UK: In The Red - The Dangers For LLPs Of Trading While Insolvent

Last Updated: 16 December 2011
Article by Henry Shinners

The UK economy has emerged from the worst recession in living memory, and we are far from out of the woods yet. The possibility of a double-dip recession remains; the sovereign debt issue in Europe continues to make daily headlines and cause turmoil in the global markets, and it may yet lead to an economic crisis to rival that of autumn 2008.

It's a gloomy picture, yet a combination of record low interest rates and a long period during which HMRC has been extremely supportive of businesses seeking to defer repayment of tax arrears has meant that, to date, there have been fewer business failures than one would have expected during such economic turmoil. Nevertheless, a significant number of UK businesses are in poor financial health and many of those may, unwittingly or otherwise, be trading while insolvent.

Impact on professional practices

So, what is trading while insolvent (or 'wrongful trading' to give it its formal title) and does it apply or matter in a professional practices context? In a traditional partnership, where partners have unlimited personal liability for all of the debts of the business, there are no increased financial consequences for the partners personally if they should continue to trade an insolvent business beyond the point that they should. However, in a limited liability partnership (LLP), where the members will consider themselves to have limited liability, greater care is needed if a nasty surprise is to be avoided.

It's important to remember that LLPs are analogous to limited companies in that an LLP is a body corporate, with a separate legal identity, and its members have limited liability. The corporate (rather than personal) provisions of the insolvency legislation are broadly applied to LLPs in the same way that they are to companies. As with companies, there are certain circumstances in which the corporate veil can be pierced, and a key risk for the members of a financially distressed LLP is that they could be held personally liable for debts of the LLP if they are found to have been trading wrongfully.

LLP members' liability

Wrongful trading is a civil action brought by a liquidator, who will consider whether the LLP's members continued to trade the business beyond the point that they "knew, or ought to have concluded", that there was no reasonable prospect of avoiding insolvent liquidation and whether, in doing so, they worsened the position for creditors. Upon a successful application by a liquidator, the court may make a declaration that the members should personally make a contribution to the LLP's assets. The quantum would be such as to restore creditors to the position that would have applied, had the LLP not continued trading beyond that point of no return.

There are also implications for members of an insolvent LLP who withdrew property – including salary, share of profits, payment of interest on a loan to the LLP or any other withdrawal of assets – from the LLP, for their own benefit, during the two years prior to the liquidation. In common with the wrongful trading remedies available to the liquidator, the "knew or ought to have concluded" insolvency test will apply. The court can order that the members are personally liable to make a contribution to the LLP's assets, up to the amount withdrawn for their personal benefit during the two-year period. These 'adjustment of withdrawals' or 'clawback' provisions of the Insolvency Act 1986 are unique to LLPs.

LLP members' defence

Members of LLPs in such circumstances are likely to find that the defences against claims brought by liquidators are limited. It is not sufficient to say, for example, that one was acting honestly, or in the best interests of the partnership. This is because the interests of creditors take priority when a business is insolvent or at risk of insolvency. What a member "knew or ought to have concluded" and the steps they ought to have taken might be considered to be subjective. The members of an LLP are expected to use, as a minimum, the general knowledge, skill and experience that could be expected of a reasonably diligent person. If, through their professional qualifications and/or experience, a member has a higher level of knowledge, skill or experience, then a higher standard will be expected. It therefore follows that the members of a professional practice will be expected to show a particularly high level of conduct.

The best way for members of a potentially insolvent LLP to minimise the risk of personal liability is to take professional advice as early as possible from an insolvency practitioner. They will be able to guide the members through the steps that should be taken to minimise the potential loss to creditors and the options available to the members generally.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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