978-0077733711 Chapter 38 Lecture Note

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Chapter 38 – Operation of Partnerships and Related Forms

CHAPTER 38

OPERATION OF PARTNERSHIPS AND RELATED FORMS

I. OBJECTIVES

This chapter is intended to acquaint students with the rules regarding the management of

partnerships, especially the rights, duties, and liabilities of partners. Students should:

A. Know the duties partners owe each other.

B. Understand how partners are compensated.

C. Appreciate the powers of partners to act for the partnership.

D. Learn how to construct a partnership agreement that will meet the needs of the partners.

E. Know the liability of partners and partnerships for torts and crimes.

II. ANSWER TO INTRODUCTORY PROBLEM

A. The default rules for management of the LLP are that each partner is a general manager of the

business with the power by herself to do anything in the ordinary course of the partnership’s

business. If the partners disagree on matters in the ordinary course of business, a majority of

the partners will determine the action of the partnership. To engage in an action outside the

ordinary course of business, such as changing the location of the partnership, unanimous

partners’ agreement is required. The fiduciary duties in the RUPA are also default

management rules.

B. These default rules are inappropriate for an LLP with 21 partners. Having 21 general

managers is unwieldy; it is also unlikely that all 21 will be skillful managers. Moreover, six

partners are more important that the other 15 partners. The six important partners will

demand the bulk of management power. Also, it is inappropriate that the 15 junior partners

can outvote the 6 senior partners on matters in the ordinary course of business. Finally,

unanimity may be too difficult to achieve in 21-partner partnership, giving too much veto

power to any one partner. Finally, the default fiduciary rules may be too restrictive on

partners who have outside interests and may impose too great liability on partners for

breaching the duty of care.

C. A well written partnership agreement will have a management section with the following

components: 1) a statement of the partners duties to the partnership, including changes to the

default fiduciary duties that meet the needs of the partners; 2) a statement of the partnership’s

duties to the partners; 3) a section listing the actions that may be taken only with the

unanimous consent of the partners and the procedure by which partner votes are taking on

such actions; 4) a section listing the actions that may be taken only by a super-majority vote

of the partners, such as 67% or 75%, including the voting procedure; 5) a section listing the

actions that may be taken only by a vote of the majority of the partners, including the voting

procedure; 6) if the partnership has several areas of practice, such as tax, litigation support,

and strategy, a section listing that actions that my be taken only by partners in a designated

area of practice; 7) a section listing the actions that my be taken only by the managing

partners’ committee, including the election and removal of managing partners and the process

by which managing partners act; 8) a section on the acts that may be taken by any

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Chapter 38 – Operation of Partnerships and Related Forms

partner or by designated individual partners, such as expense account purchases; 9) the

procedure for amending this section of the partnership agreement, being sure to protect any

unanimous or super-majority voting provision by requiring a similar vote to amend it.

D. The default compensation rule is that partners receive an equal share of the partnership’s

profits as their only compensation. They share losses the same way.

E. The default rule is inappropriate for this LLP, in which 6 of the partners generate most of the

revenue and profits for the partnership and, therefore, deserve more of the profits. Moreover,

unless profits are calculated monthly, partners are not entitled to monthly draws against the

profits, making it difficult for partners to pay personal expenses, such as a mortgage payment

on a partner’s personal residence. In addition, if there is a loss, partners are not entitled to

any distributions, so they have nothing to live on. Finally, if there is a loss, some partners

may have more outside income and be better able to use those losses to reduce their tax

liability.

F. A well written partnership agreement will have the following sections: 1) A section on the

partners’ monthly draws, that is, a salary that is the minimum amount that the partners will

receive each month. The draw for each partner may be determined yearly. It will set the

draw by formula, by agreement of the partners, or by a decision of a compensation

committee. The draw calculation for each partner will typically include one or more of the

following factors: level of partner (senior, junior, managing), number of years as a partner,

area of practice, number of clients and revenue generated by them, and the number of hours

billed. 2) A section on the partners’ share of profits after draws. Although some partners

share profits according to their capital contribution only, often the profit-sharing agreement is

more complex than the draw-sharing agreement. The profit allocation is typically made

according to a formula that considers one or more of the following factors: capital

contribution of a partner, level of partner (senior, junior, managing), number of years as a

partner, area of practice, number of clients and revenue generated by them, and the number of

hours billed. Some partnerships have rules for the allocation of client revenue when one

partner (such as a tax partner) attracts a client to the firm but another partner (such as a

consulting partner) services the client on a matter outside the first partner’s area of

competency. 3) The partnership agreement will also have subsections regulating partners’

vacations, leaves and sabbaticals, health and other insurance, and expense accounts.

III. SUGGESTIONS FOR LECTURE PREPARATION

A. Nature of Relations between the Partners.

Stress that the partners are fiduciaries of each other, owing each other the highest duty of trust

and loyalty.

B. Duties Partners Owe to Each Other. List all the duties of partners and give examples of each.

Below are listed the most important fiduciary duties. Note that the RUPA has different names

for some of the duties than does the UPA.

1. Duty Not to Have an Interest Adverse to the Partnership. Explain the conflict of interest

that arises when a partner profits personally–other than as a partner–-from a partnership

transaction. She may prefer her own interest over the partnership’s interest. Explain this

especially in the context of kickbacks.

2. Duty Not to Compete with the Partnership. Note the essence of this breach: a partner is

taking business away from the partnership.

a. McMillian v. McMillian (p. 1012): The court held that the trial court should have

found probative the profits one partner/cousin of a partnership made from a

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Chapter 38 – Operation of Partnerships and Related Forms

competing business in determining the profits lost by the partnership with which the

business competed.

Points for Discussion: Ask your students, especially your finance and accounting

majors, whether this decision surprised them. Of course, it did not. Standard

business valuation techniques include considering comparable businesses and

comparable transactions. The competing business that Robbie created to compete

and take business away from the partnership he formed with Bruce was doing much

of the same business that the partnership did or would have done. It is hard to

understand how the trial court could have concluded that the second business’s

profits were not probative to the lost profits of the partnership, until you understand

that most judges have no business or financial education, no business or financial

experience, and no business making financial decisions.

b. Additional Example: Problem Cases ## 1 and 2.

3. Duty to Serve. Explain this duty and point out the remedy for its breach: hiring a person

to undertake the breaching partner’s share of the workload and charging the partner’s

account for the expense.

4. Duty of Care. This is a good time to introduce students to the business judgment rule,

which is discussed in corporations Chapter 43. As in corporation law so too in

partnership law, the courts will defer to the judgment of business managers unless there is

a showing of bad faith, fraud, or breach of fiduciary duty. The rationale for courts being

reluctant to substitute their judgments for those of business managers is that judges are

less well equipped to make business judgments than are business managers who

continually make such decisions and who have business knowledge and experience not

possessed by judges.

5. Duty to Act within Actual Authority. Point out that this is identical to an agent’s duty to

follow instructions given to her by her principal.

6. Duty to Account. Explain this duty as a partner’s duty to tell his partners how has he has

used partnership funds and property.

a. Duty Not to Use Partnership Property for Personal Purposes. Personal use of

partnership resources is, in effect, theft.

Example: Problem Cases ## 1, 2, 3, and 4.

7. Duty of Confidentiality. List the various kinds of confidential information that partners

should not disclose: financial information; trade secrets such as customer lists, mode of

operation, secret formulae, and business plans.

8. Duty to Disclose and to Inform. Relate this duty to the agent’s duty to disclose and to

inform.

9. The Global Business Environment (p. 1015): Note that fiduciary duties vary little

worldwide, as the basic principle behind fiduciary duties, trust, is universally valued

among business partners.

10. Spector v. Konover (p.1016): This case is more fully explained in the compensation

section. It has several fiduciary duty issues. The court held that Konover breached his

fiduciary duty by diverting partnership funds to other entities that he controlled, by

refusing to distribute partnership profits so he could divert the profits to cover expenses

of his other entities, paying himself a management fee, and charging the partnership fees

that were paid to another Konover entity.

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Chapter 38 – Operation of Partnerships and Related Forms

C. Compensation of Partners

1. A partner is not entitled to a salary, but only to his share of the profits, absent an

agreement to the contrary or the application of some special rule.

Example: Problem Case # 5.

2. Profits and Losses. Note that losses are shared as profits are shared, absent a contrary

agreement. But profits are shared equally, absent a contrary agreement, even if losses are

shared unequally.

3. Spector v. Konover (p. 1016): The court held that Konover breached his fiduciary duty by

diverting partnership funds to other entities that he controlled, by refusing to distribute

partnership profits so he could divert the profits to cover expenses of his other entities,

paying himself a management fee, and charging the partnership fees that were paid to

another Konover entity.

Points for Discussion: Most of what Konover did wrong was self-dealing. Ask students

why self-dealing by a partner is wrong in a partnership context. It is because the partner

is on both sides of a transaction (he deals for the partnership on one side of the

transaction and deals for himself on the other side), so the risk is that with this conflict of

interests he will prefer his personal interest over the partnership’s interest.

Additional Point for Discussion: Ask students why Konover, even though he was

managing the partnership, was not entitled to any compensation for such management

work. It is because the default rule is that partners share profits equally. This is the

default rule when partners have not agreed otherwise. Its rationale is that many factors

may affect the allocation of profits (capital contributions, time and effort expended, value

to the partnership), such that it is impossible to determine which factor the partners think

is most important absent some indication of their intent. The court found that the partners

never had meetings or votes to give Konover the right to receive compensation. Konover

was entitled only to his share of profits and to reimbursement for out-of-pocket

expenditures on behalf of the partnership.

4. Note that an agreement regarding the partners’ requirement to contribute additional

capital is independent of the partners’ loss-sharing agreement.

5. Similarly, no profit-sharing or loss-sharing agreement between the partners will affect the

right of a creditor to collect her entire claim from any one partner. This rule makes sense,

because a creditor’s rights should not be affected without her consent.

D. Management Powers of Partners.

1. Allocation of Management Powers

a. State the power that an individual partner holds.

Note that if partners disagree about how to exercise the power each holds

individually, majority rule determines what action the partnership shall take.

b. Note that the partners may modify the allocation of powers between themselves by

unanimous consent, such as a partner agreeing to have no power to act for the

partnership. Note that a partner’s apparent authority to conduct the normal business

of the partnership continues unless third parties are notified of the limitation on the

partner’s authority. Statements of Partnership Authority and Statements of Denial

may be used to notify third parties of limitations, as well as informing third parties by

fax or email.

c. Note that partners have express, implied, and apparent authority, just as agents have

under agency law. Note that ratification may occur also. Refer to Chapter 36 for a

discussion of these agency concepts.

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Chapter 38 – Operation of Partnerships and Related Forms

d. Conveying Real Property. Note that partners may want to change the default rules

regarding when a partner may convey partnership real property. Partners may want

to expand or restrict the normal power of partners.

Example: Problem Cases ## 6 and 7.

e. Borrowing Money and Issuing and Negotiating Negotiable Instruments. Note the

traditional distinction drawn between trading and nontrading partnerships. Note that

this distinction obscures the basis for determining whether a partner has implied or

apparent authority to borrow money.

1) A partner has implied authority to borrow money if the ordinary needs of the

partnership require it to borrow money.

2) A partner has apparent authority to borrow money if

a) it appears that the partnership is a type of business that needs to borrow

money in the ordinary course of business, and

b) the lender does not know of the partnership’s history of not borrowing or

does not know of a restriction on a partner’s power to borrow for the

partnership.

3) Issuing Negotiable Instruments.

4) Negotiating Negotiable Instruments.

5) Example: Problem Case #6.

f. Effect of Partnership Agreement

NBN Broadcasting, Inc. v. Sheridan Broadcasting Network, Inc. (p. 1021). This case

is not interesting because of the law applied (it is decided on procedural grounds), but

because it is a good story, or rather a good horror story. It illustrates the need for

carefully balancing the interests of partners who intend to be equal partners.

Points for Discussion: Ask your students who fouled up here. NBN failed to protect

its position as an equal partner by agreeing to a deadlock provision giving Sheridan

the ability to dominate the management of the partnership. Ask your students why

NBN agreed to such a deadlock provision. It may have been a case of ignorance,

misplaced trust, or just wanting to make a deal so much that NBN agreed to a

provision that was not in its best interest.

Additional Points for Discussion: Dealing with a deadlock possibility is an important

consideration for inclusion in a partnership agreement. What other provisions for

breaking a deadlock could the partners have chosen? Would they want to appoint an

impartial arbiter? That’s doubtful. Should they just allow the partnership to founder

until agreement is reached? That would be better than what happened here. Should

one partner be required to buy out the other partner after deadlock persists for a

designated period of time? That is the preferred resolution, although such a buy-out

agreement may encourage a deadlock by a partner who wants to be bought out or to

buy out the other partner.

E. Partnership Agreements on Management and Compensation

1. Make sure that students know that well planned partnerships modify the default rules of

the RUPA to meet the needs of the partners. We spend a large amount of time in class

covering the management and compensation articles in partnership and LLP agreements.

2. Go over the material in the text on pages 1020-1021 on how large partnerships change

the default rules. We think this is the most important material in the chapter. Use the

Chapter Introductory Problem (p. 1011) as a context. Ask students for the default rules.

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Chapter 38 – Operation of Partnerships and Related Forms

Then ask students what is good and bad about the default rules in this context. Then ask

students to write the partnership agreement that changes the default rules.

3. Chapter Introductory Problem (p. 1011). This problem mostly deals with management

and compensation business planning issues. Note that all well planned partnerships and

LLPs, like KPMG LLP, have well structured management articles that allocate

management power. They also have compensation articles covering all aspects of

compensation. See answers C and F to the Chapter Introduction Problem at the beginning

of this chapter in this manual.

4. Log On (p. 1023): Look at the sample partnership agreements at the listed websites,

especially at the management and compensation articles. Note that such model

agreements are not crafted for the special needs of partners. Point out that it is essential

that partners anticipate their needs by writing a partnership agreement that covers the

issues they expect to encounter as partners. There is no substitute for having the

imagination to think of issues that will arise and the creativity to conceive of ways to deal

with those expected issues. While important that partners seek help from experienced

lawyers and find ideas from model agreements, partners must also make sure their

agreement meets their needs by considering the likely effects of each rule in the

agreement. Partners must understand that every rule will encourage certain behavior and

results; if the partners are unwilling to accept the risks of that behavior or result, they

should change the rule to promote the desired consequences.

F. Liability for Torts and Crimes

1. Torts

a. Remind students that the agency rules of vicarious liability under the doctrine of

respondeat superior apply to partners and partnerships. Note that most intentional

torts will not be committed within the usual course of business. However, if the

partnership allows a person who has a history of committing intentional torts to

engage in activities in which such torts may foreseeably recur, the partners and the

partnership are liable.

b. Note that under the RUPA, partners of a limited liability partnership have nearly

complete protection from liability. LLP partners have no liability for contracts of the

business, unless the partner has agreed to be liable personally on the contract. For

torts, an LLP partner is liable only if the partner committed a tort or had tort

responsibility over the person who committed the tort.

Ethics in Action (p. 1025): Ask your students whether they would be a partner in a

partnership when LLP status was available. Almost everyone will choose the LLP

form. A profit maximizer would find that ethical, because the law permits LLP

status, unless the LLP status resulted in unprofitable risk-taking by partners who did

not fear liability on partnership contracts. A utilitarian would be concerned for the

same reason. That kind of risk-taking is unlikely, however, as it would be counter to

the best interest of the partner as well. A rights theorist might find that a creditor’s

right to be paid for a debt incurred by partners for their business is greater than the

partners’ right to escape liability. However, that conclusion would probably change if

a contract creditor knowingly lent money to the LLP and chose not to obtain the

partners’ individual promises to repay. Applying Rawls’s categorical imperative

would probably result in a similar analysis, on the grounds that one would want a rule

that did not protect those who could protect themselves.

c. Ederer v. Gursky (p. 1024). This case is a good example of how some people

misconstrue what it means to be a partner in an LLP. Gursky’s argument that he has

no liability to his LLP partner for stealing profits seems to be and is, of course,

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Chapter 38 – Operation of Partnerships and Related Forms

ridiculous. The purpose of an LLP is not to relieve partners of duties to each other,

but instead to limit the LLP partners’ liability to third parties who deal with the LLP.

Thankfully, the court in this case understood this distinction and found the law to

back it up.

Points for Discussion: Ask your students whether they are convinced that section 26

of New York partnership law applies only to debts to third parties? Is that a

reasonable construction of the section? Yes, it is. Why? To release an LLP partner

from liability to his partners would give an LLP partner carte blanche to steal

partnership profits and do other harmful acts without the fear of liability.

d. Additional Examples: Problem Cases ## 8, 9, 10, and 11.

2. Crimes

Essentially, the rules regarding partners’ and partnerships’ intentional tort liability apply

to determine their liability for crimes. The crimes must be authorized or foreseeable

because of past misconduct. For some strict liability crimes, no mental culpability of the

partners may be required. There must be some strong public policy to justify such an

imposition of criminal liability on a partnership.

Example: Problem Case #11. Note that if Florence had been prosecuted for the crimes of

murder and battery, she would not have been found guilty, since she had no reason to

know that Michael would attack a patron.

G. Lawsuits by and against Partnerships and Partners

Note that under the RUPA the partnership may sue and be sued in its own name. This makes

it easier for the partnership to sue and to be sued. Partners may be sued also; note, however,

that a partner cannot be made to pay unless partnership assets are exhausted. LLP partners

can not be sued successfully on a partnership obligation unless it was a tort or contract for

which the partner has individual liability.

IV. RECOMMENDED REFERENCES

See the references in Instructor’s Manual Chapter 37.

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