LLPs are not as safe as you might think

THE LIMITED Liability Partnership vehicle is now a decade old, but its uptake has reportedly surged amid economic hard times. Members of insolvent LLPs are certainly better off than their counterparts in insolvent partnerships, who must routinely dig into their own pockets to meet creditors’ claims. This summer, though, saw the first high-profile collapse of an LLP – that of the law firm, Halliwells – and the jury is still out on whether this was the Lehman Brothers or just the Northern Rock of the legal services market. Either way, the limits to limited liability for members of LLPs in all sectors look set to be thoroughly tested before this recession is out.

What LLP members may not realise is that, under insolvency law, even the most junior of them is treated much like a company director. In larger firms, that can work harshly. Junior members are often kept out of the loop of decision-making. Under the terms of the members’ agreement, they might even be barred from receiving information about the LLP. When they were promoted into the membership, they were rarely in a position to negotiate over the small print. But the law still expects them to look out for the interests of the LLP’s creditors when insolvency beckons.

You cannot be a “sleeping director” of a company and you cannot be a “sleeping member” of an LLP. If the LLP should have ceased to trade earlier than it did, all members are potentially liable to make good the loss to creditors where they should have done more to bring this about (although those with specific management responsibilities will be the most exposed). All members, too, may potentially have to repay any money received from the LLP – including salary and profit share – within the two years before it was wound up, a rule without equivalent for companies.

Even in large LLPs, personal guarantees from members for the LLP’s debts are also widespread and likely to be called upon if the LLP fails. If the LLP takes steps to reduce these members’ liabilities when in financial difficulty, their lawfulness is likely to be challenged. The difficulty is that it will involve preferring these creditors’ interests over the interests of creditors generally, which cannot be done.

In the case of Halliwells, parts of the business were sold to other firms and the proceeds used to release some members’ personal bank guarantees. This undoubtedly preferred these members’ interests over the general creditors, but the High Court nonetheless blessed the “necessary evil” involved. The reason was that the sale of the business could not otherwise proceed. If the guarantees survived, the guarantors would have faced personal bankruptcy, and they could not practice as solicitors. Their business would then evaporate.

This decision reprieved the individuals concerned, but may prove a curse for LLPs. Banks who thought they had the comfort of personal guarantees independently of the value of the business may in practice be forced to elect between the two. Inevitably, the guarantees and security called for to support future lending will become more exacting as a result.

As a shareholder of a company, it is possible to enjoy the benefits of ownership without bearing the responsibilities of management. In an LLP, there is no such thing as care-free ownership. Not all members are equal and not all even have a stake in the LLP’s profits. All, though, have a potential liability for its losses, in spite of the limited liability epithet. The unavoidable potential liabilities attached to membership place a heavy onus on sound governance within the LLP.

In boom times, this was easier to ignore. The widespread transition from traditional partnership to LLP helped encourage a greater concentration of decision-making in professional service firms. These times of bust will underscore the dangers for LLP members of trusting too much to others.

James Mather is a barrister practising at Serle Court, Lincoln’s Inn.