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.
I have just done a complete re-write of my own standard LLP agreement, and I'm confident it's the best around. Even the published precedents are poor. So let me know if you want the best structure for an LLP and the best protections for the members.
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