If you lack a properly drafted partnership or LLP agreement, default provisions apply. These may not be in your interests.
Our services for partnership agreements include:
We act for a range of professional partnerships such as hedge funds, financial services, accountants and medics to name a few. We solve problems for either the business or for the individual partners being equally as familiar with both.
Danger of relying on default provisions
The headline point is that damaging default provisions apply if there is no partnership or LLP agreement, or if the existing partnership agreement or LLP agreement is deficient.
Therefore, every partner should insist on a written partnership agreement or LLP agreement that is kept up to date to protect his interests.
Default provisions if there is no partnership agreement or LLP agreement
We deal with a surprisingly large number of partnership disputes which arise because there is no written agreement. In the absence of an agreement statutory default provisions that apply to partnerships and LLPs if no written or verbal agreement include:
- All partners have the right to participate in the management of the company. There is nothing to govern the status of members which in practice is problematic;
- There is no ability to expel or compulsorily retire a partner. Obviously problematic as there is no way to deal with for example underperformance;
- All profits are shared equally between the partners;
- There is nothing to prevent competition (such as a partner running a competing business/poaching staff);
- The partnership can be automatically dissolved without consent or approval.
We explain below how the default provisions can have a disastrous impact on the business. We also set out typical ways of dealing with the problems caused by the default provisions.
Unlimited liability of partnerships
Partners under traditional partnerships have unlimited liability for partnership losses and debts. This means the partners may lose their home and personal assets because of losses and obligations that occur as a result of operating the business. The partners share in liability irrespective of culpability. The big risk here is fraud or professional negligence claims which are uninsured.
Profits and losses
Subject to any partnership agreement, all the parties are entitled to share equally in the profits of the business. However, most importantly, they contribute equally towards the losses, whether capital or not. This means that:
- You should have a partnership agreement if different partners invest different amounts of capital into a business.
- Similarly, if you want to weigh matters such as voting power you need a written partnership agreement.
- You cannot pay out different profit shares to different partners without a written partnership agreement.
Continuation of the partnership
Unless there is agreement to the contrary the default provision is that the partnership will be dissolved on the death or bankruptcy of any partner. This means:
- Any change in the composition of a partnership will always result in a technical dissolution of the existing firm and the creation of a new one.
- To avoid the effects of this dissolution it is preferable to include a clause in the partnership agreement that states that the partnership will continue if one of the partners has left the partnership or died.
Dissolution can cause damage to goodwill and the operation of the partnership and therefore making sure that your partnership agreement deals with continuation of the partnership is a good move. The value of any intellectual property in the partnership can be lost if a dissolution is effected against the remaining partner’s will.
The partnership agreement should specify what property belongs to the partnership and what belongs to individual partners. This means that:
- In the absence of a written partnership agreement it is more difficult to determine what will happen on insolvency or death, or when an asset increases in value;
- Uncertainty creates openings for a partnership dispute;
- All property used by the partnership for the purpose of the business will deemed to be partnership property. Therefore, if it is intended that there will be property that will be used by the partnership, but will not be partnership property, this must be made clear in a partnership agreement, identifying the property and the terms on which the partnership is to use it.
Unless there is a partnership agreement, no person may be introduced as a partner without the consent of all existing partners. If a new partner is admitted, the new partnership will be a partnership at will meaning treated as if there was no written partnership agreement unless the existing partnership agreement caters for the admission of new partners and they all agree to be bound by the terms of the partnership agreement. The requirement that each incoming partner agrees in writing to become a party to the partnership agreement, usually means that the partner must sign a deed of adherence to the terms of the partnership agreement.
Right to retire or resign from a partnership
A partner has no right to retire or resign from the partnership, unless the partnership agreement allows for it, or all other partners consent in writing. Normally a clause is inserted into the partnership agreement that gives partners the right to leave on giving an agreed amount of notice. No partner wants to be trapped into staying against his will or face the prospect of dissolution and therefore a well drafted partnership agreement will address the default position.
Expulsion and forcing a partner to leave
Without a power to force a partner out included in the partnership agreement, no partner can be expelled by a majority of the partners. The partnership agreement should therefore deal with how partners can be forced to leave, commonly called expulsion, and in what circumstances. Given the partnership default provisions do not deal with forcing a partner out, it is in the interests of all partners to secure certainty of their position under the partnership agreement. Without bespoke provisions, an noncontributing partner remains.
A clause in the partnership agreement allowing the suspension of a partner is also increasingly common, as it allows the partnership to deal with potentially embarrassing situations with the speed that is necessary to limit a public relations disaster.
Dissolution of a partnership with no partnership agreement
Unless the partners have agreed otherwise, a partnership at will may be dissolved by any partner giving notice to the others of his intention to dissolve the partnership. Due to the ruinous effects an unplanned dissolution may have, it is usual for a partnership agreement to exclude such a unilateral right to dissolve the partnership.
Deadlock with no partnership agreement
The default provisions do not deal with how disputes should be resolved. This means, in the absence of a partnership agreement dealing with partnership disputes the parties will have to litigate to resolve disputes. Partnership litigation as with any other litigation is expensive. Recognising the cost of partnership litigation, a modern partnership agreement will include a process to work through before litigation can commence designed to settle a partnership dispute out of court.
We often deal with alternative dispute resolution, such as independent experts, mediation or arbitration.
Pitfalls of LLP partnership agreements
The legislation contains several default provisions that apply if you lack an LLP agreement or if the LLP agreement is silent. As with partnerships, the LLP default provisions can lead to a disastrous position.
A fundamental principle of company law is that the LLP has a separate legal personality to its partners. Hence the LLP’s assets are not the partners personally – they belong to the LLP. However, there are exceptions to this principle. For instance, a partner, who has been party to fraudulent conduct by the LLP partnership, will be personally liable for his conduct.
The business of the LLP
Partners who have introduced capital to the LLP rank below trade creditors in an insolvent winding up. The LLP agreement should address solvent and insolvent winding up and set out the powers of any member to veto winding up where there is a choice.
The LLP agreement should as a general rule, state what the business of the LLP is. Such a clause will be useful base from which to consider provisions as to the authority to act on behalf of the LLP which individual members of the LLP are to have. It can also link to restrictive covenants which may be imposed on a member following their departure. An injunction to restrict activities is the ultimate recourse here, particularly with professional service LLPs, where the value of the LLP is tied in with the client base.
If the business of the LLP includes the creation of intellectual property rights the LLP agreement should include an assignment of such rights by the members to the LLP. Dealing with any infringement of IP will be much easier if there are assignments in place. Assignments can be built into the core terms of the LLP.
If the LLP needs working capital this must be dealt with. Working capital comes in two shapes. Firstly, there can be a requirement for members to contribute if there is a cash call. Secondly, there can be a reservation on the right to draw down on income and a requirement income is re-invested as capital.
Partners need a wage throughout the year. The LLP agreement should also cover the right of the members to draw during a financial year on account of profits for that year. Reconciliation provisions are needed to avoid the risk of over drawing.
Profit and losses
The agreement should deal with the members’ respective shares in profits made by the LLP. Income and capital profits may be shared in different proportions. In light of the tax transparency. Some LLPs run a tax account and settle the liabilities of partners from that account. But, there are plenty of LLPs that leave that leave tax to the members to deal with.
The provisions for how losses are dealt with requires thought. An LLP agreement should not provide that losses are to be automatically divided and allocated. This is because such a provision would make members, indirectly, personally liable for the LLP’s debts. Such liability would undermine the primary purpose of the members being in the LLP, namely limited liability status.
The procedure by which a person may join the LLP as a new member should be set out, if the default position, requiring the consent of all existing members, is not desired.
The agreement needs to deal with appointment of designated members and the carrying out of their responsibilities and to ensure that there are always at least two named members. As to carrying out their responsibilities, consideration should be given for the decision-making of the designated members and for the signing and filing with Companies House of various documents which are to be signed and filed.
A general question to address is the authority of a member to act on behalf of, and to bind, the LLP. The starting point it that every member has unlimited actual authority to bind the LLP in any respect, subject to any qualifications of such authority in the LLP agreement. It may be desired to limit one member’s authority to bind the LLP if there are concerns over decision making. An LLP agreement can cater for that risk.
The LLP, having its own legal responsibility, is capable of owning property. The agreement will need to make clear which assets are to be vested in and owned by the LLP, and which assets are to be retained in the ownership of some or all of the individual members and simply made available for use by the LLP. The issues arise where there is intellectual property created and owned by the LLP. Without an assignment of rights from members to the LLP disputes over infringement of IP can easily arise.
Inspection of books
The default position is that every member has a right of access to the books and records of the LLP. This is however a contractual right and therefore can be limited or excluded altogether from the LLP agreement.
It may, for example, be thought appropriate to permit those to whom management responsibility is delegated to keep confidential from the membership at large their dealings.
Duty of good faith?
The duty of utmost good faith which exists between partners will not automatically exist between members of the LLP. It is for consideration therefore whether the LLP agreement should provide that, in relation to the affairs of the LLP, the members should act towards each other with that same good faith which is required of traditional general partners to each other.
Unfair prejudice and winding up petitions
You can exclude unfair prejudice petitions in LLP agreements and it is sensible to exclude the same particular in service firms. The right to present a winding up petition under the Insolvency Act however cannot be excluded.
Power of expulsion
There is no default power of expulsion or forced retirement of an LLP member. If such a power is therefore desired, it needs to be expressly included in the agreement. The authors consider that there is no objection in principle to a power of expulsion being conferred on specified members if that is what is desired and agreed.
As with traditional partnership agreements, consideration should be given to the need for any restrictive covenants on a leaving member. In that, the purpose of a restrictive covenant will be to protect the business being conducted, it will be the LLP that will be the primary beneficiary.
Restrictions upon leaving the partnership
The UK courts do accept that longer non-competes are enforceable for partners compared with individual employees. The point behind a restriction is that it enables the partnership to consider steps to prevent anti competitive actions.
However, in order to be valid and enforceable post termination restrictions:
- Will need to be no greater than is reasonably necessary in the interests of the LLP and the individual member, and in the interests of the public, to protect a legitimate interest of the LLP requiring protection.
- It will be for the LLP, seeking to enforce the restriction, to establish that the restriction is no more than what is reasonable in the interests of itself and the outgoing member. In practice, enforcement will be difficult if the restriction is not in writing and entered into before the anti competitive behaviour takes place.
- The legitimate interest requiring protection is likely to be one or more of the following: (a) the goodwill of the business, (b) trade secrets or other sensitive commercial information of a highly confidential nature and (c) the stability of the LLPs workforce.
Special considerations for hedge funds
The structure of a hedge fund really does need to be tailored to suit the planned fund raising process. An important consideration around structure is where the investors will be based. The fund management entity needs to be planned and structured. LLPs are the most common vehicle that is started by UK fund managers.
- Under the LLP route incentive and management fees are paid to the partners as if they were earning them personally. LLPs are tax transparent meaning the fund itself is not taxed. An LLP is more flexible than a company when it comes to moving equity within the LLP. Gifting shares to employees triggers a number of tax issues which are avoided with an LLP.
LLP document drafting for hedge funds
To avoid disputes, the default provisions applying to all LLPs unless varied need addressing. In practice, the key default provisions to vary for LLPs supporting hedge funds will relate to:
- Providing a power to remove or expel a member of the hedge fund. Usually provisions for a majority vote are included in the hedge fund’s LLP agreement. It is possible to base this on voting power or on the decision of named members.
- Providing for the shares in the capital and profits of the hedge fund to be attributed to each member.
- Restricting the management of the LLP to the core members. Usually, having all members entitled to take part in management is seen as overkill and not a good use of time.
- Setting out the duties of good faith. The extent to which a duty of good faith is owed to the individual members and the LLP should be set down to avoid disputes.
- Buy out options detailing the financial obligations on leaving the hedge fund need thought. In particular, what will be done about under performance of members of the LLP hedge fund should be set out in the LLP agreement.
- Profit arrangements for members have to be tailored to meet the deferral requirements imposed under the AIFM directive. Structures set up in various off shore locations avoid the AIFM directive.
Partnership disputes usually arise following a disagreement over of a partner’s liability, income split or departure. We are able to find the best solution by considering the legal principles, whilst also understanding the individual relationships between the partners.
As with any dispute, the parties need to be proportionate in terms of costs. The courts do actively encourage the parties to consider settlement agreements. As a lead up to settlement we do find mediation surprisingly successful. We do explain the points and look for opportunities for both partnerships and individual partners.
Partnership agreements: recent track record
The partnership agreement defines the heart of the business. No two businesses are the same. The personalities driving the business always have different takes on business success factors. We listen to the views and offer our experience. Recent examples of our work include:
- Management consulting partnership: converted to a limited company. Drafted shareholders’ agreement and directors’ service agreements.
- Partner joining LLP hedge fund: assessed his risks and liabilities. In particular, we negotiated our client’s position on leaving the LLP. If this occurred, he was assured of his position and ability to carry on business elsewhere.
- Energy brokering partnership: set-up an LLP agreement.
- Veterinary practice: set up a partnership arrangement as a franchise. This involved issues relating to partners’ capital contributions and measures to preserve existing goodwill.
- Settlement agreement: for an insurance brokering partnership down-sizing after regulatory changes. Found solutions for tail end commissions.
We can help you at all stages and work with partners and the partnership business. The law of partnership is specialist and the relationship between the partnership and its partners or members differs according to the facts. We advise on all of the partnership aspects which you may encounter from review of the partnership agreement, improving the structure by for example conversion to limited company status, valuation of a partnership share and dealing with partners when they retire voluntarily or are forced out against their will.