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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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