Critical issues firms should address in their partnership or LLP agreement

All firms should be reviewing their operations, workforce and finances, and implementing measures for business continuity and to ensure financial resilience during the economic and operational challenges presented by the coronavirus pandemic.

As part of this review, firms should also check that their partnership or LLP agreement provides the necessary management powers and business protections to deal with the challenges of working capital and cash flow management and departing and under-performing partners.

Managing these issues are challenging in normal times but especially so now. Firms that do not have adequate protections and powers in their partnership or LLP agreement are vulnerable to unnecessary disputes, financial loss and potential damage to their brand (all of which can make it tougher for the firm to bounce back from the economic effects of the coronavirus) and, in the worst case scenario, insolvency.

All firms need to urgently focus on the following critical issues:

1. Cash is king now more than ever

Many firms are or will experience a cash crunch created by a decline in new business and existing clients taking longer to pay or being unable to pay. The priority is to preserve cash so that the firm can pay its fixed costs and other essential outgoings.

Common measures taken by firms in relation to its partners include reducing monthly drawings, deferring the payment of any undistributed profits and even reducing fixed profit shares. However, these measures may only be taken if the firm has the power to do so under its partnership or LLP agreement. If not, it is likely that the approval of all partners will be required, which may be problematic if the partner approval process is slow or partners are unwilling to agree to the proposed changes.

Firms may wish to generate cash through additional partner capital and/or external financing. This will also require specific powers under the partnership or LLP agreement and problems can be avoided if management has the power to raise a certain level of funding without seeking the approval of all partners.

Cash will be quickly drained from the firm when a partner leaves the firm. The firm may be obligated under the partnership or LLP agreement to repay an exiting partner’s capital, tax reserves and undistributed profits soon after the partner’s leaving date. The firm will face serious financial trouble if too many partners leave simultaneously or within a short period of time. This can be avoided if the partnership or LLP agreement contains a power to enable payments to outgoing partners to be deferred for a specified period or paid in instalments. Alternatively, the firm may rely on restrictions on the number of partners who can leave in a specified period.

2. Avoid a partner exodus

During this difficult time, most firms cannot afford to lose high performing partners. Partner exits (and the consequent loss of capital, existing and potential clients, income and knowledge) can be decelerated by including the following provisions in the partnership or LLP agreement:

• Notice period: notice periods for voluntary retirement in accountancy firms typically range between three and 12 months. Firms should consider whether the current notice period is sufficient to protect the business.
• Waiting lounge: multiple and simultaneous partner departures (such as a team move or mass exodus of partners) can de-stabilise the firm and result in a significant capital outflow. A “waiting lounge” provision is designed to tackle this by preventing more than a specified number or percentage of partners from leaving during in a specified period.
• Restrictive covenants: to safeguard the firm’s goodwill, restrictive covenants applicable to former partners need to be reviewed to ensure that they are enforceable under the current law.
• Garden leave: garden leave enables the firm to lock a partner out of the business during their notice period and gives the firm the opportunity to consolidate and transition client relationships.
• Good/bad leavers: these provisions can encourage good behaviour by departing partners (eg compliance with restrictive covenants) and penalise those who breach their obligations by deferring any payments due to the bad leaver over a longer period or setting-off any damages suffered by the firm against the bad leaver’s financial entitlements.

3. Robustly manage partner performance

Management may be firefighting on various fronts, but they cannot afford to lose their eye on the ball when it comes to managing partner performance. Firms should review their partner KPIs and performance assessment policies to ensure they are still appropriate in the current circumstances.

As cash management is critical, management may need to bear down on partners who are not actively managing their WIP, billing and collections. Incorporating these financial performance metrics in partner KPIs is crucial, as is holding partners’ feet to fire by a rigorous appraisal process.

Firms also need power under the partnership or LLP agreement to penalise under-performing partners (e.g. by reducing points or fixed profit shares, de-equitisation and/or compulsory retirement).

4. Be aware of potential unlawful discrimination

All firms must be mindful of the laws protecting partners against unlawful discrimination when introducing or exercising powers in the partnership or LLP agreement.

It is not uncommon for partners who share protected characteristics (such as sex, disability, age or pregnancy) to be unintentionally disadvantaged. Common risks areas include:

• Suspension or reduction of profit shares during periods of absence, which may discriminate against those who are on parental leave or sick leave.
• Expulsion of a partner who is unable to work for a prolonged period of sickness may amount to disability discrimination if the absence is a consequence of a disability.

CM Murray will be following up on these issues with a live online Q&A session on Critical Actions for Law Firms and other Professional Services Firms to Weather an Economic Downturn. For further details, please go to www.cm-murray.com.