Why A Properly Formed Partnership is so Important

December 13, 2013

What are the consequences of an improperly formed partnership? The case of Utnehmer v. Crull (In re Utnehmer), 2013 WL 5573198 (B.A.P. 9th Cir October 10, 2013), recently decided by the Bankruptcy Appellate Panel of the 9th Circuit here in California, may shed some light on this question.

In 2005, real estate developer William Utnehmer, the debtor and defendant in this case, undertook to develop a luxury property in Venice, California. Mary and Patrick Crull, the judgment creditors and plaintiffs in this case, were offered an opportunity to participate in the project, which they accepted. Utnehmer sent the Crulls a packet of documents, which included a cover letter, a loan agreement for $100,000, a promissory note, and a private offering memo. The loan agreement provided that $50,000 of the initial $100,000 was intended to be superseded by execution of a formal operating agreement which would recharacterize the $50,000 of the Crull's interest as an investor's equity interest in a limited liability company to be formed, with an annual preferred return, and a percentage participation in profits on a prorated basis. At the time these documents were exchanged, the documents for formation of the limited liability company and the operating agreement were allegedly being drafted. The parties subsequently executed a promissory note, which was consistent with the loan agreement but made no reference to the expected recharacterization of the $50,000 as an equity interest.

In June 2008, the property sold for $3,725,000. Other project creditors were paid, but Utnehmer told the Crulls that he could not pay them, so they sued him in state court and obtained a default judgment for the balance due under the note. Utnehmer countered the default judgment by filing a Chapter 7 bankruptcy petition. The petition named the Crulls as creditors and sought to discharge the debt, and the Crulls countered by filing an adversary complaint to determine whether the debt was dischargeable.

At trial, the bankruptcy court found that the loan agreement created a partnership between Utnehmer and the Crulls, and, therefore, the debt could not be discharged. In reaching its ruling, the bankruptcy court relied on the defalcation criteria set out by Bankruptcy Code Section 523(a)(4), and the standard established by Lewis v. Scott, 97 F.3d 1182 (9th Cir. 1996). Defalcation is the misappropriation or embezzlement of money or funds held by an official trustee or other fiduciary, and section 523(a)(4) provides that a person who files for chapter 7 bankruptcy cannot discharge debts owed, which occurred due to fraud while acting in a fiduciary duty. Under Lewis, defalcation "includes innocent, as well as intentional or negligent defaults so as to reach the conduct of all fiduciaries who were short in their accounts."

Utnehmer appealed the bankruptcy court's decision, and the appellate court reversed, finding that (1) the standard established by Lewis had been abrogated by the United States Supreme Court in Bullock v. Bank Champaign, N.A. 133 S. Ct. 1754 (2013) (a defendant must have knowledge of or gross recklessness in respect to the improper nature of the relevant fiduciary behavior for a finding of defalcation), and (2) the terms of the loan agreement did not support a finding of a partnership between the Crulls and Utnehmer. The court specifically held that "where the parties purport to establish a partnership to engage in business at a future time or upon the happening of a contingency, the partnership does not come into being until the time specified or until the contingency is removed." Because the loan agreement did not indicate any intent to form a partnership or LLC at the time it was executed, or at any point before the execution of the operating agreement or LLC formation, it was insufficient to establish a partnership between the parties. Without a partnership, Utnehmer did not owe the Crulls a fiduciary duty under section 523(a)(4).

The above case illustrates a very unfortunate and expensive consequence of an improperly formed partnership. Don't get yourself in a similar situation. Forming a partnership requires the services of an experienced Sacramento business attorney. The Law Office of Kristina M. Reed can help you avoid a situation like the one faced by the Crulls. If you have questions about forming a partnership or need an experienced attorney to review partnership documents, please contact us.