Limiting liability: How to choose between an LLP and limited company structure

It is hard to believe that more than 12 years have passed since the introduction in April 2001 of limited liability partnerships (LLP) in England and Wales. The LLP has become the common business structure for law firms of significant size. The overwhelming majority of top-200 UK law firms are LLPs and, among the top 50, Slaughter and May is the only firm that is not one.

The main reason for adopting the LLP structure is for partners to be able to limit their liability. To date, the LLP would seem to have a robust liability shield, although this has not really been tested by the courts. There may be a perception that members of an LLP are more at risk than directors or shareholders of a limited company of being held personally liable, but this is not necessarily the case. Legal start-ups faced with the decision as to which structure is more suitable should, rather, base their decision on other factors, such as taxes and the potential of attracting external investment. Figure 1 summarises some of the key differences between LLPs and limited companies in terms of taxation.

Very broadly, LLPs offer similar protection from liability as that available to directors and shareholders of limited companies. As an LLP has a separate legal personality to its members, its members will not be liable for the debts and obligations of the LLP itself. Yet, there are several areas in which an LLP member's limited liability may be at risk:

1. ?a member of an LLP may be liable to third-party clients for any losses caused by his own negligence;

2. as an agent of the LLP, a member may also owe duties to the LLP and could therefore be personally liable if those fiduciary duties are breached;

3. members carrying out a management function may owe certain duties not only to the LLP but also to other members; and

4. the concepts of wrongful trading and fraudulent trading apply equally to members of an LLP on an insolvent liquidation of an LLP as they do to directors of a company.

 

1. Liability to third-party clients

The key question here is whether a member, while carrying out his functions and duties on behalf of the LLP, could be personally liable to any client, with the LLP also being liable.

In order to establish whether the member owes a duty of care to the client, the nature of the relationship between the solicitor and the client is critical. In the overwhelming majority of cases, it will be the LLP that is the liable party, but it is possible that the member may have acted outside the normal course of business.

Any analysis of this area must ?consider the House of Lords decision in Williams v Natural Life Health Foods [1998]. Although this concerned the question of liability of a director of a limited company, the court made it clear that the principles set out in the judgment applied to the personal liability in tort to any third party of an agent who is acting on behalf of a principal.

In this case, the court remarked that not only would it need to be clear that the member conveyed to the client that he ?had assumed personal responsibility towards the client, but also that the client itself had relied on the assumption of personal responsibility. Those solicitors who have a closer, much more personal relationship with their clients will be more at risk as it may be easier, in such circumstances, for a client to establish that the member had assumed personal responsibility towards him.

The personal liability of LLP members for their own negligence has not been tested by the courts. This is likely to continue being the case, particularly as effective risk management steps have been widely adopted by most firms to limit this risk. For instance, most firms will make it clear in their terms and conditions that the client is engaging only with the LLP and not the individual lawyer, and will expressly provide that no member of the LLP is assuming personal liability for the legal advice being provided.

Directors of limited companies and solicitors who are employed by companies are also at risk of assuming a personal duty of care towards a client. Indeed, Williams v Natural Life Health Foods involved a director of a limited company.

2. Duties to the LLP

A member of an LLP is the LLP's agent and therefore owes a duty of good faith to the LLP as part of his wider obligations. Effectively, this means that a member is under a duty to act in what, in good faith, he believes to be in the best interests of the LLP.

In theory, this means that a member may be liable to the LLP whenever his own negligence causes a loss to the firm. The individual member is unlikely to get the benefit of the LLP's indemnity (which will be set out in the LLP agreement), since such action could be in breach of his obligations to the LLP.

The widely-held view, however, is that the negligence must be more than just simple negligence. Those solicitors who are directors of the limited company will also owe fiduciary duties to the limited company. Their main duty, similar to the one owed by members of an LLP, is to act in the best interests of the company.

A possible consequence of this is that a director of a limited company who is wilfully or grossly negligent may be in breach of his fiduciary duties and therefore at risk of being sued by the company for any losses caused by such acts. Solicitors employed by a company but not appointed as officers of such company will not face similar risks.

3. Duties to co-members

This duty will usually come under the spotlight when it concerns the actions of those members involved in the management of the LLP as they, by virtue of their administrative and management functions, will owe specific duties to the LLP to carry out such roles with due care and skill.

Again, this is no different to directors of companies who have a duty to conduct their office with due care and skill. For LLP member managers, it is possible that a similar general duty may arise in tort or as a matter of common law in favour of co-members.

Some of the principles arising from Tann v Herrington [2009] might be ?applied to LLPs. The case involved a dispute between an architect and a surveyor, who were operating as partners in a traditional partnership.

Herrington was the senior partner of the firm and, over the years, had assumed the responsibility of dealing with the firm's professional indemnity insurance. He had failed to notify the firm's insurers of a potential claim and they consequently refused to insure the claim. Herrington, following Tann's retirement as a partner, intended to meet the payment by ?using the increased value of certain partnership assets, thereby depriving ?Tann of his financial entitlement following his retirement.

Tann disagreed that he should be held jointly and severally liable with Herrington for such loss when Herrington should have notified the insurer. The court agreed with him and Herrington's failure to notify the insurer was held to be short of the standard required of him. This effectively meant that Herrington was required to bear the loss alone, without any entitlement to recover it from Tann during the dissolution of the partnership.

It is conceivable, therefore, that a similar outcome may arise in the context of an LLP, where a member fails to fulfil a delegated role. The LLP manager may argue that he owes a duty to the LLP alone but, in circumstances where the fellow co-members suffer the loss, it is likely that they will try to recover any possible loss in the same way as Tann.

In the later case of F&C Alternative Investment (Holdings) Limited v Barthelemy and Culligan [2011], however, which involved an LLP, the court rejected the proposition that LLP members owe fiduciary duties to each other beyond any contractual obligations contained in the LLP agreement.

The court held that an LLP is not a traditional partnership in which individual partners owe each other a duty of good faith in relation to the management of partnership affairs; members are actually free to agree between themselves the detailed terms of such duties.

Notwithstanding the decision in F&C Holdings, any delegated management power will invariably entail having a significant control over the LLP's assets and, where management have clearly assumed responsibility for the control of such assets, it will be difficult not to expect such members of management, as agents of the wider membership, to owe specific duties to the LLP and the other members.

Directors of companies are bound by similar obligations to the company. In certain circumstances, however, a shareholder may be able to bring a derivative claim on behalf of the company to enforce those duties. Directors have statutory duties to promote the success of the company and exercise reasonable care, skill and diligence amongst others. If a director is in breach of any of his duties, he may be personally liable to pay compensation to the company for any loss suffered by it. In practice, therefore, the fiduciary duties of an LLP member and a company director are broadly similar.

4. Insolvency

In the event of insolvency, the wider membership of an LLP and the ?directors of a company will face similar risks of personal liability, whereas employed non-director lawyers of limited companies will not.

Section 214A of the Insolvency Act applies to all LLPs. Known as the 'clawback' provision, it allows a liquidator of an LLP in insolvent liquidation to apply to the court to order any member to repay drawings or other payments from the LLP received during the two years prior to an insolvent liquidation of the LLP. However, this only applies when such members knew or had reasonable grounds for believing that the LLP was unable to pay its debts at the time the payments were made to it.

The clawback rules apply to all members regardless of seniority, capital contribution or profit share. The collapse of big practices may lead to developments in this area and, invariably, the contentious aspects will centre on whether members of the LLP who did not participate in the management of the business can be liable for wrongful trading and/or repayment of monies withdrawn prior to the insolvency of the firm.

Save for the specific clawback provisions, directors of companies that are in financial difficulty face similar issues to those referred to above. For instance, in the course of a company's winding up, if a liquidator has reason to believe that a director carried on business at a time when he knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation, the liquidator can apply to the court for a declaration that the director make a contribution to the company's assets.

Other relevant risks

In 2012, the high court considered whether members of an LLP could be held personally liable for the LLP's unpaid professional indemnity insurance premiums in an assigned risk pools scheme.

In the case of Zeckler v ARP Manager Capita Commercial Services, Zeckler asked the court to set aside the demand for unpaid premiums on the basis that, as a member of an LLP, he was not personally liable for its debts.

Although ARP Manager referred to the Solicitors' Indemnity Rules, which provide that a firm and any person who is a principal of that firm shall be jointly and severally liable to pay the premium, the court rejected the notion that professional rules can be incorporated into contract.

It is also important to flag that both a director and an LLP member may have to give up the protection afforded by trading through a limited liability entity if they are asked to give personal guarantees to third parties, such as landlords or banks.

Individual circumstances

Members of LLPs and directors of companies face broadly the same risks of being personally liable. In relation to insolvency, LLP members have a specific clawback rule that may apply to them. However, the risk of personal liability is ?not really an important determining factor when choosing whether to use an LLP or limited company.

The increased use of limited companies in the UK legal sector has been largely due to the introduction of alternative business structures and the prospect of attracting external investment. External investors are not as comfortable with investing in LLPs and are more inclined to invest in limited companies, which they understand better.

On the other hand, tax ?considerations and the desire to ?have a partnership ethos and the ?flexibility of a partnership structure are factors that have discouraged the use ?of limited companies.

?Miguel Pereira is a partner in the partnerships and LLPs group at Lewis Silkin LLP (www.lewissilkin.com)