Chancery Court Permits Limited Partners’ Claims Against General Partners to Proceed Despite Ongoing Bankruptcy of the Partnership
By: Scott Waxman and David Noll
On a motion to “’confirm the trial schedule,’” Vice Chancellor Glasscock determined that actions brought by the limited partners of a partnership based upon the general partner’s alleged fraud, self interest and breach of the partnership agreement were direct claims and therefore not subject to a stay pursuant to the partnership’s bankruptcy proceeding. Sehoy Energy LP et al. v. Haven Real Estate Group, LLC et al., C.A. No. 12387-VCG (Del. Ch. April 17, 2017), addressed a situation in which the general partner of a limited partnership (and the person controlling the general partner) used funds of the limited partnership to make investments into the business of a personal friend which ultimately resulted in the bankruptcy of the partnership.
Sehoy Energy LP and Dean Ketcham (the “Plaintiffs”) were limited partners of Haven Real Estate Focus Fund LP, a Delaware limited partnership (the “Partnership”). In April 2013, Plaintiffs invested money into the Partnership at the behest of Albert Adriani (“Adriani”), the managing member of Haven Real Estate Group, LLC, the general partner of the Partnership (the “General Partner” and together with Adriani, the “Defendants”). The Plaintiffs invested in the Partnership by entering into a subscription agreement after being provided a copy of the Limited Partnership Agreement for the Partnership (the “LPA”).
The LPA stated the purpose of the Partnership was to perform “’active and speculative trading in publicly traded real estate securities listed on the U.S. stock exchanges.’” The LPA further stated that limited partners had the right to inspect the books and records of the Partnership and was amended, as part of negotiations for Plaintiffs investment, to allow the limited partners to more easily withdraw their investments.
Throughout 2013, Adriani regularly communicated positive information about the Partnership’s investments to the Plaintiffs. After making an inquiry about interest income of the Partnership for the 2013 fiscal year, the Plaintiffs learned that Adriani had invested $3.7 million in SK Capital Investment (“SK”), an entity owned by Adriani’s friend Kazi Hassan (“Hassan”). Adriani represented that the loans were senior (with an exception of a first mortgage as to one property) and secured and cross collateralized by Hassan’s other businesses. After learning of this investment the Plaintiffs demanded the Partnership withdraw its money from SK as soon as possible.
Adriani continued to report positive financial information to the Plaintiffs until December 2015. At that time, the Plaintiffs received a letter stating that “’a significant asset’” of the portfolio was “’substantially impaired.’” That letter further disclosed that Hassan had received $4.4 million in loans from the Partnership and that Hassan’s business for which the loans were made was actually a “house of cards,” which had now collapsed. The Partnership’s recovery was limited to one piece of real estate with two priority mortgages. After receiving the letter, Plaintiffs made a demand to see the books and records of the Partnership, as they were entitled under the LPA, and to see audited financials for 2013, 2014 and 2015. These demands were never met.
Plaintiffs discovered the available assets of SK were limited to a piece of property with two priority mortgages and that Adriani had secured a $1 million security interest for his private investment vehicle, Haven Chicago, LP (“Haven Chicago”), but not a similar or more senior position for the Partnership. Incident to the sale of the property, nearly $1 million was available for distribution to the Partnership. Upon receipt of this money, Adriani claimed that only approximately $700,000 was owed to the Partnership and the remainder of funds were to be paid to him and Haven Chicago. The Partnership and Haven Chicago filed for bankruptcy in November 2016. Both entities were then subjected to an Automatic Stay (each a “Stay”) against litigation pending the bankruptcy proceedings.
This action was brought in May 2016 alleging ten counts relating to breach of contract, breach of fiduciary duty and fraud.
In deciding the Motion, the Court determined (1) whether the Court had jurisdiction to determine whether the Stays applied to the claims brought by Plaintiffs, (2) if the claims were derivative claims of the Partnership or direct claims of the Plaintiffs, and (3) whether the entire action should be stayed in the interest of judicial economy.
The Court of Chancery stated that jurisdiction to determine the applicability of the Stay existed, though was susceptible to collateral attack in federal Court, by virtue of the Court’s power to determine its own jurisdiction. The Court also cited the Bankruptcy Court’s prior statements that the Bankruptcy Code did not intend to override the Court of Chancery’s inherent power.
Having established that it had jurisdiction, the Court of Chancery addressed each claim by the Plaintiff to determine whether those claims could be brought in light of the Stays. The Stays only applied to actions against the debtor and not to co-defendants even if they are in a legal or factual “nexus” with the debtor. On this basis, the Court of Chancery stayed the action against Haven Chicago as that entity filed a Suggestion of Bankruptcy and Notice of Automatic Stay. The Court of Chancery continued its inquiry only as to those claims against Adriani and the General Partner.
With respect to the remaining claims, the Court of Chancery determined whether each claim was a derivative action of the Partnership or a direct action of the Plaintiffs. Because derivative actions seek to recover funds for the entity, in the context of a bankruptcy proceeding they are the responsibility of the bankruptcy trustee. For each claim, the Court of Chancery applied the two-part Tooley test: “’(1) who suffered the alleged harm (the [partnership] or the suing [partners], individually); and (2) who would receive the benefit of any recovery or other remedy (the [partnership] or the [partners], individually)?’”
The Court of Chancery first addressed the contract claims. As to contract claims, the Delaware Supreme Court decided in El Paso Pipeline GP Co. L.L.C. v. Brinckerhoff, between the briefing of this case and this decision, that while a breach of a commercial contract is generally a direct claim and is not reviewed under the two-part Tooley test, contract claims of a limited partner or party to a limited partnership agreement are not definitively direct claims and may still be subject to the two-part Tooley test. Without offering a lot of discussion, the Court of Chancery indicated that the two-part Tooley test would be applied to determine whether the claims were direct or derivative.
The Court of Chancery found that there was insufficient information briefed on two of the claims to determine if they were direct or derivative.
The contract claim was found to be a direct claim by the Court of Chancery . This claim related to the failure of the Defendants to produce audited financial statements and books and records of the Partnership. The Court of Chancery stated that the right to inspection is an individual right of the limited partners, the violation of which harmed the Plaintiffs’ ability to make informed decisions and exercise their rights to withdraw from the Partnership.
The second set of claims were those pertaining to the Defendants’ alleged breach of fiduciary dutiesThe Plaintiffs argued that the Defendants breached their duty of loyalty by making misleading disclosures of the Partnership’s performance. The Court of Chancery found that the harm from these statements was direct to the Plaintiffs. The Court of Chancery rejected the Defendants’ claim that knowing misrepresentations are a per se derivative action because the misrepresentations at issue resulted in a deprivation of the Plaintiffs’ right to withdraw from the Partnership.
Finally, the Court of Chancery turned to claims of fraud brought by the Plaintiffs. The Plaintiffs’ complaint alleged the Defendants made false and misleading statements as to the Partnership’s financial status and as to the loans made to Hassan. Plaintiffs also alleged that Adriani fraudulently induced the Plaintiffs into investing in the Partnership without disclosing Adriani’s intent to invest in Hassan. As these claims are traditional tort claims, the Court of Chancery ruled they were both direct claims of the Plaintiffs. Under the two-part Tooley test, both of these claims affected the Plaintiffs’ ability to buy and sell shares, a solely individual right.
Having concluded the Plaintiffs alleged multiple direct claims, the Court of Chancery took up the Defendants’ allegation that judicial economy required the Court of Chancery to allow the Bankruptcy Court to decide these matters. The Defendants alleged the intermingled nature of this action and the bankruptcy proceedings made it wasteful for this matter to be resolved separately in both courts. The Court of Chancery stated that these claims would only arise in the Bankruptcy Court if the Plaintiffs brought these actions before the Bankruptcy Court, negating their claims that these matters were direct harms to the partners. The Court of Chancery further noted that these actions all arose under Delaware law, making the Court of Chancery better suited to determine their merits than the Bankruptcy Court.
Sehoy Energy LP et al. v. Haven Real Estate Group, LLC et al., C.A. No. 12387-VCG (Del. Ch. April 17, 2017)