Rights of Limited Partners in the Face of a General Partner’s Self-Dealing

Limited partnerships have in large measure been replaced by limited liability companies as the passive investment vehicles of choice.  But, they are still relevant because they are still sometimes used and there are many legacy limited partnerships that are still in existence.

On the surface, it appears limited partners have very few rights and protections.  They are not allowed to participate in management or to second guess the general partner’s actions.  However, while the law requires that they stay passive insofar as management is concerned, it does afford them a number of protections to assure that their financial interests are not abused.

"A limited partner is not in the hopeless position where he must only suffer in silence when an alleged wrong occurs. He has a right of full and free access to information contained in the partnership books, and of all things affecting the partnership, as well as a right to formal accounting." Millard v Newmark & Co., 24 AD2d 333, 336 (lst Dep' t, 1966).

OK, so the limited partners inspect the books and records and obtain a formal accounting, and they show that the general partner has been taking out significant amounts of the partnership’s net cash flow – maybe, all of the partnership’s net cash flow, and maybe over many years.  Maybe he’s signed purchase orders, management agreements and mortgages with entities he’s affiliated with and is paying them under these agreements?  Now what?

The general rule is that a general partner owes a fiduciary duty to limited partners and is obligated not to engage in self-dealing, unless the partnership agreement explicitly permits the payment or transaction in question.

"General Partners owe a fiduciary duty to limited partners and are obligated not to engage in self-dealing, unless the partnership agreement permits such self-dealing." See Carella v Scholet, 2006 NY Slip Op 7957, (3rd Dep't, 2006); (NYPL §43).

Are there any limits on what the partnership agreement can permit a general partner to do?  In theory, not.  But in practice, at some point if the partnership agreement is not fair and balanced, limiteds simply won’t sign. 

To address the issue of whether the self-dealing transactions are subject to challenge, one must begin with an analysis of the partnership agreement. 

1. Does the partnership agreement provide for the general partner to be paid a management fee or other amounts for its services, or to be reimbursed for its expenses in managing the partnership?  The general rule is that the general partner is entitled to the compensation that the partnership agreement states and no more, and that if the partnership agreement does not explicitly provide for management fees, he cannot take them or pay them to an affiliate.

"The limited partners of R 103 never agreed that fees or commissions of any kind would be paid to Shawnee Equities (Hack's wholly-owned corporation) in connection with any transaction other than the acquisition of the Richmond. Hence, under all the circumstances, the court finds that the fees paid to Shawnee in connection with Glenwood Gardens involved improper self-dealing by Hack and a breach of fiduciary duty to the partnership. The appropriate remedy for such breach of fiduciary duty is to require the fiduciary to disgorge the improper payments or fees received." Delano v. Kitch, 663 F.2d 990 (10th Cir.1981), cert. denied, 456 U.S. 946, 102 S.Ct. 2012, 72 L.Ed.2d 468 (1982). Shlomchik v. Richmond 103 Equities Co., 662 F.Supp. 365 (S.D.N.Y., 1986).

2. Does the partnership agreement permit the general partner to engage in self-dealing transactions? Often partnership agreements will permit self-dealing transactions, provided that the price and terms are not less advantageous than could be obtained from independent third-parties.  If the partnership agreement contains such a provisions and an inspection of the books or an accounting reveals that the general partner has engaged in self-dealing transactions, the questions that must be answered is were the amounts paid by the partnership for the goods or services in question more than what the partnership would have paid if it had obtained them from an independent third-party.

3. Does the partnership agreement contain any relevant limitations on what the general partner can do?

4. Has the general partner violated any of his non-contractual obligations to the limited partners, such as his fiduciary duties?

"Members of a partnership owe to each other a fiduciary duty, a duty of "undivided and undiluted loyalty" and "sensitive . . . fidelity" that bars partners from entering into "situations in which [their] personal interest possibly conflicts with the interest of" the other partners." (Birnbaum v. Birnbaum, 73 NY2d 461, 465-66 [1989]).

5. Did the general partner have a duty to disclose relating to the self-interested transactions at the time they occurred?

"when a fiduciary ... deals with the beneficiary of the duty in a matter relating to the fiduciary relationship, the fiduciary is strictly obligated to make ‘full disclosure’ of all material facts,” meaning those “ ‘that could reasonably bear on [the beneficiary's] consideration of [the fiduciary's] offer’ ” (Blue Chip Emerald at 279, 750 N.Y.S.2d 291, quoting Dubbs v. Stribling & Assoc., 96 N.Y.2d 337, 341, 728 N.Y.S.2d 413, 752 N.E.2d 850 [2001] ). It is beyond dispute that the facts relating to Maynard's negotiation of a mortgage loan of about $1.5 million, which required that the property be valued at over $2 million, had a bearing on the limited partners' consideration of Maynard's offer to acquire the property based on a valuation of $842,427 (see Littman v. Magee, 54 A.D.3d 14, 17–18, 860 N.Y.S.2d 24 [2008]; Blue Chip Emerald, 299 A.D.2d at 280, 750 N.Y.S.2d 291). Since the consents were revocable and the partnership was not dissolved, Maynard had a continuing duty to inform the limited partners of material facts."  Frame v. Maynard, 83 A.D.3d 599 (1st Dep't 2011).