Member departures: Tackling repudiatory breaches and competing businesses

The limited liability partnership (LLP) has become the corporate vehicle of choice for many businesses, particularly in the legal services sector. However, uncertainty persists as to members' rights and duties in the UK.

This article considers two issues:

1. whether an LLP member can terminate membership in response to a repudiatory breach by the LLP or another member; and

2. the duties of LLP members who wish to leave and set up in competition.

Repudiatory breach

The question whether an LLP member can terminate his or her membership in response to a repudiatory breach by the LLP or another member (i.e. whether a member can claim constructive dismissal) is important. There is no judgment of any court on this issue, so what follows is the authors' view, not an authoritative statement of law.

A problem arises in applying the doctrine of repudiatory breach
to LLPs because of the application, by analogy, of partnership law.
A traditional partnership governed by the Partnership Act 1890 (PA) cannot be dissolved by a partner's acceptance of a repudiatory breach.¹

Some argue this principle should apply to LLPs. It is said that the basis for the decision in Hurst v Bryk is that a partnership is not just a contract (even though there may be a contractual underpinning) but it is also a legal relationship governed by equity and the PA. Thus, if the partnership could be dissolved by the acceptance by one partner of a repudiatory breach, that would circumvent the control of the partnership relationship by equity and the PA.

The argument runs that LLPs, too, are not merely contractual but
also reflect a legal relationship which is separate from the contract.
This is apparent in the Limited Liability Partnerships Act 2000 (LLPA), which refers in section 4(3) to a person ceasing to be a "member of"
the LLP in accordance with an agreement with the other members.
Thus, it is said, there is a concept of membership which is not
necessarily the same as a contract. Moreover, just as in the case
of a partnership, LLPs are subject to control by legislation.

However, the analogy with and attempt to apply Hurst v Bryk is misconceived. The starting point is that partnership law has no application to LLPs (see section 1(5)
of the LLPA). So, the first question is why one should follow Hurst v Bryk at all.

Even if Hurst v Bryk applies, all it says is a partnership is not dissolved by acceptance of a repudiatory breach. That is because there are statutory grounds governing dissolution and a court cannot add acceptance of repudiation to these. However, the argument that a member of an LLP may accept a repudiation and so bring to an end the contract between the individual and the LLP does not affect the continuation of the LLP.

An LLP is not dissolved by the acceptance by one member of a repudiatory breach. In a PA partnership, every change in partners is technically the dissolution of the partnership and the creation of a new partnership. That does not apply to LLPs; an individual member's departure does not lead to the dissolution of the LLP. Hence, the acceptance of a repudiatory breach by a member of an LLP would not cause the LLP to be dissolved.

There remain, however, three areas of difficulty with the application of the doctrine of repudiatory breach:

1. what happens to the membership (as opposed to the contract) of a person who accepts a repudiatory breach in the light of section 4(3) of the LLPA;

2. what happens when the breach is committed by one member, not the LLP; and

3. how does one deal with the problem that the LLP may not terminate a contract with the member on grounds that the member has acted in repudiatory breach?²

The answer to the first question is that, if a member terminates the LLP agreement as a consequence of a repudiatory breach by another party, that is a termination "in accordance with an agreement with the other members" under section 4(3), thereby bringing the relationship to an end. Nothing further is required. The doctrine of acceptance of a repudiatory breach means that the agreement is terminated in accordance with that agreement, because the agreement is terminated applying the common law to the contract.

The second point concerns agency. Every member of an LLP is the LLP's agent.³ There may be questions about whether particular things were done within actual or apparent authority so as to bind the LLP⁴ but, generally, an act done by,
for example, a managing partner on an LLP's behalf will bind it.

The third point reflects the apparent conundrum that an LLP would not be able, absent any express term, to expel a member for committing a repudiatory breach. But, this does not prevent
a member from invoking the doctrine.
The effect of the legislation is to limit
what would be a right which the LLP would otherwise have. However, there is no similar legislative restriction on members and there is no reason why
the member should not be able to
accept the LLP's repudiatory breach.

In summary, an LLP member may terminate his or her membership in response to a repudiatory breach. Therefore, LLPs (and managing partners
in particular) should be wary of behaving
in a way that could constitute a
repudiatory breach. What amounts to
a repudiatory breach will vary according
to the circumstances of each case,
but potential examples may include reducing a member's drawings or
profit share or excluding a member.

The consequences of a member being entitled to terminate his or her membership in response to a repudiatory breach are potentially very serious. The member will be entitled to leave forthwith, free of restrictive covenants, and there will be no barrier to competition with the LLP and solicitation of clients and staff. The member may also have a claim for damages for loss (e.g. profit share) during what should have been the notice period.

Competition restraints

There has been much litigation about the legality of steps taken by employees and directors of companies who wish to leave their employer or company and set up
in competition.

It has been held that a director who irrevocably forms the intention to leave and join a rival must either resign or disclose that intention.⁵ This is because, once the director decides to leave, the director's fiduciary duty to act in the best interests of the company requires that that intention be revealed. Thus, the director must either resign or disclose the conflict.

The cases concerning employees are not consistent. Some have applied the approach set out above to employees who wish to leave and join a competitor, even though, in general, employees do not owe fiduciary duties.⁶ Others have taken a more limited approach to the duties owed by employees on the basis that they do not owe fiduciary duties.⁷

This difference in approach matters to LLP members, who do not, in general, owe other members or the LLP fiduciary duties, even though partners in traditional partnerships do. Members may owe fiduciary duties where, for example, they control the LLP's property or where the terms of a contract are such as to impose fiduciary obligations. But, in general, members do not owe fiduciary duties.⁸

Note the law on the absence of fiduciary duties arose in the context of a newly-formed LLP and it is yet to be considered whether members of LLPs who were formerly Partnership Act 1890 partners owe fiduciary duties. It might be argued that it would be wrong for parties who, as partners, owed fiduciary duties, no longer to do so on becoming LLP members. However, if parties elect to use a legal structure (one of whose consequences is that the members do not owe fiduciary duties), the members cannot take advantage of that new structure but ignore inconvenient elements. There may also be an exception to the general rule
if a member has control over the property and affairs of an LLP.

If the obligation either to resign or disclose one's intention when a person wishes to leave and join a competitor is a consequence of the individual's fiduciary duty, this would not affect LLP members. Nevertheless, it seems likely that, even though they do not owe fiduciary duties, LLP members owe implied duties of good faith that would affect their ability to set up in competition. It seems likely that an LLP member would owe duties at least as onerous as those owed by an employee. Therefore, it seems likely that the limitations imposed on employees' rights
to engage in preparatory activity would also apply to LLP members.

On this basis, and if the QBE line of authority is correct, it seems likely that the limitations which are imposed on employees' rights to engage in preparatory activity would also apply to LLP members. This would impose a severe limit on the freedoms of members of LLPs to take action preparatory to establishing a new business and would enable LLPs to bring claims in the event that a member went too far.

Additionally, many LLP agreements will contain express terms of good faith and it is likely to be these, rather than implied terms, which circumscribe what members who wish to set up in competition may do.

Members' agreements often contain post-termination restraints. The law has traditionally distinguished between such restraints in employment contracts and those in commercial contracts. In both cases, the clause must be no wider than reasonable to protect its beneficiary's interest. The law takes a more restrictive approach in respect of employment contracts than commercial contracts (where it generally regards the parties
as best placed to judge reasonableness).

How should post-termination restraints in LLP agreements be regarded? There does not appear to be any case law on this point. The leading case in relation to traditional partnerships is Bridge v Deacons.⁹ It illustrates that partners
can be validly bound by covenants which are much more onerous than those which may be validly imposed on employees.

Despite arguments in other contexts for the inaptness of an analogy with partnership cases, it seems a court would be likely to apply this case to an LLP.
This is because the salient features are the same: LLP members are like partners to the extent that they all share in and benefit from a business and all have an equal interest in protecting the business.

There may, however, be arguments about the reasonableness of restraints with regard to different types of member: would it be reasonable to subject a fixed share member to the same restraints as an equity member, for example?

In practice, members' agreement should contain express provisions imposing clear limitations on members' ability to set up in competition. Furthermore, members' agreements should contain carefully drafted restrictions in order to guard against competition (as far as possible) from outgoing members.

Many LLPs have looked to bolster their post-termination restrictions in
recent times to guard against competitive threats (such as team moves) in an increasingly crowded market. Some
such covenants are novel in their
scope, but their validity has yet to
be the subject of a judicial decision.

Paul Nicholls QC is a barrister at 11 KBW (www.11kbw.com). Tim Spillane is a partner and Peter Nicholson is a solicitor at Stewarts Law (www.stewartslaw.com)

Endnotes

1. Hurst v Bryk [2002] 1 AC 185, followed in Mullins v Laughton [2003] Ch 250and Golstein v Bishop [2014] Ch 131

2. Regulation 8 of the LLPA provides that no majority of members may expel a member unless there is a power to do so under an express agreement

3. Section 6 of the LLPA

4. Section 6(2) of the LLPA

5. British Midland Tool v Midland International Tooling [2003] 2 BCLC 523

6. See for example QBE v Dymoke [2012] IRLR 458

7. See for example Lonmar Global Risks v West [2011] IRLR 1238

8. F&C Alternative Investments v Barthelemy [2012] Ch 613

9. [1984] AC 705