Worst shod: does your firm have a partnership agreement?

It is said that a cobbler's children are always the worst shod and nowhere is this better exemplified than in the legal profession. Partnerships and limited liability partnerships (LLPs) which routinely dispense advice to their clients about the best way for them to organise and regulate their businesses fall down flat when it comes to themselves. How common is the problem and what are the consequences of operating an LLP (perhaps the most favoured vehicle, currently, in solicitors' private practice) without a written agreement setting out precisely how it's meant to work?

In the main, solicitors in private practice used to operate in 'traditional' partnerships - regulated by a partnership deed or, in the absence of that, by the Partnership Act 1890. These days the LLP is, perhaps, the preferred business vehicle for solicitors - with the look and feel of a partnership but, in fact, a corporate entity with an independent personality, incorporated under the Limited Liability Partnerships ?Act 2000. However, one common problem with 'traditional' partnership remains unchanged - the situation that arises when a group of partners or members in an LLP fail to set out, in written form, terms on which they agree that they will trade in business together.

Widespread problem

Many solicitors might be incredulous at the suggestion that fellow professionals would be so careless as to set up in business without a clear written agreement detailing the mutual rights and obligations of the partners in their firms. My experience - shared by others who practice in this area - is that the problem is much more widespread than might be believed. Of the cases that I have seen, approximately one in five arise in circumstances where the LLP in question has no formal LLP agreement. With approximately 120,000 solicitors in the UK, a large proportion of whom now practice in LLPs, the problem is one which, as professionals, ought to be firmly on our radar. Instead it seems to be flying well below it.

Typically an LLP finds itself without ?a written LLP agreement in one of a number of ways:

a) the partners in an LLP simply never sign up to a formal agreement;

b) they do sign up, but some intervening act, such as the arrival of a new partner/member has the effect of wiping out the LLP agreement, leaving the position unregulated, save to the extent that statutory default provisions apply; or

c) partners in an 'old fashioned' ?partnership convert to an LLP but, in ?the process, neglect to enter into a ?new LLP agreement.

?In the absence of agreement between members in an LLP, the provisions of the Limited Liability Partnerships Regulations 2001 (SI 2001/1090) apply. These set out, pretty pithily and on just about one side of A4, the mutual rights and duties of the members and the LLP. The default provisions (see box below) apply except to the extent that they are varied by any agreement between the relevant parties. The members of an LLP have the right to agree to vary or exclude the provisions of the regulations in part, or in full, as they see fit. That agreement can be reached in writing, orally or by conduct - although the latter two options create obvious difficulties when the time comes to prove precisely what has been "agreed".

 

Deafult position The default position for members of an LLP who are subject to the regulations are: ? All of the members are entitled to  share equally in the capital and profits of the LLP.   ? Each of the members is entitled to an indemnity from the LLP in respect of personal liabilities incurred “in the ordinary and proper conduct of the business” or “in or about anything necessarily done for the preservation of the business or property of the Limited Liability Partnership”. ? Every member has the right to take part in the management of the LLP. ? No member is entitled to be paid for acting in the business or management of the LLP.  ? No new members can be admitted or interest in the LLP be assigned to someone else without the consent of all the existing members. ? Matters in the LLP are to be decided by majority decision – but no change can be made to the nature of the business without the consent of all the members.  ? All members have the right to inspect the books and records of the LLP.   ? Each member is under a duty to render “true accounts and full information of all things affecting” the LLP to any member – or to his legal representatives.  ? A member may not compete without being under obligation to account for and pay to the LLP any profits made him in that competing business.  ? No member may take a “secret profit” – i.e. a benefit for which he obtains by virtue of being a member for which he does not account to the LLP. ? (Very significantly) no majority of the members can expel any member unless a power to do so has been confirmed by express agreement between the members.

 

So take a not uncommon situation: a smallish firm of solicitors has been operating for a number of years as an LLP. ?It has employed a fairly traditional structure, and although nothing has been agreed in writing, the firm has a managing partner, senior partners and junior partners and there is an agreement as regards the way that profit share should be split.

A new member is admitted but has ?not "worked out" and the members are ?now thinking about what they can do to remove that new member who is causing disruption in the business. It is immediately apparent that, in the absence of an agreement (which naturally ought to be recorded in such a way that it is free from ambiguity), getting rid of the new member may not, in fact, be as easy as it seems - there is no right to expel in the default provisions as set out in the regulations. That's not the only problem.

The majority of partners may also be concerned to learn that their ability to ?keep information regarding the finances ?of the LLP and details of profit shares ?may similarly have been undermined by ?the regulations. It's not uncommon for ?more senior partners to wish to restrict, ?to some extent, the information flowing to more junior partners. Absent agreement that this is permitted, the regulations prevent such obfuscation.

Furthermore, unless there has been agreement reached in some way (and conduct may suffice for these purposes) the new member may say that he or she has the right to participate in the running of the business and its control, as well as taking an equal share of profits. While it is possible that the new member may have agreed the terms on which he or she will participate in the LLP and so disapplied the default position, it is certainly a dangerous starting point for a practice to be compelled to rely on the regulations. When a dispute blows up and all involved focus on their respective rights and obligations, that can be a pretty disconcerting moment for partners who are forced to evaluate their position in a framework which they have never properly considered before.

Expulsion

As is clear from the example, one of the frightening things about the regulations is that they fail adequately to provide for a number of common problematic situations that arise in practice. Expulsion is one example. On that point, in most LLP agreements it is common to permit the majority of partners, in certain circumstances, to expel a partner. Equally it is far from unusual either to impose a duty of good faith on all members or (perhaps more commonly these days) to exclude such a duty - something that would have been unthinkable in a traditional partnership. This can permit management to run an LLP in accordance with agreed procedures, in the best interests of the LLP, without being quite so concerned that they need to look over their shoulder to see whether there will inevitably be an allegation of "bad faith" when a partner is expelled.

Another important point to bear in ?mind is whether the members will wish ?to exclude liability for any losses in the ?LLP and put in place suitable arrangements so that claims between the members in relation to poor performance of the LLP, etc., are prohibited.

The purpose of this article is not to set out all of the clauses that ought to appear in a well drafted LLP agreement, but instead to highlight the difficulties that can arise where an LLP operates on the basis of the default provisions - a set of provisions which are unlikely to be satisfactory in the majority of cases. This is not a criticism of the regulations themselves but, rather, a reminder to those in practice that it is up to them to ensure that their business is governed properly and has appropriate constitutional documents.

After all, that is precisely what solicitors in private practice would advise their ?clients to do. It is always less easy to turn the focus of one's attention to oneself in a professional capacity.