Unenforceable Fiduciary Duty Limitations

Courts’ Interpretation of Fiduciary Duty Limitations & Waivers

Introduction

Courts have a variety of approaches when interpreting partnership agreements that limit or waive fiduciary duties that partners owe to each other. Relevant to the Triple Five decisions are cases involving usurpation of a partnership interest or a violation of the duty to disclose information material to the partnership.

Before reviewing the cases, a few observations are worth noting. First, before a court considers whether a partnership agreement limiting the right to disclosure or partnership opportunities should be given effect, the court will consider whether an opportunity actually belonged to the partnership. This is a threshold question because it determines what is within the scope of the partnership’s business. If information or opportunities do not relate to the partnership, a partner has no duty to present them to his partners.

Second, partners often disagree regarding the scope of their business, so it is no surprise that parties have difficulty predicting how a court will define the scope of the partnership. This is an especially important point for attorneys drafting partnership agreements and assisting partnerships as the scope of the business is defined over time.

Third, courts appear more comfortable limiting fiduciary duties based on the scope of a partnership’s business than limiting fiduciary duties based on a partnership agreement that seeks to opt out of fiduciary duties. While this is an important lesson for partners seeking prospectively to have their fiduciary duty limitations enforced, it is difficult in practice. That is, in practice, a partner or attorney will have difficulty defining the scope of a partnership prospectively because the scope of a partnership evolves as the business progresses.

The following cases demonstrate courts’ diverse treatment of partners’ attempts to limit their duty to disclose and allow usurpation of partnership opportunities. The first Minnesota case represents the notion that the scope of a partnership may be so limited that the acquisition of an asset leased by the partnership is not usurpation of a partnership opportunity, nor does it violate a duty to disclose. The second Minnesota case firmly stands for the proposition that partners may not agree to limit their duty to disclose to merely the duty to disclose upon demand. Similarly, the First Circuit case stands for the notion that a partnership agreement allowing partners to compete will be given no effect if a partner fails to disclose an opportunity that relates to the heart of the partnership’s business.

These cases are contrasted by three other cases. The Fifth Circuit case stands for the notion that sophisticated partners may waive their duty to disclose and may directly compete with each other. Similarly, the two subsequent cases stand for the principle that parties may waive their fiduciary duties in their partnership agreement to such an extent that courts will treat the partners as though they are not partners.

Minnesota Cases

Lipinski v. Lipinski, 227 Minn. 511, 35 N.W.2d 708 (1949).

In a 1949 case, the Minnesota Supreme Court allowed a partner to secretly buy land used by his partnership, without a disclosure to his partners, and then lease the land back to his partnership.

In this case, the parties formed a partnership, subject to Minnesota’s version of the UPA, to engage in commercial fishing on leased property next to a lake. Next to this property was a strip of land, owned by a third party, which they used for hauling the fish. Martin, one of the partners, had previously encouraged other partners to buy this strip of land to ensure their continued use of it, but they ignored his suggestions. Some time later, Martin heard some partners talk about ousting some partners so the remaining partners could have more profit.Worried that he might be ousted, Martin secretly purchased the strip of land to leverage his position in the partnership. Martin then requested rent payments for the partnership’s use of the land. The other partners sued, asserting that Martin never disclosed his intent to purchase the land nor did he seek their consent.

The Minnesota Supreme Court held that Martin did not violate a fiduciary duty when he bought the strip of land used by the partnership because Martin had told them about the land prior to his interest in buying it, and the purchase was outside the scope of the business. The court noted that the scope of the business was a “fishing enterprise and not an undertaking to acquire land, or to improve or develop real estate, or to sell or lease land to others.” The court observed that “[i]n determining their respective obligations, a court should always keep in mind the purposes for which the participants were associated and the manner in which the association was organized.” The court found nothing in the agreement suggesting that the enterprise had the object or purpose to acquire real estate.

Further, the court held that Martin did not buy the land “as the result of any information, priority, or advantageous position which he had obtained by virtue of the [partnership].” Because Martin had disclosed the possibility of buying the land and the partners had no interest in buying it, Martin had no duty to disclose his plan to buy it. Thus, this case stands for the notion that the scope of a partnership may be so limited that the acquisition of an asset leased by the partnership is not usurpation of a partnership opportunity, nor does it violate a duty to disclose.

Appletree Square I Ltd. Partnership v. Investmark, Inc., 494 N.W.2d 889 (Minn. App. 1993).

In a 1993 case, the Minnesota Court of Appeals would not give effect to a partnership agreement that replaced a partner’s duty to disclose all material information affecting the partnership with a duty to disclose such information only after another partner made a request.

In this case, sophisticated parties formed their partnership under the 1976 RULPA as enacted in the Minnesota Statutes. The partners’ agreement limited the partners’ duty of disclosure by stating that the general partners would “provide the partners with all information that may reasonably be requested.”

The general partners sold their fifteen-story office building to the limited partners. Years after the sale, the limited partners learned that the building was contaminated with asbestos, which prompted this suit.

In considering the partners’ agreement to waive the duty to disclose without demand, the court acknowledged that under Minnesota’s 1976 RULPA statute, “[p]artners may change their common law and statutory duties by incorporating such changes in their partnership agreement.” But the court then held that the general partners could not “replace their broad duty of disclosure with a narrow duty to render information upon demand” because that “would destroy the fiduciary character of their relationship, and it would also invite fraud.”

The court reasoned that, “[u]nless partners knew what questions to ask, they would have no right to know material information about the business.” Further, it said, “where the major purpose of a contract clause is to shield wrongdoers from liability, the clause will be set aside as against public policy.” Thus, the court concluded that the provision limiting the duty to disclose would be given no effect.

Circuit Courts of Appeal Cases

Wartski v. Bedford, 926 F.2d 11, 20 (1st Cir. 1991).

In a 1991 decision very similar to the Triple Five decisions, the First Circuit refused to allow one partner to buy an interest in the partnership from other partners without disclosing the opportunity to the remaining partner, despite a provision in a partnership agreement expressly allowing the partners to compete.

In this case, an inventor and a businessman formed a limited partnership in 1981 under Massachusetts law to develop a device

for motor vehicles. Both men were general partners with other limited partners. The partnership agreement provided that the “[g]eneral [p]artners shall not be prevented from engaging in other activities for profit, whether in research and development or otherwise, and whether or not competitive with the business of the partnership.” When the business appeared to fail, the businessman bought the limited partners’ interest in the partnership to obtain control of the business and the invention. The court found the businessman failed to disclose to the inventor his purchase of the limited partners’ interest in the partnership, which prevented the partner from participating in the purchase.

The court considered a provision in the partnership agreement stating “[g]eneral [p]artners shall not be prevented from engaging in other activities for profit, whether in research and development or otherwise, and whether or not competitive with the business of the partnership.” First, the court doubted that the partners actually intended this language to include the “technology which was the heart and soul of the partnership venture and the brainchild of the other partner.” Second, the court declared that even if the provision included the heart and soul of the partnership, a partnership agreement “cannot nullify the fiduciary duty owed by [the businessman] to the partnership.” The court explained that “[t]he fiduciary duty of partners is an integral part of the partnership agreement whether or not expressly set forth therein . . . [which] cannot be negated by the words of the partnership agreement.” Thus, this case stands for the notion that a partnership agreement allowing partners to compete will be given no effect if a partner fails to disclose an opportunity that relates to the heart of the partnership’s business.

Exxon Corp. v. Burglin, 189. Exxon Corp. v. Burglin, 4 F.3d 1294, 1300–02 (5th Cir. 1993).

The Fifth Circuit decision in Exxon is contrary to both the Wartski and Triple Five decisions. Applying Alaska law, the Fifth Circuit held that a general partner was not liable for violating the duty to disclose information it kept secret from limited partners because the duty to disclose was limited in their agreement.

In Exxon, sophisticated parties formed their limited partnership expressly subject to Alaska law. Essentially, the partnership agreement provided that “[t]he general partner must furnish the limited partners with information necessary to evaluate their interests, unless the general partner believed the information was confidential.” The court noted that the partnership agreement was between parties competing in the oil industry who were highly sophisticated parties, bargaining at arms length, with assistance of legal counsel, who paid substantial sums of money for giving up the right to disclosure.

The lawsuit arose because the general partner learned about the value of an oil field owned by the partnership but did not disclose this to the limited partners when the limited partners offered to sell their interests in the partnership to the general partner. The parties made the sale based on an agreement expressly stating that the limited partners were selling without knowing the future profit potential of the oil fields.partner. The sale agreement also gave the limited partners an option to have an independent consultant examine the fairness of the offer, which they failed to do.

The court found that the partnership agreement recognized that the partnership had “an inherent need for secrecy to protect itself from outside competition” and the general partner had an “individual need to protect its interests from the limited partners.” Accordingly, the court gave effect to the parties’ agreement, including the fiduciary duty limitations, and held that the general partner “was under no duty to disclose” the information that it deemed confidential. Thus, this case stands for the notion that sophisticated parties may waive their duty to disclose and may directly compete with their partners.

Other Cases

Singer v. Singer, 634 P.2d 766, 772–73 (Okla. Civ. App. 1981).

In a 1981 case, the Oklahoma Court of Civil Appeals held that a partner in an oil production partnership did not violate a fiduciary duty when it purchased land within the area of the partnership’s interest because of a provision in the partners’ agreement:

Each partner shall be free to enter into business and other transactions for his or her own separate individual account, even though such business or other transaction may be in conflict with and/or competition with the business of this partnership. Neither the partnership nor any individual member of this partnership shall be entitled to claim or receive any part of or interest in such transactions, it being the intention and agreement that any partner will be free to deal on his or her own account to the same extent and with the same force and effect as if he or she were not and never had been members of this partnership.

The court explained that the partners had a contractual right to compete with partners “as if there never had been a partnership.” Accordingly, it held that the partners contracted away the “right to expect a noncompetitive fiduciary relationship with any of its partners.”

Sonet v. Timber Co.,

In 1998, a Delaware court held that general partners seeking to convert their limited partnership to a real estate investment trust, which benefited them but harmed a limited partner, did not owe common-law fiduciary duties to the limited partner.202 Because the parties had the right to alter their fiduciary duties, the partnership agreement’s limitations on fiduciary duties would be given full effect as long as the provisions were clear and unambiguous. The court explained that “principles of contract preempt fiduciary principles where the parties to a limited partnership have made their intentions to do so plain.” While this case aligns with others discussed here supporting the notion that partners may limit their fiduciary duties, it goes further by explicitly stating that contractual principles may override fiduciary duties in an unincorporated business entity. This “contractarian” view is consistent with a myriad of Delaware cases.

Harmonizing These Cases by Distinguishing Battles over Ownership

One attempt to harmonize these seemingly disparate decisions could be made by distinguishing a partner’s disclosure and competition with the partnership generally, from a partner’s disclosure and competition with another partner regarding the purchase of a partner’s interest. Under the first, a partner desires to compete in the same market as the partnership, such as by opening a restaurant in the same neighborhood as the partnership’s restaurant. It is easy to think of valid reasons for this, such as when the partners already own competing restaurants in the neighborhood and want to start another one together.

But when partners compete over the purchase of a third partner’s interest, the battle is only between partners. It is difficult to think of any good that could come from allowing partners to keep secrets and compete for ownership of the partnership. Based on this distinction, a partnership agreement should be allowed to override a duty not to compete with the partnership generally, but partners should not be allowed to modify their fiduciary duties when it comes to ownership interests in the partnership.

Thus, this attempt to harmonize these seemingly disparate decisions is appealing, but unfortunately is unworkable with the cases here. First, Wartski v. Bedford held that partners may not buy an interest in the partnership from other partners without disclosing the opportunity to the remaining partner despite a provision in a partnership agreement expressly allowing the partners to compete. The Triple Five holding was similar. But Exxon Corp. v. Burglin in the Fifth Circuit and Sonet v. Timber Co. in Delaware both held that partners could waive their fiduciary duties in relation to acquiring ownership interests.211 As a result, any attempt to harmonize these cases under this distinction appears unworkable.

Relevancy of These Cases

These cases present a wide range of outcomes. Some favor allowing parties to limit their fiduciary duties, while others favor applying fiduciary duties despite partnership agreements to the contrary.

These conflicting views create uncertainty in the law. As a result, partners may be discouraged from drafting partnership agreements that provide substantial limitations on fiduciary duties. Thus, some partners are stuck with an agreement that is less than they would like. This burden may decrease their profits and increase their transaction costs.

For example, profits are decreased if sophisticated companies who compete with each other cannot establish a partnership at all, because the law prevents them from eliminating their duty to disclose. Additionally, transaction costs are increased by hiring lawyers and accountants to form and operate new business entities, such as a Delaware LLC, that has greater ability to limit fiduciary duties. Of course, those who seek to impose fiduciary duties despite contrary partnership agreements would argue that these costs are worthwhile to protect parties from abuse.

This post is also part of a series of posts on Unenforceable Fiduciary Duty Limitations.