Pay no attention to that limited partner behind the curtain

Can officers and owners of a company be sued personally for the company’s wrongdoings?

David Borinsky

Wilmington, Delaware, the second-favorite place in the US to file a lawsuit (after those little towns in Mississippi that give big jury awards), hosts what is to corporate America the most important state court in the nation, the Delaware Chancery Court.

More Fortune 500 companies by far are organized under the laws of Delaware than under any other state's. As part cause and part result of that fact, the Delaware Chancery Court has evolved into the forum of choice for resolving many business disputes.

Although cases heard by the Delaware Chancery Court tend to involve large businesses, the issues decided are generally relevant to all businesses. Because of the respect commanded by the Chancery Court, moreover, its influence extends far beyond the confines of Delaware. When the Chancery Court speaks, as it did recently in the area of limited liability companies, attention, as a character in a famous play said, must be paid.

Thousands, if not tens of thousands, of limited liability companies are formed in the United States each year. LLC are extraordinarily useful entities because their tax-related advantages are legion and because they are cheap (outside of New York) to set up. Most of all, as the name suggests, LLC limit liability.

For a variety of reasons, LLCs are better suited than limited partnerships or corporate subsidiaries for compartmentalizing a company's operations for liability purposes. For example, in the past a company may have operated different divisions as just that -- divisions with all the company's assets at risk for the liabilities of any one division. LLC rules encourage the company to place each division in a separate, wholly owned limited liability company, thereby compartmentalizing operations and limiting recourse, in the case of each division, to the assets of that division alone.

Business owners and planners in the thick of the limited liability company frenzy should pay attention to a recent Delaware Chancery case involving a failed joint venture between two health care firms, even though it involved a limited partnership rather than an LLC.

The case involved two health maintenance organizations which formed a limited partnership to jointly pursue a business opportunity. The partnership had two limited partners (the two companies -- call them Workers Paradise and Capitalist Tool) and one general partner. The general partner was a corporation whose stock was owned by the two limited partners. (Until a few years ago, this is how joint ventures were organized. Nowadays, the parties would form a limited liability company.) For a variety of reasons, the parties agreed that Workers Paradise would have the right to appoint a majority of the directors of the corporate general partner. This had the effect of vesting control of the limited partnership in Workers Paradise.

Business wasn't too good, and Workers Paradise exploited its control of the corporate general partner's board, directing the general partner to direct the limited partnership to do some things that put money in Workers Paradise's pocket and took money out of Capitalist Tool's pocket.

Capitalist Tool responded by suing not only the partnership, but Workers Paradise as well, for conspiring with the corporate general partner to cause the limited partnership to breach its fiduciary obligation to Capitalist Tool.

The Chancery Court could have thrown the case out by ruling as a matter of law that a limited partner in a limited partnership cannot enter into a conspiracy with a general partner by virtue of its ability to control the actions of the general partner.

(Note to tax nerds: the US Tax Court recently ruled that a limited partner may be treated, for payroll tax purposes, as a general partner if the facts support such a characterization)

Had I been the attorney for Workers Paradise, I would have pressed this point. I would have argued that recognizing such a cause of action would allow Sun Microsystems to sue Bill Gates personally for antitrust violations alleged to have been committed by Microsoft. Based on Workers Paradise’s argument, Sun could claim that Gates conspired with Microsoft to violate antitrust laws by virtue of the control his stockholdings gave him over the firm.

My argument was either not made by the attorneys for the defendant or was made and the court didn't buy it. It ruled instead that Capitalist Tool could go forward with its conspiracy case.

Although I have run this case by attorneys with more subtle minds than my own, it does not seem to alarm them. I am puzzled. I am, moreover, at a loss to formulate some really useful advice for clients.

What precautions can they take to avoid being accused of conspiracy for the wrongful acts of the limited partnership, limited liability company or corporation controlled by them?

It's not clear. The best advice is to not cheat people, which is what Workers Paradise appeared to be up to. Furthermore, observe entity governance formalities. Finally, don't worry about what you can't change.

Please feel free to contact me with questions about issues of entity governance, as well as about US and international tax issues.

David Borinsky [email protected]