In Martenfeld v Collins Barrow Toronto LLP, 2013 ONSC 4792, Collins Barrow Toronto LLP (“CBT”) completed journal entries to protect CBT’s capital from creditors, without making the necessary changes to the provisions in CBT’s partnership agreement (the “Partnership Agreement”). This oversight cost CBT $310,978.00 (CBT owed Marvin Martenfeld (“Martenfeld”) $260,788.25 instead of Martenfeld owing CBT $50,189.75).
CBT had a management corporation, Collins Barrow Toronto Inc (“Inc.). Each partner or a party related to each partner had their own management corporation (“Management Corp”) as a shareholder of Inc. Martenfeld’s Management Corp was called Jekel Enterprises Inc. (“Jekel”). Jekel was owned by Martenfeld’s wife. In 2003 CBT formalized its partnership by signing the Partnership Agreement. The Partnership Agreement contained the following non-competition provision:
Any Equity Partner who withdraws from the Partnership and competes with the Partnership … agrees to pay the Partnership, as a genuine pre-estimate of liquidated damages, and not a penalty, an amount equal to two times his or her then Permanent Capital … and agrees that any balance in his or her Capital Account, if any, as well as any capital loans … will constitute a down-payment that may be retained by (or paid by the Corporation to) the Partnership by way of set-off to be applied against any amounts owing in respect of this obligation…
In 2004 CBT decided to convert some of CBT’s capital into shareholder loans, in order to protect the partners from creditors, and to equalize the amount each partner had at risk. Through a series of journal entries each partner’s Capital Account became $10,000.00 and any excess became loans due from Inc. to the Management Corps.
In June of 2009 Martenfeld gave his partners notice that he was leaving CBT and going to Meyers Norris Penny LLP (“MNP”) a competing accounting firm. Martenfeld attempted to be paid his shareholder loans, and his portion of CBTs profits through negotiation and then arbitration. When the arbitration failed Martenfeld sued CBT and Inc. Both parties agreed that Martenfeld owed CBT liquidated damages for competing with CBT, and that liquidated damages were equal to two times Permanent Capital. However the parties disputed the definition of Permanent Capital. Martenfeld’s position was that Permanent Capital was the $10,000.00 in Martenfeld’s Capital Account, thus liquidated damages were $20,000.00 (two times $10,000.00). CBT’s position was that the amount moved from Martenfeld’s Capital Account to Jekel’s shareholder loan in 2004 should remain part of Permanent Capital, thus liquidated damages should be $320,988.00 (two times $160,494.00).
The court determined that Martenfeld was correct. The partnership agreement defined “Permanent Capital”:
in respect of an Equity Partner in a Fiscal Year means the lowest level of capital required of such Equity Partner at any time during such Fiscal Year, and which amount may not be reduced at any time during such Fiscal Year, as determined at the beginning of each Fiscal Year for each Equity Partner by Special Resolution.
Further according to the Partnership Agreement “Capital Account”:
means each Partner’s Capital Account as maintained pursuant to Section 9.2. Section 9.2 provides in part:
… Each Equity Partner’s Capital Account in a Fiscal Year shall consist of his or her Permanent Capital for such fiscal year…
The court determined that there was no evidence that the partners of CBT had ever passed a Special Resolution to fix their Permanent Capital, but that the partners had deliberately fixed their Capital Accounts to increase their net income through income splitting and to minimize risk. The court felt that it would be disingenuous to assert that the 2004 transactions were artificial since the partners had benefited from the transactions.
As such the court determined the Permanent Capital was equal to $10,000.00 and that CBT and Inc. owed Martenfeld and Jekel $260,788.25. Table 1 illustrates how the court calculated the damages and how damages could have been calculated had CBT amended its partnership agreement when CBT made the journal entries, or passed Special Resolutions fixing Permanent Capital
Table 1 – What CBT Had to Pay vs. What CBT Would Have Been Owed if CBT Had Modified the Partnership Agreement or Passed Special Resolutions Fixing Permanent Capital.
- That doing journal entries without any deliberation on how the transactions affects the entity’s legal agreements can have disastrous ramifications;
- How important corporate governance is. Had CBT simply passed a Special Resolution every year fixing the Permanent Capital of every partner, it is likely that Martenfeld would have owed CBT $50,189.75 instead of CBT owing Martenfeld $260,788.25.
- Partnership agreements should set out what income of the partners should be in the partnership income.
If you would like to ensure that an accounting transaction does not inadvertently affect your Client’s legal rights, feel free to give us a call.