Bill Klein has an interesting little piece on a venerable partnership case: Martin v. Peyton: Rich Investors, Risky Investment, and the Line between Lenders and Undisclosed Partners. As the abstract says,
[t]he case involved an investment by a small group of wealthy and socially prominent New Yorkers in an investment banking firm that was badly managed and on the threshold of insolvency. The decision in the case turns on the distinction between lenders and partners, or, more broadly, between debt and equity.
As many business association scholars know, the wealthy New Yorkers were sued as unintentional partners by other creditors of the investment banking firm. The article presents some interesting history. For example, the defendants were quite well-connected: Peyton was the inventor of a smokeless gunpowder, was a significant gunpowder magnate and married to a DuPont. The article goes onto show, as the abstract says,
how the unique terms of the deal, with elements of both pure debt and pure equity, were dictated by the circumstances that gave rise to it. In particular, the risky nature of the investment and the thin, or nonexistent, equity cushion led to the would-be lenders accepting a contingent return and, as a corollary, some elements of control. . . . [T]he essay examines the policy justification for the rule making silent partners liable for the firm's debts - a rule analogous to vicarious liability of employers for the torts of their employees and to the agency-law principle that makes undisclosed principals liable for unauthorized debts incurred by their agents. In addressing policy, fairness is a commonly claimed and generally admirable goal, but for market transactions it is generally not instructive, as Martin illustrates. Economic efficiency is likely to be a more meaningful policy criterion, as, again, Martin illustrates. But, as Martin also illustrates, economic efficiency, largely relying on unproven, and possibly unprovable, conjectures, can be a fickle and inconclusive criterion.
I liked the history and am generally sympathetic with the analysis, but I think there’s more to explore.
First, Klein notes that part of the deal structure was to avoid the usury laws. I would add that the usury laws were an important historical basis of partnership, as discussed in Bromberg & Ribstein on Partnership, section 1.02.
Second, Klein discusses the lawyering angle. He says that plaintiff’s failed argument that Hall, the manager of the bailed-out investment banking partnership, was a surrogate of the creditor-defendants led the court to focus on the language of the agreement. This is an interesting approach, since it suggests the more general point that an advocate's focusing on messy or hard-to-prove facts may backfire by pushing the court into a straight legal analysis that the advocate wanted to avoid. But I’m not sure this was bad lawyering, at least viewed ex ante, since the agreement did include significant partnership-type profit-sharing and control. It’s more likely, in my view, that the plaintiff was the victim of the court’s novel approach to interpreting an agreement like this, as discussed below.
Third, Klein discusses the jurisprudence of the case. He says the court stacks the deck for defendants by presuming in favor of a loan rather than partnership. But note that the standard procedure in modern partnership law is to eliminate the presumption from profit sharing in a "protected relationship" such as a loan. That elimination would put the burden of proving partnership or any other liability theory on plaintiff, just as the court did. So the court didn't so much stack the deck against this particular plaintiff as adopt a new, modern approach for the reasons stated below. Note also that the author of the opinion for the New York Court of Appeals was Andrews, who frequently espoused more rule-oriented, agreement-oriented approaches (remember his dissent in Palsgraf?).
So, fourth, and most importantly, this brings us to the policy in the case. Klein points out that the court essentially rejected the assumption in inherent agency power cases (which this case resembles) that the principal is the cheaper cost avoider. Klein notes that this rejection is consistent with the notion that it’s easy for outside creditors like the plaintiffs here to check the firm’s credit. This reasoning meshes with that of Hansmann, Kraakman & Squire in Law and the Rise of the Firm, and New Business Entities in Evolutionary Perspective, which connect the rise of corporate-type entity structures with the development of creditor-protection technologies such as better accounting.
In other words, Martin’s recognition of debt as a relationship that is “protected” from imposing partnership-type liability can be seen as an example of the rise of entity and limited liability. Indeed, I made this connection between limited liability and cases like Martin a long time ago in my Limited Liability and Theories of the Corporation, 50 Md. L. Rev. 80 (1991).
But it’s more complicated than that, because cases continue to impose liability on informal partnership relationships that look something like the debt in Martin. So what distinguishes the cases in which the courts impose partnership liability from those in which they do not? In my view, as discussed at length in Bromberg & Ribstein, Section 2.14(c), key elements in this distinction are (1) careful lawyering and attention to the formal rules on determination of partnership in the partnership laws; and (2) whether the defendants’ extension of credit is one society wants to encourage or discourage.
Klein makes both of these points, but I think there’s more to be said, particularly about the second one. An important aspect of the Martin case is the fact that the defendants were engaged in a bailout of a failing firm that potentially helped the firm's outside creditors. Contrast a case in which the defendants initially set up a risky capital structure. I emphasize this in my analysis of Martin in Bromberg & Ribstein, section 2.14(c)(5).
One fifth point: Klein argues that the limited-liability result in this case is consistent with modern policy favoring limited liability in new forms of business entities. But there's an argument on the other side: if it's easier to form a limited liability entity, why not expect the parties to do so? In other words, informal limited liability might have been seen as necessary in the days before formal limited liability was easy, but not so anymore. And perhaps third parties have a greater expectation that they can reach deep pockets who have not jumped through the limited liability hoop.
Putting all this together, many of the informal partnership cases that involve third party creditors (rather than discerning the would-be partners’ intent between themselves) are really akin to corporate veil-piercing cases, where the courts emphasize the same sorts of policies of endangering creditors and respecting expectations based on the formalities of the business.
So, in general, Klein’s analysis of Martin provides not only helpful insights but also a good opportunity for further thought on the over-neglected intellectual and practical challenges of partnership. While business association courses and “corporate” scholarship obsesses over the nuances of shareholder meetings, interesting issues like this are unfortunately shunted to a backwater of the curriculum. That’s not only an intellectual shame, but disserves our students, who are more likely to be concerned with the sort of day-by-day business deals that raise unexpected partnership issues like the one in Martin than with advising on a headline-grabbing public corporation issue.
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