The 10 most important partnership or LLP deed clauses

by Peter Garry on 24 September 2009

“… Recessions bring out the worst in people …”

(First published in the Law Society Gazette on 24 September 2009)

A recession has a way of exposing weaknesses in legal drafting. As practices try to respond to the economic climate, management teams consult the fine print of their partnership deed or LLP members’ agreement, and may find it wanting.

Management and authority

In a downturn, businesses need strong management in order to survive. Effective management requires not only the usual leadership qualities, but also the ability to implement decisions without having to run every proposed decision past a multitude of second-guessers.

Many practices have de facto management arrangements in place that have not been fully documented. Managing partners or committees may expand the scope of their decision-making into areas that were not contemplated by anyone at the time of creation of their office. This can lead to those affected by a decision (such as to de-equitise them) raising objections to the manner in which the decision was taken and/or the authority of those who made it.

Practices should ensure that they have a well-documented decision-making structure that has been put in place through a voting process that complied with the terms of the governing agreement at that time.

Involuntary retirement clauses

Some would say that not having an involuntary retirement provision is a cardinal sin, as without one it is much more difficult for a practice to thin out the equity. Others would say that partnership ethos demands that partners should stick together and find a way to pull out of the nosedive. This is a matter for individual practices to consider, but keeping in mind that in a financial crisis, if under-performing participants cannot be exited quickly, the best participants may leave of their own accord.

Consideration needs to be given to whether any involuntary retirement power should be vested in the management team or whether a wider vote should be required. It is common for involuntary retirement clauses to require a high percentage vote, but in practice sometimes this is not achievable, particularly if partners/members who feel vulnerable support one other on the basis of safety in numbers. Many agreements do not clarify whether multiple exit candidates are entitled to vote on each other’s retirement.

Retaining key players

Agreements often do not restrict how many partners/members can leave in a given year.

If there are no such restrictions then the business is at risk of losing several key participants at the same time, either because trading conditions turn down and partners give notice to retire one by one, or because entire teams wish to depart for another firm en masse. As partners start to retire, there can be a perception that “last man out pays the bills”, which can result in a stampede.

Some partnership agreements give the continuing partners the option not to acquire an exiting partner’s share (and give him an indemnity), but rather allow them to elect for dissolution instead, so that the partner who wished to exit instead becomes a partner in the dissolution and liable to contribute to any shortfall. This is particularly important for continuing partners when trading conditions are difficult, the business is in difficulty, and/or the exiting partner(s) are key to the success of the business.

Such a provision also gives the continuing partners strong leverage in trying to retain the partner if they wish to do so, or in negotiating exit terms more favourable to them than their agreement provides.

Provisions of this type have no or very little part to play in LLPs, since no member has a liability beyond his capital. Also, the obligation to indemnify and repay capital is the LLP’s, not the continuing members’, and repaid capital can often be clawed back by a liquidator. But given that the default position is that (absent current insolvency) unanimity is required in order to wind up an LLP, it might be useful to have a provision permitting say 75% of members to resolve to wind up, if only as a lever for the practice to use to try to persuade a key member, who has given notice, to remain.

While it is not ideal to detain people against their will, sometimes that is better than the alternative. A near miss and a change of heart can reinvigorate a practice, leading perhaps to biting the bullet on cutbacks or de-equitisations that are long overdue, as part of a deal to retain the key participant.

Garden leave and suspension

Quite often, in order to protect its business and goodwill, a practice will put a partner/member on garden leave or suspend him, but without first checking whether they have the power to do so. As a rule of thumb, if it’s not in the agreement there is no power.

Putting someone on garden leave or suspending them without the power to do so is tantamount to unlawful exclusion from the business, its premises and management. As such it can give rise to a number of remedies for the excluded partner/member including dissolution and damages (and/or, in the case of an LLP, winding-up or an unfair prejudice petition).

Covenants in restraint of trade

There are some quite substantial practices without any covenants in their agreement. When the partner walks, so do his clients.

For those who do have them, when times are good a lot of practices do not enforce them, preferring to avoid a dispute that might become unseemly, and to retain clients based on the quality of their ongoing practice, assisted by garden leave.

But as recession deepens one sees practices increasingly threatening retired partners/members with the consequences of their actions.

There is a common misconception that the solicitors’ conduct rules and/or case law forbid a claim against an outgoing partner/member which might prevent a client consulting his solicitor of choice, but the rules concerned only apply in relatively rare circumstances. There is no restriction on damages claims, which can be very substantial, and injunctions can be sought and will be granted in suitable cases.

Age discrimination

In the current economic climate not everyone will want to retire at age 60 or even 65. Practices should heed the following health warning: “Past performance of age discrimination claims is no guarantee as to future outcomes.”

No age discrimination claim brought so far by a partner or member has resulted in an award by a tribunal of a sum of money. But just because you haven’t heard of any successful discrimination claims does not mean that they are not frequently intimated and then settled in favour of the claimant before reaching the tribunal.

A clause that requires retirement at a specified age (or any other stipulation based on age) is prima facie discriminatory, and it is for the practice to convince the tribunal that it is justified.

The good news is that there are certain things that a practice can do now to improve its chances if faced with a claim in the future, such as conducting appropriate consultation amongst the partners/members as to what retirement provisions are regarded as reasonable given the requirements of the business, and then putting them in place.

Profit-sharing

At more or less any stage in a practice’s history there will be at least one person nursing a grievance over relative levels of remuneration. This can never be eliminated, but consulting and putting in place a transparent remuneration system will go a long way towards keeping the peace and retaining talented partners (and the goodwill and turnover that goes with them).

The remuneration system should be aligned to the objectives of the practice, rewarding the behaviours that the participants in the practice decide are most important. Such behaviours need to be carefully crafted to encourage participants to spread their efforts appropriately across a range of required activities (such as chargeable work, practice development and development of skills and know-how). The perceived accuracy and fairness of the process of assessment of each participant’s contribution are as important as the criteria against which he is assessed.

Criteria and processes should be agreed by all participants, carefully documented, followed to the letter, and reviewed from time to time.

Ownership of assets

Ownership disputes in professional practices are surprisingly common. They often involve valuable assets such as freehold buildings, or even entire businesses carried on by the practice, such as bulk conveyancing or wealth management arms. With consolidation and disposal of practices becoming increasingly prevalent in the current climate, it is important to address ownership at an early stage.

Much difficulty can flow out of two important factors. Firstly, all partnership assets are held in effect on trust. Sometimes the partnership trust will overarch another trust, such as a trust for sale of land. Whereas normally it is quite difficult to establish or dispose of an interest in land without a convincing piece of paper, interests in partnerships which encompass land or other extremely valuable assets can be established or disposed of almost with a nod of the head, because the statutory code governing partnerships does not require written agreements in relation to partnership dealings. Recessions bring out the worst in people, and there are reported cases in which the ownership of valuable partnership assets has been decided on the basis of disputed oral evidence.

Secondly, whereas professional practices are adept at devising profit-sharing schemes, those schemes tend to focus on income profits, without regard to capital profits. Who is entitled to the capital profit on the sale of a part of a practice’s business, which it has built up over many years, and in what proportions? Recently appointed equity partners/members may point to the profit figure in the accounts (swollen by the sale to many times the normal size) and demand their agreed (income) profit share proportion for the year of the sale. Almost-retired partners who have taken a shorter week and a profit share cut in the run-up to retirement, but who contributed the most to the success of the business, will baulk at a lower share of the proceeds. Even if a capital profit is not converted into income shares, the default position regarding ownership of capital is equality, which may not fit the bill either.

Any practice, but particularly practices with profit shares that vary from year to year, and with partners coming and going, ought to have provisions dealing with how capital profits will be divided in the event that they arise. This is much easier to agree before there are any prospective capital profits, since it is only human nature to start spending sudden windfalls before they are carved up.

Indemnities

In a downturn, claims against a practice tend to increase.

Consideration should be given to the terms not only of indemnities given on exit, but also indemnities that are in place for the benefit of fixed share and salaried partners.

Agreements often deny indemnity in relation to a person’s own wrongful acts, unless they are “insured”. Where insured liabilities are covered by an indemnity, it must be made clear (but sometimes it is not) whether liability over the limit of insurance cover and/or the excess/deductible under the policy are to be borne by the person concerned, and what happens when a claim falls within the scope of the insurance (and in that sense is therefore “insured”) but cover is denied, for example for lack of timely reporting (which may not be the fault of the person who caused the original problem).

Arbitration clauses and restrictions on pursuing claims

The almost universal adoption of arbitration clauses means that most professional practice disputes are conducted behind closed doors. That is good for the practices, the individuals concerned and the professions as a whole, as the spectacle of professional men squabbling over substantial sums of money does not enhance their public image.

It also prevents exiting partners/members from using the threat of a public slanging match as leverage in negotiations.

In the case of LLPs, most practices will want to exclude the right to bring unfair prejudice petitions, and some may consider excluding members from pursuing claims against one another for breach of (any implied) good faith obligations. Whilst this opens up the possibility of minority oppression, some believe it is the lesser of two evils, given that disgruntled members can achieve a great deal of mischief if these rights are not expressly excluded. That said, after an initial retreat from good faith obligations between LLP members, there is now something of a revival, with practices often now inserting an express duty of good faith between members.

Conclusion

Dust off that deed!

 

If you are affected by any of the issues raised in this post and would like a confidential, no obligation meeting or telephone discussion to explore how I can assist you, please contact me.


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