The situation is not uncommon. Business partners in a partnership dispute often simply move the business over to another entity and try to proceed without the problematic partner. And they fail to confer with an experienced business attorney to help with the process. However, in a strong (but unreported) opinion by the California Court of Appeals, the court held that a wind-up of the partnership business must actually involve a wind-up, accounting and distribution of assets rather than a self-dealing conversion of partnership assets by some of the partners to the detriment and without the consent of the other partner or partners.
In a case entitled Chmait v. Heritage Asset Management, Inc., the court sets forth the story of the four partners. In August 2013 the partners formed a general partnership by oral agreement. The business involved student debt consolidation. The business would consolidate student loan debt into one loan that the business would service and take a fee.
The four partners decided to each take an equal stake in the business at 25% each and would share equally in its profits and losses. They would equally share the ownership of partnership assets and partnership business opportunities. Decisions of the partnership were to be made by majority vote. The business opened its doors in August 2013.
The Partnership Dispute
By early 2014 three of the partners were growing concerned about the performance of the fourth partner. They eventually sat down with him and offered him two options: He could walk away from the partnership and take a 5 percent share of partnership profits in perpetuity. Or he could remain a partner, but with a reduced 10 percent stake. The fourth partner refused both options and did not think that his partners had the right to unilaterally reduce his partnership stake.
Forming A New Company
The partners formed a S-Corporation in early 2014 for unrelated reasons. They set up a bank account and filed article of incorporation but no other corporate formalities were observed until June of that year and the corporation lay dormant.
The Fourth Partner Is “Expelled” From The Partnership
Upon discovering that the fourth partner had printed two copies of the partnership’s customer list, the three partners locked him out of the company’s computers and told him he was terminated from the partnership. They took away his management duties and purported to take away his ownership stake.
All four partners met but were unable to agree on a fair partnership buyout price. The fourth partner insisted he still owned 25% while the others insisted that they had reduced his ownership share. After the fourth partner stormed out of the meeting, the other three agreed to dissolve the partnership.
“Winding Up” The Partnership (Without The Help Of A Corporate Attorney)
The court points out that the three partners did not seek professional advice on winding up the partnership but attempted to do it on their own. The did not prepare a formal list of creditors or assets, nor did they prepare a formal accounting to find out the true scope of the partnership’s assets, liabilities, profits and losses.
Instead they identified the partnership’s creditors and entered into agreements with them to settle the partnership’s debts. No evidence of this was introduced at trial.
The three partners then started depositing incoming funds into the new S-Corp rather than the partnership. They also transferred all of the partnership’s assets –including client lists, office furniture, computer equipment and CRM software—to the new corporation. The new corporation did not pay anything for these assets Partnership employees were terminated and offered employment at the new corporation. They terminated the partnership’s lease and leased new office space in the name of the new corporation.
Then in June 2014 the three partners issued themselves shares in the new corporation and excluded the fourth partner. They named themselves corporate officers and directors and operated the same student loan consolidation business under the new entity’s name.
The Fourth Partner Files A Partnership Lawsuit
The fourth partner filed a lawsuit against the other three and the new entity alleging 11 causes of action: breach of the partnership agreement, conversion of partnership assets, actual fraud, constructive fraud, conspiracy to convert the partnership assets, accounting, breach of fiduciary duty, breach of corporate opportunity doctrine, interference with economic relations, unfair competition, and declaratory relief.
After the court phase of a bifurcated trial, the trial court held that the three partners had expelled the fourth partner and dissolved the partnership in good faith. However, it also held that they did not have the legal right to unilaterally reduce his ownership stake, and at the time of the dissolution, he was entitled to 25 percent of whatever remained after wind-up. Furthermore, it found the three dissolving partners breached their fiduciary duties by transferring the partnership’s assets to the new corporation for no consideration, but this transfer was still a liquidation and, coupled with their settlement of partnership debts, it effectuated the termination of the partnership.
The trial court then ordered an accounting and appointed a Referee to determine the fair market value of the partnership business as of the date of dissolution. The Referee found the business was worth $236,000 and the trial court therefore entered judgment for the fourth partner for $59,000. An appeal followed.
Was The Partnership Wound-Up In Good Faith?
The appellate court first looked at the primary issue in the case: was the partnership even wound-up? The trial court held that the vote to dissolve was valid under Corporations Code section 16801(a) because at least half of the partners expressed their will to dissolve the Partnership and wind up its business. The appellate court presumed this referred to Corporations Code section 16801, subdivision (l), which allowed dissolution in a partnership at will, by the express will to dissolve and wind up the partnership business of at least half of the partners.
The court’s opinion notes that the trial court failed to take into account the second part of the sentence. While there may have been an express will to dissolve, the court could find no indication there was an express will to wind up the partnership business. In fact, the three partners did not seek a dissolution to terminate the partnership’s business. “On the contrary, they wanted to continue operating, just without [the fourth partner]. They dissolved because they couldn’t get him to agree to walk away.”
“Such use of the dissolution mechanism was a breach of the respondent’s fiduciary duty.” The court noted that partnership is a fiduciary relationship, and partners are held to the standard and duties of a trustee in their dealings with each other. In all proceedings connected with the conduct of the partnership every partner is bound to act in the highest good faith to his copartner and may not obtain any advantage over him in the partnership affairs by the slightest misrepresentation, concealment, threat or adverse pressure of any kind.
“Or, to put the point more succinctly, ‘Partnership is a fiduciary relationship, and partners may not take advantages for themselves at the expense of the partnership.’”
Such advantages include usurpation of partnership opportunities. The continuing fiduciary duty which survives dissolution of the partnership is breached if the ex-partner attempts to divert partnership opportunities for his personal benefit to the detriment of his former partners or when the remaining partner exclude the ex-partner from the benefits of an existing partnership opportunity.
Citing to Leff v. Gunter, a 1983 California Supreme Court case, the court notes that the Supreme Court held that a partner’s duty not to compete with the partnership survives his withdrawal from the partnership. It is no less a violation if a partner is permitted to exploit the partnership information and opportunity by the simple expedient of withdrawal from the partnership. In that case the withdrawal from the joint venture was in bad faith because the withdrawal was intended to exclude a partner from a partnership opportunity.
The court in the Chmait case found the current situation to be the same. The partnership was a going concern with active business. Every new customer brought into the business was a partnership opportunity. The three partners dissolved simply to get rid of the fourth partner and exclude him from participating in the partnership’s increasing success. Notably, the trial court rejected this argument, finding that they dissolved in good faith and not for an improper purpose. The appellate court labeled this “problematic”.
The court’s opinion noted that if they simply wished to go on with the business without their fourth partner, their proper legal recourse was to seek to judicially dissociate him from the partnership pursuant to section 16601(5) and follow the buyout procedure under section 16701. “Instead, from what we can see, the respondents used dissolution to squeeze [their partner] out,”
The Partnership’s Business Was Never Even Wound-Up
“Winding up is the process of completing all of the partnership’s uncompleted transactions, of reducing all assets to cash, and of distributing the proceeds, if any, to the partners.” Under the Revised Uniform Partnership Act [RUPA], a person winding up a partnership’s business may preserve the partnership business or property as a going concern for a reasonable time, prosecute and defend actions and proceedings, whether civil, criminal, or administrative, settle and close the partnership’s business, dispose of and transfer the partnership’s property, discharge the partnership’s liabilities, distribute the assets of the partnership pursuant to Section 16807, settle disputes by mediation or arbitration, and perform other necessary acts.
“What was done here looks nothing like the activities outlined above.”
The three partners did settle the partnership debts with creditors, although no record of this was submitted into evidence and the court had no formal record of the creditors and the amounts due or amounts paid. Moreover, the three partners did not “complete” the partnership’s uncompleted transactions—they simply transferred them to their new entity. They admitted that they continued to initiate new business—an act inconsistent with winding-up. They did not reduce the partnership’s assets to cash. In fact, “they transferred the only assets of any material value—the customer agreements—to a corporation they controlled without paying the partnership a dime for them.”
There was no final tax return. There was no evidence the partnership’s up-to-date taxes were paid. There was no accounting at all for assets or liabilities. There were no charges and credits to the partners’ accounts because the three partners did not formally account for the settlement of partnership debts.
The court found puzzling that no partner either shelled out a penny or took one in. There were no distributions to any of the partners. The court asks somewhat sarcastically whether the court is to assume the they broke exactly even in the wind-up?
But they answer this question and find that the partnership was neither wound up nor converted. “It was quite simply plundered and its business usurped in favor of the new respondent entities and their owners—their number now reduced to three.”
The court found that there was no wind-up whatsoever. “From the record before us, it appears [the three partners] orchestrated a misappropriation of the partnership’s assets in order to achieve their desired result of expelling [the fourth partner].”
“Because a wind-up was never
effectuated, the partnership never legally terminated. (See §16802, subd. (a).) Which means it remains in existence today. It is entitled to compensation for the conversion of its assets and opportunities. And [the fourth partner] is entitled to his share of the same.”
Lessons Learned for Partners and Partnership Lawyers
Partners in general partnership (or members in a LLC or shareholders in a corporation) should consult with a business attorney who has experience in partnership matters for advice on how to wind-up the partnership. No one wants to spend the money consulting a lawyer but an experienced attorney at the outset could have saved these partners from years of litigation and the high costs of litigation.
In fact, at the original partnership meeting when the fourth partner stormed out, he is reported to have said “see you in court!” However, instead of consulting with a business lawyer, they then proceeded to try to oust the partner without any legal help. This turned out to be a bad decision.
The bigger lesson is that there is no such thing as a free lunch. The three partners could not just ignore the partnership interest of the fourth partner. They could not just unilaterally eliminate it. (And yet many partners attempt to do just that.)
In a follow-up article, I will address the remedy and damages to be awarded by the court.
Talk to a Partnership Dispute Lawyer
Los Angeles business litigation attorney Laine T. Wagenseller has extensive experience with partnership and corporate lawsuits. He is the founder of Wagenseller Law Firm in downtown Los Angeles. For more information, please review our website or call us at (213) 805-7445.