Flyover 3 - Partnership Formation and Liability

Welcome to the third agency and partnership flyover lesson. We're getting into partnerships now, and we'll be covering formation and liability.

Partnership Formation

Much like an agency relationship, a partnership can be formed with a simple conversation. A partnership is an association of two or more persons to carry on as co-owners of business for profit. This differs from the principal-agent context because partners are co-owners and do not have the same type of master-servant relationship as you see in the principal-agent context.

Partners do not need to formally sit down and write out a partnership agreement to form a partnership. All it takes is for two or more people to begin carrying on as co-owners of business for profit. They do not need to precisely work out how they will split the profits or all aspects of the business.

You'll want to pay special attention to anyone entitled to a share of the profits. Profit sharing creates a presumption that someone is a partner in a business, but this is only a presumption. If they are not a co-owner or they don't have the kind of control you'd expect a co-owner to have, they're not going to be a partner. Ultimately, you're looking to see whether a particular business relationship meets the definition of a partnership. If it does, you'll analyze the problem through partnership law.

Partnership Permutations

There are different kinds of partnerships. For the MEE, you'll need to know something about three different types of partnerships: general partnerships, limited partnerships, and limited liability partnerships. We'll take each in turn.

General Partnerships

General partnerships are the most basic form of business entity. They spring into being whenever two or more persons carry on as co-owners of a business for profit. Unlike the other forms of partnership, you do not need to file anything with a state government to create this entity. General partnerships are also extraordinarily dangerous because any of the partners in a general partnership remain personally liable for any partnership liability arising during the time that they are general partners.

A creditor must first exhaust the assets of the partnership. Then they are free to go after the personal assets of any partner. This puts any partner in a general partnership at personal risk, whenever any of the other partners does anything on behalf of the partnership. If you see a business and some liability showing up on the MEE, chances are good that you'll have a general partnership question.

Limited Partnerships

Limited partnerships differ from general partnerships in significant ways. Forming a limited partnership requires some filing with the state government to obtain limited liability for the limited partners. Unlike a general partnership, where the default rule is that all partners have the right to control the partnership and act on behalf of the partnership to some extent, the limited partners in a limited partnership are passive investors.

Limited partners lack any ability to control the partnership, and they also avoid personal liability. The general partner of a limited partnership controls the entity and has unlimited personal liability for the partnership. To deal with this, many business lawyers will either avoid this entity or insert a corporate entity to serve as the general partner of the limited partnership.

Limited Liability Partnerships

A limited liability partnership operates much like a general partnership, except that the partners in a limited liability partnership are not personally liable for the partnership's obligations. Partners with personal involvement in misconduct or tortious acts may still have personal liability, but they will only be liable for those things that they personally do, not simply because they are partners in a limited liability partnership.

A general partnership may convert into a limited liability partnership by simply registering with a state. If you see a partnership and there is no discussion of any filing to obtain limited liability, chances are that it's still a general partnership.

Partnership Power

Partners in a general partnership or a limited liability partnership have very similar powers to act on behalf of the partnership. As a default, partners in these entities have apparent authority to act on behalf of the partnership when acting within the scope of the partnership's business. The general partner of a limited partnership will have the power to act on behalf of the partnership and manage its affairs. Limited partners will have little power.

Rights of Partners among Themselves

Most of the rules in this area are simply defaults. They may be freely modified by partners through a partnership agreement.

Profits and Losses

Let's take profits and losses. The default rule is that partners split profits and losses equally. This means that if one partner contributes $100,000 to the partnership and the other partner contributes just $5.75, they will still split profits evenly. They will also split losses evenly. If the partnership suffers a $200,000 loss, each partner in a two-person partnership will be assigned $100,000 in losses.

It may be worth knowing the service partner exception here. If one partner contributes capital to the partnership, meaning that they actually put in money, and the other contributes their services, the service partner ordinarily will not be liable for the other partner's capital losses.

This confuses a lot of people. A service partner in this context is just someone who has not contributed money to the partnership. The service partner will still be personally liable for a general partnership's obligations, but they will not be liable for capital losses. The loss is suffered by the other partners on their investment into the partnership.

An example helps. Imagine we launch a partnership together to market and sell freeze-dried salsa. This is a terrible idea. If I contribute $50,000 and you only contribute services, we still have a general partnership. Let's also imagine that we buy a food dehydrator and thousands of dollars of salsa. We dehydrate all that salsa, and it turns out that no one wants to buy dried-out salsa.

We lose all of the $50,000 I contributed and decide to close down the partnership. Normally, losses are allocated evenly between the partners. This means that you would have a $25,000 loss allocated to you and that you would owe the partnership $25,000. As the partner who contributed $50,000, I'd have a $25,000 loss allocated to me. The partnership would owe me $25,000 to close out my account.

The service partner exception only applies in this kind of scenario. It will let the service partner escape liability for the capital partner's losses. Instead of having to contribute some funds to cover the loss assigned to her, the service partner does not need to contribute anything in this situation. The capital partner absorbs the entire loss. Service partners still remain liable for everything else under general partnership law.

Management Disputes

If disputes arise between partners about how to manage the partnership, the default rule is that a simple majority will control for ordinary business decisions, with unanimity being required for something extraordinary.

If you're not certain about the precise line between ordinary and extraordinary, you're not alone. Extraordinary decisions are radical departures from the partnership's existing business. For example, signing a lease might be an ordinary business decision and governed by a simple majority requirement. A partnership agreement could change that default and say that any lease requires unanimity or two-thirds majority of partners. But the default rule is simple majority for ordinary business decisions.

Duty of Care

The duty of care in the partnership context is a little bit different. A partner is not liable to the partnership if they are negligent. A partner's negligence may cause the partnership to face liability, but this does not mean that the partner violated their duty of care to the partnership. There are still limits. A partner violates her duty of care if she engages in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.

This higher liability standard puzzles some people. To be abundantly clear, the duty of care applies to disputes between the partners, not in a dispute between the partnership and a third party. As partners in a general partnership assume personal liability for the other partner's actions, the best way to avoid liability is to not have reckless partners.

Duty of Loyalty

Partners in a partnership also owe duties of loyalty to the partnership. In the partnership context, the duty of loyalty applies to three things: (1) to account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the partnership business or derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity; (2) to refrain from dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest adverse to the partnership; and (3) to refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership.

This can be difficult to remember. I think of it this way: no stealing, no self-dealing, and don't compete with the partnership.

Summary

When it comes to partnerships, you should go in at least knowing these three things. A general partnership arises whenever two or more people carry on as co-owners of business for profit. No one needs to intend or actually form a partnership for one to arise.

Partners owe each other fiduciary duties. The duty of loyalty in this space covers three things: no stealing, no self-dealing, and no competing with the partnership. Negligence is not a violation of a partner's duty of care. Limited partnerships are usually passive investment vehicles. The general partner will be the only person involved with personal liability.