Answer Key PROBLEM ONE by alicejenny

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									Business Associations – Spring 2005                                           Prof. B. Clark


                          ANSWER KEY TO PROBLEM ONE:
                     Partnership Management and Review of Agency Law


Assignment: Read UPA sections 9, 10, 13-18, 25-27, 40. Answer the following
questions based on these UPA sections, and the cases assigned for the unit on Rights of
Partners in Management. Please prepare the answers to the Problem prior to class
and be prepared to discuss them.


Assume that Sam Spade and Sherlock Holmes have a detective agency partnership that
they have been operating together for 6 years. They do not have a written agreement.

Last year, Spade decided to hire an additional employee, Ace Ventura, paying him a
$15,000 salary. Holmes objected to this on a number of grounds prior to Spade and Ace
signing the employment contract. He said he refused to agree to hire Ace. Spade
nevertheless hired him. Holmes continued to object after Ace was hired. At the end of
the year when profits were divided, Holmes claimed that the $15,000 salary should not be
treated as a cost of the partnership.

(1)    Assume that you are in a jurisdiction that follows National Biscuit.

       (a) Is the partnership liable for Ace’s salary? What is Holmes’ best argument
       that it is not? Does you answer change if it turns out that Spade put up all the
       capital for the partnership?


Before getting into the details of the problem and the dispute, it is important to
recall certain basic principles regarding agency liability that will be applied in the
partnership context.

In asking whether “the partnership is liable for Ace’s salary”, we are really asking
two things:

  (1) Liability to third parties: Can Ace sue the partnership for his salary? and

  (2) When an expense is a partnership expense: Must Ace’s salary be treated as a
partnership expense deducted from profits or must Spade personally bear the
expense?

       With respect to third party liability to Ace, Ace can sue on the contract as
       long as Spade had either actual authority or apparent authority to bind the
       partnership by creating an employment contract between the partnership
       and Ace.




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       Whether this salary must be treated as a partnership expense, however,
       turns specifically on whether Spade had actual authority to enter into this
       contract. If Spade did not have actual authority (that is, if he exceeded the
       scope of his authority) to employ Ace, then Ace’s salary is not a legitimate
       partnership expense. Practically, this means that if the partnership is sued
       and is held liable to Ace on apparent authority grounds, Holmes can go after
       Spade for indemnification for the amount of the salary (this money goes back
       into partnership assets).

       How do we know this?

       The UPA makes clear that basic agency principles apply to Partnerships.
       For example, §9(1) states that:

             “Every partner is an agent of the partnership for the purpose of its
              business” (actual agency or authority relationship created)

             “[T]he act of every partner…for apparently carrying on in the usual
              way the business of the partnership…binds the partnership, unless
              the partner…has in fact no authority to act for the partnership in the
              particular matter, and the person with whom he is dealing has
              knowledge of the fact that he has no such authority” (apparent
              agency or authority created – the exception at the end reflects the
              requirement that a third party has a reasonable belief that the agent
              has said authority)

       The UPA makes clear that partners are responsible for managing the
       partnership business and codifies the basic idea that an agent’s acts on behalf
       of the principal become the responsibility of the principal, not the agent.

             18(e): “All partners have equal rights in the management and
              conduct of the partnership business.”

             §18(b) : “The partnership must indemnify every partner in respect of
              payments made and personal liability reasonably incurred by him in
              the ordinary and proper conduct of its business, or for the
              preservation of its business or property.”


       Finally, the UPA limits the agent’s ability to bind the partnership to some
       degree by emphasizing that only acts that are “usual” and “ordinary” can
       create apparent authority. See §9(1) &( 2). The UPA expressly limits the
       actual authority of partners commit certain acts that are considered so
       extraordinary or fundamental as to require authorization by all other
       partners:



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             As noted above, §18(b) only entitles partners to indemnification for
              “ordinary and proper” conduct;

             §9(3) lists acts that require unanimous consent, such as disposing of
              good-will, assigning partnership property in trust for creditors, or
              acts that make it impossible to carry on the partnership business;

             Acts in contravention of agreement (that is, in contravention of
              express limits or restrictions on authority) require unanimous consent
              See §18(h);

             Admitting new partners requires unanimous consent. See §18(g).




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Back to the Problem:

Before addressing the dispute, there is a threshold question concerning the scope of
       authority and whether Spade had actual or apparent authority to hire Ace.

Rule: Based on the UPA rules discussed above, this turns on whether Spade was
      carrying on in the “usual way the business of the partnership”?

Analysis: You want to argue facts on both sides. The following are examples of
       reasonable arguments made in class: On the one hand, the ability to hire
       employees as needed is the kind of activity that is typical and essential to
       running a business; moreover, one would expect that a manager of a business
       should have the authority to hire employees and we know from UPA §18(e)
       that partners have the authority to manage the business of the partnership
       (unlike corporations in which owners do not have management rights).

           On the other hand, the hiring of a third person in a two person run
       business may be considered a much more fundamental change than it would
       be in a larger business that typically utilizes more “ordinary” employees in
       running its business (for eg a store that routinely employs several cashiers
       and stock clerks). A two person detective agency may depend more heavily
       on the trust and personal relationship between its key employees, and hiring
       a third may fundamentally alter this relationship and involve a significant
       expense that was not contemplated by the partners.

Conclusion:

       If you conclude that Spade’s actions were not within the usual conduct of
       business or ordinary and proper, then two legal consequences follow. First,
       under the limits of §9(1) & (2), there would be no apparent agency and Ace
       could not sue the partnership for his salary. Second, under 18(b) if any
       money was already paid out to Ace, Spade would have to bear this himself, it
       would not have to be treated as a partnership expense.

       However, if you find that there is a reasonable argument that hiring Ace was
       “usual, ordinary, and proper” there is still an issue about whether Spade
       lacked actual authority to hire Ace as a result of Holmes’ objection to the
       contract. This is where we get to the details of the problem & the cases
       National Biscuit/Summers.




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(1) Assume that you are in a jurisdiction that follows National Biscuit.

       (a) Is the partnership liable for Ace’s salary? What is Holmes’ best argument
       that it is not?


Focus: The deadlock situation and confusion between two key UPA provisions:
          The first part of §18(h): “Any difference arising as to ordinary
            matters connected with the partnership business may be decided by a
            majority of the partners”; and
          §18(e): “All partners have equal rights in the management and
            conduct of the partnership business.”

Spade will argue that under 18(e) he has a right to manage the partnership business,
and that under §§ 9& 18(b) he has actual authority to act on behalf of the
partnership to hire Ace. Holmes, on the other hand, will argue that under 18(h), his
objection to the contract makes the act invalid and thus the partnership should not
be liable for Ace’s salary. Like the defendants in National Biscuit & Summers,
Holmes will claim that his objection to the contract triggered 18(h) since it became a
disputed matter that could only be resolved by majority vote, and that since there
was no majority vote approving the employment contract, it was not a valid action
by Spade.

Rule in National Biscuit Jurisdiction: National Biscuit rejected the defendant’s
argument. It held that an agent’s authority can only be restricted by a majority
vote. Thus, we have to apply a two part analysis: (1) Was the act within the
normal scope of the agent’s authority (“carrying on in the usual way”); (2) If so,
then such act is a valid action on behalf of the partnership, unless there is a majority
vote restricting the agent’s authority to act in that particular matter.

Analysis: Under National Biscuit, since only Holmes wanted to restrict Spade’s
authority to hire Ace, there was no majority restricting Spade’s authority. Thus,
Holmes best argument for why the partnership should not be liable depends on the
first part of the analysis: he must show that the act was not “carrying on in the
usual way” and thus did not constitute an “ordinary and proper” partnership
expense (see analysis on page 4).




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       Does you answer change if it turns out that Spade put up all the capital for the
       partnership?


This fact was designed to test your ability to recognize another important limit on a
partner’s authority – restrictions of authority created by agreement. The second
part of §18(h) provides that “no act in contravention of any agreement between the
partners may be done rightfully without the consent of all the partners.”

In this case, Holmes might try to argue that Spade was acting in contravention of an
agreement between the partners that Holmes’s consent would be needed to hire any
employees based on the fact that Holmes put up so much money and thus expected
more control over such matters.

Rule/Analysis: The fact that Spade put all of the capital is not determinative of
voting or management power. In fact, under the UPA, a partner’s capital
contribution (investment) in the business is irrelevant to management rights.
Absent some agreement to the contrary, each partner has an equal say in the
business (18(e)) – the one partner – one vote rule. However, where one partner
puts up all the capital, this could be evidence of an implied agreement between the
partners that the one who put up the capital (taking more risk) would have greater
management responsibility (be given more control). Of course, we’d need many
more facts about the nature of the relationship and how responsibilities where being
allocated in practice to know if this were the case.




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       (b) What if you’re in a jurisdiction that does not follow National Biscuit?


Focus: Apparent v. Actual Authority

If we are in a jurisdiction that does not follow National Biscuit, then by implication a
partner’s objection in a deadlock situation could restrict the other partner’s
authority; that is, once a dispute has arisen between partners, 18(h) would be
interpreted to require that a majority vote is necessary to authorize the disputed
action. An example of this approach occurs in Summers. The reasoning behind this
approach is that where a partner has clearly objected to a particular course of
action, it’s not fair to allow the acting partner to disregard the objecting partner’s
concerns and force the objecting partner to bear the expense for the disputed act.

[Query whether Summers would have come out the same way if the court believed that
the objecting partner was acting unreasonably and the disputed act was viewed as
necessary to preserve the business].

Assuming that Summers applies and Spade is found not to have actual authority to
enter into the contract, one consequence (devastating to Spade) is that this salary
does not need to be treated as a partnership expense. However, this does not
necessarily affect Ace’s ability to recover since he can still try to sue on apparent
authority grounds.


       (c) Does it matter whether Holmes “voted” against hiring Ace or whether he
       simply informally expressed his objection?

Simply stated, no. Formal objections are helpful and advisable for record keeping
purposes, but formalities are not required in the management of partnerships in the
way that they are in corporations and other limited liability entities.




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(2)       If the partnership becomes insolvent, could Ace sue Holmes personally for the
          $15,000 owed him by the partnership? Assume that Ace knew that Holmes
          objected to his being hired at the time the contract was signed. If Holmes is
          liable, can he get contribution or indemnification from Spade (if so, which?).

It is important to distinguish this from the previous part. In part (1), we were trying
to determine whether Ace’s employment contract was binding on the partnership
and must be treated as a partnership expense (that is, whether it must come out of
partnership profits). In this part, we are assuming that the partnership is found
liable to Ace on the contract, but that there are insufficient partnership assets to
cover its liabilities. Now the question becomes whether Ace can sue Holmes
personally for the debt? (Why Holmes, presumably because Spade is insolvent)

To answer this question, it is helpful to break this question down into two parts.
    First: Can Holmes be held personally liable for the partnership’s debts?
    Second: If so, for how much? (Can Ace sue him for the entire $15,000, only
      half, some other amount?)

Focus: To illustrate the danger of personal liability in partnerships, especially in
light of the broad scope of authority that individual partners have to act on behalf
of, and therefore create liability for, the partnership.


First Part: Can Holmes be held personally liable for the partnership’s debts?

Simply stated, yes! This is seen as the biggest disadvantage of partnerships and is
the reason most business choose to incorporate. The UPA makes clear that partners
can be held personally liable for partnership debts:

         §40(d) First part: “The partners shall contribute, as provided by section
          18(a), the amount necessary to satisfy the liabilities [of the partnership].”



Second Part: For how much can Holmes be held personally liable?

The UPA actually specifies how liabilities should be divided between the different
partners, in the absence of an agreement to the contrary:

         §18(a) “Each partner shall…share equally in the profits and surplus
          remaining after all liabilities…and must contribute towards the
          losses…sustained by the partnership according to his share in the profits.”

Rule: Thus, while partners can be held personally liable for the partnership debts,
they should only be responsible for liabilities in the same proportions that they


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share profits. If there is an express agreement specifying how partners share
profits, then you look to that agreement. If not, then under 18(a), since profits are
shared equally, liabilities are also shared equally.

Application: In this case, therefore, Holmes should only be responsible for $7500,
while Spade is responsible for the other half.

(Important Note: Remember this is only the default rule; partners can expressly
agree to share losses in any way; it doesn’t have to be equal or in the same
proportions as profits. Recall also from the Klein excerpt on Capital Accounts that
there will be situations in which it makes sense to specify a different allocation for
losses than for profits– for example if one of the partners does not have any money
to invest and wants to limit the potential money he has to pay out)




The Problem for Holmes:

Although the law recognizes that as between Spade and Holmes, Holmes should only
bear ½ of the expense, we must still ask whether Ace can nonetheless go after
Holmes for the entire $15,000?

As you might have guessed, the UPA addresses this issue as well, and puts some
limits on the extent to which a partner can be held personally liable to third parties
for partnership liabilities beyond his/her share of the loss. Specifically, the UPA
provides that where a partner is insolvent, the remaining partners have to pick up
the tab:

      Second Part of §40(d): “[I]f any, but not all, of the partners are insolvent, or,
       not being subject to process, refuse to contribute, the other partners shall
       contribute their share of the liabilities, and, in the relative proportions in
       which they share the profits, the additional amount necessary to pay the
       liabilities.”

Where a partner is not insolvent, however, the UPA only permits a third party to go
after a particular partner for the entire debt (under a joint and several liability
theory) in cases where the partner has committed some negligent or otherwise
wrongful act or breach of trust. For basic contract and other debt obligations, a
creditor can only go after the partner for the amount that partner is responsible for
(joint liability):

      §15(a) All partners are jointly and severally liable for everything chargeable
       to the partnership [due to the wrongful act or omission of a partner acting in
       the ordinary course of the business or a breach of trust by a partner who
       receives and misapplies money or property of a third person].


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         §15(b) All partners are liable jointly for all other debts and obligations of the
          partnership.

Application:

        In this case, we aren’t told whether Spade is insolvent. If Spade is not
insolvent, then §15(b) seems to apply since there is no evidence of negligence or
breach of trust. Rather, this looks like a typical contract obligation or debt that
partners would be jointly (but not severally) liable for, and thus Ace could only go
after Holmes for half and Spade for the other half. However, the more likely
scenario is that Spade is insolvent, in which case, Holmes will have to pick up the
entire tab. (Note: the qualification in 40(d) that the remaining partners must
contribute “in the relative proportions in which they share profits” isn’t relevant
since Holmes is the only remaining partner; you should know this rule, however,
since it would become relevant in the situation where there was more than one
remaining partner).

Indemnification v. Contribution

        If Holmes is forced to pay the entire amount, he can technically still go after
Spade either for contribution (for half of the $15,000, if Spade had actual authority
to enter into the contract) or indemnification (for the full amount, if Spade didn’t
have actual authority to enter into the contract). However, this isn’t very helpful,
since the bottom line is that Spade probably is insolvent.


(3)       What result in Question (2) if Ace did not know that Holmes objected to his being
          hired until after the employment contract was signed? Assume that Spade had no
          reason to expect that Holmes would object until after the contract was signed.
          But after the contract was signed, everyone learned of Holmes’ objection. Is the
          partnership liable on a theory of actual authority? Does the result depend on
          whether we are in a National Biscuit jurisdiction or not?

This is a very long-winded way of emphasizing two key facts:

         Under apparent authority, the third party (Ace) must have a reasonable
          belief that the agent (Spade) had the authority to bind the principal
          (partnership of Spade & Holmes) in the particular matter (Ace’s
          employment ). If Ace knew of Holmes objection at the time of the contract
          and should have reasonably known that Spade was consequently not
          authorized to enter into the contract, then Ace would not be able to rely on
          an apparent authority theory. Thus, if there was no actual authority and no
          apparent authority, Ace would be out of luck.




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         The third party’s reasonable belief is only relevant to a theory of apparent
          authority. Thus if Spade had actual authority to enter into the contract (as
          he would have under a National Biscuit jurisdiction assuming you concluded
          that his act was “usual” and “ordinary”), then Holmes objection to the
          contract is irrelevant. Ace can sue based on actual authority grounds, and
          doesn’t need to rely on apparent authority.




(4)       Assume that Holmes finds bills for $5,000 from the liquor store sent to Sam
          Spade for the last months’ liquor consumption (the liquor was charged on the
          firm’s account). Is the partnership liable?

See the very first analysis above.

Absent some express agreement addressing this issue, the analysis turns on whether
Spade was, or appeared to be, “carrying on in the usual way the business of the
partnership” under 9(1) and whether this would constitute and “ordinary and
proper” partnership expense under 18(b). You should make arguments based on
the facts and reasonable inferences you can draw from the nature of the business as
a detective agency.


NOTE: Planning Questions from Class

      (1) What could Holmes have done to avoid the liability incurred on Ace’s
          employment contract?

          Dissolved the partnership the moment the dispute arose – a harsh result.


      (2) What could Holmes and Spade have done to try to avoid the uncertainty of
          this type of deadlock situation and to avoid dissolution as the only solution?

          They could have drawn up a partnership agreement that specified whether
          certain kinds of decisions, such as hiring, required unanimous consent.
          They could also have appointed a third person to act as tie-breaker in the
          event of such disputes.

      (3) Final Note: All of the UPA rules applied to the above scenario are default
          rules that can be altered by partnership agreement. (See Day v. Sidley &
          Austin for an example of a partnership agreement that delegates exclusive
          management authority for certain matters to a committee of partners and
          alters the one-vote one-partner rule by tying voting power to the amount of
          investment in the business).



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(5)    Assume the partners admitted Ace as a partner. There is still no written
       agreement. One day the partners were approached by Colombo, who wanted to
       buy the building for $3 million. Spade thinks the building is only worth $500,000
       and wants to take the deal. Holmes and Ace object. Spade put up 70% of the
       capital.

       (a)    What result if Spade brings the matter to the other partners for a vote -- he
              votes yes and they both vote no. Does he have actual authority to sell the
              building?

       Whenever you are trying to determine whether a partner has the authority to
       conduct a particular transaction on behalf of the partnership in the face of
       objections by other partners, the first question should be what kind of action
       is it–this is important because it tells us how many votes are needed to
       authorize the action in the event of a dispute.

       Rule: Recall from UPA sections 18(h) and 9(3) discussed above, that
       disputes concerning ordinary matters are decided by a majority of the
       partners, while extraordinary acts and certain acts specified in 9(3) require
       unanimous consent.

       Application: So you need to determine whether this is an ordinary action
       that is resolved by majority vote, or an extraordinary or fundamental act
       that requires unanimous consent. Again you want to make arguments based
       on the facts and reasonable inferences that can be drawn from the facts. In
       this case, disposing of the building in which the detective agency is carrying
       on its business seems pretty extraordinary for a number of reasons. First,
       disposing of property and selling real estate is not something they do in the
       ordinary course of business (not done on a day to day or even monthly basis)
       – they are in the detective agency business. Securing office space for their
       business, while essential to running their business, should ideally be a rare
       activity – presumably they aren’t moving around all the time. §9(1)(2)
       Second, selling their building may make it impossible to carry on the
       ordinary business of the partnership at least temporarily. §9(3)(c) Finding
       new office space and negotiating a new lease can be quite involved and can at
       a minimum cause a significant interruption in the operations of the business.
       Finally, to the extent that their location is conducive to their ability to attract
       clients, then selling that building and changing locations could adversely
       affect the good will of the business. §9(3)(b)

       Thus, it seems that Spade would need unanimous consent to sell the building,
       which he falls far short of since he didn’t even get a majority.




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       (b)       Assume that Spade signs a deed selling the building to Colombo without
                 discussing the matter with the other two.

                 (i)        Can they invalidate the sale simply on the basis that the title to the
                            building was in the name of the partnership and thus it takes more
                            than the signature of a single partner on a deed to transfer title?

               No. The key here is the “simply on the basis that the title was in the
       name of the partnership [and thus takes more than one partner’s
       signature]”. Under UPA §10, it is clear that a partner can convey property
       that is in the name of the partnership:

                           First part of §10(1): “Where title to real property is in the
                            partnership name, any partner may convey title to such
                            property in the partnership name….”

                           First part of §10(2): “Where title to real property is in the
                            name of the partnership, a conveyance executed by a partner,
                            in his own name, passes the equitable interest of the
                            partnership….”

                           §§ 10(3)-(4) make similar provisions but under varying factual
                            scenarios.

              So the fact that only one partner’s signature was on the deed, by itself,
       would not be a basis for automatically finding a lack of authority and
       invalidating the sale. However, there may still be a problem if the partner
       did not have authority to sell the building, which takes us to the next part.

                 (ii)       If they sue to recover the property, will they succeed? (Examine
                            UPA § 9)

              Probably Yes. UPA §§ 10(1) & (2) both include the caveat that the
sale may be invalidated if the partner signing the deed in fact had no authority to do
so.

                 Second Part of §10(1) : “but the partnership may recover such
                  property unless the partner’s act binds the partnership under the
                  provisions of paragraph (1) of section 9….”

                 Second Part of §10(2)-(4): “provided the act is one within the
                  authority of the partner under the provisions of paragraph (1) of
                  section 9.




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       Thus, the issue turns on whether the partner had actual/apparent authority
to dispose of the property. See analysis described in part (b) above. (This is
relevant to both actual and apparent authority since 9(1) &(2) provide that only
acts apparently for carrying on the business in the usual way bind the partnership.)



NOTE: Subsections (c) & (d) below illustrate further the Nature of Partnership
Property and in particular the default rules under UPA § 25.

       UPA §25(1): A partner is co-owner with his partners of specific partnership
            property holding as a tenant in partnership.

       UPA §25(2) Delineates several legal consequences that follow from the
            designation of “tenant in partnership”.

The main idea is that partnership property is held in trust for the partnership, that
all partners have equal right to possession of such property for partnership
purposes, and that partners can not individually do anything to destroy or
encumber these rights.

       (c)    Can Spade sell Colombo his share of the building, making him a joint
              tenant with Spade and Ace?

       No. UPA 25(2)(b) provides that “[a] partner’s right in specific partnership
       property is not assignable except in connection with the assignment of rights
       of all the partners in the same property.”

       (d)    Can Spade promise to leave his share of the building to Colombo in his
              will?

       No. UPA §25(2)(d) provides that “[o]n the death of a partner his right in
       specific partnership property vests in the surviving partner or partners ….”
       [for partnership purposes only]. And UPA §25(2)(e) provides that “[a]
       partner’s right in specific partnership property is not subject to dower,
       curtesy, or allowances to widows, heirs, or next of kin.”




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       (e)    Can he sell Colombo his partnership position, thereby giving him an
              interest in the building? If he sells Colombo his “interest in the
              partnership,” what has he sold? Would Colombo be able to participate in
              the management of the partnership or inspect the books?

       No. Spade can’t sell his partnership position in order to give Colombo an
       interest in the building.

       Recall UPA §18(g) which requires unanimous consent to make someone a
       partner. UPA §27 also governs “transfers of interest” in partnership
       business. Partners do have some personal interest they can dispose of
       individually that doesn’t adversely affect the partnership – that is the
       partner’s rights to profits. However such transfers do not entitle the assignee
       to any other rights to manage partnership property or business . Those
       rights only come with partnership status, and 18(g) controls the admission of
       new partners.

       This is so important that it justifies quoting §27(1) in its entirety:

       §27(1): “A conveyance by a partner of his interest in the partnership does
       not of itself dissolve the partnership, nor as against the other partners in the
       absence of agreement, entitle the assignee, during the continuance of the
       partnership, to interfere in the management of administration of the
       partnership business or affairs, or to require any information or account of
       partnership transactions, or to inspect the partnership books; but it merely
       entitles the assignee to receive …the profits to which the assigning partner
       would otherwise be entitled.”

        §27(2) Permits assignee to request an accounting on dissolution.



       (f)    Is there anything Spade can do that would force the sale of the building?


        Yes – we’re back to the dissolution solution again. However, not only is this
harsh, but it isn’t always a solution, as we will see in more detail in the next sections.
The general rule is that dissolution triggers a liquidation of the business assets in
order to satisfy liabilities. (In this case, this would mean that Spade could force the
sale of the building to the highest bidder, which sounds like it would be Colombo;
any profits left over after the sale proceeds are applied to liabilities would be divided
among all of the partners; however, the remaining partners would be left without a
building for their business). There is an exception to this general rule, and in fact a
partner may be prevented from forcing this type of liquidation if the partner is
dissolving the partnership in breach of an agreed partnership term.



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