Fraud and the General Partner

A nightmare for investors in an Arizona real estate limited partnership serves as a poignant reminder of the importance of due diligence … even when the general partner looks as solid as the Rock of Gibraltar

Andrew D. Pappas, CPA

The following case study is based on a forensic engagement in which Pappas & Company played a pivotal role. The names of the individuals and legal entities involved have been changed. This case study was published, with some minor changes, including the title "This Land Is Your Land, This Land Is My Land," in Fraud Casebook: Lessons from the Bad Side of Business (John Wiley & Sons, July 2007), compiled by the Association of Certified Fraud Examiners.

Some guys just have that look about them – the darting, sloe-eyed leer; the gray grin without warmth or joy; cheap, ill-fitting clothes made of substances found nowhere in nature – that shouts Watch your wallet to even the most naïve mark and, to a more savvy target, is roughly as subtle as, to paraphrase Mark Twain, a peg-legged man having a spasm on a tin roof.

If Dennis Dixon had exhibited any of these or other telltale signs, perhaps this story would have had a different, happier ending. But Dennis Dixon not only didn’t look like a guy that a blind man could pick out of a police lineup – he looked more like a guy who would help the blind man cross the street.

By all accounts, Dennis was a solid, soft-spoken guy whose generosity – his lunch companions had long ago quit trying to pick up the check – demeanor, and purity of speech (and, presumably, thought) contributed to his being liked and trusted by most everyone who knew him. In his early 40s, he had just enough gray at the temples to radiate wisdom and maturity, but not so much as to dissuade the elderly ladies at church from wishing that their daughters had married him instead of their ne’er-do-well sons-in-law. The Dixon family’s arrival at church each week looked like a scene from a Rockwell painting – Dennis and his wife Debbie in their modest Sunday best, hand in hand with their twin, auburn-haired, freckle-faced daughters in matching dresses. After church, the Dixons’ five-year-old minivan was usually one of the last vehicles to leave the parking lot, en route to a family dinner.

Few of Dennis’s casual acquaintances knew for sure what he did for a living. College buddies remembered him getting a degree in management. He had a background in computer sales, and, looking at the way he dressed and the vehicle he drove, people who thought about it at all figured that he was reasonably successful, but certainly not enough to attract much attention or envy. (Those who remembered his first marriage assumed that, if Dennis ever had any money, most of it went to lawyers and his ex-wife in one of the messiest, noisiest, costliest divorces that anyone in that area could recall.)

People closer to Dennis knew that, toward the end of his computer sales career, he got his real estate license. Not content with simply helping people buy and sell residences, he became a broker and began doing investment deals, putting together limited partnerships with relatives and some of his more well-to-do friends.

What most people in Dennis’s world didn’t know was that, in contrast to his modest public persona, the Dixons enjoyed a lifestyle open to only the uppermost tier of the local community. Their girls attended an exclusive private school that cost more to attend each year than most people in town paid on their mortgage. And while Dennis “made do” with his aging minivan, Debbie drove a current model Mercedes that they purchased during a trip to Europe and Asia and shipped to the U.S. (Dennis joked to close friends that he and Debbie were tempted, while they were in Japan, to buy a Lexus as well, so that they could have his-and-hers cars arriving from opposite directions.)

And then there was their house – make that houses. Nestled in its own compound, out of sight in a wooded area, the Dixons’ 6,400-square-foot principal residence cost more than two million dollars to buy (for cash), and in a short time after buying it they had sunk at least that much more into improving it. (For Dennis’s real estate investors and their friends, an evening in the Dixons’ media room was not something to be missed.)

On long weekends, the Dixons would pile into one of Dennis’s investors’ airplanes for the two-hour flight to their second home overlooking Lake Tahoe. The “tree house,” as the girls called it, was a sprawling three-level, 4,000-square-foot home surrounded on three sides by 15 acres of dense Ponderosa pines, with unobstructed views of the lake and the mountain range beyond it. The four million dollars that Dixon had paid for the house had, at the time, seemed high, but he was satisfied that, with the proper “leveraging,” he had more than tripled his money.

The Company. During the last several years, Dixon had assembled a number of real estate investment groups, in the form of limited partnerships in which he served as general partner. Generally, his strategy was to buy potentially valuable land, hold it for the long term, and then sell when the appreciation would yield the desired return. Along the way, he had made a lot of money for himself and his grateful investors, who were almost always eager to pony up when he invited them to participate in the next good deal.

Two elections earlier, county voters had approved funding to expand the area’s freeway system. By the time transportation planners unveiled the new routes, Dixon had already anticipated which parcels would be the hot properties and had cultivated relationships with the owners. He and a friend, “Monk” Mason, set their sights on one parcel in particular, a rural property that was adjacent to an anticipated freeway exit ramp, and bought it for $1.7 million with a cash down payment and a promissory note secured by a deed of trust.

They created a limited partnership, “Exit 41, L.P.,” in which they were co-general partners. The 50 partnership interests sold quickly, for the most part to friends and relatives of Mason and Dixon. The proceeds from the sale of partnership interests were properly used to repay the cash down payment to Mason and Dixon and to pay them roughly $100,000 for putting the deal together. At that time, the general partners made a nominal one-time cash contribution.

Pursuant to the partnership agreement, the limited partners made annual capital contributions, and the general partners made none. In order to provide a cash reserve, the total payments exceeded the amount required to make the annual payment on the land and to cover other partnership expenses. Since the partnership’s strategy was not to develop the property but, rather, to hold it until a developer was willing to pay their price, the partnership rented the land to farmers and collected annual rents. The total rent roughly equaled the management fee that the partnership paid to Mason and Dixon in their capacity as co-general partners.

Initial Discovery. One of my long-time clients, a construction company owner named Harmon Hilton, came in to discuss his individual income tax planning. Among the topics on his agenda were the tax ramifications of the pending sale of real estate by a partnership in which he and his wife, Helen, were limited partners. I remember thinking that the partnership was cleverly named: Exit 41, L.P.

The documentation that Harmon gave me included an email from one of the general partners, Dennis Dixon. The email described the amount per limited partnership unit that each limited partner was to receive upon the sale of the land.

I reviewed Harmon’s documentation, and it didn’t take long for red flags to start popping up. Multiplying the per-unit amount times the number of units that he and Helen owned produced a figure that seemed significantly lower than I thought it should have been. When I reached Harmon by phone that day and told him what I had found, he seemed reluctant to believe that his distribution was shorted, since Dixon was Helen’s brother, but he gave me the go-ahead to investigate further.

I gathered more information, including financial statements, cash flow statements, and correspondence that Dixon had provided to the Hiltons. I also reviewed the partnership agreement for direction regarding distribution of the sales proceeds. My investigation encountered a minor roadblock when Dixon refused to give Harmon a copy of the purchase contract because the sale had not yet closed, but he did provide the sales price per acre and the number of acres being sold, which allowed me to compute the gross sales price.

I consulted with a number of commercial real estate professionals who were experienced in sales of raw land for development in the area where the subject property was located, and I was able to determine what a reasonable real estate commission would be for this transaction. I also consulted with title companies regarding a range of closing costs. Finally, I asked Harmon to obtain from Dixon the total capital contributions by all partners since the inception of the partnership. Using the information that I had obtained from my client and other sources, I calculated the amount per unit that each of the limited partners should receive.

My calculation produced a distribution that was more than 50% greater than the amount that Dixon had communicated to the Hiltons. Applying my calculations to all of the limited partners, the shortfall in proposed distributions was in excess of $1.5 million. I was confident that my original suspicions regarding my client’s proposed distribution were correct, but I needed to investigate further to determine the reason for the vast difference.

The Investigation. Our investigation began by gathering more documents to help us paint an accurate picture of the situation. In addition to helping the Hiltons request from the IRS “certified court” copies of Exit 41, L.P.’s partnership tax returns, we also reviewed and analyzed the partnership’s cash flow statements and financial statements and read all correspondence that Hilton had received from Mason and Dixon.

The detailed review confirmed our initial conclusion, i.e., that the amount of Hilton’s distribution was substantially understated.

While the financial information was relatively easy to obtain, our attempt to broaden the scope of the investigation hit a snag when Hilton asked Dixon for a copy of the contract for the pending sale. Dixon replied that he would be unable to provide a copy of the sales contract until the sale had closed. Not wanting to spark a confrontation at this early stage, we did not insist that Dixon comply with Hilton’s request. Rather, we asked Hilton to email Dixon to get the “basics” of the transaction:

• gross sales price,

• real estate commissions to be paid,

• closing costs,

• proposed distributions to repay capital contributions, and

• proposed distributions of remaining cash.

In his email reply, Dixon reported a gross sales price ($4.7 million) that was $300,000 less than our calculation of $5 million (25 acres at $200,000).

Further, Dixon’s proposed distributions to the general partners and the limited partners did not comply with the distribution provisions in the partnership agreement. Per those provisions, the capital contributions were to be paid from the net sales proceeds prior to the distribution of the remaining cash. The distribution was to be an 80/20 split: 80% to the limited partners and 20% to the general partners. Dixon had applied the 80/20 split to the net sales price (less reserves for final expenses) and showed no line item for repayment of capital contributions; as a consequence, Dixon’s method of distributions awarded him and Mason an extra $500,000.

From the information provided by Dixon, we were able to perform a calculation that allowed us to re-create Dixon’s result. We then helped Hilton draft an email to Dixon that outlined our understanding of the assumptions used by Dixon in his calculations. In his reply to Hilton, Dixon wrote, “You nailed it.”

Hilton again requested a copy of the purchase agreement, and Dixon again denied Hilton’s request, reiterating that the sale had not yet closed. In light of the information Hilton had received from Dixon and Dixon’s steadfast unwillingness to provide a copy of the purchase agreement, we recommended to the Hiltons that they engage an attorney to contact Dixon.

In a letter to Dixon, Hilton’s attorney, Gordon Goode requested:

• a copy of the purchase agreement,

• a list of limited partners who had made capital contributions and the amount contributed by each,

• total real estate commissions to be paid and to whom, and

• an explanation of how the repayment of capital contributions factors into the distributions to partners.

Goode’s letter stated that Dixon’s calculation of the proposed distributions was incorrect and not in compliance with the partnership agreement. He also suggested that Dixon hire an attorney.

Goode received a letter from Dixon’s attorney, Herb Hooker, stating that the general partners had asked him to handle the distribution of cash from the sale. Hooker’s letter included a copy of the much-awaited purchase agreement. We reviewed it, as did Goode. In addition to calling for a $4.7 million gross sales price (6% lower than the $5 million price that we calculated), the purchase agreement, in an early paragraph, called for sales commissions to be paid to the general partners – 3% to Mason, 3% to Dixon – despite the fact that the Exit 41, L.P. partnership agreement prohibited the general partners from receiving compensation from the partnership except as expressly provided; and the agreement did not provide for the general partners to receive a commission on the sale of the property.

At the end of the purchase agreement was additional language indicating that a 6% real estate commission was to be paid to a commercial real estate broker. The purchase agreement clearly provided for aggregate commission expenses of 12% – a total that both violated the partnership agreement and grossly exceeded the commission rate for transactions of this type. (Our commission survey indicated that, for an attractive property of this magnitude, a negotiated commission rate of 3% to 4% would have been in order.)

In that letter and in subsequent pieces of correspondence to Goode, Hooker:

• stated that the 12% real estate commission was reasonable and would be split equally between the buyer and the seller;

• provided the number of paid units, a listing of limited partners, and the capital contributions of each partner;

• indicated that the proposed distributions to the general partners and limited partners had been corrected and that the application of the 80/20 split would occur after repayment of capital contributions; and

• stated that Hooker would instruct the title company not to close the sale prior to the closing date stated in the contract.

Hilton told us that his total capital contributions were substantially greater than the amount indicated on the schedule provided by Dixon’s attorney.

Also, Hilton explained that, prior to investing in Exit 41, L.P., he had invested in another partnership with Mason and Dixon. The earlier partnership also owned a parcel of undeveloped land. During an economic downturn, many of the investors defaulted on their required capital contributions, the partnership was in default on its debt, and it was going to lose the land. Mason and Dixon approached Hilton and the remaining partners with an opportunity to salvage their investment in the soon-to-be-defunct partnership by investing in Exit 41, L.P.

Mason and Dixon confided to Hilton and the others that Exit 41, L.P. was in a situation similar to the other partnership, but that their investment would save Exit 41, L.P. from losing its land. In order to induce Hilton and others to invest in Exit 41, L.P. Mason and Dixon signed written agreements in which they promised, upon sale of Exit 41, L.P.’s land, to repay to Hilton and the prior partnership’s other investors the amounts that they had contributed to the prior (now defunct) partnership.

Based on Hilton’s information, we determined that the difference in the amount of capital contributions per Hilton’s records and of that provided by Dixon’s attorney was the capital he had contributed to the defunct partnership.

We met with Goode to discuss Hilton’s revelation and my findings regarding the contributions. We shared with Goode our opinion that Mason and Dixon did not intend to repay the capital that had been contributed to the defunct partnership.

After Goode received from Hooker schedules outlining the distribution of cash from the partnership, Goode asked us to analyze the schedules to determine if the proposed distributions seemed proper. During our analysis, we discovered the following:

• The amount listed as “gross sales price” was actually gross proceeds less the 6% commission to be paid to the real estate broker.

• There was no money in the checking account.

• The distribution schedules did not provide for repayment of the capital contributions to the defunct partnership made by Hilton and the other partners.

• A portion of the amount reserved for preparation of the partnership’s final tax returns was included in the amount to be distributed to the general partners.

As we analyzed the partnership tax returns, we noted that one partner, Nick Null, had not made capital contributions for four of the five years of the partnership’s existence and, according to his Schedule K-1, was treated as an expelled partner. According to the partnership agreement, expelled partners are not entitled to any distributions in excess of their contributed capital. We further analyzed the schedules to determine the amount of proposed distribution to Null and noted that he was to receive a distribution as if he were a current partner who had made all of his capital contributions.

Exchanges of correspondence between Goode and Hooker led to the following actions:

• Dixon volunteered to give up his 3% real estate commission ($141,000), which reduced the total commissions to be paid from 12% to 9%.

• Dixon acknowledged that the zero balance in the partnership checking account was due to his personally withdrawing the remaining funds (approximately $41,000). Instead of depositing the funds back into the account, Dixon agreed to have his distribution reduced by $41,000.

• Null, the partner who had not made all of his capital contributions, contributed $125,000 to the partnership prior to the sale closing and the distribution of the funds.

(Dixon reported that, per his arrangement with Null, Dixon would make the capital contributions for Null, because Null had loaned $51,000 to the partnership when it was short of cash. Dixon admitted that he did not make the payments because he did not have the funds at the time and then “forgot” that he had not made them. However, our analysis of the partnership’s financial statements and tax returns showed no records of such a loan.)

The joint efforts of Hilton, Goode and our firm resulted in Dixon’s preparation of multiple revisions to the distribution schedules. The result of these revisions was an increase of $1.4 million in proposed distributions to the limited partners, and a corresponding decrease in the amount to be distributed to Mason and Dixon. However, not all the revisions that we requested were made, and we were still concerned that there were other improprieties of which we were not yet aware.

Dixon’s attorney, Hooker, refused to revise the distribution schedules to provide for repayment of the prior capital contributions of approximately $1,100,000. The impact of that at an 80/20 split is that Dixon and Mason would receive an additional $220,000. Dixon reportedly had informed Hooker that he (Dixon) had no knowledge of any agreements promising repayment of the transferred capital. Goode gave Hooker a copy of Hilton’s agreement with Dixon. When Hooker presented the agreement to Dixon, Dixon claimed not to recall signing the document and claimed that it must have been forged. Goode offered to let Hooker view the original of Hilton’s agreement. Hooker did not accept Goode’s offer but told Goode that Dixon had changed his story and now admitted that he and Mason had signed the agreement.

Despite the signed agreements, Hooker contended that the agreement was not binding on Exit 41, L.P. as it was not in compliance with the partnership agreement.

Hilton sued Mason, Dixon and Exit 41, L.P. for repayment of his $600,000 in transferred capital. During the discovery process, records were subpoenaed from the parties involved in the sale of the land. Included in the documents was correspondence from Dixon to the buyer of the Exit 41, L.P. property, instructing the buyer to pay directly to Dixon $141,000, which was 3% of the 6% commission that the buyer was supposedly paying to the real estate broker. We also found correspondence between Dixon and the broker confirming that, by agreement between Dixon and the broker, Dixon and the broker were to split the commission.

Hilton was represented in the suit by Goode, who also subpoenaed bank records for all partnership accounts, including:

• a line of credit that Dixon had opened in the partnership’s name and was using personally; and

• an investment account that Dixon had opened in the name of the partnership.

We analyzed all documents and financial information provided, and re-created the accounting records as thoroughly as the quality of the available information allowed. We discovered that, throughout the partnership’s existence, Dixon had made large transfers of cash – calculated to be in excess of $1 million – from the partnership to himself and to various entities of his own, with sporadic repayments.

Our analysis of the investment account revealed that Dixon had invested $8,000 of partnership funds in technology company stock during the high-tech boom. He quickly doubled his investment, transferred $8,000 back to the partnership’s checking account, and continued investing the profits personally. He pocketed over $28,000 through his misuse of partnership funds and the partnership investment account. We noted that the gains were reported only on Dixon’s Schedule K-1.

According to our calculations, Dixon had failed to repay the partnership almost $100,000, including interest.

We also noted checks, totaling $137,000 and paid from the trusts of two of Null’s children, that were deposited into the partnership checking account. The checks were signed by Dixon as trustee of the trusts. The partnership had no relationship to these entities.

Outcome of the Investigation. When we met with Hilton and Goode to share the results of our investigation, Hilton expressed, in no uncertain terms, his desire to take legal action against Mason and Dixon to recover his rightful share of the excess funds that Mason and Dixon had received. He also wanted to sue Null to force a repayment of the full distribution that Null had received from Exit 41, L.P. despite the facts that, first, Null had made only 20% of the capital contributions required of him and, second, Null had been treated for tax purposes as an expelled partner.

In laying out his client’s legal options, Goode advised Hilton that he could file a “derivative lawsuit” on behalf of Exit 41, L.P. Generally speaking, in a derivative lawsuit a partner, member or shareholder (depending on the type of entity) initiates a legal action on behalf of, and ostensibly for the benefit of, the entity (in this case, Exit 41, L.P.). In a derivative lawsuit pertaining to this case, the limited partner (Hilton) would allege that the partnership is unwilling to pursue itself. This very frequently involves a claim brought by the limited partner in the name of the partnership against the general partners (Mason and Dixon) for alleged breach of fiduciary duty.

Goode advised Hilton that, in a derivative lawsuit aimed at Mason and Dixon, the remedies that Hilton could seek on behalf of the partnership should include the return of:

• the $141,000 real estate commission that Dixon received directly from the buyer of the property;

• the portion of the $1,400 reserved for preparation of the partnership’s tax returns that were included in distributions paid to Mason and Dixon;

• the $28,000 gain on the sale of stock that Dixon had purchased through the personal use of partnership funds; and

• the $100,000 that, during the life of the partnership, Dixon had taken from the partnership and failed to repay.

Hilton’s lawsuit against Dixon and Mason to recover his capital contributions continued separately from the derivative suit. This was a direct claim by Hilton and he, therefore, was not required to pursue the claim in a derivative capacity.

As for Null, Goode advised Hilton that the partnership could expand the scope of its derivative lawsuit to go after Null in an attempt to recover the excess $150,000 that the partnership had improperly paid to Null as if he were a paid-in-full partner. (Null’s position was that he was in fact a partner and was actually entitled to more than he had received.)

As one might assume, Hilton required little time in deciding to move forward with the derivative lawsuit as Goode had outlined for him.

Because of the likelihood that Dixon’s and Mason’s legal interests might be in conflict with each other, Hooker informed the two men that he could not represent both of them in defending against Hilton’s lawsuit. Hooker continued to represent Mason, while Dixon went with a new attorney, Fink.

Mason, Hooker, Dixon, Fink, Null and Null’s attorney met in an attempt to reach a settlement on the issues that Hilton raised in his derivative claim. They hatched the following plan for painlessly settling the lawsuit: Dixon would pay $35,000 to the partnership, and Null would receive $10,000 from the partnership and release the partnership from all future claims by him. The defendants submitted their proposed settlement agreement, with its net $25,000 restitution, to the limited partners for their approval.

Predictably, Hilton viewed the settlement offer – which would allow Dixon to effectively steal almost $300,000 and to repay a relatively paltry $35,000 – as an insult, and he expected his fellow limited partners to be of the same opinion. To Hilton’s dismay, however, a majority of the partners – more than 60% of them – voted in favor of the settlement. Most of the “yes” votes came from partners who were close friends or relatives of Mason, Dixon or Null. They appeared to either believe Dixon’s position that these claims were unfounded or were just eager to receive the balance of their distributions.

Because the limited partners’ vote was not sufficient to accept the settlement and negate Hilton’s derivative claim, the defendants were required to submit the settlement in court. Despite the disparity between what the defendants owed the limited partners and what they were offering to pay, the trial judge approved the settlement proposal that the limited partners, by their majority vote, had accepted.

Hilton was outraged by the judge’s decision to grant the settlement of the derivative claims, especially since there was overwhelming evidence supporting the claims against Dixon. Far from being deterred by the judge’s decision, though, he became even more committed to his fight for his transferred capital from the prior, defunct partnership.

Regarding Hilton’s lawsuit to recover his capital contributions, as is common in such cases, the judge ordered the parties to mediate their dispute. (Mediation is a form of alternative dispute resolution. It is an informal process in which a trained mediator tries to help the parties reach a negotiated resolution of their dispute. The mediator does not decide who is right or wrong and has no authority to impose a settlement on the parties.)

The attempted mediation failed after Dixon and Mason offered Hilton $75,000 and refused to go higher, despite the fact that Hilton’s capital contribution totaled $600,000.

At trial, Goode’s examination of Dixon and Mason produced a litany of inconsistent, contradictory and conflicting testimonies that exposed the general partners’ dishonest practices and generated jury sympathy for Hilton’s position. At one of the trial’s most dramatic moments, jurors reacted audibly when Dixon, in the face of document after document contradicting his claim that they only made the agreement with Hilton, finally admitted that he promised repayment of the transferred capital to all of the investors from the prior defunct partnership who invested in Exit 41, L.P. – after adamantly denying that he had an agreement with any partners other than Hilton.

Despite the financial and contractual complexities of the dispute and the evidence and testimony presented by the two sides, the jury deliberated for just one hour before arriving at a verdict. In the end, Dixon and Mason were ordered to repay to Hilton his $600,000 capital contribution and to pay him $90,000 in interest. Further, the court ordered the general partners to reimburse Hilton $150,000 for attorney fees that he incurred in his legal battle. (In Arizona, a successful litigant can recover attorney fees in only a narrow range of disputes, including contract-based disputes.)

Scorecard. The table below shows a summary of the issues raised and in whose favor they were resolved.

The general partners attempted to misappropriate over $2.2 million, with almost no one noticing. The efforts of Hilton, Goode and our firm resulted in recovering almost $1.8 million from the general partners for the limited partners, plus interest and attorney fees.

Lessons Learned. More accurately, I re-learned a few lessons in the saga of Hilton, Dixon, et al.

First, good guys don’t always win. Harmon Hilton is as solid as they come, but he suffers from a trait that is common among honest men: they too often assume that the people with whom they are dealing are as honest as they are.

Second, when money is involved, no friendship (or, in this case, blood relationship) is sacred. Dixon and Mason were able to wrongly profit from their venture not because they valued their relationships with their investors, but because they correctly anticipated that their investors would be forgiving of the wrongs done to them.

Third, one should never assume that a transaction is legally binding until he or she has sought and received informed advice from a professional who has no stake in the deal. An opportunity that “can’t wait” for the due diligence process is usually an opportunity to avoid.

Fourth, people are not always what they appear. The investors who thought they knew Dennis Dixon, from casual acquaintances to close friends, probably had little knowledge of the house of cards on which Dixon’s business deals rested or of the manner in which he went about constructing it.

Finally, even if you catch the thief, you don’t get all your money back. Therefore, it is better to have never been cheated than to catch the thief.

Recommendations to Prevent Future Occurrences. Investors in limited partnerships and other business entities may be able to avoid the fate of the faint-hearted limited partners in Exit 41, L.P. by exercising a higher degree of due diligence on the front end and ongoing scrutiny as the business progresses.

First, even when placing their money with close friends, acquaintances or relatives, investors owe it to themselves to do their homework. An old Russian proverb applies here: Doveryai, no proveryai (“Trust, but verify”). Investors should look past the façade and the promise of greater wealth, asking for business and personal references on the general partners and checking them all. They should also carefully scrutinize the periodic financial information they receive and seek independent review and verification. In this case, Hilton should have asked me, as his CPA, to look at the periodic financial information he received.

Second, investors should develop a real knowledge of the people with whom they’re placing their money: their level of sophistication, their relationship to one another and with other investors, their financial strength, their risk tolerance, and so on.

Third, investors should seek to enforce the terms of the partnership agreement. In this case, the agreement required annual audited financial statements, but the general partners produced only compiled financial statements. The partners should have demanded audited statements, not reviewed or compiled. (In an audited financial statement report, the CPA expresses his opinion as to whether the financial statements, taken as a whole, are fairly presented. This opinion is given after extensive tests of the accounting records are made. The tests include confirmation with outside parties, analytical procedures, inquiry of client personnel and a detailed study of the accounting records. In a reviewed financial statement report, the CPA expresses limited assurance that there are no material adjustments that should be made to the statements in order for them to be in conformity with accepted standards. In order for the CPA to express this limited assurance, he must satisfy himself as to the reasonableness of the statements through inquiry and analytical procedures. In a compiled financial statement report, the CPA expresses no assurance on the correctness of the financial statements. The CPA only presents, in the form of financial statements, information that is the representation of the management of the business entity. To do this, he obtains the information from management and assembles it. Reviews and compilations are usually allowed only when the potential risk to outside parties is relatively low.)

Fourth, investors should use their own legal counsel to review transactions and draft legal documents. They should not rely on the general partners – especially when the general partners may be the ultimate cause of any problems that arise.

Finally, investors should be especially cautious of transactions in which the general partners do not have a substantial financial stake. If a deal isn’t good enough to attract the general partners’ cash, investors should question whether it’s good enough for theirs.

While the preceding account is based on an actual case, the facts have been simplified and the names of all parties have been changed.

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