Points for Property Professionals 1

Undue influence in lease guarantees  

This is the first of a short series of notes on non-property legal points relevant to property lawyers and others in the property industry.

Landlords of commercial premises often require personal guarantees of the tenant’s obligations. But landlords may not be aware that a guarantee procured by “undue influence” by a third party, even without the landlord’s knowledge, may be unenforceable. This applies to guarantees of leases just as it does to bank guarantees, as the landlords found to their cost in the recent case of Trustees of Beardsley Theobalds Retirement Benefit Scheme v Yardley .

For years now, banks have been aware they need to make sure that guarantors get independent advice where there is a manifest disadvantage to the guarantor in giving the guarantee: Royal Bank of Scotland v Etridge. The bank loses out if the guarantee is procured by fraud or undue influence (for instance of a husband or boss), if the bank should have taken steps to ensure that there was no undue influence. Usually it does that by requiring separate legal advice to the guarantor. But landlords have typically not taken the same approach.

In Beardsley Theobalds the guarantor was an employee of the tenant company. A director falsely represented to the landlord that the employee was a director, and the landlord did not check. The director then got the employee to sign the lease without telling him what it was, and only showing him the signature page.

The judge held that the guarantee was unenforceable. It had been procured by undue influence, and the landlords had not taken precautions against that possibility, such as insisting on independent legal advice. The landlords had “constructive knowledge” of the undue influence, because the landlord was aware of the tenant’s precarious financial position: it was obvious that giving the guarantee was disadvantageous to the guarantor, so the landlord should have been aware of the risk that the guarantor was subject to undue influence. The landlord should also have been aware (though the judge’s reasoning for this is not stated) because the landlord could have checked whether the guarantor was a director. “They should therefore have checked that the proposed guarantor was financially sound, aware of the risks being undertaken and in full agreement with the proposal that he was to guarantee the rent for a fifteen-year period. The guarantor should have been asked to acknowledge in writing that he was fully in agreement to become a guarantor and had been made aware of the risks of signing the guarantee. He should also have provided, through [the tenant], a signed acknowledgement from a solicitor that he had been given appropriate advice before agreeing to sign or a signed waiver of the need to take such advice.”

Unusually, the judge also accepted a defence of “non est factum” (not my deed), available only when the person signing is completely unaware of the nature of the document he is signing. He also allowed a defence to the effect that the guarantor had not authorised the delivery of the deed in escrow, under which it awaited the satisfaction of conditions for two months, which the tenant struggled to fulfil. This last point has wider implications, since parties and their solicitors often fail to consider the authority of parties to deliver deeds and the need for their agreement to any escrow.

The risks to a landlord – or anyone else relying on a personal guarantee – can be reduced by:

·         placing a clear warning just above the signature space about the nature of the guarantee and the need for legal advice

·         putting the guarantee in a separate document (though this could have other implications if it is to benefit the landlord’s successors in title)

·         making sure that the guarantor has a clear financial interest in the tenant company so that the guarantee is not manifestly disadvantageous to the guarantor

·         treating the guarantor as a separate party and not assuming that the tenant or its solicitor has authority on behalf of the guarantor, eg for completion arrangements

·         checking the identity, relationship and financial standing of the guarantor, and his signature

·         insisting that the guarantor gets independent legal advice, providing information about the nature of the liabilities to the legal adviser and getting written confirmation from the legal adviser that he has given the advice.

When the music stops

Common mistakes in LLP agreements  

A limited liability partnership [1] is fairly free-form:  very little in its constitution is prescribed by law. The members of the LLP have to draw up their own agreement, carefully crafted by their lawyer. But with a few years of experience of LLP’s, some fairly basic problems are emerging that could come mean trouble for professional firms established as LLP’s.

At first, lawyers asked to draft an LLP agreement had little to go on. The temptation was just to adapt an existing partnership agreement, perhaps with a few clauses added from a company’s articles. But LLP’s are quite different from traditional partnerships, or from companies. Partnership law does not apply. [2]

Calls, contributions and over-drawing

In a partnership [3], the firm can call on the partners to contribute cash. Even without a power in the partnership agreement, the right is implicit: partners are personally liable for the debts of the firm, and they can recover from each other any outlays they have to make beyond the agreed capital. Losses are shared amongst the partners in an agreed ratio. Many draftsmen, including in some of the commercially-produced precedents, carried this forward into the LLP agreement. They said that members had to share losses of the LLP, and could if necessary be called upon to contribute to them in cash. That may be fine for small sums while the LLP is trading normally, but it potentially drives a coach and horses through the limited liability of the LLP. Say the firm closes and goes into liquidation – it will show a loss equal to the deficiency in its assets. If members are obliged to contribute to losses, the liquidator can ask them for a cheque to cover all the debts.

On the other hand, if there is no requirement to put in cash, other members can lose out. It’s not uncommon for members’ accounts to get out of balance with one another, either for good reasons or due to some manipulation or default by a member, who may have over-drawn or failed to contribute his capital. If the LLP cannot claim the money, the other LLP members may lose out. Members of the LLP do not usually expect the limited liability to be used to avoid sharing the pain equally!

Ideally you need limited obligations to put money into the LLP, which might end if the LLP ceases trading or goes into insolvency, coupled with rights between the members so they can recover any inequality in their receipts and contributions from each other. If the LLP goes into insolvency, the members do not have to make up the deficiency to the LLP, but they make payments between themselves to equalise their losses. But in running the LLP, you also have to be aware of the limited liability of the members. An overdrawn current account or capital account may not be recoverable as a debt, and could represent a loss that will end up being shared amongst the other members.

This is all subject to section 214A insolvency Act 1986 [4] which makes members of an LLP liable to repay all withdrawals form the LLP in the two years before insolvent liquidation, if they knew or had reasonable grounds to believe that the LLP was unable to pay its debts.

Minority oppression and fiduciary duties

Partners in a partnership owe each other fiduciary duties of good faith. Directors of companies owe similar duties to the company, on behalf of its shareholders. What is the equivalent in an LLP, if the LLP agreement says nothing, or excludes fiduciary duties? It was not clear for the first 10 years of the LLP Act, but F&C Alternative Investment (Holdings) Limited v Barthelemy has finally decided that there are no fiduciary duties owed by LLP members to each other, or to the LLP. The members can act purely in their own self-interest, except when they are entering into transactions on behalf of the LLP.

But LLP members who manage the LLP, effectively as directors, can and will have fiduciary duties to the LLP. That is because, as with partners and directors, the fiduciary duty comes from the agency arrangement: a person with control over the affairs or property of someone else, such as a director managing a company on behalf of its shareholders, owes a fiduciary duty.

That still leaves individual members of the LLP exposed, because the fiduciary duties are owed to the LLP, not the members. What if a minority of members is bullied by the majority? Part of the gap should be filled by section 994 of the Companies Act, the “unfair prejudice” remedy, as modified for LLP’s. But unlike a company, an LLP can exclude its members’ section 994 rights in the LLP agreement [5]. Lawyers acting for the LLP may have done that without thinking about it. That potentially leaves individual members with very few rights to combat oppression.

Not having an LLP agreement

Always have an LLP agreement! The issues above are insignificant compared to the problems arising when there is no written LLP agreement. Every active LLP should have one. It is the basic constitution of the LLP: unlike a company, there is no default set of articles that will fill most of the gaps. The default provisions for LLP’s are totally inadequate. The recent case of Eaton v Caulfield [6] provides a good illustration: full-blown litigation over what the agreed terms of the LLP were, with the judge deciding that in most cases the parties had not managed to exclude the default provisions.

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[1] Formed under the UK Limited Liability Partnerships Act 2000

[2] Section 1(5) Limited Liability Partnerships Act 2000

[3] Governed by the Partnership Act 1890

[4] Inserted by the Limited Liability Partnerships Regulations 2001

[5] Regulation 48 of The Limited Liability Partnerships (Application of Companies Act 2006) Regulations 2009

[6] [2011] EWHC 173, see this article

Another blow to ESC C16

Informal winding-up made more difficult

(revised 7 February 2012)

When solvent companies have ceased trading, they often want to distribute their assets without the expense of a formal members’ voluntary winding-up. HRMC’s concession C16 [1] allows companies to be struck off the register under the Companies Act [2] without a formal winding-up, whilst treating the distribution of assets as a distribution in a winding-up (taxed as a capital gain) rather than a taxable dividend.

But when the concession is put on a statutory footing it is to be limited to distributions not exceeding £25,000. The policy justification for this is not clear (vague references to "abuse"), but it means far more solvent liquidations and more fees for insolvency practitioners. And previously (when this article was published in its origianl form) the Treasury Solicitor’s office announced that it has withdrawn its BVC17 guidelines. The guidelines said that the Crown would not seek to recover share capital distributed to shareholders before a company's dissolution if the company has been struck off, the shareholders had taken advantage of HMRC's extra-statutory concession C16, and the amount of the distribution was £4,000 or less.

Returning the share capital, share premium account or capital redemption reserve to shareholders is an unlawful reduction of capital for company law purposes, and the company has the right to recover it. When the company is struck off, its property, including the right of recovery, vests in the Crown (or the Duchy of Cornwall or Duchy of Lancaster) as bona vacantia [3]. The Crown does not routinely pursue all these cases, but the risk is there, and it makes it difficult for professionals to recommend this route.

Under the BVC17 guidelines, it was safe to proceed if the amount involved was less than £4,000. The fact that the guidelines are being withdrawn suggests that some cases involving less than that amount may be pursued in future.

The justification given given was that the Companies Act 2006 procedure for reduction of capital out of court can be used instead. That is true: the new reduction procedure is extremely flexible and useful, but it does involve some documents and professional costs. It needs both a special resolution and a declaration of solvency by the directors. I have done many reductions of capital under the old and new procedures, and the new ones are far easier and cheaper, but there is still a cost involved. This is more cost and formality for small businesses, at a time when the Government is supposed to be reducing it.

There had already been some speculation that the usefulness of ESC C16 was ending [4], and this two changes are further nails in the coffin. Perhaps IP’s and accountants advising on striking off businesses under C16 should equip themselves with a set of legal documents to carry out reductions of capital without a large increase in costs; but those exceeding £25,000 of distributable assets will need to be done by way of formal winding-up, once the current draft Order comes into force.

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[1] http://www.hmrc.gov.uk/specialist/esc.pdf at page 62, likely to be replaced by legislation following a recent consultation

[2] Companies Act 2006 sections 1000 et seq

[3] Section 1012 Companies Act 2006

[4] See this AccountingWeb article