General Partnerships
Few people now affirmatively elect to form a partnership because so many other options are available.
Even professionals such as lawyers and accountants now have other choices. As we will see in the next
chapter, many partnerships are created accidentally by people unfamiliar with partnership law. In
addition, entrepreneurs who unsuccessfully attempt to form another type of entity may find that they
are general partners instead. For example, if two people intend to form, say, a limited liability company
and fail to satisfy the state’s filing requirements, they will find themselves in a general partnership, a
potentially ugly realization if their business is sued and they, as partners, are personally liable.
Question: Why would anyone choose to form a partnership?
Answer: There was a time when lawyers and accountants had no other choice. Now in most states
they can form professional corporations, LLCs, or LLPs. Barring unusual circumstances, a
partnership is really only appropriate as a joint venture between two corporations. The corporations
have no concerns about liability.
Taxes
A partnership is not a taxable entity, which means that profits flow through to the owners.
Liability
Each partner is personally liable for the debts of the enterprise, whether or not she caused them. Thus,
a partner is liable for any injury that another partner or an employee causes while on partnership
business as well as for any contract signed on behalf of the partnership.
Management
The management of a partnership can be a significant challenge. Unless the partnership agrees
otherwise, partners share both profits and losses equally, and each partner has an equal right to manage
the business. Large partnerships with numerous partners are almost always run by one or a few
partners who are designated as managing partners or members of the executive committee
Management Duties
Partners have a fiduciary duty to the partnership.
Transfer of Ownership
Partners have the right to transfer the value of their partnership interest, not the interest itself.
Formation
Nothing is required in the way of forms, filings, or agreements to form a partnership. If two or more
people do business together, sharing management, profits and losses, they have a partnership, whether
they know it or not, and are subject to all the rules of partnership law.
Partnership by Estoppel
In partnership by estoppel, non-partners are treated as if they were actually partners and are forced to
share liability. A partnership by estoppel exists if:
• Participants tell other people that they are partners (even though they are not), or
they allow other people to say, without contradiction, that they are partners;
• A third party relies on this assertion; and
• The third party suffers harm.
Termination
When a partner quits, that event is called a dissociation. A dissociation is a fork in the road: the
partnership can either buy out the departing partner(s) and continue in business, or wind up the
business and terminate the partnership.
Case: Marsh v. Gentry1
Facts: Tom Gentry and John Marsh were partners in a business that bought and sold racehorses. The
partnership paid $155,000 for Champagne Woman, who subsequently had a foal named Excitable Lady.
The partners decided to sell Champagne Woman at the annual Keeneland auction, the world’s premier
thoroughbred horse auction. On the day of the auction, Gentry decided to bid on the horse personally,
without telling Marsh. Gentry bought Champagne Woman for $135,000. Later, he told Marsh that
someone from California had approached him about buying Excitable Lady. Marsh agreed to the sale.
Although he repeatedly asked Gentry the name of the purchaser, Gentry refused to tell him. Not until
11 months later, when Excitable Lady won a race at Churchill Downs, did Marsh learn that Gentry had
been the purchaser. Marsh became the Excitable Man.
Issue: Did Gentry violate his fiduciary duty when he bought partnership property without telling his
partner?
Excerpts from Justice O’Hara’s Decision: Admittedly, at an auction sale, the specific identity of a
purchaser cannot be ascertained before the sale, but [Kentucky partnership law] required a full
disclosure by Gentry to Marsh that he would be a prospective purchaser. As to the private sale of
Excitable Lady, Marsh consented to a sale from the partnership, at a specified price, to the prospective
purchaser in California. Even though Marsh obtained the stipulated purchase price, a partner has an
absolute right to know when his partner is the purchaser. Partners scrutinize buyouts by their partners
in an entirely different light than an ordinary third-party sale. This distinction is vividly made without
contradiction when Marsh later indicated that he would not have consented to either sale had he known
that Gentry was the purchaser. Under these facts, it is obvious that Gentry failed to disclose all that he
knew concerning the sales, including his desire to purchase partnership property.
[P]artners, in their relations with other partners, [must] maintain a higher degree of good faith due
to the partnership agreement. The requirement of full disclosure among partners as to partnership
business cannot be escaped. Had Gentry made a full disclosure to his partner of his intentions to
purchase the partnership property, Marsh would not later be heard to complain of the transaction.
Finally, Gentry maintains that it is an accepted practice at auction sales of thoroughbreds for one
partner to secretly bid on partnership stock to accomplish a buyout. We would emphatically state,
however, for the benefit of those engaged in such practices, that where an “accepted business practice”
conflicts with existing law, the law, whether statutory or court ordered, is controlling. To hold
otherwise would be chaotic.
Reasoning: A partner has an absolute right to know if his partner purchases partnership property.
Question: Why didn’t Gentry tell Marsh he wanted to purchase the two horses?
Question: Marsh agreed to the price for the private sale of Excitable Lady. Why would Marsh care
whether he sold to a partner or to a stranger?
Answer: In a sale to a stranger, Marsh would assume that he knew at least as much, if not more,
Question: What damages would Gentry be required to pay?
Question: How would you measure profits in this case?
1 642 S.W.2d 574, 1982 KY. LEXIS 315, SUPREME COURT OF KENTUCKY, 1982.
Answer: It would be complicated. If Gentry subsequently sold the horses, then the difference
between what he had paid for them and what he sold them for would be a start. Of course, he
Limited Liability Partnerships
A limited liability partnership (LLP) is a general partnership in which the partners are not liable for the
debts of the partnership. However, partners must file a statement of qualification with state officials
and the LLP must file an annual report.
Additional Case: Apcar v. Gaus2
Facts. Smith & West, LLP had two partners: Michael L. Gaus and John C. West. The partnership
registered in Texas as a limited liability partnership. The Texas statute requires LLPs to renew their
registrations each year, but Smith & West never did so. Four years after its initial registration, the
partnership entered into a lease with MF Partners (which subsequently assigned the lease to Apcar).
Three years into the lease, Smith & West stopped paying rent and abandoned the premises. Apcar filed
suit against the two partners individually and against the partnership. Gaus, West, and Apcar each filed
a motion for summary judgment. The trial court granted Gaus and West’s motions while denying
Apcar’s.
Issue: Were Gaus and West personally liable for payments due under Smith & West’s lease?
Holding: Judgment for Gaus and West reversed, case remanded for further proceedings. Under Texas
law, an LLP must renew its registration each year, or its LLP status expires. Smith & West did not
renew their application before the expiration date; therefore, its status as a limited liability partnership
expired one year after the initial filing. Smith & West entered into the lease three years after this
expiration. Therefore, Gaus and West are not protected from individual liability for the lease
obligations.
Question: Smith & West registered as an LLP once. Why does it matter that it didn’t continue to
renew its registration?
Limited Partnerships and Limited
Liability Limited Partnerships
Limited partnerships are the first of many types of hybrid organizations that combine the limited
liability of a corporation with the tax status of a partnership.
Limited Liability Limited Partnerships
In a limited liability limited partnership, a general partner is not personally liable for partnership debts.
Question: What is the difference between a limited partnership and a limited liability limited
partnership?
Answer: In a limited partnership, the general partner is personally liable for the debts of the
Taxes
2 2005 Tex. App. LEXIS 379 Court of Appeals of Texas, 2005
A limited partnerships is not a taxable entity. Income is taxed only once before landing in a partner’s
pocket.
Formation
The general partners must file a certificate of limited partnership with their Secretary of State.
Management
General partners have the right to manage a limited partnership. Limited partners are essentially
passive investors with few management rights beyond the right to be informed about the partnership
business.
Transfer of Ownership
Limited partners have the right to transfer the value of their partnership interest, but they can sell or
give away the interest itself only if the partnership agreement permits.
Duration
Unless the partnership agreement provides otherwise, limited partnerships enjoy perpetual existence—
they continue even as partners come and go.
Professional Corporations
For many years, professional corporations (PCs) were the only option for professionals who sought to
avoid the unlimited liability of a partnership. Now, LLCs and LLPs are generally more favorable than
PCs because they offer limited liability but are not taxable entities. However, changing from a
professional corporation to an LLP or LLC has its own tax complications. The IRS may consider it to
be a sale of the assets of the professional corporation, causing the organization to incur a substantial
tax liability for capital gains.
Joint Ventures
A joint venture is a partnership for a limited purpose. Large companies who undertake a limited project
together often use them. The text gives the example of the joint venture between Imax Corp. and
cinema operators, whereby Imax would supply its big screens for a share of the box office revenue. If
students completed the joint venture research assignment, ask them to present their results.
General Questions:
What advantages does a joint venture provide to its partners?
What difficulties does it create?
Franchises
Franchises are increasingly common, being popular with down-sized executives, women bumping up
against the glass ceiling, employees tired of the corporate rat race, and people who simply aspire to
owning their own business.
Case: National Franchisee Association v. Burger King Corporation3
Facts: The Burger King Corporation (BKC) would not allow franchisees to have it their way. Instead,
BKC forced them to sell the double cheeseburger (DCB) and, later, the Buck Double (the DCB minus
one slice of cheese) for no more than $1.00. Franchisees alleged that, because this price was below
their cost, they were losing money on every double cheeseburger they sold. The National Franchisee
Association (NFA), to which 75% of BKC’s individual franchisees belonged, filed suit alleging that (1)
BKC did not have the right to set maximum prices; and (2) that even if BKC had such a right, it had
violated its obligation under the franchise agreement to act in good faith.
The court dismissed the first claim because the franchise agreement unambiguously permitted BKC to
set whatever prices it wanted. But the court allowed the NFA to proceed with the second claim. BKC
filed a motion to dismiss.
3 2010 U.S. Dist. LEXIS 123065 United States District Court for the Southern District of Florida, 2010 .
Issue: Was BKC acting in good faith when it forced franchisees to sell items below cost?
Excerpts from Judge Moore’s Decision: The motive of BKC in exercising its discretion to set prices
under the contract is key. [B]ad faith involves a subterfuge or evasion of contractual duties. [T]here are
at least two ways a plaintiff can go about raising a claim of bad faith. Plaintiffs can allege facts
identifying defendant’s improper ulterior motive(s). For example, if a franchisee had evidence that a
franchisor had a secret agenda to take over the franchise and operate it as a company-owned business,
and was deliberately setting prices to weaken the targeted franchisee, such a plaintiff could raise a
claim of bad faith by alleging the existence of that plan.
It is more likely, however, that plaintiffs will lack direct evidence of dishonesty. In these cases,
plaintiffs must allege some facts tending to show that no reasonable person could have thought that the
steps taken by the defendant were a reasonable means of carrying out the contract’s defined purposes.
If no reasonable person would have exercised discretion as defendant had, the natural inference is that
defendant must have had some hidden improper motive.
[T]he magnitude of the injury claimed by plaintiff is of central importance. [A]n inference of bad faith
may arise when the defendant exercises discretion in such a manner as to effectively destroy whatever
benefits the plaintiff could have reasonably expected under the contract. The logic is that the measure
with such severe results could not have been within the contemplation of the parties.
[N]one of the facts alleged by plaintiffs are sufficient to support a claim of bad faith. Plaintiffs rely
principally on their allegation that franchisees could not produce and sell DCB or Buck Doubles at a
cost less than $1.00, and therefore that franchisees suffer a loss on each of these items sold. There are a
variety of legitimate reasons why a firm selling multiple products may choose to set the price of a
single product below cost. Among other things, such a strategy might help build goodwill and customer
loyalty, hold or shift customer traffic away from competitors, or serve as loss leaders to generate
increased sales on other higher margin products.
The issue is not whether such a strategy was wise or ultimately successful or mistaken. In the absence
of some other evidence of improper motive, the question is whether it was so irrational and capricious
that no reasonable person would have made such a decision. There is nothing about the pricing decision
that suggests BKC was doing anything other than seeking to promote the performance of its
franchisees. Nothing about this action suggests bad faith.
[T]o the extent plaintiffs seek to raise a claim of bad faith by pointing to the injuries allegedly caused
them by BKC’s decision, plaintiffs must allege that the damage to their overall business was so severe
as to deprive them of their reasonable expectations under the contract. Plaintiffs come nowhere close to
alleging such an impact. Significantly, nowhere do plaintiffs claim that their overall business has been
appreciably impaired. Nor do they allege that their overall businesses are no longer profitable or that
their competitive positions or economic viability going forward are threatened.
For the foregoing reasons, it is ORDERED AND ADJUDGED that Defendant’s Motion to Dismiss is
GRANTED.
Note: The franchisees agreed to dismiss the lawsuit and entered into an agreement giving the
franchisees more input on the price of items on its value menu and on how long special deals run.
Question: Were BKC’s action done in bad faith?
Additional Case: Kieland v. Rocky Mountain Chocolate Factory4
Facts: Rocky Mountain is a franchisor of stores that sell chocolate and other candies. Kristine and
Scott Kieland’s Rocky Mountain store failed four years after they purchased it. Kathleen and Stanford
Evavold’s franchise was not as profitable as they thought it would be. Rocky Mountain had given both
4 2006 U.S. Dist. LEXIS 76057, United States District Court for the District of Minnesota, 2006.
the Kielands and the Evavolds a uniform franchise offering circular (UFOC) before they signed their
franchise agreements.
Rocky Mountain required that its franchisees purchase a point of sale cash register system (POS
System). At the time the Kieland’s signed their agreement the POS System was $3,000 per register
with an annual maintenance fee of $773. Their agreement stated, “We may require you to upgrade or
update your POS Systems. No contractual limitation exists on the frequency or cost of this obligation.”
Shortly after signing their agreement, the Kielands learned that they would have to purchase a new
POS System (referred to as AIM) for $20,000 per register with an annual maintenance fee of almost
$2,000.
Stanford Evavold e-mailed a pro forma budget to Kraig Carlson, a Rocky Mountain salesperson.
The email stated, “I don’t believe you can state if these (numbers) appear reasonable, but maybe you
can tell me if it is a “rainy day” or a “sunny day.” Carlson responded that the numbers “did not raise
any issues with him.” Based on this, the Evavold’s signed another agreement that stated “The
Franchisee acknowledges and agrees that no representations have been made to it by the Franchisor
regarding projected sales volumes, market potential, revenues, or profits of the Franchisee’s Store.”
The Kielands and the Evavolds sued Rocky Mountain for violating the Minnesota Franchise Act by
failing to disclose the cost of the new AIM system and by approving Evavold’s earnings estimate. Had
they known all the relevant facts, the Kielands and the Evavolds would not have purchased a Rocky
Mountain franchise. Rocky Mountain filed a motion for summary judgment.
Issue: Did Rocky Mountain violate Minnesota franchise law?
Holding: No, Rocky Mountain’s motion for summary judgment is granted. According to the court, the
Kieland’s claim that Rocky Mountain failed to disclose the cost of the new AIM system fails as a
matter of law. Pursuant to the UFOC singed by the Kielands, Rocky Mountain had the right to require
franchisees to “upgrade or update” the POS System. Although the expense of the AIM system was
approximately $13,000 more that the [old] system, and the maintenance fee was approximately $1,200
more, the UFOC authorized Rocky Mountain to require the Kielands to make such an upgrade.
Similarly, the Evavolds claim that Carlson gave them an earnings claim by replying to their email
that the numbers “did not raise any issues” fails as a matter of law. The UFOC signed by the Evavolds
clearly states that Rocky Mountain does not authorize its sales personnel to make any oral projections
regarding a franchisee’s potential success.
Question: If the purpose of the offering circular is to ensure that the franchisor discloses all
relevant facts, was that purpose achieved with the Rocky Mountain offering circular?
Answer: Not according to the Keilands and Evavolds. According to them, the circular did not state
Question: Why did Stanford Evavold ask the Rocky Mountain sales person his opinion about their
budget?
Answer: Probably because he was worried that his franchise was not making as much money as he
Question: What is wrong with that?
Answer: It may not be wrong to ask, but the court made it clear that it was wrong to rely on any
Suggested Additional Assignment
If your students obtained a copy of a franchise offering circular, this would be a good time to discuss it.
Question: In examining a franchise circular, what factors should a potential purchaser look at most
closely?
Answer: Three issues are of particular importance: (1) the financial terms, (2) the success of the
franchises, and (3) the relationship between the franchisor and its franchisees. A buyer should look at
the total cost of the initial investment and annual fees charged as well as any requirements that goods
Multiple Choice Questions
1. A sole proprietorship:
(a) Must file a tax return
(b) Requires no formal steps for its creation
(c) Must register with the Secretary of State
(d) May sell stock
(e) Provides limited liability to the owner
2. CPA QUESTION Assuming all other requirements are met, a corporation may elect to be treated
as an S corporation under the Internal Revenue Code if it has:
(a) Both common and preferred stockholders
(b) A partnership as a stockholder
(c) Seventy-five or fewer stockholders
(d) The consent of a majority of the stockholders
3. A limited liability company:
(a) Is regulated by a well-established body of law
(b) Pays taxes on its income
(c) May issue stock options
(d) Must register with state authorities
(e) Protects the owners from personal liability for their own misdeeds
4. CPA QUESTION A joint venture is a(n):
(a) Association limited to no more than two persons in business for profit
(b) Enterprise of numerous co-owners in a nonprofit undertaking
(c) Corporate enterprise for a single undertaking of limited duration
(d) Association of persons engaged as co-owners in a single undertaking for profit
5. A limited liability partnership:
(a) Has ownership interests that cannot be transferred
(b) Protects the partners from liability for the debts of the partnership
(c) Must pay taxes on its income
(d) Requires no formal steps for its creation
(e) Permits a limited number of partners
6. CPA QUESTION Cobb, Inc., a partner in TLC Partnership, assigns its partnership interest to
Bean, who is not made a partner. After the assignment, Bean asserts the right to (1) participate in
the management of TLC and (2) take Cobb’s share of TLC’s partnership profits. Bean is correct as
to which of these rights?
(a) 1 only
(b) 2 only
(c) 1 and 2
(d) Neither 1 nor 2
Essay Questions
1. Alan Dershowitz, a law professor famous for his wealthy clients (O. J. Simpson among others),
joined with other lawyers to open a kosher delicatessen, Maven’s Court. Dershowitz met with
greater success at the bar than in the kitchen—the deli failed after barely a year in business. One
supplier sued for overdue bills. What form of organization would have been the best choice for
Maven’s Court?
Answer: A sole proprietorship would not have worked, because there was more than one owner. A
partnership would have been a disaster because of unlimited liability. An LLP was a possibility, as
long as the owners did not anticipate selling their shares. A limited liability limited partnership
2. Mrs. Meadows opened a biscuit shop called The Biscuit Bakery. The business was not
incorporated. Whenever she ordered supplies, she was careful to sign the contract in the name of
the business, not personally: The Biscuit Bakery by Daisy Meadows. Unfortunately, she had no
money to pay her flour bill. When the vendor threatened to sue her, Mrs. Meadows told him that he
could only sue the business, because all the contracts were in the business’s name. Will Mrs.
Meadows lose her dough?
3. You Be the Judge: WRITING PROBLEM Cellwave was a limited partnership that
applied to the Federal Communications Commission (FCC) for a license to operate cellular
telephone systems. After the FCC awarded the license it discovered that, although all the limited
partners had signed the limited partnership agreement, Cellwave had never filed its limited
partnership certificate with the Secretary of State in Delaware. The FCC dismissed Cellwave’s
application on the grounds that the partnership did not exist when the application was filed. Did the
FCC have the right to dismiss Cellwave’s application? Argument for Cellwave: The limited
partnership was effectively in existence as soon as the limited partners signed the agreement. The
Secretary of State could not refuse to accept the certificate for filing; that was a mere formality.
Argument for the FCC: When Cellwave applied for a license, it did not exist legally. Formalities
matter.
Answer: The court ruled for the FCC because, under Delaware law, a limited partnership is not
4. Kristine bought a Rocky Mountain Chocolate Factory franchise. Her franchise agreement required
her to purchase a cash register that cost $3,000, with an annual maintenance fee of $773. The
agreement also provided that Rocky Mountain could change to a more expensive system. Within a
few months after signing the agreement, Kristine learned that she would have to buy a new cash
register that cost $20,000, with annual maintenance fees of $2,000. Does Kristine have to buy this
new cash register? Did Rocky Mountain act in bad faith?
5. What is the difference between close corporations and S corporations?
Answer: S corporations are created by the IRS and are not a taxable entity. Close corporations are
6. Pedro and Juan have a business selling ties with fraternity insignia. Pedro finds out that an online
shirt business is for sale. It sounds like a great idea—customers send in their measurements and get
back a custom-made shirt at a price no higher than off-the-rack shirts at the local department store.
Does Pedro have to let Juan in on the great opportunity?
Discussion Questions
1. ETHICS Lee McNeely told Hardee’s officials that he was interested in purchasing multiple
restaurants in Arkansas. A Hardee’s officer assured him that any of the company-owned stores in
Arkansas would be available for purchase. However, the company urged him to open a new store in
Maumelle and sent him a letter estimating first year sales at around $800,000. McNeely built the
Maumelle restaurant, but gross sales the first year were only $508,000. When McNeely asked to
buy an existing restaurant, a Hardee’s officer refused, informing him that Hardee’s rarely sold
company-owned restaurants. The disclosure document contained no misstatements, but McNeely
brought suit alleging fraud in the sale of the Maumelle franchise. Does McNeely have a valid claim
against Hardee’s? Apart from the legal issues, did Hardee’s officers behave ethically? Is all fair in
love, war, and franchising?
Answer: The court found for Hardee’s. Although the court felt that Hardee’s personnel were
2. Leonard, an attorney, was negligent in his representation of Anthony. In settlement of Anthony’s
claim against him, Leonard signed a promissory note for $10,400 on behalf of his law firm, an LLC.
When the law firm did not pay, Anthony filed suit against Leonard personally for payment of the
note. Is a member personally liable for the debt of an LLC that was caused by his own negligence?
3. Think of a business concept that would be appropriate for each of: a sole proprietorship, a
corporation, and a limited liability company.
4. As you will see in Chapter 29, Facebook, Inc. began life as a corporation, not an LLC. Why did the
founder, Mark Zuckerberg make that decision?
5. Corporations developed to encourage investors to contribute the capital needed to create
large-scale manufacturing enterprises. But LLCs are often start-ups or other small businesses. Why
do their members deserve limited liability? And is it fair that LLCs do not have to pay income
taxes?