The ghost of business past

The legal and accountancy professions have both been early adopters of limited-liability partnership (LLP) status, which is designed to protect partners’ assets from the consequences of the risk of catastrophic failure of the practice. So does it work? And what is the likelihood of seeing such a failure?

LLPs can become insolvent like any other business. LLP status is an effective method of protecting future members from the consequences of tomorrow’s actions. Only their partnership capital and undrawn earnings are at risk. However, it is not a panacea for the partners (members) appointed under the former unlimited liability partnership. For example, where property leases have been signed up in the name of, or on behalf of, the partnership, unlimited liability on the lease obligations continue for the old partners, including those partners who have retired or moved to new opportunities, until the expiry of the lease. In most cases, uninsured negligence claims also fall into the partnership year in which they are reported for liability purposes, so the long-outstanding litigation might well have been assumed as a liability of the LLP, but the claimant can look to the partners who constituted the partnership at the time of the event in dispute for settlement. Thus, for many partners, it may take many years before the protection of the LLP genuinely takes effect.

Notwithstanding the theory, is there a risk of insolvency for a major legal practice? I would suggest that the risk of insolvency as a result of prolonged poor trading performance is relatively low. Even the best run practices can suffer from economic downturns, and where this coincides with high investment, such as property relocations, incomes can decline. However, when dealing with severe income declines, the partnership or the LLP is to a large extent a self-healing or self-killing entity. As performance falls, individual partners feel the effect where it hurts, in their pockets, leaving them with a choice of doing something about it or leaving. Where problems are of a greater nature and continue to deteriorate, partners may depart in greater numbers, leaving the practice to shrink and eventually disintegrate well before it is so terminally sick that an insolvency process is needed.

The insolvency practitioner rarely has to get out their rather dusty copy of the insolvent partnerships order and become familiar with that tortuous piece of legislation. We have seen failures of high street solicitors owing to poor trading or malpractice, but not on any larger scale. That leaves us to consider the possibility of catastrophic failure. In the accountancy profession we witnessed the demise of Arthur Andersen back in 2002. However, Andersen’s life did not end in insolvency in the UK or elsewhere. The partners arranged for their own controlled disintegration and split in different directions in a variety of jurisdictions, and in the UK at least one or two nobly stayed behind to tidy up before closing the doors. They were quality people and they have survived the catastrophe. But what if a killer claim came home to roost in a major legal firm?
The first point to note is that it will be a simple matter of timing as to whether the LLP protection kicks in or if the case is all about something that dates back to the partnership. If it does date back, and if we are dealing with claims that exceed the professional indemnity cap, a number of the long-service partners will face personal insolvency risks as well as the loss of LLP capital.

Insolvencies of ‘people businesses’ are notoriously difficult to handle. A legal practice is an ultimate people business and those people will vote with their feet as to whether they stay behind to assist in realising any residual goodwill for the benefit of the creditors and the claimant, or whether they do their own thing. There will be seriously talented people who will be very marketable and who will look after themselves and their teams. The appointed insolvency practitioners might well turn out to be only bystanders watching the disintegration of the practice.

Bill Mackie, long retired from what is now Ernst & Young, famously described the insolvency process as “like holding melting ice-cream”. Hold on too long and what are you left with? An insolvency of a major legal practice might well fit that description, but in extreme degrees of heat. In the scenario I am creating, it would be over very quickly and the majority of the people would be quickly engaged elsewhere. For the LLP partners it will be a loss of capital and undrawn remuneration. However, partners should also be aware in the catastrophe scenario of the effect of Section 214A of the Insolvency Act: that there is a risk of clawback in the event of liquidation of the last two years’ drawings (of whatever description) if they knew, or ought to have known, that the LLP was unable to pay its debts at the time.

If the problem relates back to the partnership, would the claimant enforce the insolvent partnerships order route with the parallel insolvency of the partnership entity and all the partners? The mere thought of the size of the spreadsheet working out the contributions would be enough to discourage the prospective insolvency practitioner. Commercially, would such an insolvency be likely to maximise the recovery for the claimant, or would the claimant prefer to negotiate settlements based on future earning contributions?
The negotiation route has many advantages associated with it, and over time might lead to a better result. The administration process would be the better process, given the likely need for international recognition. Although not previously available, LLPs may apply for new style Enterprise Act administration, with effect from 1 October 2005. This might also raise the spectre of using the EC Regulation on Insolvency Proceedings 2000 to apply the administration process in any other jurisdictions where the practice operates.

However, to date it has not happened and we can only speculate as to how such a scenario might unfold.

Malcolm Shierson is a partner at Grant Thornton Recovery and Reorganisation