De-equitisation is it all over?

January 8, 2010

The de-equitisation of partners, the process whereby a partner in a partnership or LLP is demoted from full "equity" status (where he shares in the residual profits of the firm after payment of fixed share partners) to some other status such as "fixed share" status (where his profit share generally does not vary according to the success of the firm) has become more common place since the start of the downturn.

There are a number of reasons why firms have sought to de-equitise certain partners. The most common reason is that the contribution of a particular partner or group of partners is considered by the firm to be significantly out of kilter with that partner’s or group’s level of reward. Often, as has been the case in the last eighteen months, the firm will be spurred to initiate a de-equitisation programme as a result of an overall fall in the firm's profits.  Firms have considered that they need to realign the partner remuneration structure in order to retain rainmakers. In some cases, de-equitisation will be used to try to force a partner to leave a firm, often where an outright power or ability to expel a partner is lacking or is considered too expensive. In other cases, the firm may wish to retain the partner’s particular skill sets and "re-equitise" him once his performance has improved. In practice, this rarely happens unless the underperformance reflected temporary factors affecting his practice area. Whatever the reason, a partner receiving news of de-equitisation will often be shocked and aggrieved.

An individual partner the subject of a de-equitisation process needs to keep a cool head in order to undertake an objective assessment of his position and to respond to the firm effectively. In some cases, it may be possible for a partner to maintain his equity status. Even where this is not possible, a carefully planned and considered response can often pay dividends. This article highlights some of the issues that a partner should consider when subject to a de-equitisation process.

Does the firm have a right to de-equitise or expel a partner?

Following receipt of news that the firm is considering or has de-equitised a partner, the first thing for a partner to do is to check whether the firm has the power to do so and whether the correct procedures have been adhered to. The answer to these questions will usually be found in the partnership deed in the case of a partnership or the members agreement in the case of a LLP (subsequent references are to the members agreement but the guidance given could equally apply to a partnership deed). If there is no written members' agreement then the situation can be more complex and will depend on the relevant legislation and on historic arrangements and conduct.

It is also worth considering whether the firm has the power to expel a partner. If it does, then the absence of a right specifically allowing the firm to de-equitise a partner may be academic in practice. This is because the firm may be able to use its right to expel a partner as a lever to negotiate such new terms as it considers appropriate, including a demotion to some other status.

Even if it is possible to rely on the terms of the members agreement to protect a partner's "equity" status, a partner must consider whether such a defence is likely to be workable in practice. If the remaining partners or the firm’s management consider that the partner's remuneration is out of kilter with his performance then running a strict "legal" defence using the members agreement could lead to a breakdown of the relationship, thereby creating long term problems, particularly for the partner. In this case, the partner the subject of the de-equitisation process might choose instead to use the protection afforded by the members agreement as a bargaining tool in negotiations with the firm, for example, to increase his salary or benefits as a "fixed share" partner.

Is the firm able to exercise its power to de-equitise or expel?

Notwithstanding the fact that the members agreement may enshrine the power to de-equitise or expel a partner, an assessment will need to be made by the partner as to whether the firm is likely to be able to exercise such powers. A partner should establish who holds the power to de-equitise or expel and then consider how these are exercised. For example, if a certain percentage vote is required, is the firm likely to achieve the requisite threshold? Even if the firm is likely to be able to exercise its powers, in many cases a managing partner will not wish to ask the partners to vote on the matter for fear of causing dissension or disquiet. In such cases there may be value for the firm in seeking a consensual agreement which could include concessions to the partner as part of a deal.

What are the financial and other consequences of de-equitisation?

If the firm is proposing an alternative, for example, "fixed share" status, a partner should seek to establish the full terms the firm is willing to offer. If they have not been provided in writing, the partner should ask for the terms to be set out in a letter. The terms on offer should then be compared with the current arrangements (taking account of current partner and firm performance). If there are other options, such as moving to another firm, the partner should consider these in light of the offer. One should also consider future differentials between the current arrangements and those being proposed if individual and/or firm performance picks up.  

Many partners the subject of a de-equitisation programme understand the need to accept a temporary reduction in remuneration to reflect a short term weakness in performance. However, partners can often feel seriously aggrieved by the notion of being "demoted" to fixed share status. Some partners may therefore wish to seek to negotiate with their firm a temporary reduction in their remuneration while at the same time maintaining full equity status.  This can often be accommodated. A further benefit of taking such an approach is that the partner is more likely to benefit should the firm’s profits and his individual practice pick up in the future, whereas if he accepts "fixed share" status he may be left with a permanently depressed level of remuneration.

The long way out?

A partner the subject of a de-equitisation process should seriously consider whether the firm is using de-equitisation as a lever to force him to leave the practice. Some members’ agreements provide a different level of protection to equity partners from that which they provide to fixed share partners, something which should be seriously considered if a partner suspects a firm is trying eventually to expel him. However, in many cases the firm will genuinely wish to retain the partners skill set but cannot afford the current remuneration arrangements. If it seems likely that the firm is using de-equitisation to force a partner to leave, even if not immediately, then a partner should seriously consider whether to negotiate an exit with immediate effect which could possibly be on more favour terms to the partner than if he delays.

Conclusion

If the members agreement does not provide a right to de-equitise or expel, then a partner should consider seeking compensation if he is to accept a demotion to "fixed share" status and pay great attention to the future risks to which he is subject by virtue of his acceptance of this different status. It is important to seek expert independent legal advice.


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