Partnership Agreements Can Be Verbal—If You Want to Court Disaster

Be careful. You can become part of a partnership without even knowing it and then become personally liable for the partnership’s debts and your partner’s fraud.

In Fall v Loudon, 2008 WL 37598 (which is an unpublished but useful case), the court held that Timothy Fall and Gregg Loudon functioned as “partners” under Michigan’s partnership statute even though they did not have a written agreement. MCL 449.6 provides that “[a] partnership is an association of 2 or more persons ... to carry on a business for profit.” In Byker v Mannes, 465 Mich 637, 653 (2002), the Michigan Supreme Court stated that “the intent to create a partnership is not required if the acts and conduct of the parties otherwise evidence that the parties carried on as co-owners a business for profit.”

In the Fall case, the Michigan Court of Appeals distinguished between the existence of a partnership and the enforceability of a particular partnership agreement. The Court found that Mr. Fall had prepared a written partnership agreement, but Mr. Loudon never signed it. Then, there were disagreements about how long the partnership would last. The problem is that agreements that cannot be performed within one year of the making of the agreement must be in writing and signed by the party to be charged to be enforced. MCLA 566.132(1)(a); see Marrero v McDonnell Douglas Capital Corp., 200 Mich App 438, 441 (1993), mod on other grounds by Patterson v Kleiman, 447 Mich 429, 433-434 (1994). Partners cannot enforce long-term agreements that are verbal.

In addition, MCLA 449.20 provides: “Partners shall render on demand true and full information of all things affecting the partnership to any partner or the legal representative of any deceased partner or partner under legal disability.” MCL 449.20. MCLA 449.21(1) provides that a partner may be held to be a fiduciary of the other partner. As the court put it in the Fall case: “[E]very partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.”

The Court of Appeals quoted a passage from In Band v Livonia Assoc, 176 Mich App 95, 113-114; (1989):

The courts universally recognize the fiduciary relationship of partners and impose on them obligations of the utmost good faith and integrity in their dealings with one another in partnership affairs. Partners are held to a standard stricter than the morals of the marketplace and their fiduciary duties should be broadly construed, connoting not mere honesty but the punctilio of honor most sensitive. The fiduciary duty among partners is generally one of full and frank disclosure of all relevant information. Each partner has the right to know all that the others know, and each is required to make full disclosure of all material facts within his knowledge in any way relating to the partnership affairs. Thus, disclosure to one or several partners does not fulfill this duty as to every other partner. [Citations and internal quotations omitted.]

Like other states, Michigan now permits people to form limited liability companies. These companies can have a single member and feel like a sole proprietorship. The companies can also be an association of 2 or more persons ... to carry on a business for profit as in a partnership. The big difference between a partnership and a limited liability company (LLC) is that the members of an LLC are not liable to third parties for the debts of the business as they would be in a traditional partnership. Further, the strict law of partnership does not apply to LLC’s.

MCL 450.4202(2) provides that “[t]he existence of the limited liability company begins on the effective date of the articles of organization as provided in [MCL 450.4104].” MCL 450.4104(1) requires that the articles of organization be delivered to the administrator of the Michigan Department of Energy, Labor and Economic Growth (DELEG). Under MCL 450.4104(2), after delivery of the articles of organization, “the administrator shall endorse upon it the word ‘filed’ with his or her official title and the date of receipt and of filing[.]” And under MCL 450.4104(6), “[a] document filed under [MCL 450.4104(2)] is effective at the time it is endorsed[.]” Unlike a partnership which can be formed verbally or by conduct, an LLC can only be formed by filing the articles of organization with the State.

Further, once an LLC is properly formed, then its members have the advantage of limited liability, and a member or manager is not liable for the acts, debts, or obligations of the company. That said, if a person signs a contract on behalf of an LLC that has not yet been formed, that person can have personal liability for the contract. See Duray Development, LLC v Perrin, 288 Mich App 143 (2010). In Duray Development, the Court noted that a company can become liable if, (1) after the company comes into existence, it either ratifies or adopts that contract, (2) a court determines that a de facto corporation existed at the time of the contract, or (3) a court orders that corporation by estoppel prevented the opposing party from arguing against the existence of a corporation.

The Court of Appeals in the Duray Development case extended the “de facto corporation” doctrine to LLC’s. The doctrine (which is based on estoppel) was summarized for corporations by the Michigan Supreme Court in Estey Mfg. Co. v. Runnells:

Where a body assumes to be a corporation and acts under a particular name, a third party dealing with it under such assumed name is estopped to deny its corporate existence.

In short, a person cannot receive invoices, pay them, write letters to the “de facto” corporation, do business with it—and then claim the corporation does not exist. But this is mutual. The “de facto” corporation cannot conduct business and induce reasonable reliance on itself as a corporation and then later disclaim its corporate status.

The facts in the Dubay Development case (where the court held that the LLC was a de facto LLC) were as follows:

Perrin was an individual party to the first contract, as was his limited liability company, Perrin Excavating. However, only Outlaw became a party to the second contract, which superseded the first. And all parties dealt with the second contract as though Outlaw were a party. After the second contract, Duray Development received billings from Outlaw, and not from Perrin. Duray Development also received a certificate of liability insurance for Outlaw. Munger testified that he dealt with Perrin, Perrin Excavating, and KDM Excavating before the second contract and only dealt with Outlaw after. Duray Development continued to assume Outlaw was a valid limited liability company after filing the lawsuit and only learned of the filing and contract discrepancies once litigation began in July 2006.

Just as partners in a partnership have a fiduciary duty with regard to each other, members of LLC’s can be sued by other members if their acts are “illegal or fraudulent or constitute willfully unfair and oppressive conduct toward the limited liability company or the member.” MCLA 450.4515 provides as follows:

(1) A member of a limited liability company may bring an action in the circuit court of the county in which the limited liability company's principal place of business or registered office is located to establish that acts of the managers or members in control of the limited liability company are illegal or fraudulent or constitute willfully unfair and oppressive conduct toward the limited liability company or the member. If the member establishes grounds for relief, the circuit court may issue an order or grant relief as it considers appropriate, including, but not limited to, an order providing for any of the following:

(a) The dissolution and liquidation of the assets and business of the limited liability company.

(b) The cancellation or alteration of a provision in the articles of organization or in an operating agreement.

(c) The direction, alteration, or prohibition of an act of the limited liability company or its members or managers.

(d) The purchase at fair value of the member's interest in the limited liability company, either by the company or by any members responsible for the wrongful acts.

(e) An award of damages to the limited liability company or to the member. An action seeking an award of damages must be commenced within 3 years after the cause of action under this section has accrued or within 2 years after the member discovers or reasonably should have discovered the cause of action under this section, whichever occurs first.

(2) As used in this section, “willfully unfair and oppressive conduct” means a continuing course of conduct or a significant action or series of actions that substantially interferes with the interests of the member as a member. Willfully unfair and oppressive conduct may include the termination of employment or limitations on employment benefits to the extent that the actions interfere with distributions or other member interests disproportionately as to the affected member. The term does not include conduct or actions that are permitted by the articles of organization, an operating agreement, another agreement to which the member is a party, or a consistently applied written company policy or procedure.

Before you form a business, you should consult with an experienced business attorney—and you should then check back with that attorney as the company grows to avoid personal liability for yourself and/or unnecessary liability for the company.

Categories: Blog, Business Law