Wyrsch, Spring 2005

UNINCORPORATED BUSINESS ORGANIZATIONS

I. AGENCY

THE AGENCY RELATIONSHIP

(1) ELEMENTS
Agency is the fiduciary relation which results from the manifestation of consent by one person to
another that the other shall act on his behalf and subject to his control, and consent by the other so
to act. Rest. §1.
1. principal’s consent (express/implied, formal/informal)
2. agent’s consent (express/implied, formal/informal)
3. that agent will act on behalf of the principal (often by dealing with 3rd parties)
4. subject to principal’s control
→ fiduciary relationship

Consent
Consent is judged by an objective standard (outward manifestations); the parties’
subjective intent is irrelevant. The parties have an agency relationship where they
intended to enter into a certain category of business/interpersonal relationships even
where the parties did not intend/contemplate the legal consequences of the relationship.
Parties’ attempts to claim or disclaim agency status by contract are relevant to
determining whether an agency relationship exists, but not dispositive. Formalities (e.g.
communicating the consent) are not required for the formation of an agency relationship.

Gratuitous Agents
These are agents that consent without receiving any consideration from the
principal – i.e. no consideration is required.

Control
How much control is required to give rise to an agency relationship? At minimum, the
principal must have the right to control the goal of the relationship. The control need not
be total or continuous. Whether the agent consented to the principal’s control is
determined by how the relationship actually operated.

Acting On Behalf of the Principal

The principal’s interests are the primary purpose of the relationship and the agent must
recognize and consent to as such. Acting on behalf of is different from acting such that it
benefits someone else.

(2) AGENCY RELATIONSHIP COMPARED TO OTHER RELATIONSHIPS

BUYER – SELLER RELATIONSHIP

This is not an agency relationship – it is generally an arms length transaction in which
each party acts in his own interest. However where the seller (manufacturer) exercises
enough control over the buyer (distributor), [examples: quality control, marketing, etc.]
and the distributor can be said to be acting on the manufacturers behalf, a court may -
under the circumstances - find an agency relationship.

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DEBTOR CREDITOR RELATIONSHIP (CM p. 18)

Generally, a debtor and a creditor deal with one another at arms length and each is acting
on his own behalf. Thus creditor is not subject to liability for the debtor’s obligations.
Principals are however liable for agents in an agency relationship. Through negotiating,
creditors often require certain actions from debtors (e.g. require by K that the debtor not
take on any more debt). At some point, if there is enough control, this relationship might
become an agency relationship under the circumstances.

AGENCY vs. BAILMENT

A bailment = the rightful possession of goods by one who is not the owner. An agent is
often a bailee for the principal.

AGENT vs. ESCROW HOLDER

FRANCHISE RELATIONSHIP
A franchise = a license from the owner of a trademark/name that permits another to sell
the product/service under that name/mark. It usually includes the exclusive right to sell
the product within a specified territory. Franchise agreements usually include certain
controls over the franchisee. However, there is no agency relationship, and the franchisor
is not liable for the actions of the franchisee as though he were a principal because the
parties to the agreement are acting in their own interests. The controls are merely part of
the consideration given for the use of the trademark/name.

CORPORATE RELATIONSHIPS
Parent Subsidiary CM p. 21
The parent and subsidiary are separate legal entities. The parent is not liable to
third parties except where there are grounds for piercing the corporate veil.
If the parent has asked, directed, requested that the subsidiary engage in certain
transactions (or series of transactions) an additional argument (besides piercing
the corporate veil) for parent liability is that the subsidiary was acting as an agent
for the parent.

(2) THE AMBIGUOUS PRINCIPAL PROBLEM

EXAMPLE – EMPLOYER ADMINISTRED GROUP HEALTH INSURANCE

Where an employer obtains health insurance policies for its employees, there is a
question as to whether the employer is the agent of (acting on behalf of) the employee or
whether the employer is the agent of (acting on behalf of) the insurance company. This
determines who is liable for the employer’s acts and omissions.

APPROACHES
• Majority: the employer is acting in its own interests and/or those of the
employee, and the insurance company’s interests are adverse (therefore the
employee is bound by the employer’s acts/omissions)
• Minority: decided case by case from the perspective of the employee - the
insurance company is the principal, but only where
o the policy is “employer-administered,”
o the insurance company chooses as such,
o and the insurance company is in a position to exercise control over the
employer’s administration of the policy,

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o the employee has no choice,

o and the employee’s expectations have been frustrated

RIGHTS AND DUTIES BETWEEN PRINCIPAL AND AGENT

(1) DUTIES OF PRINCIPAL TO AGENT (CM p. 22)

Legal relationships between two people give rise to rights and duties (analogous to contract law).
The rights and duties are subject to negotiation, but there are certain rights and duties implied by
the relationship itself (default).

Commencement of Agency Relationship

(See elements of agency relationship above)

DUTY OF EXONERATION AND INDEMNIFICATION

The principle generates profits by using the agents, who are exposed to risks and losses
[such as: travel, repair, litigation, speeding ticket, computer crash, sudden injury,
insurance premiums, office supplies, materials, equipment, rent, injured by 3rd party]. Is
the principal responsible for reimbursing and compensating for such risks and losses?
• Is there a previous agreement governing the situation? If not,
• What are the reasonable expectation of the parties (See p. 77, top) depending on:
o the nature of the parties’ relationship
 is there a business custom to indemnify?
o the nature of the expense –
 was it of benefit to the principal?
 was it the result of the agent’s negligence?

DUTY TO PAY COMPENSATION

Express Contract b/t Principal and Agent

Usually there is an express agreement with terms that provide for compensation.
Where there is ambiguity in the express terms of the K, the court may look to
other evidence under K law to determine the outcome: course of performance,
course of dealings, trade usage.

Implied Contract
Has A requested that, or let, B perform services for her?
• If so, it is inferred that A will pay compensation to B for the service
Has B offered to perform services for A?
• If so, it is inferred that B will perform the services gratuitously – no
compensation is owed by A. (gratuitous agent)
Unless the following indicate otherwise:
• the nature and extent of the service
• the relationship b/t the parties

Note: Services rendered by family members

The law presumes that these are gratuitous favors prompted by kindness.

TO EXERCISE REASONABLE CARE

General Rule

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The principal is under a non-delegable duty of due care to protect its agents
(provide a safe workplace). This duty arises from the principal’s control over the
work environment. In the event of breach, the principal is strictly liable to pay
compensation.

Exceptions (common law defenses to strict liability of employer)

• contributory negligence – bars recovery whenever the agent’s own
negligence helped cause the injury
• assumption of risk – bars recovery for injuries arising from the ordinary
dangers of the work
• fellow servant rule – bars recovery from masters for the torts of a “fellow
servant,” broadly defined (anyone related in labor and whose negligence
presents a special risk of harm to the agent).

Worker’s Compensation Legislation

The defenses above have been substantially diminished by the enactment of
worker’s compensation laws, which provide relief regardless of contributory
negligence/assumption of risk/fellow servant negligence. Under these laws,
workers pay premiums for insurance that is used to compensate employees
injured in the course of employment (according to a detailed schedule of
recovery). The compensation includes
• medical care,
• cash payments to the employee (or dependents) for lost wages from
disability or death (calculated as a % of the employee’s salary),
• but does not include pain and suffering.

DUTY TO DEAL FAIRLY AND IN GOOD FAITH

Issue: Who owes the above duties?

This can be an issue where there is a co-agent vs. a subagent:

Co-agent: Co-agents have agency relationships with the same principal. A co-
agent may be appointed by the principal or by another agent actually or
apparently authorized by the principal to do so. Rest. 3d. §1.04(1) → the
principal owes the duties of compensation, indemnification, etc.

Subagent: A subagent performs functions undertaken by an agent for a principal.

An agent so empowered may appoint a subagent and agrees with the principal to
be primarily responsible for the subagent’s conduct. Rest. 3d. §1.04(9) → the
agent owes the duties of compensation, indemnification, etc.

(2) DUTIES OF AGENT TO PRINCIPAL

All of the duties between agents and principals are subject to negotiation, and will then be
governed by K law.

Commencement of Agency Relationship

(See elements of agency relationship above)

DUTY OF GOOD CONDUCT/DUTY TO OBEY

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DUTY TO INDEMNIFY PRINCIPAL FOR LOSS CAUSED BY MISCONDUCT

As a practical matter employers don’t seek the indemnification remedy (holding
employees personally liable) because as a matter of policy it would discourage
people from working, becoming directors of a corporation, etc.

DUTY TO ACCOUNT

FIDUCIARY DUTIES
Duty of care, duty of loyalty, duty to disclose.

(1) Duty of Care

An agent must exercise reasonable care in carrying out his duties.
Agents that breach this can be held personally liable for losses to the principal.
This is judged from both an objective standard and a subjective standard; for
example, a highly specialized agent will be held to a higher standard of care than
a lower level employee.

(2) Duty of Loyalty

During the relationship

Various ways of breaching this duty (CM p. 27):
• not acting in the best interests of the principal
• self-dealing
• interested director transactions with the principal without fill
disclosure
• competing with principal
• corporate opportunity doctrine: the agent can not preempt
(sabotage?) business opportunities
• misuse of inside information
• Dual agency: The dual agency rule is that an agent cannot act on
behalf of the adverse party to a transaction connected with the
agency without the permission of the principal. If the principals
are unaware of the double employment, the transaction between
them is voidable.

After the relationship (post-employment activities)

1) Is there an express agreement (or statute) that controls? If not, implied
duties govern the agent.
2) Has the ex-agent misappropriated a legitimate property interest of the
ex-principal? (e.g. trade secret, client lists, strategy, formulas,
development, product design, etc.) Note: the principal must show that the
information was confidential and non-public.
• If so, there has been a breach of the duty of loyalty
• If not,
3) Is the ex-agent merely a business competitor of the ex-principal, who
is merely exercising his right to engage in his choice of work and using
his general knowledge/expertise/experience?
• If so, there has been no breach of the duty of loyalty.

Disclosing Trade Secrets

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See CM p. 29 Most often the employment agreement sets forth

the scope of what the employee is allowed to do both during and
after the relationship. Trade secrets are property interests of an
employer.

Covenants Not to Compete

If there is an express agreement protecting the employer’s
interests, can it be enforced? This depends on whether it is
reasonable. Balancing test:
o employee’s interest in freedom to engage in work using
relevant experience vs.
o legitimate property interests of the employer

(3) Duty of Disclosure

An agent has a duty to disclose material information to the employer. To the
extent that loss has incurred as a result of the agent’s failure to disclose, the agent
is personally liable. The duty to disclose is not a separate duty.

In the context of the Duty of Care:

Where the agent fails to disclose material information and the principal
incurs losses as a result, the agent has breached his duty of care. The
burden is on the principal to prove her losses and to establish that the
agent was negligent (breached).

In the context of the Duty of Loyalty:

Where the agent fails to disclose that there is a conflict of interest and a
transaction is executed, and the principal incurs losses as a result, the
agent has breached his duty of loyalty. The principal must only show
that the agent executed a transaction with conflict of interest, and without
disclosing such to the principal. Then the burden of proof shifts to the
agent to show either that he did in fact disclose or that disclosure was not
required (i.e. that there was no conflict). If the agent cannot carry his
burden, the principal entitled to seek appropriate remedies.

REMEDIES FOR AGENT’S BREACH

1. terminate/suspend the relationship
2. reduce or modify the agent’s authority
3. demote or discipline the agent
4. be indemnified for losses incurred or liability for damages
5. refuse to compensate (or reduce compensation)
6. disgorgement of profits acquired by agent (for example but placing a constructive
trust on past/present/future profits

VICARIOUS TORT LIABILITY - PRINCIPAL vs. 3RD PARTIES

The theory upon which to hold the principal vicariously (i.e. strictly) liable for the torts of the
agent is respondeat superior. The 3 elements of this doctrine are:
1. the agent’s tort has caused physical injury to a person or property
2. a master/servant relationship (vs. independent contractor) – key issue is control
3. the tortuous activity was within the scope of the agent’s employment

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→ The principal is liable for the agent’s misconduct regardless of whether the principal
authorized, expressly forbade, or even used all reasonable means to prevent the misconduct.

JUSTIFICATIONS/THEORIES (CM p. 31)

1. Benefit theory – risk absorption: e.g. a hospital: the risk is placed on the hospital who
will distribute the risk on the patient’s – beneficiaries
2. Loss-Spreading Theory: risk distribution
3. safety incentive theory: risk assumption
4. Just & Equitable Theory – employer is not at fault here at all – injured person, person
who acted, 3rd person

Rationale:
The general rule is that the principal is liable for actions of the agent within the
scope of agent’s employment, because the principal is thought to control the
agent’s activities. (Note principal has no control over independent contractors,
and is not liable for their torts.)

(1) THE MASTER-SERVANT RELATIONSHIP vs. INDEPENDENT CONTRACTORS

If there is a master-servant relationship (and the conduct is within the scope of the agent’s
employment) the principle will be vicariously liable for the torts of the agent.
If the “agent” is really an independent contractor, the principle is not vicariously liable for the
torts of the agent.

Trend:
Employers are contracting out many functions to avoid being responsible.

DETERMINING WHETHER THERE IS A MASTER/SERVANT RELATIONSHIP OR

AN INDEPENDENT CONTRACTOR
A servant is subject to the master’s control (or right to control). In determining whether
there is a master-servant relationship the following factors are relevant:
Rest. 2d. §220:
• extent of master’s control
• whether the agent is engaged in a distinct occupation
• type and nature of occupation (is it usually done under the direction of a master
or by a specialist without supervision?)
• skill required by occupation
• whether the employer supplies the equipment and place for doing the work
• length of time of employment
• method of payment (per hour/per task)
• whether the work is part of the employer’s regular business
• the parties’ subject beliefs about the relationship
• whether the principal a business person
Modern Factors, see CM p. 32

Issue: Actual control vs. right to control

Actually exercising control over the agent is not necessary to a master-servant
relationship; having the right to control the agent is sufficient.

EXCEPTIONS/LIMITATIONS TO THE INDEPENDENT CONTRACTOR

EXCEPTION CM p. 33 (Exceptions to the Exceptions)

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Employer Negligence
Technically, where the employer is negligent, this is no vicarious tort liability,
but the employer is directly liable. Courts have increased employers
responsibility (e.g. do a background check for drunk driving, etc.) to ensure that
potential employees are trained/experienced/qualified.
• e.g., negligent hiring,
• e.g., negligent supervision

Inherently Dangerous Activity (public policy)

There are activities that increase the risk of harm/injury to 3rd persons, e.g.
transporting hazardous materials.

Non-delegable Duty (public policy)

The duty that an employer has to a group of 3rd persons is so important, that the
court/law won’t allow them to contract the function away. This applies to a wide
variety of situations (CM p. 34).
• law firm’s duty to client
• car owner’s duty to 3rd persons to maintain the car’s saftey

Apparent Relation
If the business hires another business, and if it appears to 3rd parties that there is a
relation, the hiring business may be estopped from claiming IC relationship and
avoiding liability. Even if no relation exists, there still may be liability on the
grounds of estoppel or apparent relation, if the reliance was reasonable.

Issue: unincorporated organizations/associations, joint enterprises

These don’t have a separate legal identity. If one of the members is negligent,
the association/organization can not be potentially liable. However, the members
may be individually liable depending on how extensive their participation in the
organization/association is: The roles different individuals play must be
examined to determine liability.
• mere membership vs.
• active participation and control
o active participation/control may be subject to liability.

ACTIVITY - SCOPE OF EMPLOYMENT

Generally, the employer will be liable for only those actions that are within the scope of
employment (i.e. within the employer’s control). Whether the conduct is within the scope of
employment is a matter of degree:
• there must be a nexus between the act and the employment,
In reality, this test is so vague that judges have wide discretion to decide the case based on what
is fair.

GENERAL RULE
If the act that injures a 3rd party is fairly and reasonably connected to the employment -
incidental to the employer’s business – the act is within the scope of employment, and the
employer is liable for the employee’s negligent and intentional misconduct.

Factors

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• nature of the employee’s actions

• time of the employee’s actions (during work hours?)
• place of the employee’s actions (in the workplace?)
• purpose of the employee’s actions
• §228 Rest.

DETOUR vs. FROLIC (TANGENTIAL ACTS)

If the act is a slight deviation from the employee’s duties, it is merely a detour, which is
considered to be within the scope of employment. If the act is a substantial/gross
deviation from the employee’s duties, it becomes a frolic which is considered outside the
scope of employment.

Detour: within the scope of employment (expected)

Frolic: not within the scope of employment (not expected)

The Re-entry Rule

This is where the agent ends a frolic and decides to return to his/her employment.
At some point, because the frolic is over, the agent is once again acting within
the scope of employment, and respondeat superior will result in liability for the
employer/principal.

Issue: When exactly is the employee reentering the employment?

(merely deciding to return is insufficient for reentry): it usually depends
on how far removed the agent is from the time/place of employment.

SITUATIONS - Negligent Torts (handout)

Travel Cases (CM p. 36)

Someone is driving somewhere and injures another person. If they go straight
there, the employer will be held liable. If they frolic the employer will not be
held liable. If there is a slight deviation (detour), the employer might be held
liable because this is expected. Then there is huge grey area.

Employee Disobedience Cases

The courts have held that employee disobedience doesn’t have anything to do
with whether the employee was within the scope of employment. Disobedience
does not render the conduct outside the scope of employment.

Personal Habits/Conduct
There are 2 approaches: The narrow approach rationalizes that the personal
habits of employees have nothing to do with the business, therefore the employer
shouldn’t be held liable. The permissive view rationalizes that the habits are
expected (if they are slight deviations, e.g. bathroom breaks) and employers have
to assume liability for such deviations.
• smoking breaks? If the employer bans smoking breaks, they are
exercising control, and are thus likely to be held liable.

Issue: Counter-intuitive?

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The stricter the controls/regulations the employer places on the employee are (to
prevent injuries to 3rd parties) [i.e. the more careful the employer is], the more
likely the employer is to be held strictly liable.

EMPLOYER’S LIABILITY FOR INTENTIONAL TORTS

Most resopondeat superior cases involve torts of negligence, but the doctrine also applies
to intentional torts. Where the agent acts within the scope of employment to commit an
intentional tort causing physical harm, the principal is vicariously liable. The main issue
is whether the intentional tort is within the scope of employment. Various approaches to
determine whether the tort was within the scope of employment are:

The Motive Test:

Is the agent’s purpose/motive to serve the master?

Foreseeability/characteristic of the business:

Is the conduct foreseeable from the nature of the employment and duties relating
to it?

Outgrowth of the Work Environment:

Is the risk of such misconduct fairly typical of – or broadly incidental to – the
employer’s business?

Policy Analysis: (application of vicarious liability justifications)

• Benefit Theory – risk absorption: e.g. a hospital: the risk is placed on the
hospital who will distribute the risk on the patient’s – beneficiaries
• Loss-Spreading Theory – risk distribution
• Safety Incentive Theory – risk prevention
• Just & Equitable Theory – employer is not at fault here at all – injured
person, person who acted, 3rd person

CONTRACTUAL POWERS OF AGENTS (CONTRACT LIABILITY)

PRINCIPAL vs. 3RD PARTY

GENERAL RULE
A principle is contractually liable for transactions of the agent where
• there is an agency relationship
• the transaction at issue was within the agent’s scope of authority – see below for
theories of authority (This is a narrower test than the scope-of-employment test
for tort liability.)

[Commencement of Agency Relationship

(See elements of agency relationship above)]

(1) ACTUAL AUTHORITY

• manifestation by principal
• reasonable interpretation by agent of the principal’s manifestation
• agent believes he has authority to act

EXPRESS

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The manifestation can be oral or written; e.g., resolution of the board, power of attorney,
by-laws, etc.

IMPLIED
Whatever is usual, incidental, reasonably necessary to carry out the agent’s responsibility
or authority is impliedly authorized:
• transaction was necessary (emergency)
• transaction was reasonably contemplated by the principal and agent
• implied by agent’s position/title
• implied by past conduct (i.e. principal’s acquiescence)
• implied by business custom
• implied by documents or other indicia of authority

(2) APPARENT AUTHORITY

GENERALLY
The test for apparent authority is whether, based on the circumstances, it is reasonable -
from a 3rd party’s perspective - to believe that the agent had authority. (Unreasonable
belief is insufficient.) The reasonable person is judged by both objective and subjective
standards. Reasonableness factors:
• principal’s manifestation to the 3rd party (active or inactive)
• agent’s position/title
• past dealings with the 3rd party
• business custom
• documents or other indicia of authority
• 3rd party inquiry
→ If it is determined that it was reasonable for the 3rd party to believe the agent had
authority, the K will be enforced.

(3) ESTOPPEL (Rest. §8(b)(1))

This imposes liability on the principal even where there was no manifestation attributable to the
principal. If the 3rd party reasonably believes that the agent has authority to bind the principal,
and changes his/her position in reasonable reliance of such belief, and the principal negligently
fails to notify 3rd party of the scope of authority.
• The key difference between this and apparent authority is that the 3rd party changes
position (i.e. actual reliance)*
→ principal is estopped from challenging the agent’s authority *
→ principal must pay compensatory damages to the 3rd party for their loss *

* differences between apparent authority and estoppel

(4) INHERENT AUTHORITY (Rest. §8A) – Fairness

A principal is liable for those transactions that a general agent (e.g. the President) enters into,
although unauthorized (perhaps even forbidden), if those transactions usually accompany or are
incidental to the business and the 3rd party reasonably believes the agent is acting with authority.
This amounts to enterprise liability because the principal has entrusted the agent with ongoing
responsibilities.

Issue: Whether the agent is a “general agent”

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Ongoing responsibility is the key to whether an agent is a general agent. If the principal
authorizes an agent to conduct a series of transactions involving “continuity of service,”
the agent is a general agent. If the principal authorizes the agent only to conduct a single
transaction, or to conduct a series of transactions that do not involve “continuity of
service” the agent is a special agent, not a general agent.

ELEMENTS
1. transaction by a general agent (i.e. there is “continuity of service” or ongoing
responsibility – vs. special agents who have authority only to conduct a single
transaction.)
2. reasonably incidental to the particular nature of the business (and in the interest
of the principal)
3. 3rd party reasonably believes (objectively & subjectively) that the agent had
authority

RATIONALE - fairness
It is unfair for an enterprise/principal to have the benefit of the work of its agents without
making it responsible to some extent for their failures to act carefully.

Issue: Who should bear the risk of loss?

A third party, or the business?

LIMITATIONS
1. where the 3rd party knows there is no authority (because this defeats the fairness
rationale)
2. where the agent is acting on his own behalf, not in the principal’s interests
(because this defeats the enterprise rationale)

Policy
To place the burden of risk on the principal for the agent’s misconduct and to
treat the general agent and principal as an enterprise.

Note: Acceptance
Most courts have not accepted this theory because the same result is possible under an
expanded application of apparent authority.

(4) RATIFICATION
This is after-the-fact acquiescence of the transaction.

EXPRESS
The principal specifically affirms that it will honor the transaction.

IMPLIED
The principal communicates by its conduct that it will honor the transaction (i.e. pays, or
uses the K), or fails to object to the transaction.

THE UNDISCLOSED PRINCIPAL: PRINCIPAL vs. 3RD PARTIES

DUTIES OF THE 3RD PARTY/RIGHTS OF THE PRINCIPAL

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GENERAL RULE
Generally, undisclosed principals can enforce contracts against 3rd parties.

EXCEPTIONS
Under the following circumstances, a principal will not be able to enforce a contract
against a 3rd party, because the 3rd party has special interests in who he/she is contracting
with.

Express Limitation
Where the K contains an express limitation against undisclosed principals, the
principal will not be able to enforce the K, and the 3rd party will be excused from
his/her obligations under the K.

Personal services
Where the 3rd party is expecting/contracting for personal services, and the
principal was not disclosed, the undisclosed principal will not be able to enforce
the K and the 3rd party will generally be excused from his/her obligations under
the K.

False Denial
Where the 3rd party asks the agent is asked if the agent is acting in his/her
individual capacity, or on behalf of an undisclosed principal, and the agent
falsely denies as such, the undisclosed principal will not be able to enforce the K
and the 3rd party will generally be excused from his/her obligations under the K.
By asking, the 3rd party demonstrates a legitimate interest in with whom he/she is
contracting.

Knowledge vs. Mere Suspicion

Where the agent/principal has knowledge that a 3rd party will reject the contract if
the principal’s identity is disclosed, the undisclosed principal will not be able to
enforce the K and the 3rd party will generally be excused from his/her obligations
under the K. However, if the agent/principal has a mere suspicion that a 3rd
party will reject the contract if the principal’s identity is disclosed,

Kelly Asphalt Block Co. v. Barber Asphalt Paving Co. p. 355

The plaintiff (Kelly Asphalt) was the undisclosed principal, and Booth
was its agent. Booth executed a K with another party on behalf of the
undisclosed principal. The undisclosed principal is suing the other party
to the K for to enforce the K. There was a suspicion/belief that, if the
identity of the principal were disclosed, the K would never have been
made. The 3rd party argued that this should constitute an exception to the
general rule that the undisclosed principal can use for performance of the
K. The issue was whether the 3rd party had a legitimate interest at stake,
requiring relief from his/her obligations under the K. The court that
mere suspicion is not enough: there was no misrepresentation, and there
was no manifestation by the 3rd party of his interest in the identity of the
principal.

DUTIES OF THE UNDISCLOSED PRINCIPLE/RIGHTS OF THE 3RD PARTY

GENERAL RULE

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Because a principal can generally enforce a contract against a 3rd party, in the interest of
fairness, a 3rd party can also enforce a contract against an undisclosed principal.

THE ELECTION DOCTRINE

Who should the 3rd party sue? (CM p. 53)

The English [Traditional] Rule

A 3rd party only has one cause of action for enforcement of the contract. If the 3rd
party obtains a judgment against an agent, he/she can not bring a lawsuit against
the principal regardless of whether the 3rd party is even aware of the principal’s
existence.

The American [Majority] Rule

A 3rd party only has one cause of action. However a 3rd party can only make a
valid election if he/she is aware of the principal’s existence at the time he/she
initiates the suit. If the 3rd party is unaware of the principal and obtains a
judgment against the agent, he/she not precluded from suing the principal. If the
3rd party is aware of the principal and obtains a judgment against the agent,
he/she is precluded from suing the principal.

The Growing Minority Rule

There are no restrictions on who the 3rd party may sue. A 3rd party can sue both
the agent and the principal, obtain judgments against both, and seek enforcement
of those judgments against both until he/she fully recovers his/her damages.

Grinder v. Bryans Road Building & Supply Co. p. 364

(CM p. 55) Grinder had a construction business and had an open account
with Bryans to buy supplies. Originally Grinder was a sole proprietor,
but he decided to incorporate. After incorporation Grinder was operating
as an agent of the corporation. Bryans never knew of the incorporation.
Bryans sued Grinder (in his capacity as a sole proprietor) for unpaid
bills. Grinder claimed that because he was just the agent of the
corporation/principal, he was not liable. Bryans added the corporation to
the compliant, but also argued that Grinder was still personally liable on
the theory that agents of undisclosed principles are personally liable. A
judgment was entered against both Grinder and the corporation. Grinder
then argued that, under the American Rule, if you bring an action against
the agent, knowing the existence of the undisclosed principle, there is no
valid election, and Grinder is not liable. The court rejected Grinder’s
argument and adopted the minority approach above. Bryans could sue
Grinder personally and sue the new corporation, until performance of the
K is satisfied.

LIABILITY OF AN AGENT TO 3rd PARTIES

CM p. 56

(1) AUTHORIZED TRANSACTIONS

The agent has executed a contract with authorization. The parties to the K are the principal and
the 3rd party. The agent has merely carried out his/her function and is not a party to the K. If the
principal breaches the K, the agent is not liable to a 3rd party for these acts of the principle.

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DISCLOSED PRINCIPAL
Where the identity of the principal is disclosed, the K is between the 3rd party and the
principal, and the agent is not liable for performance of the K.

Exceptions
• Express Assumption – the agent assumes liability
• Implied Promise
• Custom – for example, it is customary for expert witnesses to seek
payment from the attorney even though the attorney is merely the agent
for his/her client
• signature (see below)

UNDISCLOSED PRINCIPLE
Agents who execute contracts on behalf of undisclosed principals (e.g. an unincorporated
business that forms a corporation) are personally liable. The 3rd party can elect who to
sue (see above). An agent must provide notice that he/she is acting on behalf of a
principal. The 3rd party is not required to inquire.

PARTIALLLY DISCLOSED PRINCIPLE

The agent will be liable to the 3rd party.

Issue – Signatures
The manner in which an agent signs a contract (promissory note) may affect
his/her liability. If the agent clearly signs as an agent, and disclose the identity of
the principal, he/she has put the 3rd party on notice, and the agent will not be
liable, for performance of the K. If the agent clearly signs his/her own name and
makes no reference to agent status or the identity of the principal, the agent will
be liable for performance of the K, and no parol evidence will be admissible to
show otherwise. If the agent’s signature is ambiguous (e.g. CAD, agent or CAD,
president) parol evidence will be admissible to determine the parties’ intent.

(2) UNATHORIZED TRANSACTIONS (WARRANTY OF AUTHORITY)

The agent has entered into an unauthorized K on behalf of the principal. The law implies a
warranty of authority where an agent purports to bind another to a K. If there was no authority,
the agent is thought to have breached the implied warranty, and will be liable for damages.

EXCPETIONS
• Disclaimer – the agent disclaims (to the 3rd party) having authority to bind
• Uncertainty – the agent expresses doubts (to the 3rd party) about his/her authority
to bind.
• 3rd party knows the agent has no authority

However, if the agent manages to bind the principal through implied authority, apparent
authority, estoppel, or inherent authority, the warranty of authority is not breached and the agent
will not be held liable. The 3rd party will have gotten what he/she bargained for.

(3) NONEXISTENT PRINCIPAL

If the incorporation formalities are defective, the corporation has not yet been formed, or the 3rd
party is dealing with an unincorporated association of individuals, the principal may actually be
nonexistent. The agents are potentially liable.

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EXTENT OF AGENT’S DUTY TO 3RD PARTY

• Obligations on the contract (depends on disclosure of principal)
• Warranty of authority (depends on whether there was authority)
• Obligations in tort
• Agent’s breach of duty to the principal is not, by itself a breach to a 3rd party (there must
be a duty and breach directly to the 3rd party)

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II. GENERAL PARTNERSHIPS

UPA, RUPA, Case Law, Agency Law

NATURE & CREATION

(1) NATURE
Is a partnership is an aggregate of individuals (that has no separate legal status) or a separate legal
entity? The general rule is that a partnership is a separate legal entity.

AGGREGATE THEORY
This still applies to the federal tax system’s treatment of partnerships, liability, and
dissolution. For these topics, the focus is on the individuals as though the partnership
doesn’t exist.

ENTITY THEORY
This applies to enforcing contracts, title to property, and filing lawsuits. The partnership
itself is involved.

COMPARED WITH OTHER BUSINESSES

Advantages
Partners equally own and manage the firm.
Taxation is on a flow-through basis – partners are taxed once individually.
Partners can exit the business at will.
No formalities are required.
Flexibility

Disadvantages
Partners are personally liable for the debts of the firm.

APPLICABLE LAW
UPA and RUPA are the state laws that govern partnerships. They determine/govern:
• whether a partnership exists
• the relationship of the partners and partnership with outsiders
• relationship between the partners (but subject to the partnership agreement)
• when a partnership ceases to exist, what happens to the partners’ interests, the
partnership’s assets, and the partnership’s liabilities.
They have both mandatory and default provisions. The mandatory provisions govern the
partnership’s relationship with outsiders. The default provisions govern the partners’
relationships with one another.

PARTNERSHIP AGREEMENT
This is not required, but is useful where the partners want more flexibility than what the
default provisions (governing their relationships with one another) allow. In order to
adopt a partnership agreement that changes the default rules, there must be unanimous
approval. (Thereafter, the partnership agreement can provide for its own amendment on
a less-than-unanimous basis).

(2) CREATION

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A partnership is created by consent where 2 or more persons manifest an intention to associate as

co-owners of a business for profit. No formalities are necessary. Consent can be express or
implied in conduct. Intent to form a “partnership” is not required. If the business structure has
the essential characteristics of a partnership, the business is a partnership.

IMPLIED PARTNERHSIPS -
IS THERE A PARTNERSHIP? IF SO, WHO ARE THE PARTNERS?
This question comes up where (1) a 3rd person (tort creditor, contract creditor) is suing a
partnership, thus suing all the partners themselves; (2) the parties themselves are involved
in a dispute, e.g., over who is entitled to interests in the partnership; and (3) a government
agency has challenged the existence of the partnership.

Major Factors Include (but no one factor is dispositve):

Sharing Profits
ULPA §7 & RUPA§202 establish a presumption that receiving a share of the
business profits is prima facie evidence that you are a partner of the business.
This presumption is rebuttable where the person receiving the profits can show
that he/she is receiving payments as a creditor, wages as an employee, rent as a
lessor, an annuity as a beneficiary of a deceased partner, consideration for a sale,
etc. Note: joint ownership of property (see § 202) is not dispositive of a
partnership).

Profit Sharing vs. Revenue Sharing

There is a difference – an employee who is paid on commission is
sharing in the revenue of the business, but not the profits (which =
revenue – business expenses).

Mutual Right of Control

The incentive to exercise control originates from the right to share profits.

Co-owners of the Business

Ownership interests originate from the right to share profits.

Indicia of “partner” status

• agreements to share in profits & losses
• participation in substantive management, decision-making
• right & duty to act as an agent
• fiduciary relation with other partners
• unlimited liability for partnership debts/losses
• made true capital contributions to the partnership
• comparable ownership interest in partnership
• co-owner of partnership property
• right to examine books and records

Partnership by Estoppel (or Liability of a Purported Partner) §16, §308

Even where no partnership in fact existed, someone who misrepresents his/her
identity as a partner (or allows someone else to misrepresent his/her identity as a
partner) will be estopped from denying the partnership if 3rd party relies on the
misrepresentation. He/she will be liable to the 3rd party for the transaction, and so

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may the partnership, other partners, or supposed partners, depending on the

scenario:

Liability of the person whose status is misrepresented –

General Rule: if
• a person misrepresents him/herself as a partner, (or consents to
someone else doing so) and
• a 3rd party relies on the misrepresentation by entering into a
business transaction with the supposed partnership
→ the person whose status is misrepresented is liable to the 3rd party

Liability of the partnership – General Rule: if

• an actual partnership exists, and
• all the partners* make (or consent to) a misrepresentation of a
person’s status as partner, and
• a 3rd party relies on the misrepresentation by entering into a
business transaction with the supposed partnership
→ the partnership is liable on the transaction*
→ the partners are each personally liable

*Variation: If there is a partnership, but not all of the partners

made (or consented to) the misrepresentation, the partnership is
not liable; only those responsible for the misrepresentation are
liable on the transaction.

Liability of the supposed partnership where none in fact existed –

General Rule: if
• no actual partnership exists, and
• supposed “partners” make (or consent to) a misrepresentation of
a person’s status as partner, and
• a 3rd party relies on the misrepresentation by entering into a
business transaction with the supposed partnership
→ the supposed “partners” who made (or consented to) the
misrepresentation are each personally liable

Issue: Consent
Declarations of partnership by another in your presence, under
circumstances in which you know, or should know, that a denial is
necessary to avoid misleading a 3rd party creditor, are considered
adoptive admissions that you are a partner. Failure to deny partner status
or silence = consent to representation. J&J Builders v. Caffin p. 574.

Issue: Reliance
The reliance element requires that the 3rd party know of the
representation at the time he/she enters into the transaction. I.e., the 3rd
party can’t find out about the representation later and use it to enforce the
transaction.

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FINANCIAL STRUCTURE & PARTNERS’ CONTRIBUTIONS/DISTRIBUTIONS

(1) CONTRIBUTIONS CM p. 73

TYPES
There are no restrictions in UPA or RUPA on the nature and amount of the partners’
contributions to the partnership. A partner can contribute anything of value, subject to
negotiations and agreement among the partners.

Labor
• services (present & future)

Capital
• cash
• real/personal property
• securities
• promissory notes

Intangible
• contacts (“rainmaker”)
• name/reputation
• experience
• expertise

WAYS PROVIDED
There are 3 ways that partners can provide capital to the partnership:
1. they may contribute it – transfer ownership interest
2. they may furnish it – retain ownership interest, but partnership has permission to
use
3. they may lease or loan it – retain ownership interest
Under UPA the partner’s intent determines what type of contribution he/she made.
Under RUPA, title determines what type of contribution he/she made.

RETURN

When
This generally occurs when a partner leaves the partnership, or when the
partnership comes to an end. UPA§18(a) requires that each partner be repaid
his/her contributions after all liabilities are satisfied.

How
Remuneration for property provided to the partnership depends on the way it was
provided (see above).

Leased/Loaned – A partner who leases or loans property to the

partnership receives compensation according to the terms of eh
lease/loan agreement. When the lease/loan period ends, the property
returns to the partner.

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Furnished – A partner who furnishes property to the partnership receives

no compensation beyond a share in the profits; allowing the partnership
to use the property is what the partner contributes in return for his profit
share. When the partnership ends, the property returns to the partner
who furnished it.

Contributed – A partner who contributes property to the partnership

receives no on-going compensation beyond a share in the profits. When
the partnership ends, the partnership owes the contributor the value of the
contribution, measured as of the time of the contribution. Unless
otherwise agreed, the contributor has no right to have the property itself
returned.

APPRECIATION
If the partner contributes property, and it appreciates while the partnership is in existence,
the appreciation belongs to the partnership. The contributor has no claim on the
appreciation.

LOSS SHARING
Under both UPA and RUPA loss sharing is mandatory. If one partner contributes all
capital and the other contributes all labor, and the partnership loses money, the partner
that contributed the labor will get nothing (because there are no profits) and will have to
pay the other partner his/her equal share of the losses.

(2) DISTRIBUTION OF PROFITS

HOW MUCH
What percentage of profits each partner gets is not tied to the amount he/she contributes
(like corps). Regardless of the nature and amount of property contributed, all partners get
an equal share of the profits (after contributions, and advances/loans, and withdraws are
settled), unless otherwise agreed. UPA §18(a), RUPA §401(b)

WHEN
Neither UPA nor RUPA have default rules on when/how often profits are paid out to
partners. Tax law requires that profits and losses are added up annually, and this
generally influences when profits are distributed in most partnerships. The specifics are
generally subject to agreement. A partner has no right, however, to receive a current
distribution of profits.

(3) OTHER

INDEMNITY
The partnership must indemnify every partner for payments made and liabilities incurred
in the ordinary and proper conduct of partnership business or for the preservation of
partnership property. UPA §18(b).

WAGES
There is no right to compensation for labor, wages, or salary other than a partner’s share
in the profits of the business (default), unless otherwise agreed.

OPERATION & MANAGEMENT

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PARTNERSHIP’S/PARTNER’S DUTIES TO 3RD PARTIES

TORT LIABILITY
The partnership is liable for the torts of the partners under UPA §13 and RUPA §305(a).
The only difference between these rules and vicarious liability in agency law is that no
showing of the master’s right to control is necessary.

CONTRACT LIABILITY
See “binding the partnership”, under “management rights” below.

PARTNERS RIGHTS AND DUTIES TO THE PARTNERSHIP

These are subject to agreement among the partners. Where no agreement is made the default
rules below will apply.

A. PARTNER’S RIGHTS
To be entitled to these rights, you must be a partner in a partnership.
• is there a partnership?
• who are the partners?

(i) Share in Profits

(see above)

(ii) Property Rights

(below)

(iii) Share in Management

a) Decision-Making & Veto Power – Management rights include the

right to participate in decision making and the right to veto certain types
of decisions. In partnerships (vs. agency) there are laws in place that will
control whether there is authority to make certain decisions unless
otherwise agreed (default laws).

Basics – In partnerships, where there is disagreement among the

partners on a certain course of action, the disagreement is
resolved by vote. Each partner gets 1 vote (regardless of the
amount he/she contributed), and some decision require
unanimous approval, while others merely require a majority.

Extraordinary Decisions – These require unanimous approval.

RUPA , UPA case law
• admission of a new partner
• amending the partnership agreement
• substantial changes to the nature of the partnership’s
business
• “acts in contravention of any agreement between the
partners” UPA

Ordinary Decisions – These only require a majority.

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• anything that is “in the ordinary course of business”

RUPA
• any “ordinary matters connected with the partnership
business” UPA

Deadlock – If no majority is possible because of an even number

of partners, the status quo prevails. I.e., those who oppose the
change win.

b) Binding the Partnership – Management rights include the right

(authority) to bind the partnership to 3rd parties.

Scope of Actual Authority – Partners may define the scope of

actual authority in the partnership agreement.
• UPA: each partner is an agent for the purpose of
conducting partnership business, and therefore has
implied actual authority to bind the partnership where it
is reasonably necessary to accomplish the proper
objectives of the partnership.
• RUPA: each partner has actual authority to bind the
partnership where it is reasonably necessary to
accomplish any task within the ordinary course of
business.

Limit: If a partner knows or should know that another partner

would object to a proposed commitment, the first partner has no
actual authority (unless otherwise agreed). the decision to bind
must then be put to a vote (see above).

Partnership by Estoppel – Even if the 1st part of the analysis

fails (i.e. there is no partnership, and the person is not actually a
partner, and thus has no actual authority), the partnership may
still be bound if it allowed or consented to the misrepresentation.
(See rules above.)

(iv) Right to access books and records

This right is available to all partners and is unqualified. Under RUPA it
is also available to former partners, but limited to those books and
records that pertain to the period during which they were partners, in
order to protect a dissociated partner’s legitimate interests. UPA §§19,
20, RUPA §403.
• no proper purpose is required (like in corps) because a partner is
subject to the risk of unlimited personal liability
• abuse of this right is a breach of the duty of good faith and fair
dealing
• this right may not be unreasonably restricted by the
partnership agreement RUPA §103(b)(2)
DUTIES :Remember, this can be contracted out. SEE CCM 102

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Note: § 103 prevents one from contracting out certain rights. SEE STATUTE BOOK PAGE 49
= § 103 says you may be able to limit some of the partner duties, but can’t
completely waive them.

(i) To Perform – Care

No duty to perform is presumed by partner status (i.e. passive partners who only
contribute assets are not violating any duty). But where a partner does perform,
he/she is subject to a duty of reasonable care that is only breached on a showing
of gross negligence – there is no breach of this duty of are where the partner
makes an ordinary mistake in judgment. This is the partnership version of the
BJR. The duty of care ends when the relationship ends – no duty is owed to
former partners.

(ii) Loyalty UPA §21, RUPA §404

There is a duty of loyalty between partners and the partnership. Partners are
prohibited from:
• competing with the partnership RUPA §404(b)(3), §UPA 21
• taking business opportunities away from the partnership
• using the partnership’s property for personal gain
• engaging in a conflict of interest transaction, or self-dealing
unless the other partners give informed consent.

Remember, these can be contracted out somewhat, but not entirely based on §
103.

Remedy for breach – Disgorgement of gain, and/or damages

Scope – Under UPA the duty of loyalty begins during the formation of
the partnership under §21, and continues until after the partnership
terminates. However under RUPA, the duty of loyalty does not extend to
the formation of the partnership, §404(b)(1), which is treated as an arm’s
length transaction. Under RUPA the duty not to compete ends upon
dissolution, but the other duties extend until the partnership terminates.

(iii) To Disclose
This is a special kind of duty of loyalty that applies where partners’ interests are
potentially or actually adverse.

Situations
• formation of the partnership (only under UPA; not RUPA)
• renegotiation of profit shares
• sale or purchase of a current partner’s interest
• exercise of management rights where the result disadvantages
one partner

Requirements - In partner v. partner transactions where the partners’

interests are adverse there must be:

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Full disclosure of material information – This means that the

person who has the material information must disclose it.
Material information is information that
• relates to the value of the partnership interest
• could not be learned by examining the books and records
• (relates to the partnership’s ability to properly conduct
the business of the partnership in the context of the duty
of care)
Materiality depends on the facts and circumstances:
sophistication of the investors, access to the information, nature
of the information, etc. Walter v. Holiday Inn p. 640

Good faith and fair dealing (generally not a duty, but an

obligation instead) – This means that partners deal with each
other candidly, without coercion (process), and that partners
have a duty to provide a fair price in the transaction (substance).

Issue: Acting in self interest (to protect ones own interest) in the above
situations is not a breach of any duty of loyalty, see RUPA §404(e), and
is acceptable as long as it is not excessive.

(iv) To Account
This arises where one partner alleges breach of duty against another partner.
UPA §22 provides for the right to an accounting of partnership affairs (where
adequate books and records have not been kept) and §20 provides for a duty to
provide information. RUPA §405(b)

Issue: What if the partnership agreement reduces or eliminates these duties?

This is an unclear area of the law. Although UPA and RUPA generally allow major
customizing of the relationships between the partners using the partnership agreement,
there are some limits on what the partnership agreements may change with regard to
partners’ duties.
• the partnership agreement can not totally eliminate fiduciary obligations to one
another,
• The more fundamental the duty that is being altered, the more likely it will be
subject to judicial scrutiny
• fundamental changes to the partnership that significantly alter the nature of the
partnership, or the partner’s stake (liability) may require unanimous consent, no
matter what the partnership agreement says (e.g., choosing to become an LLP –
see RUPA §1001).
• RUPA §103(b) lists restrictions on customizing the partnership agreement:
o it can not unreasonably restrict the right of access to books and records
o it can not eliminate the duty of loyalty
However, partnership agreements that authorize partners to compete with the partnership,
or self-dealing by a managing partner are commonplace and ordinarily enforceable.
Balancing the competing interests at stake - freedom of contract (as long as it is legal)
vs. protection of fiduciary nature of the partnership relation& partners’ interests – has
produced inconsistencies in the law.

PARTNER’S PROPERTY RIGHTS - CREDITORS RIGHTS

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Creditors’ rights are built into the partnership statutes.

PARTNERSHIP PROPERTY vs. INDIVIDUAL PARTNER’S PROPERTY.

It is often not clear whether a partner is contributing the use of his property (i.e. furnishing the
property), or ownership of the property itself. E.g., a partner may use his own laptop/car/property
for business use. Ideally all the property will be clearly designated as separate property or
partnership property, but often it is not.

[Who cares about this distinction?

• Creditors who may disagree with the individual and the partnership
• Partners who are departing/joining may disagree with the partnership
• Upon dissolution, the partners who may disagree with one another
• Heirs who are trying to settle the estate of a deceased partner
• The government for taxation purposes]

GENERAL RULES
• If the property is acquired during the partnership, it belongs to the partnership.
UPA §8, RUPA §203
• If the property is purchased by the partnership (using partnership assets), it
belongs to the partnership.
• If the property is contributed to the partnership, it belongs to the partnership.
UPA§8. (The value of such property at the time of contribution is returned to the
partner who contributed the property).
• If the property is merely furnished by a partner to the partnership for the
partnership’s use, the property is separate property belonging to the partner.
• If the property is leased to the partnership by a partner, the property is separate
property belonging to the partner.

TESTS FOR DISTINGUISHING B/T SEPARATE AND PARTNERSHIP PROPERTY

Under UPA
The intention of the parties controls.

Under RUPA
Title to the property controls.

Relevant Factors
• purchased by?
• used/possessed exclusively?
• record title?
• who pays for the taxes, improvements, repairs?
• recorded as partnership asset?
• payment of an underlying loan?
• other factors

PARTNERS PROPERTY RIGHTS

Partners generally have 2 kinds of property rights: their rights to specific (tangible) partnership
property (assets) and their rights to an economic (intangible) interest in the partnership itself.

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IN SPECIFIC PARTNERSHIP PROPERTY (ASSETS)

Ownership vs. Use/Possession

Under UPA
• Partnership property is considered to be co-owned by the partners –but
they don’t own it to the point where they can assign it. (reflective of the
aggregate theory). §25
• Each partner has the right to use/possess partnership property for the
purposes of the business, but not for other purposes. §25

Under RUPA
• Partnership property is considered to be owned by the partnership
(reflective of the entity theory). §501
• [same as UPA] A partner may use/possess partnership property only on
behalf of the partnership. §401(g).

IN THE PARTNERSHIP ITSELF

This is an intangible “economic” right in the partnership itself that includes a share of the
partnership’s profits, and reimbursement for the value of contributions.

Under UPA
Each partner is entitled to an equal share in the profits (unless otherwise agreed)
and to receive, usually when the partnership ends, the value of any property
he/she contributed to the partnership. §26

Under RUPA
[same as UPA] Each partner is entitled to an equal share in the profits (unless
otherwise agreed) and to receive, usually when the partnership ends, the value of
any property he/she contributed to the partnership. §502

RIGHTS OF THE INDIVIDUAL PARTNERS’ CREDITORS

Scenario: A creditor has a claim against an individual partner. Issues: Can the creditor reach the
partner’s interest in specific partnership property? Can the creditor reach the partner’s economic
interest in the partnership itself?

PARTNERSHIP PROPERTY

Under UPA
• the partner’s right to use/possess specific partnership property (for the
purposes of the partnership’s business) is not assignable
• and is not subject to attachment by creditors of the individual partner

Under RUPA
• the partner’s right to use/possess specific partnership property (for the
purpose of the partnership’s business) is not transferable
• and is not subject to attachment by creditors of the individual partner

INDIVIDUAL PARTNER’S INTEREST IN THE PARTNERSHIP ITSELF

Under UPA

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• A partner can assign this interest as collateral for debt (§27)

• If the creditor if the individual partner has a charging order (§28) – i.e. a
court order that requires the partnership to any amounts owed to the
partner directly to the partner’s creditor instead – the creditor can reach a
partner’s economic rights in the partnership (right to profits & right to
value of contribution).

Under RUPA
• A partner can assign this interest as collateral for debt (§502, 503)
• If the creditor if the individual partner has a charging order (§504) – i.e. a
court order that requires the partnership to any amounts owed to the
partner directly to the partner’s creditor instead – the creditor can reach a
partner’s economic rights in the partnership (right to profits & right to
value of contribution).

PARTNERSHIP CREDITORS’ RIGHTS

Scenario: A creditor has a claim against the partnership itself. Issue: Can the creditor reach the
specific partnership property? Can the creditor reach the partners’ rights to use/possess specific
partnership property? Can the creditor reach the partners’ economic interest in the partnership’s
profits?

PARTNERSHIP PROPERTY
• A partnership can assign its assets as collateral for debt §25(2)(B)
• The assets of the partnership are subject to attachment, §25(2)(C), RUPA §307

INDIVIDUAL PARTNER’S PROPERTY (i.e. profits & value of contributions)

Under UPA
• majority –§15: Partners are personally liable for the obligations of the
partnership so partnership creditors can levy on a partner’s individual
property
• minority – follows the RUPA approach below

Under RUPA
The partnership creditor must exhaust the partnership’s assets before levying on a
partner’s individual property where the partner is personally liable for the
partnership obligations under §306 (i.e. as long as the obligation was not incurred
before the partner’s admission). §307(d).

DISSOCIATION OF A PARTNER, DISSOLUTION & TERMINATION OF A

PARTNERSHIP

INTRO TO TERMINOLGY
• Dissociation – a partner leaves (RUPA)
• Dissolution
o Under UPA, a partner leaves; either
 the winding-up process begins or
 the business continues
o Under RUPA, the beginning of the winding up process

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• Continuation – though there has been a ‘dissolution’ under UPA (a partner leaves), or a
‘dissociation’ under RUPA, the business will continue without the member who caused
the dissociation/dissolution
• Winding-Up Process – there has been a dissolution (which triggers this process) and
necessary steps must be taken to end the business
• Liquidation – this is where all of the assets are sold, and the financial affairs settled
• Termination – this is a ‘catch-all’ term that refers to any method of disposing of the
business (including liquidation, sale, etc.)

DISSOCIATION (A Partner Leaves)

Under the UPA, the term ‘dissolution’ applies to both the end of a partnership and where there is
a change in the composition of the partnership. In an effort to resolve the resulting confusion,
RUPA uses 2 separate terms: ‘dissolution’ and ‘dissociation’.

GROUNDS UNDER UPA §31

No fault grounds -
• The expiration of a term (or undertaking) where the partners have agreed
that the partnership will carry on for a definite term or for a particular
undertaking.
• If the partners have not agreed to continue the partnership until the end
of a term or undertaking, each partner has the right to leave at will. See Prentiss
v. Sheffel (p. 798)
• Express will of all the partners (mutual agreement).
• Expulsion of a partner pursuant to the partnership agreement.
Wrongful grounds -
• If it violates the partnership agreement (e.g., a premature departure
where the partners have agreed that the partnership will carry on for a definite
term) and if there are no other applicable grounds under this section
Neutral causes -
• Involuntary withdrawal of a partner such as death or bankruptcy
• Where carrying on the business would be unlawful.
• Court order for dissolution, § 32 – partner declared crazy, incapabale, of
performing, guilty of prejudicial conduct affecting the business, p/s can only be
carried on at a loss, cirumstances that render a dissolution equittable.

GROUNDS UNDER RUPA §601

• notice of a partner’s at-will withdrawal
• any event specified in the partnership agreement as causing dissociation
• expulsion of a partner as provided by the partnership agreement
• expulsion by unanimous vote (under certain circumstances §601(4))
• expulsion by court order where there has been serious misconduct
• involuntary withdrawal due to insolvency, death, disability

CONSEQUENCES OF A MEMBER LEAVING

There are 2 possible consequences: (1) winding up of the business (discussed below); and
(2) continuation of the business.

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(1) Winding-Up Process

(discussed below)

What Determines That the Winding-Up Process is the Consequence?

Under UPA, when a partner is authorized to leave the partnership (either
under the partnership agreement, or under the default rules above), the
partnership automatically enters the winding-up process, unless
otherwise agreed in a continuation clause. Under RUPA, if one of the
events specified in §801 has occurred, only then does the partnership
enter the winding up process. (see below)

(2) Continuation (CM p. 85)

What Determines That Continuation is the Consequence?

Under UPA, when a partner wrongfully leaves the partnership, the
remaining partners have the right to continue the business UPA §38(2)(b)
as a new partnership. Alternatively, when a partner is authorized to leave
the partnership (either under the partnership agreement, or under the
default rules above), and the partnership agreement contains a
continuation clause, the partnership continues. Under RUPA, when a
partner leaves the partnership under any of the circumstances above, it is
presumed that the partnership will continue without that partner.

Requirement of Continuation Clause –

Under UPA, in order for the partnership to continue after an

‘authorized’ dissolution, the partnership agreement must provide
as such. If there is no continuation clause in the partnership
agreement, termination automatically follows from dissolution.
UPA §38(1). If the partnership anticipates dissolution from the
beginning, and provides for continuing the business in the
partnership agreement, it can evaluate and distribute the
departing partner’s interest in a way that is convenient to the
business and fair to the partner.

Under RUPA, there is no requirement that the partnership

agreement contains a continuation clause; continuation of the
partnership is automatic where a partner dissociates (unless one
of the events listed in §801 has occurred).

Incoming vs. Withdrawing Partner – When someone leaves or joins the

partnership, there must be some exchange of money for the value of the
interest in the partnership. However, there are no shares of stock that
you can buy and sell. Each partner is designated a percentage of interest
both upon entering the partnership and upon leaving. There are various
business valuation methods to determine the value of the partnership in
order to figure out the dollar value of the partner’s interest. The method
should be chosen in advance and specified in the partnership agreement.

Methods of Valuing the Partnership – CMM p. 124, 125

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• liquidation (will result in the lowest valuation)

• book value (equity = assets-liabilities)
• FMV
• appraised value (relies on an independent opinion)
• mutual agreement
• capitalized earnings (doesn’t look at assets and liabilities
like the book value method: looks at earning
power/profit-making potential of the business)

Issue: Intangible assets - these contribute to the worth of the

business but don’t show up on the balance sheet

Default Provisions
RUPA §701: If a partner dissociates, the partnership will buy out
the leaving party’s interest at the ‘buyout price’ which can be
determined by the partners. If they don’t agree, (b) suggests
FMV as a price but doesn’t really specify. The issue is ripe for
dispute.

UPA §§38(1), 42: Buyout is allowed where a partner retires or

dies and the value is measured as at the date of dissolution.

Partnership Creditor’s Claims

Under UPA
There is continuity of the partnership’s obligations to creditors
where there is some continuity of partners in the new firm. UPA
§§17, 41 (reflective of the aggregate theory)

Under RUPA
Relationships between a partner and its creditors are not affected
by the dissociation of a partner or by the addition of a new
partner, unless otherwise agreed. RUPA §703 (reflective of the
entity theory).

What Happens to the Partner Who Enters/Leaves

Authority – A leaving partner may still have lingering apparent authority
to bind the partnership, where the 3rd party has no knowledge of the
dissociation. (UPA §35, RUPA §702(a)) A partnership can protect itself
from being bound by the ex-partner by putting 3rd parties on notice. This
is practically impossible under UPA § 35, but RUPA §704 provides that
constructive notice (by filing a statement of dissolution with the state)
can suffice to relieve the partnership from liability. This is a big
improvement over UPA because it’s more formal/official.
Actual v. Apparent – CMM p. 126, 127

Fiduciary Duties

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Liability – A leaving partner can negotiate with a 3rd party creditor of the
partnership to get a release from liability. (UPA §36, RUPA §703)
Otherwise the partner remains subject to personal liability.
An incoming partner is not personally liable for obligations that the
partnership incurred prior to becoming a partner (UPA §17).

WINDING-UP PROCESS/DISSOLUTION

CAUSES OF DISSOLUTION

Under UPA §31 & 32

• expiration of a term (specified in partnership agreement)
• express will of partner
• express will of all partners
• expulsion of a partner (pursuant to partnership agreement)
• express will, even when in violation of partnership agreement
• illegality of continuation
• death
• bankruptcy
• by court order

RUPA §801
• express will of a partner (other than dissociation) (???)
• death of a partner + express will of other partners
• express will of all the partners
• expiration of a term
• event agreed upon
• illegality of continuation
• court order (under certain circumstances)

EFFECT OF DISSOLUTION – THE WINDING-UP PROCESS

The partnership continues after dissolution. (RUPA §802) Dissolution merely triggers
the winding-up process. The partnership is not terminated until the winding up process is
completed.

Authority
Upon dissolution, transactional authority (other than the authority partners need
to carry out the winding up process) ends. (statement of dissociation – RUPA
§804) Any partner has the right to participate in the winding up process. (RUPA
§803) Any partner may bind the partnership for any act that is appropriate for
winding up the business or if the 3rd party has not been put on notice that the
partnership is winding up. (RUPA §804)

Fiduciary Duties

Liability RUPA §306

Settling the Partnerships Accounts – Liquidation

UPA §40 Order of Priority:

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• pay all the creditors (other than partners)

• pay the partnership back for loans to a partner (outside creditors
have priority over partner creditors)
• pay the partners back their capital contributions (If partners
contributed services, property, etc. they should put a price tag on it in the
partnership agreement to protect the person at this stage from being
cheated of the value of his contribution.)
• pay all the partners an equal share of the partnership profits
(regardless of original contributions unless otherwise provided) – or
divide up the losses
Note: The federal bankruptcy laws apply to partners (re: creditors rights issues)
and override the UPA.

RUPA §807
• pay inside (partners) and outside creditors equally - this elevates
the status of the partners
• payment to partners of their liquidating distribution (includes
contributions and profits).

TERMINATION OF THE PARTNERSHIP

Possible scenarios – CMM p. 131

NOTICE TO 3RD PARTIES

§805 Statement of Dissolution: Under RUPA there is a formal statutory mechanism for
putting people on constructive notice that the business is ending. The statement of
dissolution (permissive, not mandatory) provides this. It is in the partnership’s best
interests to file one.

III. LIMITED LIABILITY PARTHERNSHIPS (LLPs)

INTRODUCTION: CMM p. 144

A creation of the law, this makes limited liability available for all partners of a general
partnership. A proper filing must be made with the state. Under UPA §15, partners are subject to
personal liability in the event that the partnership can not meet its obligations. If a partnership
invokes the limited liability partnership provisions of its governing statute it can eliminate
(partially or completely) the automatic personal liability for partnership obligations.

NATURE
Generally, LLPs are no different from general partnerships; most of the characteristics of a
general partnership (such as fiduciary duties, etc.) also apply to LLPs. The major difference is in
terms of the personal liability of the partners. Under RUPA §306(c) an obligation of the
partnership is solely an obligation of the partnership (reflecting the entity theory) and does not
subject the partners to personal liability. §306(c)

CREATION
Protection from personal liability requires that the partnership to meet certain requirements (in
order to put 3rd parties on notice of the limited liability):
1. The partnership must file a statement of qualification with the state. RUPA §1001. There
are certain requirements for what must be included in the statement of qualification.

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2. The partnership must notify all 3rd parties with whom it had dealt in the past of the new
LLP status. RUPA §1002
a. Name issue (must write “LLP” after name to ensure protected status).
3. The partnership must then file an annual report with the state in order to retain its LLP
status. RUPA $1001

Issue – defective LLP

If there is some defect in the process of becoming an LLP, there is no protection from
liability.

Issue – effective date

The partnership can not erase old obligations by filing the statement of qualification.
Therefore, 2 classes of creditors are created: debts and obligations incurred pre-
registration are subject to full partnership liability and do not enjoy the new LLP status.
(see §306).

FILING
There are certain requirements for what must be included in the statement of
qualification. §1001

NOTIFICATION TO 3RD PERSONS OF NEW STATUS

There is an obligation to notify all 3rd persons with whom the partnership had dealt with
in the past of the new LLP status (similar to agency law and partnership law) in order to
maintain the protection. RUPA §1002 – the letterhead, etc. must contain the initials
‘LLP.’ You are not required to explain the full legal implications, but you have to
disclose the status.

ANNUAL FILING REQUIREMENT

Under RUPA §1003, an annual report must be filed with the state so that they can
monitor. Failure to file the report – does this affect liability protection? No, doesn’t
automatically fail your status as LLP, that must be done by Sec of State. Look instead to
state statutes. See comments to §1003, though they are not binding on a judge.

APPLICATION TO PROFESSIONAL FIRMS

There are other special requirements that apply to professional firms, established by
licensing boards/regulatory bodies, which will govern the LLP, e.g., duties to clients, etc.
This may give courts an opportunity to ignore the statutory provisions that offer liability
protection, and find liability regardless of LLP status. Some statutes expressly provide
for this.

FOREIGN LLC RUPA §1102

Incorporated in one state but does business in another.

ADVANTAGES AND DISADVANTAGES

ADVANTAGES OF LLP STATUS (CM p. 94)

• You maintain the tax advantages of a partnership
• Partners are better protected from liability
• It’s easy to covert form a general partnership to an LLP (simply a matter
of filing forms, registering)

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• Major redrafting/restructuring of your partnership agreement is not

necessary
• The exiting general partnership norm – apart from the liability question –
still applies. i.e. maintains existing general partnership norm. The business
remains governed by partnership law (stability, consistency, predictability).
• Incorporates existing body of general partnership law/decisions

SPECIAL PROBLEMS WITH LLP’S (CM p. 93)

• There are requirements to establish an LLP, and to maintain it; e.g., filing
an annual report. A violation of these requirements (if they are considered
substantive) could deprive the partner’s of the LLP protection.
• All partnership rules apply: in the absence of a partnership agreement
governs the relationship between the partners, the default provisions will apply.
• Partner CYA behavior: Given the fact that there are distinctions being
made w/ respect to the partners’ liability, partners may be interested in
rearranging the relationship between the partners, e.g., demand more
compensation for being exposed to higher risk.
• Professional Firms: Is there a possibility that LLP protection doesn’t
apply to professional firms because of the duties/rules imposed by state
regulatory & licensing bodies?

SCOPE OF LIABILITY PROTECTION

FULL SHIELD PROTECTION

There is no vicarious liability for either tort or contract obligations. See, e.g., RUPA
§306(c) (providing protection from liability for both the partnership’s tort and contract
obligations).

PARTIAL-SHIELD PROTECTION CMM p. 140

Partners remain (personally) vicariously liable for contract debts, but are protected from
vicarious liability for the torts of other partners (negligence, malpractice, etc.). See, e.g.,
CM p. 96, Delaware Statute.

Issue: Is a partner’s contribution to the partnership insulated by partial shield

protection?

PERSONAL MISCONDUCT
There is no difference between general partnerships and LPPs: partners who commit torts
can still be held directly liable for their actions. LLP protection only extends to those
who are innocent, but who (under the law of general partnerships) would have been
personally liable for the misconduct of their fellow partners.

LIABILITY OF THE PARTNERSHIP

There is no difference between general partnerships and LPPs: the partnership itself
remains vicariously liable for the torts of its partners and for the contract obligations
undertaken on its behalf by its partners. LLP protection only applies to personal liability
of the partners, not vicarious liability of the entity.

SUPERVISORY RESPONSIBILITY

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Even though under both full-shield and partial-shield statutes, the partner is protected
from liability for the tortuous misconduct of other partners, many statutes contain
language that suggests partners are liable for the negligence of those whom they
supervise (i.e., an action for negligent supervision is implied).
For a supervisory partner to be found liable under this exception, he/she probably must
have some knowledge of what’s going on, or share some benefit, or have direct
supervision over the negligent partner. The exact scope of liability for negligent
supervision is yet undefined, but could have a serious effect on the supervisory partners’
relationships with the supervised partners.

INNOCENT PARTNER (no knowledge, no involvement)

Helping colleagues serve clients may be dangerous in an LLP because if you become
involved, you might take on potential liability for the work.

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IV. LIMITED PARTNERSHIPS

NATURE & ORGANIZATION

OVERVIEW
There are managing partners, and passive partners (investors). The managing partner may be an
entity, such as a corporation or an LLC.

ADVANTAGES
• This form is useful where the business needs investors, but doesn’t want to bring
outsiders into the management.
• This form is more attractive for investors than a general partnership, because they
will not be subject to personal liability.
• This form retains the tax benefits of the partnership form (partners are taxed once
individually)
• This form draws a clear distinction between partners (in theory) so that partner’s
know what their roles are.
• Legal precedent is widely available
• Exit privileges are restricted for limited partners (stability)

STATUTES
• ULPA
• RULPA ‘76
• RULPA ‘85
• RE-RULPA’01
The UPA also functions as the gap-filler. If the RULPA doesn’t provide for a particular
situation, the UPA provisions will govern.

Issue: Possible Application of Securities Laws

One of the key issues is whether the 1933 and 1934 Acts (issuance and trading of
securities) apply to limited partnerships requiring registration, etc. This hinges on
whether there is a security. An investment contract falls within the definition of security
if it satisfies the elements of the Howey test (see CM p. 68). There is also a test, (the
Williamson test) to determine whether securities laws apply to limited partnerships.

CREATION
Unlike a general partnership, the LP requires certain formalities. It is created by filing a
“certificate of limited partnership” with the state specifying two classes of partners: the general
partner (who has management authority and is subject to personal liability) and the limited
partner (who only invests and receives profits from the partnership in an ownership capacity –
like a shareholder - and who is not subject to personal liability). (See RULPA §201 –’76 version
w/ the ’85 amendments). The certificate must indicate the name of the LP, and some other basic
requirements.

SUCCESSFUL CREATION
If the certificate of limited partnership substantially complies with the ULPA, filing the
certificate brings the LP into existence either immediately, or on a later date specified in
the certificate. The LP is a legal entity, distinct from its co-owners (not an aggregate of
partners).

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DEFECTIVE CREATION
If there is substantial non-compliance with the creation requirements, the LP will legally
remain a general partnership. This presents a problem for the limited partners who
believe that they are protected from personal liability, and rely on the general partners to
manage the details. If the limited partner believes in good faith that he/she is a limited
partner rather than a general partner, and takes action, - either files a the certificate of
limited partnership or files a certificate of withdrawal - then that limited partner would
not be subject to personally liability as though he/she were a general partner. §304.

RELATIONSHIP b/t LIMITED PARTNER & GENERAL PARTNER

GOVERNING DOCUMENT
Under RULPA, the document that governs is the partnership agreement. Every issue is
subject to negotiation and customization. The partnership agreement details the rights,
responsibilities, and relationships of the partners.

THE LIMITED PARTNER vs. THE GENERAL PARTNER

PERSONAL LIABILITY
General partners are subject to full personal liability for tort and contract obligations of the
partnership. Limited partners have more limited liability.

TRADITIONAL RULE
A limited partner is not liable to 3rd parties for partnership transactions or debts unless
he/she takes part in the control of the business. ULPA §7.

Degrees of Participation/Control

Mere Consultant, Advisor - This does not amount to control, therefore

does not subject the limited partner to liability for partnership
obligations.

Personal, Active Participation - This does amount to control, therefore

does subject the limited partner to full liability for partnership
obligations.

Participation as an Employee – Grey area.

No Participation, but Full Financial Control - Grey area.

Indirect Participation as an Officer in a Corporation - I.e., one of the

general partners is a corporation, and the limited partner is an officer of
that corporation. Grey area.

Creditor Reliance - Split of Authority: Whether 3rd party reliance is

required in order to hold the limited partner liable depends on:
• whether the purpose of the rule is to punish the limited
partner

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o in which case only the extent of the limited

partner’s participation determines liability
o no 3rd party reliance is required
o and the 3rd party creditor gets the benefit of a
windfall
• whether the purpose of the rule is to protect creditors
o in which case the creditor’s reliance is required
Courts were split on what the purpose of the rule was.

CURRENT RULE - RULPA §303 (’76 w/ ’85 amendments)

This has been adopted in all jurisdictions, and provides generally that a limited partner is
not liable to 3rd parties for the obligations of the partnership unless:
1. he/she participates in the control of the business and
2. based on his/her conduct, the 3rd party entered the transaction in reliance
• or [partnership by estoppel] he/she permits his/her name to be used in the name
of the limited partnership and a 3rd party (who has no actual knowledge that the
limited partner is a limited partner) enters into a transaction with the partnership
This rule specifies a number of “safe-harbor” activities that do not constitute “control”
for the purposes of finding liability under the 2nd exception.

Reliance Issue
Under this rule, whether or not 3rd party reliance is required to hold the limited
partner liable is based on the extent of the partner’s participation: The more fully
the limited partner participates, the less likely it is that 3rd party reliance is
required. (CM p. 104-5).

NEW RULE - RE-RULPA § 303 (2001)

This provides full, status-based liability for limited partners for the partnership’s tort and
contract obligations, regardless of whether the limited partner participates in the
management and control of the partnership.

MANAGEMENT
The general partner(s) manage the partnership and have the power to bind the partnership.
General partners owe fiduciary duties of loyalty and care to the partnership in carrying out their
management function. See §105 (requiring that the general partnership keep certain books and
records as a responsibility to the limited partners).

Issue: Extent of General Partners’ Fiduciary Duties

There is an overriding duty of good faith and fair dealing. General partners also owe a duty of
disclosure, but how far does it go? Do general partners have to voluntarily disclose or disclose
only on demand? What responsibilities to limited partners have to inquire when there are clear
red flags? Appletree Square I Limited Partnership v. Investmark, Inc. p. 813

DEFAULT RULE
Limited partners are passive – they merely invest in the partnership. If the limited partner
doesn’t agree with management decisions being made by a general partner, he/she has
forfeited the right to participate/control, and the BJR would give deference to the general
partner.

OPTION TO ENLARGE THE MANAGEMENT ROLE

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However it is not unlawful for the limited partner to participate as long as there is
agreement that precludes the application of the default rule. Traditionally, such
participation exposed the limited partner to liability (see above).

DERIVATIVE ACTION
In extreme circumstances, limited partners can bring derivative suits to assert partnership
claims against the general partners. RULPA §§1001-1004.

PROFIT/LOSS SHARING
This deviates substantially from general partnership law which provides (a default rule) that
partners share profits equally, regardless of the amount they contribute.

AMOUNT DISTRIBUTED
Subject to the partnership agreement (which can provide that managing partners be
compensated for labor), profits and losses are allocated and distributions are shared in
proportion to the value of partners’ contributions.

LIMITS ON DISTRIBUTIONS §607

If issuing distributions would render the partnership insolvent, the distributions can not
me made.
If your liabilities exceed your assets, you’re insolvent (at least on paper).

TRANSFER OF PARTNERSHIP INTERESTS

TRANSFER OF MANAGEMENT AUTHORITY

Unless otherwise agreed, no partner (general or limited) may transfer his/her management
authority to another person without the consent of all the partners. (I.e., unanimous
approval is required.)

TRANSFER OF FINANCIAL INTEREST IN THE PARTNERSHIP

(i.e. the right to receive dividends) Unless otherwise agreed, this is freely
assignable/transferable.

DISSOCIATION/DISSOLUTION
General partners’ powers to dissociate from the partnership are discussed above. Limited
partners do not have the same power to dissociate and are subject to certain limitations. Whether
a limited partner may dissociate depends on whether the partnership agreement provides as such
(or provides a term for the partnership). The default rule is that a limited partner may only
withdraw by giving at least 6 months notice to the general partners. The default rule for when the
partnership is for a particular term is that the partner may not withdraw until the expiration of that
term (unless otherwise agreed0.

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V. THE LIMITED LIABILITY COMPANY

ULLCA [Corporations & Partnerships, “the best of both worlds”], Agency Law

NATURE & CREATION

NATURE
The LLC is a separate legal entity, §201. The owner’s are called ‘members.’ It can consist of
merely one person, §202.

MAJOR FEATURES
• Taxation is flow-through: members are taxed once.
• Members are protected from personal liability
• The LLC statute bears a close resemblance to RUPA
• Major customizing is possible – the statute governs mostly as a default rule.

CREATION
‘Articles of organization’ must be filed with the state in order to create an LLC. They must
identify the name of the firm (which must contain the initials LLC), the address of its principal
place of business, the name of the registered agent for service of process purposes, and that the
firm is an LLC. Most states require the LLC to file annual reports.

FINANCING THE LLC (same as partnerships under RUPA)

An LLC is funded by contributions from members which may include tangible or
intangible property, or any other benefit to the company, including contracts for services
performed, see ULLCA §401. Other financing is obtained through loans from partners
&/or 3rd party creditors.

CONVERTING ANOTHER ENTITY INTO AN LLC

Generally, the LLC assumes the rights and obligations of the converted entity as its
“successor in interest.” Like, LLPs under RUPA, 2 sets of creditors are created. For pre-
LLC transactions (entered into on behalf of the organizers) the members will be subject
to personal liability, unless the LLC ratifies the transactions. For post-filing transactions,
the members are shielded from personal liability.

Issue: Member’s Personal Guarantees in exchange for LLC Credit

Regardless of whether you set up an LLC (or incorporate), creditors may require
a personal guarantee from the members as a condition of extending credit to the
LLC, which undermines the protections these forms have against personal
liability.

Issue: Member Misconduct

Are members personally (individually) liable for their own misconduct?
Compare Curole with Estate of Countryman (handout): Estate of Countrymen
held that a member who participates in the tortuous misconduct of an LLC is not
protected from personal liability (i.e. that members are liable for their own torts).
In contrast, Curole held that in order for a member to be held personally liable
for his own misconduct, such misconduct must occur outside the scope of the
member’s employment (i.e., that members are not liable for their own torts if the
torts are committed in the member’s capacity as a member of the business).

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Notice to 3rd Parties

When converting another entity to an LLC, substantial compliance with the
formalities that are required by the statute (e.g. filing requirements, etc.) puts 3rd
parties on constructive notice of the limited personal liability. However, where
there has been non-compliance (e.g. omitting the initials “LLC” from the name of
the business, etc.) constructive notice may be defective. The undisclosed
principal doctrine of agency law would then apply to determine whether the
agent can be held personally liable for the obligations of the LLC to a 3rd party.
Water, Waste & Land, Inc. v. Lanham p. 836.

DEFECTIVE ORGANIZATION
Where there is a failure to form an LLC pursuant to the statutory requirements, the court
will generally find that a partnership exists, and hold the “members” (who are actually
merely partners) personally liable. See Compton v. Kirby (handout), Harvey v.
Covington (handout).

THE OPERATING AGREEMENT

The operating agreement is especially important because it governs out the relationship between
the members. It is elective (see ULLCA §103), not required, but failure to draft one results in the
application of the LLC statutes’ default provisions.

GENERAL HIERARCHY
The rules that govern LLCs are generally ranked in the following hierarchy:
• state constitution,
• state statute,
• articles of organization,
• operating agreement
• internal policies

OPERATING AGREEMENT vs. STATE LLC STATUTES

Where the state statute allows customizing, the operating agreement controls, even if it
departs from the default state law provisions. Elf Inc. v. Jaffari p. 842
The parties to an LLC agreement may contract to avoid the applicability of the default
statutory provisions that would govern in the absence of the agreement.
Some states, e.g., DE, have express policies behind their LLC laws to give maximum
effect to freedom of contract.

OPERATING AGREEMENT vs. STATE CONSTITUTIONS

An LLC can not be created to undermine anything in a state constitution.

OPERATING AGREEMENT vs. ARTICLES OF ORGANIZATION

Where these are in conflict, the operating agreement will control internal matters but the
articles will control matters involving 3rd parties who rely on the articles to their
detriment.

OPERATION
Like corporations, §112 provides for broad powers and allows the LLC to “do all things” that an
individual can do in order to carry on its business or affairs.

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LIABILITY

LIABILITY OF THE ENTITY TO 3RD PARTIES

Tort Liability
Contract Liability

PERSONAL LIABILITY OF THE MEMBERS

Generally, members of an LLC are not personally liable for the obligations of the LLC.

Exceptions:
Under some (narrow) circumstances, a court may find that members are subject
to personal liability.

Professional Firms - The same issues that apply to LLPs, apply to LLCs;
duties imposed by state licensing bodies may deprive professionals of
limited liability

Piercing the LLC Veil – (or reverse piercing)

The LLC liability protection is not absolute, and courts will apply this
doctrine where it is necessary to prevent injustice.

Factors:
• the entity was the alter ego or mere instrumentality of an
owner
• the owner used the entity not merely to protect
him/herself from liability, but to promote some type of
fraud or injustice
• the entity was undercapitalized (lacked enough assets to
meet reasonably foreseeable obligations)
• the owner
o disregarded the entity’s economic separateness
(commingling of assets)
o misappropriated entity funds
o disregarded the entity’s governance formalities

Personal Guarantee – (see above)

LLC = the undisclosed principal

If a member (agent) conducts a transaction on behalf of the LLC, but
does not disclose the identity of the LLC (as principal) the undisclosed
principal doctrine of agency law applies to subject the agent/member to
personal liability. (see notice to 3rd parties above)

MEMBERS’ RIGHTS AND DUTIES

Relationships between members and the LLC are generally governed by the operating agreement,
but in the absence of an agreement the default rules apply.

(a) MANAGEMENT AUTHORITY

The ULLCA distinguishes between a manager-managed LLC and a member-managed
LLC.

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Manager-Managed
If the LLC is manager-managed, members to not have apparent authority to bind
the LLC. ULLCA §301(b)(1): in a manager-managed LLC, “a member is not an
agent of the company for the purpose of its business” solely because he/she is a
member. [Note: a major difference b/t an LLC and a partnership – partners do
have apparent authority to bind the business simply because of their status as
partners.]

Member-Managed
If the LLC is member-managed, the authority of the members is similar to that of
partners in a partnership. Compare ULLCA §301(a) with UPA §9 and RUPA
§301.

When is an LLC manager-managed versus member-managed?

Unless the articles of organization specify that LLC is manager-managed, it will
be considered member-managed. ULLCA §203 – Comment.

Scope of Authority
Members (member-managed) and managers (manager-managed) have actual
authority and apparent authority to bind the company to 3rd parties (unless the
operating agreement restricts actual authority). Apparent authority extends to all
acts for carrying on in the ordinary course of the company’s business and
business of the kind carried on by the company. Beyond this, actual authority
created before, or ratified after, the act must exist in order for the act to bind the
company.

Statutory Provisions Conferring Authority

Where a statutory provision confers authority for specific acts, and conflicts with
the LLC’s operating agreement, the statutory provision will govern/prevail. (I.e.,
customizing is only allowed where it does not conflict with/undermine other
statutory provisions.)

(b) FIDUCIARY DUTIES OF MEMBERS

General partners owe broad fiduciary duties, while limited partners owe no duties solely
as a result of their limited partner status.

The general rule for when someone owes fiduciary duties is where the person has
authority to act on behalf of the business, where the person has been given management
authority, or where the person otherwise occupies a position of trust.

In the context of the LLC, members fiduciary duties depend on whether it is a member-
managed or manager-managed LLC. Fiduciary duties of loyalty and care are imposed on
members of member-managed LLC’s. They are not imposed on members of manager-
managed LLC’s solely based on the member’s member status. ULLCA §409.

Remedy for Breach of Fiduciary Duty

If a member has a cause of action (e.g., for personal injury) against the LLC,
he/she is bringing it in his/her own capacity. Any recovery would belong to the
member bringing the direct suit. The plaintiff/member must bear his own

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expenses and is not required to follow any procedural steps to pursue the
litigation besides what is usually required.

Because an LLC is an entity separate and distinct from its members, most
breaches of the fiduciary duty will directly harm the LLC (rather than its
members). If the person responsible for the harm to the LLC is the same person
who normally manages the LLC (i.e. acts on behalf of the LLC), the other
owners can bring a derivative suit on behalf of the LLC (over the objections of
management). All proceeds from a derivative suit belong to the entity (not the
owners who bring the suit). Reasonable legal expenses would be paid by the
defendant (manager) if the derivative suit was successful. A breach of the
operating agreement, on its own, does not necessarily create grounds for a
derivative claim.

Procedural Requirements for a Derivative Action:

ULLCA, §1101-04 - In order to bring a derivative action on behalf of the
LLC
• The plaintiff must be an existing member
• The plaintiff must have been a member at time of wrong (to
prevent someone from buying into a lawsuit)
• Either the managers who normally have authority to act on
behalf of the LLC have refused to act, or a demand that they act
would be futile (i.e. the BJR applies – deference is given to
management)
• the pleading must conform to ULLCA §1103

MEMBERS’ PROPERTY RIGHTS IN THE LLC (handout)

The ULLCA approach, which is identical to RUPA, is contained in Article 5.

MEMBERS’ PROPERTY RIGHTS IN THE LLC

Distributional Interest
§501, 502: the members are not co-owners, but they have a distributional interest
that may be transferred subject to §§502, 503.

Interest in Member Status

Members can not transfer their ownership of your member status. In order to do
so, unanimous approval is required (unless otherwise agreed in the operating
agreement).

LLC CREDITORS RIGHTS

Creditor’s who have a claim against the LLC can not hold the members personally liable
for the claim.

INDIVIDUAL MEMBER’S CREDITORS’ RIGHTS

Member’s Voluntary Assignment of Distributional Interest

§502: A transferee/creditor only has the right to receive the distributions that the
transferor/member would have been entitled to, not the right to act as a member,

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(unless otherwise agreed) The LLC doesn’t owe the same duties to the transferee
that it owes to the member/transferor (unless the LLC was abusive). The
transferee/assignee is locked in and can only wait for distributions, because
he/she is not entitled to participate in management, have access to information,
etc.

§ 503(b): It is possible for a transferee to become a member, but it depends on

the operating agreement which would probably contain a mandatory contribution
provision for membership in the LLC.

Member’s Involuntary Transfer of Interests to a Judgment Creditor

§504: The judgment creditor is not allowed to upset the LLC, but can file a
separate action in a court, for a charging order to charge (charging order = lock
step with RUPA) the distributional interest of the member, to the extent that
distributions are made. This puts the judgment creditor in the same position as
the voluntary transferee/assignee. No duties are owed by the LLC to the
judgment creditor.

DISSOLUTION
Articles 6, 7, and 8 of ULLCA provide for dissociation, continuation, and winding-up/termination
of the business. They are almost identical to the RUPA approach discussed above. They are
default provisions, and can be displaced by provision in the operating agreement.

DISSOCIATION
There are certain causes of dissociation, and certain grounds for dissociation. When a
member leaves, the LLC continues. The LLC must sell or buyout the dissociated
member’s distributional interest. Article 6, Article 7.

DISSOLUTION
“The entity is not terminated upon dissolution, but continues until all business issues are
resolved.” There are certain grounds for dissolution. Dissolution triggers a 3 part
process: dissolution (all new business ends), winding-up (all members’ actions must be
towards winding up the uncompleted transactions of the LLC), and termination (contact
business connections and file something with the state for constructive notice).
Uncompleted transactions of the LLC at the time of dissolution are assets of the LLC and
subject to distribution among the members. Article 8.

VI. IN THE FUTURE

THE MODEL ENTITY TRANSACTIONS ACT (META)

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