When friends decide to buy vacation property together, they may not consider the legal status of their relationship—at least until litigation starts. Importantly, they may not be aware that they might have formed a general partnership and thus have fiduciary duties to each other.
When clients come to you after a purchase or business has fallen apart, the first thing to determine is whether they had a partnership.
Keep in mind that a general partnership is the default business entity when two or more persons jointly engage in a business for profit and otherwise don’t choose an alternative form of entity for their business operations. Whether a particular association is a partnership depends on whether a community of interest arises between the parties, whether the business is undertaken as a common enterprise with a mutual right of control, and whether the business is operated for the parties’ joint account with the right in each owner to share in the profits. Greene v Brooks (1965) 235 CA2d 161.
Once you know you’re dealing with a general partnership, certain fiduciary duties come into play, including the duty of loyalty and the duty of care. Corp C §16404.
Here’s a scenario illustrating how the fiduciary duty issue arises in a partnership: Two couples formed a partnership to buy a beach house. The first couple provided most of the down payment, while the other provided some cash and agreed to make the mortgage payments. When the second couple failed to make the payments, the first couple declined the second couple’s demand to use joint funds to do so. The first couple then acquired the property at a foreclosure sale, and the second couple sued.
The following issues are raised: (1) whether the first couple had a fiduciary duty to make the mortgage payments, and (2) whether the first couple could purchase the house in a foreclosure sale without breaching a fiduciary duty to the other couple.
This factual example was presented in Jones v Wagner (2001) 90 CA4th 466, in which the court affirmed a judgment after trial for the first couple. The court held that: (1) the first couple had no legal or equitable duty to use partnership funds to make mortgage payments on the house after the partners who were individually liable on the mortgage stopped making payments; and (2) the first couple could bid and purchase the house at the foreclosure sale.
The court cited Corp C §16404 for the proposition that “[t]here were unquestionably fiduciary duties among the partners here, as in all partnerships.” 90 CA4th at 471. However, the court refused to create an obligation to make capital contributions beyond the couples’ original agreement. With respect to the foreclosure sale bid, the court again relied on Corp C §16404(e) in holding that a partner doesn’t breach his or her fiduciary duty “merely because the partner’s conduct furthers the partner’s own interest.” 90 CA4th at 473. The court ruled that the first couple could bid at the foreclosure sale even though the property was partnership property. The court recognized that there might have been a different result if the parties had so provided in the partnership agreement.
For everything you need to know about fiduciary duty law as it relates to California-based business entities, presented in a clear and structured way with many factual examples, check out CEB’s newest book Understanding Fiduciary Duties in Business Entities.
© The Regents of the University of California, 2016. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited.