The myths and realities of LLP conversion

When limited liability partnerships (LLPs) became a viable business vehicle in early 2001, many people were naturally sceptical and based their approach to the possibility on a ‘why bother?’ attitude. There was, they argued, no point in converting because the limitation on liability for negligence would not work, and all major creditors, such as banks, would want personal guarantees. Clients, they argued, would not want their law firms getting out of possible liability by means of incorporation, and the requirements for financial disclosure were a disincentive, as groups such as staff and clients would make play of the profits to be revealed. Straightforward trading losses were simply not on the radar.

Now, seven years later and in the centre of the maelstrom of the financial crisis, opinions may differ, and those who took that attitude may reflect, when looking at their continued unlimited joint and several liability as partners, that they wish they had taken a more positive view.

Personal guarantees

It became apparent early on that banks were delighted by the prospect of being able to take debentures from their law firm customers. With security over book debts and work in progress, they were in a world familiar to them from their normal commercial work. Many commercial bank managers had frankly never understood partnerships, because specialist teams looking after professional service firms were then rare. The consequence was, and still is, that in very many cases those firms that have converted to LLP status have been able to do so either without any personal guarantees to their bank at all, or, at worst, have had to give limited and separate guarantees.

It does, of course, depend on the gearing of the firms and the normal financial ratios that will interest a firm’s bankers, but the reality is that members in many converted firms, if they now hit the buffers financially, will not have their personal assets at risk. Interestingly, it seems that in at least some cases, the banks’ criteria for lending to law firms have not changed during the chaos of the past few months, so it may still be possible to arrange matters for new conversions on the same basis.

One exception to that is likely to have been with regard to those firms that work from premises governed by commercial leases. There, personal guarantees are likely to have been required by landlords. Of course, that would have been the case if the partnership had converted to a limited company rather than an LLP. In other words, this is one liability that probably could not be avoided, whatever the regime. A well drafted LLP agreement will spread the liability of any such guarantees, which will probably only come from four of the LLP’s members, amongst the other equity members as well.

Claims against the business

Start talking to a room full of lawyers about risk and they will all instinctively think about negligence and professional indemnity (PI) insurance issues. There was a fear that the courts would not allow LLPs to be shielded against the full force of negligence claims, despite the fact that the government’s stated intentions when introducing the LLP legislation were to provide a regime that would give some comfort in the face of ever larger and more frequent negligence claims. Again, therefore, why bother?

In reality, although the case law is not as clear as it might be and has not directly tested the extent of the LLP shield, it does seem that a would-be claimant against an individual member of an LLP will have some major hurdles to jump. Even then, however, liability would only attach to that member, co-extensively with the corporate LLP. In other words, it would not attach to the other members personally.

Further, it would in any event be covered by the firm’s PI insurance. To the insurer, the risk is the same, and the extent of it is not varied by the identity of the defendant(s). So the only real area for concern is those areas where either insurance is not available (because the claim is higher than the aggregate of the LLP’s asset value and its insurance cover) or where claims are made and the insurer tries to recoup its expenditure when the LLP is insolvent (for example, premiums for run-off cover, or excesses on post-insolvency claims). There are some defences, perhaps by means of tailor-made further layers of insurance, but even if they are not available or chosen, the position must still be better than in the partnership scenario.

What is more, there are many types of claims that could be made against the firm that are not capable of being covered by insurance, but where the shield of an LLP should protect personal assets in the event of a wipe-out claim. One classic example is discrimination claims. These can crop up through a firm’s carelessness or simple ignorance of the myriad anti-discrimination laws, and be of devastating effect. With no limitations on the claims, and no insurance cover, structural defences such as incorporation may be the only effective response.

Client attitudes

It was initially thought that clients would see that firms seeking to convert were trying to weasel out of their potential liabilities. Happily – and possibly curiously – that does not seem to be the case. An early convert firm discussed the matter with major clients prior to conversion. Clients asked what the current situation was, and, on being told of the principles of joint and several liability, indicated they thought anyone operating under that system must be mad!

Perhaps, ironically, there is at least anecdotal evidence that clients see conversion as a plus, in that they expect modern, forward-thinking firms – which they hope their lawyers are – to be looking to convert. One firm’s commercial partner, when on a pitch for work against three rivals, was somewhat surprised when the query addressed to him was “we see the other three firms are LLPs, and you are not. Why not?” There seems no evidence that clients are troubled by conversion.

Staff concerns

Another key group of shareholders whose possible concerns were an initial worry were the staff. How comfortable would they feel? Again, with one specific exception, there is no evidence known to the writer of any concerns. The Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE) transfer is accomplished within the transfer documentation, and provided there has been reasonable communication with the staff, there is unlikely to be any concern. Indeed, many will not even notice.

One area where diplomatic efforts may need to be made is with regard to salaried partners, i.e. employees given the status of partners. Are they to be made members, in which case they will be taxed as self-employed (with significant resultant NIC savings) even if their contractual status remains that of employees? If they are to be members, should they be self-employed or employees? What rights should they have, and what indemnities may they need? If they are not to be members, what is to happen to them as far as titles and status are concerned? These are all issues that should be faced early on in the conversion process and talked through carefully.

Financial disclosures

Another area of early concern was the obligation for disclosure of the LLP’s accounts or, for small firms, some elements of them. Partners seemed to think that others would be concerned whatever they saw, i.e. whether they viewed profit levels as excessive, or troublingly low. The fact that hundreds of thousands of companies had operated successfully under these constraints for decades appeared to be ignored. For some this may remain a concern, but many now see this obligation as part of a growing (and welcome) trend towards transparency in the profession.

The obligation may, in any event, be mitigated by the ‘small business’ rules, if the LLP is of a size that would qualify as a ‘small company’. The limits have recently changed. Two out of three boxes have to be ticked. The one that law firms are likely to fail first, because of their configuration, is the requirement to have 50 or fewer staff. Very many, however, will be able to tick the other two, namely turnover of less than £6.5m and gross balance sheet assets of less than £3.26m. If they do, then their obligations will, broadly, be limited to filing an abbreviated balance sheet – an anachronism in a world of transparency, which surprisingly survived the Companies Act 2006, and tells the reader remarkably little.

Further, such firms are unlikely to need to have their office accounts audited. This may not, however, be as much of a plus in the long run as it may first seem. Certainly, it will reduce the annual accountancy bill, but in the world after the implementation of the Legal Services Act 2007, those firms that will be looking for financial tie-ups with businesses outside the legal sector may find that audited accounts would be welcomed as giving a greater degree of assurance as to the firm’s financial position.

Insolvency

It may be that some law firms, especially if they have been concentrated on the property sector, will be starting to have to face up to the possibility of the insolvency of the business. What then is the position of an LLP? The starting point is that it does just what it says on the tin – it limits the members’ liability to their investment in the business. Oddly, even that investment may be capable of being protected.

It has been clear from the start that positive balances on members’ current accounts, and any loan accounts, are debts due from the corporate LLP to the individual members. The members should therefore be able to prove for those amounts as unsecured creditors. Furthermore, the amended Statement of Recommended Practice, issued in 2006 by the Consultative Committee of Accountancy Bodies, states that even members’ capital accounts, if they are repayable to the member on his departure (death, retirement etc), are to be classed as a debt in the balance sheet. Why then should this not be identical in nature to the members’ other interests?

Also, why should those interests not be capable of being secured? In other words, is there anything to stop members arranging for the LLP to grant them debentures to secure their investments? To the writer, it seems not. Of course, such debentures may need to be subordinated to bank security, but they may well come ahead of all other debts.

There is one chink in the LLP’s armour on insolvency. Section 214A of the Insolvency Act 1986, which applies to LLPs only, creates an extension to the normal regime of prohibitions on disposals at an undervalue, preferences, wrongful trading, and so on. Nicknamed the ‘claw back’ provision, its (very badly drafted) provisions broadly state that if there is an insolvent liquidation, the liquidator may seek to persuade a court that a member took from the LLP, at any time within the two years prior to the onset of liquidation, a ‘withdrawal’ at a time when he knew, or ought reasonably to have known, that the business was or would become insolvent, and would be unable to trade out of that insolvency. If he can substantiate that, the court has a discretion to order that the withdrawn sums be paid back. This clearly is a lessening of protection, but it may not in practice be that daunting, particularly when viewed against the backdrop that any liquidator who would like to make such a claim will first have to persuade a creditors’ committee to fund the litigation – for which he will need crystal clear chances of success. In any event, it still does not even approach the extent of the perils of unlimited joint and several liability.

Conclusion

For many, the question of ‘why bother?’ will by now have changed to ‘why not?’. With the spectre of business losses looming, many will be casting around for whatever protection they can get. Several thousand firms have already converted, and more are geared up to do so next April/May, at their financial year ends. It is to be hoped, for their sakes, that they have not left it too late.

Simon Young is a solicitor and the founder member of the Law Consultancy Network. He can be contacted at simon@syoung.co.uk