An LLC is the Key: The False Dichotomy Between Inadvertent Partnerships and the Freedom of Contract

52 Texas Tech L. Rev. 243

71 Pages Posted: 23 May 2019 Last revised: 25 Feb 2020

Date Written: April 25, 2019

Abstract

A general partnership is defined by statute as two or more persons associated as co-owners of a for-profit business. Whether this definition is satisfied is a factual question. While the intent to attain a certain legal status—to be “partners” in the eyes of the law—is relevant to the issue of partnership formation, it is not dispositive. Hence, if a jury finds that two or more people satisfied the statutory definition of a general partnership, those people are partners even if they expressly disclaimed any intent to be partners—indeed, even if they signed a contract denying that they are partners.

Recently, in a high-profile verdict, a Texas jury found that two pipeline companies that were contemplating a joint venture became partners despite agreeing in writing not to be. As a result, the jury found that the defendant owed the plaintiff—and breached, by competing with the partnership—a fiduciary duty of loyalty. This led to a half-billion-dollar judgment against the defendant.

On appeal, the defendant argued that sophisticated parties must be able to govern their business relationships as they see fit and explore potential joint ventures without owing any fiduciary duties. Therefore, the defendant argued, partnership law must allow sophisticated parties to contract around partnership as a matter of law. Perhaps based on this freedom of contract argument, a Dallas appellate court overturned the jury verdict. The case is now on appeal to the Texas Supreme Court.

But the dichotomy that the defendant posed, between inadvertent partnerships and the freedom of contract, is false. In fact, there is a better way for sophisticated parties to avoid partnership and the accompanying fiduciary duties. Parties who are exploring a joint venture and do not wish to be partners can form a Delaware limited liability company (LLC) (and possibly a Texas LLC) to govern their potential business venture. Not only will this exempt the parties from the definition of partnership, it will allow them to waive all fiduciary duties and replace them (or not) with contractual duties.

Since sophisticated parties can form an LLC to avoid forming a partnership, avoid fiduciary duties and structure their affairs as they see fit, there is no “freedom of contract” basis for allowing such parties to contract around partnership as a matter of law. Moreover, there is good reason to prohibit it: such a rule would undermine the protections that partnership law provides to unsophisticated parties.

Inadvertent partnerships protect unsophisticated parties by providing a set of default rules to govern business relations among those who fail to create their own rules by agreement. Partnership law also subjects partners to mandatory fiduciary duties to protect unsophisticated parties from sharp dealing because partners in informal partnerships typically place great trust in their co-partners.

Unfortunately, if sophisticated parties could contract around partnership formation simply by contract, so could unsophisticated parties—in writing or otherwise. This would leave unsophisticated parties without the default provisions and mandatory fiduciary duties that partnership provides.

The Texas Supreme Court should therefore refuse to allow two sophisticated parties that choose the wrong way to avoid partnership to ruin partnership law for the unsophisticated parties who depend on it. Although the Court could possibly craft a decision that allows sophisticated parties to contract around partnership as a matter of law and without harming unsophisticated parties, doing so would be worse than simply overturning the appellate court’s decision. And if the Texas Supreme Court fails to protect unsophisticated parties, the Texas Legislature should step in to protect them.

Keywords: Inadvertent partnership, Partnership, LLC, Delaware LLC

Suggested Citation

Leahy, Joseph Kieran, An LLC is the Key: The False Dichotomy Between Inadvertent Partnerships and the Freedom of Contract (April 25, 2019). 52 Texas Tech L. Rev. 243, Available at SSRN: https://ssrn.com/abstract=3351223

Joseph Kieran Leahy (Contact Author)

South Texas College of Law - Houston ( email )

1303 San Jacinto Street
Houston, TX 77002
United States
7136462936 (Phone)

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