Limited Partners: You Don’t Have to Take it Anymore General Partners: Beware


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Clifford R. Horner, Esq.

Author: Clifford R. Horner, Esq.


Limited partnerships holding real estate are quite common and are somewhat of a hybrid business entity, combining elements of partnership and corporate-type duties. Much like corporate directors, general partners have a fiduciary obligation to limited partners to act in good faith, to deal fairly, and to refrain from obtaining any advantage over the limited partners in the affairs of the business by even the slightest misrepresentation or concealment. Such duties are fundamental to the relationship and cannot be contracted away in the partnership agreement or otherwise. Specifically, when the real estate interests of the partnership are being liquidated, in what manner does this fiduciary duty exist and to what extent?


A recent California case more clearly defined what duties are owed among partners during a transaction involving the merger and liquidation of limited partnership real estate assets. The court clarified that during a merger or liquidation, general partners must strictly adhere to the common standard of utmost care and fairness. Failure to abide by such standards confers upon the bought-out limited partner an individual cause of action against the general partner for any resulting inequities.


THE EVEREST CASE


The recent case of Everest Investors 8 v. McNeil Partners (December 16, 2003) 114 Cal. App. 4th 411, involved fourteen real estate limited partnerships owning eighty-one real estate holdings including commercial property, apartment buildings, multi-family units and self-storage properties valued in excess of $600 million. The partnerships merged into a new entity, becoming a wholly-owned subsidiary of the new entity. The interests of the limited partnerships ("Everest") were liquidated and the limited partners cashed out. The general partner ("McNeil") retained an equity interest in the post-merger entity.


The litigation arose from the events of the liquidation of the limited partner real estate holdings. During the liquidation process, the general partner set up an "independent special committee" to negotiate the final terms of the transaction. This "committee" was made up of only one individual, who was on the general partner's board of directors. This committee ultimately recommended the transaction to the limited partners, who approved the transaction. While the limited partners recouped more 150 percent on their investment in the partnership, they alleged that the return should have been even greater. Everest discovered that the post-merger entity had projected that it could "flip" (or quickly resell) the properties acquired in the transaction for more than they were valued at for purposes of the merger and liquidation, which the post-merger entity (which no longer included the limited partners) in fact proceeded to do after the merger.


The wrongful actions of defendants, as alleged by Everest included: (1) structuring the transaction as a merger of the entire group of McNeil Partnerships rather than conducting sales of each partnership's real estate holdings, resulting in a distribution to the limited partners of an amount less than the fair market value of each individual partnership; (2) allocating a portion of the settlement price ($35,000,000.00) to the management company controlled by the general partner (McREMI), notwithstanding that McREMI possessed only contracts that could be canceled on short-term notice and otherwise had no meaningful assets and no function other than to manage the real estate holdings for the limited partnerships; (3) including in the transaction oppressive "break-up" fees of $18 million that were designed to deter competing offers from third parties or rejection of the deal by the limited partners; (4) requiring that the limited partners pay nearly $2 million in "success fees" to corporate insiders employed by McREMI; and (5) structuring the transaction so that the general partner acquired an ownership interest in the postmerger entity, effectively constituting a sale of the limited partnership assets to the general partner, giving it more incentive to value the assets for purposes of the merger at a lowball price, and allowing the general partner to profit from the sale of the assets to third parties at higher prices, which it did, thus obtaining a benefit from the transaction which the limited partners could not share. Everest claimed that had the transaction been conducted properly, the total distribution to the limited partners and the general partner would have been increased by $159,000,000.00 (comprised of $31,000,000.00 improperly allocated as the value of McREMI, $126,000,000.00 in higher purchase prices, and $2,000,000.00 in improperly allocated success fees), with the limited partners receiving 95 percent of that increase, or about $151,000,000.00.


Consequently, the limited partners (which were comprised of five California limited liability companies) filed an action for breach of fiduciary duty, unfair competition and constructive fraud. McNeil filed a motion for summary judgment asserting that Everest's claims were derivative in nature and barred by application of the business judgment rule. The California Court of Appeal held that the general partner had a fiduciary obligation to deal with the limited partners in good faith and could not seek to obtain any advantage over Everest during the dissolution and liquidation of partnership assets. The Court stated that the business judgment rule did not provide a shield for the general partner under these circumstances. These concepts are discussed in more detail below.


FIDUCIARY OBLIGATIONS OF GENERAL PARTNERS TO LIMITED PARTNERS


Partnerships are generally characterized as "hybrid" entities wherein some aspects the law treats them as an aggregate of the individuals, and in other aspects, they are viewed as entities. One aspect in which a limited partnership is viewed as an entity is with respect to the ownership of property. Therefore, the partnership, and not the individual partners, owns the assets. On the other hand, individual partners hold an interest in the partnership itself.


This concept shapes the fiduciary relationship that partners have to one another. Partners must act with the highest level of good faith to each other and "may not obtain any advantage over [other partners] in the partnership affairs by the slightest misrepresentation, concealment, threat or adverse pressure of any kind." This principle governs both general and limited partners and such duties cannot be waived or disposed of by way of the partnership agreement.


As reinforced by Everest, these obligations also apply to actions taken during the dissolution and liquidation of partnership assets and in the distribution of the proceeds of such liquidation to the limited partners. Therefore, one partner cannot dissolve the partnership for personal gain unless the other partners are fully compensated for their share of any prospective business opportunity. (Note that this concept of "fiduciary duty" applies equally in the corporate context. Thus, a majority shareholder or corporate director breaches its fiduciary duty to minority shareholders by using its control over the company to obtain an advantage not available to all shareholders and in a manner detrimental to the minority, if such action is not taken for a compelling business purpose.)


Derivative vs. Individual Actions


A "derivative" action is one where the complaint is based on some injury to the company or its property, which injury is consistent among all individual interest holders. In a limited partnership setting, a derivative action enforces a claim which the partnership entity has against others (including an individual partner) but which the partnership fails to enforce, often due to the improper influence of the general partner or majority owners. It is filed in the name of the individual partner who initiates the action, with the partnership entity being named as a defendant. However, any benefits resulting from the action are ultimately retained by the partnership, and not the individual plaintiff.


An "individual" action is filed where one partner (or stockholder) possesses an individual right to sue resulting from injury to himself. However, the wrong complained of need not be unique to that plaintiff - others may have suffered the same or similar injury. This individual injury must not be incidental to an injury of the entity. In fact, an injury to a limited partner's interests may occur absent any injury to the partnership because the limited partner's interest is separate and apart from the partnership's ownership interests.


The devaluation of assets for the purpose of cashing out limited partners, as allegedly occurred in Everest, results in injury to the individual, not the partnership. Therefore, Everest clarified that such a claim is individual in nature, and not derivative. This distinction is significant because any judgment obtained for the plaintiff in such a suit will be retained by such individual limited partner and will not be for the benefit of the partnership.


The Business Judgment Rule


The business judgment rule is a principle which affords judicial deference to corporate directors and general partners in the exercise of their business judgment on behalf of the entity. The rule grants broad discretion in business (corporate or partnership) decision-making, using the reasoning that the entity (and its officers, directors, etc.), and not the courts, understands most clearly what is in the best interest of the entity at the time that such decisions are made.

In the Everest case, the court refused to accept the general partner's argument that its actions were protected by the business judgment rule, clarifying that the business judgment rule cannot be used as a shield against allegations of bad faith or fraud. The Everest transaction revealed possible benefits to the general partner that were not afforded to the limited partners. Evidence of this type of activity precludes the application of the business judgment rule and causes courts to look with a much more critical eye at a particular business decision.


CONCLUSION


Recent California caselaw clarifies that general partners in a limited partnership (like corporate officers, directors and majority shareholders) do in fact have a fiduciary duty to act in good faith and with the utmost care in relation to the other partners and minority shareholders, especially during the liquidation of the partnership assets and in any merger transaction. Any action which appears to be taken for the purpose of obtaining any advantage over the limited partners will give rise to an individual course of action by one of the harmed limited partners, will not be afforded the protections of the business judgment rule, and will be closely and critically examined by the courts.

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