Limiting limited partners' limited liability

In the midst of my semi-annual updating of my partnership treatise, I caught up with a disturbing bankruptcy court opinion from a few months ago: In re Adelphia Communications Corp., 376 B.R. 87 (Bkrtcy.S.D.N.Y., 2007), involving a creditor's (Lucent) $45 million claim against a limited partner for liability for the debts of a Delaware limited partnership.

As most lawyers know, limited partners in most states are generally protected from vicarious liability by provisions based on Revised Uniform Limited Partnership Act Section 303. The Delaware version provides:

(a) A limited partner is not liable for the obligations of a limited partnership unless he or she is also a general partner or, in addition to the exercise of the rights and powers of a limited partner, he or she participates in the control of the business. However, if the limited partner does participate in the control of the business, he or she is liable only to persons who transact business with the limited partnership reasonably believing, based upon the limited partner's conduct, that the limited partner is a general partner.

The limited partner argued in Adelphia that the plaintiff had actual knowledge of its status as a limited partner. But even accepting this, the court denied summary judgment because the relevant creditor belief under the statute has to be "based on the limited partner's conduct" and "material issues of fact exist as to whether the conduct of ACC would support a reasonable belief that ACC was a general partner."

Yikes! It seems that while the court was focusing on the "based on the . . . " language, it forgot about the "reasonable" belief part. How can the plaintiff have a reasonable belief in the limited partner's status as a general partner when it actually knows the limited partner is a limited partner?

The court reasoned in part that an "actual knowledge" standard would "invite abuse of the limited partnership form and allow limited partners to control the partnership with impunity." But the statute is supposed to provide clear protection of limited partners except where creditors are misled.

Denial of summary judgment might be justified where a conflict between the paper record and the limited partner's participation in control makes the partner's status unclear. But the court apparently concluded that the only relevant belief is one based on the partner's conduct, not on the record. In other words, this case isn't about cognitive dissonance, it's about disregarding what you know.

So the states may have to change their limited partnership statutes. They might clarify the effect of a third party's knowledge or notice of the limited partner's paper status as such. Or maybe this case will be enough to finally provoke the demise the remaining shred of control liability and make complete (shareholder-like) lp limited liability the default rule.

There was, in fact, some consideration during the drafting of 2001 ULPA of making all limited partnerships, in effect, limited liability limited partnerships, which would in effect eliminate the control rule. Some might say this would just make the limited partnership identical to a manager managed LLC. But the LP would still be a distinct standard form in providing by case law and statutory provisions for somewhat less governance role for passive investors than do LLCs.

I doubt any state courts will follow the Adelphia case because they would not want to frustrate the protection their legislatures clearly intended to provide. But Adelphia suggests that limited partners may not have limited liability precisely when they need it most – in bankruptcy, at least in the important Southern District of NY.

And, finally, a plug for an old idea of mine. This case illustrates a fundamental problem with federal bankruptcy: it provides potentially different precedents on state law issues, introducing confusion and inhibiting efficient legal evolution. For applications of this idea to partnerships, see The Illogic and Limits of Partners' Liability in Bankruptcy, 32 Wake Forest Law Review 31 (1997); and Partner Bankruptcy and the Federalization of Partnership Law, 33 Wake Forest Law Review 795 (1998).