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.”
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.
Texas Court Rejects Claim by Unpaid Creditor That Two LLC Organizers Were Liable as General Partners
LLC organizers sometimes refer to themselves loosely as “partners” during the preliminary stages of a development project, before they get around to forming their limited liability company, but those words can come back to haunt them. Say, for example, that during the pre-formation phase, one of the organizers signs a contract in his own name, intending that the LLC carry out the contract. The LLC is formed, but then the project doesn’t go forward, the parties fall out, and the organizer that signed the contract can’t pay. In that case the creditor on the contract may seek payment from both the contract signer and the other organizer, on the theory that the organizers were partners and therefore were both liable.
The Lawsuit. That scenario played out in Lentz Engineering, L.C. v. Brown, No. 14-10-00610-CV, 2011 Tex. App. LEXIS 7723 (Tex. App. Sept. 27, 2011). William Wilkins and Alden Brown were planning to purchase and develop a real estate project. Wilkins entered into a contract to purchase the property, and Brown and Wilkins met with an attorney in February 2005 and agreed to form a Texas LLC to carry out the development. In March Brown gave Wilkins $400,000 to purchase the property, and Wilkins acquired the real estate in April. One day later, the attorney filed articles of organization for the LLC, which identified Brown and Wilkins as the LLC’s managers.
During the summer Brown became suspicious of Wilkin’s conduct and attempted to recover his money and obtain title to the property. Meanwhile, Wilkins entered into a contract in his own name with Lentz Engineering for engineering services. Lentz performed its work under the contract but was not paid.
Lentz then sued both Wilkins and Brown for breach of contract. Lentz’s theory was that Wilkins was directly liable on the contract, and that Brown was liable because he was partners with Wilkins and was therefore fully liable for the debts of the partnership. Wilkins defaulted on the lawsuit but Brown defended on the ground that he and Wilkins were not partners.
Judicial Admission. Brown’s first difficulty was self-inflicted. Lentz contended that Brown had judicially admitted in a motion for summary judgment that a partnership existed between Brown and Wilkins. For example, Brown’s motion stated: “Although Wilkins and Brown entered into a partnership to acquire the Manvel property, that partnership was not formed until March 2005.” Brown also made other, similar statements in his motion. Id. at *4-5.
The court dismissed the “judicial admission” contention, because Brown had taken a contrary position in other pleadings and even in the same summary judgment motion. To be considered a judicial admission, a party’s statement must be clear, deliberate, and unequivocal, and Brown’s contradictory statements didn’t satisfy that standard.
Partnership Formation. The court then considered the main argument, i.e., whether Brown and Wilkins had formed a partnership. The Texas statute’s definition of a general partnership is similar to that of most states: an association of two or more persons to carry on a business for profit as owners, regardless of whether the persons intend to create a partnership or whether the association is actually called a “partnership.” Tex. Bus. Orgs. Code Ann. § 152.051(b).
Facts and Circumstances. Whether a partnership exists depends on all the facts and circumstances. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *9. The factors considered in determining if a partnership has been created include:
(a) sharing of profits of the business;
(b) sharing of losses or liability for claims;
(c) contributing or agreeing to contribute money or property to the business;
(d) participating in control of the business; and
(e) expressing an intent to be partners in the business.
Tex. Bus. Orgs. Code Ann. § 152.052. Note that the first three factors – sharing profits, losses, and contributions – are present in almost every LLC. The fourth factor, participating in control, is present in all member-managed LLCs and in some manager-managed LLCs. Only the last factor, expressing an intent to be partners, is not present in an LLC.
The court found uncontroverted evidence of only two of the factors, splitting profits and participating in control of the business. There was contradictory evidence about expressions of intent to be partners. Lentz Eng’g, 2011 Tex. App. LEXIS 7723, at *12-14.
Going the other way, both Wilkins and Brown expressed their intent to form an LLC, they opened a bank account in the name of the LLC, and the Certificate of Organization for the LLC was filed before the date on which Wilkins signed the contract with Lentz Engineering. Id.
The relative timing of filing the Certificate of Organization and signing the contract seems to have carried extra weight with the court:
Although courts have held promoters of a company may be liable on contracts made by other promoters prior to formation of the company as if the promoters were partners, Lentz has not cited any authority to suggest that liability should be imposed on one promoter because of another promoter's conduct after the formation of the company.
Id. at *15. The court concluded that the evidence did not conclusively establish the existence of a partnership and that the trial court’s finding of no partnership was not against the great weight and preponderance of the evidence. The trial court’s ruling in favor of Brown was affirmed.
Lessons Learned. The substantial overlap between an LLC and the five factors listed in the Texas statute is a little scary. New business organizers who refer to each other as partners, before the LLC is created, may rue the day they used that terminology. They may have already discussed and agreed on the first four factors, and if they introduce each other as partners, the stage is set. If one partner signs a contract before the LLC is formed, and then things fall apart and the LLC is not formed, the organizers may find that as partners they are all jointly and severally liable on the contract.
How to avoid this outcome? Expunge the word “partners” from any description of the organizers. One of the great benefits of LLCs is their limited liability; don’t open the door to personal liability by calling yourselves partners.
Organizers should strive to form the LLC early. Any contracts should not be signed until after the LLC is formed, and then they should be signed in the name of the LLC.