"Arbitration of Limited Partnership Cases"
Published in the Securities Arbitration Commentator, February 1992. The article addresses the marketing of limited partnerships in the 1980's and the arbitration of securities claims.
Covering Significant Issues &: Events in Securities/Commodities Arbitration
Vol. JV. No.9
Arbitration of Limited Partnership Cases
By Douglas J. Schulz*
Securities attorneys are being called upon more often than ever to evaluate limited partnerships, a task which can be extremely arduous given the volume of paperwork involved and the complexity of the investment itself. Most limited partnership investments were made in the 1980's, and it has taken investors a number of years to
Since 1980, over $100 billion of limited partnerships have been sold, with over one half of that amount con stituting sales of real estate limited partnerships. 1987 was the most pro ductive year, with sales declining ever since due to changes in the tax laws and investor disenchantment. Estimates are that if all investors liquidated their limited partnerships today, only 25% would realize a return of their original equity. Limited partnerships were risk laden, loaded with up-front management fees, poorly structured, and riddled with conflicts of interest. It is important for both claim ant and defense attorneys to understand the risks of limited partnerships and, in suitability cases, how these risks meshed with the goals, needs and de sires of the client.
The driving force behind the sale of so many partnerships by brokerage firms was the high level of commis sions and fees, making limited partner ships a significant profit center. Like wise, the 8% gross sales commission generated by the broker is about the highest percentage the broker can cam on any one product. The broker's percentage payout is also among the high est attainable on any product. The average limited partnership investment was larger than most investments made by clients; therefore, sales could be the highest commission generators for brokers.
Of course, such fees are not out of line with commission charges on mu tual funds or public offerings of stock, which also concern initial (or continu ing) distributions of an investment. Moreover, limited partnerships are longer-term vehicles forinvestment, so the money, once invested, remains tied up for some time. Their structure dic tates a long-term outlook, plus frequent limitations on transferability and the lack of a ready secondary market. Indeed, this long-term character was a factor in the impression many investors and brokers alike assumed that the partnerships involved only conserva tive risks. As a result, in the worst instances, there were promises of safety, impeccable management, and forecasts of exceptional returns that did not materialize.
For defense attorneys, a limited partnership case may be more difficult to defend than most, where the broker age firm bears much culpability for the way limited partnerships were both organized and marketed to brokers. In many cases, brokers merely repeated to their clients what they were told about the limited partnerships by the broker age firms. A great majority of limited partnership claims involve unsuitabil ity allegations. It is no wonder, since the point-of-sale situation often pre sented the explosive mixture of an in come-seeking, rather conservative in vestor, high commissions, and a broker who did not fully comprehend the risks inherent in a complex product.
A typical real estate limited part nership is replete with risks, which are the subjects of disclosure in the Pro spectus. For example, many are formed under a ''blind pool;" at the time of the investment, properties have not yet been purchased. Therefore, even an experienced investor cannot evaluate what he is purchasing. Another risk is that there is not an established secondary market for most limited partner ships; this illiquidity disallows for a bail-out should the investment go bad. That is why, in many arbitration Awards concerning limited partnership disputes, the Award grants rescission, compelling the brokerage firm to return the adjusted purchase price inexchange for a tender of the Claimant's limited partnership interests.
Additionally, leveraged invest ments mean higher risks. Not only are the limited partnerships oftentimes leveraged; the Prospectus sometimes allows leverage as high as 100%. One of the advantages of limited partner ships issupposed to be limited liability; yet, some investors have been exposed to liability, through recourse notes and otherwise, that have caused them liabil ity in excess of their initial cash invest ment. Beyond the risks of the specific partnership, there are the general risks of real estate investments. Some propectuses are thorough enough to list these general risks; many that I have read do not.
Commissions and fees add to the risk of a particular investment, too, because the investment cannot realize a profit or a return of capital until these costs are overcome by the investment. Front-end fees on a real estate limited partnership can run 18-20%. The in vestor, in such a situation, has an uphill battle from the beginning, with only 80% of his investment in the ground. In addition to the front-end fees, there can be hefty administrative expenses and management fees, assessed by the gen eral partner and its affiliates.
Tax consequences can be one of the greatest risks a client can assume in purchasing a limited partnership. For many investors, promised tax advan tages are a large factor in the invest ment decision. If an investor is not careful, he may subject all of his in come to calculation under alternative minimum tax computation, which could force him into a higher tax bracket overall. It is also possible for an investor to have tax liability which exceeds his yearly distribution. In addition to these yearly shortfalls, some investors have been hit with a single tax bill in an amount which exceeded their initial investment for in come they never received. Other tax risks include depreciation recapture, partnership status changes, realloca tion of losses and auditing.
The final area of risk is the con flicts of interest which the general part ner has. A general partner has incentive to transact on behalf of the limited partnership because he receives com missions and fees for each transaction. Conflicts may arise when the general partner takes actions which may not be in the best interest of the limited part nership in order to generate fees and commissions. In addition, the general partner may have an incentive not to liquidate these partnerships even if they are performing poorly, since the trans action fees, commissions, and management fees are a major source of his income. General partners also manage their own real estate investments, in addition to other eal estate limited partnerships.Interrelated transactions do occur and are permitted by federal and state regulators, assuming adequate disclosure in the Prospectus. Such potential conflicts become rele vant to brokerage arbitrations, where the brokerage firm, as sponsor or selling agent, failed to assure adequate due diligence, disclosure, or oversight regarding an errant general partner's ac tivities.
For both defense and claimants' attorneys, understanding the role of an expert witness in limited partnership cases can be crucial to the outcome. An expert witness needs to explain to the arbitration panel the risks of this complicated investment vehicle and how these risks were suitable or not for the investor. For defense attorneys, an expert witness can be used to offset the negative press limited partnerships have received recently and to counter act the claimant's expert witness. An expert witness will also assist informu lating and defending against discovery requests.
For claimant's cases, the expert should carefully scrutinize what invest ments can be made by the limited part nership. Investors may be shocked to learn that their limited partnership was investing in other limited partnerships, not direct investments in real estate. An investor may have thus taken on additional risk and conflicts with no oppor tunity to assess same.
For both sides, the expert will also testify to the economics of the limited partnership; forexample, he will calcu late yield to date, current yield, as well as the current value and status of the limited partnership. Such testimony will be of benefit to the arbitration panel in reaching any conclusions on appropriate damages.
About the Author
• Mr. Schulz sold limited partner ships during the 1980's. As a securi ties expert. he has been called upon to evaluate limited partnerships and tes tify to their suitability. Mr. Schulz' company INVEST is based in Dallas, Texas. Mr Schulz has worked for IDS. Merrill Lynch, and Bear Stearns and has had his own commodities firm. He is an arbitrator for the New York Stock Exchange. Mr. Schulz also conducts due diligence for in vestment and merchant banking firms.