Partner exits: leaving empty handed

Preserving the financial interests of a partnership or LLP when a partner or member leaves can be complex. Disputes may arise over the return of capital contributions or whether remuneration should be withheld from a departing partner who has breached their duties. This article considers the key legal issues for those on either side of the negotiating table.

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Returning capital contributions – how to get your capital out

A partner’s capital contribution is money or other value contributed to fund the business, rather than a loan. It represents a financial stake in the partnership and is generally exposed to the risks of the business. The treatment of a contribution depends on the legal structure and the terms of any written agreement.

How partnership capital is created

Partnership capital may comprise cash or assets contributed by a partner as capital rather than as a loan. Undrawn profits may also become capital where there is clear evidence of an intention to capitalise them.

Each partner’s capital contributions should be recorded in a capital account, separate from the partnership’s current account. Without a clear partnership agreement, uncertainty may arise over how capital and profits should be allocated. If a contribution is intended to be a loan, this should be documented because loans and capital contributions are treated differently, particularly on insolvency.

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

A partnership agreement should specify the financial entitlements of a departing partner, including how their capital contribution will be dealt with.

If there is no agreement, or the agreement does not address a partner’s departure, the default legal rules may apply. In some circumstances, a partner may be able to dissolve the partnership and require it to be wound up. Any repayment of capital will depend on the partnership’s assets and liabilities, and partnership debts must be settled before capital is returned.

Dissolution can have serious commercial consequences for the continuing business. A clear written partnership agreement can help avoid uncertainty and reduce the risk of a dispute escalating to this point.

Insolvency

Partners in a traditional partnership are generally personally liable for partnership debts, with joint and several liability potentially applying. Insolvency law provides procedures for dealing with partnership insolvency, but these do not guarantee that partners will recover their capital contributions.

If the partnership is insolvent, its assets will generally be used to meet creditor claims before capital can be returned. Partners may also face personal claims from creditors and, depending on the circumstances, personal insolvency proceedings. A partner who has made a genuine loan to the partnership may rank as a creditor, whereas a capital contribution is generally returned only after the partnership’s liabilities have been addressed.

How LLP capital is created

An LLP is a separate legal entity. The treatment of a member’s contribution depends on the LLP agreement and the circumstances in which the contribution was made. A sum advanced as a loan may be a debt owed by the LLP to the member; a capital contribution is not automatically repayable as a debt.

Why is it important?

The distinction affects the member’s rights if the LLP becomes insolvent. A member who is a creditor in respect of a genuine loan may rank alongside other unsecured creditors, subject to the applicable insolvency rules and any security or priority rights. A capital contribution is generally exposed to the LLP’s business risks and may not be recoverable if the LLP lacks sufficient assets.

Insolvency

Unlike partners in a traditional partnership, members of an LLP are not generally personally liable for the LLP’s debts merely because they are members. However, personal liability may arise in particular circumstances, including under guarantees or where a member has separate legal liability. Capital contributions and any amounts due to members remain subject to the LLP’s agreement and the insolvency process.

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

Where an LLP agreement does not clearly address a departing member’s financial entitlements, the default provisions and the circumstances of the contribution become important. A member should not assume that their capital will automatically be repaid on departure.

Depending on the facts, possible routes may include negotiation, a claim based on the agreement or the circumstances in which the contribution was made, an unfair prejudice application, or winding up the LLP. The availability and prospects of these options will depend on the member’s rights and the relevant evidence. Specialist advice should be obtained before taking steps that could affect the LLP’s continued operation.

What should you include in your partnership or LLP agreement?

A carefully drafted agreement should set out how a departing partner or member’s financial entitlements are calculated and paid. Relevant provisions may address:

• Profit share for completed financial years.
• Profit share for the period up to departure.
• Repayment and valuation of capital contributions.
• Member or partner loans.
• Unrealised profits and work in progress.
• Payment timing, set-off rights and any permitted deductions.

Forfeiting profit share in circumstances of fiduciary breach

Partners and LLP members may owe fiduciary duties to the business, including duties of loyalty and good faith. Where a partner or member breaches those duties, questions may arise over whether remuneration or profit share can be withheld or recovered to compensate for the harm caused.

In certain circumstances, the forfeiture rule may prevent a fiduciary from retaining remuneration attributable to a breach of duty. Its application is fact-sensitive, however, and it does not create an automatic right to withhold all profit share or recover capital.

The case law has considered forfeiture in different contexts, including remuneration linked to particular transactions. Whether forfeiture is available in a longer-term relationship involving a particular instance of wrongdoing will depend on the nature of the duty, the breach and the remuneration in question.

The court will consider the circumstances of the breach and whether forfeiture is appropriate. Serious or repeated misconduct, such as diverting a major client or concealing partnership profits, may give rise to claims. The outcome will depend on the evidence and the applicable legal principles.

Work in progress can also be contentious when a partner or member leaves. Issues may arise over unbilled work, responsibility for ongoing matters and the transfer of client relationships to a competing business. The relevant agreement and the circumstances of any alleged breach will need to be considered before deciding whether forfeiture or another remedy may be available.

Can forfeiture be imposed?

A partnership or LLP should not assume that it can automatically withhold remuneration or capital otherwise due to a departing partner or member. Before taking action, it should consider:

• Whether the individual owes fiduciary duties in the relevant circumstances.
• Whether a breach of duty has occurred and can be established.
• Whether the individual may have employment status, which can affect the legal basis for withholding remuneration or making deductions.
• Whether forfeiture is available under the relevant legal principles and is appropriate in the circumstances.
• Whether the partnership or LLP has acted in a way that could amount to affirmation or waiver of the breach.

The partnership or LLP agreement should always be reviewed. For future protection, consider:

• Making relevant payments subject to clearly drafted obligations and conditions, where legally appropriate.
• Including carefully drafted provisions dealing with the consequences of a breach, while avoiding terms that may be unenforceable as penalties.
• Expressly addressing whether forfeiture is intended to apply or be excluded, so that the financial consequences of a breach are clear.

Gannons can help partners, LLP members and management review partnership arrangements, assess financial entitlements on departure and consider the options available where a breach of duty is alleged.