Over the limit
5 September 2005
Many UK law firms with an international presence have previously shied away from converting to an LLP. This has principally been for tax and regulatory reasons. However, as previously unexplored territory is successfully tested, international firms are considering the risk management opportunities that LLP status could afford to their businesses.
Operating through an LLP is not a panacea for all the risks inherent in practising in partnership. Negligent members still retain unlimited liability and all of the members could be subject to statutory claw-back of previously drawn down profits under the Insolvency Act 1986, or could lose their capital contributions where the LLP is in financial difficulty. Members of an LLP also owe similar duties and are subject to certain statutory offences or disciplinary proceedings applicable to directors of a company. But aside from circumstances broadly involving personal negligence, fraud or acting without due regard, a member's liability will be capped and the risk of individual bankruptcy in the event of an Armageddon claim greatly ameliorated.
On the other hand, concern has been expressed that by becoming an LLP the partnership ethos will be replaced with a corporate-driven philosophy, the team spirit among international partners and staff will be lost and the historic culture, values and brand of the firm depersonalised. A balance must be struck. Much will depend on the risk adversity of the partners in a firm considering conversion looking to ringfence their personal liability and the maintenance of the provision of a seamless worldwide service of universal quality. But the conflict is not insurmountable and because of the flexibility of internal governance of an LLP, the same mutual duty of good faith and joint financial responsibility between partners can be largely replicated by contract.
This dichotomy of interests is exaggerated in the case of an international practice. In certain jurisdictions it is not possible or is highly impractical to carry on business as an LLP. If the overseas businesses of the law firm are transferred to the UK LLP in some instances, the partners left in the overseas offices who have to continue to practise in partnership would still have joint unlimited liability for all the debts and losses of each of their respective partnerships, but they would lose the benefit of being able to call on their previous partners for a financial contribution. It is therefore necessary to implement a risk-sharing structure between the LLP and these parallel partnerships.
If the members of the LLP, together with the partners in the parallel partnerships, are treated as partners in a worldwide partnership, rather than recognising the separate existence of the LLP and of each partnership, the limited liability for global risks will be lost. Accordingly, the separate partnerships must operate independently by holding separate management and partners' meetings, maintaining separate records and preparing separate accounts.
This liability issue should also be addressed in the new engagement letter and all other external communication and publications. It must be clear that any collective term, such as international practice, refers to the separate businesses of the LLP and each of the parallel partnerships.
Where the instruction is taken by the LLP, the engagement letter should allow the LLP to sub-instruct the parallel partnerships as agent for the client on international aspects of the matter or, where the instruction is taken by a parallel partnership, this too must be clearly stated.
One way of achieving a balance between effective worldwide risk management and the one-firm ethic is by using a 'valve' partner arrangement. All partners in the old partnership would become members of the newly incorporated LLP and those practising in non-LLP countries would also be partners in parallel partnerships. The LLP would hold all of the IP of the partnership, set global strategy and standards and define the firm's values, which is then licensed to and adopted by the parallel partnerships. Nominated members of the LLP also become partners in the parallel partnerships and act as 'valve' partners, through whom profit adjustments are made and who may have negative control over key decisions at partners' meetings for the purpose of implementing global strategy or appointing new partners. As profits are shared on a global basis, a loss in one jurisdiction will reduce the pool so that risk of losses is spread and exposed partners protected.
This only goes some way to managing international risk and does not fully protect those members of the LLP who are also partners in a parallel partnership and potentially exposed beyond their investment in the LLP. At a business level, it is possible to use the assets of the network to protect partners with unlimited liability through a series of cross-indemnities between the various entities. An agreement to that effect can be put in place, but must take into account how entities share protection, where more than one entity requires protection and how liability is borne where more than one entity is required to pay under the indemnity. The inter-entity agreement must also provide that no individual has unlimited exposure as a result of a claim under an indemnity.
However, if the LLP and all the parallel partnerships are insolvent, exposed partners still have residual unlimited liability. If the protected members were to stand behind unprotected partners, or be under an obligation to contribute to the loss of an unprotected partner, this could create a deep pocket for creditors. One solution to manage such risk would be for each member and partner to covenant that should another partner suffer a personal exposure, which cannot be satisfied by the LLP or another entity, they will contribute to that partner's lost assets up to a specified maximum, which aggregates to a fraction of the LLP's capital. Payments are made to the dependents of the exposed partner and so no deep pocket for creditors is created. The liability to make payments to dependants by non-bankrupt members is capped at an insurable amount.
Managing risk at an international level will prove a difficult area for any law firm with overseas offices considering conversion to an LLP. The approach considered in this article is only one way to deal with the many thorny issues that arise and may not appeal to every partnership. Other structures involving complex licensing arrangements and cross-sharing of profit and loss, perhaps utilising an overarching entity such as a Swiss verein, could achieve a similar level of international risk management, but are not without problems of their own. Conversion to an LLP will not remove unlimited liability for a partner completely, but the risk can be reduced to a more acceptable level and global arrangements can be put in place to meet the needs of most firms.
Rachel Khiara is an associate in the private client department of Allen & Overy