“… In these difficult times, in which many professional practices are facing potential or actual insolvency, it is important for “partners” to know what liabilities they face …”

Last week’s Court of Appeal judgment in the case of Tiffin v Lester Aldridge LLP [2012] EWCA Civ 35 has brought more certainty to the frequently arising issue, “When is a partner not a partner?”

This will enable partnerships and LLPs to draft or redraft their governing agreements with greater confidence that their intentions as to the status of fixed share partners or members (as non-employees) will be upheld. Equally, individuals will have more clarity as to whether or not they are giving up their employment law rights when they become a “partner”.

Matters such as introduction of capital into the business, a share of profits that varies in size depending on the success of the business, a voice in management, and the apparent intention of the parties (as intimated by the nature of the documentation that is drawn up) are all relevant considerations when determining whether someone is a true Partnerships Act partner.

In these difficult times, in which many professional practices are facing potential or actual insolvency, it is important for “partners” to know what liabilities they face. While anyone held out as a partner is likely to have claimants knocking at their door in the event of their firm’s insolvency, any “partner” who is not a true partner will (still, despite Tiffin) have a much better chance of sending such claimants away empty-handed. Tiffin has undoubtedly made rebuffing such claims more difficult in some cases, but there are still ample opportunities for salaried and some fixed share partners to escape the financial consequences of their firm’s insolvency.

“… If someone is completing on Friday it does not help them if their solicitor ceases to practise on Thursday …”

Some legal practices are only now, with one week to go, receiving premium quotes for their 1 October 2010 professional indemnity insurance renewal. It is nail-biting for them as they may have only one quote – it is “take it or leave it.”

There is talk of practices being quoted premiums in excess of 400% of last year’s premium, with no discernible reason other than that they fall into a particular “demographic” (for example, being a practice with four or less principals).

There is much less capacity and a lot more caution in the insurance market, following the withdrawal of Quinn (which insured 10% of the market).

And it does not help that the number of legal practices in the Assigned Risks Pool (ARP) has swollen to over 400, compared with typically less than 30 in better times (28 in 2007/8).  Insurers who insure the solicitors’ profession have to pick up the tab for claims against practices in the ARP, and thus naturally seek to recoup their losses through higher premiums across the board.

In the past, practices in the ARP were usually there because they were otherwise uninsurable, in other words the risk of substantial losses arising is so great that no insurer with half his marbles would insure them.

Such practices are still in the ARP, but there is a new breed of potential ARP entrant, that is the perfectly good practice that in previous years has been insured for a premium that is a reasonable proportion of their turnover, which has led an exemplary existence and “deserves a break”, but is not getting one in this year’s renewal season.

Faced with an unaffordable premium, such practices have the unenviable choice between entering the ARP (and paying an unaffordable premium) or ceasing their practice before 1 October 2010 (or, if they are confident of obtaining a better quote before the end of October 2010, relying on the 30 day “grace period” - firms which put insurance in place within that period are treated as though they never entered the ARP).

But cessation at short notice is not as straightforward as such practices might hope. There are obligations to clients to give them reasonable notice to enable them to find a new home for their work. If someone is completing on Friday it does not help them if their solicitor ceases to practise on Thursday. Such conduct risks breach of contract claims and disciplinary proceedings, and in a bad case possibly Solicitors Regulation Authority (SRA) intervention. Solicitors who have been so cavalier as to, in effect, abandon their practice may find that they are uninsurable in the future, even if the SRA and/or the Solicitors Disciplinary Tribunal do not pull the plug on them.  Others may simply have to accept that they are insolvent and have an obligation to creditors to cease to trade, whatever the consequences may be.  In such cases, it may be “cavalier” to trade on.

If cessation can be achieved before the renewal date there will be a run-off premium for the obligatory six year run-off policy. That will typically come in at 250% or more of the current year’s premium. Still, reasons to be cheerful, that is better than more than 400% (with an additional sting in the tail – see below) for only one year if the practice continues.

Those trading behind the firewall of an LLP might not be personally liable for the run-off premium, but even if they are not their LLP will probably go into insolvent liquidation, and they might face clawback or other claims from a liquidator or even be at risk of being disqualified for wrongful trading. They will also risk disciplinary proceedings for being in “policy default”.

So closing down carries certain difficulties with it. If the partners decide to continue in practice, there are finance deals out there to finance the unaffordable premium, or failing that the practice can go into the ARP (which runs its own instalment scheme). Either way, the practice is now committed to a premium that it cannot ultimately afford to pay, much like a house buyer with a NINJA* loan which will assure him a few months in a mansion before it is repossessed.

The ARP premium may be as punishing as (or worse than) the premium offered by the insurance market, and if in due course the practice ceases whilst in the ARP without a successor practice (see below) then there will be an ARP run-off premium.

If the practice continues without going into the ARP, but subsequently ceases without a successor practice, its run-off premium will be based on its premium for the year of cessation, so if it ceases in 2010/11 the run-off premium will be be 250%+ of its 400% (of the previous year’s) premium for the 2010/11 year.  That means that having paid a premium of say £50,000 in 2009/10, the total cost of professional indemnity insurance incurred in 2010/11 could be say £700,000 (2010/11 premium of £200,000, plus run-off premium of £200,000 X 250% = £500,000, total £700,000).

One option may be to try to keep the practice going at least as long as it takes to get the best value for goodwill, preferably on a merger, even if that only means the partners being credited in the books of the merged firm with the value of their capital in their current firm.  At the other end of the scale, preserving goodwill may only result in being able to get a job (not necessarily a partnership) at another practice on the back of the book of work that individuals can bring with them.

In the latter case, taking work away from a failing/ceasing practice needs to be done in a structured way by mutual consent of the partners.  If one partner “does his own thing” and takes away a group of clients without a “by your leave” then the others would have grounds to recover the value of that work from the partner concerned.

(And partners seeking a merger or new position must be careful to ensure that they are not moving from frying pan to fire.)

Clients of course are entitled to exercise their own judgement in the matter and may not co-operate in being moved across to wherever partners can find new berths.

Even if transfer of goodwill (and obtaining some value for it) can be achieved, there may well be difficulties such as lease liabilities and claims from redundant staff.  Even in a merger, such claims are likely to remain as liabilities of the old pre-merger practice (which will continue a separate existence for the purposes of being wound up, either in dissolution or liquidation).  

In some cases transfer of a book of work can amount to a TUPE transfer, with the result that potential acquiring practices may be cautious. They will want the partner and his work but not the entire team.

To add to these difficulties, practices acquiring partners of ceasing practices and/or their goodwill may wish to be very careful to ensure that they do not automatically become a successor practice to the ceasing practice. If they do they will become responsible for insuring the risk of future claims arising from the ceasing practice’s past work. This is a minefield that can be traversed, but only with the “right equipment” (an in-depth analysis of the proposed course of action, with a copy of the succession rules at your side, tweaking the proposal as required to avoid succession).

With effect from 1 October 2010 the succession rules themselves have been tweaked, with the result that a partner or partners joining one or more new practices will be able to elect to pay a run-off premium rather than bring the burden of succession with them to the practice that they are joining.  This will make obtaining a job easier (especially for sole practitioners who are closing down their practice) but leaves the job-seeker with the run-off liability.

The best solution may be not to close down the practice but to look for “birds of a feather” – good practices in similar difficulties (brought about by the catastrophic insurance market, not poor business stewardship or poor claims history) with whom to merge.  Being “in the same boat”, such firms will not be as “picky” about succession and other issues. Such a merger will be too late to affect the premium that each practice (or the merged practice) has to pay this year, but at least being a larger practice next time round in 2011 might give rise to a lower premium, especially if there is a focus in the meantime on better preparation for next year’s renewal, for example putting better risk management processes in place which will be attractive to insurers.  And in the meantime economies of scale may be achieved.

This avoids a run-off premium or an ARP premium and/or an ARP run-off premium.

In any event, practices in this predicament may well have to find ways to reduce their partner numbers so that the increased premium leaves the remaining partners with enough profit to live on.

Poorly-performing partners may be given the choice of leaving with an indemnity or remaining in the practice and sharing the burden of greatly reduced profits and large potential liabilities if cessation occurs in the future. Some partners may regard the opportunity to leave as a “Get out of jail free card”, indeed those managing the process may be trampled in the stampede towards the exit. It is important to get the balance right with a view to retaining the most effective partners.

Faced with many different options, the partners in a practice facing a difficult insurance renewal would do well to prepare a number of different spreadsheet models, to enable them to ascertain and compare the possible outcomes.
_________________________________________________________

*No INcome, Job or Assets (sadly for aspiring mansion owners these loans are no longer available).

“… It is possible inadvertently to throw away these defences in the course of the process leading up to administration, a PVA and/or IVAs …”

This article describes the run-up to a professional partnership insolvency, and the choices faced by the partners who control the partnership. It then goes on to identify particular issues faced by salaried and fixed share partners, and the opportunities open to them to try to avoid personal liability for the firm’s debts.

The primary driver behind the swathe of LLP conversions during the last ten years, namely the risk of insolvency brought about by a catastrophic negligence claim in excess of the limit of a practice’s professional indemnity insurance, has not really come to pass. In these hard times many firms are instead sinking under the weight of their trading losses, brought about by decreasing turnover, and sometimes aggravated by partners who have seen the writing on the wall and have left, taking clients with them.

Most commonly, salaried and even fixed share partners are not involved in management, and they have either no idea or only a faint perception as to how badly things are going for their firm. The first they may know of a problem is when the equity partners tell them that they are proposing to put the practice into administration and/or pursue a partnership voluntary arrangement (PVA), and/or in some cases individual voluntary arrangements (IVAs). It is quite common for the salaried and fixed share partners to be asked to co-operate in these processes. This invitation needs to be approached with extreme caution.

Very often the equity partners will have had their heads in the sand, hoping for an upturn in work that never comes and/or compassion and time to pay from a growing roster of creditors, who may have become increasingly impatient. A final demand from HMRC in connection with failure to pay PAYE and/or VAT is commonly what prompts the equity partners to consult an insolvency practitioner.

Administration is usually only going to be possible and worthwhile if the firm has a decent business which someone is willing to buy. Client loyalty is a big issue here. In the case of a professional practice, given regulatory issues and the practical point that a professional practice in administration will rapidly lose its clients and goodwill, any administration is almost certainly going to have to involve a “pre-pack”, in other words a sale will have to be agreed with a buyer prior to and be triggered by the commencement of the administration.

Even if a buyer can be found, an administration may provide only very temporary relief for the partners, as they will still have unlimited personal liability for the debts of the firm. The evil day when they have to face up to their liabilities may have been briefly deferred, and the sale of the goodwill of the practice may well have provided some much-needed additional funds, but in most cases there will still be a substantial rump of indebtedness that the partners will have to address (whether or not the firm goes into liquidation).

A PVA may be standalone or may follow an administration. Whether or not preceded by an administration, IVAs may also be required if creditors are trying or threatening to pursue individual partners into bankruptcy. Indeed sometimes, especially in the case of smaller firms, interlocking IVAs are used instead of a PVA. Consideration has to be given as to how the partners’ professional regulatory body will react to a PVA or IVAs, in particular whether that body will permit the partners to continue in practice after a PVA and/or IVAs are in place. Clearly this is crucial and a decision of the regulator must be sought before any steps are taken, otherwise the PVA (and any associated IVAs) will have achieved nothing, particularly if (as is common) they include, as part of the proposal to creditors, a contribution from ongoing profits of the firm over a number of years (with the result that the PVA and/or IVAs fail, and the final outcome is liquidation and/or bankruptcy).

Sometimes therefore, depending on the profession concerned, the equity partners may have to accompany their PVA with a “merger” with another firm, in which they can be “supervised” in their professional work by partners who are not the subject of an insolvency regime (this is particularly common where the practice needs to hold client money).

I put “merger” in inverted commas as more likely than not the partners of the insolvent firm will not be granted much if any status in the firm with which they are merging, often becoming salaried partners or consultants or indeed accepting a lower rank, just to generate income to live and to enable them to make any agreed ongoing contribution to their PVA/IVAs.

Whether the firm has to “merge” or not, salaried and fixed share partners will no doubt wish to consider their prospects for advancement (and their continuing exposure to future liabilities) in a firm that has suffered such trauma and/or in which some or all of the partners may be paying off creditors for some time. Particularly if the firm is able to continue without “merging”, salaried and fixed share partners may wish to consider whether they should (a) ask to be given another title and not be held out as partners going forward, or (b) find a job elsewhere. Either way, the purpose will be to avoid incurring potential liability for further debts that may arise in the future. In order for this to work, effective notice has to be given to everyone who has dealings with the firm, and there is a right and a wrong way to do this.

A PVA with or without IVAs may, depending on the terms proposed, put an end to the salaried and fixed share partners’ exposure to liability for the firm’s debts. But creditors may not accept the PVA/IVAs, or if they do the PVA/IVAs may fail because the firm and/or the partners may be unable in the final event to comply with the agreed terms.

One way or another, salaried and fixed share partners may well be exposed to creditor claims.  Although they may well not be true partners (which can only be determined after a careful review of their precise rights and obligations) they may be liable to creditors anyway under section 14(1) of the Partnership Act 1890 (holding out). Such liability depends not only on whether they have been held out as partners but also on whether the creditors concerned have relied on them when advancing credit to the firm. This is a very important potential defence. By adopting the right strategy it is possible to use this defence to keep creditors at bay for a long time or indeed to deflect them entirely.

Other technical (but nonetheless highly effective) defences are likely to be available to fixed share and salaried partners against HMRC and landlords.

It is most important therefore that salaried and fixed share partners do not do anything that will jeopardise these defences. It is possible inadvertently to throw away these defences in the course of the process leading up to administration, a PVA and/or IVAs, and salaried and fixed share partners should therefore obtain specialist and independent legal advice at the very first intimation of the firm’s insolvency, otherwise they may be at risk of falling into a number of traps which will result in them being dragged along by the equity partners into personal insolvency that might otherwise have been avoided.

“… An intending purchaser who is aware of the firm’s difficulties should not purchase the firm from the partners, even if no winding-up or bankruptcy petitions have been presented …”

(First published in the Law Society Gazette on 2 August 2007)

Partners of an insolvent law firm cannot continue to practice indefinitely.  Leaving aside that they should not trade whilst insolvent, their creditors will eventually reel them in.  If they are made bankrupt their practising certificates will be suspended.  If they enter into individual voluntary arrangements (IVAs) they will probably not be permitted to continue running their own firm.  To avoid bankruptcy the partners will need to persuade the required 75% by value of creditors to vote in favour of their IVAs.  One option for the partners is to find a purchaser for the assets of the firm, whilst it is still a going concern, with a view to delivering the proceeds to creditors via an insolvency practitioner, in return for the creditors supporting their IVAs.  This article explores that process.

The attraction for a purchaser

Just because a firm has got itself into a position of insolvency does not mean that its business and goodwill are worthless.  It may be burdened with historic debt, overstaffed, offering some services unprofitably, recording time and billing inefficiently, failing to collect bills, and/or may have suffered some catastrophic event.  A purchaser will be able to purchase assets free of all indebtedness.  If he perceives that other core problems can be eliminated, reduced, or left behind, he may be willing to pay more than a rock bottom price.

He should, however, seek a heavily discounted price, because:

• As creditors circle, the timetable may be very tight, and there may be no alternative purchaser.
• When a firm ceases to trade, WIP and debtors may in practice be difficult to recover.  For a vendor, reasonable value realised at a fire sale price is better than little or no value realised on a cessation.  There may be a further discount to reflect the purchaser’s efforts in effecting collections.  Payment may be deferred until after, and be conditional upon, billing of the WIP and collection of the debtors.
• There are uncertainties inherent in any transfer of goodwill, no matter how the process is presented to clients, more so when insolvency is involved.  A purchaser may be able to negotiate a price to be determined over time by reference to future turnover.
• Any such agreement to buy now and pay later reduces not only the purchaser’s risk but also his financing costs.
• Without an ongoing practice, leases and staff cease to be assets and become liabilities.  A purchaser may be willing to employ existing staff and/or to take assignments of leases of premises where they work.  In an administrator sale the employment obligations imposed by the TUPE Regulations are not as strict as on a normal transfer of an undertaking.  With the agreement of employees it is permissible to reduce their remuneration or fix other inferior terms of employment.  The National Insurance Fund will pay pre-existing debts owed to employees, and redundancy pay to those whom the purchaser decides not to re-employ.  The purchaser may wish to take on key and/or support staff in order to preserve goodwill.  If the purchaser takes on staff and/or leases, the overall indebtedness of the current partners will be reduced, making it easier for them to agree IVAs with their creditors (by enabling them to offer a higher dividend and/or to reduce third party contributions).  These benefits to the partners (and the creditors) may be reflected in a further reduction in the price.  A purchaser may thus receive a credit for acquiring staff and premises that he might have required anyway in due course.
• On any sale of the business of a firm of solicitors, succession for professional indemnity insurance purposes may well occur, pursuant to the Law Society’s Minimum Terms and Conditions.  Succession is beneficial to the insolvent firm and its creditors, as otherwise the firm will be liable for an insurance premium for compulsory, automatic run-off cover.  Succession passes on to the purchaser the responsibility for insuring against future claims arising out of the past negligence of the purchased firm, thus increasing the purchaser’s premiums for a number of years.  This effect can to some extent be mitigated if succession occurs in the early part of the indemnity year, as the benefit of the remainder of the policy will pass automatically to the purchaser.  A purchaser should consider these potential gains and losses and negotiate accordingly.

The insolvency regime

By virtue of the Insolvent Partnerships Order 1994 (as amended from time to time), much of the insolvency regime applicable to companies is also applicable to partnerships and LLPs.  An intending purchaser who is aware of the firm’s difficulties should not purchase the firm from the partners, even if no winding-up or bankruptcy petitions have been presented.  To do so would risk an application by any subsequent liquidator or trustees-in-bankruptcy, seeking to set aside the transaction, or extract a higher price, on the grounds that inadequate consideration had been paid.  Equally, after presentation of one or more petitions, unless approved by the Court all transactions (other than administrator sales – see below) will be void if a winding-up or bankruptcy order is subsequently made.

If an administrator sale has not been achieved before a winding-up or bankruptcy order is made, the practice will cease.  By the time of appointment of a liquidator or trustee-in-bankruptcy, it will probably be next to worthless.

Administration

The only way in which a purchaser in these circumstances can acquire unassailable title to a worthwhile asset is through an administration of the firm before a winding-up or bankruptcy order is made.

Whilst an early administration is advisable, a number of issues may arise:

• Few, if any, insolvency practitioners are going to want to trade a firm of solicitors, even for a short period.  To do so the appointee would have to be a solicitor.
• The compulsory addition of ‘in administration’ to the name of the firm would do nothing for the value of the goodwill.
• Accordingly all parties will wish the proposed administrator to be in control of the firm only for long enough to sign his name on the sale and purchase agreement.  Best practice is to set up automatic completion of the sale on entry into administration, so that the administrator is in control of the firm for only a notional blink of the eye.  But, to achieve this, all of the terms of sale have to be agreed in advance of commencement of the administration.
• The partners may not wish to appoint an administrator until they are satisfied that their major creditors are content with the proposed sale terms, and will support their IVAs.
• The four-way dialogue that ensues between proposed administrator, proposed purchaser, partners and creditors puts the creditors on notice of the proposed administration.  They will know that once an administration notice has been filed in Court, they will lose the ability to present a winding-up petition, and will have little or no further influence over the sale terms.
• Thus, creditors may present a winding-up petition earlier rather than later, especially if they sense that the intending purchaser is beating down the price.  By presenting (or supporting) a petition, prior to an administration notice being filed, they ensure that an administration can only be commenced by an application to the Court, and that accordingly they will receive notice of the hearing of the application, and can be heard in opposition.  Advertisement of a winding-up petition may be the beginning of the end for the firm and its goodwill.  Some creditors (especially HMRC, who may act on principle) may be prepared to run that risk in order to bring pressure to bear on the parties to reach a resolution and/or to show their resolve to achieve the price that they consider to be appropriate.

A race ensues to negotiate terms and commence an administration as soon as possible, before winding-up or bankruptcy petitions are heard.