When the partnership fails

April 1, 2011

This article was written for and first featured in Accountancy Magazine

The accountancy profession generally has embraced enthusiastically the limited liability partnership business structure. The 'Big 4' all converted to LLP status soon after the LLP legislation was enacted and there has been a steady stream of conversions ever since. 

Whilst most LLP's will have a comprehensively drafted members agreement, the recent case of Eaton v Caulfield and others [2011] EWHC 173 (Ch) demonstrates the pitfalls of entering into an LLP without having a written members agreement in place. As far as the authors are aware, Eaton is the first reported case dealing with the application of section 994 of the Companies Act 2006 (unfairly prejudicial conduct) and section 122 of the Insolvency Act 1986 to LLP's.

The facts

The case of Eaton involved three legal headhunters, who incorporated an LLP in 2007. The purpose of the incorporation of the LLP was to formalise their relationship, as prior to 2007 the three of them had been working together, and marketing themselves under a common brand to the outside world.  Crucially, there was never a written LLP members agreement. Mr Eaton's (the Petitioner's) case was that the only express (orally) agreed terms related to profit sharing, the sharing of overheads and the way in which capital contributions were to be dealt with.

The relationship between Mr Eaton and Mr Caulfield (the First Respondent) deteriorated over time. In 2008, matters came to a head and Mr Caulfield sought summarily to expel Mr Eaton from the LLP. Mr Caulfield effected this in a number of ways: locking him out of the office; blocking his access to the IT system; removing his profile from the LLP's website; and informing clients and candidates that Mr Eaton no longer worked at the LLP. Mr Eaton had no option other than to present an unfair prejudice petition, pursuant to section 994 of the Companies Act 2006. Section 994 gives the Court an extensive jurisdiction to remedy mis-management of a company/LLP that is unfairly prejudicial to the interests of its members. The usual order, if unfair prejudice is proved, is for the petitioning member’s share to be bought out by the wrongdoing members for fair value.

Finding of unfair prejudice

In Eaton, the Judge held that Mr Caulfield's expulsion of Mr Eaton was unfairly prejudicial. The basis for this decision was that there was no written members agreement and that the members had not made any express agreement as to expulsion. Regulation 8 of the Limited Liability Partnerships Regulations 2001 (the "LLP Regulations"), therefore, applied, which states that: "no majority of the members can expel any member unless a power to do so has been conferred by express agreement between the members".

The Respondents had to show that a power of expulsion was expressly agreed and the circumstances in which such a power could be exercised. An unlawful expulsion and exclusion from the business was a clear example of unfairly prejudicial conduct. Accordingly, the Court can order the Respondents to buy out Mr Eaton’s interest in the LLP. Furthermore, the Judge found that there had been a complete breakdown in the relationship between the members and that Mr Eaton would be entitled to have the LLP wound up on a just and equitable basis, pursuant to section 122 of the Insolvency Act 1986. 

The Judge did not agree with Mr Eaton that there was an express agreement that each individual member's capital contributions would be returned to him on departing the LLP, but made the finding that Mr Eaton was entitled to a third share of the total capital contributions on the basis that default Regulation 7(1) states that all members are entitled to share equally in the capital and profits of the LLP.

The importance of a written LLP members agreement

The key message from Eaton is that it is vitally important to have in place a written members agreement which reflects the way in which the members want the LLP to be run, and to understand that Regulations 7 and 8 (the default provisions) of the LLP Regulations will govern any matters which have not been agreed. For example, in Eaton, the members could have agreed the circumstances in which a member might be expelled, the procedure for doing so and a mechanism for the departing member's profits and capital contributions to be distributed to him. Unlike the regime applying to limited companies, the members could, by agreement in writing have excluded the operation of section 994. Even if there is no agreement to exclude section 994, if the parties have a well-drawn members agreement with which they comply, it will be more difficult for a leaving member to apply successfully to Court.

An LLP members agreement should also cover matters which are not addressed by the default provisions, including: provisions relating to the return of capital, how management decisions are to be taken (for example, whether decisions require unanimous consent or only a simple majority), whether a member is a 'contributory' in relation to the winding up of the LLP, and the extent of the duty of care owed by the members to the LLP and each other.  

Litigation tactics

A supplementary novel point which arose from Eaton is the costs advantage of the petitioner making an open offer at the beginning of proceedings. The usual position is that the remaining members can protect their position in respect of the costs of litigation by making an offer of a buy-out under the principles set out in the case of O’Neill v Phillips [1999] 1 WLR 1092 (a buy-out of the petitioner’s share of the LLP at fair market value). Prior to the petition being presented, Mr Eaton made an open offer to the Respondents for them to buy-out his share of the LLP, although there was no obligation upon him to do so. This offer was rejected. This led to indemnity costs (which could work out in practice at around 90 per cent of the legal fees, as opposed to around 70 per cent on the standard basis) being awarded against the Respondents for a large percentage of the trial costs. 

Members Agreement – checklist

  • Express power of expulsion and the grounds upon which the power can be exercised.
  • Exclude the operation of section 994 of the Companies Act 2006, otherwise it will apply.
  • Set out how profits and capital are to be shared, otherwise they will be shared equally.
  • Describe the procedure for how management decisions are to be taken is unanimous agreement required or will a simply majority suffice to pass certain decisions?
  • Explain what happens if a member leaves, including notice periods, how his/her profit share will be determined, and when his/her capital will be returned.

Authors: Gavin Foggo (partner) and Molly Ahmed (associate) of Fox Williams LLP, who acted for the Petitioner in Eaton. Both specialise in contentious partnership law.
© Fox Williams LLP 2011


Related pages:

Litigation, Arbitration and Alternative Dispute Resolution more

Partnership and LLPs more

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