Held to ransom?

Legal practices increasingly face a range of challenges if they are to enjoy a secure future. Increased administration, additional professional regulation whether through Law Society of Scotland practice rules or otherwise, proposed changes to complaints procedures, additional onerous tax legislation and competitive pressure from outside sources, all increase the pressures on the partners who run the firm. Against this background, and given the increased mobility of individual solicitors between firms, the issue of partnership succession is one which any firm may find itself addressing at almost any time.

The makeup of the legal profession in Scotland has changed dramatically over the last 10 to 15 years and this change is accelerating. The continuing growth of large firms and their development of specialised services are placing significant pressure on smaller practices to maintain fee income and profitability.

Capital issue

Generally, with larger firms there is a structured approach to succession planning. However experience of smaller practices highlights that significant problems do arise in this area.

When a partner is looking to retire and has built up a substantial capital account, this can lead to problems for the remaining partners in raising funds to pay out the retiring partner. This situation, where senior partners are sitting with large capital balances, also has an impact on taking on junior partners to carry on succession as there is often a marked reluctance by younger solicitors to make a career move which is going to result in substantial capital payments in the not too distant future to outgoing partners.

You might expect that there would be few if any firms of solicitors without a proper partnership agreement in place. Our own experience indicates that this is certainly not the case. Even when there is a partnership agreement this can often be out of date and does not take into account any changes that have taken place over the years, so that it does not provide the answers when a succession issue confronts the firm as currently constituted.

Case study: value lost

Cases like the following may arise. A seven partner city firm with minimal growth and four long-serving partners with significant balances in their capital accounts, is approached by a firm of similar size, proposing a merger. An initial problem is that there is no unanimous decision between the partners whether to continue with the existing firm, merge with the known suitor, or indeed approach other firms with a view to a merger.

The individual circumstances of the partners involved result, effectively, in a conflict of interest:

• Two of the long serving partners are, in theory, happy to retire. However, because of a significant pension shortfall, this option is not open to one of them.
• One of the junior partners announces that, on the back of the merger offer, he is resigning from the practice and moving to another firm. On the basis that he is a significant fee earner for the firm he is looking for the inclusion of goodwill on his retrial.
• There is no partnership agreement in place so there are no formal guidelines to cover this position.

Unfortunately, but perhaps not surprisingly, matters become extremely acrimonious and the partnership is dissolved with the various partners going their separate ways. Two other negative spin-offs are the level of legal and accountancy fees in attempting to resolve the problem and the effect of the situation on the day-to-day management of the firm. Consequently this adversely affects the conversion of work in progress to fees and ultimately profits.

First questions

Our experience would indicate that this is not a unique example. To avoid any such scenario there are various key areas which any firm is strongly recommended to address immediately.

It is essential for partnerships to have a formal partnership agreement to ensure that all matters which the partners consider relevant are covered.

Solicitors will be aware that they now have the option to trade as a limited liability partnership (LLP) or a limited liability company (LLC). Whilst LLP status is similar to partnership status from the point of view of ownership of the firm, there is a significant increase in governance required by an LLP and this can only serve to improve the management of the practice. LLC status represents a significant change to the structure of the practice, with the issue of shares and the elimination of partner capital accounts, although as with a LLP, more onerous governance is required.

Individual and common goals

Once the practice trading entity has been decided, the next and possibly most critical stage is to prepare a comprehensive partnership agreement which fully covers succession and related issues. The agreement should also cover the question of goodwill, and if relevant, the valuation of partnership property.

It is imperative that all partners have an input into the partnership agreement and overall plans for the firm. Cases have been known of the senior partners preparing the agreement and presenting it to the remaining partners as a fait accompli. This has the immediate effect of alienating the junior partners and prejudicing any succession arrangements which the senior partners are hoping to put in place.

Account needs to be taken of the individual aspirations of the partners so that these are recognised at the outset. Recognition of the partners’ preferred retiral dates and property related matters must be incorporated into the agreement.

The fact that one agreement is trying to cover the aspirations of various individuals, which may in fact be completely opposite, will no doubt result in difficulties in negotiation. All the partners must realise that some level of compromise is going to be required. Ultimately everyone’s interest depends on the success of the firm.

Next step: the practice plan

Once the partners’ preferred structure and the individual partners’ plans have been identified, they should be incorporated into the partnership agreement. The partners can then go on to prepare a medium/long term plan for the practice. This plan will identify the future direction of the firm and will incorporate various matters in the partnership agreement, such as outgoing and incoming partners and the property arrangements. The plan will lay out the aims and objectives of the practice and should be reviewed and updated on a regular basis to take account of any new factors which may arise.

It needs to be recognised that a comprehensive partnership agreement and a practice plan will not necessarily guarantee the future of the firm and there will definitely be cases where practices may need to merge or be taken over to survive in the current climate. The continued expansion of the larger firms is currently resulting in a number of acquisitions and mergers and it is possible that succession planning will identify this as a possible option. By addressing this issue on their own terms the partners will be able to make a decision based on facts rather than have an unwanted alliance foisted on them.

The property as pension fund

Pension performance is critical to all partners and has a significant impact on retiral plans. Current legislation does give partners the opportunity to set up a pension scheme utilising the partnership property. This could prove to be a significant benefit to the practice, whether partnership or sole trader, and this is an area which should be considered as there are potentially significant tax savings, as well as pension benefits, by adopting this approach.

Practice properties and goodwill are two other issues which can have a bearing on the issue. The position with properties is relatively straightforward where property is effectively owned by all the partners. It can be much more complicated when the property is owned by an outgoing partner and issues can arise both for the remaining partners, in negotiating lease terms, and also for the outgoing partner, should the remaining partners wish to relocate.

Case study: the agreement holds

Another case study, not untypical, concerns a five partner provincial firm with steady growth. Three of the partners are aged over 50. All the partners have significant balances on their capital accounts. The firm owns properties, all of which are equally owned by the partners, who have taken out personal loans to finance the purchases. The youngest partner decides that it is time for a career change and announces his resignation from the firm. On the basis that he is one of the major fee earners, and is moving out of the profession and leaving his contacts with the firm, he feels that he is entitled to a goodwill payment.

In this instance there is a partnership agreement which states that goodwill will not be included in any practice valuation. In addition the agreement sets out the mechanism to treat the disposal of the outgoing partner’s share in the properties.

Whilst the overall outcome may not suit the retiring partner, he is bound by the partnership agreement, which he originally signed up to.

Better prospects

The key to any succession plan is not only to ensure that the outgoing partner is happy, but to ensure that the continuing partners are satisfied with the arrangements for the outgoing partner and the future of the practice. Adopting a formal approach to succession planning and having an agreement in place in advance of potentially difficult issues arising, will greatly increase the chances of a smooth transition. It will also have the benefit of encouraging existing staff to make their future with the firm, or indeed possibly attracting outsiders to join the firm at partnership level.

In a Len Deighton novel one of the characters says that his boss adopts an ostrich approach to everything, burying his head in the sand but leaving his backside high in the air. This could well describe the attitude of practising solicitors who do not take active steps to consider and address the issue of succession!

Alex Johnston, Associate, Campbell Dallas, Chartered Accountants and Business Advisers

t: 0141 887 4141