A world without consequences?

As we have become more accustomed to LLPs over the last ten years we have come to appreciate that, in fact, they don't offer a wholly risk-free environment. While a well-drafted retainer may close-off personal liability for negligent advice in private practice, there are all sorts of trapdoors that can admit personal liability to those who own or operate an LLP.

Those risks don't necessarily arise as a result of giving advice '“ they come from running a business. For instance, section 214A of the Insolvency Act 1986 has, among other things, the consequence that anyone admitted as a member of an LLP and who has drawn funds from it (profits, salary and so on) may be called upon, in certain circumstances, to repay those drawings where they have been taken in the two years before the LLP was liquidated. That includes any of the members who did not take the steps that they ought, in order to ensure that the finances of the LLP were in good shape. Even those members of an LLP who might reasonably have expected to escape a meltdown can get caught in the crossfire.

Running a business has some similarities to walking a tightrope. Both activities call for skill '“ and can end badly if things go wrong. Before the arrival of limited liability partnerships and alternative business structures, those in legal partnerships knew where they stood; they took the risk of running their business but they balanced that against the opportunity to make significant profits if they got it right. Then, along came LLPs: partnership, but (allegedly) without personal risk. All of a sudden it looked like there might be a safety net under the tightrope.

What effect has the (perhaps misguided) belief that LLP's offer protection had on those in practice? Have some lawyers actually ended up in trouble precisely because they thought that they were invulnerable? Let's consider how the adoption of LLPs led to some important changes in borrowing habits.

Cultural shift

Before LLPs, banks lent money to solicitors' partnerships knowing that the individual partners in the firm were compelled to make the loan repayments. The partners themselves were conscious of this and a desire to take drawings when the finances of the business did not merit such was tempered by the knowledge that, one day, the borrowing would have to be repaid '“ as a personal liability.

With the advent of LLPs, things began to change. Medium and larger-sized firms, with respectable turnovers, began to find that some lenders were willing to permit borrowing on the basis of a covenant to repay given by the LLP itself '“ not from the individual standing behind the business. And with plenty of work in progress (WIP) on the books, there seemed to be no impediment to substantial lending. It has been suggested (including by BDO's Dermot Power) that some lenders to law firms were simply too inexperienced in valuing WIP to make a realistic assessment of its true value. In some cases this may have contributed to the banks being prepared to lend more than, on a prudent basis, they ought to.

Where there is too much borrowing, the assets of a firm don't support this and the individuals who own the business are not (directly) on the hook to repay the lenders, this can be fertile soil for a budding LLP meltdown. When the WIP turns out to be worth a fraction of its book value and an LLP becomes distressed, with its overdraft beginning to run out of control, the slide into the red is well underway. With lending withdrawn by the banks, or very tightly controlled, and creditors lining up, what happens next? In some cases a call for capital, perhaps kindly extended to the fixed-share partners, seems to be a growing feature of the times.

And when the going gets even tougher and creditors don't get paid, the integrity of the LLP as a barrier to liability begins to erode. Tax transparency within the LLP can be a contributing factor '“ because, for instance, when the LLP fails to make a payment to HMRC, the liability for tax actually tracks through to the individual members.

In circumstances such as these, you have to ask whether, to some extent, excessive borrowing and drawings by law firms results from the illusion that LLPs are a safe place from which to operate. The reality is that, although they offer some protection, LLPs do not relieve those running a business from personal liability if they run that business badly. In terms of the way that firms handle their finances it is possible that LLPs have actually had a rather negative impact on the profession and have led to some of the current problems faced by legal businesses that have adopted the LLP as their chosen vehicle. A belief in one's invulnerability can make anyone careless. LLPs may have had an effect of that kind on some members of the legal profession, resulting in some of the distressed law firms in existence today.