Ethics and new lawyers

How are bad apples getting into the barrel?

A solicitor, qualified in 2017, forged a decree absolute for a client's divorce, and got two clients to pay fees of around £1,600 each into her personal account instead of to her firm. 

What has happened to the intake of my profession? I am disturbed at a case like this one - a very junior solicitor abusing her position in blatant but, in terms of the gain involved, minor ways. Solicitors should have such a thorough grounding in ethics that no-one could be any doubt that doing these things was completely wrong. There may be some malicious individuals who train as lawyers in order to subvert the legal system, but surely they target clients in organised crime or look to pull off some large fraud? Why would you go through all the hard work stress and cost of qualifying only to throw it away? Are there really people passing all those exams who who have no moral commitment to their clients and are also too stupid to realise the inevitability of these petty offences being discovered, or the inevitable penalties?

Do students no longer get the moralistic grounding I got from my chain-smoking ethics lecturer, dismissing any departure from the highest standards as "very shoddy"?

 

Or is it that we are not looking after our young people well enough? Is there more to be done to protect mental health and make sure that those we trust to administer justice can cope with the pressures put on them?

Solicitors' ethics: the client or the public?

How should lawyers deal with disreputable instructions?

The Solicitors Regulation Authority has published another warning about solicitors becoming involved in dubious investment schemes, after recent cases led to the closure of seven firms and other regulatory action. This rightly highlights the welcome change of attitude we solicitors have had to make. 

It used to be that we represented the client's interests without regard to any wider morality, so long as we were not knowingly participating in criminal conduct or misleading the court. Now, we are required to have broader ethical standards and to have a duty to the public. I'm glad about that. 

Lawyers are now expected to carry out some due diligence and assure themselves that their clients are behaving legally, rather than just accepting the assurances and half-truths clients my give them. The public may assume, rightly or wrongly, that because a solicitor is involved, the investment is legitimate or money is protected.

Professional ethics grew up in the admirable tradition that solicitors represent their clients fearlessly and independently, and that everyone is entitled to legal advice. Solicitors rightly represent people accused of crimes or wrongdoing without allowing personal feelings to cloud judgement, drawing the line at actual knowledge: if you don't know your client is guilty, you can and should represent him in court. But in transactional matters we need a more rigorous approach that avoids actually assisting in schemes that are suspicious or disreputable. The fearless and independent advice is then that the client should not do it. 

Forfeiture of partnership and LLP profit shares

Having your slice and eating it

A partner can potentially forfeit all part of his profit share if he breaches his fiduciary duties, according to a recent decision of the High Court. That comes as a surprise to many partnership lawyers, and has some interesting implications for partnerships and LLPs.

Hosking v Marathon Asset Management LLP was an appeal on a point of law from the decision of an arbitrator, so the court was only asked whether forfeiture was possible in principle. The court did not have to decide on the details of how it would work, either generally or in this particular case, so there is a lot of room for interpretation. The judge did quote with approval Snell’s Equity saying “a fiduciary's fees may not be forfeit if the betrayal of trust has not been in respect of the entire subject matter of the fiduciary relationship and where forfeiture would be disproportionate and inequitable.”

A fiduciary is a person in a particular position of trust, such as a trustee, a director or an agent. In other contexts, it has been held that a fiduciary who breaches his fiduciary duties forfeits any right to remuneration for performing them. Most of the cases concerned agents, as in Imageview Management Ltd v Jack, where a footballer’s agent negotiating for a player to join Dundee United made a secret deal with the club for his own benefit, and forfeited his commission. Most of the cases concerned dishonesty.

In Hosking the arbitrator found Mr Hosking guilty of a series of serious breaches of his fiduciary duties to his LLP, largely by making preparations to leave and compete with the LLP. In that particular LLP, full-time working partners got twice the profit share of non-executive partners. Because of this, the arbitrator concluded that 50% of the profit share should be regarded as remuneration for executive services, and ordered it to be forfeited for the entire period in which Mr Hosking was in breach of fiduciary duty. This amounted to over £10 million.

The effect on partnerships and LLPs may be surprising:

• Unlike a straightforward agency, the roles and responsibilities of partners are very complex. Everything a partner does is governed by his fiduciary duties to his partners or his firm. The arbitrator equated the whole of a partner’s share attributable to his work in the LLP with remuneration for performing his fiduciary duties, and said it was "proportionate and equitable" that he should forfeit the whole amount. As well as acting in breach of his fiduciary duties, Mr Hosking must also have performed his duties to a very considerable extent during that period, for the benefit of the LLP and his partners. He got no credit for that work. Was the betrayal of trust really “in respect of the entire subject matter of the fiduciary relationship”? Did it really “go to the whole contract”? 

• The compensation awarded against him for the actual breach seems to have been £1.38 million, so the forfeiture was worth many times the proven financial loss. Can that really be "proportionate and equitable"? 

• The forfeiture period was only four months. What if the breach of fiduciary duties had lasted much longer, perhaps his entire career with the LLP? Would he still have lost all his remuneration for the entire period? 

• Is it fair or realistic to characterise a profit share at a rate of over £30 million a year as remuneration for executive services? Where do you apply for a job like that? 

• A partnership or LLP agreement will not normally attribute a proportion of profit share to remuneration of working partners. It may have a formula which appears to show working partners getting more than others, but the reasons behind that may be varied and complex. Even if the profit share includes a fixed salary, you cannot always conclude that it represents the partner’s remuneration for performing fiduciary duties, or for working for the LLP. Some partners contribute their work, some capital, some contacts or know-how, or in most cases a mixture of all of them; the maths of how their shares are calculated will rarely be a guide to valuing these separate contributions. 

• Does the operation of forfeiture really depend on how partners structure their agreements? If there is a fixed share, often called a “salary”, is that going to be seized upon as remuneration? If partners get interest on their capital, is the rest of their share “remuneration”? If all partners get different shares, can you infer “remuneration”? What if they all get the same, but some do more work than others? What if shares depend on personal contribution, such as personal billings, or on management responsibilities? 

• In a partnership or LLP, the profit shares must go somewhere. They must still add up to 100%. If the profit share is forfeited, what happens to it? In this case the arbitrator said that it would fall into the general pool and be shared, including by Mr Hosking, according to the partners’ remaining entitlements. That result is a bit random: if there had been only one other partner, Mr Hosking would have received back half the amount he forfeited, under his remaining profit share. But if the arbitrator had held that he forfeited only half his remuneration, or that the “remuneration” element was less, he would then have got back a larger proportion of the forfeited amount. 

• What if the partnership or LLP agreement makes no provision for the sharing of the amount forfeited? What if all other partners were on fixed shares? 

• Partnership disputes typically involve a wide range of allegations and counter-allegations. What if all the partners had been in breach of fiduciary duties, perhaps in different ways and different degrees of seriousness? Would they all forfeit their profit shares, and where would they go? The potential for forfeiture is likely to create enormous arguments in partnership disputes as each partner claims that the others should forfeit all or part of their profit shares.

• What if some partners are complicit in the breach of duty? Do partners forfeit their shares as against some partners but not others? Do they forfeit shares to each other? If all but one of the partners are guilty, does the innocent partner get 100%?

• We seem to have slipped from forfeiture for “dishonesty” in the early cases to forfeiture for any breach of fiduciary duty in Hosking. In a commercial context, such as partnerships and LLPs, there really has to be more allowance for the realities of business life. Forfeiture is a punitive measure, not a compensatory one, and gives a windfall to the injured party even if all his losses have been made good. Bad behaviour, short of criminal fraud, does not normally have this effect.

At least the judge accepted that the partnership deed or LLP agreement can exclude forfeiture. I have already modified my standard forms (I immodestly think my LLP agreement is the best there is!) with a clause you can have for free: “Without prejudice to any other remedy for any breach of fiduciary duty or of this agreement, no part of the profit share of any Member is liable to be forfeited under the principle of equity that a fiduciary may forfeit remuneration due to his breach of fiduciary duty.”

Partnerships and LLPs are a business arrangement founded on contract. In my view there should be limits on how far equitable principles should intrude into partnership law. Enforcing fair dealing and openness between partners is essential, but this decision seems to go too far. 

Proportionate liability clauses upheld

Need a small slip make you liable for the whole loss?

For many years, businesses have been trying to limit liability according to their fair share of the fault.  Among the first to argue for "proportionate liability" were the big accountants, who are regularly sued over corporate failures because their insurers had deep pockets. The issue frequently arises in the constructions industry, where there are often several firms of contractors and professionals who might share responsibility for a fault or delay.

In most cases, where there are two or more possible defendants, they will be jointly and severally liable for the loss. that means the claimant can sue any or all of them, and recover the whole of his loss from the chosen defendant, leaving the defendants to sort out contributions amongst themselves. that can be very unfair to defendant if the others have gone bust or disappeared. In the very worst cases it can even make claimants careless about the choice of contractors: so long as they have one solid defendant, they need not worry about the competence or financial strength of the others.

"Net contribution clauses" have often been inserted in contracts, but lawyers have doubted whether they worked. Now the Court of Appeal has confirmed that they do - even in consumer contracts.

In West v Ian Finlay & Associates a very simple term was held to work: "Our liability for loss or damage will be limited to the amount that it is reasonable for us to pay in relation to the contractual responsibilities of other consultants, contractors and specialists appointed by you". The clause protected an architect from liability for the part of the claimant's loss fairly attributable to defective work by the (insolvent) building contractor. It survived challenges under the Unfair Terms in Consumer Contracts Regulations and the Unfair Contract Terms Act 1977.

All businesses which could potentially share liability with others should review their contract terms and consider whether they should be using a net contribution clause. That includes most businesses in the construction industry and most professional firms. It remains to be seen whether the same approach can be extended to exclude liability for the defaults of your own sub-contractors.

Consumer credit licences all expire

If you haven't acted, your consumer credit activities are now illegal

All licences granted by the OFT under the Consumer Credit Act 1974 lapse at midnight tonight. That includes the group licence granted to all solicitors.

 

From tomorrow (1 April 2014), consumer credit businesses - including ancillary activities such as credit brokerage and debt collection - require authorisation by the Financial Conduct Authority. If you haven't already applied for interim authorisation, you will need to stop carrying on the regulated activity until you have gone through the application process - likely to take some months.

 

There is no general permission for solicitors, so those engaged in consumer credit activities, including debt collection from consumers, now have to be dual-regulated by the FCA and the SRA (and pay two sets of fees for the privilege). Will consumers be any better off? No, of course not.

Negligence: staying out of the firing line

Shared responsibility in a professional team

Professionals work in teams, formally or informally, on all sorts of projects. Where something goes wrong, it may not be clear that one professional firm is solely responsible.  One professional may have relied entirely on another to do his bit, either by agreement between them or because it naturally fitted in the other's area of expertise; or one may have appointed the other to assist. Successive advisers may have made the same mistake. Two advisers may assume that each other are dealing with an issue. If work or advice has been negligent, the client will be tempted to sue all parties and let them fight it out amongst themselves. It may come down to assessing the contributions to be made by different parties.

In Flanagan v Greenbanks Ltd (t/a Lazenby Insulation) & Cross two successive firms carried out negligent surveys to assess suitability for cavity wall insulation. The Court of Appeal said that both were liable: the negligence of the later survey had not absolved the earlier one of responsibility, nor could the second firm assume that the first had done its work correctly without checking.

Firms can improve their position if sued by including suitable terms in their conditions of engagement - subject always to the usual considerations on limitation and exclusion clauses, especially in consumer contracts. Something like this can help:

"Where other professionals are engaged by you or on your behalf (including any predecessor of ours), we will be entitled to rely on the work and advice of those other professionals and to assume that they have carried out their work with due care and skill and to all relevant standards. We will not be responsible for checking or re-doing their work, or for checking their instructions, assumptions or conclusions, unless specifically instructed to do so, and then only to the extent falling within our area of expertise. We may review or comment upon the work of other professionals where we consider it appropriate but we will not be obliged to so and by doing so we do not assume responsibility for such work. Where we engage or recommend other professionals, our responsibility for their work is limited to selecting professionals whom we believe to be reasonably suitable for the purpose. Where we engage such professionals with ourselves as principals (and not as your agents) our liability for loss or damage arising directly or indirectly from their act or default (including negligence) is limited to the amount we are actually able to recover from them. If we recommend the engagement of other professionals but you decline to do so, we will not be liable for any loss or damage which would have been avoided had such professionals been engaged."

Of course it also helps if the roles of the professional teams are clearly defined, and if each member has a proper definition of its scope of work and terms of engagement. Specifically exclude from your scope of work any high-risk areas you don't regard as part of your role, and adapt your contract terms carefully to each situation.

Valuing partner contributions

Fame at last: published in Solicitors Journal

I have had an article published in Solicitors Journal (25 November 2013) about valuing partner contributions in law firms -http://www.solicitorsjournal.co.uk/management/business-development/finders-minders-and-grinders-working-out-attribution-system-between- (but you have to be a subscriber or to sign up for a trial to read the full article). 

It argues that different partners perceive value very differently, that it's easy to over-estimate the importance of any individual, and that firms have to be careful not to reward more than once for each £1 of profit earned, and to know whether they are recognising achievement only in the current year, or for an entire career.

It's a privilege to talk to your lawyer

Privilege and withholding embarrassing documents

Are you heading for a legal dispute? Or do you deal with sensitive issues that could be pored over in court later? You should be aware of the law on disclosure of documents and the implications of privilege.

The normal rule in any civil dispute, including tax cases, is that both parties must disclose documents which support or adversely affect any party’s case. Failing to disclose documents, or destroying them (including deleting emails) may be punishable as contempt of court, and can result in the court drawing inferences from the absence of documents you would expect to see. As soon as a dispute starts, your lawyer should advise you on preserving and securing evidence – but it may be too late by then. If the authenticity of documents may be questioned, particularly in relation to emails and electronic documents and records, you may need to get specialist help to preserve forensic-quality copies of the records with their original date and time information.

But what if you don’t want to disclose embarrassing evidence? You may be able to rely on privilege. You are entitled not to disclose privileged evidence, and no inferences can be drawn from your failure to provide it. The courts are fiercely protective of legal professional privilege, which they see as fundamental to our system of justice. Searches (by regulatory authorities, police or under court orders) must be arranged to protect privilege.

There are two kinds of privilege: legal advice privilege, which protects confidential communications between lawyer and client, and litigation privilege. Legal advice privilege covers communications between lawyer and client for the purpose of taking and giving legal advice. It includes documents created for the purpose, but not the client’s background preparations or reactions which are not to be communicated to the lawyer. It applies whether or not there is a contemplated dispute. It includes communications with in-house lawyers (except in EU competition cases) but does not include general business advice which is not given in a legal context.

Litigation privilege covers confidential communications or documents brought into existence for the dominant purpose of use in actual or contemplated litigation, including criminal proceedings or adversarial regulatory investigations, such as competition inquiries by the OFT or FSA investigations. Unlike legal advice privilege, it includes communications with third parties.

Privilege can be waived, sometimes accidentally: if you waive privilege in a document to advance your case on an issue, all other privileged documents relevant to that issue also lose privilege. If you copy documents for some other purpose, privilege may be lost, and it is lost if the documents cease to be confidential. So care is needed to preserve privilege, including appropriate markings: this lies behind the wording often seen on the bottom of emails about privilege.

If your business is dealing with sensitive issues, the last thing you want is for your deliberations to be used in evidence against you. It may make sense to carry out all your internal discussions with or through a lawyer, so that you attract legal advice privilege. No other profession offers this advantage.

Help! The bank has frozen my account!

Collateral damage from money-laundering legislation

I have seen this more than once: a client rings in a panic, having had his business bank account frozen by the bank. His bank won’t tell him why. They are suddenly completely uncooperative, and he is naturally livid. He wants to know how to get the account unfrozen, and if necessary to take immediate legal action. What should you do if it happens to you?

The reason is almost always that the bank has formed a suspicion that the account or the customer is involved in money-laundering (or terrorist financing). Once it forms that suspicion, the bank is obliged by law to block transactions; otherwise it risks committing an offence of converting or transferring criminal property under the Proceeds of Crime Act 2002 or facilitating the retention or control of terrorist property under the Terrorism Act 2000. [1] It also has to make a report to the Serious Organised Crime Agency (SOCA) explaining its suspicions.

You may be an entirely innocent party. The suspicion could relate to an investor, employee, customer or supplier. The concept of “proceeds of crime” is extremely wide, and can include, for instance, the benefit of tax evasion, or business cost savings arising from minor offences.

Suspicions can be triggered by the bank’s internal systems, far away from your relationship manager. All banks now operate back-office systems for flagging up and reporting unusual transactions. Your manager might know why something has happened, but it may still look suspicious to someone – or a computer – in head office.

What is more, the bank is prevented from telling you why it has done what it has done: it is an offence to “tip off” a person if that could prejudice an investigation following the report. The only way to avoid lying to you is for the bank to say nothing at all, so it just clams up. Of course this can be a nonsense: any criminal or terrorist, and most well-informed people, will know that if a bank or professional adviser suddenly refuses to act on instructions and won’t tell you why, it is probably because they have a made a money-laundering report.

SOCA can give consent to allow transactions to proceed, or if it doesn’t respond within seven working days, the freeze ends. But if SOCA refuses consent, the freeze is extended until 31 days from the date of refusal of consent. In that case, SOCA will usually have notified the police or other enforcement agencies. If they want further time to investigate, they will have to make an application to court.

The courts have consistently supported banks when they have relied on their duties under the money-laundering legislation, even if the customer is entirely innocent. [2] So the customer usually has no remedy, even if his business is left in ruins. A Mr Shah has been claiming losses of $330 million from HSBC which he alleges flowed from their blocking of transfers from his account.

To be protected, the bank just has to satisfy the court that it had a suspicion. The suspicion does not even have to be reasonable: if the bank has a suspicion, it must report and it must stop the transaction. The court has said that the bank must “think that there is a possibility, which is more than fanciful, that the relevant facts exist. A vague feeling of unease would not suffice. But the statute does not require the suspicion to be 'clear' or 'firmly grounded and targeted on specific facts' or even based on 'reasonable grounds'." [3]

Mr Shah tried a variety of different attacks on the bank’s position. He said that the bank’s suspicion was irrational; negligently self-induced; mistaken; and/or automatically generated by computer. He said that the bank was negligent, or breached its duty to give him relevant information about his affairs. The Court of Appeal dismissed all these claims apart from the last. It allowed the claim to go forward only in case Mr Shah could prove that the bank did not in fact have a suspicion at all; or he could prove loss from the bank’s failure to tell him what was going on, at a time when it was not protected by the “tipping off” requirement – perhaps because the investigation had ended. In a second visit to the Court of Appeal, the court even refused to order the bank to tell Mr Shah which employees had the suspicions and made the reports, on grounds that it was not relevant; public interest immunity could also apply.[4] Mr Shah’s lawyers made a third unsuccessful visit to the Court of Appeal [5] before the remains of his case came on for trial in December 2011. The trial is still going on, with a decision not expected for several months, but the legal principles are clear.

So what advice do I have for the innocent bank customer, without the resources of Mr Shah, to fund costs? Each case depends on its facts, but early litigation is not likely to be successful. In the short term, the best answer is usually to work with the bank to allay the suspicion and get the freezing lifted. If the client thinks he knows what has caused the suspicion, give the bank the evidence. Ask them to seek the permission of SOCA to proceed with the transaction, as a matter of urgency. Whilst pointing out the possibility of a claim may focus their minds and make them review their decisions, it is unlikely that there will be a successful claim if there is a genuine suspicion. Bank customers should perhaps be alive to these issues beforehand and try to head them off, for example by giving the bank an explanation in advance of transactions that may look suspicious. As Mr Shah is finding out, the cards are heavily stacked against the customer.

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[1] It could also be that t has not completed its client due diligence under the Money Laundering Regulations 2007 or its ongoing monitoring has noticed a problem with it, which can oblige it to block bank account transactions under Regulation 11.

[2] K v National Westminster Bank; R (UMBS Online Limited) v SOCA; Shah v HSBC Private Bank [2010]

[3] R v Da Silva

[4] Shah v HSBC Private Bank [Oct 2011]

[5] Shah v HSBC Private Bank [Nov 2011]

A tax windfall for solicitors?

Make a back claim for VAT bad debt relief

An extraordinary VAT case that could be worth a lot of money to solicitors: if you issue a VAT-only invoice to your client and the client fails to pay, you can claim VAT bad debt relief and get the full amount back, not just a proportion representing the VAT rate.

This arises when someone else is paying the costs, but your client is VAT registered and can reclaim VAT on your fees. You bill the client for the VAT element and send a non-VAT invoice to the third party, who pays the net of VAT costs. Most often that is the client’s insurer paying your litigation costs, but it could also be a tenant paying a landlord’s costs, or the losing party in litigation paying the winner’s lawyer’s costs. But what if your client fails to pay the VAT? You may have difficulty recovering it; if you were instructed by the insurer you may have no real relationship with the client, and you will not have been able to do credit checks or get money on account.

Previously it was assumed (and case law said) that you had to treat this like any other bad debt, and the fact that you had issued separate invoices for the fee and the VAT was irrelevant: you had (at 20%) recovered 5/6^th of your VAT-inclusive fee so you claimed bad debt relief on 1/6^th, and got 1/6^th of that back, or 1/36^th of the total; you were out of pocket by 5/36^th. In Simpson & Marwick v HMRC[1] the Upper Tribunal said this was wrong: if the bad debt is clearly identified as the VAT element, it can be claimed in full – HMRC loses the entire 6/36^th.

It is worth reviewing records and talking to your accountants about making back claims for relief. The case could yet be appealed so make appropriate disclosures in any claim.

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[1] [2011] UKUT 498 (TCC)

The lawyer's smoking gun

Insolvency, fraud and privilege

In almost every company insolvency, someone suggests (often quite loudly) that the directors have been guilty of fraud or misconduct. Sometimes the allegation may be serious, and the authorities investigate. One rich source of evidence may be the legal advice given to the company – it may be the smoking gun, proving that the directors knew exactly what they were doing. But can the prosecutors use it?

Legal advice from a lawyer is absolutely privileged from disclosure in most circumstances. That can be the reason why canny directors route sensitive management and compliance discussions through their solicitor – that’s very common in competition law discussions, for instance.

The privilege belongs to the client, not the lawyer, and the client can waive it. That is an important point in connection with insolvency, where the client is often the company. What if the liquidator or administrator waives privilege and provides the advice to the prosecutor or regulator, to be used against the directors who took the advice? I have been there myself, when my advice on financial services compliance was later used by the SFO to help convict the directors, in what turned out to be a fraud – of course I had not been told the half of it.

But the legal distinction between advice to the company and advice to the directors is a fine one, especially when dealing with issues of fraud or regulatory compliance. It’s the directors who may go to jail, even if the company pays the lawyer’s bills. Can the liquidator really pull the rug out from under the directors by turning over the legal advice to the prosecution?

No, the court has said in R. (Stewart Ford) v The Financial Services Authority in October 2011. It held that joint interest legal professional privilege applied to the legal advice. Even where the lawyer’s retainer is in the name of one party – the company – others may be able to rely on the privilege if they had a joint interest in the advice. For joint privilege to arise, the facts must demonstrate that all those sharing the privilege, and the lawyer, knew, or ought to have known, that they enjoyed legal professional privilege with the others. To claim privilege, the director had to show:

i) That he communicated with the lawyer for the purpose of seeking advice in an individual capacity;

ii) That he made clear to the lawyer that he was seeking legal advice in an individual capacity, rather than only as a representative of the company;

iii) That those sharing the joint privilege (the other directors and the company) knew or ought to have appreciated the legal position;

iv) That the lawyer knew or ought to have appreciated that he was communicating in an individual capacity.

v) That the communication with the lawyer was confidential.

The directors succeeded, and the FSA were barred from relying on two crucial emails from the lawyer which had been handed over by the administrators.

The lawyers who gave the advice were my old firm Irwin Mitchell. Interestingly, the authors of the two legal textbooks on the subject were leading counsel on opposite sides in the case!

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

Salaried partner or employee?

When is a partner not a partner? When he’s an employee. When is a salaried partner an employee?  When he’s not a partner, of course.

Or when the Employment Appeal Tribunal says he’s not. The EAT has decided two recent cases concerning solicitor salaried partners – in opposite ways.

The status of “salaried partner” or “fixed share partner” has been very useful for law firms. Clients like to deal with partners, so salaried partners are given the title as a badge of confidence by the firm, without all the financial consequences of admitting an equity partner.

Firms treat salaried partners in different ways. At one end of the scale, there is the person who is clearly an employee, but who is held out to the public as a partner. He has a contract of employment, he is paid under PAYE and he takes no significant part in the firm’s overall management. He gets no profit share but is indemnified against any losses. At the other end is the fixed-share partner who takes a full part in partnership decisions, gets paid only if there are profits to distribute, perhaps contributes capital to the firm, and often has a small share of profit, which might be linked to individual or team performance. In between are a variety of other arrangements, often poorly thought through, which try to treat the person as an employee whilst making him self-employed for tax purposes. The documentation often looks like an employment contract, with varying degrees of lip-service to the partnership ideal.

In Stekel v Ellice [1]  Megarry J. said that a salaried partner on a fixed salary, not dependent on profits, could still be a true partner, at least if he was entitled to a share in the profits on a winding-up. The relationship is a question of fact, and is not determined by what the parties call it.

Employment protection  Self-employed status can be attractive to the salaried partner who is taken outside the PAYE system. But it is a lot less attractive when the relationship ends, and salaried partners may be tempted to claim employment rights when they are dismissed, as Jeremy Briars did recently in Williamson & Soden v Briars [2]. He won comprehensively. The Employment Appeal Tribunal upheld the Tribunal’s ruling that there was no doubt that Mr Briars was an employee for the purposes of the definition in the Employment Rights Act (ERA) [3]. The question was not whether he was truly a partner within the definition of the Partnership Act 1890 [4], but whether he was an employee within the ERA definition. He had made a seamless transition from employed status with very little change in his role or terms. He received a fixed salary, not dependent on profits, plus a small profit share. He did not share in losses. The documents did not demonstrate acceptance of the heavy burden of partnership. And perhaps most importantly, he was subject to the control and direction the equity partners in a manner appropriate to an employee rather than a true partner.  

It is often said that someone who has been treated as self-employed and has reaped the tax benefits could not easily convince a tribunal that he was in fact an employee when it suited him. But this point was not even mentioned in the judgment in Williamson & Soden, despite Mr Briars having been treated as self-employed for tax purposes for about six years.

Tiffin v Lester Aldridge LLP [5] went the other way. There, the fixed share partner had signed documents and received a benefits package that more clearly pointed to partnership; he received a small profit share, and he was entitled to a small share of surplus on a winding-up; he had limited votes at partners’ meetings, and he contributed a small sum as capital. The Tribunal and EAT both found that Martin Tiffin was a partner, and not an employee, and the Court of Appeal agreed. There was no minimum share of profits, surplus or voting required.

The position in an LLP ought to be slightly different. Whether or not two or more people are in partnership is a test of the relationship: as a matter of fact, are the partners carrying on business in common with a view of profit? In an LLP, though, the question of who is a member of the LLP is more defined: a member is a subscriber to the incorporation document or someone admitted by and in accordance with an agreement with the existing members [6]. There should be no room for arguing that a member of an LLP, recorded as such and registered at Companies House, is not in fact a “true” member of the LLP. But it seems you can be both a member and an employee of an LLP: “A member of [an LLP] shall not be regarded for any purpose as employed by the [LLP] unless, if he and the other members were partners in a partnership, he would be regarded for that purpose as employed by the partnership.”[7]

That looks odd, and it is. True partnership and employment are mutually exclusive, it seems; so if he and the other partners were truly partners in a partnership, he could not be an employee; though if they were not truly partners, and he was just called a partner, he could be an employee. What does the section add? Is it not effectively saying that a member of the LLP can never be an employee? Apparently not. In Tiffin v Lester Aldridge and in Kovats v TFO Management LLP [8] the section was assumed to mean the opposite of what it says: that if he and the other partners would not have been partners in a partnership, he could be an employee. In Kovats the EAT specifically recognised the possibility that a person could be both a member of the LLP and an employee.

Tax benefits  But there is one important difference in an LLP. A member of an LLP is always taxed as self-employed, even if he is, in law, an employee. His taxation status does not depend on whether he is an employee within the meaning of the ERA, but on whether he is a member of the LLP. For income tax purposes, in a trading LLP all the activities of the LLP are treated as carried on in partnership by its members.[9] There is no exception for members who are also employees. So we have a potential category of salaried partners (members) in LLPs who are employees for employment protection purposes, but taxed as self-employed. This is very useful, as it allows firms to confer the taxation benefits of LLP membership (and gain exemption from employer NICs) without any real pretence at making the salaried partner a true partner. So long as he is admitted as a member in accordance with the LLP members’ agreement, and perhaps has a small profit share (so that the membership is not a sham or blatant tax avoidance), he can have a contract that resembles an employment contract, and be subject to control and supervision as an employee, without losing the beneficial tax treatment. The potential for tax planning here is considerable, and we could see increasing use of LLP member status intended mainly to save tax.

[IMPORTANT NOTE: With effect from 1 April 2014, major changes have been made to the taxation of LLP members where their status amounts to "disguised employment". It is now very difficult to take salaried and fixed share LLP members out of PAYE. The legislation affects tax (including national insurance) treatment but not employment rights. This article was written before the 2014 legislation and the above paragraph is no longer correct.] 

By the same token, the taxation status of an LLP member ought to be irrelevant to his status for employment rights purposes, though this point does not seem to have been considered in Tiffin or Kovats. In a Partnership Act partnership, unlike an LLP, the tests for employment rights and tax purposes are the same, so a person treated as an employee for employment rights purposes should also be subject to PAYE.

Restrictive covenants  It is said that post-termination restrictions will be harder to enforce against employees than partners, and that restrictions on employees must be narrower in scope if they are to be reasonable. But in fact it is the position and role of the individual that affects the enforceability of the covenant, not his status as employee or partner. Covenants have been enforced against senior employees [10] which might well not have been enforceable against junior partners. In all cases there must be a legitimate interest to protect and the restriction must be no more than is reasonable to protect it, but it is relevant to look at the respective bargaining power of the parties, their mutuality of obligation, and the extent to which the individual would have expected to benefit from the goodwill protected by the covenant.

Having the salaried partner sign new covenants in the same form as the equity partners may well help, both in demonstrating the reasonableness of the mutual obligations and in showing that the partner is a true partner.

What lessons can be learned from the cases? Many salaried partners will be employees, with employment protection rights, if no special effort is made to ensure that they are genuine partners. To make them genuine partners, consider making their remuneration depend on the availability of profits, so they share in risk; having them bear a small share of losses, and/or share in capital profits; having them contribute capital; making them parties to the main partnership or LLP agreement; giving them a benefits package appropriate to a partner; giving them votes at partners’ meetings; and generally treating them as far as possible as partners.

In a partnership, if those things (or many of them) are not done, the firm is at risk of being charged PAYE if HMRC alleges that the individual is not a partner, so it may be safer to operate PAYE from the start. In an LLP you are on safer ground from a tax perspective, so long as the salaried partner has been admitted as a member in accordance with the members’ agreement and the membership is not a sham or an artificial step for the purposes of tax avoidance.

The overall look and feel of the relationship and the documents is important. When reading Williamson & Soden v Briars and Tiffin v Lester Aldridge, it strikes you that the Tribunal’s first impression was important. Jeremy Briars’ engagement looked like employment; Martin Tiffin sounded like a partner. Displacing that initial impression is going to be difficult.

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[1] [1973] 1 WLR 191

[2] [2011] UKEAT 0611_10_2005

[3] ERA 1996 Section 230: an individual who has entered
into or works under a contract of service

[4] PA 1890 sections 1 and 2: carrying on a business in common with a view of profit,
and receipt of a share of the profits is prima facie evidence that he is a partner, but
does not of itself make him a partner; and the remuneration of a servant (employee)
by a share of the profits does not of itself make the servant a partner.

[5] [2010] UKEAT 0255_10_1611 Court of Appeal [2012] EWCA Civ 35

[6] Limited Liability Partnerships Act 2000 section 4

[7] Limited Liability Partnerships Act 2000 Section 4(4)

[8] [2009] UKEAT 0357_08_2104

[9] Income Tax (Trading and Other Income) Act 2005 section 863

[10] eg in Thomas v Farr PLC [2007] EWCA Civ 118