Feature

posted 23 Jun 2005 in Volume 8 Issue 2

Limiting loss: Managing the insolvency of an LLP

In the April issue of Managing Partner, Peter Ashford touched on some of the dangers of converting to limited-liability partnership as a risk-management strategy. In this issue, Fergus Payne, partner and joint head of partnerships and LLPs group at Lewis Silkin, tackles the issue head on, with an examination of what happens when an LLP gets into financial difficulties. For all those firms that have or will convert, it makes essential reading.

We are currently seeing an increase in the popularity of limited-liability partnerships (LLPs) as a business vehicle both for professional-services firms and other businesses, following a slow uptake upon their introduction in 2001. Distinct from both a traditional unlimited partnership and a limited-liability company, an LLP is a body corporate with a legal personality separate from that of its members (unlike a general partnership in England and Wales). It is an alternative business entity that combines the flexible management and capital structure of a partnership with the benefits of limited liability for it members.

What happens and what legal procedures apply if an LLP gets into financial difficulties?

Reflecting the fact that LLPs are in most respects to be treated as corporate entities, it is no surprise that the insolvency regime for LLPs is largely the same as for companies. This regime is governed by the Insolvency Act 1986 (as amended) and the Company Directors Disqualification Act 1986. This article gives a brief overview of the current law relating to LLPs and insolvency.

Insolvency

LLPs, like limited-liability companies, are allowed to:

Propose a voluntary arrangement;
Apply to the court for an administration order;
Go into receivership;
Resolve to go into voluntary liquidation, to appoint a liquidator and to allow a liquidator to receive an interest in a transferee company or LLP on a voluntary liquidation;
Resolve to be wound up by the court.

Voluntary arrangements

A voluntary arrangement will enable an insolvent LLP to seek the sanction of the court for proposals that the LLP’s members believe will offer creditors of the LLP a better return than on a winding up (such as by trading out of financial difficulties) and allow the LLP to survive. The arrangement itself is a composition in satisfaction of an LLP’s debts or a scheme of arrangement of an LLP’s affairs, which is made between the LLP and its creditors and approved by the court. Under a voluntary arrangement, if approved by the court, the LLP would formally agree terms with its creditors for the settlement of its debts. Thereafter, an insolvency practitioner would supervise the implementation of the voluntary arrangement.

A voluntary arrangement may be proposed by an administrator where there is an administration order or by a liquidator, if the LLP is being wound up, or by the LLP itself in other circumstances.

The procedure is initiated by the LLP (or by the LLP’s administrator or liquidator) making a proposal to its creditors. The proposals provide for a nominee who is a qualified insolvency practitioner to act in relation to the voluntary arrangement. The nominee must report to the court within 28 days on whether, in his opinion, a meeting of the creditors should be called. When the administrator or liquidator proposes the arrangement, the nominee reports on whether a meeting of the members and a meeting of the creditors should be called. The meeting summoned by the nominee decides whether to approve the voluntary arrangement which, subject to certain restrictions, may be approved with or without modifications. It is then binding on all the creditors who have notice of the meeting and are entitled to vote.

It is now possible for certain LLPs to be eligible for a moratorium on actions by creditors during the period in which the proposals are being considered. The LLP must satisfy two or more of the requirements for being a small LLP (as set out in section 247 (3) of the Companies Act 1985), namely, a turnover of not more than £5.6m or a balance-sheet total of not more than £2.8m or not more than 50 employees.

Administration

The law in relation to the administration of LLPs is potentially confusing at this point in time. The pre-Enterprise Act 2002 procedures were applied to LLPs when the LLP Regulations 2001 came into force. With effect from September 2003, however, the administration procedure applying to companies was changed substantially by the Enterprise Act 2002. The most significant change was the ability for companies to appoint an administrator out of court. The new procedures have yet to be introduced for LLPs, although it is understood that legislation will follow soon, now that the general election is out of the way.

By way of further clarification, do not be confused by the recent announcement from the Insolvency Service to the effect that only companies incorporated under the Companies Acts (or their foreign equivalents) can enter into administration or a voluntary arrangement. The regime referred to above is unaffected and continues to apply in relation to LLPs.

An administration order offers more effective protection than a voluntary arrangement and may enable an LLP experiencing financial problems to trade out of its difficulties or to achieve a more advantageous realisation of the LLP’s assets than on a winding-up. It is a court order to appoint an administrator to manage the LLP’s affairs and its purpose must be to:

Save all or part of the LLP as a going concern;
Approve an LLP’s voluntary arrangement;
Sanction a compromise or arrangement;
Achieve a more advantageous realisation of the LLP’s assets than in a liquidation.

While an administration order is in force, the LLP cannot be wound up and an administrative receiver cannot be appointed or, if previously appointed, he must vacate office. There are restrictions preventing any creditor from enforcing any security over the LLP’s property or starting any legal proceedings against the LLP.

A court may make an administration order when the LLP is, or is likely to become, unable to pay its debts and the court considers that making the order could achieve one of the purposes referred to above.

The LLP itself, or one or more of its creditors (including any existing contingent or prospective creditors), may make a petition for an administration order.

The administrator takes control of all the property to which the LLP is, or appears to be, entitled. The administrator prepares proposals for achieving the purposes for which the administration order was made and calls a meeting of creditors to consider those proposals.

If the majority of creditors approve the proposals, the administrator then manages the affairs, business and property of the LLP in accordance with the proposals.

Receivership

Receivers are generally appointed by secured creditors to enforce their security; the powers of a receiver will vary according to the terms of their appointment.

Traditionally the most common form of corporate receiver, an administrative receiver, is a receiver or manager of the whole, or substantially the whole, of an LLP’s property, who is appointed by or on behalf of the holders of any debentures of the LLP, secured by a floating charge. An administrative receiver has the power to sell or otherwise realise the assets covered by the floating charge and apply the proceeds to the debt owed to the secured creditor. This power is now only available in respect of floating charges created prior to 15 September 2003 when the relevant provisions of the Enterprise Act 2002 came into force.

Receivers who are not administrative receivers may be appointed in other circumstances. Subject to the terms of the charge, a receiver may be appointed under the Law of Property Act 1925 to realise property, but the powers of an LPA receiver are limited and do not extend to running a business. Under powers contained in an instrument or document creating a charge over an LLP’s property, a receiver or manager may be appointed until the debt is recovered.

Liquidation

Voluntary liquidation can either be a members’ voluntary liquidation where the designated members have made a statutory declaration of insolvency or a creditors’ voluntary liquidation where the statutory declaration cannot be made. The liquidation starts when the members determine to wind up the LLP. Their means of making such determination will usually be provided for in the members’ agreement. In the absence of any contractual provision, the determination will be made by a decision of the majority of members, for example, on the petition of a creditor or creditors on grounds that the LLP cannot pay its debts. The court may also order the LLP to be wound up on the petition of the LLP itself, one or more of the members, the Secretary of State for Trade and Industry, the Financial Services Authority or the Official Receiver.

Clawback of withdrawals

On winding up an LLP, there are special ‘claw back’ provisions applied to members. These provisions apply only to LLPs and not to companies, and only in the context of any winding up –not in any other form of insolvency proceedings, for example, a voluntary arrangement or administration. Section 214A of the Insolvency Act 1986 enables liquidators to claw back withdrawals made by the LLP’s members within the two-year period prior to the commencement of a winding-up.

The legislation provides that a member or former member of the LLP will be liable to make a contribution to the LLP’s assets if:

Within the period of two years prior to the commencement of winding up, he was a member of the LLP who withdrew property of the LLP – such a withdrawal includes the distribution of profit shares, salary, repayment of loans, payment of interest or any other withdrawals of the LLP’s property;
It is proved by the liquidator to the satisfaction of the court that at the time of the withdrawal the member knew or had reasonable grounds for believing that the LLP was unable to pay its debts (within the meaning of Section 123 of the Insolvency Act 1986) at the time of the withdrawal. Alternatively, the member knew that the LLP would become unable to pay its debts after the assets of the LLP had been depleted by that withdrawal, taken together with all other withdrawals made by any members contemporaneously or in contemplation when that withdrawal was made.

However, that member will not be liable unless he 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 facts that a member ought to know or ascertain are those that would be known, ascertained or reached by a reasonably diligent person having both:

The general knowledge, skill and experience that may be reasonably expected of a person carrying out the same functions as are carried out by that member in relation to the LLP;
The general knowledge, skill and experience that the member actually has.

In this context, an LLP goes into insolvent liquidation if it goes into liquidation at a time when its assets are insufficient for the payment of its debts, other liabilities and the expenses of the winding up.

An application can only be made by a liquidator. If a member is found liable, the court may order that a member makes such contribution to the LLP’s assets as the court thinks proper. The court cannot make a declaration in relation to any person in a matter that exceeds the aggregate of the amounts or values of all the withdrawals referred to and made by that person within the two-year period.

Anyone who was a member or a shadow member during the two-year period before the commencement of the winding up is vulnerable, whether or not he has continued to be a member to such date.

In practice, it may prove difficult for liquidators to claw back withdrawals under this section. There are a number of separate elements to be proven and the burden of proof will be firmly upon the liquidator.

Separately, where an LLP is wound up, both past and present members of the LLP are liable to contribute to the assets of the LLP to the extent that they have agreed to do so in the LLP members’ agreement. It is therefore common to see a provision in an LLP members’ agreement stating that the members are not liable to contribute in this way.

Other personal liability of members

In the same way that there are restrictions on the re-use of company names to prevent the ‘phoenix company’ phenomenon, restrictions also apply on the re-use of LLP names where the original LLP has gone into insolvent liquidation.

Members of an LLP may also be liable to contribute to the assets of the LLP on a winding up if they are guilty of fraudulent or wrongful trading.

The relevant provisions of the Company Directors Disqualification Act 1986 also apply to LLPs. Consequently, a member or shadow member of an LLP could be disqualified from being a member of an LLP, or a director of a company, if the LLP of which he or she was a member has become insolvent and the court considers that the conduct of the member was such as to make that member unfit to be involved in the management of another LLP or a company.

Despite their name of limited-liability partnerships, it is worth noting that partnership law does not apply to LLPs. In a traditional partnership, each partner has an unlimited liability to third parties for the firm’s debts. However, in an LLP each member is liable only to contribute to the assets of the LLP to the extent specified in the LLP members’ agreement.

However, the LLP’s members are subject to the same personal liabilities that may apply to a company director on the insolvency of a limited company as well the claw-back provisions referred to above.

The insolvency regime for LLPs is largely the same as for companies, although with time it will be interesting to see which specific procedure becomes the most used for LLPs in financial difficulties and how often liquidators try to enforce the claw-back provisions against members of an insolvent LLP.

Fergus Payne is partner and joint head of partnerships and LLPs group at Lewis Silkin. For further information contact bethfarrer@spada.co.uk