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Dissociation of One Partner in Two-Person Partnership Triggers Dissolution, Not Buyout

Wednesday, August 17, 2011

Erica Smith | Bloomberg Law Corrales v. Corrales, No. G043598, 2011 BL 208326 (Cal. Ct. App. Aug. 10, 2011) The California Court of Appeal reversed a ruling on valuation of a partnership following one partner's departure. The court found that the valuation was based on the incorrect premise that the partner's interest would be bought out, and that his departure actually triggered dissolution of the partnership.

Brothers' Partnership Ends After One Starts Competing Business

This case involves litigation between two brothers, appellant Richard Corrales and respondent Rudy Corrales, who together formed an entity called RC Electronics (RCE) pursuant to a written partnership agreement with an indefinite term. RCE's business was to repair, refurbish, and sell computer tape drives. Richard provided the financing and business know-how, and Rudy ran the business. Over time, Rudy's family became involved in the business as well: his wife was the office manager and prepared RCE's business records, and their daughters also worked for the company. Despite RCE's success during 15 years in business, Richard learned that Rudy and his family had set up their own business to compete with RCE. After Rudy refused to respond to Richard's questions about the other business, Richard sent Rudy a "Notice of Dissociation" informing him that Richard was withdrawing from the partnership. The brothers filed lawsuits against each other, and the suits were tried together. A significant issue was how to value RCE for buyout purposes under the provision of California's partnership law that requires a partnership to buy out a dissociated partner's interest, Cal. Corp. Code § 16701. The trial court agreed with the valuation method proposed by Rudy's expert and also found that Richard had not proven damages arising from Rudy's breach of duty in pursuing a competing business. Richard appealed, arguing that the evidence did not support the business valuation proposed by Rudy's expert, that his own expert's valuation estimates should have been adopted by the court, and that he did show damages based on Rudy's breach of duty.

Buyout Provision Inapplicable; Partner's Departure Triggered Dissolution

The court of appeal found that the judgment regarding the partnership buyout was reached in error because it "rested solely on an inapplicable statute." Corrales at 4. The buyout provision, Section 16701, sets forth the procedure for valuing a dissociated partner's interest where the remaining partners continue the partnership business without him. However, it was incorrect to follow the buyout procedure because "[w]hen Richard withdrew from RCE, the partnership dissolved by operation of law; by definition, a partnership must consist of at least two persons." Id. at 6 (citing definition of "partnership" as "an association of two or more persons" in Cal. Corp. Code § 16101(9)). As the court explained, a "partnership at will" exists where the partners have not specified when the partnership will end (as was the case with RCE, where the partnership agreement reflected an indefinite term). See Cal. Corp. Code § 16101(11)). Under California partnership law, dissolution of a partnership at will occurs when at least half of the partners of the partnership express their desire to dissolve and wind up the partnership, and a partner's dissociation "'constitutes an expression of that partner's will to dissolve and wind up the partnership business.'" Id. (quoting Cal. Corp. Code § 16801(1)). When one partner dissociates from a two-person partnership, the business dissolves because "[o]ne person cannot carry on a business as a partnership." Id. at 7 (citing Cal. Corp. Code § 16101(9)). Upon dissolution, the proper procedure to wind up the business is to satisfy the partnership's obligations to its creditors and then distribute any surplus to the partners. See Cal. Corp. Code § 16807. The buyout remedy comes into play only when the business continues without dissolving, so Section 16701 is inapplicable to a two-person partnership when one partner leaves. Thus, the court of appeal found that it was improper to follow the buyout procedure in Section 16701 and reversed the judgment on that basis. The court directed the trial court to enter a judicial dissolution of the partnership on remand, pursuant to Sections 16801 and 16807.

Damages from Competing Business to Be Addressed During Winding Up Process

Regarding Richard's claim that he was damaged by Rudy's breach of fiduciary duty in developing a competing business, the court pointed out the general rule that partners may not sue each other for damages stemming from partnership business until after an action for dissolution and accounting. An exception to the rule applies in "an action for damages for a tort 'of such a nature that it not only terminates the partnership but wrongfully destroys it, and where the erring partner converts to his own use its entire assets.'" Id. at 8 (citations omitted). The court found this exception inapplicable because no evidence showed that Rudy converted all of RCE's assets or destroyed the business, and because it was Richard's departure that terminated the partnership. Noting that an accounting was necessary as part of the winding up process under Section 16807, the court stated that any amounts improperly earned by Rudy's competing business could be added to the partnership assets in the accounting and then distributed to the partners as part of the winding up process.
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