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Unintended Partnerships: The Accidental Business Entity

As the California cannabis industry comes out of the shadows and into the light, it is not surprising that technical details of California’s business laws have not traditionally been on a cannabis company’s radar. As the industry matures, however, laws that a business partner would never have before thought to enforce against another business partner will now become viable options in settling business disputes.

On October 6, 2017, Governor Brown signed AB 1159 into law. The bill states that “commercial activity relating to medicinal cannabis or adult-use cannabis conducted in compliance with California law and any applicable local standards, requirements, and regulations shall be deemed to be: (1) A lawful object of a contract; (2) Not contrary to, an express provision of law, any policy of express law, or good morals; and (3) Not against public policy.”  In short, the California courts will enforce contracts for commercial activity relating to medicinal cannabis or adult-use cannabis.  It is only a matter of time then, before an agreement regarding commercial cannabis activity is hauled into the California courts and enforced to the same degree as an identical contract regarding any other industry.

But given the “handshake mentality” that the cannabis industry in California has operated on, admittedly by necessity, for so long, many such contracts will not be in a signed writing. It is vital, however, that cannabis companies be aware that a signed writing is not always required for a contract to be enforceable. And that rule extends not only to small one-off agreements, such as a contract to sell some farming equipment or a promise to buy cannabis flowers next season, but also to an agreement regarding the very existence of a “business.”

Cannabis companies often form business entities, such as corporations and limited liability companies, to protect their owners from personal liability for the vast array of liabilities that can arise when manufacturing and selling goods. Previously, most cannabis companies created informal alliances and partnerships in order to pool capital and resources with little regard to traditional business and even employment structures; it is expected that many cannabis companies will likely continue to operate in this fashion. Different entity types have different rules and many of the rules arise by default whether the business owners wish them to or no. Sometimes such rules can be waived if the proper corporate formalities are adhered to and business partners are encouraged to consult with an attorney to ensure that the business entity they choose to operate their business meets their expectations.  Critically, a business can arise based purely on the agreement of two or more people whether any corporate formalities (such as registering the business with the Secretary of State) are adhered to or not.

Specifically, a partnership is considered a separate business entity from that of its owners and has its own special corporate rules that arise by default unless the partners take proper action. The question of whether a partnership was formed, and thus a business entity created, is decided based entirely on the conduct of the parties and it is immaterial that the parties may not have considered themselves to be creating a partnership. In fact, a partnership may be found to exist even if the parties expressly declared the contrary.[1]

While parties must actually express their mutual intent to form a partnership, the word “partnership” or even “partners” is not required to be said at any point. Namely, if the arrangement the parties describe and agree to is what the law considers a partnership, then a partnership will be considered to have been created.[2] The key is whether the parties intended to “carry on as coowners a business for profit.”[3]

An essential element of a partnership is the right of joint participation in the management and control of the business.[4] There are, of course, other factors to be considered as well though, including:

  • Sharing of profits;
  • Use of a fictitious business name statement (also known as a DBA (doing business as));
  • The maintenance of partnership books;
  • Written or oral declarations by one alleged to be a member of a partnership are admissible against the declarant to prove the partnership’s existence;[5]
  • Conduct of the parties;[6]
  • How title to real property is taken or held; and
  • Representation regarding partnership to third parties.[7]

Whether a partnership has been formed is important for a multitude of reasons. Not only does status as a partnership affect one’s taxes, for example, but it also gives one’s partners the ability to demand accountings and hold one’s fellow partners to a high level of fiduciary duties in all business undertakings. Fiduciary duties include a duty of loyalty to the business (and therefore the other partner), a duty to avoid self-dealing (ie. to a certain extent, not to compete with the partnership), and so forth. Fiduciary duties are very easy to breach if one is not careful, and especially so if the actor is not aware that fiduciary duties apply.

In its simplest form – parties who act as partners in conducting their business will likely be treated as partners for legal purposes, whether or not they formalize their relationship with a signed written partnership agreement. Cannabis companies should thus enter business relationships with great care and, whenever possible, with detailed written agreements expressly outlining the rights and obligations of each party.

[1] Universal Sales Corp. v California Press Mfg. Co. (1942) 20 C2d 751.

[2] There are multiple types of partnerships, rules for formation of a general partnership are set out in California Corporations Code §16202 and for a limited partnership in California Corporations Code §15902.01.

[3] California Corporations Code §16202(a)).

[4] See Spier v Lang (1935) 4 C2d 711, 716; Fritz v Gilbert (1936) 8 C2d 68; see also Zorich v Petroff (1957) 152 CA2d 806.

[5] Blumenthal v Greenberg (1900) 130 C 384.

[6] Weiner v Fleischman (1991) 54 C3d 476, 482; see also In re Marriage of Geraci (2006) 144 CA4th 1278, 1292; Love v The Mail on Sunday (CD Cal 2007) 489 F Supp 2d 1100.

[7] Individuals may be subject to partnership liability and treated as “ostensible partners” as a result of misrepresentations to third parties that suggest that they are partners in a partnership. See California Corporations Code §16308 (regarding purported partnerships). Partners who consent to such nonpartner misrepresentations may also be bound by them. For further discussion of ostensible partnerships, in which the court states the requirements necessary to establish liability under that doctrine, see Armato v Baden (1999) 71 CA4th 885