In Kovacik v. Reed,[1] the California Supreme Court carved out an exception to the statutory scheme of dividing up losses in a partnership for the important class of firms known as service partnerships. Kovacik and Reed entered into a general partnership to operate a kitchen remodeling business. Kovacik made an initial capital contribution of $10,000. Reed made no capital contribution, but did contribute a promise of future services by agreeing to superintend the partnership’s work and to estimate the jobs on which the partnership bid. Kovacik and Reed agreed to share profits equally, but made no provision for allocating losses. Reed apparently took no salary. Unfortunately, things did not go as planned and Kovacik dissolved the partnership, after only ten months, on grounds that it was unprofitable. Kovacik claimed that the partnership had lost $8,680 and brought a proceeding for an accounting in which he sought to recover one half of the partnership’s capital loss from Reed.
On the face of the statutes, Kovacik had a strong claim. It appears that the partnership had no liabilities falling under UPA (1914) §§ 40(b)(I) or (II). Accordingly, the next set of liabilities to be satisfied were those “owing to partners in respect of capital”; in other words, return of capital was the senior remaining claim on the partnership’s assets. Assuming for the sake of simplicity that there had been no adjustments to the initial capital accounts (there being no facts to the contrary), the partnership owed $10,000 to Kovacik “in respect of capital” and nothing to Reed. Kovacik therefore was entitled to the entire $1,320 apparently realized upon the liquidation of the partnership, leaving a capital loss of $8,680. Per § 40(d) both partners were required to contribute to satisfaction of that liability in accordance with the rules laid out in § 18(a). In turn, § 18(a) provides that the $8,680 loss was to be shared among the partners “according to [their] share in the profits,” which it will be recalled were shared equally.
On dissolution, the partnership thus had suffered a capital loss, in the form of a capital deficit, of $8,680. Equal sharing of that loss required a debit to each partner of $4,340. Because Reed made no capital contribution, however, he would not bear any share of the capital loss unless he was required to pay in $4,340. Likewise, unless Reed paid him $4,340, Kovacik would bear the entire $8,680 loss. On the face of the statute, Reed is therefore obliged to equalize the losses by paying Kovacik the demanded sum of $4,340.
Courts have strictly applied the UPA provisions in most situations, except those involving a so-called “service partnership,” of the sort present in Kovacik, in which some partners contribute only services. Although none of the relevant UPA sections make any distinction between general partnerships in which all partners make capital contributions and a service partnership, many courts have refused to apply the statute to firms of the latter type if doing so would mean that the service-only partner would be required to make a cash contribution out of personal assets towards his share of any capital losses.[2]
Kovacik is typical of these decisions. The Kovacik court acknowledged the general rule, but held that where the partners had agreed that one was to contribute capital and the other only services, neither partner could be held liable to the other for contribution towards capital losses.[3] “Thus, upon loss of the money the party who contributed it is not entitled to recover any part of it from the party who contributed only services.” The California Supreme Court made no effort to ground this exception in the statute. Instead, the court explained its holding as follows:
The rationale of this rule . . . is that where one party contributes money and the other contributes services, . . . in the event of a loss each would lose his own capital—the one his money and the other his labor. Another view would be that in such a situation the parties have, by their agreement to share equally in profits, agreed that the value of their contributions—the money on one hand and the labor on the other—were likewise equal; it would follow that upon the loss . . . of both money and labor, the parties have shared equally in the losses.
Whatever one makes of this rationale, it has been widely accepted by the courts.[4]
But how would the rule apply where there was both a capital and an operating loss? After all, the court in Kovacik too some pains to note that "Actually, of course, plaintiff here lost only some $8,680 or somewhat less than the $10,000 which he originally proposed and agreed to invest."
Suppose you had the following facts: Abel and Baker are partners. Abel contributed $10,000 cash to the partnership and provides no services to the partnership. Baker contributed to cash to the partnership and did all of the labor of the partnership business. Profits were divided 50-50. After two years in business, they have decided to dissolve the partnership. After liquidating the partnerships assets, the firm owes its outside creditors $100,000 but has paying off the partnership’s creditors, the business has suffered a loss of 20,000. In a state that follows the rule of Kovacik v. Reed, how much money—if any—must Baker pay to settle the losses? My assumption is that he has to pay $10,000 (50%) of the operating loss but none of the capital loss. After all, while it is true that his labor in the court's view is equivalent to Kovacik's capital, that logically should only extend to a capital loss. Right?
Now suppose you were in a UPA (1997) jurisdiction. Section 8.06 makes no distinction between capital and operating losses. And the commentary thereto makes clear that the drafters intended the statute to overturn Kovacik. So you have a net loss of $30,000 and Baker should have to pay $10,000 to the creditors and make good half of Abel's capital loss. Right?
[1] 315 P.2d 314 (Cal. 1957). See generally Stephen M. Bainbridge, Contractarianism in the Business Associations Classroom: Kovacik v. Reed and the Allocation of Capital Losses in Service Partnerships, 34 Ga. L. Rev. 631 (2000).
[2] See, e.g., Kovacik v. Reed, 315 P.2d 314 (Cal. 1957); Becker v. Killarney, 532 N.E.2d 931 (Ill. App. 1988); Snellbaker v. Herrmann, 462 A.2d 713 (Pa. Super. Ct. 1983). The leading precedent to the contrary is Richert v. Handly, 330 P.2d 1079, 1081 (Wash. 1958), in which the Washington Supreme Court (without any analysis) held that where the parties had not agreed upon or specified the basis upon which losses were to be shared, the UPA provisions controlled. Each partner, including the service-only partner, therefore was required to contribute toward the capital loss sustained by the partnership according to his share of the profits. Richert perhaps can be reconciled with Kovacik by invoking the limitation set forth in the latter that service-only partners who are compensated for their services can be held liable for their share of capital losses. Although this fact did not assume any prominence in the opinion, it appears that the service-only partner in Richert was compensated for at least a portion of his services, 330 P.2d at 1080–81, and, therefore, perhaps could be held liable even under Kovacik and its progeny.
[3] A later decision made clear that the dispositive fact is that one partner was to provide only services. The Kovacik rule therefore still applies even if the partner who contributed the firm’s capital also contributes some services, so long as the other partner contributes only services. De Witte v. Calhoun, 34 Cal. Rptr. 491, 494–95 (Cal. App. 1963).
[4] See Snellbaker v. Herrmann, 462 A.2d 713, 716 (Pa. Supr. 1983) (collecting cases); David B. Sweet, Annotation, Joint Venturers’ Comparative Liability for Losses, Absence of Express Agreement, 51 A.L.R.4th 371 (same).
