Financial debts for LLP members: up to what point?

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DURING THE LAST YEARS, times have been tough for professional services companies. In the legal and accounting sectors, we have seen high profile bankruptcies such as those of Vantis and the law firm Halliwells.

Speculation continues as to the number of critical care professional services companies with their banks. What does all of this mean for the firm’s individual partner? Will he be personally responsible for the financial debts of the company? Many professional service companies now operate as Limited Liability Companies (LLPs) and therefore the risk of personal liability of a member is very low, but there are still risks that LLP members can ignore.

The good news is that unlike partners in general partnerships who are jointly and severally liable for all the debts and obligations of the business, LLP members enjoy limited liability. The liability of an individual member of an LLP is limited to the amount, if any, for which it has agreed with the other members to be liable on the liquidation of the LLP.

So at first glance everything is clear and simple. As a member of an LLP, one can be assured that during tough economic times all personal property will be safe from the clutches of creditors as liability is generally limited. This will be particularly reassuring for members of an LLP who are not actively involved in management and may not be aware of the financial health of the LLP.

However, there are a few important exceptions to note. The insolvency regime of LLPs is broadly the same as that of companies. Members of an insolvent LLP can be held liable for fraudulent or unlawful transactions in the same way as directors of a business.

Worse yet, there is a specific “clawback” provision in Section 214A of the Insolvency Act that only applies to LLPs. A liquidator may require members to repay withdrawals or other payments received from the LLP during the two-year period prior to the insolvent liquidation of the LLP if those members knew, had reasonable grounds to believe or should have known that the LLP was unable to pay his debts at the time the money was paid.

Anyone who has been a member of the LLP during that two-year period is vulnerable whether or not they have left the LLP since or the decision to make the payment was made by others, that is, tell the direction.

It is not clear whether, in an insolvent liquidation, a non-executive member who was never involved in the financial management of the LLP “should have known” that the LLP could not pay its debts. The legal test of what a member should have known is what would be known or verified by a reasonably diligent person having both (a) the general knowledge, skill and experience that might reasonably be expected of a person performing the same function as the member and (b) the knowledge, skills and experience that that member actually possesses.

This has remained largely untested by the courts when it comes to LLPs. There is speculation that the liquidator of Halliwells, the insolvent law firm, could take legal action against all of the former partners.

Indeed, the liquidator can do this because there is no fundamental difference, in law, between the owners and the management of an LLP, which is not the case for companies (i.e. – say directors and shareholders). However, most commentators would expect courts to take into account a company’s management structures and size when considering a liquidator’s claim.

Large companies typically delegate key financial decisions to a board or committee with a small number of members. It is these limbs that are likely to be subjected to a more rigorous test.

This does not mean that other members, even fixed-share partners, should simply ignore the risk of clawback or illicit transactions. Until the courts provide guidance, it cannot be assumed that it will be a defense to simply argue that one was unaware of the financial information. For now, the risk remains that the courts may determine that any member should have known of the LLP’s financial situation.

There are other risks which may be more common in times of economic uncertainty and which may further threaten the limited liability of an LLP Member. For example, personal guarantees may have been given by members, upon conversion to LLP or upon incorporation, to an owner or to a bank.

It would have depended on the LLP’s financial situation at the time. If the LLP fails to meet its financial obligations, the owner or bank may enforce their guarantees against members in addition to or in lieu of the guarantee given by the LLP.

In difficult economic conditions, the risk that authorized drawings will exceed profits increases. An LLP Member Agreement may provide for immediate reimbursement of excess prints.

A prudent withdrawal policy is advised, as well as the flexibility to carry over excess withdrawals as the first charge against the following year’s profits.

Members should also check the terms of their member’s agreement to see how business losses are handled. Most agreements will allocate losses to a reserve account on the balance sheet or allocate losses among members up to a capped amount. The allocation of unlimited losses among members, however, will compromise the limited liability of the LLP.

Overall, the limited liability of members of a UK LLP remains strong, but we are waiting to see how that will happen when a rigorous liquidator finds that there have been insolvent transactions. So the message is for all members to keep a close eye on the financial health of the LLP, to ask for financial information and to ask for answers when things are not clear.

Miguel Pereira is a partner in the Partnerships and LLP team of Lewis Silkin LLP

Image Credit: Shutterstock


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