Insolvency of LLPs – liability and risk for partners

Brexit is unresolved. Its long shadow is looming on the horizon and the outlook for the UK economy remains uncertain. The fortunes of some businesses may well deteriorate in the period following our departure from the EU, particularly in the event of a disorderly exit.

Against this background, those risking exposure in the event of insolvency should review their position. This includes partners of professional service firms. In traditional partnerships, partners face unlimited liability. This note focuses on members of Limited Liability Partnerships (LLPs) and, in particular, circumstances in which they may be required to restore property.

Limited liability?

As a general rule, liability is “limited”. The LLP has a separate legal personality, contracting in place of the members. In the event of insolvency, members are only liable to contribute to the LLP’s assets in the amount prescribed by the LLP agreement. These agreements typically include wording to exclude such liability.

Yet there remain situations where members may be ordered to restore property to the LLP. A key risk arises from provisions in the Insolvency Act 1986 (the “Act”) concerning the ‘adjustment of withdrawals’ at s.214A.

Power to adjust withdrawals

By s214A, the court has power to require a member (past or present) to contribute to the LLP’s assets in such amount as it thinks proper, up to the total of sums withdrawn during a two year period.

Action under s214A may be brought by a liquidator (but not an administrator) against a member, where:

• within the period of two years before the winding up,
• the member withdrew property (which expressly includes profit share and salary) of the LLP,
• knowing (or having reasonable grounds for believing) at the time of the withdrawal that the LLP either (a) was unable to pay its debts at the relevant time or (b) would become so following each withdrawal; and
• the member knew (or ought to have known) that the LLP’s financial position meant that there was no reasonable prospect of the LLP avoiding insolvent liquidation.

Two-year period

Thus the scope for claims is time limited: only withdrawals made in the two year period prior to commencement of the winding up are captured by s214A.

Where an LLP goes into administration before it is wound up, time spent on the administration will “eat” into the look-back period, reducing the scope for claims. In Milne v Rashid [2018] CSOH 23 an administration lasted some 14 months before the LLP entered liquidation.  The result was that the liquidator’s action under s214A was restricted to withdrawals made within the 10 month period prior to the administration starting.

An inability to pay debts

‘Inability to pay debts’ amounts to insolvency under the Act and is defined at s.123. Typically it requires reference to the LLP’s balance sheet and cash flow.

So the liquidator must prove that at the time of each of the withdrawals, the LLP member knew, or had reasonable grounds for believing, that the LLP was insolvent. In practice, proving actual knowledge presents a challenge: the liquidator will rarely, if ever, be privy to the full facts and circumstances at the times withdrawals were made. However, the existence of reasonable grounds for believing that the LLP was insolvent lowers the bar since it introduces a level of objectivity. Nonetheless, those involved in the firm’s financial management are likely to be more vulnerable here.

No reasonable prospect of avoiding insolvent liquidation

The final requirement is to show that the LLP member knew, or ought to have concluded, that after each withdrawal there was no reasonable prospect that the LLP would avoid going into insolvent liquidation.

The legal test here has regard to what would be known or ascertained by a reasonably diligent person having both (a) the general knowledge, skill and experience that may be reasonably expected of a person carrying out the same function as the member and (b) the knowledge, skill and experience that the member actually has.

This two-fold test introduces basic objective standards which are further elevated by the member’s actual ability from a subjective standpoint. In this sense the test is reminiscent of the standard applied to directors in the context of wrongful trading claims at s.214 of the Act.

The upshot is it will not be a sustainable defence for a member to say that they were not aware of the LLP’s parlous financial position since they will be caught by the minimum objective standards imposed. Those with a financial background or role within the business will find that they are impressed with higher standards. Knowledge is indeed a dangerous thing.

Returning to Milne v Rashid, happily for Mr Rashid the court held that whilst he ought to have known that the LLP was unable to pay its debts, it did not follow that he knew  – or ought to have concluded – that there was no reasonable prospect of avoiding insolvent liquidation. On the evidence there was no suggestion of an insolvent liquidation occurring, or being likely to be initiated, and there were good reasons why family members (who controlled and supported the LLP) wished to avoid it. Thus the claim failed.

Conclusion

Claims against members of professional service firms under s214A present an increased risk during or in the wake of an economic downturn. Experience has shown liquidators are willing (read duty-bound) to pursue members who have received distributions when the LLP’s financial position does not justify payment. The possibility of having to account for up to 2 years of “profit” share is a chilling prospect.

The liquidator examines the position with 20:20 hindsight, armed with an accountancy background. However, there can be no excuse for members choosing not to take an active role and informing themselves as to the financial state of the LLP from materials available. If the business is faltering, prudent individuals may wish to seek expert advice personally. Carrying on regardless is a dangerous course and the consequences can be disastrous.