Breaking Up is Hard To Do – Chapter 1

Business entities can take many forms, from the large publicly traded corporation to the limited partnership or limited liability company with sophisticated investors to the simple business a handful of people form. While corporations, limited partnerships and LLCs require some affirmative steps to form, the general partnership is the law’s “default” business organization: what you have if the facts fit nothing else. 

Fortunately Texas’s principal partnership statutes establish a set of rules to govern a partnership that were designed for, and work well with, a small, informal group of co-owners of a business. Partners are free to vary these rules by agreement, in most cases orally or by practice.

The Texas Legislature recently codified all business entity statutes into the Texas Business Organizations Code (“TBOC”). The TBOC currently applies only to entities formed under Texas law on or after January 1, 2006, and any entities formed under Texas law before that date that affirmatively have elected to be governed by the TBOC. Entities formed under Texas law on or before December 31, 2005, that have not elected to be governed by the TBOC remain subject to prior law. In the case of a general partnership, that is the Texas Revised Partnership Act (“TRIM”). Effective January 1, 2010, the TBOC will apply to all Texas entities regardless of the date of formation. As the TBOC was intended as a codification of existing law, its provisions affecting general partnerships (or other entities) do not differ materially from prior law.

If the parties properly have filed a certificate or articles of incorporation, a certificate of limited partnership, or some other formation document with a governmental agency, then in almost every instance their relationship will be treated as a corporation, limited partnership, limited liability company, or whatever else the formation document states. The statute governing that type of entity controls the entity’s internal affairs and its dealings with third parties. That statute may provide, of course, that the parties may vary the statutory rules by agreement, perhaps in all cases, perhaps in some, and perhaps only if the change is agreed in writing.

If the parties have not properly filed an instrument of formation, one should consider whether their relationship is a general partnership. Under the TBOC: An association of two or more persons to carry on a business for profit as owners creates a partnership, regardless of whether: (1) the persons intend to create a partnership; or (2) the association is called a “partnership,” “joint venture,” or other name. 

Points to note from the definitions Under this definition of partnership: • No filing is required. • No written agreement is required. • The persons involved do not need to use the words partners or partnership. • The statute says “to carry on a business,” which implies the intent to carry on is sufficient; there is no need for them in fact to do so. • The goal must be a “business for profit.” A non-profit purpose is insufficient for a partnership, but that, taken with “to carry on,” suggests a profit motive is sufficient even if the relationship loses money. • The persons must be associated “as owners.” Principal and agent, lender and borrower, and other persons may associate and intend to make a profit, but they are not partners. Ownership implies joint control, which often is the most important factor in determining if a relationship is a partnership—and can be the most difficult to analyze.

Factors suggesting a partnership The statute goes on to provide that the following factors suggest a partnership: • Receipt of or right to receive profits • Expression of intent to be partners • Participation in the right to control the business • Sharing of or agreement to share losses or liabilities • Contributions of or agreements to contribute money

Factors insufficient to establish a partnership At the same time, any of the following by itself is not sufficient to find a partnership: • Receipt of or right to receive profits in repayment of debt, as wages, as rent, in liquidation of a former partner’s interest, or in consideration of the sale of a business • Co-ownership of property • Sharing of or right to share gross returns • Ownership of mineral property even if subject to a joint operating agreement.

Applying these principles to a common scenario —a group of musicians in a band or other performance artists who have not entered into a written agreement and have not made any filing with a government agency—it is easy to conclude that their relationship is a partnership. Two or more persons have been associated to carry on a business (live or recorded performances) making or hoping to make a profit, and in most circumstances they make decisions jointly or by ceding control to one or more members.

They may have never used the word partner or partnership to describe themselves or their relationship. Yet they probably have contributed cash or other property to their joint enterprise, have shared profits from their successful performances or recordings, and have shared losses from their unsuccessful ones. That is a partnership. Of course, it may not be just the performers themselves who advance funds, share in cash received, and/or participate in making decisions. A manager or “angel” very well might be involved in all these features. It is possible that the relationship is one of principal and agent, or of lender and borrower. Depending on the degree of ownership and control, however, they too may be partners. 

The TBOC and TRPA set out many principles to govern the partners’ relationship with one another and the partnership and to govern the partnership’s relationship with third parties. Partners have broad freedom to design their own agreement among themselves. In most informal partnerships, however, they have not done so, at least not through a written agreement that unambiguously states the rules that apply. Where a written agreement is absent and an oral agreement is not proven, the statutory rules would control.

Below are some statutory rules that frequently are relevant. Almost all may be changed by agreement of the partners. That agreement can be inferred from conduct as well as a written, signed, instrument. But if not changed these are the rules that apply by default. 

Sharing of profits and losses: Sharing of profits is per capita. Sharing of losses follows sharing of profits; thus if the partner did not agree to a different sharing of profits, losses also are borne per capita.

One partner, one vote: Each partner has an equal vote in management of the partnership. Ordinary decisions are controlled by a simple majority; actions outside the ordinary course require unanimous approval.

Apparent authority: Each partner is an agent of the partnership with apparent authority to bind the partnership in the ordinary course of its business. If the partner acts beyond any limitations on that scope imposed by agreement with or vote of the other partners, then unless the third party with whom the partner is dealing is aware of that lack of authority, the partnership nonetheless is bound.  

Joint and several liability: Each partner is jointly and severally liable with the partnership and the other partners for the debts and obligations of the partnership. 

Duties: Partners owe duties of care and loyalty to one another and the partnership. The latter embraces important concepts such as using partnership property only for partnership purposes, not competing, and bringing business opportunities within the partnership’s scope to all the partners. 

No ownership of partnership property: Partnership property belongs to the partnership, not any individual partner. 

Unanimous vote to admit new partners: All partners must agree to the admission of any new partner.

No right to expel: Ordinarily a group of partners may expel another partner only if they have an agreement providing for expulsion and follow its requirements and procedures.

Power to withdraw: A partner has the power to withdraw at any time. If the partner has agreed not to withdraw, or if the partnership has a definite term or is for a particular undertaking and the withdrawal occurs before the term or the undertaking is complete, the withdrawal nonetheless is effective but the partner may be liable for damages and subject to other remedies.

Redemption of withdrawn partner’s interest: If a partner withdraws, then unless the remaining partners wind up the business, the partnership must redeem the withdrawn partner’s interest for its “fair value.”24 If the partnership and the partner have not reached agreement on this fair value within 120 days, the partnership must pay its estimate of the amount owed, and either the partnership or the withdrawn partner may institute a legal action to determine the correct amount. 

Winding up: A partnership is wound up on vote of a majority- in-interest if it has no definite term or particular undertaking. If it has a definite term or particular undertaking, then it is wound up at that time or by unanimous agreement of the partners. On a winding up, the partners who have not wrongfully caused the winding up control the liquidation of the partnership’s assets and settlement of liabilities, although a partner or a partner’s legal representative may petition a court “for good cause” to have a third party conduct the winding up. Profits and losses are allocated to capital accounts, and partners must contribute if assets are insufficient to cover obligations.

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