Objective or Subjective Standard for “Irreconcilable Differences” Dissolution Clause in Partnership Agreement

CALIFORNIA COURT OF APPEAL INTERPRETS PARTNERSHIP AGREEMENT PROVISION REGARDING A PARTNER’S RIGHT TO TERMINATE THE PARTNERSHIP

A question that arises from time to time from the principals of a new business is “what happens if I just can’t get along with my co-founder(s)?”. Frequently, buy-sell agreements can be constructed to address this scenario, such that the founder(s) with the ability to buy out the other(s) can do so. Occasionally, though, each principal brings such value to the enterprise that it is difficult to imagine proceeding without all parties on board. In such cases, buy-sell provisions would not protect the integrity of the business, but at the same time none of the founders wishes to bind him/herself forever to the others. The tendency in such a case is to provide an “out” such that if a founder determines that irreconcilable differences are frustrating the fundamental purpose of the business, the founder can call it quits, and doing so will not be a breach of the founder’s fiduciary duty.

Such a provision was the subject of the lawsuit in Crow Irvine #2 v. Winthrop California Investors Limited Partnership, 104 Cal. App. 4th 996; 128 Cal. Rptr. 2d 644 (Court of Appeal, 4th Dist. Dec. 23, 2002). In that case, a partnership agreement provided that if “either partner believes in good faith that irreconcilable differences between the Partners prevent the Partnership from achieving its purposes”, the partnership could be dissolved. The fundamental question was whether a “belief in good faith” (a subjective standard) was sufficient grounds for termination, or whether the moving partner (Winthrop) would be required to show that the irreconcilable differences would, in fact, make it impossible for the partnership to achieve its business purpose (an objective standard).

In the trial court, Crow asserted that the business of the partnership could continue despite the fundamental differences of the partners. The partnership’s business was certain specific real estate developments, it being contemplated that six multi-story office buildings, two hotels and retail and entertainment malls would be undertaken as Phase I, with a similarly ambitious bevy of projects to be undertaken later in Phase II. As it developed, the partners soon got tired of each other and were even engaged in extensive litigation.

In reaching the conclusion that Winthrop would be required to prove the impossibility of the business succeeding to have the right to terminate the partnership, the trial court logically turned to the case, In re Marriage of Vryonis,202 Cal App. 3d 712 (1988) which held that, to qualify as a ‘putative spouse’, a party’s good faith belief that his or her marriage was valid must be ‘objectively reasonable’. [Some commentators believe that the Judge in Vryonis must have been an unmarried male to come to the conclusion that anything about a marriage could be measured by the ‘objectively reasonable’ standard. Other commentators apparently disagree. (Citations imaginary and, therefore, omitted.)]

The Court of Appeal analyzed the Vyronis reasoning as well as a number of other cases, most notably the recent Storek & Storek, Inc. v. Citicorp Real Estate, Inc. 100 Cal App. 4th 44 (Court of Appeal, 1st Dist. July 15, 2002). In that case the Storek brothers finally had to put their ambitious project in Old Oakland into bankruptcy when Citibank refused to advance further funds, citing violations of certain covenants in the loan agreements. The Storeks argued that the implied covenant of good faith and fair dealing applicable to all California contracts prevented Citibank from refusing to make further advances unless it could prove that the project would ultimately fail (the ‘objective standard’). The Court of Appeal in Storek held that a covenant of good faith and fair dealing cannot trump an objective statement in the agreement, such as a condition to further advances that is not met; that is, the lender cannot be required to show its objective standard belief that further lending would be beyond all risk tolerances if the lender could base its refusal to provide further advances on an unambiguous term in the loan agreement.

Ultimately, the Court of Appeal in Crow v. Winthrop reversed the trial court and held that, in a partnership with language that allows a partner to terminate in a good faith belief that the business will not succeed or achieve its fundamental purpose, the partner need only come to a subjective belief in the pending failure, and cannot be required to prove that failure of the property development project was inevitable.

Niesar & Vestal has extensive experience in advising clients on issues of partnership law, as well as successful strategies for minimizing conflicts among business founders. Our litigation group handles a variety of business disputes, including litigation as well as alternative dispute resolution for all types of business and commercial disputes. Please contact Gerald Niesar for more information.