Fraud suspicions are hard enough to investigate if you’re a business owner and call the shots. But what if you’re a limited partner (LP) in a business where a general partner (GP) is possibly engaged in mismanagement, self-dealing or fraud? With little control over the company, limited partners that suspect general partners of fraud face several challenges.

The problem

In a limited partnership, one or more general partners (GPs) manage the business while limited partners (LPs) contribute capital and share in the profits. LPs don’t run or manage the business. In fact, in most states, if they become involved in management decisions they can lose their LP status. Other states allow minor exceptions to this rule by, for example, allowing an LP to vote on issues that affect the partnership’s basic structure. But even when LPs have the nominal power to vote to remove a GP, partnership structures can make removal impossible from a practical standpoint — unless the GP in question has committed fraud.

Since LPs don’t participate in day-to-day business operations and a board of directors doesn’t review management decisions, GPs have almost complete control of the partnership. This makes it easy for criminally inclined GPs to enrich themselves at the business’s expense.

Forms of abuse

One example of this kind of abuse is self-dealing — payment of exorbitant fees and benefits to the GP at his or her direction. For example, instead of simply drawing one fee for managing the company, the GP may pretend to provide additional services and be paid separately for them.

Or a GP may control or own another company that provides goods or services to the limited partnership at inflated rates. In a deal like this, the GP is working both sides, acting for the company providing the services and the company paying for them. This puts him or her in a position to approve contracts that charge the partnership exorbitant fees.

Possible solutions

Since LPs have no control over the partnership, you should make sure you know a GP’s reputation and record before investing money. Also determine in advance whether the GP provides goods or services to the partnership, either directly or indirectly. If so, how much is the limited partnership paying for them? You want to ensure that any transactions are at arm’s length and in line with market rates.

Keep in mind that your potential losses are limited to your capital contributions. The GP alone is subject to claims, debts in bankruptcy and lawsuits. However, some GPs intentionally run partnerships into the ground with no intention of paying creditors, and LPs can’t do anything to stop it.

Take action

If you’re already involved in a limited partnership but suspect general partners of fraud, it’s not too late to act. Engage a forensic accountant to investigate the facts and get to the bottom of your suspicions.

(This is Blog Post #694)