Is Loss Sharing an “Indispensable Essential” of Partnership?
September 06, 2022
What makes a partnership a partnership? What makes a partner a partner? To be clear, I’m referring to partners in a general partnership.
Although the heyday of general partnerships is long past, replaced by other forms of limited liability business entities, we in the business of business divorce still encounter and litigate cases in which two or more individuals, sometimes with written agreements but more often without, enter into an unincorporated, joint business arrangement of some sort only to have a later falling out at which point one or the other players asserts there is no legally cognizable partnership or joint venture, or that there is a partnership but Person X is not a partner.
We’ve seen and frequently written about the latter type of partnership dispute involving law firms organized as limited liability partnerships. LLPs, as they’re known, are simply general partnerships available to certain licensed professionals including lawyers, featuring a qualified form of limited liability unlike the traditional partnership in which the general partners are personally liable for the debts of the partnership. LLPs otherwise are governed by the same, general partnership law that governs any kind of general partnership.
It’s no accident that law firms occupy a disproportionate share of the litigated cases involving disputed partner status. In large part that’s because of the widespread use of the title “partner” for lawyers of a certain seniority who are more accurately defined as contract or non-equity partners, which admittedly sounds like an oxymoron. In many such cases, the dispute hinges on the wording of the partnership agreement — if there is one — and/or the manner of compensation of the disputed partner and/or the firm’s tax reporting of the disputed partner’s compensation and share of the partnership’s capital, income, and loss.
Earlier this year, in my annual Winter Case Notes, I wrote about a December 2021 decision in the Epstein v Cantor case in which the court dismissed all the non-contract claims in a complaint brought by a putative partner of a law firm organized as an LLP against his alleged partner claiming he and others had “raided” the partnership by transferring its assets and clientele to other firms. One factor the court prominently cited in ruling that Epstein was not a partner of the firm was the fact that, under the parties’ written partnership agreement, he received a percentage of a certain portion of the firm’s gross income while all net profits and losses were allocated to the defendant Cantor, as also reflected in the LLP’s tax returns. The decision cited in support the New York Court of Appeals’ 1958 opinion in Steinbeck v Gerosa for the proposition, which I’ve seen expressed in countless cases involving disputed partner status, that “[a]n indispensable essential of a contract of partnership or joint venture, both under common law and statutory law, is a mutual promise or undertaking of the parties to share in the profits of the business and submit to the burden of making good the losses.”
The Court Grants Reargument
Last March, however, the Epstein case took on new life following a motion to reargue by Epstein who argued that Steinbeck was overruled sub silentio by the Court of Appeals’ 2018 opinion in Congel v Malfitano, a wrongful partnership dissolution case that I wrote about here, in which the Court, quoting from a 1939 Court of Appeals opinion in Lanier v Bowdoin, wrote:
The partners of either a general or limited partnership, as between themselves, may include in the partnership articles any agreement they wish concerning the sharing of profits and losses, priorities of distribution on winding up of the partnership affairs and other matters. If complete, as between the partners, the agreement so made controls.
The arguments submitted on both sides focused on the issue of non-shared losses. According to Epstein’s argument, Lanier‘s broad pronouncement endorsing partners’ freedom of contract to allocate losses as they wish, cited with approval almost 80 years later in Congel, effectively abrogates Steinbeck‘s interim observation treating loss sharing as an “indispensable essential” of a partnership, thereby justifying the court’s reconsideration of Epstein’s partnership claims.
The court agreed with Epstein and granted reargument in a Decision & Order issued last March, writing:
In short, the current law seems clear: excepting illegality and public policy considerations, where a partnership agreement exists, it controls, and the partners’ rights and obligations are determined by contract law (Congel, supra at 287-288). . . . [T]he Court is inclined to grant the parties an opportunity to submit briefs reconciling Court of Appeals precedent as to the indispensability [of] profit and loss sharing.
The Court Reinstates Epstein’s Partnership Claims
The parties subsequently filed briefs as directed. Rather than arguing that Congel abrogated Steinbeck, Epstein’s brief sought to reconcile the two by arguing that Steinbeck controls in the absence of a written partnership agreement while Congel controls when, as in the case before the court, there exists a written partnership agreement that varies Partnership Law § 40’s default rule providing “each partner must contribute toward the losses, whether of capital or otherwise, sustained by the partnership according to his share in the profits.”
Cantor’s brief countered that in Congel, unlike the case before the court, the existence of the partnership was not in dispute; that neither Congel nor Lanier involved partnership agreements providing for no sharing of losses; and that a number of post-Congel court decisions continue to follow Steinbeck‘s rule that the essential elements of partnership include sharing of both profits and losses.
In its decision last month, after a thorough review of the parties’ arguments, the court fashioned its own approach to the issue, invoking a multi-factor test laid out in the Appellate Division’s 1988 opinion in Brodsky v Stadlen as follows:
No one characteristic of a business relationship is determinative in finding the existence of a partnership in fact (see, Partnership Law § 11; Reuschlein & Gregory, Agency and Partnership § 262). Case law reveals a series of factors to be considered in determining whether or not there is a partnership: (1) sharing of profits, (2) sharing of losses, (3) ownership of partnership assets, (4) joint management and control, (5) joint liability to creditors, (6) intention of the parties, (7) compensation, (8) contribution of capital, and (9) loans to the organization (see generally, 43 NY Jur, Partnership, §§ 30-40).
Applying those factors to the facts at hand, the court found a mixed bag:
And here, CEM [the law firm] duly registered as a limited liability partnership with the Secretary of State. CEM consistently held Plaintiff out to the public and to clients as a founding partner of CEM. The attorney who drafted the Agreement affirmed that the parties intended their arrangement to comprise a partnership. Plaintiff did not contribute startup capital in the form of money but did contribute in the form of a client base. Cantor was contractually barred from eliminating any area of practice required to service CEM’s clients without Plaintiff’s consent. On the other hand, year after year, CEM filed tax returns with the IRS wherein Schedule B1 shows that Cantor owned 100% of CEM and K-1 shows that Cantor owned 100% of CEM’s capita1. Only Cantor could sign CEM bank account checks. Only Cantor was responsible for maintaining CEM’s books and records. The admission of any new partner required only Cantor’s consent. Lastly, implying that he was not one, the Agreement afforded Plaintiff the right of election to become “a full and equal partner,” which Plaintiff did not exercise. [Footnotes omitted.]
“In short,” the court concluded, “issues of fact abound sufficient to warrant reinstating the claims against the Cantor Defendants.”
We’ll keep an eye on this one. My crystal ball sees a future appeal unless the case settles.
What Kind of Losses Are Being Shared?
The key provision in the partnership agreement in Epstein provides that “net profits and losses generated by the Partnership shall be allocable to Cantor,” which strikes me as a matter of tax accounting rather than addressing partner liability for partnership debt or other third-party obligations. The question is, which type of losses do the cases contemplate when, as Steinbeck put it, an “indispensable essential” of partnership is the mutual promise to “submit to the burden of making good the losses”?
The question leads me to wonder how the controversy over loss-sharing and its impact on partner status in the Epstein case correlates to the raison d’être for LLPs, namely, the limited liability of the LLP partners codified in Section 26(b) of the Partnership Law as an exception to the rule imposing joint and several liability on general partners for the partnership’s debts and obligations. Under Section 26(b), other than personal liability for their own negligence and that of persons under their supervision and control, LLP partners have no liability
for any debts, obligations or liabilities of, or chargeable to, the registered limited liability partnership or each other, whether arising in tort, contract or otherwise, which are incurred, created or assumed by such partnership while such partnership is a registered limited liability partnership, solely by reason of being such a partner or acting (or omitting to act) in such capacity or rendering professional services or otherwise participating (as an employee, consultant, contractor or otherwise) in the conduct of the other business or activities of the registered limited liability partnership.
Do partnership “debts,” “obligations” and “liabilities” either individually or collectively encompass “losses” of the submit-to-the-burden-of making-good-the-losses type mentioned in Steinbeck? If they don’t, and what the cases are talking about when referring to “sharing of losses” is the allocation of any net loss on the LLP’s income statement reflected on the partnership’s tax return, then there’s some irony in the fact that such losses generally confer a tax benefit — not a burden — on the recipient. If, on the other hand, “sharing of losses” does encompass partnership “debts,” “obligations” and “liabilities,” a partnership agreement that allocates 100% of losses to one partner and 0% to the other partner arguably creates an illusion of asymmetric loss-sharing.