Ribit Revisited - A Commercial Conundrum: Does Prudence Permit the Jewish "Permissible Venture?"
Prof. Steven H. Resnicoff
An initial question is whether the religious motivation for the permissible venture warrants special treatment. In other words, should secular law, as a permissible accommodation72 to Jewish religious interests, treat the permissible venture as a loan rather than as a partnership?
The permissible venture developed as a substitute for express loans within Jewish law. Historically, Jewish communities were relatively insular, separated from their Gentile neighbors. They were governed by rabbinic courts which applied Jewish law. Jewish law permitted a person to form a "partnership" while restricting his liability for the acts undertaken by his partnership. Similarly, Jewish law did not recognize the doctrine of vicarious liability. Nor were there regulations restricting the business operations of individual or group money-lenders or special tax treatment for interest income or expenses. In short, the pitfalls of partnership status described above did not exist within the Jewish law system.
Potential problems arise in transferring this religious law mechanism from its original historical and legal context into the current secular legal framework. The risks that inure from characterization as a partnership would tend to discourage or heavily burden the use of permissible ventures. A judicial or legislative response, reducing the probability of partnership characterization, would encourage investment and accommodate Jewish religious concerns. The courts have long recognized that government may take certain acts to accommodate religious interests.73 The parameters of such allowable accommodation are broader than the scope of noninterference mandated by the Free Exercise Clause.74 Nonetheless, because the adoption of accommodating measures is peculiarly a matter of public policy, it is the proper subject, in the first instance,75 for the legislature, not the judiciary. Assuming for the moment that there were no alternative legal grounds for characterizing the permissible venture under secular law as a loan, there would be no authority for the judiciary to label it so.
Indeed, even the legislature may not transform a permissible venture which is really a partnership into a loan merely by declaring it to be one. Nonetheless, appropriately drafted legislation could protect Financiers from particular pitfalls. State law problems might dissipate, for example, if the legislature would (1) recognize the permissible venture as establishing a limited partnership,76 (2) authorize lenders to participate in permissible venture limited partnerships, (3) provide that such limited partnerships be valid immediately upon the execution of a form permissible venture agreement, either without a recording requirement or contingent upon subsequent recordation, and (4) specify the tax treatment applicable to the various aspects of permissible venture transactions.77 Of course, such measures could be challenged as going beyond the pale of allowable accommodation and representing an unconstitutional fostering of religion.78 But the permissible venture is neither a religious document nor a religious ritual. Moreover, any legislation would arguably have the secular purpose of affording Jewish borrowers the same type79 of access to financing as non-Jews enjoy. These measures might also be structured to permit similar relief to transactions between non-Jews which were established in a permissible venture format.
Even if the regulations pass constitutional muster, legislative efforts by a single authority may be frustrated by permissible ventures which involve the laws, rules or regulations of various authorities. Therefore, it is important to decide whether, without new rules or laws, a permissible venture establishes a secular partnership.
The permissible venture was designed as a legal fiction. Although it resembles a partnership, it is in effect a disguised loan. The sticking point is that there is a possibility, albeit attenuated and remote, that the venture's form will have substantive significance, i.e., that the Financier will actually participate in the profits and losses of the permissible venture business rather than merely receive scheduled payments. Ultimately, I contend, for reasons set forth below, that this possibility is de minimus and should not affect the conclusion that the permissible venture is essentially a loan, not a partnership. Case law generally stands for the proposition that whether parties are partners depends on the substance of their relationship rather than on the label they give to it.80 The elements that truly mark a partnership are not present in permissive ventures either formally or substantively. Consequently, courts reviewing permissible ventures should conclude that they are loans, not partnerships.
Five features are commonly regarded as highly probative of the existence of a partnership:
(1) The parties must intend to create a partnership. It is, however, unnecessary for the parties to have understood that the legal impact of their contract was to establish a partnership.81 Nor is it essential that they foresaw all of the legal consequences of their having formed a partnership. It is enough that the parties intended to agree to the terms of their contract, and that, as a matter of law, those terms were sufficient to establish a partnership;82
(2) To establish a partnership, the parties must engage in a profit-seeking commercial enterprise.
(3) Each of the parties must own a proprietary interest in the partnership business itself.
(4) The partes must share in the profits of the business. This component is a necessary, albeit not a sufficient, condition of a partnership.83 The sharing must be based on the parties' co-ownership of the partnership business.84 Thus, although the Uniform Partnership Act (the "UPA") provides that the sharing of profits is generally prima facie evidence of a partnership, one exception is if the profits are received "[a]s interest on a loan, though the amount of payment varies with the profits of the business."85
(5) Another requisite element of a partnership is that the parties must be at risk in the event that the partnership sustains losses.86
The substance of a permissible venture, not merely its formal elements, must be explored in order to determine if it constitutes a partnership. A few introductory remarks regarding the "substance versus form" approach are in order.
Courts frequently search beneath the superficial forms of legal entities or transactions to ascertain the form's true or substantive nature. In some instances, this approach may be legislatively prescribed.87 In the alternative, courts have justified this approach on equitable or policy grounds.88
The inquiry into the substance of a transaction is often phrased as an effort to discern the parties' true intent. There is a probing evaluation of the party's subjective understanding of the transaction. If the formal partnership is only a smokescreen, and the parties intended an altogether different relationship, such as a debtor-creditor relationship, the partnership form may be disregarded.89
Even if a permissible venture states that the Financier and Recipient will pursue a "partnership" or "joint venture," such language should not be dispositive as to the parties' intent. As mentioned above, these terms may only reflect a rabbi's inelegant efforts to translate into English the Hebrew term "shutfus."
Furthermore, certain permissible ventures, such as those used for consumer financing, are surely not partnerships. Because a permissible venture agreement accommodates at least some non-partnership arrangements, it cannot be said that execution of a permissible venture universally reflects an intention to create a secular partnership.90
Many Jewish law authorities allow the use of permissible venture agreements even where the Recipient is not engaged in a commercial activity but seeks only the equivalent of a consumer loan.91
There are several reasons, in addition to those set forth below regarding business permissible ventures, why these arrangements fail to constitute secular partnerships. Consumer financing ventures do not involve the carrying-on of a business for profit, the parties are not co-owners of a partnership business and they do not truly share in the profits and losses of such a business.
A majority of Jewish law authorities allow use of a permissible venture for a consumer purpose provided that the Recipient is also involved in some business enterprise.92 The permissible venture financing is deemed to permit the Recipient to continue his business activity without liquidating the capital previously dedicated to it. Secular law does not seem to contain any mechanism by which to classify the arrangement and thereby find that a partnership business.
Commercial permissible ventures involve, at most, a conditional sharing of profits and losses. Even when used to directly fund a business activity, permissible venture agreements may not in substance require the sharing of profits and losses. Given the presumptions set forth in the document, the permissible venture requires, in effect, that the Recipient make scheduled payments unrelated to the actual profits and losses of the business. This obligation remains in effect until and unless the Recipient satisfies certain conditions regarding the proof of profits.93 Thus, even if the Financier's mere participation in profits would prove the existence of a partnership, the permissible venture agreement represents no more than an agreement permitting the Recipient the right to establish such a partnership in the future.
For example, consider a case in which A advances money to B for use in a business to be operated by B. A and B agree that if A rolls snake-eyes twelve times in a row, A and B will share equally in the profits from the business. If A's dice do not cooperate, however, A will simply get a 12% annual return on the investment. Because A will not participate in the profits until and unless the dice roll a certain way, it appears that there is no partnership until and unless the dice so fall. In the meantime the arrangement might be characterized as a partnership subject to a condition precedent.94 Provided that the Recipient does not actually prove profits or losses, no partnership would ever be established.95 The same principle applies to a permissible venture. Until and unless the Recipient proves actual profits or losses by the evidentiary standards of the permissible venture agreement, the Financier will merely receive a fixed return on his money and no partnership will be formed.
Neither of the two apparent objections to this analysis is persuasive. Contrary to the "condition precedent" argument, one might contend that the permissible venture agreement creates a partnership subject to a condition subsequent. Yet this characterization seems artificial and inapt. Given the presumptions of the permissible venture agreement, there is no initial sharing of profits and losses. Only the Recipient's affirmative act could create this sharing. The more natural view is that there is no partnership until and unless such an affirmative act is performed. Moreover, whereas the "condition precedent" argument refers to the Recipient's act as the operative condition, the "condition subsequent" alternative awkwardly refers to a passive development, the Recipient's failure to act, as the condition. In any event, this objection is of limited significance. It is highly likely that the Recipient will fail to provide the requisite proof of the venture's profits. Consequently, the Financier would never share in the profits and losses and at no time would a partnership exist.
Another objection might be that the bringing of proof is not a condition at all but, rather, an inherent and integral element of any legal relationship. Here, the contention might continue, the parties simply agreed that only a particular level of proof would be acceptable to them. This is an easy argument to state, but there seems to be no authority which declares that the need to satisfy a consensual requirement, even one pertaining to the level of proof, cannot also be deemed a condition, particularly where the standards of proof are so significantly in excess of those generally applicable under secular law.
As a matter of substance, the permissible venture does not involve the sharing of profits and losses. In many contexts it is practically, and in some cases perhaps even theoretically,96 impossible to establish such profits and losses. In no case is there more than a remote probability that a Recipient will agree to take the requisite oath or be able to adduce the necessary witnesses.
Where the Recipient is engaged in many business activities, he must be prepared to offer competent testimony as to the profitability of each.97 Moreover, permissible ventures may be of very brief duration as, for example, when the Recipient has the need for short-range, immediate financing, or may involve only a particular piece of equipment. These limitations may make it exceedingly difficult, if not impossible, to determine the amount, if any, of profits or losses directly attributable to the permissible venture.98 permissible ventures involving short-run financing during the start-up period of a business, during which time a negative cash-flow is anticipated, would involve equally complex questions regarding the determination of profits.
Several commentators have stated that the relevant restrictions render the loss-sharing provisions of the permissible venture "nugatory."99 What is left is the Financier's right to receive, and the Recipient's virtually unconditional obligation to pay, the payout set forth in the permissible venture agreement.
Even if the permissible venture involved the sharing of losses, the type of loss-sharing typical would not be typical to a partnership.100 Ordinarily, partners agree to unlimited exposure for partnership losses. By contrast, a Financier in a permissible venture agrees to put at risk only the amount of his investment (one-half of the total sum he advances),101 and he accepts no personal liability at all.102
Nevertheless, case law suggests that the limited liability of a Financier will not preclude him from partner status. A party providing funds to a business and sharing in its profits will be treated as a partner if the obligation to repay to it the funds advanced depends upon the success or failure of the business.103 Once the repayment obligation is conditioned on obtaining profits, any agreement between the parties to limit the liability of the Financier is ineffective as to third parties as a matter of law.
Additionally, most permissible ventures do not involve any meaningful co-ownership of the venture's business. The Financier generally possesses no control over the business. The lack of control, although permitted by the UPA, has been cited as evidential as to the absence of a partnership.104 In some instances, the Financier may be entirely unaware of the use to which his money is put. Some permissible venture agreements provide that the investment is deemed to have been made in the commercial activity of the Recipient which happened to have been most profitable during the term of the venture. Thus, the use first becomes identifiable after the venture terminates, when it is possible to ascertain the profitability of the Recipient's various activities. Surely it is strained to state that, during the term of such a permissible venture, the Financier meaningfully co-owned the venture's unidentifiable business.
Nor is the Financier automatically entitled to participate in the profitable operations of the business. During the venture, the Recipient can avoid the Financier's participation by merely making the scheduled payments set forth in the permissible venture. When the venture terminates, the Recipient is entitled to buy out the Financier's purported ownership interest for an amount equal to the Financier's original investment, less the Financier's pro rata share of any loss. The Recipient can do this even if the fair market value of the Financier's ownership interest is far greater than the Financier's original investment. Upon paying the Financier, the Recipient may retain all of the hard assets of the venture and may continue the business for his own benefit. In effect, the Recipient merely repays the principal loaned by the Financier.105
The entire circumstantial framework tends to establish that the parties sought and established the equivalent of a secular loan arrangement. The fixed schedule of payments set forth in the permissible venture embodies a definite rate of return on the aggregate funds the Financier advances. Therefore, the Financier cannot be motivated by the possibility of earning a higher return on the investment, because the Recipient, by refusing to take an oath or bring witnesses, can force the Financier to accept the fixed payments. Moreover, the Recipient cannot be seriously motivated by the hope that the Financier will end up receiving less than the fixed payout. The likelihood of successfully proving profits and losses would not even warrant the expense of the preparatory steps, such as maintaining adequate bookkeeping106 and ensuring the presence of qualified Jewish witnesses.
The negotiations between the parties typically reflect their expectation of a fixed rate of return. The parties often do not focus on the details or the profitability of the Recipient's business, but on the Recipient's ability to make the fixed schedule of payments set forth in the permissible venture. Because the nature of the venture business, assuming that the transaction actually involves a business, is not customarily specified, the parties do not reach a firm understanding of the way in which the Recipient might actually prove the venture's profits or losses. Indeed, the parties may not even discuss the use of a permissible venture until all of the economic parameters are agreed to; then one of the parties might mention that, of course, a permissible venture agreement will be utilized. Moreover, Financiers often provide money for the start-up period of a business, in which there is an expectation of cash-flow losses. The parties, therefore, anticipate receiving the fixed payments. In addition, there may be no meaningful relationship between the actual profit expected from the permissible venture business and the rate of return incorporated in the payment schedule.107 For example, where a Financier provides $100, $50 of which is a no-interest loan and $50 of which is an investment, the permissible venture contain a payment schedule representing a 20% annual return, or $10, on the $50 invested. The permissible venture may declare that a profit of 20% or greater is expected but, in fact, the Recipient will want to proceed with the permissible venture transaction even if his expected profit is only between 20% and 10%. By utilizing a permissible venture agreement, the Recipient really received $100. The required payment of $10 reflects only a 10%, not a 20%, annual return on the total amount provided by the Financier.
Furthermore, the purportedly interest-free loan component of the transaction defies credibility. It is not the custom of average Financiers, especially institutional lenders, to make interest-free loans. Similarly, the fact that the Recipient receives only nominal consideration for managing the permissible venture business, ordinarily as little as $1, is highly unusual and is hardly indicative of any meaningful negotiation between the parties.
In the permissible venture agreement, the presence of terms which are uncharacteristic of a partnership108 but which are permitted in a "shutfus," further indicates the parties' intent not to form a partnership. Of course, if a court finds for other reasons that a partnership was formed, some of these restrictions might not be enforceable.109 Nevertheless, the fact that the parties intended to include these terms may impact on the threshold question as to whether a partnership was established.
The economic impact of the permissible venture is almost always exactly the same as if the Financier had made an interest-bearing loan to the Recipient. Of course, there is a possibility of a different result if (1) the profitability of the business is less than the interest rate implied by the payment schedule, (2) the profitability is susceptible to proof in the manner set forth in the permissible venture, and (3) it is practicable for the Recipient to provide the necessary proof. The confluence of these three factors, however, is extraordinarily unlikely; as a practical reality, the Recipient's obligation to repay the monies furnished is essentially unconditional.
Courts have often disregarded the form of an entity or transaction even though there were eventualities in which the economic consequences of the purported form would differ from the substantive form recognized and enforced by the court.110
A minority of courts, however, have found that there was no partnership even where the parties actually shared profits and losses.111 Consequently, the fact that a permissible venture provides for the remote possibility of participation in the profits and losses should not prevent secular recognition of the transaction as a loan.
It is perhaps unusual to disregard a form which parties have chosen for themselves, especially if the parties themselves are the ones asking for the form to be disregarded. When courts have followed substance rather than form, they have generally done so over the protests of the parties involved in order to prevent the parties from frustrating public policies. In the permissible venture context, however, the parties' motive is the provision of financing for a fee, while avoiding a religious prohibition against interest. This motive, without more,112 would not offend any legitimate public policies. In addition, one might argue that even if a court disregards form for one purpose in order to safeguard public policy, it should not disregard the form as to purposes unrelated to the policies.
An arguably better view, however, is that the legal relationship between the parties should be governed by their "true" intent as evidenced by their conduct. Identification of an improper motive should not be a sine qua non for piercing the parties' elected form. Instead, a motive inconsistent with the purported transaction should be regarded simply as evidence that the substance of the transaction in fact differs from the form adopted. There are occasions where parties are entitled to benefit themselves through the selection of a particular form. If they do not utilize that form in its ordinary manner, or observe the practices customarily associated with it, then they should be found in fact not to have employed the form. The parties, however, might remain liable to third parties on equitable grounds.113
Irrespective of the merits of this argument in general, courts have stated that they follow substance rather than form in determining whether a partnership exists.114 Even if a permissible venture were perceived as imbued with the form of a partnership, in substance it should be recognized as a loan.
The characterization of a permissible venture as a secular loan, rather than as a partnership would promote, not offend, any public policy. There is no significant public policy which would require a permissible venture to expose the Financier to the joint and several liability of a general partner. Secular law permits investors to accomplish the financial objectives of the Financier without incurring personal liability. For example, these objectives may be achieved by a person who invests in a corporation's common stock.115 If there are business profits, he receives a proportion of the gain.116 If the business collapses, his loss is limited to the amount of the investment. This is true even though the investor, through use of his voting rights, may even exercise actual control over the corporation. The possibility that third parties dealing with the corporation may mistakenly rely on the shareholders' financial status does not prevent this result.
The Uniform Limited Partnership Act ("ULPA") and the Revised Uniform Limited Partnership Act ("RULPA") provide vehicles for accomplishing, in the partnership context, what the parties to a permissible venture desire.117 In exchange for infusing capital into a business, a limited partner, with no right to manage the venture, participates in the partnership's profits without being personally liable for its obligations. The ULPA and the RULPA protect innocent third parties by requiring a public filing to provide notice of the limited partnership. The ULPA and the RULPA even provide a safety value for certain persons who mistakenly believe that they became limited partners in a limited partnership. The ULPA provides that a person who contributes capital to a partnership and mistakenly believes that he became a limited partner does not necessarily, by exercising the rights of a limited partner, become a general partner or become bound by the debts of the partnership.118 Therefore, the investor can avoid becoming a general partner by promptly renouncing his interest in partnership profits and in any other compensation from the partnership. A similar provision of the RULPA addresses a person who made a contribution to a partnership but who, in good faith, erroneously believed that he became a limited partner in a limited partnership.119
The RULPA provides that the person, upon learning of his mistake, may avoid classification as a general partner if he either promptly causes an appropriate certificate of limited partnership or certificate of amendment to be filed or withdraws from future equity participation in the business. The RULPA,120 however, does not apply to claims by third parties who had already transacted business with the partnership believing in good faith, at the time of the transaction, that the mistaken investor was a general partner.
The financial terms of a carefully drawn permissible venture arrangement closely resembles a limited partnership. Neither the Financier nor the Recipient perceive the permissible venture as a valid general partnership under secular law and, as a result, third parties rarely, if ever, learn about or rely upon the existence of the permissible venture. It is therefore improbable that third parties would ever detrimentally rely on the existence of a partnership between the Financier and the Recipient.121 Absent proof of reliance in a particular case, there is no policy justification for contravening the parties' intent and treating them as if they were general partners.
Restrictions on the activities of institutional lenders, whether imposed by statute or by agreement, are often the result of a concern to ensure the financial stability of banks. Participation in a partnership, or in particular types of business activities, might be barred as a matter of public policy if they involve undesirable risks.
If a permissible venture agreement does not create a secular partnership, however, only the principal and the opportunity cost of the loan is risked. Neither the amount at risk, nor the probability of the risk, is significantly different from that involved in ordinary loans. Every time a lender makes a loan, the principal and the opportunity cost of the money is at risk. If a borrower files in bankruptcy, for instance, a lender may recover little or nothing at all.
The literal terms of the permissible venture agreement, if enforced, operate to increase the degree of risk as to the amount deemed to have been invested or one-half of the total monies advanced. Pursuant to a permissible venture agreement, the Financier is not allowed to recover such monies if the Recipient proves that there are net business losses or insufficient profits, even if the Recipient were financially solvent. Nevertheless, given that the likelihood that the Recipient could satisfactorily establish these facts is exceedingly small, the net increase in risk is negligible.
Additionally, public policy would be served by characterization of a permissible venture as a secular loan. With respect to tax law, for instance, the United States Supreme Court has declared that state law characterizations of a particular business entity or form are not controlling122 Even where a taxpayer has admittedly complied with the letter of the tax law in creating a type of transaction, the courts can disregard the technical form employed and treat what is perceived to be its substance.123 This is true even where there are possible, although unlikely, scenarios in which the form of the transaction will have substantive significance. Although there is no reported federal tax case involving a permissible venture, courts following substance rather than form under tax law have often treated as "interest" payments bearing very different labels.124 The commercial function of the payments made pursuant to a permissible venture agreement is to substitute for religiously prohibited interest. Consequently, payments pursuant to a permissible venture should be treated as interest.
Similarly, in examining usury implications, substance generally controls form. The courts examine all of the circumstances surrounding the transaction in an effort to ascertain the parties' intent.125 If the fixed rate of return, based on the total funds advanced by the Financier, exceeds allowable interest rates, a court should find that the transaction was a usurious loan.
It is obviously essential that the document be prepared carefully by a trained professional. The following provisions should be included in a permissible venture document to minimize the probability that a court would find that a partnership was created. First, the agreement should state that it is merely for Jewish law purposes, and that although its specific terms are intended to be enforceable under secular law,126 the agreement is not intended to establish a "partnership" or "joint venture" of any sort under secular law.127 The agreement should indicate that, under Jewish law, the permissible venture arrangement does not authorize the Recipient to obligate the Financier personally in any way. Furthermore, the document should state that the Recipient is not intended to have, under secular law, any actual or apparent authority to bind the Financier.
Second, the agreement should specify that the Recipient is barred from releasing the Financier's name, disclosing that a permissible venture was executed or representing that a religious or secular partnership was established. These restrictions should reduce the Financier's exposure to third party claims based on estoppel. The permissible venture agreement should also indicate that the liability of the Financier is limited to the amount of money invested.128 The agreement should also specify that the Financier is not personally liable for the debts of the venture or for the claims of the Recipient or of third parties;129
Third, the agreement should contain an indemnification and "hold harmless" clause, shielding the Financier from, any liability in excess of his investment. A clause should also be inserted specifically stating that the Recipient has no control whatsoever over the Recipient's business,130 and that any losses in the permissible venture business must be proved only through competent testimony under Jewish law.131 In addition, the agreement should indicate that it is the parties' intention that, under secular law, the Financier's investment should be treated as a conditional, non-recourse loan.
Even if a court determines that no partnership was formed, it may still enforce the express terms of the permissible venture agreement under contract law. By taking the prescribed oath or producing the specified witnesses, the Recipient could frustrate the Financier's practical expectations. To reduce the likelihood of this result, the permissible venture should contain a clause providing that the Recipient must invest the funds diligently and with scrupulous care and that the Recipient bears various responsibilities for the safeguarding of the funds. The agreement should provide that the Recipient must satisfy specified conditions regarding the type of venture which may be pursued and that the Recipient must make ongoing financial disclosures.
If the Recipient chooses to take an oath to establish that the actual profits of the venture were less than the presumed amount, the agreement should state that the oath must also include a statement that the Recipient has faithfully fulfilled all of his obligations and responsibilities under the permissible venture agreement. Furthermore, if the Recipient chooses to bring witnesses to testify that the venture sustained losses, the Recipient must take an oath that he has faithfully fulfilled all of his obligations and responsibilities under the permissible venture agreement.
Finally, if the Financier contends that the Recipient has not faithfully performed one or more of the Recipient's obligations or responsibilities, the Recipient must prove through two qualified witnesses that he has faithfully performed them all.
If he has confidence in the truthfulness of a statement, a Jewish Recipient might overcome his general aversion to oath-taking, particularly if the stakes are high. Consequently, where there is a clear and unexpectedly large liability, a Recipient might be inclined to take such an oath. Requiring that the oath also recite that the Recipient's many other duties were performed, particularly those responsibilities which are difficult to define precisely, makes it less probable that a Recipient will take the oath. Moreover, requiring an oath in addition to the production of witnesses regarding losses decreases the already remote likelihood that losses will be established.
The references to Jewish law in the permissible venture agreement might raise enforceability problems under secular law which would endanger the Financier's ability to recover his money.132 To avoid any such risk, the permissible venture agreement should also include a clause requiring compulsory submission of any dispute to a particular rabbinic court for binding arbitration based on Jewish law. The provision should be crafted to ensure that, under applicable sate law, any arbitration award could be entered as a judgment in state court.
A sample permissible venture containing or referring to such provisions is printed below in the Appendix.
Despite the foregoing arguments, there remains a substantial risk that the form of a permissible venture, which incorporates elements analogous to a secular partnership, will compel a reviewing court to treat it as such, with all the attendant adverse consequences. Accordingly, the following section suggests that in some cases a permissible venture could be restructured as a non-recourse loan, a familiar non-partnership form.
In a typical non-recourse loan, a lender provides funds to a borrower, obtains collateral to secure repayment of the funds and agrees that, in the event of default, the borrower will not be personally liable to the lender. The lender will collect only from the collateral. A permissible venture is similar in that a Recipient is not personally liable to the extent that he satisfactorily proves the venture sustained net losses.
In non-recourse loans, however, lenders usually limit the amount advanced to a fraction of the value of the collateral they obtain. In this way, even if the value of the property depreciates, they can still recover all of their money. A permissible venture is different because if the borrower suffers losses in the venture business, and can prove them, Jewish law forbids the Financier to collect the full amount of his principal, even from collateral. The Financier must deduct from his claim an amount equal to one-half of the losses.
This formal procedure explicitly requiring that the Financier share in the losses may lead a court to rule that the permissible venture is a partnership. If the transaction can be restructured as a non-recourse loan, the court might reach a different conclusion. The problem is finding collateral which would automatically decrease in value if the venture incurs net losses, thereby satisfying the requirements of Jewish law.
One choice is to establish a fractional interest in the assets of the venture. The numerator of the fraction would be the number of dollars advanced, and the denominator would be the sum of the numbers invested by both the Financier and the Recipient.133 Consider, for example, a permissible venture in which a Financier advances $100, $50 as an interest-free loan and $50 as an investment, and a Recipient invests the $50 which was provided as a loan. As to the $50 of "investment" funds,134 the Financier might receive an undivided 50% (50/100%) security interest in the assets of the permissible venture business. To ensure that the Financier does not collect more than the amount permitted by the permissible venture, this security interest must be expressly subordinate to the claims of creditors of the permissible venture business. It should be perfected, however, to establish its priority over other potential personal creditors of the Recipient who were not involved with the permissible venture business.135
A Financier desires that whenever possible the Recipient be personally liable for full repayment of the monies advanced as an investment. Under Jewish law, there can be no such liability if the existence and extent of losses is properly established. The permissible venture agreement, under the non-recourse loan model, could provide that even if there are losses, the Recipient would be personally responsible for losses if he violated particular terms or conditions, such as restrictions on allowable permissible venture businesses or the requirement of diligence or best efforts in the pursuit of the business.136 The subordination of the Financier's rights as to the collateral could be similarly conditioned.
In specific circumstances, technical problems may arise in connection with using the non-recourse loan alternative in specific circumstances. For example, where funds are used in a cash-loss period in order to build up intangible assets such as good will, the security interest may not be meaningful collateral. Alternatively, if any of the assets of the venture are subject to a pre-existing security interest, then the Financier would not be assured of repayment of his principal even if the venture suffers no losses. Moreover, in order for a financing statement to be effective, it must describe the collateral which is covered. The parties will either have to list the pertinent assets or to describe them as the assets used in the venture. To make the description meaningful and effective, the parties may have to agree upon and identify the parameters of the venture's business. Specifying this business at the outset, however, may detrimentally affect the Financier. Under Jewish law, specificity is not required, and the Financier's investment may be deemed to have been made in whatever business activity of the Recipient was in fact most profitable during the term of the venture.
Assuming that a permissible venture could be structured as a non-recourse loan in a particular case, the first question is whether this combination of features, non-recourse debt and the sharing of profits, evidences a partnership. It seems that the combination does not. Non-recourse loans are often made,137 without causing the lender to be considered a partner of the borrower.138 Authorities, including the UPA, have determined that receipt of a percentage of profits in lieu of interest on a loan does not establish a partnership. A number of cases have determined that an investor is a partner where the obligation to repay depends on the profitability of the business. The use of a non-recourse loan appears functionally tantamount to making the repayment obligation conditional on the profitability of the partnership. If there are no losses, then the value of the collateral will permit full repayment of the funds. If there are losses which are properly established, the collateral will be worth less than the full amount of the funds advanced and the loan will not be repaid in full. Nonetheless, if form alone is followed, use of a non-recourse debt should avoid the conclusion that the permissible venture constitutes a partnership. Alternatively, if substance rather than form approach is applied, it should be used to evaluate the entire transaction. For the reasons set forth above,139 the transaction, considered as a whole, should be found to involve a substantively unconditional repayment obligation.
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