Hedge funds seem to turn all conventional wisdom on it's head. Hedge funds don't act like other shareholders -- they get seats on boards, push through reform, that kind of thing. Now, investors in hedge funds don't act like regular investors, either. The WSJ reports today that investors in Lipper Convertibles (the article calls it an investment partnership, so we'll assume it's an LP) are suing former investors. Lipper Convertibles was flying high and making large distributions at one time, apparently due to some profit inflation by the portfolio manager in an attempt to attract new investors. During this time of 40% profit inflation, some investors took their distributions and cashed out. The ones that didn't, and the ones that invested during the inflationary time, are now suing the investors who cashed out, saying that the profits were "unjust enrichment." (OK, so the investors in question are people like Sylvester Stallone, John Cusak, Ed Koch, and Henry Kravis' kids, but that's not the point.)
The point is whether there is any sort of theory of recovery here. In corporate law, shareholders who sue the entity for 10b-5 causes of action or otherwise look to the entity for recovery, not the current shareholders, or even the anonymous shareholders who sold the overpriced shares to them. This has led some to argue that private securities litigation is nothing but an intra-shareholder wealth transfer, which I've blogged about before. These hedge fund investors have a leg up on shareholders in a publicly-held corporation, however: they know the exiting investors.
Lipper Convertibles, of course, is not a corporation, and so the theory would be slightly different for a limited partnership. (Other hedge funds named as examples in the article facing investor suits are LLCs.) Generally, we don't look to limited partners, current or former, to disgorge prior distributions that were larger than otherwise available under the partnership agreement due to fraudulent bookkeeping on the part of an employee of the partnership. (Is that right? I think I may be convincing myself otherwise.) The partnership agreement could have a clawback provision that would operate either upon discovery of an accounting error, such as this one, or upon some other happening. I can imagine an investment partnership with illiquid assets such as real estate having provisions that allow partners to exit but be subject to an earnout provision or clawback over time. However, the WSJ article does not mention any sort of partnership agreement provision. These suits seem to be following some sort of theory based on fraud, unjust enrichment and fairness.
One of the suits mentioned involved a fund that was in bankruptcy, and the trustee is attempting to clawback distributions under the bankruptcy code. That trustee may have a doctinal leg to stand on, but I'm not sure if the other cases do. I would be happy to hear what others think.
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1. Posted by Beth Young on August 22, 2006 @ 16:16 | Permalink
I assumed that the cases were preference actions, based on the way the claims were described in the article. When I was a bankruptcy associate in the mid-1990s I worked on a case with very similar facts.
2. Posted by Vic Fleischer on August 22, 2006 @ 20:28 | Permalink
Clawbacks are common for GPs but I think would be unusual for LPs. The tax provisions of the agreement will dictate that the allocation and distribution provisions have "substantial economic effect," meaning that the capital accounts have to mean something. But I would assume that once an LP has left the partnership, there's no way to make negative adjustments to the (now nonexistent) capital accounts that would dictate a clawback in any event.
Beth seems right then -- were the transfers fraudulent conveyances? (For any non-bankruptcy types out there, note that the transfer need only take place at a time when the partnership was insolvent, not that there needs to have been intentional "fraud" in the usual sense.) Or is the trustee reaching back further in time because the LPs are insiders? Any bankruptcy gurus out there?
3. Posted by Bobby Bartlett on August 22, 2006 @ 20:52 | Permalink
If this is a Delaware limited partnership, it's possible that the LPs are relying on DRLPA 17-607 (excerpt below). During my practice days, this section was sometimes a contentious topic with regard to LP transfers of private equity interests. To the extent the transferee was assuming all of the transferor’s liabilities, sophisticated transferees might demand indemnification against any potential claw-back liability. But it still seems like a weak claim given the knowledge requirement in subsection (b). Anyway, here’s the section:
§ 17-607. Limitations on distribution.
(a) A limited partnership shall not make a distribution to a partner to the extent that at the time of the distribution, after giving effect to the distribution, all liabilities of the limited partnership, other than liabilities to partners on account of their partnership interests and liabilities for which the recourse of creditors is limited to specified property of the limited partnership, exceed the fair value of the assets of the limited partnership, except that the fair value of property that is subject to a liability for which the recourse of creditors is limited shall be included in the assets of the limited partnership only to the extent that the fair value of that property exceeds that liability. For purposes of this subsection (a), the term "distribution" shall not include amounts constituting reasonable compensation for present or past services or reasonable payments made in the ordinary course of business pursuant to a bona fide retirement plan or other benefits program.
(b) A limited partner who receives a distribution in violation of subsection (a) of this section, and who knew at the time of the distribution that the distribution violated subsection (a) of this section, shall be liable to the limited partnership for the amount of the distribution. A limited partner who receives a distribution in violation of subsection (a) of this section, and who did not know at the time of the distribution that the distribution violated subsection (a) of this section, shall not be liable for the amount of the distribution. Subject to subsection (c) of this section, this subsection shall not affect any obligation or liability of a limited partner under an agreement or other applicable law for the amount of a distribution.
(c) Unless otherwise agreed, a limited partner who receives a distribution from a limited partnership shall have no liability under this chapter or other applicable law for the amount of the distribution after the expiration of 3 years from the date of the distribution.
4. Posted by Beth Young on August 23, 2006 @ 7:16 | Permalink
Your suggestion makes a lot of sense, Bobby, because there was some mention in the article of certain defendants refusing to return the payments on the ground that they had no knowledge that the distributions were made when they shouldn't have been (under (a) above, when the partnership was insolvent).
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