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

On level terms

Terms and conditions for consumer contracts

In June I wrote about the Ashbourne case [1] on consumer contracts, focusing on penalty clauses. But perhaps the biggest impact should be on the way businesses write their standard terms for dealing with consumers.

The Unfair Terms in Consumer Contracts Regulations 1999 caused a major shift in contract law. Until then, unless the OFT intervened, most contract terms meant what they said. There were exceptions for some kinds of exclusion clauses, but most terms did not have to be reasonable or fair. Contract terms for dealing with consumers looked much like business-to-business standard conditions: heavily slanted in favour of the supplier.

Now, most consumer contract terms are automatically unenforceable if they are unfair.

A term is unfair “if, contrary to the requirement of good faith, it causes a significant imbalance in the parties' rights and obligations arising under the contract, to the detriment of the consumer”. All written terms must be in clear and intelligible language. The only terms exempt from a fairness assessment are terms required by law or regulatory requirements, any terms individually negotiated with the consumer, the definition of the main subject matter of the contract, and the adequacy of the price. Even then, the last two must be expressed in clear and intelligible language, and are narrowly interpreted.

Unfairness is judged in the context of the particular consumer’s position, not in relation to consumers generally. The Ashbourne case demonstrated that the courts are prepared to be quite picky in deciding what is unfair, looking at each term individually and the effect it could have. The court held that the following were (or would be) unfair in the context of a health club contract:

·         A long minimum period (1, 2 or 3 years), even with exceptions for contingencies such as unemployment or moving house – “the defendants' business model is designed and calculated to take advantage of the naivety and inexperience of the average consumer using gym clubs at the lower end of the market”

·         A term allowing the supplier to terminate the contract due to the consumer paying late, if the delay was not sufficient to amount to the consumer indicating he or she was no longer intending to be bound by the contract or undermining the supplier’s confidence in his or her ability to pay

·         A term requiring the consumer to pay the whole undiscounted balance for the minimum period if the consumer breached the contract

·         A requirement for a notice of termination to be given in an unexpected manner, in this case to a central office rather than to the club

·         Terms allowing payments to be recovered from the consumer despite representations made to him by the supplier.

What does this mean for your standard terms and conditions, if you deal with consumers? You really have two options.

The first is to continue as before with potentially unfair terms, but to accept that many of them will be unenforceable against consumers. Most companies selling primarily to business buyers will probably do this – if you are a consumer business, what’s the point of using terms you know are unenforceable? So long as you give way quickly and do not build a business model based on unfair terms (as Ashbourne did) you should be reasonably safe from action by the OFT, unless you are in a particularly sensitive sector such as (at the moment) health clubs.

Otherwise, reassess your terms for dealing with consumers. Consider having separate terms for consumer and business sales. Have your terms drafted so that they are fair in the context of your particular business. Unfortunately that is not an easy thing to do, and it is likely to increase the legal costs of drafting your terms. Your lawyer can no longer use a standard form, or write the terms with minimal knowledge of your business. You need to work with him to decide what is fair in circumstances, and to adapt your business model if necessary.

Then you both need to make sure the terms are in plain and intelligible language. The requirement is probably different depending on the target audience – are your consumers likely to be educated and technically astute? Important terms should be given prominence, perhaps with bold type or capital letters – though every term is important if it happens to cover the issue that arises. The more you try to explain things, the longer and more unintelligible the contract gets. The OFT then says that the time available to the consumer to read the contract affects its fairness [2].

The OFT publishes a general guide to making contract terms fair and a selection of guides for particular industries. In January 2012 the Financial Services Authority published guidance "Unfair Contract Terms: improving standards in consumer contracts" which is helpful even to other industries, particularly in discussing clauses that allow the business to vary the contract, and the benefits of setting out valid reasons for making changes. It stresses that give the business wide discretion are likely to be unfair, and the importance of plain English.

And while you are reviewing your contracts, don’t forget the consumer’s cancellation rights![3]

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[1] OFT v Ashbourne Management Services {2011] EWHC 1237. The Court’s order is at http://www.oft.gov.uk/shared_oft/consumer-enforcement/ams/order.pdf

[2] http://www.oft.gov.uk/shared_oft/reports/unfair_contract_terms/oft311.pdf at pages 10-11

[3] Especially under the Consumer Protection (Distance Selling) Regulations 2000 as amended or the Cancellation of Contracts made in a Consumer’s Home or Place of Work etc. Regulations 2008

Revised 13 February 2012 to note the FSA guidance.

What's it worth?

How to value property in shareholder disputes  

To value shares in a company, you often have to value the underlying assets, including properties. But how should a valuer do that? What assumptions should be used? What deductions should be made?

When shareholder makes a successful complaint about unfair prejudice in the way the company’s affairs are run, the court will usually order his shares to be bought out at a valuation, as if the unfair prejudice had not occurred. The court is not bound to follow Red Book valuation principles, but instead has "a very wide discretion to do what is considered fair and equitable in all the circumstances of the case, in order to put right and cure for the future the unfair prejudice which the petitioner has suffered at the hands of the other shareholders of the company."[1] In Shah v Shah [2] the court has given useful guidance on the valuation of underlying assets. The case may well have wider implications, affecting any situation in which a property is being valued when there is no actual intention that it should be sold.

The company’s business was loss-making, so the shares were to be valued by reference to net asset value, but it continued to trade, so there was no likelihood that its property would be sold. As well as deciding items disputed between the expert witnesses, Mr Justice Roth decided that:

1.       The values should not be reduced by the full corporation tax liability that would arise upon disposal. For a property very unlikely to be sold, 10% of the liability should be deducted; for one where there was no sale planned but it was possible, 20%.

2.       Costs of sale, and a contribution to the purchaser’s stamp duty, should not be allowed.

3.       Possible void periods and the weakness of tenant covenants should be reflected in the yield, not separately deducted from the estimated rental value.

The case would make an instructive read for any valuer giving expert advice in court proceedings, and for share valuers incorporating asset valuations into their valuations of companies.

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[1] Re Bird Precision Bellows Ltd [1986] 1 Ch 658

[2] [2011] EWHC 1902 (Ch)

Agreeing to differ?

Agreements to agree are unenforceable in England. That includes obligations to negotiate in good faith.

The logic is that (i) an agreement to agree in good faith is too uncertain to enforce, (ii) it is difficult to say whether termination of negotiations is brought about in good faith or not, and (iii) it is impossible to say whether good faith negotiations would have led to an agreement, and if so on what terms, so it is impossible to establish any loss flowing from breach of the obligation to negotiate.[1] To be a binding contract, there has to be an intention to create legal relations and sufficient certainty as to the essential terms.

A recent case [2] has affirmed these principles in relation to heads of terms for a deal: for an agreement to be enforceable, the parties must have reached sufficiently complete and certain agreement on all essential terms. The parties can leave out non-essential terms, but the absence of essential terms means there is no contract, and it cannot be saved by an obligation to negotiate.

A common tourist trap for English companies doing deals abroad is to assume that the same rule applies elsewhere. Our “subject to contract” concept may not be recognised. In many countries the opening of negotiations or the agreement of heads of terms may lead to obligations of good faith, and to possible liability for breaking off negotiations.

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[1] Walford v Miles [1992] 2 AC 128; Petromec v Petroleo Brasileiro [2005] EWCA Civ 891

[2] Barbudev v  Eurocom [2011] EWHC 1560

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