Ideoblog

CSX and the law professors

Judge Kaplan of the SDNY held that hedge funds violated the securities laws by refusing to disclose their positions.  In reaching this conclusion the judge heard a lot from law professors, while emphasizing that the market didn't operate in a law school classroom.

The big issue in the case involved swaps the hedge funds had entered into with brokerage firms. The hedge funds had no legal voting rights or beneficial ownership. But did they have the kind of power that requires disclosure under the Williams Act designed to warn shareholders and managers of a play for control?  

The swaps resulted in the counterparties holding short positions.  Judge Kaplan noted that the hedge fund (TCI)

manifestly had the economic ability to cause its short counterparties to buy and sell the CSX shares. The very nature of the TRS transactions, as a practical matter, required the counterparties to hedge their short exposures. And while there theoretically are means of hedging that do not require the purchase of physical shares, in the situation before the Court it is perfectly clear that the purchase of physical shares was the only practical alternative. . . .

Thus, TCI patently had the power to cause the counterparties to buy CSX. At the very least, it had the power to influence them to do so. And once the counterparties bought the shares, TCI had the practical ability to cause them to sell simply by unwinding the swap transactions. * * *

The voting situation is a bit murkier, but there nevertheless is reason to believe that TCI was in a position to influence the counterparties, especially Deutsche Bank, with respect to the exercise of their voting rights.

The judge was reluctant to focus merely on legal rights. Though he noted the concern of some amici about “upsetting . . . the settled expectation of the marketplace that equity swaps, in and of themselves do not confer beneficial ownership of the referenced shares,” he said this position

exalts form over substance. The securities markets operate in the real world, not in a law school contracts classroom. Any determination of beneficial ownership that failed to take account of the practical realities of that world would be open to the gravest abuse.

As support for this potential for abuse the judge cited Henry Hu & Bernard Black, Equity and Debt Decoupling and Empty Voting II: Importance and Extensions, 156 U. PENN. L. REV. 625, 735-37 (2008), as well as a June 2 letter from Joseph Grundfest, Henry Hu and Marti Subrahmanyam to the SEC General Counsel.

The judge was, to be sure, wary of the consequences of holding that TCI had beneficial ownership.  But he wasn't letting Chicken Little into his courtroom. He had these words about another law professor:

A major proponent of the hypothesis that dire consequences will ensue from a determination of beneficial ownership in this case is defendants’ expert Frank Partnoy. Having considered Partnoy’s positions and Marti Subrahmanyam’s responses, the Court believes Partnoy’s views are exaggerated and declines to accept them. In addition, Partnoy’s views in this respect are unpersuasive because his failure to engage with the specific circumstances of this case renders his generalizations suspect.

Partnoy, of course, has written on the problems of insisting on linking share voting with ownership rights. 

Interestingly, Henry Hu's empty voting co-theorist, law professor Bernie Black, did not join Hu in the Grundfest et al letter. Instead, he wrote his own letter to the SEC arguing that TCI’s swaps did not trigger Rule 13d-3(b), which looks at whether TCI prevented vesting beneficial ownership “as part of a plan or scheme to evade the reporting requirements of Section 13(d).” Judge Kaplan thought Black’s position “unpersuasive.”

In the end, the judge did find a violation of the "plan or scheme" provision, but didn’t enjoin voting of the shares, relying on Rondeau v. Mosinee.

Another law professor, Steve Davidoff, has a good analysis of Judge Kaplan’s reasoning and the state of play.

My own view (as still another law professor) is that this case – with its swirl of opposing positions – is the perfect illustration of why we need a better theory of share voting rights, and how derivatives affect those rights. We certainly need such a theory before regulating these practices and risking costly mistakes. Bruce Kobayashi (another law professor, though an economist) and I have theorized, for example, that empty voting may overcome conflicts of interests among shareholders – e.g., between diversified shareholders who simply want to maximize the value of their portfolio, and non-diversified shareholders who want to maximize the value of specific shares in their portfolios. Moreover, to the extent that the Williams Act inefficiently inhibits the market for control, it might not be such a bad idea to find an end run around it.  On the other hand, I'm not persuaded of Partnoy's strong position against one-share-one-vote.  Judge Kaplan’s caution about wading into the beneficial ownership issue is therefore justified.

The CSX case also illustrates that, under current rules, share voting can only be described as chaotic. One possible future here is that we might learn that corporate-type share voting is not so essential after all – a consideration underlying my theory of the uncorporation of large firms.

Delaware uncorporation jurisprudence takes a step back

Francis Pileggi has an interesting post on a books-and-records claim in connection with a limited partnership takeover. His thorough description of the case leaves little work for me in that regard, but I do want to make a few points about two interesting aspects of the case.

First, As Mr. Pileggi suggests, there is the fact that the Delaware court was willing to imply a proper purpose requirement into an agreement that plainly didn’t have one. Indeed, the court went out of its way to do so, since it had already determined with some basis that the agreement didn’t cover the request, and that there was no improper purpose problem with materials that would have been within the agreement.  The court expressed concern at several points in the long opinion that the plaintiff was interested in the books and records mainly as a potential bidder for control rather than an owner.

My article The Uncorporation and Corporate Indeterminacy discusses my hopes and concerns about whether courts would, as they should, apply contracts rather than general governance rules in uncorporation cases. An opinion last month by Chancellor Chandler gave me cause for hope. This case pushes me back slightly in the direction of concern.

Second, the case is interesting for the light it casts on takeovers in uncorporations. I’ve written in my Rise of the Uncorporation that even publicly held uncorporations are generally fairly takeover-proof because the owners often have minimal management rights, and the rights may not be tradable. I have reasoned that this doesn't leave the owners too vulnerable because the tradeoff is that they get some assurance of receiving a stream of cash flows.

But here we have a takeover.  Moreover, the court characterizes the plaintiff as specializing in tender offers for partnerships, a business that is given some legs by the deep discounts in the targets’ real estate investments. So the partnerships' governance structure does allow room for takeovers to come into play when the firm is facing particularly hard times.

Unless, that is (as in this case), the courts decide to add takeover protection that the firm’s agreement does not expressly provide.

Exploring Martin v. Peyton

Bill Klein has an interesting little piece on a venerable partnership case: Martin v. Peyton: Rich Investors, Risky Investment, and the Line between Lenders and Undisclosed Partners. As the abstract says,

[t]he case involved an investment by a small group of wealthy and socially prominent New Yorkers in an investment banking firm that was badly managed and on the threshold of insolvency. The decision in the case turns on the distinction between lenders and partners, or, more broadly, between debt and equity.

As many business association scholars know, the wealthy New Yorkers were sued as unintentional partners by other creditors of the investment banking firm. The article presents some interesting history. For example, the defendants were quite well-connected: Peyton was the inventor of a smokeless gunpowder, was a significant gunpowder magnate and married to a DuPont. The article goes onto show, as the abstract says,

how the unique terms of the deal, with elements of both pure debt and pure equity, were dictated by the circumstances that gave rise to it. In particular, the risky nature of the investment and the thin, or nonexistent, equity cushion led to the would-be lenders accepting a contingent return and, as a corollary, some elements of control. . . . [T]he essay examines the policy justification for the rule making silent partners liable for the firm's debts - a rule analogous to vicarious liability of employers for the torts of their employees and to the agency-law principle that makes undisclosed principals liable for unauthorized debts incurred by their agents. In addressing policy, fairness is a commonly claimed and generally admirable goal, but for market transactions it is generally not instructive, as Martin illustrates. Economic efficiency is likely to be a more meaningful policy criterion, as, again, Martin illustrates. But, as Martin also illustrates, economic efficiency, largely relying on unproven, and possibly unprovable, conjectures, can be a fickle and inconclusive criterion.

I liked the history and am generally sympathetic with the analysis, but I think there’s more to explore.

First, Klein notes that part of the deal structure was to avoid the usury laws. I would add that the usury laws were an important historical basis of partnership, as discussed in Bromberg & Ribstein on Partnership, section 1.02.

Second, Klein discusses the lawyering angle.  He says that plaintiff’s failed argument that Hall, the manager of the bailed-out investment banking partnership, was a surrogate of the creditor-defendants led the court to focus on the language of the agreement. This is an interesting approach, since it suggests the more general point that an advocate's focusing on messy or hard-to-prove facts may backfire by pushing the court into a straight legal analysis that the advocate wanted to avoid. But I’m not sure this was bad lawyering, at least viewed ex ante, since the agreement did include significant partnership-type profit-sharing and control. It’s more likely, in my view, that the plaintiff was the victim of the court’s novel approach to interpreting an agreement like this, as discussed below.

Third, Klein discusses the jurisprudence of the case.  He says the court stacks the deck for defendants by presuming in favor of a loan rather than partnership. But note that the standard procedure in modern partnership law is to eliminate the presumption from profit sharing in a "protected relationship" such as a loan. That elimination would put the burden of proving partnership or any other liability theory on plaintiff, just as the court did. So the court didn't so much stack the deck against this particular plaintiff as adopt a new, modern approach for the reasons stated below. Note also that the author of the opinion for the New York Court of Appeals was Andrews, who frequently espoused more rule-oriented, agreement-oriented approaches (remember his dissent in Palsgraf?).

So, fourth, and most importantly, this brings us to the policy in the case. Klein points out that the court essentially rejected the assumption in inherent agency power cases (which this case resembles) that the principal is the cheaper cost avoider. Klein notes that this rejection is consistent with the notion that it’s easy for outside creditors like the plaintiffs here to check the firm’s credit. This reasoning meshes with that of Hansmann, Kraakman & Squire in Law and the Rise of the Firm, and New Business Entities in Evolutionary Perspective, which connect the rise of corporate-type entity structures with the development of creditor-protection technologies such as better accounting.

In other words, Martin’s recognition of debt as a relationship that is “protected” from imposing partnership-type liability can be seen as an example of the rise of entity and limited liability. Indeed, I made this connection between limited liability and cases like Martin a long time ago in my Limited Liability and Theories of the Corporation, 50 Md. L. Rev. 80 (1991).

But it’s more complicated than that, because cases continue to impose liability on informal partnership relationships that look something like the debt in Martin. So what distinguishes the cases in which the courts impose partnership liability from those in which they do not? In my view, as discussed at length in Bromberg & Ribstein, Section 2.14(c), key elements in this distinction are (1) careful lawyering and attention to the formal rules on determination of partnership in the partnership laws; and (2) whether the defendants’ extension of credit is one society wants to encourage or discourage.

Klein makes both of these points, but I think there’s more to be said, particularly about the second one. An important aspect of the Martin case is the fact that the defendants were engaged in a bailout of a failing firm that potentially helped the firm's outside creditors. Contrast a case in which the defendants initially set up a risky capital structure. I emphasize this in my analysis of Martin in Bromberg & Ribstein, section 2.14(c)(5).

One fifth point:  Klein argues that the limited-liability result in this case is consistent with modern policy favoring limited liability in new forms of business entities.  But there's an argument on the other side:  if it's easier to form a limited liability entity, why not expect the parties to do so?  In other words, informal limited liability might have been seen as necessary in the days before formal limited liability was easy, but not so anymore.  And perhaps third parties have a greater expectation that they can reach deep pockets who have not jumped through the limited liability hoop.

Putting all this together, many of the informal partnership cases that involve third party creditors (rather than discerning the would-be partners’ intent between themselves) are really akin to corporate veil-piercing cases, where the courts emphasize the same sorts of policies of endangering creditors and respecting expectations based on the formalities of the business.

So, in general, Klein’s analysis of Martin provides not only helpful insights but also a good opportunity for further thought on the over-neglected intellectual and practical challenges of partnership. While business association courses and “corporate” scholarship obsesses over the nuances of shareholder meetings, interesting issues like this are unfortunately shunted to a backwater of the curriculum. That’s not only an intellectual shame, but disserves our students, who are more likely to be concerned with the sort of day-by-day business deals that raise unexpected partnership issues like the one in Martin than with advising on a headline-grabbing public corporation issue.

CEOs as partners

Rich Booth has an interesting little paper, Five Decades of Corporation Law - From Conglomeration to Equity Compensation. Here’s some of the abstract:

This brief essay recounts developments in corporation law over the last fifty years. It begins with the rise of finance capitalism and the conglomerate corporation which was followed by the emergence of hostile takeovers in the late 1970s and 1980s. . . . . Target managers vigorously sought ways to defend themselves from takeover. But the genie was out of the bottle. Although the initial motivation for takeovers was the bust up of inefficient conglomerate companies - because investors figured out that they could roll their own diversified portfolios more cheaply - diversified investors also figured out that they could tolerate more risk. So they demanded higher returns from all companies. Faced with this irresistible force, target managers also sought ways to share the gains. The result was that executive compensation evolved from a salary and bonus system to one based on stock options and other forms of equity. . . . . Ironically, the primary justification for takeovers had been that target companies tended to hoard cash and use it for uneconomic growth. Thus, the takeover did not die because of defensive tactics and protectionist state takeover laws. It simply went in house. The implications of this evolution are significant. For one, it calls into question the traditional notion that the stockholders own the company and that the CEO is a glorified employee. It may make more sense to think of stockholders and managers as in partnership with each other with the board of directors charged primarily with the role of arbitrating the competing claims of these two groups of owners. . . . .

Rich expressed some of this in an earlier article in the Illinois “uncorporation” symposium a few years back: Executive Compensation, Corporate Governance, and the Partner-Manager, 2004 U. Ill. L. Rev. 269.

Let me suggest a different subtitle for this work: From Corporation to Partnership. The evolution of CEOs from employees to partners is only part of this bigger story. Takeovers are, indeed, the mechanism of change, but I think the change is more drastic than Rich indicates. Once we give the managers the incentives of ownership we lose some of the rationale for giving shareholders strong voting and fiduciary rights. Why not make them glorified creditors? As long as they get their cash, we don’t have as much need for these monitoring devices. Then we can also scrap the monitoring board and other costly paraphernalia of the corporate form.  For more on this, see my Rise of the Uncorporation.

The Uncorporation and Corporate Indeterminacy

Last fall, as discussed here and here, Bill Carney, Delaware Chancellor William Chandler, Bob Thompson and I debated whether Delaware corporate is excessively indeterminate and unstable. Here’s the Carney & Shepherd paper that provoked the debate. Now I've posted my response, The Uncorporation and Corporate Indeterminacy. Here’s the abstract:

William Carney and George Shepherd argue that Delaware's success in corporate law is a "mystery" when one considers the high transaction costs engendered by the indeterminacy and instability of Delaware law. This paper shows that the mystery is clarified by analyzing Delaware law on "uncorporate" cases – that is, limited partnerships and limited liability companies. In this setting, parties can rely on specific contractual incentive and disciplinary devices rather than on open-ended fiduciary duties. Delaware lawmakers provide substantial coherence by focusing on the parties' contracts. It follows that the problems of Delaware law seem to be mainly a function of the corporation rather than of Delaware lawmakers.

Blackstone and executive compensation

The WSJ’s George Anders complains about Steve Schwarzman’s getting $350 million from Blackstone Group in 2007 though its stock is down to half the IPO price. He notes:

Blackstone's top executives set their own pay, without the checks and balances -- sometimes perfunctory, sometimes real -- set up by other public companies. Whether its shareholders should welcome that freedom is an open question.

Anders observes that Blackstone Group is a partnership, lacking the usual corporate safeguards on pay.

Pay decisions are made within the partnership, where Mr. Schwarzman and Blackstone co-founder Peter Peterson call the shots. The company's three outside directors don't play a role there. Blackstone's newly arrived outside holders are equally devoid of clout. As annual-meeting season gets under way this spring, don't wait for any feisty shareholder speeches at a Blackstone gathering. Company spokesman Peter Rose says the company doesn't need to call such a meeting and probably won't.

But Anders also observes that Schwarzman's cash comes from the fact that he’s a big owner, and that employees and executives still own about 75% of the firm. These insiders have strong incentives to maximize share value, which is what the outside owners would want them to do. 

Although I don't agree with the slant in Anders' article, it nicely presents the issues:  do we really need conventional corporate governance when we've got heavily incentivized insiders. I give an extensive argument why not in my The Rise of the Uncorporation. But I suppose we’ll find out soon enough whether the law accommodates that approach.

A Bear swimming in the murky waters of corporate law

Gordon Smith has a nice summary of the issues in the Delaware lawsuits challenging Bear’s 39.5% lockup share sale to Morgan. 

Basically, as we all know by now, it comes down to Omnicare. The transaction effectively forces the Bear shareholders to accept the deal because the managers and Morgan will own 45% of the stock and the board has no effective way to embrace a superior transaction if it should come along.

Gordon also says the plaintiffs seem to be arguing that the threat to the shareholder franchise justifies application of the Blasius “compelling justification” standard. Gordon notes that this standard is generally applied in board elections and, anyway, is probably met in this case.

Then Gordon asks rhetorically:

Which board of directors was more faithful to its obligations: the board that allowed existing majority shareholders to commit themselves to a transaction that they viewed as favorable (Omnicare), or the board that is planning to issue stock to the acquiring company to make approval of the transaction over the objections of the existing shareholders much more likely (Bear Stearns)?

However, as Gordon notes, "[t]he lawyers have structured the Bear Stearns-JP Morgan transaction in a manner that elides the obvious pitfalls in Omnicare."

In my view, in both cases the essential issue should be whether the board exercised its fiduciary obligations to preserve shareholder value, which is what the shareholders as a whole wanted them to do. And in both cases it arguably did, because the deal protection move secured the only promising deal in sight – in Omnicare, the Genesis bid, and in Bear, the quintupling of the Morgan bid.

As dissenting Justice (now Chief Justice) Steele observed in Omnicare:

We should not encourage proscriptive rules that invalidate or render unenforceable precommitment strategies negotiated between two parties to a contract who will presumably, in the absence of conflicted interest, bargain intensely over every meaningful provision of a contract after a careful cost benefit analysis.

I criticized Omnicare in Why Corporations? as exemplifying the excessive rigidity of the corporate structure:

The courts. . . engage in a rigid structural analysis that applies equally to all corporations. They have been said to be creating a “sacred space” in which shareholders exercise inviolate rights to vote and sell [referring here to Gordon’s article with Bob Thompson, Toward a New Theory of the Shareholder Role: “Sacred Space” in Corporate Takeovers, 80 Tex. L. Rev. 261(2001)] The term aptly conveys the courts’ disregard of mundane day-to-day realities and specific governance terms.

I would add that it’s questionable whether the shareholders really deserve this “sacred space.” It’s not just about Hanging Chads and Empty Voting (e.g., Hu & Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, 79 S.Cal. L. REV. 811 (2006)). Who are the “shareholders” anyway? The 19% employee ownership concerned about their jobs, the arbs, long-term investors, or what?

In any event, my guess is that the Chancery Court will not block or invalidate the transaction, finding some kind of exception to Omnicare. Some years later the Supreme Court will give us a Bear Stearns “save the firm” exception to the Omnicare qualification of the Unitrin application of Unocal. [Keep in mind that the Omnicare court was closely divided, and the dissenters included the current CJ.] In other words, if this case gets adjudicated, it will lead to still more indeterminacy in Delaware corporate law.

I’ve been writing for years that there is a way out of the corporate mess: partnership-type structures that, among other things, limit shareholder voting and fiduciary rights while improving managerial incentives to maximize value. See Why Corporations?, above, and more recently The Rise of the Uncorporation.

A revised version of the latter is forthcoming. I will also soon be posting my take on how partnership-type firms address the indeterminacy of corporate law, previewed here.

What was Ringling all about?

The Ringling case has fascinated me since I first researched a long note on the case for my casebook back in the early 1980s (p. 160). Among other things, I've wondered with generations of students why the parties fought so hard over board membership. Now the ever-interesting Mark Ramseyer has an explanation. Ringling Bros.-Barnum & Bailey Combined Shows V. Ringling: Bad Appointments and Empty-Core Cycling at the Circus. Here's an excerpt from the abstract:

The Ringling case presents itself as an irrational spat over board seats among spoiled investors. It is not. The investors were not fighting over board seats; they were fighting instead over corporate offices. Neither were they irrational. Although Edith Ringling pushed her incompetent son and Aubrey Haley her inappropriate husband, they did so to their private advantage. * * * The Ringling circus did not degenerate into the chaos in which it found itself because the investors were spoiled or irrational. It degenerated because the law could not enforce the duty of loyalty.

Here's some excerpts from the paper:

Why did the shareholders fight so bitterly and endlessly to put themselves or their relations in office? Posit a world where the circus paid its officers their market salary, and returned investors their proportional share of the profits. * * * In such a world, Edith, Aubrey, and John would care about the president's ability. They would not care about his kinship.

Yet Edith, Aubrey, and John did care about kinship. They cared about it more than managerial talent, and they probably cared because the circus let its senior officers collect more than their market salary. In the process, it returned controlling investors more than their proportional share of company profits, and other investors less. Given this dynamic, investors had an incentive to favor less talented relations over more talented strangers. And because no inter-investor alliance dominated all others, any promise a shareholder made to one shareholder could always be trumped by a promise to the other. * * *

During the season, senior officers (or partners, before 1933) traveled with the circus. They attached private cars to the end of the circus train, and lived the life of a circus impresario. According to contemporaneous accounts, they lived profligately appointed lives. Although the accounts do not detail the accounting, we can assume that they charged these lavish room, board, and travel expenses to the circus. Off season, senior officers scoured Europe for new talent. Again, contemporaneous reports detail flamboyant travel arrangements. * * *And again, we can assume they billed these expenses to the circus.

Worse, however, the officers who traveled with the circus could also skim door receipts off the top. * * * All told, senior circus officers took a significant portion of their compensation as perquisites that came with the job, and probably skimmed a substantial amount of cash. Necessarily, they "froze out" those investors working elsewhere. * * *

The circus could have mitigated this problem by selling stock to the public as planned in 1929. Although controlling officers could still pay themselves supra-market salaries (a problem potentially presented in Eisner), unhappy shareholders would at least have a market for their stock. They might have to sell at depressed prices, but at least they could sell. With the stock closely held, circus shareholders instead had an incentive to take control. Control did not just give them the chance to shape policy. It gave them access to resources other investors could not have. Most perversely, investors had an incentive to fight for control over the circus even when they could not properly run it -- and had that incentive because the law did not effectively enforce the duty of loyalty. * * *

Had courts effectively enforced the duty of loyalty, managers would receive only the market value of their services, and investors would earn returns proportional to their interests. Investors would look for work at the firm where they could contribute the most -- not where they invested the most. They would try to appoint to the presidency the man or woman best suited for the job -- not the closest blood relative.

Now let me consider a possible solution: the partnership. Had Ringling been a partnership, it would not have been remitted to weak fiduciary duties. Instead, it would, by default, have been dissolvable at will. Aggrieved members could have extricated themselves from the business, taking with them not just the stock market's depressed value of a mismanaged firm, but their share of the underlying value of the business.

Now, to be sure, that may not have been much if the business had to liquidate on dissolution. But the threat of liquidation might have brought all parties to their senses and promoted a buyout and continuation. This would have stopped the "cycling" and endless dissipation of business assets.

Perhaps a Ringling partnership agreement would have provided for a buyout and member right to continue the business. Perhaps the buyout amount would have been low enough to force something like corporate continuity. But in this situation the court would have had significant power to dissolve the partnership or fashion some alternative remedy.

To be sure, these remedies also exist in close corporations, though not necessarily when Ringling arose. But even now, close corporation remedies are often awkward and turn on proof of shareholder wrongdoing – which might gotten back to the weak loyalty duties Ramseyer complains of.

For a recent discussion of the potential advantages of partnership, including the tradeoff between fiduciary duties and liquidation and distribution rights, see my Rise of the Uncorporation. This paper, currently being revised, focuses on publicly held firms, which present different issues than in Ringling. But the partnership form is even more clearly suitable for closely held firms than for large firms.

Finally, I should add that Ramseyer's analysis explains why the parties were fighting, but not the somewhat strange judicial resolutions.  I have my theories, but those are for another day.

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).

LLP partners are liable to each other

In last December's opinion in Ederer v. Gursky the NY Court of Appeals held that partners in a law firm organized as a limited liability partnership could be held personally liable for a withdrawing partner's share of partnership assets – that is, they were not protected by the LLP liability shield.

The case involves interpretation of Section 26(b) of the NY LLP Act:

no partner of a partnership which is a registered limited liability partnership is liable or accountable, directly or indirectly (including by way of indemnification, contribution or otherwise), for any debts, obligations or liabilities of, or chargeable to, the registered limited liability partnership or each other, whether arising in tort, contract or otherwise, which are incurred, created or assumed by such partnership while such partnership is a registered limited liability partnership, solely by reason of being such a partner.

The court held that "any debts, obligations or liabilities" refers only to liabilities to third parties and not among the partners.

The court got this one right.

As the court notes, this provision was appended to the statutory section providing for partners' vicarious liability to third parties. It does not qualify the partners' duty to account among themselves. (I would also note that if the section did apply to obligations among the partners, it would be unnecessary to add the "by way of" parenthetical – which as the court explains was intended to prevent third party creditors from making an end run around the liability limitation through indemnification and contribution.)

Why, you might ask, are the partners treated better than third party creditors? The answer is that the statute was intended to deal only with vicarious liability. LLP statutes were a response to the savings and loan crisis of the 1980's, which threatened lawyers and accountants with massive personal liability. They were not intended to adjust partners' liabilities to each other. In any event, as the court noted, the partners can easily deal with their own liabilities by agreement.

You might also ask why LLPs should be different from professional corporations or LLCs where there is no such personal liability for inter-member debts. The answer is that partnerships, unlike these other business associations, were designed to be personal-liability entities. Tacking on LLP provisions just takes care of third party creditors but leaves the rest of the act intact.

Indeed, this is why I have always been a bit dubious of LLP statutes. I have argued in several articles that statutes should be coherent – all the parts should fit. LLP statutes are not coherent precisely because of this tacking on of limited liability. This case is an example of what can happen.

The dissent tells a possible horror story of a 2% partner who is left holding the bag for a 49% interest when the other 49% partner absconds with the money. But this probably won't happen because a 2% profit-sharer will be liable under the default provisions of the statute only for 2% of the losses.

Maybe you're still not happy with this analysis.  You might protest that the plaintiff, as a former partner, was essentially a creditor of the firm, and therefore subject to the liability shield. Well, he might have been technically a creditor, but the debt was owed to him as a former partner, and this duty to account to former partners is not subject to the liability shield, as discussed above. Under the UPA, which applies in NY, the firm would technically wind up the plaintiff's interest on his withdrawal (though the firm didn't cease operations until two years after plaintiff left), and plaintiff would be entitled to an accounting of that interest.

Does it matter that the defendants were not wrongdoers? No. If they were subject to the liability shield, then they would be liable only for their misconduct. But they were not subject to the liability shield. Another way to look at this is that they were directly rather than vicariously liable under their contract, as defined by the default provisions of the partnership agreement.

Finally, as the court says at the end of its opinion:

we emphasize that the law of partnerships contemplates a written agreement among partners specifying the terms of their relationship. The Partnership Law's provisions are, for the most part, default requirements that come into play in the absence of an agreement. For example, the right to an accounting exists, “absen[t an] agreement to the contrary” (Partnership Law § 74). Partners might agree, as among themselves, to limit the right to contribution or indemnification or to exclude it altogether. In this case, however, there was no written partnership agreement; therefore, the provisions of the Partnership Law govern.

The court is hinting that this is a classic case of the shoemakers' children – lawyers who failed to make any agreement, much less one that clarified this issue.

Perhaps they (and you too!) should have read Bromberg & Ribstein on Limited Liability Partnerships. The 2008 edition published in December, just as the Ederer case was being decided, states in Section 3.09(b):

Since capital contributions are paid last under U.P.A. § 40(b), capital contributors might have to bear the consequences of the partners’ not having to contribute toward the deficit. This is arguably inconsistent with the purpose of the liability limitation, which is to limit partners’ liabilities to creditors rather than to reallocate the burden of partnership losses among the partners. Thus, it has been held that the LLP liability limitation does not limit partners’ liability to account to withdrawing partners [citing the lower court opinion in Ederer that the Court of Appeals affirmed].

Also, Section 404(b) says:

The [LLP] statutes are intended only to cover the liability of partners to creditors rather than inter-partner adjustments.

Although the statutory language isn't crystal clear, the intent seems obvious enough that it frankly never occurred to me that the statute could be read differently. And now nobody else should have any doubt, at least in New York, unless the legislature changes the statute.