Structuring for success
By Zulon Begum
It’s a good time for firms to review their structure to ensure they can survive difficult trading conditions, as Zulon Begum and Wendy Chung explain
Most law firms have now eased into their operational changes and risk management measures in response to the covid-19 pandemic.
However, cracks may begin to form if the firm has not properly considered the suitability and effectiveness of its legal structure as the world emerges from the peak of the pandemic.
A review of the structure may help some firms to navigate difficult trading conditions.
An ineffective structure can lead to a snowball effect for a struggling firm; and can result in missed growth opportu-nities for other firms.
Law firms in England and Wales are typically structured as one of the following:
- A limited liability partnership (LLP).
- A partnership established under the Partnership Act 1890 (general partnership).
- A private limited liability company (Ltd).
- In some cases, a public limited company (Plc).
When choosing the best structure for a firm, there are several factors that need to be carefully evaluated to ensure the existing or proposed structure meets the firm’s strategic objectives; provides a degree a flexibility to facilitate future changes in strategy; and protects the firm as far as possible from present and future difficult trading conditions.
For the purposes of this article, ‘partner’ refers to a partner in a general partnership or a member of an LLP; and the term ‘partnership agreement’ refers to a partnership agreement of a general partnership or a members’ agreement of an LLP.
General partnerships or LLPs have the most freedom to decide their governance, decision-making powers and procedures and remuneration structure (usually set out in a contractual partnership agreement between all the partners).
Changes to the partnership agreement can be made quickly in response to changes in trading conditions.
The scope for agile decision-making has proved to be valuable during the pandemic when firms were forced to make partner capital calls and or make changes to partner remuneration and profit distributions in order to conserve the firm’s cash.
Ltds and Plcs are generally governed by articles of association, a shareholders’ agreement and company laws which are more prescriptive in relation to decision-making.
The distribution of profits by a Ltd or Plc is also restricted due to capital maintenance rules.
For a Ltd or an unlisted Plc which has shares with greater than nominal value, this can be problematic.
For example, when a senior lawyer ceases to be a shareholder, the firm might not have sufficient distributable reserves to fund the buyback of their shares and the continuing shareholders may not be willing to stump up the cash to buy the shares.
Complex arrangements and different classes of shares may also be required to create differing financial entitle-ments for shareholders depending on their contribution and or seniority (for example, if the firm wished to replicate the features of a lockstep/modified lockstep remuneration system).
In a general partnership or LLP, the remuneration structure for senior lawyers can be changed relatively easily by agreement or the exercise of delegated powers.
Protection from instability
Most firms rely on high performing lawyers to bring a profitable flow of client work and attract talent.
All firms should have in place constitutional protections for the firm and its goodwill in the inevitable event that a key lawyer resigns or is forced to leave, as well as to discourage partner behaviours that can lead to structural instability or damage the goodwill of the firm.
- Long notice periods for resigning (typically 6-12 months).
- The firm may also have a power to extend the notice period if the firm is in financial difficulties or even during difficult trading conditions.
- Restrictions against multiple and simultaneous partner resignations, such as a team move.
If permitted, this can result in substantial capital outflow to former partners and lead to serious financial difficulties for the firm.
Restrictions on former partners against working for a competitor, soliciting existing and potential clients and poaching employees.
Sanctions against partners, such as powers to de-equitise, compulsorily retire or reduce the profit share of a disruptive or underperforming partner.
The above protections are fairly typical in general partnerships and LLPs and, provided they are carefully drafted and kept under review, they are usually enforceable.
However, such protections are not always used to the same extent by Ltds and Plcs or, in some cases, are more difficult to enforce against senior lawyers who only have an employment relationship with the firm.
There may be scope to impose more onerous restrictions and or sanctions where a lawyer is a shareholder and director of the firm, but careful thought will need to be given to the enforceability of such provisions.
Personal liability risks
The biggest drawback of being a partner in a general partnership is the risk of joint and several unlimited liability.
Each partner is personally responsible for the debts of the general partnership, even if they were incurred without that partner’s knowledge or consent.
Also, there is no limit to a partner’s financial exposure. Each partner is usually required to give a personal guarantee to lenders and landlords on behalf of the general partnership.
This exposure is heightened by the real risk of being personally liable for significant professional negligence claims that are not be covered by insurance.
A general partnership does not have any separate legal personality and cannot legally own its assets.
The partners are often required to hold the legal title to office leases in their own name and on trust for the general partnership.
This financial exposure can be significant and creates a cumbersome process when a partner joins or exits the general partnership.
The exiting partner will seek to be released from any further personal liability and an incoming partner will want to be indemnified in respect of liabilities before they joined.
The above issues do not apply to Ltds, Plcs and LLPs which have a legal personality that is separate from its shareholders or members.
This means that all contracts and legal title to property can be held in the name of the entity.
The personal liability of the members of a Ltd, Plc and LLP is usually limited to the amount of capital that they contributed.
However, their limited liability status does not apply in certain circumstances involving the entity’s insolvency.
This factor is often overlooked but will need to be carefully considered by any firm that is struggling in the current trading conditions.
Regulated law firms in England and Wales can be owned and managed by persons who are not English or European qualified lawyers provided they are approved as a licensed body – colloquially known as an alternative business structure (ABS).
An ABS can raise capital for investment and growth from external investors by giving them an ownership interest in return.
An ABS that is facing insolvency will have options outside of the legal sector to find a buyer to rescue its business.
Struggling firms that are not already registered as an ABS will find it difficult to manage the ABS application process while dealing with potential insolvency.
If external investment is required immediately or in the future, thought should be given to the structure that is most likely to appeal to target investors.
A general partnership is unlikely to be attractive for private equity or venture capital investors with an investment strategy in low risk businesses, due to the joint and several unlimited liability of any investor that becomes a partner.
Institutional investors also tend to be more familiar with a Ltd/Plc’s tax treatment, duties and liabilities of its directors and shareholders, its capital structure and governance.
Although investors in the legal sector are becoming more comfortable with investing in LLPs, they are likely to spend more time and money in obtaining advice for investing in an LLP.
Firms can also access external investment by structuring as a Plc and listing their shares on a stock exchange.
However, complex structures sitting beneath the listed Plc may need to be put in place to facilitate a listing.
A firm’s structure can significantly influence its culture. Partnerships and LLPs are perceived to have a collegiate culture.
The partners in a general partnership have a duty of good faith to each other and to the general partnership, which is conducive to an ‘in it together’ mentality and encourages trust and confidence between the partners.
A collegiate culture also tends to exist in LLPs, although arguably to a lesser extent than in general partnerships due to the limited liability status of LLP members and the absence of an automatic duty of good faith between members.
A general partnership or LLP is commonly preferred where:
- Equity ownership is dispersed between a number of individuals;
- Succession involves junior lawyers being promoted to equity and senior lawyers retiring from equity; and
- A lockstep or modified lockstep style remuneration structure (where profits are shared among all partners in ac-cordance with their points or units, which are awarded in recognition of the number of years they have been a partner) is adopted over an ‘eat what you kill’ style remuneration structure (where each partner’s profit share is based on their own personal contribution).
Firms with ownership that is concentrated in a few individuals or is static tend to be more suited to a Ltd or Plc structure.
However, a collegiate culture can also be replicated in a Ltd and Plc by offering tax-efficient share schemes to staff and management, which help to incentivise a collective contribution to the firm’s profitability.
Firms with international operations or ambitions for international growth will need to consider the tax and regulatory impact of their structure.
Many jurisdictions do not allow non-lawyer ownership or management or profit-sharing with non-lawyers.
Some jurisdictions also do not allow entities with limited liability status (such as a Ltd, Plc or LLP).
Finally, tax is an important factor but should not be the only driver in structuring decisions as tax rules tend to change frequently.
The UK government has introduced job protection and business loan schemes during the pandemic, which are likely to be funded by future tax changes and increases.
At present, profit retention for capital investment or working capital purposes is more tax efficient in a Ltd or Plc (where the corporate entity pays corporation tax, its shareholders pay dividend tax and capital gains tax and the directors pay income tax and employee national insurance contributions).
If a firm operates a full-distribution model by distributing all or substantially all of its profits each year, then the tax status of a general partnership or LLP may be more favourable, where partners are taxed as self-employed individuals (provided they satisfy certain criteria) by paying income tax, capital gains tax and self-employed national insurance contributions.
The general partnership and LLP do not pay any employers’ national insurance contributions in respect of the partners.
Zulon Begum is a partner and Wendy Chung a senior associate at CM Murray cm-murray.com