Individual implications of ABS conversion

The number of UK law firms '“ more than 11,000, many with only one or two partners - is expected to drop dramatically in the next 10 years as a result of mergers, competition, and the arrival of alternative business structures. The days of old fashioned style equity partnerships, in perpetuity, seem to be long gone, with ABSs likely to be one of the biggest drivers of change.

Already the number of law firms thinking about converting to ABS is growing but partners are often not fully up to speed with the personal and legal implications this could have for them as individuals. One of the most significant ones is the lock-in period after ABS conversion. Any investor in a business will likely want to keep the star partners, whether they are 'minders, grinders or finders'. They will not have invested in a law firm, where the partners can, if they wish, jump ship relatively quickly.

Lock-in period

Typical notice periods for law firm partners are usually six to 12 months. In contrast, lock-in periods for high-calibre partners usually go well beyond a year, typically four to five years. This isn't the only issue lock-in clauses throw up. Partners will want comfort that the post ABS vehicle cannot terminate their service for performance or redundancy reasons during the lock-in period and guaranteed repayment of their personal capital invested in the firm.

Other difficult questions can arise: Is there a right for a partner to retire from practice, whether due to ill health or otherwise, during a lock-in period? What proportion of any consideration proceeds vests during the lock-in period? Who decides whether the partner has breached his duty to stay during the lock-in period, and is this a subjective or objective test?

Share options schemes

Share option schemes can be another major sticking point. Share option rights, in a corporate entity, may typically be offered to previous equity partners, salaried partners and even senior associates of a law firm, after an ABS conversion. These schemes are often very detailed. Where they are being offered, the guiding principles should be debated, laid out and agreed between all the parties at an early stage. Again, the termination provisions will usually be the crux area where careful drafting pays off.

Many of our requests for advice from law firm partners centre on the termination provisions, when they are thinking of leaving or under threat of expulsion. Some law firms, faced with financial challenges, seek to dismiss underperforming or unwanted partners based on allegations of gross misconduct partly in order to avoid making payments to them. In ABS firms these payments may now include valuable share rights. The definition of termination for 'cause' in the ABS share scheme is a key area for debate and careful drafting. Does 'cause' include gross misconduct only or also negligence and even a material breach of duty? Does causing damage to the reputation of the firm, solicitation of clients or even litigating against the firm, post termination make any unvested share rights void? These are all important issues that need to be worked through from the outset.

Status and influence

The third important issue is the impact of an ABS conversion on employment status. Some longstanding equity partners do not immediately realise that leaving an old fashioned partnership and entering into a new LLP or other similar structure following an ABS still may not provide UK employment protection. Salaried partners, fixed share partners and even senior associates, can be invited to join a new LLP structure or multi-disciplinary partnership, following an ABS conversion. Recent case law, particularly the ruling in Tiffin v Aldridge [2012] EWCA Civ 35 has restricted the circumstances in which LLP partners qualify as employees with UK employment rights, such as the right to claim unfair dismissal, unlawful discrimination or to maternity leave. The case law in this area is not precise and careful ground work is required to know where you stand.

Another big issue for partners within an ABS is the impact on a partner's decision-making and voting rights. A growing number of law firms have had quasi-corporate structures for some considerable time, so that converting to a corporate style ABS structure involves little transition or change in decision-making powers. However, more traditional law firms may find much more of a culture change in relation to decision-making rights. An equity partner may have been used to making or contributing to all key decisions in their firm or department for, say, the previous 20 years. The introduction of management boards and streamlined management structures following an ABS can involve the reduction of some partners' voice and influence. When an ABS conversion takes place or a multi-disciplinary practice (MDP) is formed, it appears to be common for previous equity partners to have less decision-making powers than they had before. Partners plainly need to be clear on what their roles and rights are in respect of decision making, post ABS, and on any proposed changes to line management and other structures.

No-compete clauses

The impact of ABS conversions on post-termination restrictions is also important to be aware of. It has long been the case that the courts will uphold certain restrictions, following the termination of a partnership in relation to solicitation of clients, employees and other reasonable non-compete provisions in respect of departing partners. It is arguable, however, that a partner who signs up to a commercial agreement as part of an ABS conversion may be considered by the courts to be reasonably subjected to longer periods of restrictions following the transaction. Case law suggests that such business agreements are easier to enforce for longer periods of time, post termination of a partnership. In addition, law firm partners will need to carefully consider the interplay between any such post-termination restrictions and the lock-in clauses in an ABS agreement.

Tax and bonuses

The tax implications of moving to an ABS structure are also likely to be under consideration by many partners. This change in status can have a material effect on an individual partner's tax position from year to year. Partners should seek expert tax advice as to what their firm's ABS conversion will mean for them, as an individual, not just for the firm as a whole. Partners may need to familiarise themselves with rules on capital gains tax (CGT), for example, in relation to any share rights they may acquire, as well as pension planning rules and other income tax aspects.

Law firm partners may also need to consider and adapt to any new contractual bonus schemes introduced post ABS. These can be very different to previous lock step or variable drawings arrangements. Corporate vehicles generally adopt more discretionary performance remuneration with the use of key performance indicators and clear appraisal objectives in order to reward high performance and to motivate senior staff. Former equity partners will need to understand exactly how such schemes work and who makes the decisions on such discretionary bonuses. They will also need to identify whether the appraisal processes are fair and suitable, and agree SMART targets at the commencement of each financial year. In our experience, some partners fail to tie down and examine these issues at a sufficiently early stage of the process.

Commercial drivers

Finally, some commercial points. Partners need to understand the commercial drivers if a private equity firm is involved in an ABS. Private equity will typically be looking for a profitable exit within three to five years. This can lead to very different aims on the part of the investors and the partners looking for a long term and secure career at their chosen firm. Private equity investors are also likely to introduce debt into the firm, on a preferential basis, which will rank before the repayment of any personal capital of the partners. Careful consideration should also be given as to what stage any private equity investor secures board control of the new entity, such that the partners are in a relatively weak minority.

The conversion to an ABS may involve big personal changes for law firm partners. While their day-to-day work may stay the same there may well be a real change in many elements of their terms of engagement. Careful thought and planning will help ensure a more successful ABS for each individual partner.