Partner exits: leaving empty handed

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Preserving the financial stakes in a partnership or LLP when a partner/member leaves the business can be a thorny issue. Issues arise both for partners looking to ensure the return of capital contributions and management seeking to resist payment of remuneration to a partner who has breached their duties. To help you, we summarise below the recent changes to the law for people sitting on either side of the negotiating table.

If you are facing a challenge please do call us as we are always happy to provide an initial steer and fee quote.

Returning capital contributions – how to get your capital out

A partner’s capital contribution is the sum paid into the firm for the purposes of funding the business and is intended to be risked by them in using it to that end. This financial stake in the partnership will therefore include their initial and further monetary contributions but not property.

The position varies depending upon whether the business is a partnership or an LLP and what has been committed to written agreement.

How partnership capital is created

Partnership capital is created by two means.  This can be via assets or cash injected from a partner intended as capital rather than a loan. Capital is also created upon the capitalisation of profits, provided there is an evidenced intention to convert undrawn profits into capital.

A record of each partner’s capital contributions should be recorded in a capital account, separate and distinct from the partnership’s current account. In the absence of a clear partnership agreement, there is a risk that the capital may be shared equally, even if the initial contributions were unequal. If the injection was intended as a loan this should be documented as there are differences between how capital and loans are treated, especially upon insolvency.

How do you get your capital out when you leave a partnership?

It is common for the partnership agreement to specify that the outgoing partner’s share will include their capital contribution. If there is no agreement or the terms are silent on partner exit, a partner leaving a partnership will be able to dissolve the partnership and wind it up. As part of this process and provided that there are sufficient funds, they will be entitled to a repayment of their capital contribution after payment of debts.

The ability to dissolve a partnership is very draconian and may be used to hold the remaining partners to ransom. Consequently, there is a huge risk in having a verbal partnership agreement.

Insolvency

As a partnership is not a separate legal entity, the general rule is that the individual partners are jointly and severally liable for all partnership debts. However, for the purposes of insolvency, partnerships can be treated as legal entities in their own right, in order to benefit from rescue procedures (such as voluntary arrangements with creditors) that are normally reserved for companies. But, once the partnership is controlled by an administrator, it will not be possible to extract your capital contribution until the partnership’s creditors have been paid.

Where the partnership has become insolvent, there is still a strong risk that each partner will be pursued by a creditor for the partnership’s debt. In addition to winding-up the partnership, the partners may also be individually subject to a bankruptcy order. Inevitably in most insolvency cases the partners sacrifice capital contributions in payment of the partnership’s debts.  Those with loans would be repaid in priority to partners capital contributions.

How LLP capital is created

Absent an LLP agreement to the contrary, a sum contributed by a member will be treated as a loan and a debt owed by the LLP. In contrast, capital does not constitute a debt of the LLP owed to the member.

Why is it important?

This distinction is important as it affects the member’s position in the case of insolvency. Where a sum is treated as a loan to the LLP, the firm owes a debt to the member; in the case of the LLP’s insolvency, the firm will be liable to repay the amount to the member – this is known as the “Member’s Right to Return”.  In contrast, if a sum is in fact capital, the member will be an unsecured creditor, meaning they rank behind the LLP’s other creditors for priority of repayment.

Insolvency

One of the main benefits of an LLP over a traditional partnership is that an LLP has separate legal liability for its debts. The LLP will be treated in the same way as a company for the purposes of insolvency. The members of an LLP, unlike partners in a partnership, do not have open-ended personal liability for the LLP on insolvency. This means that members cannot be pursued individually by a creditor for an LLP debt. The liability of an LLP member is limited to their capital contributions and any profits due, so as with a partnership, members will not be able to regain their capital.

The LLP agreement is silent on returning capital to members – what can you do?

Where there is no LLP agreement addressing the financial entitlements of exiting partners, the default regulations will apply; this means that there will be no provision for the exiting partner.

The only options for outgoing members to challenge the refusal to pay out their capital contribution are winding up the LLP or an application for unfair prejudice. There are situations in which the court may find that a contribution should be returned to a member on the basis that the loss of such entitlement would represent a gift to the LLP. There is a risk that the court will refuse to imply such an agreement but it is clear that there is scope for return of capital contributions, despite the current legislation.

What should you include in your partnership or LLP agreement?

The simplest way to ensure the return your capital contribution is a well-drafted partnership/LLP agreement that is clear about the financial entitlements of outgoing partners. Key clauses will include:

Share of profits for previously finished year

Share of profits for current year in respect of period of cessation

Capital contributions

Members’ loans

Unrealised capital profits

As always, careful drafting of such terms can simplify and streamline partner exits. Is it time to review and redraft your partner agreements to facilitate changes to the business to make it stronger for on-going partners?

Forfeiting profit share in circumstances of fiduciary breach

How to keep business profit from a wrongdoing partner

Common to both partnerships and LLPs, the partners owe certain fiduciary duties to the business. These principally include good faith, honesty and acting to the benefit of the partnership. If these duties are breached, can you withhold or recall payment of their profit share as compensation for the harm to the business?

What duties are owed?

The duties owed by individuals differ under partnerships and LLPs:

Partnerships

Partners are fiduciaries and all partners are agents of each other. Duties are therefore owed to the partnership and other partners.

LLPs

Members are agents of the LLP but do not act as agents for all purposes. Members do not automatically owe each other fiduciary duties. In practice, the position under an LLP can be less onerous.

What can be forfeited?

Partners/members who breach their duties may lose their right to their proportion of profit share. Where profit shares are characterised as remuneration, this can be susceptible to forfeit. This means that breach of fiduciary duties may be compensated by withholding profit share from the wrongdoing partner/member.

When does the forfeiture rule apply?

The case law to date focuses on the application of the forfeiture rule to one-off transactions, rather than long-term relationships with a single instance of wrongdoing – in such cases it is felt that forfeiture would not be appropriate.

The court is unlikely to impose forfeiture where the breach was by someone acting in good faith or honestly and/or where it would not be ‘proportionate and equitable’ to do so. In practice, this means that an honest belief that something is not a duty or unknowingly doing something wrong will be unlikely to attract forfeiture. However, clear cases of serious and/or continuous breach, such as losing a major client or hiding partnership profits may qualify.

The status and ownership of work in progress is another area that causes problems when a partner/member leaves. What happens to unbilled work at the time of exit? What can the partnership do when an exiting partner transfers their current work to a new firm in competition with the partnership/LLP? The forfeiture rule may now apply to such circumstances to provide a level of redress.

Can forfeiture be imposed?

As explained, not every situation will give rise to a right of the partnership or LLP to forfeit remuneration or capital otherwise due to partners.  Before taking action partnerships need to consider:

Is the partner/member a fiduciary?

Has the partner  breached a fiduciary duty?

Will the partner have grounds for claiming they are not a partner but in fact an employee. Under UK employment law it is very difficult to forfeit employment income unless there is a right of set off and the claim is properly made out.

Was the breach honest? In the circumstances, would it be proportionate and equitable to apply the forfeiture rule?

When considering whether to impose the forfeiture rule, be careful not to waive the breach; in such cases, there would be no ability either to clawback payments made, withhold profit due or apply for forfeiture.

Steps partners be aware of

Always consider your partnership agreement and do not assume that all partnerships are the same.  In terms of future forfeiture consider:

  1. Making payment of profit share conditional on compliance with fiduciary duties
  2. Including a forfeiture clause – ensure that this does not look like a penalty clause as this will be disregarded by the court
  3. Expressly excluding forfeiture to protect all partners/members in the future