Partnership Interest Secretly Transferred to Family Member

Does a partner have an obligation — separate and apart from the terms of a partnership agreement — to disclose the fact that one of the partners has transferred their interest to another member of the partnership?

The question seems to answer itself.  Of course it is.  After all, is there anything more material to the business of a partnership than the identities of the partners?  But in a case earlier this year involving a secret transfer from a mother to one of her sons, the New Jersey Appellate Division’s came to the contrary conclusion.  The narrow reading given by the court to the Uniform Partnership Act and its failure to find that there was a duty to disclose the transfer is troubling.

Fiduciary Duties under the Uniform Partnership Act

The question that is lurking in this decision, Taylor v. Taylor, Docket No. A-4363-09T1 (N.J. App. Div. July 8, 2011), is whether the adoption of the UPA fundamentally altered the relationship between the partners of a partnership, and whether precedent going back to the early 20th Century is still good law.  The Taylor decision suggests it is not.

I do need to confess my personal bias.  I think the current trend of allowing parties in a business relationship to contract away basic principles of honesty and loyalty, demonstrated by statutory and occasional court approval of agreements that eliminate fiduciary duties, is a bad idea.  In my opinion, it’s like the Japanese gangster who willingly cuts off his own fingertip to atone for a mistake.  The fact that the Yakuza participated in the wrong done to himself doesn’t make it right.  On the other hand, I appear to be in the minority and the drafters of the Uniform Partnership Act, adopted in New Jersey in 2000, and a growing number of courts seem to think otherwise.

Undue Influence Claim

Not that the outcome of the Taylor case is particularly surprising.  The court there rejected an undue influence claim asserted by one brother alleging that the other brother had wrongfully coerced their mother into transferring her interest in the family business to him before her death.  Moreover, because the business that they owned together had already been sold, the breach probably caused no damages.

The narrow reading given to the Uniform Partnership Act by the Appellate Division, however, is difficult to reconcile with the well-established precedent that partners stand in an elevated fiduciary relationships to one another, obligated to exercise the “utmost good faith.”  See, e.g., Stark v. Reingold, 18 N.J. 251 (1955).  It is also difficult to square with another Appellate Division opinion earlier this year – also involving a family partnership – describing the relationship of partners as “one of trust and confidence, calling for the utmost good faith, permitting of no secret advantages or benefits … a duty of the finest loyalty.”  Pass v. Kirschner, Docket No. A-40002-07T3 (N.J. App. Div. March 9, 2011).

The Taylor family was the owner of a health club and a corporation in which the health club operated.  Originally the businesses were owned by the father and two sons, Rick and George.  When the father died, his interest passed to their mother.  The mother later decided that she wanted to transfer her interest to Ricky, thus eliminating it from the assets that would pass by her will.

Mrs. Taylor, however, insisted that the transfer be kept from George and continued to act as though she were one of the three owners.  She executed various documents in connection with the sale of the business and continued to sign checks almost a year after she had performed the transaction.

George sought damages on the basis that Ricky had breached his fiduciary duties to him and also sought to expel him from the partnership (apparently notwithstanding the prior sale of the business.)  The court held, however, that the concealment by mother and son of the transfer had not “materially affected the partnership business,” (emphasis in original.)  Nor had Ricky breached his fiduciary duties of loyalty and care.

Fiduciary Duties under the UPA

If a partnership agreement does not specify the limits, those duties are specified – and limited – by the UPA.  The relevant statutory provisions are:

The only fiduciary duties a partner owes to the partnership and the other partners are the duty of loyalty and the duty of care set forth in subsections b. and c. of this section, as those duties may be clarified or limited in the partnership agreement …

b. A partner’s duty of loyalty to the partnership and the other partners is limited to the following:

(1) to account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the partnership business or derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity;

(2) to refrain from knowingly dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest materially adverse to the partnership; and

(3) to refrain from actions intended to cause material injury to the partnership in the conduct of the partnership business before the dissolution of the partnership.

c. A partner’s duty of care to the partnership and the other partners in the conduct and winding up of the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.

The Taylor panel read the definition of fiduciary obligations narrowly, perhaps too narrowly, as not falling within one of the clearly articulated duties.  One of the principles of a partnership is the ability of the partners to do business with the people they choose.  The other is the limitation on transferability.  A partner may transfer their right to profits and losses, but not the management rights.  The transferee has no right to exercise the partnership rights.  A partner who transfers all of his or her interest is subject to expulsion by unanimous vote of the partnership. 

The opinion is silent about what the partnership agreement said about transferability of the partners’ interest.  Nonetheless the opinion reads as though it purported to be a complete conveyance of the partnership interest, not the mere assignment of the partners interest.

Knowing who the partners are may also have an impact on whether and how the partnership continues.  A partner has the right to withdraw, even in breach of the partnership agreement, and be paid the fair value of their interests.  Moreover, the transfer of the complete interest could in itself cause the dissolution of the partnership if the transferring partner is withdrawing.

In short, the manner in which the Taylor court construed the breach of fiduciary duty claim as not including any duty of disclosure of matters that are material to the partnership business and the partner should give anyone involved in the partnership a bit of pause.  It is probably no longer correct to assume that a partner must disclose material events and that the concept of a “duty of the finest loyalty” may be fading into history.