DAVID J. WILLIS ATTORNEY
Copyright © 2018. All rights reserved worldwide.
PARTNERSHIPS AND JOINT VENTURES
By David J. Willis, J.D., LL.M.
Texas partnership law is found in Business Organizations Code ("BOC") Title 4. For real estate investors, it is also important to have a working knowledge of the Texas Property Code. Professional investors keep a paperback copy of the Property Code on their desks.
A partnership agreement may be oral or written, but it is certainly more prudent for real estate investors to reduce their agreement to writing. There's an old saying about marriage that is equally applicable to partnerships: "Going in, it's all about love. Coming out, it's all about money." So it's best to have the exits clearly marked.
BOC sec. 152.052 sets forth rules for determining if a partnership has been created:
(a) Factors indicating that persons have create a partnership include the persons':
(1) receipt or right to receive a share of profits of the business;
(2) expression of an intent to be partnership in the business;
(3) participation or right to participate in control of the business;
(4) agreement to share or sharing;
(A) losses of the business; or
(B) liability for claims by third parties against the business; and
(5) agreement to contribute money or contributing money or property to the business.
No one of the above factors is dispositive. The existence or non-existence of a partnership depends on the totality of the circumstances.
Texas Business Organizations Code sec. 152.051(b) provides that a partnership exists when two or more persons associate together for the purpose of carrying on a business for profit, regardless of whether or not they actually intended to create a partnership. A true legal partnership, however, must rise to a higher level than mere casual collaboration. A Houston appeals court decision describes a situation where a partnership was not found to exist: "The parties did not associate for the purpose of carrying on a single business in which they each held an ownership interest; instead, the four separate businesses agreed to work together for their mutual, but individually realized, benefit. Such coordinated business efforts do not, alone, create a partnership under Texas law. The parties did not share profits, losses, or liabilities." Further, the court failed to find any evidence that the businesses in question ever actually intended to be partners in the legal sense—an important and essential element. Westside Wrecker Serv. v. Skafi, 361 S.W.3d 153, 173 (Tex.App.—Houston [1st Dist.] 2011, pet. denied).
Whether or not a partnership exists is unfortunately the subject of much litigation. A plaintiff typically alleges the existence of a partnership in order to invoke the fiduciary duty responsibilities of a partner—or, more specifically, how the defendant "partner" in question may have violated that duty by misappropriating funds or assets.
The moral here is that one does not want to casually slide into an inadvertent partnership that could have unfortunate consequences in terms of liability. A partnership should be established deliberately and correctly with a comprehensive written partnership or joint venture agreement. One should not, for instance, casually refer to one's business associates as "partners" (a much overused term nowdays) unless they are in fact partners in the legal sense. You may be creating an unintended partnership. Also, if an associate of yours falsely represents to others that a partnership exists, and those others reasonably rely on that representation to their detriment, then a partnership (known as a "partnership by estoppel") may be created. Fleishman-Hillard, Inc. v. Oman, No. SA-11-CA-921-H, 2012 WL 13028770 (W.D. Tex. Nov. 21, 2012).
General partnerships are the focus of BOC Title 4, chapter 152. A general partnership is an association of two or more persons or entities (all of which assume unrestricted personal liability for partnership debts and activities) who intend to carry on a business for profit. Each partner has equal rights in the management and conduct of the business of a general partnership. In contrast with the common law, the BOC does not specifically require an intention to share profits or losses, although this is an important evidentiary factor in determining whether or not a partnership exists. Ingram v. Deere, 288 S.W.3d 886, 895-96 (Tex. 2009).
Texas subscribes to the entity theory when it comes to partnerships and joint ventures. Both are considered to be legal entities which may be sued and held liable for damages. A partnership is an entity distinct from its partners, and partnership property is not considered to be the individual property of the partners (BOC sec. 152.056 and 152.101). A partner may use or possess partnership property only on behalf of the partnership. This ties in with the fiduciary duty of partners both to the partnership and one another, specifically including a partner's duty of loyalty (BOC sec. 152.205) and duty of care (BOC sec. 152.206). More on the partners' fiduciary duty below.
Even though a partnership is a distinct entity, each partner nonetheless remains jointly and severally liable for all debts and obligations of the partnership. Personal liability is not automatic, however, at least not if the partnership alone is the object of a lawsuit. A judgment against a partnership as an entity must be accompanied by a judgment against the individual partners (named separately as defendants) in order to be enforceable against the partners' individual non-partnership assets. American Star Energy and Minerals Corporation v. Stowers, 457 S.W.3d 427 (Tex. 2015). See also BOC sec. 152.306, which requires that a judgment against a partnership must go unsatisfied for 90 days before a creditor may proceed against an individual partner and his assets.
The most important contrast with an LLC is that neither a general partnership nor a joint venture has a liability barrier—no firewall, which is a distinct disadvantage in a business as litigation-prone as real estate investing. When it comes to potential liability and protection of personal assets, there is little difference between a partnership format and simply owning assets in one's individual name. For this reason, general partnerships and joint ventures should almost always be structured so that the partners themselves are LLCs or corporations. Anytime an investor is considering a transactional structure, one of the first questions should be "Where is the firewall? Where is the liability barrier that is going to protect my personal assets?
Fiduciary Duty of the Partners
BOC sec. 152.205 describes the general partners' duty of loyalty to one another. Partners in a general partnership are, to use the legal term, fiduciaries, which requires honest and honorable conduct. "As a fiduciary, a partner is under an obligation not to usurp opportunities for personal gain, and equity will hold a partner accountable to the partnership if he does so. . . . Thus, the [general] partnership relation imposes upon all partners an obligation of the utmost good faith, fairness and honesty in the dealings with each other with respect to matters pertaining to the partnership business." In re. Leal, 360 B.R. 231, 235-6 (Bankr.S.D.Tex. 2007).
Different rules apply to partners in limited partnerships so long as the limited partner in question does not "change hats" and exercise operating control over the LP business, since that crosses a legal boundary that has multiple implications. No fiduciary duty exists in the case of a limited partner simply because he is a limited partner. Strebel v. Wimberly, 371 S.W.3d 267, 281 (Tex.App.—Houston [1st Dist.] 2012, pet. denied).
There is a four-year statute of limitations for breach of fiduciary duty actions contained in Chapter 16 of the Texas Civil Practice & Remedies Code.
Liability for the Actions of other Partners
Pick your partners well. Supposedly, a general partnership (and the individual partners) are liable only for actions of a partner when those actions fall within the ordinary course of business of the partnership or are authorized by the partnership (BOC sec. 152.303). So two things need to be considered here: first, the fact that real estate investing involves a truly broad range of activities, which means that almost anything done on or about an investment property, or even indirectly affecting the property, can conceivably be considered as within the partnership's ordinary course of business; and second, trial courts (in their capacity as finders of fact) have significant flexibility in interpreting any given set of circumstances before them, a level of flexibility to which appeals courts tend to defer.
Take an admittedly extreme example: suppose your managing partner, unbeknownst to you and the other partners, opens a shady massage parlor on the premises. Are you liable for the consequences (at least the civil ones)? The answer is almost certainly yes, given that the actual use of the property is something that is most definitely the business of the entity that owns it. This is another good reason to enter into partnerships, if at all, in the capacity of an entity that possesses a liability barrier, and not in your personal name.
In Texas, a plaintiff must first secure a judgment against the partnership before pursuing actions against the individual partners. American Star Energy and Minerals Corp. v. Stowers, 457 S.W. 3d 427 (Tex. 2015) referencing Bus. Orgs. Code sec. 152.306.
Piercing the Veil of a Partnership or Joint Venture
How difficult is it to pierce the veil of a general partnership? The question is based on a misunderstanding of the law, since a general partnership or joint venture has no veil to pierce. Shoop v. Devon Energy Prod. Co., L.P., No. 3:10-cv-00650-P, 2013 WL 12251353 (N.D. Tex. Mar. 29, 2013). Piercing and alter-ego-type allegations are "inapplicable with regard to a partnership because there is no veil that needs piercing. . . . Pinebrook Props., Ltd. v. Brookhaven Lake Prop. Owners Ass'n, 77 S.W.3d 487, 500 (Tex.App.—Texarkana 2002, pet. denied). The partners in a general partnership or joint venture are potentially jointly and severally liable for all of it, which reiterates the importance of engaging in a partnership only in the capacity of an LLC or corporation.
Veil-piercing in the case of limited partners is a slightly different case, but is generally rejected in Texas because a "person doing business with [a limited partnership] always has recourse against any general partner. . . ." Peterson Grp. v. PLTQ Lotus Grp., 417 S.W.3d 46, 56-57 (Tex.App.—Houston [1st Dist.] 2013 pet. denied).
The presence of fraud or misrepresentation can affect the outcome of any court case, but especially ones involving piercing. As is true with LLCs, do not rely on a limited partnership to limit your liability if you utilize the entity to commit actual fraud. "As a general matter, a limited partnership is an entity separate and distinct from its partners, with separate, distinct liabilities and obligations. Nevertheless, Texas law allows the separateness of the entity to be ignored if the limited partnership is used as a straw man for the purposes of obtaining an impermissible result [such as actual fraud] under Texas law. . . ." In re Sewell, 413 B.R. 562, 571-72 (Bankr.E.D.Tex. 2009).That being said, "limited partners are generally not responsible for the limited partnership's obligations unless they take some action to accept or subject themselves to such liability"—such as interfering with management or control of the business. Peterson Grp. V. PLTQ Lotus Grp., 417 S.W.3d 46, 56-57 (Tex.App.—Houston [1st Dist.] 2013, pet. denied).
The Partnership Agreement
A partnership agreement consists of "any agreement, written or oral, of the partners concerning a partnership" (BOC sec. 151.001(5)). To the extent that a partnership agreement does not otherwise provide, the BOC governs. Deere v. Ingram, 198 S.W.3d 96,101 (Tex.App.—Dallas 2006). Fundamentally, partnership agreements are contracts between the partners, and the law applicable to the construction of contracts applies unless the BOC provides to the contrary. Having said that, an oral partnership will likely violate the statute of frauds (see chapter 12), so sensible investors will insist on having a clear and comprehensive written partnership agreement that does not require the intervention of a court to interpret and apply it. Exxon Corp v. Breezevale Ltd., 82 S.W.3d 429, 443 (Tex.App.—Dallas 2002, pet. denied).
A joint venture differs from a general partnership in its narrower scope, but is otherwise governed by the law of general partnerships. Smith v. Deneve, 285 S.W.3d 904, 913 (Tex.App.—Dallas 2009, no pet.). The practical difference is this: general partnerships are usually created for the long term for a broad range of business purposes. They may contemplate engaging in various enterprises with the intention that the partnership will endure from one transaction to the next into the indefinite future. Joint ventures, by contrast, generally have a specific task or time frame. They perform that task, net profits are distributed, and they are done. One example would be investors pooling resources and efforts in order to buy, rehab, and re-sell either a specific residential house or a commercial project—a flip, in other words. Another example would be investors acquiring raw land to hold for a couple of years and then sell.
“A joint venture is a distinct legal entity. This relationship is similar to a partnership, but the principal distinction is that a joint venture is usually limited to one particular enterprise. A joint venture must be based on an agreement, either express or implied.” Varosa Energy, Ltd. v. Tripplehorn, No. 01-12-00287-CV (Tex.App.—Houston [1st Dist.] 2014, no pet.). The agreement must provide for the sharing of both gains and losses. Arthur v. Grimmett, 319 S.W.3d 711 (Tex.App.—El Paso 2009, pet. denied). “A joint venture has four elements: (1) a community of interest in the venture; (2) an agreement to share profits; (3) an agreement to share losses; and (4) a mutual right of control or management of the enterprise. Generally a joint venture is governed by the [same] rules applicable to partnerships.” Smith v. Deneve, 285 S.W.3d 904, 913 (Tex.App.—Dallas 2009, no pet).
The first step is in creating a sound joint venture is to draft a clear written agreement. The second step is usually to convey the subject property into it. A joint-venture agreement dealing with real estate does not, by itself, represent an interest in property or act as a transfer of that property. For that, a deed is required as a necessary second step. Sewing v. Bowman, 371 S.W.3d 321 (Tex. App.—Houston [1st Dist.] 2012, pet. dism’d].
In a properly registered limited partnership, the general partner is the only member to assume unrestricted liability. The limited partners have liability only to the extent of their contributions to the partnership. LPs are governed by BOC Title 4, chapter 153, but also chapters 151, 153 and 154 and Title 1, to the extent applicable. At least in the context of real estate investment, all of the partners usually are (or should be) LLCs or corporations. It is important to note that the limited partners are strictly prohibited from engaging in the conduct or management of the business. This job is the sole province of the general partner. Accordingly, LP agreements tend to be heavy in their emphasis upon the powers and duties of the general partner.
In most cases, the general partner is formed and established specifically for the purpose of managing the LP. Our preference is to use a traditional Texas LLC for this purpose. The limited partners may be any sort of entity, including another LP. A series LLC (Texas or Nevada) is also a good choice, since additional internal firewalls are then built into the structure.
LPs are most common in commercial transactions, but their usefulness in other investment arenas should not be overlooked. A basic LP (illustrated in the accompanying diagram) includes a general partner that owns a 1% interest and a limited partner that owns a 99% interest. There may of course be more partners. If there is more than one GP, then one of them should be designated the managing partner.
An LP is an excellent way to bring in a passive "money partner" who is cautious about incurring liability beyond the amount invested.
What about TICs? How are these different from other partnerships? Our explanation will reveal our bias against these arrangements.
TICs are written up as general partnerships but are nonetheless focused on a specific deal, often a larger project such as an apartment complex or a strip center. Promoters seek out investors, usually affluent novices, who are packaged together in their personal capacities. In other words, these newbie investors do not form an LLC or corporation to act on their behalf in the deal; they sign the TIC agreement individually and then go on to personally guarantee a seven or eight-figure note to a bank. If the value of the investment (often inflated to begin with in order to provide up-front fees for the promoters) declines, the results are usually unfortunate for the investors. The promoters—who have since taken their profits and moved on to other schemes—are the winners.
Real estate lawyers are accustomed to counseling TIC investors who have awakened to find that a lender suddenly seeks to hold them individually liable for a very large sum. Few consulted an attorney before signing up with the TIC. Many are otherwise smart and successful professionals who should have known better.
Minimal Contents of a Partnership Agreement
When it comes to drafting contracts and agreements, partnership agreements included, we prefer that the effective date, the name and contact information of the parties, and the subject property all be plainly visible on the first page. The agreement should go on to address the following:
What are the respective percentage interests of the partners?
How will the partnership be managed? By majority vote? Will some issues require unanimous vote? Will there be a managing partner? What are the limits of his authority? What are the specific actions and duties required of each partner?
What about the investment property or project itself? Are there parameters for its rehabilitation and resale that need to be stated?
What will be the term (length) of the agreement? Presumably it will end when the project is finished and net proceeds are distributed, but this needs to be spelled out.
How will funds be handled? Who will sign checks? What about additional, future contributions if necessary?
Will there be loans as well as capital contributions by the partners? What about loans made by banks or hard money lenders? Promissory notes will need to be authorized and executed.
What about meetings of the partners? What constitutes a quorum? Who controls the agenda?
Suppose a partner wants to sell his interest or cash in? Suppose a partner dies? Will remaining partners have a right of first refusal to buy the decedent's interest? On what terms?
What happens if a partner's spouse files for divorce? Will remaining partners unwillingly wind up in business with the ex?
Every contract or agreement should have a default paragraph. What constitutes a default by a partner? If default occurs, what is the procedure for expelling a defaulting partner?
A good partnership agreement should address the issue of dispute resolution. Will mediation be required before one partner may sue another? That is usually good policy.
Finally, never underestimate the "miscellaneous" paragraph at the end of a contract. It deals with such issues as amending the agreement, which law applies and where venue will be located if a suit is filed, and so forth.
A complete partnership agreement will address all of these items and more, which is not to say that partnership agreements need to be unduly complex, long, or intimidating. Consult an attorney knowledgeable in the field in order to draft a partnership agreement and before signing one. Never use forms off the Internet for this purpose.
No contract or transaction should ever be entered into without a consideration of asset protection ramifications if the deal fails. It is often the attorney who must counsel a starry-eyed, in-a-rush client that a proposed transaction could fail as well as succeed. In the event of failure, what is the exit strategy? Which of the client's assets will be exposed and how can that exposure be limited?
Lawyers can often see disaster looming, not because they are prescient but because they have seen this film before. In certain cases, when a happily oblivious client is determined to self-destruct, a lawyer may find it necessary to decline the representation.
Intelligent structuring implies an awareness not only of the mechanics of a proposed transaction but also of potential outcomes and their consequences. A willingness to look down the road, so to speak, where it may fork one way or another. Clients are sometimes astonishingly reluctant to this, accusing the attorney of trying to "kill the deal"—an unjust charge in most cases. An attorney's job is to make the deal work, ideally in the client's best interest, which brings us back to structuring issues.
Knowledgeable investors will have an entity, a management company, that (acting through an assumed name) is utilized for business with tenants, vendors, contractors, brokers, and other persons who might one day get riled up and file a lawsuit. The management company is substantially a shell that contains employees, rental furniture, leased vehicles, and minimal cash. It is an equity-free dead-end for creditors. Hard assets reside in a separate holding company that does business with no one. The public should not even know that the holding company exists. In any case, prudent investors avoid signing contracts, leases, and the like in their personal name. All decisions that may have liability implications are made with an eye toward asset protection.
In the context of a partnership, it is therefore preferable for the investor to choose an existing entity (or perhaps form a new entity) in order to participate in the deal, making the enterprise a partnership of entities. This provides the best protection. And when it comes to personal signatures and guarantees, the solution is often to just say no.
The Menace of Family and Friends
Why not collaborate with friends and family members? They know you best, after all. Caution, however, is advised. All lawyers can tell stories of clients who propose doing a transaction with a brother-in-law, or perhaps borrowing money from parents, and declare that no partnership agreement is necessary because the other party is family or a close friend. In fact, the reverse is true. In transactions involving family and friends it is more important to reduce the agreement to a signed writing, not less so. Anyone who has witnessed the agony of intra-family litigation knows this to be true.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright © 2018 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, http://www.LoneStarLandLaw.com