must govern . . .Covalt was legally invested with an equal voice in the management of
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the partnership affairs . . . neither partner had the right to impose his will or decision
concerning the operation of the partnership business upon the other.”

“Where the partnership consists of only two partners there is ordinarily no question of
one partner controlling the other and there is no majority. The rights of each of the two
partners are equal. If the partners are unable to agree and if the partnership agreement
does not provide an acceptable means for settlement of this disagreement, the only
course of action is to dissolve the partnership.”
Question: How are the assets of a partnership managed?
Answer: Each partner contributes something of value to the partnership, and then is
deemed to have his/her own “account” on partnership books. A running “account
balance” is kept by:
 ADDING his/her contributions
 ADDING his/her share of the profits
 SUBTRACTING money distributed to him/her
 SUBTRACTING his/her share of the losses
Revised Uniform Partnership Act § 401. Partner's Rights and Duties
(a)
(b)
Each partner is deemed to have an account that is:
(1)
credited with an amount equal to the money plus the value of any other property,
net of the amount of any liabilities, the partner contributes to the partnership and
the partner's share of the partnership profits; and
(2)
charged with an amount equal to the money plus the value of any other property,
net of the amount of any liabilities, distributed by the partnership to the partner
and the partner's share of the partnership losses.
Each partner is entitled to an equal share of the partnership profits and is chargeable with a
share of the partnership losses in proportion to the partner's share of the profits.
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Question: How can partners enforce their rights to profits or loss-sharing?
Answer: Through a judicial accounting proceeding.
Revised Uniform Partnership Act § 405. Actions by Partnership and Partners.
(a)
(b)
A partnership may maintain an action against a partner for a breach of the partnership
agreement, or for the violation of a duty to the partnership, causing harm to the
partnership.
A partner may maintain an action against the partnership or another partner for legal or
equitable relief, with or without an accounting as to partnership business, to:
(1)
enforce the partner's rights under the partnership agreement;
(2)
enforce the partner's rights under this [Act], including:
(i)
the partner's rights under Sections 401, 403, or 404;
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(ii)
(c)
the partner's right on dissociation to have the partner's interest in the
partnership purchased pursuant to Section 701 or enforce any other
right under [Article] 6 or 7; or
(iii)
the partner's right to compel a dissolution and winding up of the
partnership business under Section 801 or enforce any other right under
[Article] 8; or
(3)
enforce the rights and otherwise protect the interests of the partner, including
rights and interests arising independently of the partnership relationship.
The accrual of, and any time limitation on, a right of action for a remedy under this
section is governed by other law. A right to an accounting upon a dissolution and winding
up does not revive a claim barred by law.
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Example 6.6 on p. 150 illustrates this principle. A and B form a general partnership. They
both contribute something of value (A contributes capital, B contributes equipment). Each
must share in the losses of the partnership according to his share in the profits (unless they
have agreed otherwise).
Example 6.6 on p. 150 is based on the Richert v. Handly case.
Richert v. Handly (330 P2d 1079 (Wash. 1958))
Facts: Richert and Handly formed a logging partnership. Richert contributed money. Handly
contributed equipment and services (and was compensated for the services). The partnership
lost money, and Richert wanted Handly to contribute towards those losses.
Issue: In the absence of an agreement, do partners have to share losses?
Holding: Yes. A partner may be required to contribute toward a loss sustained by the
partnership according to his share in the profits.
Reasoning: The Court held that where the parties had not agreed upon specified basis upon
which losses were to be shared, or whether the claims of one partner were to take priority over
claims of the other, provisions of Uniform Partnership Act were controlling. As a result:
The rights and duties of the partners in relation to the partnership shall be determined,
subject to any agreement between them, by the following rules:
(1) Each partner shall be repaid his contributions, whether by way of capital or
advances to the partnership property and share equally in the profits and surplus
remaining after all liabilities, including those to partners, are satisfied; and must
contribute toward the losses, whether of capital or otherwise, sustained by the
partnership according to his share in the profits.
(6) No partner is entitled to remuneration for acting in the partnership business, except
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that a surviving partner is entitled to reasonable compensation for his services in
winding up the partnership affairs
Example 6.7 on p. 151, however, illustrates a slightly different situation, with a different,
controversial outcome. In Example 6.7, A and B form a general partnership. A contributes
capital and B contributes only skill and labor. When the business produces losses, A cannot
force B to contribute toward the capital losses. The rule here is that although the general rule is
that partners share jointly in both profits and losses (unless otherwise agreed), if one partner
contributes only capital, he cannot recover capital losses from the other partnership who
contributed services.
Example 6.7 on p. 151 is based on the Kovacik v. Reed case.
Kovacik v. Reed (315 P.2d 314 (Cal 1957))
Facts: Kovacik and Reed formed a joint venture to do kitchen remodeling work for Sears
Roebuck Company. Kovacik invested about $10,000.00 in the venture and Reed superintended
and estimated the jobs. Kovacik agreed to share the profits with Reed on a 50-50 basis.
Kovacik did not ask Reed to agree to share any loss that might result and Reed did not offer to
share any such loss. They did not discuss a possible loss.
The venture worked on a number of remodeling jobs. Reed’s only contribution was his own
labor -- Reed worked on all of the jobs as job superintendent. Kovacik provided all of the
venture’s financing. However, the venture turned out to be unprofitable and Kovacik
demanded contribution from Reed to cover amounts which Kovacik claimed to have advanced
in excess of the income received from the venture. Reed at no time promised, represented or
agreed that he was liable for any of the venture’s losses and he consistently and without
exception refused to contribute to or pay any of the loss resulting from the venture. The
venture was terminated and Kovacik sought dissolution and an accounting.
Issue: Does Reed have to contribute to the venture’s losses?
Holding: No. Where the plaintiff and defendant entered into a joint venture wherein plaintiff
contributed money capital as against defendant’s skill and labor, upon loss of the money,
plaintiff was not entitled to recover any part of it from defendant who contributed only services
Reasoning: Inasmuch as the parties agreed the Kovacik was to supply the money and Reed
the labor to carry on the venture, Reed was not liable for one half the monetary losses.

“It is the general rule that in the absence of an agreement to the contrary the law
presumes that partners and joint adventurers intended to participate equally in the
profits and losses of the common enterprise, irrespective of any inequality in the
amounts each contributed to the capital employed in the venture, with the losses being
shared by them in the same proportions as they share the profits.”
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
“However, it appears that in the cases in which the above stated general rule has been
applied, each of the parties had contributed capital consisting of either money or land or
other tangible property, or else was to receive compensation for services rendered to the
common undertaking which was to be paid before computation of the profits or losses.
Where, however, as in the present case, one partner or joint adventurer contributes the
money capital as against the other’s skill and labor, . . . neither party is liable to the
other for contribution for any loss sustained. Thus, upon loss of the money the party
who contributed it is not entitled to recover any part of it from the party who
contributed only services.”

“The rationale of this rule . . . is that where one party contributes money and the other
contributes services, then in the event of a loss each would lose his own capital the one
his money and the other his labor. Another view would be that in such a situation the
parties have, by their agreement to share equally in profits, agreed that the value of their
contributions the money on the one hand and the labor on the other were likewise
equal; it would follow that upon the loss, as here, of both money and labor, the parties
have shared equally in the losses.”
Question: Which outcome feels “fairer”: Example 6.6 or Example 6.7?
Answer: Example 6.6 generally feels more fair to students, especially considering the
fact that the services-contributing partner may have been responsible for the losses.
However, the two cases are easily distinguished since in Example 6.6 both partners are
contributing something tangible (money, equipment) while in Example 6.7 one partner
contributes only his expertise and labor.
Question: Which partners in a general partnership act as agents of the partnership?
Answer: They all do. Each partner has the authority to act as agent for the partnership.
Revised Uniform Partnership Act §301 Partner Agent of Partnership
Subject to the effect of a statement of partnership authority under Section 303:
(1)
Each partner is an agent of the partnership for the purpose of its business. An act of a
partner, including the execution of an instrument in the partnership name, for apparently
carrying on in the ordinary course the partnership business or business of the kind carried
on by the partnership binds the partnership, unless the partner had no authority to act for
the partnership in the particular matter and the person with whom the partner was dealing
knew or had received a notification that the partner lacked authority.
(2)
An act of a partner which is not apparently for carrying on in the ordinary course the
partnership business or business of the kind carried on by the partnership binds the
partnership only if the act was authorized by the other partners.
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Example 6.2 on p. 146 illustrates this principle. Even if A and B did not intend to form a
partnership, RUPA § 202 makes them partners as a matter of law and RUPA §301 provides
that they all have the power to bind the partnership.
I think that the citation at the end of the first full paragraph on p. 147 should be to RUPA (or
UPA, see highlighted note above) §301, not RULPA. I also think that the penultimate sentence
of the first paragraph in the Example 6.2 breakout box should read “C seeks to hold A liable on
the contract on the theory that A was B’s partner”
Question: Which partners in a general partnership can be held personally liable for the debts of
the partnership?
Answer: They all can.
Revised Uniform Partnership Act § 306 Partner’s Liability
(a)
(b)
(c)
Except as otherwise provided in subsections (b) and (c), all partners are liable jointly and
severally for all obligations of the partnership unless otherwise agreed by the claimant or
provided by law.
A person admitted as a partner into an existing partnership is not personally liable for any
partnership obligation incurred before the person's admission as a partner.
An obligation of a partnership incurred while the partnership is a limited liability
partnership, whether arising in contract, tort, or otherwise, is solely the obligation of the
partnership. A partner is not personally liable, directly or indirectly, by way of
contribution or otherwise, for such an obligation solely by reason of being or so acting as
a partner. This subsection applies notwithstanding anything inconsistent in the
partnership agreement that existed immediately before the vote required to become a
limited liability partnership under Section 1001(b).
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Example 6.2 on p. 147 illustrates this principle. A provides capital and controls day-to-day
operations in B’s custom auto-making business. A receives a share of the profits when
automobiles are sold (not interest on his capital contributions). A and B are therefore partners
regardless of their intentions. When B agrees to build an automobile for C but instead
disappears, A is liable.
Example 6.2 on p. 147 is based on the Lupien v. Malsbenden case.
Lupien v. Malsbenden, 477 A2d 746 (Me. 1984)
Facts: Malsbenden lent money ($85,000) to Cragin, the owner of York Motor Parts, an auto
repair business. Cragin agreed to pay the money back through the profits of the business.
Cragin contracted to build a car for Lupien. In later trips to the shop to check on the status of
the car, Lupien always dealt with Malsbenden, who updated Lupien on the status of the car,
lent him a car, and otherwise handled the day-to-day business affairs of York Motor Parts.
13
Cragin “disappeared,” and York Motor Parts breached its contract with Lupien by failing to
complete the car. Lupien sued Cragin and Malsbenden for the breach.
Issue: Was Malsbenden a mere “lender” to York Motor Parts, or was his activity within the
reach of that of partner?
Holding: Partner.
Reasoning: The evidence shows that, unlike a banker, Malsbenden had the right to participate
in the control of the business and did so. Malsbenden’s financial interest and involvement in
the day-to-day activity of Your Motor Parts was the “total involvement” of a partner.
For purposes of the law, the “right to control” was the major factor in including Malsbenden as
a partner with Cragin, whether or not they agreed to be partners.
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=2.0&fn=_top&mt=208&cite=477+A.2d+746
Note: Many aspects of business associations law are subject to the rule “unless otherwise
agreed.” The smart lawyer knows the default rule, and how to contract out of it for his/her
client if necessary.
Question: When is a general partnership liable for what a partner does?
Answer: When a partner commits a wrongful act or omission while acting for the
partnership.
Revised Uniform Partnership Act § 305. Partnership Liable for Partner's Actionable Conduct
(a)
(b)
A partnership is liable for loss or injury caused to a person, or for a penalty incurred, as a
result of a wrongful act or omission, or other actionable conduct, of a partner acting in the
ordinary course of business of the partnership or with authority of the partnership.
If, in the course of the partnership's business or while acting with authority of the
partnership, a partner receives or causes the partnership to receive money or property of a
person not a partner, and the money or property is misapplied by a partner, the
partnership is liable for the loss.
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Question: A and B are partners in a dry cleaning business. A makes very rude remarks about
someone (someone who had worked for the partnership) at his son’s birthday party at a local
zoo. Is B liable for those defamatory remarks?
Answer: No. B is not liable for those defamatory remarks because the party is not
within the ordinary course of partnership business.
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Question: How is a partnership ended?
Answer: This question illustrates an important difference between the UPA (1914) and
the RUPA (1997).
Under the UPA (1914) rule, if one partner dies or removes himself, the partnership was,
theoretically and legally, dissolved (although in practice the business of the dissolved
“old” partnership usually continued in a “new” partnership with slightly different
membership and that agreed to take on all the liabilities of the “old” partnership).
The RUPA (1997) approach, however, offers the possibility of the dissociation of a
partner. The remaining partners can simply pay the former partner (or his estate) for
his interest - a kind of buyout right -and they do not have to dissolve the partnership to
do it.
This difference also illustrates two different conceptions of the partnership. Under the
UPA (1914) dissolution approach, the partnership is seen as an aggregate of its
partners, and it legally ceases to exist when any of its component partners is removed.
Under the RUPA (1997) dissociation approach, the partnership is seen as more as an
entity, which continues even when the partners change. The RUPA (1997) approach
reduces the number of circumstances under which a partnership will dissolve; RUPA
(1997) substitutes dissociation for some of the situations that would result in dissolution
under the UPA (1914).
Revised Uniform Partnership Act § 601. Events Causing Partner's Dissociation
A partner is dissociated from a partnership upon the occurrence of any of the following events:
(1)
the partnership's having notice of the partner's express will to withdraw as a partner or on
a later date specified by the partner;
(2)
an event agreed to in the partnership agreement as causing the partner's dissociation;
(3)
the partner's expulsion pursuant to the partnership agreement;
(4)
the partner's expulsion by the unanimous vote of the other partners if:
(i)
it is unlawful to carry on the partnership business with that partner;
(ii)
there has been a transfer of all or substantially all of that partner's transferable
interest in the partnership, other than a transfer for security purposes, or a court
order charging the partner's interest, which has not been foreclosed;
(iii)
within 90 days after the partnership notifies a corporate partner that it will be
expelled because it has filed a certificate of dissolution or the equivalent, its
charter has been revoked, or its right to conduct business has been suspended by
the jurisdiction of its incorporation, there is no revocation of the certificate of
dissolution or no reinstatement of its charter or its right to conduct business; or
(iv)
a partnership that is a partner has been dissolved and its business is being wound
up;
(5)
on application by the partnership or another partner, the partner's expulsion by judicial
determination because:
(i)
the partner engaged in wrongful conduct that adversely and materially affected
the partnership business;
(ii)
the partner willfully or persistently committed a material breach of the
partnership agreement or of a duty owed to the partnership or the other partners
under Section 404; or
15
(iii)
(6)
(7)
(8)
(9)
(10)
the partner engaged in conduct relating to the partnership business which makes it
not reasonably practicable to carry on the business in partnership with the partner;
the partner's:
(i)
becoming a debtor in bankruptcy;
(ii)
executing an assignment for the benefit of creditors;
(iii)
seeking, consenting to, or acquiescing in the appointment of a trustee, receiver,
or liquidator of that partner or of all or substantially all of that partner's property;
or
(iv)
failing, within 90 days after the appointment, to have vacated or stayed the
appointment of a trustee, receiver, or liquidator of the partner or of all or
substantially all of the partner's property obtained without the partner's consent
or acquiescence, or failing within 90 days after the expiration of a stay to have
the appointment vacated;
in the case of a partner who is an individual:
(i)
the partner's death;
(ii)
the appointment of a guardian or general conservator for the partner; or
(iii)
a judicial determination that the partner has otherwise become incapable of
performing the partner's duties under the partnership agreement;
in the case of a partner that is a trust or is acting as a partner by virtue of being a trustee
of a trust, distribution of the trust's entire transferable interest in the partnership, but not
merely by reason of the substitution of a successor trustee;
In the case of a partner that is an estate or is acting as a partner by virtue of being a
personal representative of an estate, distribution of the estate's entire transferable interest
in the partnership, but not merely by reason of the substitution of a successor personal
representative; or
termination of a partner who is not an individual, partnership, corporation, trust, or estate.
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Thus, under RUPA (1997 ????), unlike the UPA (1914), the dissociation of a partner does not
necessarily cause a dissolution and winding up of the business of the partnership. If the
partner’s dissociation does not result in the winding up of the partnership, then the remaining
partners purchase his/her interest. If the partner’s dissociation results in dissolution, or if
dissolution results for another reason, then the partnership is terminated.
Revised Uniform Partnership Act § 801. Events Causing Dissolution and Winding Up of
Partnership Business
A partnership is dissolved, and its business must be wound up, only upon the occurrence of any of
the following events:
(1)
(2)
in a partnership at will, the partnership's having notice from a partner, other than a partner
who is dissociated under Section 601(2) through (10), of that partner's express will to
withdraw as a partner, or on a later date specified by the partner;
in a partnership for a definite term or particular undertaking:
(i)
within 90 days after a partner's dissociation by death or otherwise under Section
601(6) through (10) or wrongful dissociation under Section 602(b), the express
will of at least half of the remaining partners to wind up the partnership
business, for which purpose a partner's rightful dissociation pursuant to Section
602(b)(2)(i) constitutes the expression of that partner's will to wind up the
partnership business;
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(3)
(4)
(5)
(6)
(ii)
the express will of all of the partners to wind up the partnership business; or
(iii)
the expiration of the term or the completion of the undertaking;
an event agreed to in the partnership agreement resulting in the winding up of the
partnership business;
an event that makes it unlawful for all or substantially all of the business of the
partnership to be continued, but a cure of illegality within 90 days after notice to the
partnership of the event is effective retroactively to the date of the event for purposes of
this section;
on application by a partner, a judicial determination that:
(i)
the economic purpose of the partnership is likely to be unreasonably frustrated;
(ii)
another partner has engaged in conduct relating to the partnership business
which makes it not reasonably practicable to carry on the business in partnership
with that partner; or
(iii)
it is not otherwise reasonably practicable to carry on the partnership business in
conformity with the partnership agreement; or
on application by a transferee of a partner's transferable interest, a judicial determination
that it is equitable to wind up the partnership business:
(i)
after the expiration of the term or completion of the undertaking, if the
partnership was for a definite term or particular undertaking at the time of the
transfer or entry of the charging order that gave rise to the transfer; or
(ii)
at any time, if the partnership was a partnership at will at the time of the transfer
or entry of the charging order that gave rise to the transfer.
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Example 6.8 on p. 152 illustrates this principle. If A wants to end an at-will general
partnership with B, he has the right to end the partnership and force a sale of the partnership
assets (with the creditors paid from the proceeds of the liquidation).
Example 6.8 on p. 152 is based on the Dreifuerst v. Dreifuerst case.
Dreifuerst v. Dreifuerst (280 N.W. 2d 335 (Wisc. Ct. App. 1979)
Facts: Three brothers formed a partnership to operate two feed mills. There were no written
articles of partnership. Some years later, Cletus and Roy Dreifuerst brought an action against
their brother Claude Dreifuerst dissolve and wind up the partnership. There was no allegation
of fault, expulsion or contravention of an alleged agreement as grounds for dissolution (it was a
partnership at will), but the brothers were unable to agree to a winding-up of the partnership.
The trial court ordered an in kind distribution of the partnership assets: one mill to Cletus and
Roy and one mill to Claude. Claude appealed, seeking a sale of the assets and division of the
proceeds.
Issue: In the absence of a written agreement to the contrary, can a partner, upon dissolution
and wind-up of the partnership, force a sale of the partnership assets?
Holding: Yes. Under statutes providing that unless otherwise agreed any partner who has not
wrongfully dissolved partnership has right to wind up partnership and force liquidation, partner
17
likewise has right to force sale upon dissolution and windup of partnership in absence of
written agreement to the contrary.
Reasoning:



A partnership at will is a partnership which has no definite term or particular
undertaking and can rightfully be dissolved by the express will of any partner.
Winding-up is the process of settling partnership affairs after dissolution.
Winding-up is often called liquidation and involves reducing the assets to cash
to pay creditors and distribute to partners the value of their respective interests.
Thus, lawful dissolution (or dissolution which is caused in any way except in
contravention of the partnership agreement) gives each partner the right to have
the business liquidated (its assets sold for cash) and his share of the surplus paid
in cash.
Question: When does it make sense to dissolve a partnership?
Answer: Under the approach of UPA (1997), a partner who wants out need not
dissolve the partnership; disassociation will be enough to force the partnership to pay
him his fair share. But under the approach of UPA (1914), a partner who wanted out
had to withdraw and then receive his fair share in dissolution.
So under UPA (1997), dissolution makes sense only when the partnership can no longer
carry on a business. The Owen v. Cohen case provides another example of such a
situation.
Owen v. Cohen (19 Cal.2d 147, 119 P.2d 713 (1941))
Facts: Ross Owen and Israel Cohen had an oral agreement to be partners in a bowling alley
business in Burbank. They had no express term for the partnership. Owen put up about $7000
(loan to partnership) to, among other things, buy the other half of a bowling alley (Cohen
owned half of it already). The two agreed that Owen would be repaid out of the profits of the
business. They made money for 3 ½ months, but then their partnership became troubled. This
seems largely to have been the result of Cohen’s bad behavior, e.g. “I haven’t worked in 47
years and I do not plan to start now” and “It will cost you plenty to buy me out.”
As the partners fought, their profits declined. Finally, Owen filed an action for the dissolution
of the partnership and for the sale of the partnership assets in connection with the settlement of
its affairs.
Issue: does the evidence warrant a decree of dissolution of the partnership?
Holding: Yes - because of Cohen’s bad behavior
Reasoning: The court reads the statute to provide that courts shall decree a dissolution
whenever a partner has been guilty of such conduct as tends to affect prejudicially the carrying
on of the business, a partner willfully or persistently commits a breach of the partnership
18
agreement, or otherwise so conducts himself in matters relating to the partnership business that
it is not reasonably practicable to carry on the business in partnership with him, or when other
circumstances render a dissolution equitable.
The court also implied a term for the partnership: the time it takes to repay the $7000 out of
proceeds.
NOTE: An excerpt of Owen v. Cohen is attached as an appendix to this chapter.
Question: Under the Revised Uniform Partnership Act (1997), which section would cover
this?
Answer: Recall that under RUPA § 801(5), a partnership may dissolved upon partner
application, if there is a judicial determination that (i) the economic purpose of the
partnership is likely to be unreasonably frustrated; (ii) another partner has engaged in
[bad] conduct relating to the partnership business which makes it not reasonably
practicable to carry on the business in partnership with that partner; or (iii) it is not
otherwise reasonably practicable to carry on the partnership business in conformity
with the partnership agreement
Question: What happens after a partnership is dissolved?
Answer: “Winding up” of the partnership as a legal entity and, sometimes, of the
business. The business may also be sold. In this process, the law is concerned about
third parties and orderly dissolution.
Revised Uniform Partnership Act § 802. Partnership Continues After Dissolution
(a)
(b)
Subject to subsection (b), a partnership continues after dissolution only for the purpose of
winding up its business. The partnership is terminated when the winding up of its business
is completed.
At any time after the dissolution of a partnership and before the winding up of its business
is completed, all of the partners, including any dissociating partner other than a wrongfully
dissociating partner, may waive the right to have the partnership's business wound up and
the partnership terminated. In that event:
(1)
the partnership resumes carrying on its business as if dissolution had never
occurred, and any liability incurred by the partnership or a partner after the
dissolution and before the waiver is determined as if dissolution had never
occurred; and
(2)
the rights of a third party accruing under Section 804(1) or arising out of
conduct in reliance on the dissolution before the third party knew or received a
notification of the waiver may not be adversely affected.
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Revised Uniform Partnership Act § 807 Settlement of Accounts and Contributions among
Partners
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(a)
In winding up a partnership's business, the assets of the partnership, including the
contributions of the partners required by this section, must be applied to discharge its
obligations to creditors, including, to the extent permitted by law, partners who are
creditors. Any surplus must be applied to pay in cash the net amount distributable to
partners in accordance with their right to distributions under subsection (b).
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Question: What does this mean?
Answer: Pay off creditors in order of priority, then figure out who gets the remaining
cash within the partnership (remember the partner accounts).
Revised Uniform Partnership Act § 807 Settlement of Accounts and Contributions Among
Partners
(b)
(c)
(d)
(e)
(f)
Each partner is entitled to a settlement of all partnership accounts upon winding up the
partnership business. In settling accounts among the partners, profits and losses that result
from the liquidation of the partnership assets must be credited and charged to the
partners' accounts. The partnership shall make a distribution to a partner in an amount
equal to any excess of the credits over the charges in the partner's account. A partner shall
contribute to the partnership an amount equal to any excess of the charges over the
credits in the partner's account but excluding from the calculation charges attributable to
an obligation for which the partner is not personally liable under Section 306.
If a partner fails to contribute the full amount required under subsection (b), all of the
other partners shall contribute, in the proportions in which those partners share
partnership losses, the additional amount necessary to satisfy the partnership obligations
for which they are personally liable under Section 306. A partner or partner's legal
representative may recover from the other partners any contributions the partner makes to
the extent the amount contributed exceeds that partner's share of the partnership
obligations for which the partner is personally liable under Section 306.
After the settlement of accounts, each partner shall contribute, in the proportion in which
the partner shares partnership losses, the amount necessary to satisfy partnership
obligations that were not known at the time of the settlement and for which the partner is
personally liable under Section 306.
The estate of a deceased partner is liable for the partner's obligation to contribute to the
partnership.
An assignee for the benefit of creditors of a partnership or a partner, or a person
appointed by a court to represent creditors of a partnership or a partner, may enforce a
partner's obligation to contribute to the partnership.
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no&sv=Split&vr=2%2E0
Question: Can a partner simply sell his partnership interest?
Answer: No. The default rule is that all current partners must consent to the transfer of
a general partnership interest and the admission of a new partner. However, a partner
20
can transfer his financial (but not governance) interest. The transferee would then share
in the partnership profits and losses, but without a voice in management.
Revised Uniform Partnership Act § 401. Partner's Rights and Duties.
(i)
A person may become a partner only with the consent of all of the partners.
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Revised Uniform Partnership Act § 502. Partner's Transferable Interest in Partnership.
The only transferable interest of a partner in the partnership is the partner's share of the profits and
losses of the partnership and the partner's right to receive distributions. The interest is personal
property.
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This makes sense as a matter of simple contract law. Suppose A is a partner in a
partnership. Can A agree to give B a sum of money equal to A’s partnership
distribution? Yes. Can B agree to indemnify A for any amounts A has to pay because
of the partnership? Yes. A can simply assign the financial aspects of his partnership to
B.
Question: Can partnerships merge?
Answer: Yes, easily. They may simply combine assets by agreement. Partners in the
non-surviving partnership become partners in the surviving partnership. Or all the
partners become partners in a new partnership.
Limited Partnerships
Question: What is a limited partnership?
Answer: A partnership composed of one or more persons who control the business and
are personally liable for the partnership’s debts (general partners) and one or more
persons who contribute capital and share profits but who cannot manage the business
and are liable only for the amount of their contribution and any undistributed gains
thereon IS THIS RIGHT? [AP: I’m really not sure, where does the “undistributed
gains” language come from. It makes sense to me that any profits that have not yet
been distributed remain the assets of the LP, available to creditors] (limited partners).
RULPA (1976/1985) §101 Definitions
21
(7)
“Limited partnership” and “domestic limited partnership” mean a partnership formed by
two or more persons under the laws of this State and having one or more general partners
and one or more limited partners.
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Question: What is the advantage of this organizational structure?
Answer: It enables persons to invest their money in a business without taking an active
part in managing the business, and without risking more than the sum originally
contributed. At the same time, it secures the skills and cooperation of others who have
ability and integrity but insufficient money
Question: What rules govern limited partnerships?
Answer: Like general partnerships, limited partnerships have also been the subject of a
model uniform law. The Revised Uniform Limited Partnership Act (RULPA) was
drafted in 1976, and revised in 1985. Another revision was produced in 2001, the
Uniform Limited Partnership Act, but so far it has not been adopted in a majority of the
states. References in the book are to the RULPA (1985). Is this correct? [AP: that has
been my understanding all along. But maybe we should be moving to RULPA
(2001)???]
Question: How is a limited partnership formed?
Answer: A limited partnership must file with the state.
RULPA (1976/85) § 201. [Formation] Certificate of Limited Partnership.
(a)
(b)
In order to form a limited partnership, a certificate of limited partnership must be
executed and filed in the office of the Secretary of State. The certificate shall set forth:
(1)
the name of the limited partnership;
(2)
the address of the office and the name and address of the agent for service of
process required to be maintained by Section 104;
(3)
the name and the business address of each general
(4)
the latest date upon which the limited partnership is to dissolve; and
(5)
any other matters the general partners determine to include therein.
A limited partnership is formed at the time of the filing of the certificate of limited
partnership in the office of the Secretary of State or at any later time specified in the
certificate of limited partnership if, in either case, there has been substantial compliance
with the requirements of this section.
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As we will see, all limited liability financial associations are required to (1) file with the
22
state and (2) provide some notice that they are limited liability entities. Otherwise,
other parties might be led to assume too much risk.
Question: How is a limited partnership governed?
Answer: The limited partner(s) has/have no voice in the active management of the
limited partnership, the general partner is the manager. It is a more hierarchical
structure than the general partnership. However, the limited partners may in some
circumstances have the right to vote on certain major decisions.
RULPA (1976/1985) § 403. [General Partner] General Powers and Liabilities.
(a)
(b)
Except as provided in this [Act] or in the partnership agreement, a general partner of a
limited partnership has the rights and powers and is subject to the restrictions of a partner
in a partnership without limited partners.
Except as provided in this [Act], a general partner of a limited partnership has the
liabilities of a partner in a partnership without limited partners to persons other than the
partnership and the other partners. Except as provided in this [Act] or in the partnership
agreement, a general partner of a limited partnership has the liabilities of a partner in a
partnership without limited partners to the partnership and to the other partners.
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RULPA (1976/1985), § 302. Voting.
Subject to Section 303, the partnership agreement may grant to all or a specified group of the
limited partners the right to vote (on a per capita or other basis) upon any matter.
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8CA17F2002-5611DD8320AE42787FBF1D&n=1&vr=2.0&service=Find&sv=Split&mt=ULA&ss=CNT
Question: Which partners in a limited partnership can be held personally liable for the debts of
the partnership?
Answer: The widely accepted rule is that every general partner is personally liable for
the business obligations, but each limited partner is liable only for the amount of capital
that he/she has contributed to the limited partnership.
RULPA (1976/85) §303 [Limited Partner] Liability to Third Parties
(a)
Except as provided in subsection (d), a limited partner is not liable for the obligations of a
limited partnership unless he [or she] is also a general partner or, in addition to the
exercise of his [or her] rights and powers as a limited partner, he [or she] participates in
the control of the business. However, if the limited partner participates in the control of
the business, he [or she] is liable only to persons who transact business with the limited
23
(b)
(c)
(d)
partnership reasonably believing, based upon the limited partner's conduct, that the
limited partner is a general partner.
A limited partner does not participate in the control of the business within the meaning of
subsection (a) solely by doing one or more of the following:
(1)
being a contractor for or an agent or employee of the limited partnership or of a
general partner or being an officer, director, or shareholder of a general partner
that is a corporation;
(2)
consulting with and advising a general partner with respect to the business of the
limited partnership;
(3)
acting as surety for the limited partnership or guaranteeing or assuming one or
more specific obligations of the limited partnership;
(4)
taking any action required or permitted by law to bring or pursue a derivative
action in the right of the limited partnership;
(5)
requesting or attending a meeting of partners;
(6)
proposing, approving, or disapproving, by voting or otherwise, one or more of
the following matters:
(i)
the dissolution and winding up of the limited partnership;
(ii)
the sale, exchange, lease, mortgage, pledge, or other transfer of all or
substantially all of the assets of the limited partnership;
(iii)
the incurrence of indebtedness by the limited partnership other than in
the ordinary course of its business;
(iv)
a change in the nature of the business;
(v)
the admission or removal of a general partner.;
(vi)
the admission or removal of a limited partner;
(vii)
a transaction involving an actual or potential conflict of interest
between a general partner and the limited partnership or the limited
partners;
(viii)
an amendment to the partnership agreement or certificate of limited
partnership; or
(ix)
matters related to the business of the limited partnership not otherwise
enumerated in this subsection (b), which the partnership agreement
states in writing may be subject to the approval or disapproval of
limited partners;
(7)
winding up the limited partnership pursuant to Section 803; or
(8)
exercising any right or power permitted to limited partners under this [Act] and
not specifically enumerated in this subsection (b).
The enumeration in subsection (b) does not mean that the possession or exercise of any
other powers by a limited partner constitutes participation by him [or her] in the business
of the limited partnership.
A limited partner who knowingly permits his [or her] name to be used in the name of the
limited partnership, except under circumstances permitted by Section 102(2), is liable to
creditors who extend credit to the limited partnership without actual knowledge that the
limited partner is not a general partner.
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LW11.07&scxt=WL&pbc=4BF3FCBE&findtype=VQ&cxt=DC&db=1009859&cite=N8CA17F2
002-5611DD8320A-E42787FBF1D&n=1&vr=2.0&service=Find&sv=Split&mt=ULA&ss=CNT
Why does the book refer to “RULPA §§ 9(1) and 17(1)” on p. 143? I think these are
Uniform Partnership Act (1914) sections for partner agency and liability of incoming
partners – do they apply to limited partnerships? [AP: oops. §9(1) refers to the old
ULPA, the book should say RULPA §404(a); same for §17(1), which should be RULPA §303.
Notice that RULPA (2001) creates a complete liability shield for limited partners, even if they
participate in control – just noticed that you’ve laid this out below.]
24
The Control Rule for Limited Partnerships
Question: Under RULPA (1976/85), what happens if the limited partners participate in the
management of the limited partnership?
Answer: Under the RULPA (1976/85), actively participating in management may
forfeit a limited partner’s limited liability.
This approach is illustrated by the 1948 Holzman v. de Escamilla decision. Note that
Holzman v. de Escamilla was decided before RULPA 1976/85, which gave limited
partners the right to vote on certain major decisions (see the list in RULPA § 303(6)
above).
Holzman v. de Escamilla (Hacienda Farms) (86 Cal.App.2d 858, 1948)
Facts: Hacienda Farms organized as a limited liability partnership: de Escamilla as the general
partner, Russell and Andrews as limited partners. The partnership went into bankruptcy, and
the trustee (Holzman) bought an action to declare Russell and Andrews liable as general
partners because they took part in control of the business.
What did they do?
 Andrews told de Escamilla what crops to plant.
 Russell and Andrews went to the farms about twice a week and oversaw the crops.
 Checks needed two partner signatures (i.e. nominal general partner had no control over
cash).
 At one point, Andrews and Russell asked de Escamilla to resign as manager. De
Escamilla did and was replaced.
Issue: Was this enough control to justify declaring Russell and Andrews general partners?
Holding: Yes.
Reasoning: Russell and Andrews were general partners because they exercised control over
the business.
NOTE: An excerpt of Holzman v. de Escamilla (Hacienda Farms) is attached as an appendix to
this chapter.
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&fn=_top&mt=208&cite=86+Cal.App.2d+858&sv=Split
RULPA (1976/85) vs. RULPA (2001)
The liability of limited partners who exercise management rights is one of the sources of
controversy relating to the different RULPA revisions. In the 2001 version of the uniform act
25
(ULPA 2001), a limited partner’s limited liability is not affected by management participation.
The limited liability results directly from his/her/its status as a limited partner, not unlike
members in LLCs (discussed below).
RULPA (2001) § 303. No Liability as Limited Partner for Limited Partnership Obligations
An obligation of a limited partnership, whether arising in contract, tort, or otherwise, is not the
obligation of a limited partner. A limited partner is not personally liable, directly or indirectly, by
way of contribution or otherwise, for an obligation of the limited partnership solely by reason of
being a limited partner, even if the limited partner participates in the management and control of
the limited partnership
The comment to RULPA (2001) §303 explains:
“This section provides a full, status-based liability shield for each limited partner, even if the
limited partner participates in the management and control of the limited partnership.” The section
thus eliminates the so-called “control rule” with respect to personal liability for entity obligations
and brings limited partners into parity with LLC members, LLP partners and corporate
shareholders.”
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LW11.07&scxt=WL&pbc=4BF3FCBE&findtype=VQ&cxt=DC&db=1009859&cite=N8CA17F2
002-5611DD8320A-E42787FBF1D&n=1&vr=2.0&service=Find&sv=Split&mt=ULA&ss=CNT
Question: How are financial rights allocated in limited partnerships?
Answer: Sharing in profits and distributions in a limited partnership is according to the
capital contributions of the limited and general partners.
Only the general partners must share in the losses, again according to their capital
contributions.
RULPA (1976/1985) § 503. Sharing of Profits and Losses.
The profits and losses of a limited partnership shall be allocated among the partners, and among
classes of partners, in the manner provided in writing in the partnership agreement. If the
partnership agreement does not so provide in writing, profits and losses shall be allocated on the
basis of the value, as stated in the partnership records required to be kept pursuant to Section 105,
of the contributions made by each partner to the extent they have been received by the partnership
and have not been returned.
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LW11.07&scxt=WL&pbc=4BF3FCBE&findtype=VQ&cxt=DC&db=1009859&cite=N8CA17F2
002-5611DD8320A-E42787FBF1D&n=1&vr=2.0&service=Find&sv=Split&mt=ULA&ss=CNT
RULPA (1976/1985) § 504. Sharing of Distributions.
Distributions of cash or other assets of a limited partnership shall be allocated among the partners
and among classes of partners in the manner provided in writing in the partnership agreement. If
the partnership agreement does not so provide in writing, distributions shall be made on the basis
of the value, as stated in the partnership records required to be kept pursuant to Section 105, of the
26
contributions made by each partner to the extent they have been received by the partnership and
have not been returned.
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LW11.07&scxt=WL&pbc=4BF3FCBE&findtype=VQ&cxt=DC&db=1009859&cite=N8CA17F2
002-5611DD8320A-E42787FBF1D&n=1&vr=2.0&service=Find&sv=Split&mt=ULA&ss=CNT
Question: What causes the dissolution of a limited partnership?
Answer: The limited partnership must specify an ending date for the limited
partnership. Unless the limited partnership agreement provides otherwise, only the
withdrawal of the general partners results in the dissolution of a limited partnership.
Limited partners may withdraw, or die, and the limited partnership should continue,
although most agreements restrict the voluntary withdrawal of limited partners (and
their capital). A limited partnership may also be dissolved by judicial decree.
RULPA (1976/1985) § 201. Certificate of Limited Partnership.
(a)
In order to form a limited partnership, a certificate of limited partnership must be
executed and filed in the office of the Secretary of State. The certificate shall set forth:
***
(4)
the latest date upon which the limited partnership is to dissolve; and
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LW11.07&scxt=WL&pbc=4BF3FCBE&findtype=VQ&cxt=DC&db=1009859&cite=N8CA17F2
002-5611DD8320A-E42787FBF1D&n=1&vr=2.0&service=Find&sv=Split&mt=ULA&ss=CNT
I am assuming that the reference on page 152 is meant to be to RULPA §201(a)(4) (not
RUPA). [AP – yep!!]
RULPA (1976/1985) § 801. Nonjudicial Dissolution.
A limited partnership is dissolved and its affairs shall be wound up upon the happening of the first
to occur of the following:
(1)
at the time specified in the certificate of limited partnership;
(2)
upon the happening of events specified in writing in the partnership agreement;
(3)
written consent of all partners;
(4)
an event of withdrawal of a general partner unless at the time there is at least one other
general partner and the written provisions of the partnership agreement permit the
business of the limited partnership to be carried on by the remaining general partner and
that partner does so, but the limited partnership is not dissolved and is not required to be
wound up by reason of any event of withdrawal, if, within 90 days after the withdrawal,
all partners agree in writing to continue the business of the limited partnership and to the
appointment of one or more additional general partners if necessary or desired; or
(5)
entry of a decree of judicial dissolution under Section 802.
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07&scxt=WL&pbc=4BF3FCBE&findtype=VQ&cxt=DC&db=1009859&cite=N8CA17F20025611DD8320A-E42787FBF1D&n=1&vr=2.0&service=Find&sv=Split&mt=ULA&ss=CNT
Question: Can a limited partner sell his/her interest?
27
Answer: The financial interest is transferable, but any voting or governance rights
cannot be transferred to the new limited partners unless all of the remaining partners
consent
RULPA (1976/1985) § 702. Assignment of Partnership Interest.
Except as provided in the partnership agreement, a partnership interest is assignable in whole or in
part. An assignment of a partnership interest does not dissolve a limited partnership or entitle the
assignee to become or to exercise any rights of a partner. An assignment entitles the assignee to
receive, to the extent assigned, only the distribution to which the assignor would be entitled.
Except as provided in the partnership agreement, a partner ceases to be a partner upon assignment
of all his [or her] partnership interest.
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LW11.07&scxt=WL&pbc=4BF3FCBE&findtype=VQ&cxt=DC&db=1009859&cite=N8CA17F2
002-5611DD8320A-E42787FBF1D&n=1&vr=2.0&service=Find&sv=Split&mt=ULA&ss=CNT
Limited Liability Partnerships and Limited Liability Limited Partnerships
Like other entities having limited liability, LLPs and LLLPs are formed by filing with the state.
Question: Why does limited liability seem to correspond to requirements that an entity be
formed “officially”?
Answer: Notice and accountability. If liability is incurred, third parties, or the state
itself, will be able to locate the parties if certain information has been provided upon
formation. It may also serve to provide notice to third parties of the limitation on the
partners’ personal liability.
The liability rules for such entities vary from state to state. Like a GP, the LLP is liable for all
tort and contract claims that arise in the ordinary course of business. However, unlike the GP,
a general partner in the LLP may only be personally liable for partnership obligations that arise
because of a wrongful or negligent act committed by him or someone under his supervision.
LLPs are falling off in use, though still favored by many law firms.
Example 6.3 on p. 148 illustrates this principle. Liability for the malpractice claim against
Lorena and Michael might be limited to the LLP, because filing deadlines arise in the ordinary
course of business. As noted in the example, however, in some states the partner in a
professional LLP who is responsible (directly or indirectly) for the malpractice may be held
personally liable.
An LLLP is like a limited partnership, except the general partners also enjoys limited liability
for the debts and obligations that arise while the election (to be an LLLP) is in place. The
LLLP form is relatively new, and not available in most states.
The default rules for management and control are the same in LLPs and LLLPs as they are for
general and limited partnerships.
28
Limited Liability Companies
Question: What is a limited liability company?
Answer: A limited liability company is a relatively new type of entity, widely available
since the late 1990s. It is a hybrid form, offering some features of a partnership, and
some features of a corporation. For example, like a corporation, the members of an
LLC have limited liability. However, an LLC can elect to be taxed as a partnership,
with all profits and losses flowing through to the members (and therefore no “entitylevel” taxation). Like a partnership, the management of an LLC can involve either a
decentralized, member-managed structure, or a more centralized, manager-managed
structure, like a corporation.
State LLC laws vary widely, although the 1995 Uniform Limited Liability Company
Act has led to increased uniformity, but has not been widely adopted.
Note: We sometimes ask our students what a “limited liability corporation” is – a term
sometimes bandied about. We explain that it’s a trick question, since the truth is that there is
no such entity with that name. There are “limited liability companies” and there are
“corporations,” but there are entities with the moniker “limited liability corporation.” At best,
“limited liability corporation” is a redundant explanation, since all corporations have limited
liability.
Question: What are the owners of an LLC called?
Answer: Members
Question: How is an LLC formed?
Answer: By filing Articles of Organization with the state. The Articles of
Organization must include the
 Name of the LLC
 Address of the LLC’s registered agent
The members also enter into an Operating Agreement, which is a contractual agreement
setting for the members’ rights and duties.
Question: How is an LLC managed?
Answer: An LLC may be either more member-managed or more manager-managed.
If it is member-managed, all members have the authority to make management
decisions, and may act as agents for the LLC.
If it is manager-managed, managers (who do not have to be members) make most
ordinary decisions relating to the LLC, and act as its agent. The members have no
29
authority as agents of the LLC, and make only the major decisions.
LLCs are designed to be flexible. The specifics of the entity’s management and
structure are spelled out in its Operating Agreement.
Question: How are the financial rights distributed in an LLC?
Answer: Here again the LLC is very much a customizable, contractual arrangement
among the members and therefore there is a great deal of variation in the way financial
rights are allocated. Some possibilities include:
 Sharing profits according to member contributions, or
 Equal sharing of profits
Uniform Limited Liability Company Act (1996) § 405. Sharing of and right to distributions.
(a) Any distributions made by a limited liability company before its dissolution and winding up
must be in equal shares.
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te=Unif.+Ltd.+Liability+Co.+Act+405&fn=_top&mt=208&vr=2.0&pbc=4BF3FCBE
Distributions must generally be approved by all the members (unless otherwise agreed)
Uniform Limited Liability Company Act (1996) § 404. Management of limited liability
company.
(a)
(b)
(c)
In a member-managed company:
(1)
each member has equal rights in the management and conduct of the company's
business; and
(2)
except as otherwise provided in subsection (c), any matter relating to the
business of the company may be decided by a majority of the members.
In a manager-managed company:
(1)
each manager has equal rights in the management and conduct of the company's
business;
(2)
except as otherwise provided in subsection (c), any matter relating to the
business of the company may be exclusively decided by the manager or, if there
is more than one manager, by a majority of the managers; and
(3)
a manager:
(i)
must be designated, appointed, elected, removed, or replaced by a vote,
approval, or consent of a majority of the members; and
(ii)
holds office until a successor has been elected and qualified, unless the
manager sooner resigns or is removed.
The only matters of a member or manager-managed company's business requiring the
consent of all of the members are:
(1)
the amendment of the operating agreement under Section 103;
(2)
the authorization or ratification of acts or transactions under Section
103(b)(2)(ii) which would otherwise violate the duty of loyalty;
(3)
an amendment to the articles of organization under Section 204;
(4)
the compromise of an obligation to make a contribution under Section 402(b);
30
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
the compromise, as among members, of an obligation of a member to make a
contribution or return money or other property paid or distributed in violation of
this [Act];
the making of interim distributions under Section 405(a), including the
redemption of an interest;
the admission of a new member;
the use of the company's property to redeem an interest subject to a charging
order;
the consent to dissolve the company under Section 801(b)(2);
a waiver of the right to have the company's business wound up and the company
terminated under Section 802(b);
the consent of members to merge with another entity under Section 904(c)(1);
and
the sale, lease, exchange, or other disposal of all, or substantially all, of the
company's property with or without goodwill.
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te=Unif.+Ltd.+Liability+Co.+Act+404&fn=_top&mt=208&vr=2.0&pbc=4BF3FCBE
And if the members cannot or do not agree, then they generally have no right to remuneration
Uniform Limited Liability Company Act (1996) § 403. Member's and manager's rights to
payments and reimbursement.
(d)
A member is not entitled to remuneration for services performed for a limited liability
company, except for reasonable compensation for services rendered in winding up the
business of the company.
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te=Unif.+Ltd.+Liability+Co.+Act+403&fn=_top&mt=208&vr=2.0&pbc=4BF3FCBE
Question: Are the members of an LLC personally liable for its debts?
Answer: No. An LLC limits the liability of its members and managers unless (as is the
case with corporations) the LLC is improperly formed, the member has unpaid capital
contributions, or the veil of limited liability is pierced.
Example 6.4 on p. 148 illustrates this principle. Donald and Larry are not protected from
liability when they fail to identify the LLC as the principal in the transaction. We-Develop was
given no notice that it was dealing with a limited liability entity.
Example 6.4 is based on Water, Waste & Land, Inc. DEBA Westec v. Lanham
Water, Waste & Land, Inc. DEBA Westec v. Lanham, 955 P.2d 997 (Colo. 1998).
Facts: Donald Lanham and Larry Clark were both members and managers of an LLC called
Private Income Investors (“P.I.I”). Lanham and Clark contracted with Westec, through oral
agreement, to perform engineering work on a building that PII was working on.
During their negotiations, Clark gave a business card to representatives of Westec that included
Lanham’s name, the address of P.I.I., and “P.I.I,” but that did not indicate that P.I.I. was an
LLC. All correspondence during the contract term was addressed to Lanham.
31
Westec billed Lanham for the work done and was not paid. Westec brought suit against
Lanham and Clark for breach of contract.
Colorado’s LLC law included a notice provision under Section 7-80-208 which provided that
the filing of the articles of organization puts 3rd parties on “constructive notice” that the
company is an LLC.
The lower court held that the business card reading “P.I.I.” satisfied 7-80-208 and put Westec
on constructive notice that Lanham and Clark were “agents” of P.I.I.; and therefore, their
liability was limited.
Issue: Did the Colorado provision properly put Westec on notice, or did Lanham and Clark
have a common law duty of an agent to disclose his principal?
Holding: Lanham breached his common-law agency duty to provide notice of his limited
liability status.
Reasoning: The statutory notice provision applies only when a 3rd party tries to impose
liability on members or managers of an LLC simply due to their status with the company.
Lanham received a form contract from Westec with his name on it. At this point, he could
have clarified to Westec that he was acting on behalf of P.I.I, but failed to do so.
Under the common law agency doctrine, an agent is liable in contract when he fails to disclose
his principal and when he discloses that there is a principal, but fails to disclose what that
principal is.
Since Lanham, as agent of P.I.I., failed to disclose the fact that he was acting on behalf of his
principal, he breached his common-law agency duty to provide notice of his limited liability
status, and therefore is personally liable in contract to Westec.
It is the duty of the agent to disclose his/her limited liability status, and not the duty of a 3rd
party to inquire through investigation of the status of a possible “agent.”
Question: How long does an LLC last?
Answer: In most states an LLC exists in perpetuity (unless otherwise agreed).
Question: What happens when a member wants to withdraw?
Answer: It varies. If the LLC follows a partnership model, a withdrawing member
may have the right to have the LLC buy his/her interest at fair value
Why do the citations in the textbook shift from the ULLCA to the RULLCA at this point? [AP:
because we went from drinking tea to drinking wine at precisely this point in the writing
process. OK – back on task. My view is that we should choose one of the ULLCAs and the
32
2006 version is probably the right one, since the earlier 1996 version was designed for pre“check the box.” I would adopt the convention of “ULLCA,” explaining at some point that we
are referring always to ULLCA (2006).]
Revised Uniform Limited Liability Company Act (2006) § 601. Member's Power to
Dissociate; Wrongful Dissociation.
(a)
(b)
(c)
A person has the power to dissociate as a member at any time, rightfully or wrongfully,
by withdrawing as a member by express will under Section 602(1).
A person's dissociation from a limited liability company is wrongful only if the
dissociation:
(1)
is in breach of an express provision of the operating agreement; or
(2)
occurs before the termination of the company and:
(A)
the person withdraws as a member by express will;
(B)
the person is expelled as a member by judicial order under Section
602(5);
(C)
the person is dissociated under Section 602(7)(A) by becoming a debtor
in bankruptcy; or
(D)
in the case of a person that is not a trust other than a business trust, an
estate, or an individual, the person is expelled or otherwise dissociated
as a member because it willfully dissolved or terminated.
A person that wrongfully dissociates as a member is liable to the limited liability
company and, subject to Section 901, to the other members for damages caused by the
dissociation. The liability is in addition to any other debt, obligation, or other liability of
the member to the company or the other members.
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Revised Uniform Limited Liability Company Act (2006) § 701. Events Causing Dissolution.
(a)
(b)
A limited liability company is dissolved, and its activities must be wound up, upon the
occurrence of any of the following:
(1)
an event or circumstance that the operating agreement states causes dissolution;
(2)
the consent of all the members;
(3)
the passage of 90 consecutive days during which the company has no members;
(4)
on application by a member, the entry by [appropriate court] of an order
dissolving the company on the grounds that:
(A)
the conduct of all or substantially all of the company's activities is
unlawful; or
(B)
it is not reasonably practicable to carry on the company's activities in
conformity with the certificate of organization and the operating
agreement; or
(5)
on application by a member, the entry by [appropriate court] of an order
dissolving the company on the grounds that the managers or those members in
control of the company:
(A)
have acted, are acting, or will act in a manner that is illegal or
fraudulent; or
(B)
have acted or are acting in a manner that is oppressive and was, is, or
will be directly harmful to the applicant.
In a proceeding brought under subsection (a)(5), the court may order a remedy other than
dissolution.
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FCBE
In other states, a member may not withdraw unless it is permitted by the LLC agreement.
Question: Can a member simply share his interest in the LLC?
Answer: LLC states generally permit a member to sell or transfer his financial interest,
not his governance interest.
Uniform Limited Liability Company Act (1996) § 501. Member's distributional interest.
(a)
(b)
(c)
A member is not a co-owner of, and has no transferable interest in, property of a limited
liability company.
A distributional interest in a limited liability company is personal property and, subject to
Sections 502 and 503, may be transferred in whole or in part.
An operating agreement may provide that a distributional interest may be evidenced by a
certificate of the interest issued by the limited liability company and, subject to Section
503, may also provide for the transfer of any interest represented by the certificate.
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FCBE
Revised Uniform Limited Liability Company Act (2006) § 501. Nature of Transferable
Interest.
A transferable interest is personal property.
http://web2.westlaw.com/find/default.wl?rp=%2ffind%2fdefault.wl&sv=Split&rs=WLW11.07&ci
te=Unif.+Ltd.+Liability+Co.+Act+501&fn=_top&mt=208&vr=2.0&pbc=4BF3FCBE
[AP: it probably makes sense to also include §502, which defines “transferable interest”]
SECTION 502. TRANSFER OF TRANSFERABLE INTEREST.
(a) A transfer, in whole or in part, of a transferable interest: (1) is permissible;
(2) does not by itself cause a member’s dissociation or a dissolution and winding up of the
limited liability company’s activities; and
(3) subject to Section 504, does not entitle the transferee to:
(A) participate in the management or conduct of the company’s activities;
or
(B) except as otherwise provided in subsection (c), have access to records or other information
concerning the company’s activities.
(b) A transferee has the right to receive, in accordance with the transfer, distributions to which
the transferor would otherwise be entitled.
(c) In a dissolution and winding up of a limited liability company, a transferee is entitled to an
account of the company’s transactions only from the date of dissolution.
(d) A transferable interest may be evidenced by a certificate of the interest issued by the
limited liability company in a record, and, subject to this section, the interest represented by the
certificate may be transferred by a transfer of the certificate. (e) A limited liability company
34
need not give effect to a transferee’s rights under this
section until the company has notice of the transfer. (f) A transfer of a transferable interest in
violation of a restriction on transfer contained in
the operating agreement is ineffective as to a person having notice of the restriction at the time
of transfer.
(g) Except as otherwise provided in Section 602(4)(B), when a member transfers a transferable
interest, the transferor retains the rights of a member other than the interest in distributions
transferred and retains all duties and obligations of a member.
(h) When a member transfers a transferable interest to a person that becomes a member with
respect to the transferred interest, the transferee is liable for the member’s obligations under
Sections 403 and 406(c) known to the transferee when the transferee becomes a member.
Question: Can two LLCs merge?
Answer: Yes. Both LLCs must adopt merger plans and file merger documentation
with the state. One LLC survives the merger, and the other ceases to exist.
Bonus Question: What is the difference between a limited partnership and a limited liability
company?
Answer: One answer is that at least one of the partners in a limited partnership must be
personally liable for the debts of the firm. However, in many states, investors can
avoid this by making a corporation the general partner.
Another answer is that, at least under the RULPA (1976/1985), limited partners risk
losing their limited liability if they actively participate in management OR SHOULD
THIS SAY “IF THEY RUN THE BUSINESS”?. [AP; I agree with “actively
participate” ] Investor preference for the clear, status-based protection from liability
from the LLC form may in part have contributed to the RULPA (2001) change to full
limited liability for limited partners, even when they exercise control over the entity.
Corporations
If there is a spectrum of typical characteristics of business organizations, general partnership
are at one end and corporations at the other.
Generally speaking, owners (partners) of a general partnership:
 have the right to participate in management;
 are subject to unlimited personal liability for the partnership’s obligations;
 act as agents to bind the partnership; and
 face tax liability for distributions (but the entity itself is not taxed).
Generally speaking, owners (shareholders) of a corporation:
 have no rights to participate in daily management;
 are subject to limited liability for the corporation’s obligations;
 do not act as agents for the corporation; and
35

face tax liability for distributions (e.g. dividends) and the entity itself is also taxed
Note: People who are shareholders of a corporation may also have other roles, e.g., director of
manager, in the corporation. In that capacity, a shareholder may act as an agent, but not
because of his shareholder ownership.
Question: How is a corporation formed?
Answer: The persons forming the corporation (the incorporators) file articles of
incorporation with the state. The articles of incorporation include information such as:
 the corporate name,
 the number of authorized shares, and
 the name and address of each incorporator.
The articles of incorporation may also include information such as
 the Corporate purpose,
 provisions regulating the management of the corporation, and
 limitations on the power of the corporation and its shareholders, officers or
directors.
The Model Business Corporation Act §2.02. Articles of Incorporation, and the DGCL
§102. Contents of Certificate of Incorporation, contain more detailed corporation
formation provisions and are discussed in Chapter 7.
Question: How is a corporation managed?
Answer: Management of a corporation is centralized. The legal authority to manage a
corporation’s business and affairs is vested in a board of directors which is elected by
the shareholders. Except in extraordinary circumstances, the board hires (and delegates
authority to) professional executive officers to run the company, subject to the direction
and periodic review and approval of the board.
Very major decisions must be taken by the same board, but most decisions (“day-to-day
operations”) are delegated by the board and made by the executive officers. The Chief
Executive Officer (CEO) and many of the other top managers serve at the pleasure of
the board.
MBCA § 8.01. Requirement for and Duties of Board of Directors.
(a)
(b)
(c)
Except as provided in section 7.32, each corporation must have a board of directors.
All corporate powers shall be exercised by or under the authority of, and the business and
affairs of the corporation managed by or under the direction of, its board of directors,
subject to any limitation set forth in the articles of incorporation or in an agreement
authorized under section 7.32.
A corporation having 50 or fewer shareholders may dispense with or limit the authority
of a board of directors by describing in its articles of incorporation who will perform
some or all of the duties of a board of directors.
36
DGCL § 141. Board of directors; powers; number, qualifications, terms and quorum;
committees; classes of directors; nonstock corporations; reliance upon books; action without
meeting; removal.
(a)
The business and affairs of every corporation organized under this chapter shall be
managed by or under the direction of a board of directors, except as may be otherwise
provided in this chapter or in its certificate of incorporation. If any such provision is
made in the certificate of incorporation, the powers and duties conferred or imposed upon
the board of directors by this chapter shall be exercised or performed to such extent and
by such person or persons as shall be provided in the certificate of incorporation. * * *
http://delcode.delaware.gov/title8/c001/sc04/index.shtml#141
Question: How are board members elected?
Answer: Normally by a plurality of the shares entitled to vote, with each share entitled
to one vote. This means that if there are five directorships to be filled, the five top
vote-getters fill the seats. If there are only five nominees for the directorships to be
filled, receiving just one vote is enough for a nominee to be seated.
MBCA§ 7.28. Voting for Directors; Cumulative Voting
(a)
(b)
Unless otherwise provided in the articles of incorporation, directors are elected by a
plurality of the votes cast by the shares entitled to vote in the election at a meeting at
which a quorum is present.
Shareholders do not have a right to cumulate their votes for directors unless the articles of
incorporation so provide.
MBCA § 7.21. Voting Entitlement of Shares
(a)
Except as provided in subsections (b) and (c) or unless the articles of incorporation
provide otherwise, each outstanding share, regardless of class, is entitled to one vote on
each matter voted on at a shareholders' meeting. Only shares are entitled to vote.
Question: How are financial rights allocated in a corporation?
Answer: According to shares (“pro rata”). Corporate shareholders only share in the
business profits if the board of directors declares a dividend or other distribution.
MBCA § 6.40. Distributions to Shareholders.
(a)
(c)
A board of directors may authorize and the corporation may make distributions to its
shareholders subject to restriction by the articles of incorporation and the limitation in
subsection (c).
***
No distribution may be made if, after giving it effect:
(1)
the corporation would not be able to pay its debts as they become due in the
usual course of business; or
(2)
the corporation's total assets would be less than the sum of its total liabilities
plus (unless the articles of incorporation permit otherwise) the amount that
would be needed, if the corporation were to be dissolved at the time of the
distribution, to satisfy the preferential rights upon dissolution of shareholders
37
(d)
whose preferential rights are superior to those receiving the distribution.
The board of directors may base a determination that a distribution is not prohibited
under subsection (c) either on financial statements prepared on the basis of accounting
practices and principles that are reasonable in the circumstances or on a fair valuation or
other method that is reasonable in the circumstances.
***
Subchapter V would be better, but may not be necessary.
http://delcode.delaware.gov/title8/c001/sc05/index.shtml
Question: Are shareholders liable for the debts of the corporation?
Answer: Limited liability is a key feature of the corporation. Shareholders liability is
generally limited to his original investment in the corporation (unless otherwise
agreed).
MBCA§ 6.22. Liability of Shareholders.
(a)
(b)
A purchaser from a corporation of its own shares is not liable to the corporation or its
creditors with respect to the shares except to pay the consideration for which the shares
were authorized to be issued (section 6.21) or specified in the subscription agreement
(section 6.20).
Unless otherwise provided in the articles of incorporation, a shareholder of a corporation
is not personally liable for the acts or debts of the corporation except that he may become
personally liable by reason of his own acts or conduct.
Question: Can shareholders transfer their shares?
Answer: In general, shareholders are free to transfer their stock without the
consent of the corporation or the other shareholders. Normally, shareholders
cannot force the corporation to buy back their shares, but have broad rights to sell
their shares to other investors.
MBCA § 6.27. Restriction on Transfer of Shares and Other Securities.
(a)
(b)
(c)
(d)
The articles of incorporation, bylaws, an agreement among shareholders, or an agreement
between shareholders and the corporation may impose restrictions on the transfer or
registration of transfer of shares of the corporation. A restriction does not affect shares
issued before the restriction was adopted unless the holders of the shares are parties to the
restriction agreement or voted in favor of the restriction.
A restriction on the transfer or registration of transfer of shares is valid and enforceable
against the holder or a transferee of the holder if the restriction is authorized by this
section and its existence is noted conspicuously on the front or back of the certificate or is
contained in the information statement required by section 6.26(b). Unless so noted, a
restriction is not enforceable against a person without knowledge of the restriction.
A restriction on the transfer or registration of transfer of shares is authorized:
(1)
to maintain the corporation's status when it is dependent on the number or
identity of its shareholders;
(2)
to preserve exemptions under federal or state securities law;
(3)
for any other reasonable purpose.
A restriction on the transfer or registration of transfer of shares may:
38
(1)
(2)
(3)
(4)
obligate the shareholder first to offer the corporation or other persons
(separately, consecutively, or simultaneously) an opportunity to acquire the
restricted shares;
obligate the corporation or other persons (separately, consecutively, or
simultaneously) to acquire the restricted shares;
require the corporation, the holders of any class of its shares, or another person
to approve the transfer of the restricted shares, if the requirement is not
manifestly unreasonable;
prohibit the transfer of the restricted shares to designated persons or classes of
persons, if the prohibition is not manifestly unreasonable.
***
Note: Shares are generally freely transferable as a matter of corporate law.
Executive compensation schemes, securities laws (especially the rules against
insider trading), and the absence of an elective market often restrict the
transferability of shares.
Question: How long does a corporation last?
Answer: A corporation has perpetual existence unless otherwise agreed (and put in the
articles of incorporation). Because shares are freely transferable and inheritable, the
life of the entity is independent of the lives of the original owners.
Question: How can a corporation be dissolved?
Answer: The parties may agree in advance to dissolve the corporation in specific
circumstances (e.g. death of a key participant). Or the board can recommend, and a
majority of shares approve, a voluntary dissolution. Shareholders have no right to
withdraw and demand payment from the corporation.
Corporations are often dissolved upon insolvency, or upon merger.
Question: Can a corporation merge?
Answer: Yes. A corporation can combine with another corporation with a merger.
Once the merger plan is approved by both boards and both sets of shareholders, and the
articles of merger are filed with the state, the assets and liabilities of both corporations
are combined in the surviving corporation, and the articles of merger are filed with the
state.
Bonus Exercise
A. Partnership. An association of 2+ persons to carry on as co-owners a business for
profit. Each will be liable for business obligations.
B. Corporation. Shareholders provide capital, directors and officers manage business.
None is liable for business obligations.
C. Limited partnership. A partnership with a general and limited partners. Only general
partner liable for business obligations.
39
D. Limited liability company. Co-owned and co-managed by members (unless managermanaged). None is liable for business obligations.
E. Proprietorship (employer/ employee). Owner liable for business obligations.
F. Proprietorship (debtor/creditor). Owner liable for business obligations.
Question: Based on the facts from Hypothetical 6.1 on p. 142, which form(s) would you
suggest for the following fact patterns: [AP: one of the reasons the hypo 6.1 gets rid of Charles
is to make the capitalist-manager relationship more streamlined throughout the chapter, but
especially here]
1.
Anita hires Brandon to work for her.
2.
Brandon will own the business, and he will borrow capital from Anita.
3.
Anita and Brandon will share profits and operate the business together.
4.
Anita will provide capital; Brandon will manage business. They both share profits.
5.
Anita will provide all capital, and will manage with Brandon. Charles gets half of
profits.
6.
Anita and Brandon will provide capital and share in profits, but management goes to
Charles, Anita’s nephew.
Answers:
1. B, D, E (we emphasize that it’s not always necessary to have a firm!) [The answers
have to be changed to reflect change in characters // notice that we make capital
female!]
- Anita may not want the equality of a partnership, but an entity with more centralized
management. If we were to show him slide 6 (comparing partnerships, LLCs, and
corporations) she would point us to the forms on the right and center-right.
- Without knowing more about Anita’s liability needs, a corporation, LLC and
proprietorship would all meet his criteria. In the corporation, Anita would provide most
(or all) of the capital and Brandon would work for her as management.
- An LLC could work for Anita too, depending on how much ownership interest she is
willing to cede and the amount of management she is willing to assume. If she does not
seek to work at all, she should elect manager management. If she would like a role in
management, she should opt for member management.
- While not listed in the text, a garden variety proprietorship might meet Anita’s needs
as well as a corporation or LLC. As sole proprietor, Anita would have exclusive control
over the business; of the corporation, LLC, and proprietorship, Anita would probably
40
have the most power in a proprietorship. The downside of the proprietorship is that
Anita would have unlimited liability for the business’ obligations.
2. B, D, F (again, a “firm” with ownership may not be what’s called for)
- Brandon wants to own his own business, but he lacks adequate funds to do so. No
problem, he can capitalize with contributions from Anita (making her a shareholder)
and form a corporation. Brandon would not be the sole owner in this arrangement,
however.
- Brandon can also accomplish his goals by creating an LLC. Anita would help
capitalize the business and become a member. As with a corporation, Brandon would
not be sole owner.
- Brandon could retain sole ownership of the business if he elected to go into business
as a proprietorship. This would form a debtor-creditor relationship with Anita,
however, who has loaned him funds to start the business.
3. A, B, D
In this scenario, Anita and Brandon have the most basic of business needs. They want
to operate the business together (management and control) and share in its profits
(financial rights). These needs are met by the corporation, partnership, and LLC alike.
All would allow the two individuals to participate in management of the company and
share profits.
4. A, B, C, D
Anita wants to invest, Brandon wants to manage, and both want the profits. This is a
classic arrangement. Look at the options available to businesspeople in these
circumstances. Under these criteria, the full spectrum of organizational choices is
available.
- If the two entrepreneurs seek equality in management, agency, and liability, they may
choose a GP. If they instead would like to restrict management and liability rights, they
could opt for the somewhat less democratic LP.
- If they are willing to opt for centralized management, they could go to the other end
of the business spectrum and incorporate. Liability would be capped at what the
shareholders have contributed, as opposed to the partnership form where partners can
be held liable for the debts of the business.
- Of course, Anita and Brandon may go for an LLC. Their business would be like a
partnership in that as members the two of them would provide capital and manage the
business. The LLC would also entail one of the downsides of the partnership—lack of
freely transferable interests. The business would be similar to a corporation in that the
two entrepreneurs would not be personally liable for the debts of their LLC. Contrast
41
this with a partnership, where as partners our two entrepreneurs could be held liable for
the debts of the business.
5. A, B, D
This business arrangement can be met equally well by a partnership, corporation, or
LLC. The two individuals desire to participate in management and distribute profits per
capital. A partnership would allow them to achieve this sharing of control and profits.
- Their arrangement also lends itself to the corporate form. Anita would provide the
necessary capital as a shareholder; both would operate in management and share
profits.
- Anita and Brandon seek to co-own and co-manage the business. This arrangement
could be addressed using the member-managed LLC form.
6. A, B, D
The corporation, partnership, and LLC all meet the business’ needs where those
involved delegate management to another person. Charles will be handling
management for the business. Delegating management responsibilities doesn’t alter the
equation. Doing so not only fits with the centralized management of the corporation,
but can also be accomplished with a partnership (managing partner) or LLC (managing
member, without ownership interest).
42
[AP: the chart should mention that a sliging is necessary for an LLP]
Wrap-up Question: What is a limited liability corporation?
Answer: There is no such thing as a “limited liability corporation.” This frequently
used term is wrong. There is a “limited liability company.” All corporations are
limited liability entities. [AP: maybe my earlier note is now unnecessary]
C.
Planning Considerations
Three issues that arise when choosing an organizational form hinges are
 How does the form handle majority and minority interests?
 How does the form affect the firm’s ability to raise capital?
 What are the tax implications of the choice?
1.
Balancing Ownership Interests
The manner in which different interests (majority and minority) are handled is a critical factor
in choosing the best form of business organization for an undertaking
Question: How does a general partnership deal with the risk of opportunistic behavior by
43
either majority or (in rarer cases) minority partners, and how does that compare to a
corporation?
Answer: In a general partnership, the default rule allowing at-will dissolution (or
disassociation) is critical. Generally, any partner (majority or minority) can withdraw
from the firm – creating a risk of excluding partners from pending profits or leaving the
business without the partner’s special skills.
In the simplest terms, the corporation favors the majority shareholders, who elect the
board. The corporation locks in capital, but creates the risk of management
opportunism.
2.
Economics of the Choice
Question: Why has the corporation, rather than the partnership, often been used for raising
substantial amounts of money?
Answer: The excerpt from Judge Posner on pp. 155-6 explains that the corporation’s
perpetual existence removes the need for special provisions limiting a capitalcontributing participant’s withdrawal or dissolution. In addition, the corporation
encourages passive investing by
 a complex of legal rights vis-a-vis management and any controlling group of
shareholders and
 the fact that equity interests in a corporation are broken up into shares of relatively
small value that can be traded in organized markets.
Question: If a corporation is at such a tax disadvantage, why do people keep incorporating?
Answer: Section D is devoted to this question.
D.
Tax Consequences (Brief Overview)
Question: What is double taxation?
Answer: when a corporation is first taxed on its income and then shareholders are
taxed on any income distributed to them. There is a substantial tax burden on
corporations as opposed to other organizational choices, which is just one of several
reasons corporate lawyers often advise their clients: “when in doubt, do not
incorporate.”
1.
Corporation vs. Partnership
Example 6.11 on p. 159 presents a profitable business with a net income of $80,000, and
personal income to the owners (in the form of salaries) of $70,000.
44
Question: How should they organize their business?
Answer: The example demonstrates that corporations are tax-disadvantaged, and
identifies why flow-through tax forms are often preferred by business planners.
Salaries
Business Income (Loss)
Business Tax
Dividends/Share
Total Personal Income
Personal Tax
TOTAL TAX
Partnership
(000)
$70
$80
$0
$80
$150
$14.7
$14.5
Corporation
(000)
$70
$80
$12
$68
$138
$12.9
$24.7
[AP: after recomputing (see attached spreadsheet) – and assuming married filing jointly with
standard deduction ($10900) and 3 personal exemptions (couple + dependent = $10,500) and
tax tables for 2008, calculations are slightly off. Personal tax should be $0.7 and $2.6 – not
enough to change anything. (probably rounding off error in original set of calculations, now
lost in time)
Question: How does pass-through tax treatment work in Example 6.11?
Answer:

First, we assume that income is equal for both business entities - $80 in business
income (after having paid salaries, for instance, of $70).

Second, the partnership is taxed $0—because income (and therefore the tax
burden) “passes through” to the partners. The $80 of business income is
distributed in full to the partners along with the personal income (added
together, total $150).

Third, the partners are then taxed on their total income, in this case, $150. This
results in a personal income tax of $14.7.
Question: How does corporate double taxation work in Example 6.11?
Answer:


First, again income is equal for both business entities - $80 in business income
(after having paid salaries, for instance, of $70).
Second, but now the business entity is taxed—the first level of taxation. Here,
the corporation itself is taxed $12. Unlike the partnership and its use of “flow
through” taxation, $12 of tax burden is born by the business itself. With
business income reduced from $80 to $68, total income (with salaries, etc. of
$70) is $138.
45

Third, we now move on to personal taxes on the shareholders—the second level
or “double” taxation. Here, $12.9 of personal tax is paid at the shareholder level.
Question: Which form makes out better?
Answer: Often, students do not grasp the full effect of corporate double taxation until
they have added the two taxes and compared the value with the pass-through personal
tax. In fact, a cursory glance at the personal tax is deceiving in that it looks as though
the corporation made out better, at least before looking at the business tax.
Here, the business tax of $12 at the corporate level added to the $12.9 of personal tax
yields a value of $24.9. Compare that with the more modest $14.7 total taxes paid
using the pass through partnership.
Unless the firm plans on retaining its earnings, the flow-through tax treatment of noncorporations is quite advantageous. In the event a business makes money and
distributes it, the income of a non-corporation flows through to its members who must
pay tax—but tax is paid only once. If, however, the business is a corporation, the
corporation pays tax on its income when earned and the shareholders pay tax on any
dividends—taxes are effectively paid twice.
If the business makes money and retains it, the situation remains for an organizational
form receiving entity treatment—tax is paid only once. It is paid by the members after
it has flowed through the entity. A corporation can only defer tax on shareholders in
this scenario. They will eventually be taxed when the income is distributed or when
they sell their shares.
Question: What is the bottom line for this money-making entity?
Answer: Owners can reduce their tax bill by using the flow-through entity.
Example 6.12 on p. 160 presents a business with net losses of $20,000, and personal income to
the owners (in the form of salaries) of $70,000.
Question: How should they organize their business?
Answer: The example demonstrates that corporations are significantly less able to
soften the blow of ordinary business losses. Again, flow-through tax forms are often
preferred by business planners.
Salaries
Business Income (Loss)
Business Tax
Dividends/Share
Partnership
(000)
$70
($20)
$0
($20)
Corporation
(000)
$70
($20)
$0
$0
46
Total Personal Income
Personal Tax
TOTAL TAX
$50
$0.8
$0.7
$70
$2.8
$2.6
[AP: after recomputing (see attached spreadsheet) – again assuming married filing jointly with
standard deduction ($10900) and 3 personal exemptions (couple + dependent = $10,500) and
tax tables for 2008, calculations are slightly off. Personal tax should be $0.7 and $2.6 – again
not enough to change anything, really.
Question: How does the tax treatment of a partnership work in the context of losses?
Answer: In a partnership, the business’ losses flow through to the partners (just as
income does), who are then able to deduct those losses from their income.

First, we start with equal businesses losses (and income) for both entities. Both
the partnership and corporation have ($20) in business losses (note, personal
income remains at $70).

Second, we show how the business itself addresses its losses. Here, the
partnership is taxed $0—income (and therefore the tax burden) “passes
through” to the partners. The ($20) of business loss is distributed in full to the
partners along with the personal income of $70.

Third, owners can then deduct the business losses (set off against income), by
$20,000. They are able to reduce their taxable income—and thus their personal
tax—by using the deductions.
Question: How are the same losses treated in the context of a corporation?
Answer: Again, there are equal business losses (and income) for both entities. Both
the partnership and corporation have ($20) in business losses and $70 in personal
income.
At the entity level, corporate losses can be carried forward to offset income in future
years. The corporate form becomes disadvantageous at the owner level. Unlike a
partnership, where owners can then deduct the business, owners cannot take advantage
of corporate losses to reduce individual income. Individual shareholders can deduct
losses only by selling their shares and deducting capital losses (if the shares are sold at
a loss).
The event of a business losing money makes an even stronger case for the advantages
of flow-through as opposed to entity tax treatment. At the entity level, neither the
partnership nor the corporation is taxed. But at the owner level the partnership is
superior for taxation purposes. Why? For a business receiving flow-through treatment,
business losses flow through to members, who are able to deduct them from other
income (so called “sheltering” of income).
47
The corporation’s ability to soften the blow of losses is significantly more limited.
Ordinary business losses can be deducted only against income the business generates in
the future. But the present value of loss deductions is lost – these deductions are more
valuable if taken now rather than in the uncertain future.
2.
Avoiding Corporate Double Tax
Question: If the advantages of flow-through treatment are decidedly superior to corporate
taxation, why incorporate? What does the corporation offer that continues to attract new
businesses? Is there a way around double taxation?
Answer: There are a number of techniques used by business planners to avoid double
taxation. Two examples are


Choosing subchapter S corporation status, and
“Zeroing out” income
Question: What is “subchapter S” corporation status?
Answer: Subchapter S of the Internal Revenue Code allows a corporation to elect to be
a flow-through entity (similar to a partnership) if:





It is a domestic corporation or LLC with no more than 100 shareholders
The shareholders are all individuals, estates or qualified trusts, or taxexempt entities
No shareholders are nonresident aliens
The corporation has only one class of stock
All shareholders consent to the choice of subchapter S treatment
Question: How do you “zero out” income?
Answer: By making deductible payments to shareholders such as



deductible salaries/bonuses for work,
rental payments on rental properties, or
interest on loans.
The Internal Revenue Code allows a corporation to deduct “reasonable compensation”
from gross income in determining its taxable income. Dividends, however, are not
deductible.
Planners must be sure that compensation is reasonable; the IRS can pursue excess
compensation as “constructive dividends” and the corporation could consequently lose
its deduction.
48
Personal Income
Business Income
Business Expense
Business Tax
Dividends/Salary
Total Personal Income
Personal Tax
TOTAL TAX
Corporate (No Deductions)
$70
$80
$12
$68
$138
$12.7
$24.7
Corporate (Deductions)
$70
$80
($80)
$0
$80
$150
$14.5
$14.5
Note: I was not sure how you are calculating the tax rates for these examples, so I am not sure
how to finish adapting the zeroing out hypothetical to the numbers actually used in the book.
[AP: I found and updated an old spreadsheet and I inserted the calculations for tax year 2008–
see attached spreadsheet. FYI here are the assumptions I used]
Std deduction 10,900 (married filed jointly)
Personal exemption 3,500 (2 - couple / 1- dependent / total 3 = $10,500)
Married Filing Jointly or Qualifying Widow(er) Filing Status
• 10% on the income between $0 and $16,050
• 15% on the income between $16,050 and $65,100; plus $1,605.00
• 25% on the income between $65,100 and $131,450; plus $8,962.50
• 28% on the income between $131,450 and $200,300; plus $25,550.00
• 33% on the income between $200,300 and $357,700; plus $44,828.00
35% on the income over $357,700; plus $96,770.00
These items are deducted from income at the corporate level. For example, $80 of payments is
made to shareholders, with the effect leaving the corporation’s taxable income at $0 (“zeroing
out” shareholder payments). Thus, this corporation has $0 of business taxes.
Note that the shareholders pay more in personal taxes after “zeroing out.” Their personal taxes
are about $1,800 more when the corporation zeroes out, here, than when it does not.
As with flow through tax treatment, the full effect of “zeroing out” income may be difficult to
see until taxes are added at the corporate and shareholder levels. Here, a corporation electing
not to “zero out” will pay $24.7 in total taxes. Compare that with a corporation that chooses to
zero out, and the corporation and shareholders pay only $14,500 in total taxes.
The corporation has achieved the effect of flow through treatment and successfully avoided
double taxation.
49
Question: How realistic is zeroing out income? Would there ever be a scenario in which a
corporation could pay out all of its income in deductible form?
Answer: Zeroing out is more achievable in some corporations and not others. To begin
with, size plays a role? In addition, it matters whether the corporation is public or
closely held. But at some point there may be too much of a good thing, particularly if
“wages” or “rental” paid to the corporation’s owner-shareholders is well beyond what
one would expect in a market arms’-length transaction. In such a situation, the IRS will
disallow the deductions and treat the payments as de facto distributions to the ownershareholders.
Summary
The main points of this chapter are:

The organizational choices are on a continuum of easy in – out (partnership) and
permanence (corporation)

There are several kinds of partnerships – general partnerships, limited liability
partnerships, limited partnerships and limited liability limited partnerships - each with
different management and liability attributes

Corporations come as publicly traded corporations and closely held corporations - with
different governance, management and liquidity attributes

Limited liability companies are hybrids that have partnership and corporate attributes
(subject to agreement otherwise)
50
APPENDIX A
86 Cal.App.2d 858, 195 P.2d 833
District Court of Appeal, Fourth District, California.
HOLZMAN
v.
DE ESCAMILLA et al.
Civ. 3671.
July 23, 1948.
MARKS, Justice.
This is an appeal by James L. Russell and H. W. Andrews from a judgment decreeing they
were general partners in Hacienda Farms, Limited, a limited partnership, from February 27, to
December 1, 1943, and as such were liable as general partners to the creditors of the
partnership.
Early in 1943, Hacienda Farms, Limited, was organized as a limited partnership (§§ 2477 et
seq., Civil Code) with Ricardo de Escamilla as the general partner and James L. Russell and H.
W. Andrews as limited partners.
The partnership went into bankruptcy in December, 1943, and Lawrence Holzman was
appointed and qualified as trustee of the estate of the bankrupt. On November 13, 1944, he
brought this action for the purpose of determining that Russell and Andrews, by taking part in
the control of the partnership business, had become liable as general partners to the creditors of
the partnership. The trial court found in favor of the plaintiff on this issue and rendered
judgment to the effect that the three defendants were liable as general partners.
The findings supporting the judgment are so fully supported by the testimony of certain
witnesses, although contradicted by Russell and Andrews, that we need mention but a small
part of it. We will not mention conflicting evidence as conflicts in the evidence are settled in
the trial court and not here.
De Escamilla was raising beans on farm lands near Escondido at the time the partnership was
formed. The partnership continued raising vegetable and truck crops which were marketed
principally through a produce concern controlled by Andrews.
The record shows the following testimony of de Escamilla:
A. We put in some tomatoes.
51
Q. Did you have a conversation or conversations with Mr. Andrews or Mr. Russell before
planting the tomatoes?
A. We always conferred and agreed as to what crops we would put in.
***
Q. Who determined that it was advisable to plant watermelons?
A. Mr. Andrews.
***
Q. Who determined that string beans should be planted?
A. All of us. There was never any planting done-except the first crop that was put into the
partnership as an asset by myself, there was never any crop that was planted or contemplated in
planting that wasn't thoroughly discussed and agreed upon by the three of us; particularly
Andrews and myself.'
De Escamilla further testified that Russell and Andrews came to the farms about twice a week
and consulted about the crops to be planted. He did not want to plant peppers or egg plant
because, as he said, 'I don't like that country for peppers or egg plant; no, sir,' but he was
overruled and those crops were planted. The same is true of the watermelons.
Shortly before October 15, 1943, Andrews and Russell requested de Escamilla to resign as
manager, which he did, and Harry Miller was appointed in his place.
Hacienda Farms, Limited, maintained two bank accounts, one in a San Diego bank and another
in an Escondido bank. It was provided that checks could be drawn on the signatures of any two
of the three partners. It is stated in plaintiff's brief, without any contradiction (the checks are
not before us) that money was withdrawn on twenty checks signed by Russell and Andrews
and that all other checks except three bore the signatures of de Escamilla, the general partner,
and one of the other defendants. The general partner had no power to withdraw money without
the signature of one of the limited partners.
§ 2483 of the Civil Code provides as follows: ‘A limited partner shall not become liable as a
general partner, unless, in addition to the exercise of his rights and powers as a limited partner,
he takes part in the control of the business.’
The foregoing illustrations sufficiently show that Russell and Andrews both took 'part in the
control of the business.' The manner of withdrawing money from the bank accounts is
particularly illuminating. The two men had absolute power to withdraw all the partnership
funds in the banks without the knowledge or consent of the general partner. Either Russell or
Andrews could take control of the business from de Escamilla by refusing to sign checks for
bills contracted by him and thus limit his activities in the management of the business. They
required him to resign as manager and selected his successor. They were active in dictating the
crops to be planted, some of them against the wish of Escamilla. This clearly shows they took
part in the control of the business of the partnership and thus became liable as general partners.
52
Tyler v. Wilson, 58 Cal.App.2d 583, 137 P.2d 33.
Judgment affirmed.
53
APPENDIX B
119 P.2d 713
Supreme Court of California.
OWEN
v.
COHEN.
L. A. 17917.
Dec. 5, 1941.
CURTIS, Justice.
This is an action in equity brought for the dissolution of a partnership and for the sale of the
partnership assets in connection with the settlement of its affairs.
On or about January 2, 1940, plaintiff and defendant entered into an oral agreement whereby
they contracted to become partners in the operation of a bowling -alley business in Burbank,
California. The parties did not expressly fix any definite period of time for the duration of this
undertaking. For the purpose of securing necessary equipment, plaintiff advanced the sum of
$6.986.63 to the partnership, with the understanding that the amount so contributed was to be
considered a loan to the partnership and was to be repaid to the plaintiff out of the prospective
profits of the business as soon as it could reasonably do so. Defendant owned an undivided
one-half interest in a bowling-alley establishment in Burbank and the partnership purchased the
other one-half interest for the sum of $2,500, of which amount $1,250 was paid in cash and the
balance of $1,250 was evidenced by the partners' promissory note. As part of this transaction
plaintiff assumed payment of the sum of $4,650 owing on a trust deed on the property, title to
which he took in his own name. The partnership also purchased alleys and other requisite
furnishings, and as part payment therefor the two partners executed promissory notes in the
total sum of $4,596, secured by a chattel mortgage on said equipment.
Plaintiff and defendant opened their partnership bowling-alley on March 15, 1940. From the
day of its beginning until the institution of the present action on June 28, 1940-a period of
approximately three and one-half months-the business was operated at a profit. During this
time the partners paid off a part of the capital indebtedness and each took a salary of $50 per
week. However, shortly after the business was begun differences arose between the partners
with regard to the management of the partnership affairs and their respective rights and duties
under their agreement. This continuing lack of harmonious relationship between the partners
had its effect on the monthly gross receipts, which, though still substantial, were steadily
declining, and at the date of the filing of this action much of the partnership indebtedness,
including the aforementioned loan made by plaintiff, remained unpaid. On July 5, 1940, in
response to plaintiff's complaint and upon order to show cause, the court appointed a receiver
to take charge of the partnership business, which ever since has been under his control and
management.
54
As the result of the trial of this action the court found that the partners 'did not agree upon any
definite term for the continuance of said partnership, nor upon any particular undertaking to be
accomplished; that the said partnership was a partnership at will'. From this finding the court
concluded that plaintiff was entitled to a dissolution under section 2425, subdivision (1)(b), of
the Civil Code. The court further found that the parties disagreed 'on practically all matters
essential to the operation of the partnership business and upon matters of policy in connection
therewith'; that the defendant had 'committed breaches of the partnership agreement' and had
'so conducted himself in affairs relating to the business' that it was 'not reasonably practicable
to carry on the partnership business with him'. From this finding it was concluded that the
partnership was dissoluble by court decree in accordance with the provisions of section 2426 of
the Civil Code.
Pursuant to these findings of fact and conclusions of law, the trial court rendered a decree
adjudging the partnership dissolved and ordering the assets sold by the receiver. It was further
decreed that the proceeds of such sale and of the receiver's operation of the business on hand
upon the consummation of such sale be applied, after allowance for the receiver's fees and
expenses, to payment of the partnership debts, including the amount of $6,986.63 loaned by
plaintiff to the business; that one-half of the remainder of the proceeds be paid to plaintiff,
together with the additional sum of $100.17 for his costs; and that defendant be given what was
left. It was also provided that in bidding at the sale of the partnership assets, either party might
use, in lieu of cash, credit to the extent of any sums which would accrue to him out of the
proceeds; and that if the money derived from such sale proved to be insufficient to pay
plaintiff's costs, a personal judgment to the extent of the deficiency was to be rendered against
defendant. It is from this decree that the defendant has appealed.
The principal question presented for consideration is whether or not the evidence warrants a
decree of dissolution of the partnership. Defendant's objection to the finding that the
partnership was one at will is fully justified by the uncontradicted evidence that the partners at
the inception of their undertaking agreed that all obligations incurred by the partnership,
including the money advanced by plaintiff, were to be paid out of the profits of the business.
While the term of the partnership was not expressly fixed, it must be presumed from this
agreement that the parties intended the relation should continue until the obligations were
liquidated in the manner mutually contemplated. These circumstances negative the existence of
a partnership at will, dissoluble at the election of a member thereof (Mervyn Investment
Company v. Biber, 184 Cal. 637, 194 P. 1037), and demonstrate conclusively that the assailed
finding is without support in the record. However, our determination of this issue does not
necessitate a reversal of the decree, for other facts found by the court relating to defendant's
breach of the partnership agreement amply justify the decision rendered. In such event the law
is settled beyond question that the finding which does not conform to the evidence becomes
immaterial and may be disregarded.
It is not necessary to enter into a detailed statement of the quarrel between the partners.
Whether the disharmony was the result of a difference in disposition or to other causes, the
effect is the same. Most of the acts of which complaint is made are individually trivial, but
from the aggregate the court found, and the record so indicates, that the breach between the
55
partners was due in large measure to defendant's persistent endeavors to become the
dominating figure of the enterprise and to humiliate plaintiff before the employees and
customers of the bowling-alley. In this connection plaintiff testified that defendant declined to
do any substantial amount of the work required for the successful operation of the business;
that defendant informed him that he (defendant) 'had not worked yet in 47 years and did not
intend to start now'; and that he (plaintiff) 'should do whatever manual work he could do on the
premises, but that he (defendant) would act as manager and wear the dignity'. The record also
discloses that during the preparation and before the opening of the bowling -alley
establishment, defendant told a mutual acquaintance that plaintiff would not be there very
long. Corroborative of this evidence is plaintiff's testimony that a few weeks prior to the filing
of this action, when he had concluded that he and defendant could not reconcile their
differences, he asked defendant to make an offer either to buy out his (plaintiff's) interest in the
business or to sell to him (plaintiff); that defendant replied, in effect, that when he was ready to
sell to plaintiff, he would set the price himself and it would cost plaintiff plenty to get rid of
him. In addition, there is considerable evidence demonstrating that the partners disagreed on
matters of policy relating to the operation of the business. One cause of dispute in this
connection was defendant's desire to open a gambling room on the second floor of the
bowling-alley property and plaintiff's opposition to such move. Another was defendant's
dissatisfaction with the agreed salary of $50 per week fixed for each partner to take from the
business and his desire to withdraw additional amounts therefrom. This constant dissension
over money affairs culminated in defendant's appropriation of small sums from the
partnership's funds to his own use without plaintiff's knowledge, approval or consent. In
justification of his conduct defendant claimed that on each occasion he set aside a like amount
for plaintiff. This extenuating circumstance, however, does not serve to eliminate from the
record the fact that monetary matters were a continual source of argument between the
partners.
Defendant urges that the evidence shows only petty discord between the partners, and he
advances, as applicable here, the general rule that trifling and minor differences and grievances
which involve no permanent mischief will not authorize a court to decree a dissolution of a
partnership. 20 R.C.L. 958, par. 182. However, as indicated by the same section in Ruling
Case Law and previous sections, courts of equity may order the dissolution of a partnership
where there are quarrels and disagreements of such a nature and to such extent that all
confidence and cooperation between the parties has been destroyed or where one of the parties
by his misbehavior materially hinders a proper conduct of the partnership business. It is not
only large affairs which produce trouble. The continuance of overbearing and vexatious petty
treatment of one partner by another frequently is more serious in its disruptive character than
would be larger differences which would be discussed and, settled. For the purpose of
demonstrating his own preeminence in the business one partner cannot constantly minimize
and deprecate the importance of the other without undermining the basic status upon which a
successful partnership rests. In our opinion the court in the instant case was warranted in
finding from the evidence that there was very bitter, antagonistic feeling between the parties;
that under the arrangement made by the parties for the handling of the partnership business, the
duties of these parties required cooperation, coordination and harmony; and that under the
existent conditions the parties were incapable of carrying on the business to their mutual
advantage.
56
As the court concluded, plaintiff has made out a cause for judicial dissolution of the
partnership under section 2426 of the Civil Code:
(1) On application by or for a partner the court shall decree a dissolution whenever:
***
(c) A partner has been guilty of such conduct as tends to affect prejudicially the carrying on of
the business,
(d) A partner willfully or persistently commits a breach of the partnership agreement, or
otherwise so conducts himself in matters relating to the partnership business that it is not
reasonably practicable to carry on the business in partnership with him,
***
(f) Other circumstances render a dissolution equitable.'
Defendant next questions the propriety of that portion of the decree which provides for the
payment of plaintiff's loan to the business, to-wit, the sum of $6,986.63, from the proceeds
realized upon the sale of the partnership assets. It is his contention that since the partners
agreed that the amount so contributed was to be repaid from the profits of the business, which
the evidence established to be a profitable enterprise, the court's order directing the discharge
of this partnership obligation in a manner violative of the express understanding of the parties
is unjustifiable. Mervyn Investment Company v. Biber, supra. That a party to a contract may
absolutely limit his right to receive a sum of money from a specified source is indisputable.
Lynch v. Keystone Consolidated Mining Company, 163 Cal.690, 123 P.968; Martin v. Martin,
5Cal.App.2d 591, 43 P.2d 314. But defendant's argument based upon this settled precept is of
no avail here, for his above described conduct, creative of a condition of disharmony in
derogation of the best interests of the partnership, constituted ground for the court's decree of
dissolution and its order directing the sale of the assets for the purpose of forwarding the
settlement of the partnership affairs. Defendant, whose persistence in the commission of acts
provocative of dissension and disagreement between the partners made it impossible for them
to carry on the partnership business, is in no position now to insist on its continued operation.
These circumstances not only render the assailed provision of the decree invulnerable to
defendant's objection, but also establish its complete accord with established principles of
equity jurisprudence.
***
The judgment is affirmed.
GIBSON, C. J., SHENK, J., EDMONDS, J., HOUSER, J., CARTER, J., and TRAYNOR, J.,
concurred.
CA. 1941
Owen v. Cohen
19 Cal.2d 147, 119 P.2d 713
57