Ohio LLC's Incentive Compensation Creates Partnership With Former Employee
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.
Ohio LLC Shields Privacy of Litigation Plaintiffs
Parties to litigation normally cannot keep their identities out of the public eye--plaintiffs and defendants are named in the complaint that starts a lawsuit. Complaints are public documents that are filed with the court. But a group of allegedly defrauded investors in Ohio recently used a limited liability company to bring a securities fraud lawsuit while keeping their names out of the court records.
The events that led to this lawsuit are sadly reminiscent of the Bernie Madoff debacle. Fair Finance Co. is an Ohio loan company founded in 1934. The company was owned by the Fair family and sold investment certificates to Ohio residents for a generation, including to members of Ohio’s Amish community. In 2002 wealthy Indianapolis investor Timothy Durham took control of the company.
In November 2009 the FBI raided Fair Finance’s offices and seized computers and records. Federal investigators suspected that Fair Finance was being operated as a Ponzi scheme, according to court records. The ongoing investigation has not yet resulted in any charges or arrests, but the company and its eight Ohio offices have been closed since November 24, 2009.
On December 21, a lawsuit was filed by a group of Ohio residents against Fair Finance and several other defendants, including Timothy Durham. In their complaint the plaintiffs seek rescission and damages for breach of contract, securities fraud, and negligent misrepresentation.
The lawsuit was brought by 16 plaintiffs. Two are trusts, 13 are individuals, and one is Fair Recovery, LLC. Fair Recovery is an Ohio LLC that was formed on December 10, 2009. According to the complaint, Fair Recovery is pursing the claims of 20 individual investors, all of whom are members of the LLC. The LLC members invested a total of $1,360,000 in Fair Finance.
Under Ohio’s LLC Act, an LLC is formed by filing Articles of Organization, and according to Fair Recovery’s Articles of Organization, its purpose is “to engage in any lawful act or activity.” The Articles are not required to disclose the LLC’s members, and Fair Recovery did not disclose its members' identities.
According to local newspaper reports, some members of the local Amish community invested with Fair Finance and have claims against it. The articles point out that the Amish faith discourages its members from settling disputes in court, and speculate that Fair Recovery was formed to press the legal action on behalf of Amish investors and to keep their names out of the public record. The law firm representing Fair Recovery and the other plaintiffs declined to say whether any are Amish.
This is a rather novel use of an LLC. Apparently Fair Recovery has no other business, and was formed simply to press the claims of its members in the litigation against Fair Finance. Using such an entity would not normally confer any benefit in litigation, so it appears that the only added value it provides is protection of the privacy of its members.
It remains to be seen how well the LLC will hold up as a privacy shield. For one thing, the identity of Fair Recovery’s members will probably become the subject of pretrial discovery procedures. For example, the defendants will be entitled to depose the Fair Recovery members to investigate the details of their claims. But pretrial discovery information is not usually filed with the court, so the identity of the Fair Recovery claimants presumably will be kept out of the court records prior to trial. The trial itself should be open to the public, but it may or may not be necessary at trial for testimony to identify the Fair Recovery members. Fair Finance must know, of course, who its investors are. It can probably determine easily who the Fair Recovery plaintiffs are, and could disclose that information if it chose to do so.
