New Partnership Law

The California Revised Uniform Partnership Act (RUPA) went into effect January 1, 1997. The new law has not generated much publicity, but it makes fundamental changes to the way partners in general partnerships (GPs) deal with each other, and between GPs and third parties. RUPA also affects relationships among partners of limited partnerships (LPs) and members of limited liability companies (LLCs). These changes will have a profound and long lasting effect on the way these entities do business.

The bottom line message of RUPA is --

(1) When entering into new business relationships, be sure that all parties know and agree in writing to all legal aspects of the relationship.

(2) Be very careful in dealing with current relationships to avoid a minefield of liability.

Preliminary and Fundamental Matters:

Effective Dates: The current Uniform Partnership Act (UPA) applies to all GPs formed before January 1, 1997. UPA also applies to LPs to the extent not covered by the California Revised Limited Partnership Act (RLPA). RUPA is the law for all California GPs formed from January 1, 1997 onward. It is also the law for existing general partnerships that elect to be governed by it. Beginning January 1, 1999, RUPA will apply to all GPs no matter when they were formed. RUPA will also apply to LPs (to the extent not covered by RLPA) under the same schedule.

Formation of Partnership: A partnership is formed whenever two or more persons associate as co-owners to carry on a business for profit, whether formed under UPA or RUPA, unless they explicitly form another type of entity. Even if you do not intend to form a partnership, as long as you have a business for profit, unless you have fulfilled the requirements to form some other entity, you will have formed a GP by implication.

There are specific preliminary requirements for most entities to be formed. For instance, if a corporation is intended, Articles of Incorporation must be filed with the Secretary of State; if an LP is intended, the partners must have a written limited partnership agreement and file Form LP-1; if an LLC is intended, its members (as LLC owners are called) must have a written operating agreement and file Articles of Organization (Form LLC- 1). By comparison, if the persons intend to have no formal entity at all, have not signed a written agreement, and have filed no documents, but are considered to have gone into a business together for profit, they are partners in a GP.

Since general partners have specific duties to each other, and since each general partner is (usually) fully liable to third parties for actions taken in the course of the business, it is dangerous to enter a business relationship with others without carefully defining the relationship and considering the consequences.

This is especially true since September 30, 1994, when the LLC became available as a valid form of entity in California. The prime distinction between a GP and an LLC is this -- the potential liability of an LLC member to third parties is normally limited to the member's investment in the LLC, while a GP partner's potential liability to third parties is unlimited. As a result, there are really no good reasons to enter or form a GP, since an LLC accomplishes the same purpose without the liability exposure. The cost of this limited liability is the $800 annual California tax on LLCs.

The LLC operating agreement is somewhat similar to a GP partnership agreement and requires the same careful planning and documentation to establish well-defined relationships among the parties. Other than certain necessary "fill-in-the-blank" forms that must be filed to form and operate an LLC, there is little difference between the formation and operation of an LLC and that of a well-planned GP with a written partnership agreement.

Since RUPA governs any person considered to be a general partner, it will apply primarily to existing GPs, and to those new business entities who, intentionally or inadvertently, are considered to be GPs. RUPA will apply especially to GPs by way of "default rules" to the extent those rules are not modified by the partnership agreement. RUPA will apply to LPs insofar as general partners of an LP have fiduciary duties to each other and to the limited partners. RUPA also applies to LLCs insofar as LLC managers (who may also be members) have fiduciary duties to other members.

Here is a summary of some of the major changes to partnership law made by RUPA:

Authority to Bind Partnership:

A major source of litigation among partners, as well as between partnerships and third parties, results from actions taken unilaterally by one partner. The typical questions are, did the partner create a partnership obligation to a third party, and if so, is the partner liable to the other partners for acting outside his or her authority?

To address these questions, RUPA has established a system of filing statements with the Secretary of State that provide notice to third parties in major transactions. A GP may file a Statement of Partnership Authority to name those partners authorized to sign an instrument transferring real property, and to specify the authority (or limits of authority) on some or all partners to enter into transactions. A certified copy of the Statement may (and should) be filed with the County Recorder where real property is owned by the partnership.

A purchaser of real estate or other property from a RUPA-governed partnership is entitled to rely on a recorded Statement unless the purchaser has actual knowledge to the contrary. In situations other than purchase transactions, a third party is not deemed to have knowledge of a limitation on a partner's authority merely because the limitation is contained in a filed or recorded Statement; so while the filing system cannot be relied upon in all situations, it adds certainty to a large portion of partnership transactions.

Since almost all real estate transactions, and many other property transactions, will now include investigation of filed and/or recorded Statements, it will force partners to agree in writing on the partners' areas of authority, thus adding certainty to their relationship.

Fiduciary Duties:

Partners in a GP have always been considered "fiduciaries" to each other. The current UPA makes no explicit mention of fiduciary duty, but a large body of case law has developed in the courts. RUPA attempts to define the nature of partners' fiduciary duties in an extensive, explicit manner. Although the State Bar committee that drafted the legislation has stated that the cases decided under UPA would not be decided any differently under RUPA, it remains to be seen whether courts will use the language of RUPA to refine or change the nature of partners' fiduciary duties.

RUPA fiduciary duties include the following:

(1) The duty of loyalty, which the statute says includes:

1. accounting to the partnership for any property, profit or benefit derived by the partner in operating the partnership business or using partnership information (including the use of a business opportunity that would, under customary circumstances, be an opportunity that the partnership would take);
2. not dealing with the partnership as or for an adverse party, except in the partner's capacity as a lender to the partnership; and
3. not competing with the partnership until the partnership has dissolved.

(2) The duty of care, which is limited to avoiding grossly negligent or reckless conduct, intentional misconduct or a knowing violation of law.

(3) The duty of good faith and fair dealing, which underlies all contractual relationships.

The partners may not agree to eliminate the duty of loyalty, nor to "unreasonably" reduce the duty of care, nor to eliminate the obligation of good faith and fair dealing. However, as long as it would not be "manifestly unreasonable", they may identify specific types of activities or authorize (after full disclosure) specific actions that do not violate the duty of loyalty. They may also agree on standards to measure good faith and fair dealing.

Many entities are formed as single-purpose ventures, such as development of one shopping center or the operation of one restaurant. The parties often intend to engage independently in other businesses which might actually compete with the entity's business, such as a shopping center five miles away, or a restaurant serving different cuisine. Without an agreement allowing this kind of competition, the competing party may violate the duty of loyalty. Accordingly, the parties should agree specifically on the kinds of competition that would not violate the duty of loyalty, and to make sure that the allowed competition is not "manifestly unreasonable." Existing court decisions may be of help in defining the boundaries of reasonableness, and legal counsel can assist in drafting appropriate language; but it remains to be seen how the courts will apply this new statutory language.

RUPA's fiduciary duty rules will apply to LPs insofar as general partners of an LP have fiduciary duties to each other and to limited partners. The rules will also apply to LLCs insofar as LLC managers (who may also be members) have fiduciary duties to other members, LPs and LLCs should also check their agreements to ensure compliance with RUPA's fiduciary rules.

RUPA does not limit fiduciary duties to those expressly listed in the statute, but rather, lists those which are included. The courts will likely expand the list to take account of particular situations. Thus, it is important to agree on what activities are not considered violations of fiduciary duties, and to consider whether any of those activities appear unreasonable.

Dissociation:

Another major source of uncertainty and dispute in partnerships has involved a partner's withdrawal from the partnership and the resulting dissolution of the partnership. Under the current UPA, unless the partners have agreed otherwise, a partner's withdrawal or resignation requires the partnership to dissolve and liquidate. There has been no firm assurance of continuity of the partnership business by the remaining partners. RUPA reverses the situation by making a partnership continue on a partner's withdrawal (now called a "dissociation") unless the partnership agreement expressly provides for dissolution when a partner dissociates.

A partner may not give up the power to dissociate, but the dissociation may be "wrongful" if the partnership agreement so provides, in which case the dissociated partner may be liable for damages to the partnership and the other partners. If the partnership continues after the dissociation, the dissociated partner is entitled to be paid for the value of his or her partnership interest, offset by the amount of any such damages and any other amounts he or she owes to the partnership.

RUPA sets rules for determining the buyout price and the time and manner of payment, depending on the circumstances of the dissociation. For instance, a partner who wrongfully dissociates is not entitled to receive payment until the partnership dissolves and winds up its business.

Litigation:

RUPA clarifies the relationships of parties involved in a partnership/nonpartner lawsuit. A partnership may sue in its own name without being joined by the partners. If a partnership is sued, its partners are not parties to the lawsuit unless they are also named. An action may be brought against both a partnership and its partners, either in the same action or in separate actions. A judgment against a partnership is not, by itself, a judgment against its partners.

Under RUPA, a judgment creditor against a partnership is not allowed to obtain the assets of any partner to satisfy the judgment except in limited circumstances, such as exhaustion of remedies against the partnership, determination that the partnership is clearly unable to satisfy the judgment, or the partner's independent contractual obligation to satisfy the judgment.

Conversion to Another Entity:

Partners may want to consider converting their GP to an LLC or other form of entity in light of the limited liability advantages now available. RUPA provides a mechanism for a RUPA-governed GP to convert to an LLC or LP without dissolving the partnership; however, the laws governing LLCs and LPs do not yet contain express provisions for conversion from GPs, so the process is still cumbersome. Legislation is expected to be presented which will allow for easier conversion. Conversion from a GP to a corporation is not allowed; instead, the GP must dissolve and liquidate first, and the former partners may then contribute liquidated assets to a new corporation.

Professional Organizations:

Some confusion has arisen in the choice of entities due to the proliferation in the number of choices now available -- GPs, LPs, LLCs, "C" corporations, "S" corporations, etc. Some professional groups are now organized as "limited liability partnerships." They operate much the same as GPs, but have some of the attributes of LLCs. These entities are limited to accounting and law partnerships, and may not currently be used by any other type of business.

Other professional or business entities that require state licensing may also be limited in the type of entity available. For instance, real estate brokerage companies may not currently organize as LLCs or GPs (although brokers may operate as a partnership, so long as all partners are licensed brokers). You should check with your particular licensing agency to determine what entity choices are available.

Proceed With Caution:

If you are involved in a partnership, or are considering a business relationship with others, we urge you to consult with counsel to determine how to maximize certainty and minimize risk. If you are currently in a partnership, you may want to consider electing to be governed by RUPA. If you are starting a new business, we suggest you consider carefully, with legal counsel and financial advisors, the most advantageous form of entity. Please feel free to call us if you have any questions.

Very truly yours,

RICHARD T. BOWLES
email Mr. Bowles

CHARLES S. GOLDMAN
email Mr. Goldman