CASE LAW UPDATE: A SURVEY OF RECENT TEXAS PARTNERSHIP AND LLC CASES

CASE LAW UPDATE: A SURVEY OF RECENT TEXAS PARTNERSHIP AND LLC CASES By Elizabeth S. Miller Professor of Law Baylor University School of Law Waco, Texas The University of Texas School of Law 2008 PARTNERSHIPS, LIMITED PARTNERSHIPS AND LLCs July 17 & 18, 2008 Austin, Texas 2008 Elizabeth S. Miller, All Rights Reserved

2008 Partnerships and Limited Liability Companies Case Law Update: A Survey of Recent Partnership and LLC Cases Elizabeth S. Miller Addendum LLC Veil Piercing Insert within Veil Piercing section beginning on page 74: Gonzalez v. Lehtinen, No. 13-06-441-CV, 2008 WL 668600 (Tex.App. Corpus Christi March 13, 2008, rule 53.7(f) motion granted), summarized under heading Personal Jurisdiction on page 85. Asshauer v. Glimcher Realty Trust, 228 S.W.3d 922 (Tex.App. Dallas 2007, no pet.), summarized under heading Personal Jurisdiction on page 85. Effect of Merger of Limited Partnership into LLC Allen v. United of Omaha Life Insurance Company, 236 S.W.3d 315 (Tex.App. Fort Worth 2007, pet. denied). The court held that a limited partnership s rights as the designated beneficiary of a key man life insurance policy vested in an LLC pursuant to a merger of the limited partnership into the LLC so that the policy proceeds were payable to the surviving LLC. The policy in issue insured the life of Marvin Fred Allen, who was the CEO of CreditWatch Services, L.P., a Texas limited partnership, and the president of the limited partnership s LLC general partner when the policy was purchased in 2001. Allen signed the application in his individual capacity as the insured and in his capacity as president of the LLC general partner as the policy s applicant/owner. He designated the limited partnership as the sole beneficiary. In 2002, the limited partnership merged with an Ohio limited liability company. The survivor of the merger was the Ohio LLC, CreditWatch Services, Ltd. (which later changed its name to CreditWatch Services LLC). The insurance policy s beneficiary designation was never changed. Six months after the merger, Allen died, and the insurer subsequently issued a check in the amount of the policy proceeds payable to CreditWatch Services. CreditWatch Services LLC deposited the check into its account. Allen s widow brought suit claiming that the insurer should have paid the proceeds to Allen s estate because the policy s designated beneficiary ceased to exist after the merger and because the LLC had no insurable interest in Allen s life at the time of his death. The court held that, regardless of whether the limited partnership s interest as beneficiary was characterized as a chose in action or an expectancy, the interest was transferable and vested in the surviving LLC pursuant to the language of the merger agreement and the Texas and Ohio merger statutes. Both the Texas Revised Limited Partnership Act and the Ohio Revised Code provide for the vesting of all rights and interests in the surviving entity without further act or deed, and the terms of the merger agreement were consistent with the statutes. The court rejected the argument that the merger was the corporate equivalent of the death of a natural person beneficiary. The court stated that, while the separate existence of a non-surviving entity ceases, all of its rights and obligations continue to exist in the surviving entity. The court also rejected the argument that, because Allen was no longer employed by the limited partnership or its successors, the surviving LLC had no insurable interest in Allen s life at the time of his death. The court held that the limited partnership had an insurable interest in Allen s life when Allen designated the beneficiary designation and at all times thereafter because the Legislature has enlarged the class of persons considered to have an insurable interest by enacting Sections 1103.054 and 1103.056 of the

Texas Insurance Code. These provisions allow an insured individual to designate or consent to the designation of any individual, partnership, association, or corporation as beneficiary, and Section 1103.053 provides that a beneficiary designated in accordance with these sections has, at all times after the designation, an insurable interest in the life of the insured individual. According to the court, other provisions of the Insurance Code that confer on corporations and partnerships insurable interests in their officers, shareholders, and members do not limit the provisions of 1103.054 and 1103.056 to partnerships in which the insured is a member. Standing American Heritage, Inc. v. Nevada Gold & Casino, Inc., S.W.3d, 2008 WL 340353 st (Tex.App. Houston [1 Dist.] 2008, no pet. h.) (holding that plaintiff had standing to sue for breach of agreement regarding formation of LLC). R2 Enterprises, Inc. v. Whipple, No. 2-07-257-CV, 2008 WL 2553444 (Tex. App. Ft. Worth June 26, 2008, no pet. h.) (mem. op.). The dispositive issue in this case was the lack of standing of the plaintiffs, a 1% general partner and a 49.5% limited partner, to sue the other 49.5% limited partner for damages for breach of the partnership agreement and breach of fiduciary duty. Whipple and Reeves each owned a 49.5% limited partner interest, and R2 Enterprises, Inc. ( R2 ), a corporation owned solely by Reeves, owned a 1% general partner interest in Rivendell Luxury Homes, L. P. ( Rivendell ), which they formed for the purpose of building and selling homes. Rivendell entered into a contract with a developer to buy 12 lots over a total of three years. After Rivendell purchased one lot, built on it, and sold it, Whipple withdrew approximately $89,000 from Rivendell s accounts and later testified that at that time he intended to dissolve the limited partnership. Reeves individually purchased the three additional lots Rivendell was obligated to buy that year and signed a waiver of his and Rivendell s right to purchase the remaining eight lots under contract. Reeves eventually sold the three lots to a third party builder. Whipple testified that with the money he withdrew he paid off the debts incurred in building the Rivendell home and then invested in a rental property company. This company purchased the eight remaining lots from the developer, and Whipple built homes on these lots. Reeves and R2 sued Whipple on numerous causes of action, and Whipple filed counterclaims. Pursuant to a trial amendment, Rivendell was also added as a plaintiff for purposes of certain claims. The jury found that Whipple breached the limited partnership agreement and his fiduciary duty and awarded Reeves and R2 future damages, exemplary damages, and attorney s fees. The jury also found in favor of Rivendell on its causes of action but found that Rivendell suffered no damages. The trial courted initially entered a judgment for Reeves and R2. Whipple sought a JNOV on the grounds that Reeves waived his right to purchase the lots, that only Rivendell had standing or capacity to recover damages, and that Whipple owed no fiduciary duty to Reeves and R2. The trial court agreed with Whipple s waiver argument, vacated its prior judgment, granted the motion for JNOV, and ordered that Reeves and R2 take nothing on their claims. Reeves and R2 appealed, and the question presented on appeal was whether the trial court erred in granting the motion for JNOV. Whipple s contention that Reeves and R2 did not have standing to bring the lawsuit was dispositive and thus was the only basis for JNOV that the court addressed. The trial court granted the motion for JNOV on the ground of waiver by Reeves, but the appellate court affirmed the JNOV because of the lack of standing on the part of Reeves and R2. The court explained that an individual stakeholder in a legal entity does not have a right to recover personally for harm done to the legal entity. For example, a stakeholder does not have standing when damages are based on diminution of the entity s worth or the entity s loss of profits. Reeves and R2 sought damages based on their shares of the projected profit from the development and sale of the eight lots Rivendell initially agreed to purchase from the developer. The court of appeals explained that the direct injury was to Rivendell, the party who had contracted with the developer and who had expected to receive the profits from the development and sale of the eight lots. Any recovery based on future earnings under the contract belonged to Rivendell alone; therefore, Rivendell was the party with the primary legal right to recover and had exclusive standing to bring suit.

LLP Liability Shield Ederer v. Gursky, 881 N.E.2d 204 (N.Y. 2007). A withdrawn partner sued the partnership and its partners for breach of contract and an accounting of funds owed the withdrawn partner under a withdrawal agreement between the partner and the partnership. The partners claimed that they did not have personal liability because the partnership was an LLP, but the court concluded that the New York LLP liability shield only applies to debts and liabilities to third parties and does not protect partners from liability for obligations of the partnership to other partners or eliminate the right to an accounting. The New York LLP provisions state that [e]xcept as provided by subdivisions (c) and (d) of this section, no partner of a partnership which is a registered limited liability partnership is liable or accountable, directly or indirectly (including by way of indemnification, contribution or otherwise), 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. Subdivision (c) excludes from the liability shield any negligent or wrongful act or misconduct committed by [a partner] or by any person under his or her direct supervision and control while rendering professional services on behalf of the LLP. Subdivision (d) allows partners to opt out of or limit the scope of the liability protection. The court reviewed the background and history of LLP legislation and rejected the defendants argument that the statutory protection from liability for any debts applies to debts of the partnership to the partners as well as debts to third parties. The court concluded that the liability protection under the LLP provisions is restricted to liability to third parties because the phrase any debts is part of a provision that has always governed only a partner s liability to third parties and is part of Article 3 of the New York Uniform Partnership Act ( Relations of Partners to Persons Dealing with the Partnership ) rather than Article 4 ( Relations of Partners to One Another ). The court also rejected the defendants two arguments reconciling the right to an accounting in a winding up with their interpretation of the LLP provisions. The defendants argued that their fiduciary duty as partners to account to one another is different from personal liability for debts disclosed by an accounting, and they further argued that a partner is only personally liable for debts disclosed by an accounting that are attributable to that partner s own torts or wrongful conduct or supervisory lapses. The court responded that the right to an accounting is restitutionary in nature and that it is not limited in the manner argued by the defendants. The court pointed out that the statute confers a right to an accounting absent an agreement to the contrary and stated that partners may thus limit the right to contribution or indemnity or eliminate it altogether, but the partners in this case had no written partnership agreement and were governed by the default provisions of the statute as interpreted by the court. The dissenting opinion pointed out that a former partner is a third party where a partnership is concerned and argued that there is no good reason to treat him more favorably than any other third party. The dissenting opinion describes how the majority s approach results in odd and perverse results where a withdrawn partner is able to hold remaining partners personally liable for his share when the business of a partnership goes badly after the partner withdraws and before the partner is paid his share while third parties are restricted to recovery from the partnership. Limited Partnership Liability Shield In re Adelphia Communications Corp., 376 B.R. 87 (Bankr. S.D. N.Y. 2007). A New York bankruptcy court engaged in a lengthy analysis of Section 17-303 of the Delaware Revised Uniform Limited Partnership Act, which, like Section 3.03 of the Texas Revised Limited Partnership Act and Section 153.102 of the Business Organizations Code, provides that a limited partner is not liable for the obligations of a limited partnership unless the limited partner is also a general partner or, in addition to the exercise of the rights and powers of a limited partner, participates in the control of the business. The Delaware statute also provides, like the Texas statutes, that a limited partner who participates in the control of the business is liable only to persons who transact business with the partnership reasonably believing, based upon the limited partner s conduct, that the limited partner is a general partner. The New York bankruptcy court concluded, however, that this provision can result in liability to a third party based on the limited partner s acting as a de facto general partner even if the third party has actual knowledge of the limited partner s on paper status as a limited partner.

TABLE OF CONTENTS Page I. Introduction... 1 II. Recent Texas Cases Involving General Partnerships... 1 A. Existence of Partnership... 1 B. Partner s Personal Liability... 9 C. Partner s Fiduciary Duty... 10 D. Partnership Property... 16 E. Interpretation and Enforcement of Partnership Agreement... 18 1. Financial Rights... 18 2. Arbitration Provisions... 19 3. Withdrawal/... 20 4. Winding Up Distributions... 21 5. Statute of Frauds... 22 6. Illegality... 23 7. Absence of Terms/Indefiniteness... 23 F. Effect of Death or Withdrawal of Partner... 24 G. Action for Accounting... 25 H. Amount of Distribution or Value of Partnership Interest Upon Withdrawal/Dissolution... 25 I. Winding Up... 27 1. Appointment of Receiver... 27 2. Authority of Partner... 28 J. Divorce of Partner... 28 K. Partnership s or Partner s Standing to Sue... 29 L. Personal Jurisdiction... 29 M. Necessary Parties... 30 N. Sufficiency of Pleadings and Service of Process on Partners or Partnership... 30 O. Recovery of Attorney s Fees in Suit Between Partners... 31 P. Collateral Estoppel/Res Judicata... 32 Q. ERISA... 32 III. Recent Texas Cases Involving Limited Partnerships... 32 A. General Partner s Personal Liability... 32 B. Authority of General Partner or Other Agent... 33 C. Statutory Liability Protection of Limited Partner... 34 D. Piercing Partnership Veil... 34 E. Fiduciary Duty of Partners and Affiliates... 37 F. Indemnification... 41 G. Interpretation of Limited Partnership Agreement... 41 1. Fiduciary Duties... 41 2. Financial Rights... 41 3. Arbitration Provisions... 43 4. Transfer Restrictions and Buy-Out Provisions... 44 5. Covenant Not to Compete/Release... 46 6. Dissolution... 47 7. Removal of General Partner... 47 H. Partnership Property... 48 I. Dissolution of Limited Partnership/Events of Withdrawal of General Partner... 50 J. Judicial Dissolution... 50 K. Divorce of Partner... 52 L. Derivative Claims... 52 i

M. Creditor Remedies: Charging Order, Turnover Order... 52 N. Fraudulent Transfer... 53 O. Bankruptcy... 54 P. Subrogation Rights of LimitedPartner Guarantors of Partnership Debt... 56 Q. Succession to Limited Partnership s Rights as Beneficiary of Letter of Credit... 56 R. Property Tax Exemption... 57 S. Standing... 59 T. Personal Jurisdiction... 61 U. Sufficiency of Pleadings and Service of Process on Partners or Limited Partnership...... 62 V. Scopeof Discovery of LimitedPartnership Information... 64 W. Diversity Jurisdiction... 64 X. Attorney Liability... 65 IV. Texas Cases Involving Limited Liability Companies... 66 A. Nature of Limited Liability Company... 66 B. Pre-Formation Contracts... 66 C. Fraudulent Inducement in Formation of LLC... 67 D. Fiduciary Duties... 67 E. Limited Liability of Members; Personal Liability of Members Under Agency or Other Law... 70 F. Authority of Manager... 71 G. Admission of Member... 72 H. Conflict Between Regulations and Articles of Organization... 72 I. Buy-Sell Provisions... 72 J. Capital Call Provisions... 73 K. Dissolution/Winding Up... 74 L. Veil Piercing... 74 M. Fraudulent Transfer... 79 N. Charging Order... 81 O. Turnover Order... 81 P. Franchise Tax... 83 Q. Property Tax Exemption... 83 R. Workers Compensation... 83 S. Marital Property... 84 T. Recovery of Attorney s Fees... 84 U. Arbitration... 84 V. Personal Jurisdiction... 85 W. Service of Process... 87 X. Standing... 88 Y. Pro Se Representation... 89 Z. Derivative Suits... 89 AA. Diversity Jurisdiction... 90 BB. Bankruptcy... 92 CC. Conflict of Laws... 93 DD. Attorney-Client Privilege... 94 EE. Attorney Disqualification... 94 V. Texas Cases Involving RegisteredLimitedLiability Partnerships... 94 A. Limited Liability of Partners... 94 B. Effect of Registration; LLP as Successor Partnership... 96 C. Suits Against Foreign LLPs... 97 D. Diversity Jurisdiction... 98 ii

Case Law Update: A Survey of Recent Partnership and LLC Cases Elizabeth S. Miller I. Introduction This paper summarizes recent Texas cases involving issues of partnership and limited liability company law. II. Recent Texas Cases Involving General Partnerships A. Existence of Partnership [Note that the definition of a partnership recited in some of the cases summarized below requires the following four elements: (1) a community of interest in the venture, (2) an agreement to share profits, (3) an agreement to share losses, and (4) a mutual right of control or management of the enterprise. This formulation of the definition of a partnership was cited by the Texas Supreme Court in the relatively recent case of Schlumberger Technology Corp. v. Swanson, 959 S.W.2d 171 (Tex. 1997) and dates back to Coastal Plains Development Corp. v. Micrea, Inc., 572 S.W.2d 285 (Tex. 1978). In Coastal Plains, the Texas Supreme Court pronounced that a community of interest, an agreement to share profits, an agreement to share losses, and a mutual right of control or management of the enterprise are essential elements of a joint venture. These requirements were derived from cases pre-dating the Texas Uniform Partnership Act (TUPA). Interestingly, this test requires an agreement to share losses as well as an agreement to share profits. Even assuming the requirement of an agreement to share losses was appropriate in the context of joint ventures (and there is really no reason to distinguish in this regard between partnerships and joint ventures), it was clearly inappropriate under 1 TUPA to extend it to the context of partnerships. Nevertheless, the Coastal Plains expression of the essential elements of a joint venture, including the requirement that there be an agreement to share losses, has been recited with regularity in both partnership and joint venture cases. The Texas Revised Partnership Act should put an end to the courts reliance on the four factor formulation requiring an agreement to share losses to establish a partnership. The Texas Revised Partnership Act (TRPA) lists factors indicating the creation of a partnership, and factors not indicating the creation of a partnership, without stating that any factor is essential or dispositive. (The commentary notes that profit-sharing and a mutual right of control have historically been most important and states that they will likely continue to be.) TRPA lists an agreement to share losses as a factor that would tend to indicate that a partnership has been created, but makes clear that an agreement to share losses is not a necessary element. Tex. Rev. Civ. Stat. Ann. art. 6132b-2.03(c) (stating that "[a]n agreement to share losses by the owners of a business is not necessary to create a partnership"). Thus, if the issue is whether a relationship formed on or after January 1, 1994, constitutes a partnership, reliance on the line of cases requiring an agreement to share losses is clearly misplaced. Further, the drafters of TRPA apparently intended to eliminate any distinction between a partnership and joint venture. The analysis of whether a joint venture has been created should therefore be no different from that of a partnership. See Tex. Rev. Civ. Stat. Ann. art. 6132b-2.02(a) (stating that "an association of two or more persons to carry on a business for profit as owners creates a partnership, whether the partners intend to create a partnership and whether the association is called a 'partnership,' 'joint venture,' or other name"). While courts have begun to rely on the TRPA provisions, some courts continue to recite the four-factor definition of a partnership or joint venture that requires an agreement to share losses along with an agreement to share profits, a community of interest, and a mutual right of control. In some cases, the reference may be explained on the basis that the relationship in question arose prior to the effective date of TRPA. In a few recent cases, courts have acknowledged TRPA s provisions addressing the creation of a partnership and have noted the express difference between the statutory provisions and the common law 1 TUPA did not contain a reference to loss sharing as an essential element of a partnership. In fact, partners may fail to consider the possibility that the business will sustain losses, and thus fail to agree regarding the sharing of losses, or partners may even agree that losses are not to be shared. For example, partners A and B might agree to share the profits but agree that partner A will bear all the losses. Such an agreement would in essence be an agreement by partner A to indemnify partner B against loss, since their agreement would not affect the rights of third parties to hold either partner personally liable for partnership debts and obligations. 1