The value of limited protection

The value of limited protection

Joint liability can leave partners bankrupt as claimants recover their losses. With the Big Four covering itself by becoming limited liability partnerships, it is only a matter of time before others follow suit.

With all the Big Four firms now trading as limited liability partnerships, can your firm afford not to make the change? The fact that partners are jointly liable for the firm’s debts, means that, if a claimant brings a successful ‘armageddon’ claim against your firm, and the claim is uninsured, it might result in the personal bankruptcy of every partner.

Those who were partners at the time when the negligent advice was given are directly exposed, even if they had no personal responsibility for the advice. The claimant can recover from any one of them, leaving him or her to recover from the others their shares of the loss under the partnership agreement.

Even retirement does not protect them if the remaining partners cannot afford to meet the loss. New partners, who were appointed after the negligence occurred, may also suffer indirect exposure. If the claim results in a loss occurring in the accounting year after they became partners, under the partnership agreement they will generally have agreed with the remaining partners to share that loss.

Even a person who is ‘held out’ as a partner, commonly known as a ‘salaried partner’, may incur a personal liability if the client can show that he relied on the fact that he was a partner.

Of course, engagement letters can often successfully ‘cap’ liability, provided the cap is reasonable. However, section 310 of the Companies Act 1985 still makes it impossible to limit liability for auditing work.

Clients may well be resistant to liability caps in many contexts, and no cap is available when no formal contract of engagement is in place; either because it has been overlooked or because the firm has ‘accidentally’ assumed a duty of care without entering into a formal engagement.

It is often argued that insolvency is not a risk in practice, because a claimant is generally better off to settle at a figure that allows the firm to continue to practise.

But what if the claimant is more interested in revenge than maximising his return? Even if the claimant is prepared to be business-like in his approach to settlement negotiations, these could take years. How is a firm to retain its best partners and attract new ones if the spectre of doom hangs over it?

Even if the spectre of ‘armageddon’ remains remote, will the firm be able to attract able new partners if its competitors offer the attraction of a limited liability structure, and it does not? Surveyors are already finding that this can be an issue. That is why so many firms, having looked very carefully at the risk profile of their clients and at the insurance cover likely to be available in years to come, are deciding to seek the protection of an LLP structure, despite the costs and disruption of conversion and the disclosure obligations.

Like a company, an LLP is a body corporate. When it contracts, the LLP itself is bound and not its members, so it provides protection in the same way as a company. Because the courts of most countries recognise the characteristics of corporations established in other countries, this protection is likely to stand up outside the UK as well.

Unlike a company, however, an LLP is tax transparent, so conversion does not normally create any of the tax problems associated with incorporation as a company, such as a cessation of the partnership trade, and employer’s national insurance on members’ future remuneration.

Succession to membership of an LLP can be dealt with in the same way as succession to a partnership, and there is no need to deal with transfers of company shares.

But as in the case of incorporation of a company, the protection of an LLP is not perfect, and care has to be taken to shore up its defences against the risk of an disasterous claim. Pre-incorporation liabilities will remain liabilities of the partners, even though they will normally be indemnified by the LLP. While it may be possible to persuade banks and landlords to release the partners in some cases, personal guarantees may be required unless the covenant of the LLP alone is acceptable. Obtaining releases for the partners will always require painstaking negotiation and will often come at a price.

An LLP member who is personally negligent may still incur liability to the client in tort, if he has assumed a personal duty of care and the client has relied on that assumption. At least, however, he should suffer no personal liability for the negligence of others.

Furthermore, at least the member himself will not be ’employed as auditor’ for the purposes of section 310, so it will be possible to ask clients to agree expressly in engagement letters that members and employees do not assume a personal duty of care.

Provided that the LLP is responsible for the advice, and properly insured, it is thought this kind of protection is likely to viewed as reasonable, and therefore enforceable despite the Unfair Contract Terms Act 1977.

It is also important to remember that, if an LLP does become insolvent, it may be possible for the liquidator to claw back amounts that have been distributed to the members. For example, members will generally make drawings on account of profits throughout the year. Those profits may have to be paid back if a claim notified in the latter part of the year means that there are in fact no such profits.

Finally, a claimant who is determined to recover from members personally may argue that the business of the partnership has carried on exactly as before and that the LLP is therefore really a sham, or that its members should be liable as if they were partners because they have been ‘held out’ as partners.

To counteract the sham risk, it will be important to make sure that all the steps necessary to transfer the partnership business to the LLP are carried out and that the LLP genuinely carries on its own separate business – especially if the partnership has to continue to practise in parallel as well as owing to some clients (for example, trade unions) insisting on personal liability for audits.

The ‘holding out’ risk can be reduced by making sure that every client is notified of the fact that partners have now become members of the LLP, and thereafter avoiding any reference to members as partners. If it is decided to call the members ‘partners’ because that term is so well understood, as many converted LLPs have done, it will be all the more important to use engagement letters, publicity material and notifications to clients to make absolutely certain that it can be proved beyond any doubt that every client must have known that the LLP was just that, and that the ‘partners’ were in fact members of the LLP.

With careful planning, an LLP can provide its members with a high degree of protection from all these risks. Every partnership therefore needs to give serious thought to whether it can afford not to incorporate as an LLP.


With the ultimate punishment faced by Andersen following its disastrous audit of Enron, more and more firms have either made the switch to limited liability status or are at the very least considering it.

In June this year, mid-tier firm BDO Stoy Hayward became another in a string of large UK accounting firms to vote in favour of adopting limited liability status. The firm will join Smith & Williamson, RSM Robson Rhodes and MRI Moores Rowland who have all taken on the new legal status.

A date for BDO’s changeover has not yet been agreed but it is expected to happen early in 2004.

Managing partner Jeremy Newman said the move to LLP status would provide some protection against ‘doomsday scenarios’ and was ‘a more modern way to conduct our business because it involves greater transparency’.

He added: ‘The requirement for audited accounts will not be a major change for the business. For our people and our clients, the change should be seamless’.

Big Four firm Ernst & Young became an LLP as soon as the law had passed on to the statute books in 2001, while KPMG, which had already sought to protect itself by incorporating its audit business in 1996, followed suit in 2002.

Nick Land, chairman of Ernst & Young UK, said: ‘The introduction of LLPs is an important step forward in beginning to provide a fair and reasonable measure of protection for businesses such as ours in a society where litigation is often seen as a way of avoiding or masking responsibility.’

Pricewaterhouse-Coopers became an LLP on 1 January 2003 and is due to release its first ever UK-only results within the next few weeks.

And newly rebranded Deloitte followed suit, becoming an LLP on 1 August this year. Deloitte’s chief executive and senior partner John Connolly said his firm’s reasons were founded in a need to ensure the firm’s attractiveness to employees.

Under the new legislation, only the partners directly involved in a negligence claim would face the possibility of personal bankruptcy.

The legislation has removed the concept of ‘joint and several’ liability which held responsible all partners of a firm even if they were not directly involved with any negligent work.

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