Ontario Court Of Appeal Provides Guidance On Derivative Actions For Limited Partners

While the Limited Partnerships Act¹("LPA") is silent on the rights a limited partner may have to make a derivative action claim, a recent Ontario Court of Appeal case has provided direction on the matter.

This new decision provides guidance and a framework for derivative action claims in the context of limited partnerships, making the threshold clear and providing greater opportunity for limited partners who may have no other recourse to bring a claim against third parties for the benefit of the partnership.

Derivative Actions

A derivative action has been an equitable remedy available to shareholders of corporations for over 150 years in very limited circumstances such as fraud² and has also been a statutory remedy, beyond just fraud, in corporate statutes for decades, including the Business Corporations Act³ ("OBCA"). Under corporate law, a derivative action allows a shareholder⁴ to be authorized by a Court to commence an action in the name of, and on behalf of, the corporation against a third party. In Ontario, the three-part test for a derivative action can be found in subsection 246(2) of the OBCA, if a court is satisfied that,

• the directors of the corporation or its subsidiary will not bring, diligently prosecute or defend or discontinue the action;
• the complainant is acting in good faith; and
• it appears to be in the interests of the corporation or its subsidiary that the action be brought, prosecuted, defended or discontinued.

Therefore, the derivative action remedy arises because, despite the action against the third party being for the benefit of the corporation, management refuses to commence the action.

A derivative action under corporate law is necessary as an exception to the Rule in Foss v. Harbottle⁵ that any action in which a wrong is alleged to have been done to a corporation, the proper claimant is the company.

What is new in Ontario is the availability of that remedy to limited partners of limited partnerships.

Limited Partnerships

A limited partnership is not a corporation (although one or more partners might be corporations). Like any partnership, it is a legal relationship among the partners. A limited partnership differs from a general partnership in two important respects. The first difference being that partners of a general partnership and a general partner (of which there must be at least one) of a limited partnership have unlimited liability whereas limited partners, as far as Ontario law is concerned, have liability that is limited to the value of money and other property contributed or agreed to be contributed by the limited partner to the limited partnership⁶. For this reason, the general partner of a limited partnership is almost exclusively a corporation having limited liability for the benefit of its shareholders. The second difference being that a limited partner, in that capacity, is precluded from taking part in the control of the business of the partnership. If a limited partner takes part in the control of such business, then the limited partner will lose its limited liability protection⁷. "The limited liability of the limited partner is premised on their status as a passive investor in the partnership business"⁸.

In Canada, a benefit of a partnership is that it is not a taxable persons under the Income Tax Act (Canada). Profits and losses are taxed in the hands of the partners. This allows for losses to be set off against other sources of income. It also allows for profits and capital gains to be taxed in the hands of each partner which can avoid duplication of taxes associated with carrying on business through a corporation. A limited partnership can be an important tool to avoid or minimize the increased risk of higher capital gains tax as a result of implementation of the 2024 Federal Budget.

For those reasons, limited partnerships are a common business structure in Canada, particularly in land development and commercial leasing.

In Ontario, there is nothing in the LPA or the ⁹ (which also applies to limited partnerships to the extent not modified by the LPA) that requires a written partnership agreement. However, given the very limited statutory provisions, a written limited partnership agreement is highly recommended for both general partners and limited partners.

Limited partnerships usually fall within one of three common structures:

• The first is where the general partner is a subsidiary or controlled by the limited partner or limited partners. In this regard, the limited partners maintain their liability protection by only indirectly controlling the business of the partnership by being the controlling minds of the general partner. In this structure, the general partner is usually a shell corporation having little or no assets of its own.
• The second is where the general partner has a significant interest in the business of the partnership and the limited partners are simply passive investors (the classic "silent partner") with no ownership in or control over the general partner.
• The third is a hybrid where the general partner is controlled by a limited partner or group of limited partners and the other limited partners are simply passive investors with no ownership in or control over the general partner.

Background of the Case

The limited partnership in Binscarth¹⁰ falls within that third structure. The passive limited partners of the of Binscarth Holdings LP ("Binscarth LP") brought an action against the general partner, Binscarth Holdings GP Inc. ("Binscarth GP"), Binscarth GP's sole director Grant Anthony, 1862438 Ontario Inc. ("186"), a corporation wholly owned and operated by Mr. Anthony and who had entered into a Management Agreement with Binscarth LP, 975393 Ontario Inc. ("975"), another corporation wholly owned and operated by Mr. Anthony, and Laura Colligan, a real estate broker hired for the sale of a property of Binscarth LP and alleged to be the common law spouse of Mr. Anthony.

In addition to being the controlling mind of Binscarth GP (and thereby Binscarth LP) and those other corporations, Mr. Anthony was also directly or indirectly a limited partner of Binscarth LP. All the limited partners, including the limited partners who commenced the action, were related to Mr. Anthony or were corporations controlled by relations of Mr. Anthony – it was a family business organized by Mr. Anthony's parents. Not all the limited partners took part in the action.

The issue that the court had to determine was whether a derivative action is available to a limited partner and whether the limited partners had standing to bring a derivate action claim against the parties.

Why Seek a Derivative Action Remedy

As noted earlier, a statutory derivative action remedy, commonly found in most modern corporation statutes, is broader than the common law fraud exclusion to the Rule in Foss v. Harbottle. Although Ontario's legislature chose to include a statutory derivative action remedy in the OBCA, no such statutory remedy has ever been included in the LPA.

It appears that the reason that the plaintiffs sought the derivative action remedy is that they did not have the capacity to commence an action on behalf of the limited partnership, a power reserved to the general partner (which Mr. Anthony controlled), and due to a concern that if they commenced an action directly in the name of the limited partnership, they would lose their limited liability by taking part in the control of the business of the partnership.

Another incentive for bringing a derivative action claim is that, since the claim is being brought on behalf of the corporation (or, in this case, limited partnership), the costs (or at least a portion of such costs) of the legal proceedings will be at the corporation (or, in this case, limited partnership's) expense. Whether that was a motivating factor in this case is unknown.

The Decision

In looking at the case at hand, the Court of Appeal determined that the limited partners could not bring a derivative action claim against Binscarth GP or Mr. Anthony, as both the LPA and the Limited Partnership Agreement for Binscarth LP provided the limited partners with a direct claim as against Binscarth GP and Mr. Anthony. They could not avail themselves of the derivative action for any claims against any parties if they already could bring those claims against those parties in their own name.

However, when it came to claims against those who were not involved in the limited partnership, the court allowed the limited partners to bring a derivative action claim.

The Court of Appeal stated that derivate action claims "are extraordinary in nature and leave need not be granted where other recourse exists." Looking at the history of derivative actions, the court found that such actions were created to protect shareholders who otherwise would have no standing to bring a claim. Applying this corporate scheme to limited partnerships, the Court of Appeal used the same logic to determine that:

In that regard, rather than applying the very restrictive fraud exclusion to the Rule in Foss v. Harbottle, the Court of Appeal chose instead to apply the broader statutory derivative action remedy found in section 246 of the OBCA with necessary differences in wording to apply to limited partnerships.

The Court of Appeal further provided direction in applying the three-part test to a limited partnership in that "a court must be sensitive to the context of a limited partnership, the management role of the general partner, the terms of the limited partnership agreement governing the partners, and the provisions of the LPA."

The Court of Appeal then set out a non-exhaustive list of factors such as "whether the general partner's failure to act is unreasonable or in bad faith; the existence of any conflict of interest between the general partner and the proposed third-party defendant; the presence of a strong prima facie case against the third party; and alternative, non-derivative remedies that may be available to the limited partner. These are simply some factors to consider and do not represent an exhaustive list."

This case has provided welcome clarity on the role of derivative actions in the context of limited partnerships, and has provided greater protections for those limited partners who may otherwise have no alternative recourse.

Although such a claim is to be used as a last resort, knowing a derivative action claim may be available when all else fails should provide some greater comfort to limited partners. Also knowing some of the factors that a court should consider in deciding whether to authorize a derivative action, a general partner can consider what protections may be warranted in the drafting of a limited partnership agreement since that agreement and the intentions of the parties will be a factor that a court should consider.

Footnotes

1 Limited Partnerships Act, RSO 1990, c.L.6

2 See, for example, Atwool v. Merryweather (1867) LR 5 EQ 464n

3 Business Corporations Act, RSO 1990, c.B.16

4 Under several corporate statutes, a derivative action is not limited to shareholders. For example, the derivative action remedy in the OBCA is available to a complainant which includes a person who, in the discretion of the court, is a proper person to make an application.

5 Foss v. Harbottle (1843) 2 Hare 461, 67 ER 189

6 Limited Partnerships Act, R.S.O. 1990, c.L.16, section 9.

7 Idem, section 13(1).

8 Canadian Home Publishers Inc. v. Parker, 2019 ONCA 314, 146 O.R. (3d) 27, leave to appeal refused, [2019] S.C.C.A. No. 233.

9 Partnerships Act, RSO 1990, c.P.5

10 Binscarth Holdings LP v. Grant Anthony[x], 2024 ONCA 522,

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.