New era in partnership law

The partnership form of business organisation which has served the needs of profit-making business well for many years is about to undergo dramatic changes.  Whereas the partnership form as we currently know it regulated by the Partnership Act 1890 will remain, a new form of limited liability partnership (LLP) is likely to be introduced in the near future.  Under the current proposals, incorporation by way of an LLP will be available only to those firms which are subject to professional regulation, which would include solicitors and accountants.  Any professional firm that chooses this new form of organisation will see dramatic changes within its structure.

Reasons for LLP

Currently professional persons, in order to conduct business, must do so either by way of partnership or limited liability company.  Many professional practices are run by way of partnership because the regulations laid down by their governing body prohibit incorporation as a limited liability company.  The traditional view, prevalent in the last century, was that to allow incorporation would cause a decline in business standards; because partners are jointly and severally liable for the debts of a partnership1 so standards in business life would be maintained – partners would be unlikely to undertake risky or underhand business deals if ultimately their personal assets were at stake.  A limited partnership under the Limited Partnerships Act 1907 is not appropriate for a professional partnership, as limited liability applies only to partners who do not engage in management.

In the accountancy profession it has been argued that originally accountants adopted the partnership form as a business organisation because it offered professional respectability, and the emphasis placed on personal and shared responsibility helped to form the profession itself.  The unlimited liability of the auditor was the best guarantee that the job would be well done and was the best form of protection for the client2.

However, in recent years it has also been the accountancy profession that has been lobbying hard for changes to the law to allow for some limitation of personal liability.  This has come about mainly as a result of a number of high profile cases in which accountancy firms have been found liable in negligence to third parties.

The case which caused the most concern was ADT Ltd v BDO Binder Hamlyn3.  In this case, BDO Binder Hamlyn was found liable to ADT for £65 million as a result of a negligent audit that was carried out of Britannia Security Group Plc prior to its purchase by ADT.  As the professional indemnity insurance was capped, so the partners were ultimately jointly liable for over £150,000 each.

Another factor prompting a rethink in partnership law has been the growth in size of firms over the past years.  Whereas the number of partners in firms is normally limited to 20, there are exceptions to this rule – and firms of both solicitors and accountants exist with well over 200 partners.  This growth has naturally meant a breakdown in the homogeneous nature of the partnerships of this size.  It is impossible for partners to know each other, let alone be able to place the trust and confidence in each other which has traditionally been at the heart of the partnership form.

One option for accountancy firms to limit personal liability was to incorporate as LLPs overseas.  Strenuous lobbying resulted in legislation being passed in Jersey using the law of Delaware as a model, which would permit incorporation of this form.  However, when Price Waterhouse intimated the intention of following this option the Inland Revenue announced this would mean that it would be taxed as a company – resulting in adverse taxation implications4.  The Law Society of England and Wales also indicated that solicitors contemplating taking this course of action risked bring barred from practising in England and Wales as a Jersey registered LLP would not be considered as a “qualified person” under the provisions of the Solicitors Act 19744.  As this avenue appeared to be closed, further lobbying ensued which has resulted in the publication of a draft Bill on Limited Liability Partnerships in the UK.

Draft Bill

In keeping with our existing legislation on partnerships, the draft Bill is very short – consisting of a mere 17 clauses.  That said, the meat of the provisions is to be bound in lengthy regulations and in references to inter alia the Companies Acts.

The consultation document6 states that the draft legislation is based on three general principles drawn from company and partnership law.  These are first, limited liability; second, corporate personality, and third, partnership flexibility.  It is said that “the general intention is that the LLP will have the internal flexibility of a partnership with external obligations equivalent to those of a company”.

Examining each of those principles in turn:

1. Limited liability

Under the proposals, the LLP itself will have separate legal personality and liability of members (partners are called members in the draft Bill) will, on the face of it, be limited to the assets held by the LLP.  However, there are a number of provisions that qualify this.

First, if the LLP becomes insolvent then a liquidator may apply to the court to recover withdrawals of property from the firm made by a member within the two years prior to a winding-up and at a time when that member knew or had reasonable grounds for believing that the firm was insolvent by the withdrawal8.  The burden of proof will rest with the liquidator and the court cannot declare in his favour if it is satisfied that there remained a reasonable prospect that the firm would avoid going into insolvent liquidation.  These provisions are very similar to section 214 Insolvency Act 1986 where a director can be personally liable to contribute to the assets of a company in insolvent liquidation.  For LLPs no distinction is made in the draft legislation for the type of withdrawal that is made.  The claw back provisions could therefore cover withdrawals that are in effect remuneration and might under company law be seen as directors’ remuneration.  Profit distributions, akin to dividends, payments of interest and repayments of loan capital would also be covered.  Also falling within the ambit of these provisions might be payments for expenses.  It is these claw back provisions that have caused a good deal of angst amongst the professions.

Second, an individual member will remain personally liable to a third party for her own negligence, but not for the negligence of her co-partners.  This is a significant change to the current law and deserves further comment.  Currently, if a partner is liable in negligence, then all the partners in the partnership are jointly and severally liable (jointly liable in England and Wales).  Under the new form the partner in BDO Binder Hamlyn who said “yes” in response to the question “do you stand by these accounts?” and “no” in answer to the question “is there anything else we should know?” may have been the only partner liable for whatever part of the £65 million was not covered by professional indemnity insurance.  This individualistic liability will entail a psychological leap for the members in a partnership.  Currently they rely on each other, and have to trust each other in their business dealings.  A negligent slip by one could mean that they are all liable.

Although in the LLP the members may still share profits (and that will depend on the agreement contained in the incorporation document – discussed below), they will not share liabilities beyond the amounts to which the partnership is liable.  This suggests that LLPs will be peopled by far more individualistic members, who merely want to group together for convenience and synergies of size rather than for factors of mutual trust and confidence.  For many it may be that this individual risk is too great a step to take.  It may not be comfortable knowing that you are liable for the negligence of your partner, but it may be a comfort to know that they will share your liability with you.

There is also an interesting contrast in relation to negligent advice given by directors of a company.  It is often argued that the main advantage of incorporation as a limited liability company is that of limitation of liability.  This, in the case of directors, is often negated because personal guarantees are required and given as a condition of funds being made available.  However, if negligent advice is given by a director then it is normally the company rather than the individual that is liable.

It looked for a time as if this protection given by the corporate form was being whittled away.  In William v Natural Life Health Foods Ltd9 the Court of Appeal took the view that a company director could be personally liable for negligent advice given to a customer of the company.  However, the House of Lords10 allowing an appeal held that there had to be reasonable reliance by the plaintiff or an assumption of personal responsibility by the defendant so as to create a special relationship between plaintiff and defendant, and in the instant case there had been no personal dealings between the director and the client to suggest this relationship existed.  So a director of the company will normally be protected by the corporate form against liability for negligent advice.  By contrast, a member of an LLP while carrying out agency functions for the LLP similar to those carried out by a director for a company will be personally liable for her own negligence.

There is a further consideration to be taken into account as far as liability is concerned.  As the draft Bill currently stands, it is only those firms which are subject to regulation by a supervisory body that could incorporate as LLPs.  As mentioned, this would mean that there was a further regulatory tier concerning requirements for professional indemnity insurance and contributions to guarantee funds.  The ultimate effect would be that a client of a solicitor would not suffer in the event that negligent advice were given.  For other creditors of the LLP, the matter would however be different, and, subject to any personal guarantees, they would have no redress except as provided for under the legislation.

The position of unsecured creditors was the cause of some concern during the discussions leading to the publication of the draft Bill.  Initially proposals were made that LLPs should be subject to minimum capital adequacy requirements or that some form of bonding or compulsory insurance should be available to creditors in the event of insolvency.  However these were discarded after it was pointed out that a limited liability company could be incorporated with minimal share capital, and there was no requirement in company law for a minimum capital input.  Instead, the claw back provisions referred to above are designed to overcome the fact that, unlike a limited liability company, the LLP will not be subject to rules preventing the erosion of capital.

The position of unsecured creditors of solicitors’ firms in Scotland has been the cause of some concern.  Plans by the Law Society of Scotland to introduce minimum capital adequacy requirements for firms in Scotland were recently discussed, but it is understood that these plans have now been dropped.  Given that there is no minimum capital adequacy requirement for an LLP, it remains to be seen whether these proposals will re-surface for those firms choosing this route.

2. Corporate personality

The “quasi” separate juristic personality of a partnership is well known in the law of Scotland11.  A Scottish partnership has been described as “a quasi corporation, possessing many but not all the privileges which the law confers on a duly constituted corporation”12.  It is however unknown in the law of England.  The draft Bill however goes further than the Scottish quasi-separate personality in conferring a completely separate personality on the LLP with unlimited capacity to enter into relations with third parties.  The members of an LLP are to act as agents of the LLP, akin to partners under partnership law13.

The corollary of this separate personality, with liability limited to the assets of the LLP (subject to the provisos discussed above), is that information about the LLP requires to be disclosed.  For limited liability companies the disclosure requirements are onerous.  For the LLP disclosure is required, but elements of privacy may be maintained.  Clause 3 of the draft Bill sets out the disclosure requirements on incorporation.  These include subscribing and registering with the Registrar of Companies an incorporation document.  This document must state the name of the LLP and the names of the members.  Continuing disclosure requirements are also imposed, in that notice of changes of membership, of change of name and of any change in address of the registered office must be given to the Registrar.  As it is intended that the LLP will have the internal flexibility of a partnership, an LLP will not have to register and disclose details of its internal arrangements.  Thus the “LLP agreement” between the members, containing such information as profit sharing ratios, indemnities, capital contributions and so on can remain secret.

However, the most radical requirement for disclosure – certainly as far as the secretive nature of partnerships is concerned – is that audited accounts will have to be filed with the Registrar of Companies14 which will need to contain financial information equivalent to that provided by companies.  This requirement represents a sea change in the historically secretive nature of partnerships who have jealously guarded their financial privacy, and will no doubt be a decisive factor for many considering incorporating as LLP.

3. Partnership flexibility

The third guiding principle enunciated in the draft Bill is that of partnership flexibility.  It is stated that the members of an LLP should generally be free to organise their business on any basis they agree amongst themselves, subject to the mandatory requirements and provisions which will apply in default of agreement between the members.  Thus the “LLP agreement” between the members may remain secret (although presumably it will be possible to glean a number of these secrets from the audited and published accounts).  Profit sharing ratios can be agreed privately and one can envisage that this will provoke heated debate.  If an individual member is going to be liable for her own negligence, then it may be that she will want a greater share of the profits for the particular transaction that she is carrying out.  One can imagine partners having to decide who actually brought in the business, who carried out the work and who should receive the remuneration for a transaction, not to mention who will be liable in the event of a claim for negligence.  Who do existing clients belong to?  What of negligent work carried out by employee solicitors who are not members?  Are existing and new clients going to be viewed as clients of the firm or clients of individual members?  What if there is a claim which is not covered by the assets of the LLP, insurance or the assets of the member who gave the advice?  The LLP may become insolvent without the individual members, but where does that leave the members as regards a viable entity through which to carry on business?  What assets should be held by the LLP?  The questions and permutations are endless as, one can imagine, is room for argument over the terms of the LLP agreement.  The draft Bill also provides that in the event that agreement is not attained or no provision is made relating to the internal management of an LLP then, as with partnership currently, the provisions of the Partnership Act 1890 will apply.

General provisions of note

There are a number of other provisions of note in the draft Bill that have been drawn from both company and partnership law.  Thus, as with company law the Bill provides for penalties to be imposed on members for wrongful and fraudulent trading:  powers of investigation into LLP affairs are given along with the ability to disqualify members15.  Members of an LLP can lose their limited liability if a person who is not eligible to become a member of an LLP (i.e. is not a member of a regulated profession) becomes a member.  After a period of six months any member of the LLP who knows that it is carrying on the business while ineligible to do so will become jointly and severally liable with the LLP for debts contracted after that time, all reminiscent of the provisions in the Companies Acts for personal liability of shareholders in the event that the number of shareholders of a company falls below that required by law.

One general question that is posed by the discussion document is whether any business should be able to incorporate as an LLP or whether, as is currently proposed, the form should be limited to regulated professions.  The authors see no reason why the limitation should apply, though there may be an argument for having a capital adequacy rule and/or a compulsory insurance or bonding requirement in the case of unregulated businesses.  For the regulated professions, presumably the argument is that, because they will still be subject to the requirements of their governing bodies, no clients of the firms should lose out as a result of negligent advice.  But it is just in these professions that the largest claims have arisen, and while claims for negligence are not unknown in other business contexts (see Williams above) they have certainly not proved to be the same fruitful grounds for litigation.  In the regulated professions, as with any other business, it is the unsecured creditors that will lose out in the event of insolvency of the LLP.  But that is just the case as now.  Small businesses incorporate as limited liability companies with minimum share capital.  Those creditors with sufficient negotiating strength procure personal guarantees, others are left to fend for themselves.  It would be no different for a business trading through an LLP.  The main advantage would be for the traders in that flexibility would be attained while some measure of protection was given through the limitation of liability.  It has long been a criticism of the Companies Acts that they are too cumbersome and highly regulated for the majority of small businesses:  this would seem a perfect opportunity to make a more flexible trading form available to all.

A final point to mention is that the DTI consultation paper recognises that tax neutrality must be provided if the new form is to be taken up by existing partnerships.

Summary

The proposed reforms discussed above herald a new era in the law of partnership.  What has been sought is a balance between public and private interests: between the interests of members, clients and creditors of an LLP as well as the maintenance of confidence in the law regulating the professions.  As always where there is a balance to be struck there are winners and losers. Although limitation of liability is touted as one of the main advantages of the LLP it is not going to be as all-encompassing as may have been wished by some.  The claw back provisions on insolvency and the personal liability of members for their own negligence are perhaps the main drawbacks from the point of view of prospective members, while unsecured creditors and employees of LLPs will need to re-think strategies.

The need for disclosure of information about the LLP, in particular accounts, will no doubt cause some angst as the advantages of privacy and, in particular, financial privacy are eroded.  But perhaps the most intangible but far reaching changes will concern the relationship between the members themselves.  No longer will those choosing the LLP as a business organisation need to have the trust and confidence in each other as under the 1890 Act.  Rather than pulling together as a unit each member is likely to be far more interested in her own performance and liability.  No doubt, for those choosing this form turbulent times lie ahead in negotiation of the LLP internal document which will set out the rights and obligations, the duties and liabilities, and the remuneration of each member.

1.  Partnership Act 1890 s9 (liability is joint in England and Wales, rather than joint and several) 
2. “True and Fair:  A History of Price Waterhouse”, Edgar Jones, pub Hamish Hamilton 1995
   
3. [1996] B.C.C. 808
   
4. Financial Times, March 11, 1997, p16
   
5. Financial Times, April 25, 1997, p7
   
6. http://www.dti.gov.uk/cld/11p/chp1.htm
   
7. Consultation Document para 1.1
   
8. Regulations 7.1 and Schedule 4
   
9. [1997] 1 B.C.L.C/ 131; [1997] B.C.C. 605
   
10. [1998] 1 W.L.R. 830 [1998] 2 All E.R. 577
    
11. Partnership Act 1890 s4(2)
    
12. Forsyth v Hare (1834) 13S 2, Lord Medwyn
    
13. The wording of clause 7 is very similar to s5 of the Partnership Act 1890
    
14. Regulations part 5 and Schedule 2 
15. Regulations Part 7.1 and Schedule 4, Part 6.1 and Schedule 3, Part 8.1 and Schedule 5