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41.2 Operation: The Partnership and Third Parties

Learning Objectives

  1. Understand the partners’ and partnership’s contract liability.
  2. Understand the partners’ and partnership’s tort and criminal liability.
  3. Describe the partners’ and partnership’s tax liability.

By express terms, the law of agency applies to partnership law. Every partner is an agent of the partnership for the purpose of its business. Consequently, the following discussion will be a review of agency law, covered in Chapter 40 "Partnerships: General Characteristics and Formation" as it applies to partnerships. The Revised Uniform Partnership Act (RUPA) adds a few new wrinkles to the liability issue.

Contract Liability

Liability of the Partnership

Recall that an agent can make contracts on behalf of a principal under three types of authority: express, implied, and apparent. Express authority is that explicitly delegated to the agent, implied authority is that necessary to the carrying out of the express authority, and apparent authority is that which a third party is led to believe has been conferred by the principal on the agent, even though in fact it was not or it was revoked. When a partner has authority, the partnership is bound by contracts the partner makes on its behalf. Section 41.4.2 "Partnership Authority, Express or Apparent", Hodge v. Garrett, discusses all three types of authority.

The General Rule

Section 305 of RUPA restates agency law: “A partnership is liable for loss or injury, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course”RUPA Section 305. of partnership business or with its authority. The ability of a partner to bind the partnership to contract liability is problematic, especially where the authority is apparent: the firm denies liability, lawsuits ensue, and unhappiness generally follows.

But the firm is not liable for an act not apparently in the ordinary course of business, unless the act was authorized by the others.RUPA, Section 301(2); UPA, Section 9(2). Section 401(j) of RUPA requires the unanimous consent of the partners for a grant of authority outside the ordinary course of business, unless the partnership agreement provides otherwise.

Under the Uniform Partnership Act (UPA) Section 9(3), the firm is not liable for five actions that no single partner has implied or apparent authority to do, because they are not “in the ordinary course of partnership.” These actions are: (1) assignment of partnership property for the benefit of creditors, (2) disposing of the firm’s goodwill (selling the right to do business with the firm’s clients to another business), (3) actions that make it impossible to carry on the business, (4) confessing a judgment against the partnership, and (5) submitting a partnership claim or liability. RUPA omits that section, leaving it to the courts to decide the outer limits of the agency power of a partner. In any event, unauthorized actions by a partner may be ratified by the partnership.

Partnership “Statements”

New under RUPA is the ability of partnerships, partners, or even nonpartners to issue and file “statements” that announce to the world the establishment or denial of authority. The goal here is to control the reach of apparent authority. There are several kinds of statements authorized.

A statement of partnership authorityA public filing setting out or limiting partners’ authority. is allowed by RUPA Section 303. It specifies the names of the partners authorized, or not authorized, to enter into transactions on behalf of the partnership and any other matters. The most important goal of the statement of authority is to facilitate the transfer of real property held in the name of the partnership. A statement must specify the names of the partners authorized to execute an instrument transferring that property.

A statement of denialA public filing that a partner has no authority to perform some act(s) on the firm’s behalf or that a person is not a partner., RUPA Section 304, operates to allow partners (and persons named as partners) an opportunity to deny any fact asserted in a statement of partnership authority.

A statement of dissociationA public filing that a partner is withdrawing from the firm., RUPA Section 704, may be filed by a partnership or a dissociated partner, informing the world that the person is no longer a partner. This tells the world that the named person is no longer in the partnership.

There are three other statements authorized: a statement of qualification establishes that the partnership has satisfied all conditions precedent to the qualification of the partnership as a limited liability partnership; a statement of foreign qualification means a limited liability partnership is qualified and registered to do business in a state other than that in which it is originally registered; and a statement of amendment or cancellation of any of the foregoing.RUPA, Section 1001(d); RUPA, Section 1102. Limited liability partnerships are taken up in Chapter 42 "Hybrid Business Forms".

Generally, RUPA Section 105 allows partnerships to file these statements with the state secretary of state’s office; those affecting real estate need to be filed with (or also with) the local county land recorder’s office. The notices bind those who know about them right away, and they are constructive notice to the world after ninety days as to authority to transfer real property in the partnership’s name, as to dissociation, and as to dissolution. However, as to other grants or limitations of authority, “only a third party who knows or has received a notification of a partner’s lack of authority in an ordinary course transaction is bound.”RUPA, Section 303, Comment 3.

Since RUPA is mostly intended to provide the rules for the small, unsophisticated partnership, it is questionable whether these arcane “statements” are very often employed.

Personal Liability of Partners, in General

It is clear that the partnership is liable for contracts by authorized partners, as discussed in the preceding paragraphs. The bad thing about the partnership as a form of business organization is that it imposes liability on the partners personally and without limit. Section 306 of RUPA provides that “all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law.”RUPA, Section 306. Section 13 of UPA is in accord.

Liability of Existing Partners

Contract liability is joint and several: that is, all partners are liable (“joint”) and each is “several.” (We usually do not use several in modern English to mean “each”; it’s an archaic usage.) But—and here’s the intrusion of entity theory—generally RUPA requires the judgment creditor to exhaust the partnership’s assets before going after the separate assets of a partner. Thus under RUPA the partners are guarantors of the partnership’s liabilities.RUPA Section 306.

Under UPA, contract liability is joint only, not also several. This means the partners must be sued in a joint action brought against them all. A partner who is not named cannot later be sued by a creditor in a separate proceeding, though the ones who were named could see a proportionate contribution from the ones who were not.

Liability of Incoming Partners

Under RUPA Section 306(b), a new partner has no personal liability to existing creditors of the partnership, and only her capital investment in the firm is at risk for the satisfaction of existing partnership debts. Sections 17 and 41(7) of UPA are in accord. But, again, under either statute a new partner’s personal assets are at risk with respect to partnership liabilities incurred after her admission as a partner. This is a daunting prospect, and it is the reason for the invention of hybrid forms of business organization: limited partnerships, limited liability companies, and limited liability partnerships. The corporate form, of course, also (usually) obviates the owners’ personal liability.

Tort and Criminal Liability

Partnership Liability for Torts

The rules affecting partners’ tort liability (discussed in Section 41.2.1 "Contract Liability") and those affecting contract liability are the same. Section 13 of UPA says the partnership is liable for “any wrongful act or omission of any partner acting in the ordinary course of the business of the partnership or with the authority of his co-partners.”UPA, Section 13.A civil “wrongful act” is necessarily either a tort or a breach of contract, so no distinction is made between them. (Section 305 of RUPA changed the phraseology slightly by adding after any wrongful act or omission the words or other actionable conduct; this makes the partnership liable for its partner’s no-fault torts.) That the principal should be liable for its agents’ wrongdoings is of course basic agency law. RUPA does expand liability by allowing a partner to sue during the term of the partnership without first having to get out of it, as is required under UPA.

For tortious acts, the partners are said to be jointly and severally liable under both UPA and RUPA, and the plaintiff may separately sue one or more partners. Even after winning a judgment, the plaintiff may sue other partners unnamed in the original action. Each and every partner is separately liable for the entire amount of the debt, although the plaintiff is not entitled to recover more than the total of his damages. The practical effect of the rules making partners personally liable for partnership contracts and torts can be huge. In his classic textbook Economics, Professor Paul Samuelson observed that unlimited liability “reveals why partnerships tend to be confined to small, personal enterprises.…When it becomes a question of placing their personal fortunes in jeopardy, people are reluctant to put their capital into complex ventures over which they can exercise little control.…In the field of investment banking, concerns like JPMorgan Chase used to advertise proudly ‘not incorporated’ so that their creditors could have extra assurance. But even these concerns have converted themselves into corporate entities.”Paul A. Samuelson, Economics (New York: McGraw-Hill, 1973), 106.

Partners’ Personal Liability for Torts

Of course, a person is always liable for his own torts. All partners are also liable for any partner’s tort committed in the scope of partnership business under agency law, and this liability is—again—personal and unlimited, subject to RUPA’s requirement that the judgment creditor exhaust the partnership’s assets before going after the separate assets of the partners. The partner who commits a tort or breach of trust must indemnify the partnership for losses paid to the third party.RUPA, Section 405(a).

Liability for Crimes

Criminal liability is generally personal to the miscreant. Nonparticipating copartners are ordinarily not liable for crimes if guilty intent is an element. When guilty intent is not an element, as in certain regulatory offenses, all partners may be guilty of an act committed by a partner in the course of the business.

Liability for Taxes

Corporate income gets taxed twice under federal law: once to the corporation and again to the shareholders who receive income as dividends. However, the partnership’s income “passes through” the partnership and is distributed to the partners under the conduit theoryThe theory that a business entity does not itself owe taxes on income; it only acts as a pass-through for its members to receive income.. When partners get income from the firm they have to pay tax on it, but the partnership pays no tax (it files an information return). This is perceived to be a significant advantage of the partnership form.

Key Takeaway

The partnership is generally liable for any contract made by a partner with authority express, implied, or apparent. Under RUPA the firm, partners, or even nonpartners may to some extent limit their liability by filing “statements” with the appropriate state registrar; such statements only affect those who know of them, except that a notice affecting the right of a partner to sell real estate or regarding dissociation or dissolution is effective against the world after ninety days.

All partners are liable for contracts entered into and torts committed by any partner acting in or apparently in the normal course of business. This liability is personal and unlimited, joint and several (although under UPA contract liability it is only joint). Incoming partners are not liable, in contract or in tort, for activities predating their arrival, but their capital contribution is at risk. Criminal liability is generally personal unless the crime requires no intention.

Exercises

  1. What is the partnership’s liability for contracts entered into by its partners?
  2. What is the personal liability of partners for breach of a contract made by one of the partnership’s members?
  3. Why would people feel more comfortable knowing that JPMorgan Bank—Morgan was at one time the richest man in the United States—was a partnership and not a corporation?
  4. What is the point of RUPA’s “statements”? How can they be of use to a partner who has, for example, retired and is no longer involved in the firm?
  5. Under what circumstances is the partnership liable for crimes committed by its partners?
  6. How is a partnership taxed more favorably than a corporation?