Business acquirors sometimes give the acquired company’s management financial incentives to enhance the acquired company’s value. These are often structured as bonus compensation for achieving defined milestones, and sometimes include equity in the acquired company or in the buyer.

In a recent Ohio case the buyer of a company’s assets provided incentive compensation to the company’s management, based on the profits of a division of the company. The employee was later terminated, and claimed the company had entered into a partnership with him and then breached its fiduciary obligations.

Although the contract never referred to a “partnership,” the court held that the incentive compensation provisions created a partnership between the buyer and its employee. Rhodes v. Paragon Molding, Ltd., No. 24491, 2011 Ohio App. LEXIS 3553 (Ohio Ct. App. Aug. 26, 2011). And once the court determined that a partnership existed, the door was opened to the former employee’s claims of breach of fiduciary duty.

Huntin’ Buddy Industries was a seller of turkey and duck calls designed by Roy Rhodes, one of its owners. In 2004 Huntin’ Buddy sold its assets to Paragon Molding, Ltd., an Ohio LLC. As part of the acquisition, Rhodes entered into a five-year employment agreement with Paragon. In the asset sale agreement Rhodes was given profit-sharing rights based on the “Roy Rhodes Championship Call division” (Division).

Fifteen months after the acquisition, Paragon terminated Rhodes’ employment and contended that his profit-sharing rights in the Division were also terminated. Rhodes sued, claiming that the profit-sharing provisions in the asset purchase agreement had created a partnership between Rhodes and either Paragon or its executive officers, and that Paragon and its principal officers had breached their fiduciary obligations to him. The trial court ruled on summary judgment that no such partnership or fiduciary duty existed.

The Court of Appeals first stated the Ohio partnership rule:

A partnership exists when there is (1) an express or implied contract between the parties; (2) the sharing of profits and losses; (3) mutuality of agency; (4) mutuality of control; (5) co‑ownership of the business and of the property used for partnership purposes or acquired with partnership funds.

Id.at **7 (quoting Grendell v. Ohio EPA, 146 Ohio App.3d 1, 764 N.E.2d 1067 (2001)).

The court pointed out that the parties had no express partnership agreement, and then examined the relevant provisions of the Huntin’ Buddy asset purchase agreement. The salient terms were:

1.         “Rhodes will maintain 35% of the value of the [Division].”

2.         “Should [the Division] be sold, Roy Rhodes will be entitled to 35% of the net purchase price related to the [Division].”

3.         “Should [Paragon] be sold as an entirety including [the Division], Roy Rhodes will be entitled to 35% of the net value of the [Division] only.”

4.         “Should any profits be distributed from the [Division], Roy Rhodes will be entitled to 35% of said profits after taxes.”

Id.at **10.

The court’s analysis focused on the co-ownership requirement. The agreement did not say that Rhodes “owns” 35% of the Division. But, said the court, the language “Rhodes will maintain 35% of the value” of the Division meant that the parties intended for Rhodes to retain ownership of 35% of the Division. That interpretation was also supported by the clause that Rhodes is entitled to 35% of distributions of Division profits.

There was also a deposition in the case that may have been the final nail in the coffin of Paragon’s argument. One of Paragon’s owners agreed in his testimony that Rhodes “owned thirty-five percent” of the Division. The Court of Appeals noted that “even the owner of Paragon intended for Rhodes to retain a thirty-five percent ownership interest” in the Division. Id. at **12.

So the court found that an implied partnership had been created. “Accordingly, this evidence supports a conclusion that an implied partnership existed between Rhodes and Paragon such that Rhodes was entitled to ownership of thirty-five percent of the company itself, thirty-five percent of any profit distribution instituted by the company, and thirty-five percent of the net profits generated during the sale of the company.” Id. at **12-13.

Partners in a partnership owe each other fiduciary duties, id. at **7-8, and the court found ample evidence in the record to create a genuine issue regarding whether Paragon had breached its fiduciary duties. For example, Paragon purported to strip Rhodes of his 35% interest when it terminated his employment, and Rhodes was excluded from any involvement in or information about the Division. Result: The Court of Appeals reversed the trial court’s summary judgment dismissing Rhodes’ fiduciary duty claims, and sent the case back for a trial on Rhodes’ fiduciary duty claims.

The court didn’t discuss what type of entity Paragon was, so the result presumably would have been the same if Paragon had been a corporation instead of an LLC. But Paragon’s LLC status may have affected the phraseology used by the drafter of the incentive compensation language. The clause on distributions of profits in particular sounded like it could have come from a partnership or LLC operating agreement: “Should any profits be distributed from the [Division], Roy Rhodes will be entitled to 35% of said profits after taxes.” Although this clause does not directly refer to ownership of the Division, it satisfies part of the definition of a partnership and provides additional support for the court’s conclusion.