Introduction:
As discussed elsewhere, there are two types of partnerships under California law, the General Partnership and the Limited Partnership. In both types of entities, the question arises as to whether a general partner who incurs expenses both to defend him or herself and/or to repay him or herself for liability imposed due to a judgment against him or her for partnership activities is entitled to have defense costs and, if necessary, judgment costs reimbursed by the Partnership.
This article shall discuss the basic law concerning that right to reimbursement.
The Basic Law:
Most of the law existing pertains to General Partnerships but the law is applicable to both types of partnerships when the issue relates to reimbursement of the General Partner.
The general partnership statutes include reimbursement requirements that are substantively identical to those for limited partnerships.
A. Corporations Code section 15904.06, subdivision (c), sets forth when a limited partnership must reimburse a general partner:
A limited partnership shall reimburse a general partner for payments made and indemnify a general partner for liabilities incurred by the general partner in the ordinary course of the activities of the partnership or for the preservation of its activities or property.
It also appears that, if the partnership agreement includes a provision specifying when reimbursement can be made, a court will enforce such a provision. (See Bardis v. Oates (2004) 119 Cal.4th 1, 12-13 [enforcing reimbursement provision, but finding no application where partners did not comply with the provision].)
1. Statutory Right to Reimbursement
Corporations Code section 15904.06 requires reimbursement for payments made by a general partner for liabilities incurred either (a) in the ordinary course of the activities of the partnership, or (b) for the preservation of the partnership’s activities or property.
There appears to be a strong argument that, before any partner can receive reimbursement for any expenses, the court must first determine that the expenses were actually incurred either in the ordinary course of the Partnership’s activities or for the preservation of its activities/property.
In Loveless v. Melton (Cal. App. 2007) 2007 WL 4340925, 17, the court held that the court must first determine that the conditions to reimbursement exist before the partner can receive reimbursement. Unfortunately, the case is not published. However, it cites Leboire v. Royce (1960) 53 Cal.2d 659, 668-69, as support for its conclusion. In Leboire, the appellate court found that the trial court had discretion to deny reimbursement where the facts did not support the conditions to reimbursement under a predecessor statute. (Ibid.)
The wording of the statute itself further supports this conclusion. The statute allows reimbursement, suggesting that the partner would first pay the expense and then later receive repayment from the partnership, not that the partnership would pay the expense in the first instance. Further, as a practical matter, whether an expense was incurred in the ordinary course of the Partnership’s activities or for the preservation of its activities/property often cannot be determined until there are factual findings by a court or jury.
Certainly, any general partner using partnership assets to defend him or herself can expect a motion from the opposing parties or other partners demanding that such repayment be delayed until the trier of fact determines that the expenses were properly incurred. Even if no such motion is made, assuming the general partner is found guilty of some transgression, the other partners are sure to demand reimbursement to the partnership for any sums advanced.
Since litigation is expensive, there is a great advantage to the general partner in having the partnership advance the costs. Thus, assuming a fight between partners, one of the common initial struggles in court is seeking the court to order that such reimbursement not occur until the matter is concluded.
a. Ordinary Course of the Partnership’s Activities
Litigation costs incurred in defending the Partnership could conceivably be considered a part of the Partnership’s ordinary course of activities if it were a lawsuit by a third party arising from the Partnership’s common activities (e.g., a real estate deal). However, that hypothetical lawsuit stands in contrast to a lawsuit brought by one of the Partnership’s own partners that alleges misconduct in the management of the Partnership. A strong argument may be advanced that such an internal lawsuit would not be considered a part of the Partnership’s ordinary course of activities; a partnership’s ordinary activities should not include defending itself against claims of internal mismanagement.
b. Preservation of the Partnership’s Activities or Property
The other type of claim for reimbursement stems from expenses incurred for preservation of property or business of the partnership. The same arguments that apply to ordinary course of business might apply to reimbursement to preserve the partnership assets, e.g. internal claims are harder to justify for reimbursement than third party claims. However, in an action which seeks monies or assets of the partnership in which the General Partner is paying for defense on behalf of the Partnership the right to reimbursement is likely to be granted.
c. Contractual Rights to Reimbursement
Many Partnership Agreement include a reimbursement provision which usually provides wording which specifically requires reimbursement for defense costs and for any judgment imposed upon a general partner and often provides for these expenses to be paid during the course of any litigation against the general partner.
The courts have usually held that such a clause will not allow reimbursement for intentional wrong doing by the general partner (and at times even gross negligence by the general partner) even if the clause would seem to indicate that such reimbursement would be provided. (Some states, such as Delaware often do allow such reimbursement for their partnerships.) The courts in California normally hold that such reimbursement for fraud, breach of duty or conversion would be voided by public policy. Thus, while the protection afforded a general partner can be enlarged by the correct wording, it is not a complete bar to all possible types of expenses and liabilities.
What such clauses can allow, however, is reimbursement during the course of the proceeding (defense costs such as attorney’s fees and costs incurred in court) but that would have to be reimbursed to the partnership if the general partner is found to have violated the law or committed intentional wrongdoing.
Practical Considerations:
Given the costs of litigation and the danger of facing a substantial personal judgment, the right to claim indemnity and payment of legal costs from the Partnership has significant tactical advantages for the general partner. This is particularly true if the general partner has the partnership pay the costs during the litigation.
The fact that the other partners who may be claiming wrongdoing on the part of the general partner must find means to pay their own legal bills while the general partner uses the partnership funds…partially owned by his opposing party-partners (!)…gives the general partner a decided advantage.
Any prospective partner should carefully review any partnership agreement to determine if such rights are included in the partnership agreement. Further, should any litigation commence, challenging the right of the general partner to use such funds should be an initial consideration of the other partners.
In terms of being a general partner, having such a clause strongly worded will give not only an advantage in terms of contesting other partners or third parties, but greatly alters the cost benefit analysis as to the entire litigation. It may be the single most important part of the partnership agreement.