978-0077733711 Chapter 39 Lecture Note

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Chapter 39 – Partners’ Dissociation and Partnerships’ Dissolution and Winding Up

CHAPTER 39

PARTNERS’ DISSOCIATION AND PARTNERSHIPS’

DISSOLUTION AND WINDING UP

I. OBJECTIVES

This chapter is intended to acquaint student with the process by which partners leave and enter

partnerships. A student should be able to:

A. Define dissociation and distinguish wrongful dissociation from nonwrongful dissociation.

B. Understand the consequences of wrongful and nonwrongful dissociations.

C. Know the causes of dissolution.

D. Know the powers of partners during winding up.

E. Understand how assets are distributed during winding up.

F. Know the liability of partners who dissociate from a partnership and the liability of partners

who join an existing partnership.

G. Learn how to write a partnership agreement that modifies the default rules of the RUPA to

meet the needs of the partners.

II. ANSWER TO INTRODUCTORY PROBLEM

A. The default rules are long and complex, so we refer you to the textbook. A good summary of

some aspects of the rules is in the Concept Review on page 1043. It is possible to expand

that summary to include other events, such as transfers of transferable interests and partner

bankruptcies. The outline can include more information, such as details on valuing a

partnership interest and the procedures during the winding up process.

B. There are several objections to the default rules, but here are a few important ones in a

partnership for a term. If a partner dies, a vote of only 50% of the partners can dissolve the

partnership and wind up the business. While this is a good rule if the deceased partner was

important to the partnership’s success, this can be bad also, because the business may be

worth more as a going concern. If a partner dies, any other partner may dissociate and do so

nonwrongfully. While this rule protects a partner who thinks her risks have increased due to

the death of the partner (who may have been a mentor, friend, valuable manager, or

rainmaker), the rule may result in a drain on partnership capital and talent. The risks are a bit

different if a partner retires, because the retiring partner may be able to take clients with her,

making continuation of the business less desirable. The method of valuating a partner’s

partnership interest is good because it reflects true value, but it is bad because it doesn’t state

a definite, concrete valuation methodology. Thus, if partners can’t agree on the valuation

method, a court will value the partnership interest, which introduces significant risks, because

most judges have no financial education, no financial experience, and no business making a

financial decision for our partnership. The timing of the payment for the value of the

partner’s interest is also troubling, as it may be too long in some cases (when the partnership

dissolves, unless there is no hardship) and too quick in others (120 days after a written

demand for payment).

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Chapter 39 – Partners’ Dissociation and Partnerships’ Dissolution and Winding Up

C. A well written partnership agreement should have a section dealing with partners’ leaving and

entering the partnership. For partners leaving the partnership, it should include the following

subsections: 1) Causes of partners’ dissociation, including automatic dissociations such as by

death, judicial dissociations, and dissociation by vote of the partners (including the procedure

by which partners act); 2) the effect of dissociation on the partnership, including when the

partnership continues and when it dissolves (such as automatic and judicial dissolutions and

dissolution by vote of the partners); 3) the effect of dissolution on the rights of other partners,

such as the right of selected partners (perhaps a founding partner) to dissociate if a friend or

other founding partner dies or retires; 4) the powers of the partners during winding up,

including who may wind up the business; 5) the buy-out of dissociated partners, including the

valuation methods and allowable deductions against the partnership interest; 6) the timing

and financing of the buy-out of a partner, including whether in a lump sum or installments

and whether financed by a life insurance policy, an annuity, or otherwise; 7) the effect of

dissociation on a partner’s management authority, including the duties to notify partnership

creditors of the dissociation; 8) the dissociated partner’s liability for competing with the

partnership after dissociation; 9) the dissociated partner’s liability for partnership obligations,

including the dissociated partner’s duty to disclose material facts and the partnership’s

agreement to indemnify the dissociated partner. For partners entering the partnership, the

agreement should including the procedure for admitting new partners, including eligibility

rules, terms of admission, and process for partners’ approval of the terms of admission. The

terms of admission should include the new partner’s capital contribution obligation, share of

partnership losses, and liability for partnership obligations incurred before he became a

partner. The terms of admission also may contain the new partner’s compensation and

management power or merely refer to those sections of the partnership agreement. Figure 3

on page 1109 in Chapter 42 of the corporation law material may be referred to for suggestions

in writing a buyout agreement not only among shareholders in a corporation, but also

partners in a partnership.

III. SUGGESTIONS FOR LECTURE PREPARATION

A. Introduction

Briefly define and distinguish dissociation, dissolution, winding up, and termination. Note

that neither dissociation nor dissolution terminates the partnership. The partnership remains

in existence until winding up has ended and termination of the partnership occurs. Note that

dissociation of a partner may lead down either of two paths: dissolution and liquidation of

the assets or continuation of the business.

B. Dissociation and Dissolution

1. Define dissociation and wrongful and nonwrongful dissociations. Define dissolution.

Note what types of dissociation cause dissolution and which ones grant an option to the

partners to dissolve the partnership.

a. Stress that dissociation results from a partner ceasing to be associated in carrying on

the business.

Example: Problem Case # 2.

b. Point out that dissolution is the start of the winding up process and will follow some

dissociations automatically and other dissociations by choice of the partners.

c. Point out the nonwrongful dissociations on page 1029. Note that a partner has the

power and the right to dissociate from a partnership in these ways. Stress the

consequences of nonwrongful dissociation.

Examples:

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Chapter 39 – Partners’ Dissociation and Partnerships’ Dissolution and Winding Up

1) Ann retires from a partnership with no term. This is nonwrongful, since the

partnership is at-will. Ann’s dissociation also dissolves the partnership. The

business will be wound up unless all partners including Ann agree not to wind up

the business.

2) Ann retires at age 65 from a partnership with a term expiring in 2027. The

partnership agreement permits partners to retire after reaching age 65. The

dissociation is nonwrongful. The partnership is not dissolved automatically, but

may be dissolved only by unanimous agreement of the partners or in accordance

with the partnership agreement.

3) In a partnership with a term expiring in 2027, Ann assigns her partnership interest

to her personal creditors. There is no dissociation. However, her partners may

expel her from the partnership, causing a nonwrongful dissociation. No

dissolution occurs unless the remaining partners decide unanimously to dissolve

the partnership.

c. Note that wrongful dissociations breach the partnership agreement, are caused by a

partner’s being in a bankruptcy proceeding, or are ordered by a court due to a

partner’s breach of his fiduciary duty. Note that a partner has the power but not the

right to dissociate from a partnership in these ways. Stress to your students the

consequences of wrongful dissociation (p. 1030).

Meyer v. Christie (p. 1031): The court found that the joint venture was not at-will,

but instead had been formed to complete a residential development project. The joint

venture’s term, therefore, did not terminate until the project was completed. By

leaving the venture prior to completion of its objective, Christie and Glenn

wrongfully dissociated.

Point for Discussion: Note that the court awarded damages of lost profits to Meyer

and Pratt. The court did not think profits were speculative, despite Christie and

Glenn’s having left the joint venture before the acquisition of the land or the

construction of any buildings on the land. In fact, the court cited concrete evidence

of the profits that the development might have generated: the profits generated from

the second venture that Christie and Glenn created to develop the land, which

development was generally the same as the development contemplated by the first

venture. In essence, Christie and Glenn stole the business idea from the first joint

venture and were found liable to the other partners in that venture for the portion of

the second venture’s profits that should have gone to Meyer and Pratt.

Additional Examples:

1) Abe leaves a partnership before its 30-year term expires. This is a wrongful

dissociation. The partnership will not be dissolved unless the partnership

agreement provides otherwise or a majority of the remaining partners vote for

dissolution. However, that wrongful dissociation allows any other partner to

dissociate within 90 days; that second dissociation would be nonwrongful.

2) Abe steals $1,000 from the partnership, which leads to judicial dissolution. This

is a wrongful dissociation for the stealing partner.

3) Abe refuses to take part in the management of the partnership business, which

leads to judicial dissociation. This is a wrongful dissociation and is grounds for a

judicial dissolution.

4) Problem Case # 1.

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Chapter 39 – Partners’ Dissociation and Partnerships’ Dissolution and Winding Up

d. Point out the acts that may appear to cause dissociation or dissolution, but do not,

including transferring a transferable interest, suffering a charging order against a

partnership interest, adding partners, and partners’ being deadlocked.

2. Schwartz v. Family Dental Group, P.C. (p. 1033): The court found that the

partnership agreement permitted two partners to vote to expel the third partner.

Points for Discussion: Ask you students whether they think the three partners

really thought when they formed the partnership that one of them could be expelled by

the vote of the other two. We seriously doubt that was the intent, especially in a

partnership like this in which the partners are basically equal. Do your students think the

appellate court erred by interpreting section 9(a) of the partnership agreement to apply to

expulsion of a partner? Is expelling a partner “concerning the conduct of Partnership

business”? It is not really the conduct of business, is it?

Additional Point for Discussion: This is another good example of a poorly

drafted partnership agreement. Probably what the partners wanted section 9(a) to state

was that a majority of the partners could decided issues in the “ordinary” course of

business, which would not include expelling a partner. They also should have had a

comprehensive section that left no doubt about the only ways, if any, a partner could be

expelled.

Additional Example: Problem Case #3.

3. The Global Business Environment (p. 1039): Note that while partnership law in countries

other than the U.S. is more nearly like the UPA, it will not be surprising if foreign

countries adopt laws similar to the RUPA. Other countries watch carefully American

laws regarding business forms. Those countries often adopt and adapt American law.

C. Winding Up

1. Fiduciary Duties during Winding Up.

Note that fiduciary duties continue during winding up.

2. Compensation of Winding Up Partner.

The RUPA changes the UPA rule and requires the payment of reasonable compensation to

a partner who is winding up the business of the partnership.

3. Authority of Winding Up Partner.

a. Express authority. The partners may unanimously agree to confer any authority on

the winding up partner.

b. Implied authority

1) To engage in any transaction necessary to a liquidation of the assets.

Examples:

a) Hiring an auctioneer to auction the assets of the partnership.

b) Contracting to sell the partnership to a business in the same field.

2) To preserve assets and to enhance them for sale.

Paciaroni v. Crane (p. 1036). This case is cited in the comments to the RUPA as

the classic case in which business can continue during the winding up process.

The court held that the majority partners are permitted to race Black Ace, the

partnership’s most valuable asset.

Points for Discussion: Ask your class why the court permitted the racing of

Black Ace during winding up. Racing him in the season’s remaining stakes races

would preserve and enhance the value of Black Ace. Ask the class who should

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Chapter 39 – Partners’ Dissociation and Partnerships’ Dissolution and Winding Up

be allowed to train Black Ace due to the dispute between the partners concerning

who should train him. Note that the court said that a majority of the partners

controls the decision. The court, however, required the majority partners to post

a bond if they wish to continue to race Black Ace.

3) To complete executory contracts. Under this authority, a partner is able to

liquidate assets–by selling goods pursuant to a contract–and to preserve

assets–by avoiding liability for breach of contract.

Example: A bicycle manufacturer has a partially completed contract to

manufacture 500 bicycles for a national retailer. The winding up partner would

be permitted to order additional parts and to hire employees to complete the

contract.

4) To borrow money to do any of the above.

c. Apparent authority. Appropriate notice of dissolution must be given. Otherwise,

persons who extended credit to the partnership or who knew of the partnership will

believe that the business is being continued and that, therefore, any partner may do

what she did prior to dissolution. Note that the notification requirements to eliminate

apparent authority provide greater protection for third parties who have not

previously done business with the partnership than agency law. Note that the best

protection against third parties who are not given individual notice is the filing of the

Statement of Dissolution, which eliminates all apparent authority to conduct business

in the usual way after 90 days have passed.

Example: Dizzo Company, a partnership operating a retail toy store, is dissolved.

Notice of the dissolution is published in a newspaper in the locality in which the

partnership and its creditors and customers do business. Abe, a partner, contracts on

behalf of Dizzo to buy a new shipment of toys from Apex Toy Company, which did

not read the notice. Apex has previously extended credit to Dizzo. Dizzo is liable on

the contract for having failed to give Apex personal notice of the dissolution. Abe is

liable to his partners for having exceeded his actual authority. If Apex had not

previously done business with Dizzo but knew of Dizzo’s existence, Dizzo would

nonetheless be liable to Apex. Publishing notice in the newspaper was not enough,

because the creditor must know or have reason to know of the dissolution. This puts

the burden on the partnership to let third parties know the partnership has been

dissolved.

4. Distribution of Assets

a. List the order of distribution of partnership assets. Note that partners who are

creditors are paid pro rata along with other creditors. Payments to partner-creditors

may be temporary when a partnership is insolvent, because a partner may be asked to

contribute to pay all the unpaid claims of creditors.

b. Example: Problem Case #9.

D. Continuation of Business

1. Note again here that winding up need not always follow dissociation. For example, the

partners may merely fail to choose to wind up, in which case the business will continue

as before. After dissociation, often partners make a well considered choice whether to

dissolve and wind up the partnership or whether to continue the business.

2. Liability of Successor. Note that when the business of the partnership is

continued–whether by another partnership, by a sole proprietorship, or by a

corporation–the successor has liability for the debts of the business even though it has

not agreed to take over liability.

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Chapter 39 – Partners’ Dissociation and Partnerships’ Dissolution and Winding Up

3. Dissociated or Outgoing Partner Liability. The text states the liability of dissociated

(outgoing) partners for obligations prior to and after her withdrawal from the partnership.

Note that the notice requirement to escape liability for future obligations (that is, to avoid

purported partnership) are similar to the notice requirement to eliminate the apparent

authority of partners to carry on the usual business of the partnership after dissolution.

The easy cases are when the creditor expressly agrees to release the outgoing partner or

when the creditor has no reason to know the partner has left the partnership.

Additional Examples: Problem Cases #5 and 6.

4. Buyout of Dissociated Partners. Providing an appropriate buyout price for partners who

dissociate from the partnership (such as by retirement or death, or even if partners can’t

get along) is essential to avoiding litigation, preventing legal distractions for the

continuing partners, and ensuring that the partnership will continue without financial

strain. Note the default rule for the amount and timing of payment for the dissociated

partner’s share of the partnership. Stress to your students the need for well-planned

partnerships (indeed any business) to have a succession plan with a buyout arrangement

that is good for the partners who leave and the partners who remain.

Dixon v. Crawford, McGilliard, Peterson & Yelish (p. 1040). The court determined that

the dissociated partner was entitled to his share of the going concern value of the

partnership business without the dissociated partner. Thus, it was appropriate to include

goodwill in valuing the partnership’s remaining business, that is, the business absent the

clients the partner took with him.

Points for Discussion: Both the dissociating partner and the partnership presented

testimony from expert witnesses regarding valuation of the business. The court had to

decide which valuation to accept and how much of it to accept. Why did the parties need

to go to court to resolve the valuation issue? BECAUSE THEY HAD NO

PARTNERSHIP AGREEMENT. Here we have lawyers in a law partnership, and even

they are so foolish as not to have a written partnership agreement. That is pathetic. That

is one of the main points of this case. A partnership should have a well-constructed

partnership agreement, including a section on the buyout of partners, including the

amount and timing of the payments.

Additional Points for Discussion: What should the partners’ agreement have been

included regarding the buyout price? The partners can do whatever they want, although

it should be clearly articulated and able to be administered without disagreement. It is

common in a professional partnership merely to return to a dissociated partner the

amount in the partner’s capital account, reflecting her capital contribution and any share

of profits not yet distributed to her. This is administratively simple, avoids conflict and

litigation, and reflects the sentiment that partners are to make a profit while they are

working, not by receiving a capital gain on their investment in the partnership. Some

professional partnerships add to the amount in the capital account a portion of accounts

receivable, on the grounds that the uncollected accounts have not yet been recognized as

profits in a business that usually is cash basis (not accrual). Of course, since not all

accounts receivable are collected, they should be discounted in accordance with an

historical collection rate. Moreover, if profits are distributed to each partner in all or in

part in relation to the income produced by a partner’s clients, only the accounts

receivable attributable to a dissociated partner’s clients should be considered.

a. Additional Examples: Problem Cases ## 4, 7, 8, and 9.

b. Ethics in Action (p. 1044): The default rule for valuing partnership interests does not

state a valuation methodology such as discounted cash flows or a multiple of

earnings. Thus the default rule introduces ambiguity that fosters disputes and

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Chapter 39 – Partners’ Dissociation and Partnerships’ Dissolution and Winding Up

litigation. If there is litigation, a judge who knows little about business valuations

may make the valuation decision.

The rationale for the default rule’s delaying the buyout of a wrongfully dissociating

partner until the partnership terminates reflects the partners’ expectations that they

will not have to buy out a partner until the partner dies or otherwise dissociates

rightfully. To make the partnership liquidate assets that are gainfully invested is a

hardship on the remaining partners. The default rule, therefore, is justified under

profit maximization, utilitarianism, and the categorical imperative. Its ethical basis

crumbles a bit when the partnership suffers no hardship in paying the wrongfully

dissociating partners earlier, which is why the default rule has that exception.

Nonetheless, as the answer to the Chapter Introductory Problem indicates, a well

planned partnership should have a section that delineates when a partner who

dissociates is paid and how much she is paid. Students should be asked to suggest

solutions for each of the events listed in the ethics problem. They should be asked to

evaluate their solutions by responding to several questions. What behavior will your

proposed rule encourage? Will the rule benefit you? Does it affect you differently if

you are the dissociating partner or the buying partner? Are you willing to accept the

consequences that the rule will foster? Such questions will help students consider the

ethics of the rule under profit maximization, the categorical imperative, and justice

theory.

5. Incoming Partner Liability.

a. Ask students why it is appropriate not to make incoming partners liable for at least

the amount of partnership assets, which is the UPA rule. The UPA rule seemed to

make sense because partnership assets are the minimum benefit partners receive by

being partners: they have the right to control the assets of the partnership.

Nonetheless, requiring such liability was a hollow gesture, because it really meant

that incoming partners had no liability. Once the partnership assets were exhausted,

the new partners could not be forced to pay unpaid creditors.

b. You may wish to explain more carefully why a partnership and a new partner may

agree that a new partner will assume full liability for all partnership debts, even

those incurred before she became a partner. Explain it this way: if

PricewaterhouseCoopers offers to one of your students partnership status and an

annual draw of $250,000 in return for assuming full liability, would your student

accept the offer of partnership? Of course she would. Fortunately for them,

however, PWC and other accounting and consulting firms are usually LLPs today,

meaning that new partners receive all the benefits of partnership but have liability

limited to their capital contributions. LLPs do not and should not require any of

their partners to assume full liability on partnership debts.

c. Examples: Problem Case # 10.

E. Partnership Agreements Modifying the Default RUPA Rules

1. It is important that partners not accept all the default rules of the RUPA as immutable

rules. As was discussed in Chapter 38, partners may modify the default rules to meet their

needs.

2. Example: Chapter Introductory Problem (p. 1028): This problem will help your students

understand the good and bad of the default rules and find better solutions to partnership

problems than the default rules provide. We like to approach a problem like this by

throwing out a scenario (such as a partner dying in partnership with a term), covering the

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Chapter 39 – Partners’ Dissociation and Partnerships’ Dissolution and Winding Up

default rules regarding dissociation, dissolution, and buyout of the deceased partner,

asking students what is good and bad about those rules, and then suggesting better

solutions that can be included in the partnership agreement.

3. The Concept Review on page 1043 can provide a framework for analyzing the Chapter

Introductory Problem.

4. Log On (p. 1042): The RUPA is not only a source of law, but also a source of content for

the partnership agreement. Many partnership agreements parrot the content of the RUPA.

It is better to use the RUPA as a foundation and to modify it to meet the partners’ needs.

IV. RECOMMENDED REFERENCES

See the references in Instructor’s Manual Chapter 37.

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