Partnerships – what keeps management up at night?

1. What are the board’s powers?
2. The partnership agreement is the starting point, but never the end point
3. What happens if the board takes a decision outside its powers?
4. What can the board do to avoid these risks?
5. Conclusion
6. Contact us

The past ten months have been nothing less than a rollercoaster for all businesses. Cracks are now appearing with the inevitable blame game as scape goats are sought for the myriad of things that may have gone wrong. This article aims to provide helpful guidance on some of the responsibilities of boards and managing partners and the steps that can be taken to mitigate the risk of things going wrong and the strain on firms which results.

The significant flexibility enjoyed by partnerships and LLPs over how they run their business, including how they divide up responsibility for management of the firm’s affairs, is often an advantage over the more rigid management structure for companies and their directors. 

In a limited company, the management role of the board of directors is enshrined in company law, with only a few matters required to be decided by shareholders.  The position in partnerships and LLPs is very different.  Partnership and LLP law does not distinguish between owners and managers in the same way that company law does.  Instead, the law empowers the partners as a whole to take decisions.  This is not always practical, and so management boards are typically given a range of delegated authority from the partners as set out (for better or for worse) in the partnership agreement.

This means the flexibility that allows partners to write their constitutions on a blank canvas – or have no written partnership agreement at all – tends to be a double-edged sword, particularly when the firm faces unprecedented commercial and financial pressures of the kind which the pandemic has wrought. 

The challenges of Covid mean that the management boards of partnerships and LLPs are, more than ever, being called upon to take business-critical decisions under pressing time constraints.  Important decisions might include:

• redundancies and pay reductions amongst employees
• giving notice of compulsory retirement to one or more partners, whether because of underperformance or restructurings
• reducing partner profit shares
• seeking further capital contributions for the partners
• exercising rights to prevent partner departures, such as garden leave provisions, notice periods, “departure lounge” clauses and good and bad leaver provisions.    

Yet in the rush to address urgent commercial needs, it is vital that board members do not unwittingly overstep their authority or breach the partnership agreement in some other way, potentially exposing themselves to personal liability and calling into question the validity of their decisions.

What are the board’s powers?

A management board, partnership committee, managing partner and any manager and governing body is entirely a creation of the partners.  They are not constituted in legislation in a way that a board of directors is for a company (the exception is the designated members of an LLP, but these are only offices with additional responsibility and no additional powers). The board’s powers and responsibilities in a partnership or LLP are wholly dependent upon the terms of their appointment, which are typically set out in a written partnership agreement, although may also arise through custom and practice.

As a first step, it would be wise for board members who are straying into new territory to carefully check their partnership agreement to make sure they are empowered in all aspects of a matter on which they are engaged.  There are many situations in which a board may assume it is empowered to act, but which require partner approval for some element.  For example, a board empowered to set policies as to partner absences might assume it was empowered to agree with a partner to that he or she will take a period of absence on reduced remuneration.  It would be easy to overlook a potential need for wider partner approval to vary partner remuneration, even when that reduction has been agreed by the partner in question. 

More complex situations may engage numerous elements of the partnership agreement and require multiple partner resolutions to approve, often with different voting thresholds: for example, a new expenditure policy may require only a simple majority of the partners, whereas the decision to give notice of compulsory retirement on a partner may require the approval of 75% of the partners, or perhaps even all of the other partners.

The partnership agreement is the starting point, but never the end point

The partnership agreement may not give all the answers.  On the face of the agreement, a particular decision may be neither expressly reserved to the partners nor within the scope of the board’s powers.  This might include, for example, where the management board seeks to limit partner drawings in order to preserve cashflow or cover anticipated losses.  If this power is not expressly given under the partnership agreement, there may be an implied term that the board can take a decision which has been evidenced by former practices, or the words in the agreement giving a general management power to the board are sufficiently wide to include it.     

Whilst the agreement is the starting point for understanding the powers of the board, other legal duties are layered on top of the authority granted to it by the agreement.  These must be complied with.  Most board members will be well aware that they must take care to avoid direct or indirect discrimination when taking decisions.  Fewer board members will be aware that a board discretion must ordinarily be exercised in good faith, rationally and for the purpose which it was conferred.

The board may be able to reduce profit shares and drawings (or even make one partner pay more than his/her fair share of losses) for example, but it cannot do so in an arbitrary or irrational way, such as by singling out a partner for particularly harsh cuts in profits where objective data does not justify it.  

All of these constraints on powers, and the distinct possibility of a difference of opinion in the interpretation of the agreement, mean decision-making by the board during the pandemic is heavy on ambiguity and riddled with traps for the unwary manager.    

What happens if the board takes a decision outside its powers?

If a board acts when it does not have the requisite authority to do so, or it does so in a manner that fails to meet the standard for proper decision-taking, the decision risks being ineffective.  For example, a wrongfully expelled partner who was given a void notice of expulsion will not cease to be a partner and will continue to accrue a right to share in the profits.  For the board member taking the decision, the act might amount to a breach of the partnership agreement for which he or she may be sued personally by the other partners, which the partnership or LLP may not cover via an indemnity.  It can certainly lead to unwelcome disputes among partners.

What can the board do to avoid these risks?

When difficult decisions fall to be made, the board should always:

• act on the best information they can reasonably get, without ignoring important metrics: for example, deciding to give notice of compulsory retirement on the basis of selective performance figures, particularly without allowing the affected partner to make representations, risks a successful challenge to the decision
• consider both the express terms of their powers under the partnership agreement and whether any implied restrictions may have been breached in the course of decision-making
• where matters need to be referred to a vote of the partnership as a whole, ensure the necessary processes under the agreement are followed, including notice of the meeting being sufficient
• check if any proposed decision or policy does not disproportionately affect partners with particular protected characteristics such as gender or age(or if they do, ensure the proposal is robustly justified on objective grounds): these policies can otherwise be challenged on the basis of indirect discrimination
• always act in good faith and avoid any appearance of improper motives or bad faith: a common charge will be that the board members have a conflict of interest in decisions.  Board members are also partners and so a decision taken by the board invariably affects them personally.  This does not rule out their being involved in decisions, but it emphasises the need to document the rationale behind decisions which might benefit them personally, despite being objectively justifiable as a course of action.  Much risk can be overcome by taking care to note all of the factors that are being considered or discounted and that all board members have arrived at the conclusion independently without surrendering their power to a single member or a subset of the board
• seek specialist advice: just as the board of a company might engage outside counsel to guide it through decision-making in difficult areas, the boards of law firms and other professional services partnerships, who might ordinarily be comfortable making such determinations, should consider taking independent advice to support their judgments. 

Before any difficult manoeuvres (such as profit share reductions or compulsory retirements) are attempted at all, management should consider whether any amendments to the partnership agreement should be made in advance, for example to clarify any ambiguities in the board’s powers or any processes which need to be updated.  Perhaps more obviously during the pandemic, provisions requiring that notices must be given by hand and not by email, or that partners’ meetings must be held in person (and cannot be conducted via Zoom or Teams) should be amended.  However, such amendments will themselves require careful thought as to how to navigate these formalities. 

It pays for management to be careful not to overstep their authority, however well-intentioned those decisions may be, but avoiding doing so is more challenging than it may first appear.  Given the potential consequences of an invalid or unlawful board decision, it pays to get it right.

Conclusion

There are a handful of overarching lessons for directors and managers from all of the pitfalls we discuss above.  Most importantly, you should where possible anticipate the hazards posed by the pandemic and its economic consequences before they arise.  However, when problems do arise, they can be dealt with much more easily when the issues can be detected via clear reporting lines and properly mapped responsibilities.  Otherwise, valuable time and energy might be diverted to the blame game and exercises to pass the buck elsewhere, instead of focussing on remedying the problem.  Seeking professional advice at an early stage is of course important to mitigate any issues which have arisen. 

Contact us

If you have any questions about these issues in relation to your own organisation, please contact a member of the team or speak with your usual Fox Williams contact.