UK: Professions Legal Update

Contents

• Looking forward to 2007
• Treatment of Post Dissolution Receipts
• The "Ordinary Course of Business" Confirmed

Looking forward to 2007

We believe all professional firms, of whatever size, that are not companies, are going to have to address some fundamental constitutional issues within the next three years. This article explains why.

There are, as we go to press, a significant number of LLP conversions happening or about to happen. There are over 7,600 LLPs on the UK register. The growth in LLP registrations is strong. It will continue. There are other well known firms with LLP conversion pencilled in for dates in 2004 or early 2005. Not all these 7,500 LLPs are being used by professional firms. Indeed we believe that more than half are not. But with all the top 6 accounting firms either converted or about to convert, and major law firms moving too, the proportion of UK PLC’s wealth generated from professional firms trading as LLPs has already grown to a number of billions.

The Government ought to be pleased with this uptake. By 2007 we are confident that well over half the fees generated by professional firms (excluding health professionals) operating in the UK will come from either companies or LLPs, putting pressure on some firms that are reluctant to convert from partnerships to join that trend. There will need to be a "reason" why competitors have not embraced limited liability, and we doubt the issues of financial disclosure will be a sufficient reason.

At the same time as this inevitable momentum to LLP is "taking off", the long awaited Partnerships Bill has been published, heralding the reform of partnership law and, for some, the sad demise of the 1890 Partnership Act. It is anyone’s guess as to when parliament will find time to debate and enact this Bill. It is most unlikely to happen this side of a general election. We do not think the momentum towards LLP is however any reason to hold back on taking this new partnership law onto the statute book. The reforms are designed to help businesses that do not have sophisticated partnership agreements. It is correct politically to badge many of the reforms as designed to help small enterprises and sustain entrepreneurial activity in this country.

Mr Justice Toulson, the chairman of the Law Commission, is looking for support to demonstrate the need for the Bill, and examples as to why government should progress these proposals that he has inherited from his predecessor, Mr Justice Carnwarth. Each time a small firm, trading as a partnership because it has wanted to avoid the formalities and costs of being a company, is dissolved there is potential damage to employment, the tax net and competition. We support the proposals and hope they have a speedy passage to the statute book, beating our 2007 date in the title to this article.

Much of the new partnership law can be overridden by a partnership agreement. But for many smaller businesses, who have no agreement, the introduction of separate legal personality, continuity of the partnership business, a right to expel partners and other reforms will be most welcome. The Bill seeks to bring the law of partnerships up to date with the needs of modern businesses. Even some large partnerships, with 30 and more partners, we meet have existed as partnerships at will, with no written constitution, and so these businesses, by 2007 or earlier, are going to have to look very hard at the new Bill, to see whether they really want to become subject to all the "default rules" in the Bill. Each default rule will apply to these informal partnerships but can be overridden or varied by a partnership contract.

We have always counselled against the dangers of partnerships at will, and believe that businesses that have been content to risk dissolutions, and the other problems endemic in partnerships at will should, now in 2004, start to plan for the day the new Bill becomes an Act of Parliament. The Bill might "gather dust" but we think it is a "better bet" that it will more likely be law within the next three years.

The current proposals are that the Bill will apply to all new partnerships after its enactment and to existing partnerships within two years after its enactment, unless a partner elects during this two year period for the default regime under the 1890 Act to continue to apply to him or her. When firms are focussing on clients and performance it can be surprising how quickly issues like these can creep up on the firm. Knowing whether the new or old default regime should apply to a given partnership is not something many partners we have met could make on an informed basis, and there is no easy way of identifying and informing all partnerships of the choice they have to make and the issues involved, unlike the ability to circulate all company directors off the register. Registration of partnerships although much debated is not in the draft Bill.

But what of the firms, perhaps many in number, who are now partnerships, with written agreements, and who do not intend to become LLPs? They will obviously not be so profoundly affected by the new Partnership Act, because it will not impose as many new provisions on such firms compared to those with no constitution. But they are going to have to address the rights of members to withdraw and may find that their existing agreement is deficient in many or some areas.

For example the Bill contains a provision allowing a bare majority of partners to dissolve a firm; something which currently needs unanimity under the 1890 Act. Often partnership agreements are very weak in the area of dissolution, the draftsman having run out of energy or the firm thinking it will never happen to them. We encounter problems here regularly on LLP conversions. Many firms’ present constitutions simply rely on the closing sections of the 1890 Act which only cover a part of the issues raised by dissolution. Such firms must be aware and address these issues. Dissolution, and the new concepts of liquidating a partnership, require thought and planning.

One of the most interesting provisions in the draft Bill is Clause 7(4). It is an example of the clear and concise drafting of the Bill. It reads simply "A partnership is not capable of engaging a partner as an employee". There appear to be doubts that, under Scots law at least, a partnership can "employ" a person who is a "partner", partly because of the issues of separate legal personality. The Bill is therefore drafted to abolish that most awkward entity, the salaried partner, with all the dangers of holding out and unlimited liability. Add to these the additional confusion of tax status of salaried partners and of their other rights and obligations, and the reform might be seen as obvious and welcome.

But for some firms this is going to need much thought and planning. Many will seek to bring their salaried partners into a wider equity partnership in advance of the Bill becoming law. But this is not a simple process. It needs planning. Salaried partners are employees. They may have a number of reasons to wish to remain so including employment law and pension rights. The apparent tax advantages may not appeal to them, and once they are aware of them they will want the benefit to flow to them and not other partners. No one has yet worked out what happens if firms do nothing, continue with "salaried partners" under clear employment contracts, and the law governing that status is changed by Act of Parliament such that the partnership ceases to have the capacity to employ them.

However as a matter of social policy the abolition of salaried partnership is to be supported. Regular readers will recall cases we have reported, always involving small firms, where salaried partners have faced being bankrupted due to claims exceeding PI cover. We know of cases where large numbers of salaried partners have found themselves pursued by banks and landlords when their firm has split up or otherwise collapsed on the basis that they thought they were full partners and treated them as such. The principle of holding out of salaried partners to third parties is clearly well established law. But the abolition of salaried partnership status by the new Partnership Act is, once the initial changes have been managed, likely to be welcome to all concerned. Making a firm look larger than it is by appointing numerous employees with the title partner will have to change.

The full impact of the reforms will no doubt be a topic to which we will return in future editions, but this article should give readers some "food for thought" and an opportunity to embrace and plan changes over time thereby avoiding being made to appear to be reacting to new law. Put another way, you are being warned and will be warned further!

The facts of the case are quite simple. Two brothers were in a farm partnership comprising two farms and livestock. One brother died, in 1998, which of course had the effect of dissolving the partnership between them. Later in 2001 the livestock had to be destroyed as part of the policy to control foot and mouth disease and the surviving brother was paid almost £120,000 in compensation. There had been no settling of dissolution accounts. The partnership was governed by the 1890 Act.

The litigation was on behalf of the estate of the deceased brother and sought to determine how this significant receipt should now be shared. The Court had to decide whether the receipt was governed by s42 Partnership Act 1890 which states that where a member of a partnership has died, and the other partner carries on the business without agreeing a final account, then the estate is entitled at its option either to the share of the profits attributable to the capital share of the deceased partner left in the business or to interest at 5% on his share of the partnership assets. This would allow the Court to determine the matter but would have involved quite complicated calculations of what derived from his brother’s use of his partnership assets. The alternative was that the receipt was a capital sum, in which case it fell to be divided equally between the estate and the continuing brother, applying the provisions of s24(1) of the 1890 Act to that effect. There was no agreement to the contrary so this capital receipt was to be split equally. The judge at first instance found that it was indeed a capital receipt noting that the compensation money was far more than the cattle were worth at the market. The money should therefore be split in equal shares.

On appeal the Court agreed that the receipt was a capital one and that s42 should not apply. The compensation was for far more than the value of the partnership at its dissolution date, but it was right that the surviving partner should be able to deduct from the capital receipt before sharing it the costs he had incurred in maintaining the herd from the dissolution date to the date of culling. In that respect the appeal succeeded.

In December 2003 Mr Justice Lawrence Collins confirmed the Courts’ approach to the issue of whether fellow partners were liable for the fraudulent misconduct of another partner and the proper interpretation of the "ordinary course of business" under s10 Partnership Act 1890 in the case of McHugh and Lynch v Kerr and Allen.

The Appellants in the case were accountants and had been in partnership with the founder of their firm since the 1980s. In 1997 the founder partner was convicted of fraud and theft. In short he had forged a client’s signature on five share transfer forms for the sale of shares in Glaxo Wellcome plc ("Glaxo"). The Respondents were partners in a stock broking firm which had dealt with the sale of the shares and had confirmed to the London Stock Exchange, or the registrars of Glaxo, the genuineness of the signatures.

The shares were sold and the proceeds went to the founder partner. Accordingly the dividends went to the purchaser of the shares rather than the founder partner’s client. The defrauded client brought a claim against Glaxo which was compromised, with Glaxo arranging to purchase shares to replace the original shares and including the loss of dividends. Glaxo sued the founder partner and his co-partners, the Appellants. The Appellants joined the Respondents (the stockbrokers) as third parties. Glaxo also sued the Respondents and were successful, therefore discontinuing their proceedings against the Appellants. The stockbrokers claimed against the other accountant partners for their loss in paying Glaxo.

s10 Partnership Act 1890 states that "where by any wrongful act or omission of any partner acting in the ordinary course of business of the firm… loss or injury is caused to any person not being a partner in the firm…the firm is liable therefor to the same extent as the partner so acting or omitting to act". The House of Lords held in Dubai Aluminium that what is the ordinary course of business is a question of fact, and whether the partner’s act is to be regarded as done in the ordinary course of business is a question of law to be judged on the primary facts. It was made clear that such liability is based on the legal policy that carrying on a business enterprise involves a risk to others, and that if wrongful acts are carried out by the agents of a business then the responsibility to compensate the wronged person will fall on the business.

The accountancy firm did not provide a share dealing service as such. However there was evidence that a small amount of such activity was conducted on behalf of a few individual clients. The Appellants claimed that in committing the frauds the founding partner had been acting not as a partner in the firm but personally. They placed reliance on the fact that the Respondents had lodged the share transfer forms and that Glaxo had relied upon confirmation by the stockbrokers that the signatures were genuine. The proceeds of the fraud had not been received by the Appellants although the founding partner did use an account in the name of the firm as a conduit for the money.

The Respondents argued (and the judge accepted) that it defied common sense to suggest that the completion of share transfer forms, if in fact authorised, would be outside the scope of an accountant’s business and it was clear from the evidence that the Appellants did carry out at least some share transfer work. In giving his judgement as to whether the Appellants could show whether they had any prospect of a successful defence, the judge emphasised that whether an act is done in the ordinary course of business does not depend on whether the partner was authorised to do the very act he did. The question for the Courts was whether there was a sufficient connection between the founding partner’s wrongdoing and the acts in which the firm engaged. In this case it was "almost impossible" to see how the acts could not be within the ordinary course of business of the firm.

This ruling was despite the fact that the sale of shares was a very small part of the firm’s business and that it did not normally charge for this service. The judge commented that the fact that some of those share transactions were carried out for friends, or were one-off transactions, were not matters which affected the question of whether they were part of the ordinary course of business of the firm. Nor did it matter that the firm was never intended to receive any benefit in terms of fees. Furthermore at least two of the share transfer forms had been forwarded to the Respondents under cover of a letter written and signed by the founder partner on behalf of the firm.

This decision again highlights the importance of trust and honesty between partners. Importantly the draft Partnerships Bill, mentioned in our main article, retains the concept of vicarious liability of a partnership for loss and injury caused by a partner’s wrongful act or omission when occurring in the "ordinary course of business". Interestingly under the draft clause a partnership may also be vicariously liable to a partner, which is not currently the case under s10. The Law Commission has also made it clear that the expression "wrongful act or omission" is intended to have the same meaning given to the phrase in Dubai Aluminium.

Copyright © 2004 Mayer, Brown, Rowe & Maw. This Mayer, Brown, Rowe & Maw publication provides information and comments on legal issues and developments of interest to our clients and contacts. It is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed in this publication.

Mayer, Brown, Rowe & Maw is a combination of two limited liability partnerships, each named Mayer, Brown, Rowe & Maw LLP, one incorporated in England and one established in Illinois, USA.