Financial liabilities for LLP members: how limited?

OVER THE LAST FEW YEARS, times have been difficult for professional service firms. In the legal and accountancy sectors we have seen some high profile collapses such as Vantis and the law firm Halliwells.

Speculation continues as to the number of professional service firms in intensive care with their banks. What does this all mean for the individual partner of the firm? Will he or she be personally liable for the firm’s financial liabilities? Many professional service firms now operate as limited liability partnerships (LLPs) and therefore the risk of personal liability for a member is very low, but there are still some risks which members of LLPs may be unaware of.

The good news is that, unlike partners in general partnerships who are jointly and severally liable for all the debts and obligations of the firm, LLP members enjoy limited liability. The liability of an individual member of an LLP is limited to the sum, if any, which he or she agreed with the other members to be liable for on the winding up of the LLP.

So, on the face of it, everything is clear and simple. As a member of an LLP one can rest assured that, during difficult economic times, any personal assets will be safe from the claws of creditors as liability is on the whole limited. This will be particularly reassuring to those members of an LLP who are not actively involved in management and may not be aware of the LLP’s financial health.

However, there are a few important exceptions to note. The insolvency regime for LLPs is broadly the same as for companies. Members of an insolvent LLP can be liable for fraudulent or wrongful trading in the same way as directors of a company.

Worse still, there is a specific “clawback” provision in section 214A of the Insolvency Act which applies only to LLPs. Members can be asked by a liquidator to repay drawings or other payments received from the LLP during the two year period prior to the insolvent liquidation of the LLP if such members knew, had reasonable grounds for believing, or ought to have known, that the LLP was unable to pay its debts at the time the monies were paid.

Anyone who was a member of the LLP during this two year period is vulnerable, whether or not he or she has since left the LLP or the decision to make the payment was made by others, i.e. management.

It is unclear whether, in an insolvent liquidation, a non-management member who was never involved in the LLP’s financial management “ought to have known” that the LLP could not pay its debts. The legal test for what a member ought to have known is what would be known or ascertained by a reasonably diligent person having both (a) the general knowledge, skill and experience that may be reasonably expected of a person carrying out the same function as the member and (b) the knowledge, skill and experience that member actually has.

This has remained largely untested by the courts in relation to LLPs. There is speculation that the liquidator of Halliwells, the insolvent law firm, may bring claims against all the former partners.

Effectively, the liquidator can do so because there is no fundamental difference, in law, between owners and management in an LLP, which is not the case in respect of companies (i.e. directors and shareholders). Most commentators, however, would expect the Courts to take into account the management structures of a firm and its size when considering an application from a liquidator.

Larger firms will typically delegate key financial decisions to a board or committee comprising a small number of members. It is these members who are likely to be subject to a more rigorous test.

This does not mean other members, even fixed share partners, should simply disregard the risk of clawback or wrongful trading. Until the Courts provide some guidance, it cannot be assumed that it will be a defence to simply argue that one was not privy to the financial information. For now, the risk remains that the Courts may determine that any member ought to have known the financial condition of the LLP.

There are other risks which may be more prevalent during uncertain economic times which may further threaten the limited liability of an LLP member. For example, personal guarantees may have been given by members, at the time of conversion to LLP or on incorporation, to either a landlord or bank.

This would have depended on the financial condition of the LLP at the time. If the LLP fails to meet its financial obligations, it is possible that the landlord or bank could enforce their guarantees against members in addition to, or instead of, enforcing security given by the LLP.

In tough economic conditions the risk of permitted drawings exceeding profits increases. An LLP members’ agreement may provide for the immediate repayment of excess drawings.

A cautious drawings policy is advisable, as well as the flexibility to allow excess drawings to be rolled over as a first charge against subsequent year’s profits.

Members should also check the terms of their members’ agreement to see how trading losses are dealt with. Most agreements will either allocate losses to a reserve account in the balance sheet or allocate the losses between members up to a capped amount. The allocation of unlimited losses between members will, however, undermine the limited liability of the LLP.

On the whole, the limited liability of members of a UK LLP remains robust, but we are waiting to see how this will stand up where a rigorous liquidator believes there has been insolvent trading. The message, therefore, is for all members to keep a close eye on the LLP’s financial health, request financial information and ask for answers where matters are unclear.

Miguel Pereira is a partner in the Partnerships & LLPs team at Lewis Silkin LLP

Image credit: Shutterstock

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