Joint Ventures Based on a General Partnership
Joint ventures are a subset of partnerships. Many if not most joint ventures use, as their structural basis, a general partnership. This approach will be discussed first. However, it is also possible to form a joint venture based on limited partnership, and this model is addressed below.
A joint venture differs from a general partnership in its narrower scope and focus (usually investment in a single property venture), but is otherwise governed by the law of partnerships. Smith v. Deneve, 285 S.W.3d 904, 913 (Tex.App.—Dallas 2009, no pet.). A partnership or joint venture is a form of contract, whether written or oral. Texas courts have historically supported the concept of freedom of contract, allowing the parties to make agreements and allocate risks as they see fit, so long as some express statutory or common-law principles are not violated in the process. El Paso Field Servs., L,P. v. MasTec N. Am., Inc., 389 S.W.3d 802 (Tex. 2012).
In contrast to a joint venture, the typical general partnership is created for the long term for a broad range of business purposes. The partners may contemplate engaging in various enterprises with the intention that the partnership will endure from one transaction to the next into the indefinite future. Most joint ventures, by contrast, 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.
Law Applicable to General Partnerships
The law applicable to general partnerships (including joint ventures based on the general partnership model) is found in Business Organizations Code (“BOC”) Title 4. The BOC defines 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).
A “joint venture is governed by the same rules as a partnership.” Enterprise Prods. Partners, L.P. v. Energy Transfer Partners, L.P., 529 S.W.3d 531 (Tex.App.—Dallas 2017, pet. filed). “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 Entity Theory
Texas subscribes to the entity theory when it comes to general partnerships and joint ventures. Both are considered to be legal entities that 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 Sec. 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 to 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.
“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.” Smith v. Deneve, id.
Even though a partnership is a distinct entity, each general 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 Section 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.
Where is the Firewall?
The most important contrast with an LLC is that neither a general partnership nor a joint venture based on a general partnership 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?”
Written Versus Oral General Partnerships
A partnership agreement consists of “any agreement, written or oral, of the partners concerning a partnership” (BOC §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. 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).
Although a general partnership agreement may be oral or written, 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.
Unfortunately, joint ventures are often undertaken informally, without a written agreement, so doubt can arise as to whether, legally speaking, a partnership has been formed at all. BOC section152.052 sets forth rules for determining if a partnership has been created (the so-called “five factors” to which reference is frequently made in partnership cases):
(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. They are also non-exclusive, meaning that not all factors need be demonstrated in any particular case. Just “one factor standing on its own can be strong enough to support the existence of a partnership”—even an oral general partnership. Black v. Redmond, 709 Fed. App. 766 (5th Cir. 2017). The existence or non-existence of a partnership thus depends on the totality of the circumstances.
BOC Section 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 or use the term “partners.” All sorts of circumstantial information can be used to make this determination, even the bankruptcy schedules later filed by the parties after the business has failed. Palasota v. Doron, No. 10-16-00326-CV, 2018 WL 2054511 (Tex.App.—Waco May 2, 2018, no pet. h.).
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 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) 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).
Based on the foregoing, it should be clear that the first step 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. Avoid junk forms from the Internet.
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].
Fiduciary Duty of Partners and Joint Venturers
BOC Section 152.205 describes the general partners’ duty of loyalty to one another. Joint Venturers operating in the context of a general partnership are, to use the legal term, fiduciaries, which requires honest and honorable conduct with respect to both the partnership enterprise and the other partners. “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).
If the totality of circumstances supports it, courts will go to considerable lengths, first to find that a partnership exists where none was expressly stated, and then to find that one partner breached his fiduciary duty to the other, all resulting in an award of actual and exemplary damages plus attorney’s fees. Harun. v. Rachid, No. 05-16-00584-CV, 2018 WL 329292 (Tex.App.—Dallas Jan. 9, 2018, no pet. h.).
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 Joint Venturers
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 §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 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 §152.306.
Piercing the Veil of a Joint Venture Based on a General Partnership
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).
Joint Ventures Based on a Limited Partnership
The above discussion has focused on joint ventures that use as their basis a general partnership. It is, however, also possible to base a joint venture on a limited partnership. LPs are governed by BOC Title 4, Chapter 153, but also Chapters 151, 153 and 154 and Title 1, to the extent applicable.
There are certain critical differences between general and limited partnerships. Firstly, a limited partnership is a registered entity, meaning that, like a corporation or an LLC, it must pay fees to file a certificate of formation which becomes public record. (Accordingly, there is no such thing as an oral limited partnership.) An LP is also subject to annual reporting and fees. A general partnership is burdened by none of this and has the ability to operate privately.
Secondly, different operational rules apply. In a general partnership, all partners may take part in the enterprise, and all partners have full, unrestricted liability. In a limited partnership, only the general partner may engage in management. In exchange for giving up control, the limited partners are held liable only to the extent of their respective contributions to the LP. The general partner is the only member to assume unrestricted liability. For this reason, the general partner is usually a corporation or LLC with minimal assets established specifically for the purpose of managing the LP and nothing else. The general partner is typically is a 1% owner. Since management is the sole province of the general partner, LP agreements tend to be heavy in their emphasis on the powers and duties of the general partner.
The limited partners may be any sort of entity, including another limited partnership. But they should definitely be entities, not individuals. Only amateurs participate in a joint venture, regardless of how it is structured, in their individual, personal capacities.
Limited partnership tend to be more common in commercial transactions, but their usefulness in other investment arenas should not be overlooked. In the most basic form of a limited partnership (two partners), the general partner owns a 1% interest and a limited partner owns a 99% interest. There may of course be more partners with different percentages of ownership. If there is more than one general partner (and this is allowed), 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.
Investments: The Real Estate Product and the Legal Product
When tempted to participate in any venture of substance, an investor should inquire into at least two things: first, the economic nature of the investment itself—basic due diligence, in other words. What is the investment product being sold? Are the fundamentals underlying the real estate, the management of the project, and the anticipated ROI solid? This inquiry is essential, of course, and most everyone knows to do this. Unfortunately, that’s where many investors will stop . . . and in doing so they miss an essential second question: What is the legal product associated with this investment?
There are a couple of parts to the question regarding the legal product. Firstly, what specific documents are involved and are they of first-class quality from the perspective of legal draftsmanship? Are they serious legal work or a lot of random contract clauses amateurishly cobbled together from the Internet? A review of the prospectus is entirely insufficient here. One should dig deeper and insist on seeing, well in advance, all documents that the investor will be asked to sign.
The second part of the “legal product” inquiry is this: What reputable lawyer or law firm drafted the documents? Do these attorneys actively and openly stand behind the project (at least in a legal sense), or is the law firm’s name nowhere to be found? Is the promoter’s attorney available for the investor’s attorney to call and ask questions? The visibility (the presence or absence) of a quality attorney standing behind a project and its promoter can be quite telling and, as much as anything else, can provide an indication as to the legitimacy and trustworthiness of both. Good lawyers and law firms, in order to protect their liability, tend to look into such clients before allowing the firm’s name to be used in association with the project. The absence of this should be a red flag if not an outright disqualifier.
This firm routinely receives requests that we “look over” proposed documents for an investment. Often these consist only of a prospectus, or perhaps a marketing plan with impressive graphs and tables, without any substantive underlying legal documents that the client would be expected to sign. There may be no mention of the law firm that prepared these documents or is standing behind the promoter. In such situations, caution is in order for both the investor and the investor’s attorney.
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 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 joint venture, 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.
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 © 2020 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, www.LoneStarLandLaw.com.