Over the last few months we have seen a number of professional practices, of varying sizes, forced into dissolution or insolvency proceedings.  Times are extremely tough and it is very possible we can expect to see the failure and collapse of more law firms in the coming months. Salaried Partners (“SPs”) or Fixed Share Partners (“FPs”) in traditional partnerships will be largely unaware of the personal liabilities they may face in such circumstances.  It is not necessarily the case that only equity partners will face such risks.

Holding out

Before we explore the potential risks, it is worth summarising a few of the basics.  The law does not recognise SPs or FPs, either one is a partner or not.  Most SPs, depending on how their employment contracts are drafted, are not in fact partners at all and will be treated as being employees.  FPs will be recognised as partners if they fulfil the necessary criteria to be a partner, namely, participation in management, contribution of capital and the sharing of some risk (i.e. sharing in losses as well as profits).  Notwithstanding whether SPs or FPs fulfil such criteria, given that they are held out as being partners of a partnership, it is implicit that they are also held out as being liable for the partnership’s debts.  In theory, this means that if a firm were to become insolvent, SPs and FPs would be equally liable alongside the equity partners for the debts owed by the firm.  The Partnership Act 1890 is pretty clear on this point; it provides that:

"Everyone who by words, spoken or written, or by conduct represents himself, or who knowingly offers himself to be represented, as a partner in a particular firm, is liable as a partner to anyone who has on the faith of any such representation given credit to the firm."

Insolvency

Given that partners of a firm are individually and jointly liable for the debts of the firm, they will all be contributories, with unlimited liability, on its winding up.  In insolvency, the affairs of the partnership will be wound up by a liquidator and he will have the power to pursue the partners’ assets in order to pay off the firm’s creditors.

It is normal for SPs and FPs to obtain indemnities from the equity partners in respect of any liabilities of the firm brought against the SPs or FPs (except for any liabilities resulting from claims arising from their personal fraud, dishonesty or wilful misconduct).

This is all well and good if the estates of the equity partners are sufficient to cover such indemnity claims.  Whether or not the indemnities are of value to an SP or FP will depend on whether the equity partners have any assets against which the claim may be enforced.  Indeed, given that a liquidator is likely to pursue the assets of the equity partners first, it is very probable such assets would have been utilised by the liquidator by the time the liquidator decides to pursue any SPs or FPs.  It is also entirely possible that any equity partners would face bankruptcy as a result of the liquidator making such claims.

Options

What can FPs or SPs do to limit the above risks? There are three possibilities.

First, seek to change their title so that they are no longer held out as partner.  The immediate drawback is that such a step may be perceived as being a demotion in the eyes of clients.  Another drawback is that the firm may have to start making national insurance contributions in relation to the FPs, an additional cost at a time when the business is under pressure to keep overheads down. Also, the Partnership Act 1890 provides that every partner is jointly liable for the debts and obligations of the firm incurred while he is a partner.  This means that even if SPs or FPs change their role, this would not affect their liability for debts and obligations accrued previously.

Secondly, it is entirely possible that major creditors of the firm, such as the landlord or the bank, may not have placed any reliance on the fact that the SPs and FPs are held out as partners.  It is clear from the provisions of the Partnership Act that, in addition to the holding out itself, reliance on such representation is also necessary.  Where there is no reliance, the SPs and FPs will not face any liability.  Whether any reliance was placed will be a question of fact.  It is therefore open to the firm, unless it has already done so, to clarify the status of its SPs and FPs with creditors by making it clear that it is not intended that they be jointly and severally liable for the debts of the firm and to request a letter from any major creditors confirming this.  The value of such a letter will depend upon its terms and how explicit and unconditional its provisions are.  In reality, however, a firm may be reluctant to approach a creditor with such a request as it may not wish to cause alarm or alert them to possible financial problems ahead.  In such circumstances, it is doubtful whether a creditor would be content to narrow or limit its potential recourse should it be concerned about recovering amounts owed to it.

Thirdly, converting to an LLP. In general terms, all members of an LLP enjoy the same protection of limited liability as do members of a limited liability company.  This means that any claims for outstanding debts would be made against the LLP’s assets not the personal assets of an individual member.  It is possible that if a firm has not already converted to an LLP, it is because there are very good reasons why, particularly as costs for converting are now relatively small given that conversions are now tried and tested.

Depending on the size of the FP and SP pool in a firm, and the importance of such pool to the future success of the firm, it is possible that the FPs and SPs, as a collective unit, may approach the equity partners in order to obtain detailed financial information about the firm, and, if necessary, to negotiate the introduction of possible measures to protect their own personal assets.  The firm may have no choice but to listen to their requests.

For more information on these issues please contact

or your usual Lewis Silkin contact