UK: Welcome News For LLPs

Last Updated: 2 September 2015
Article by Richard Isham

Under the terms of an LLP Agreement, each individual member will usually have a profit share. Some members (e.g. founders) will have a significantly higher profit share than others and will also have a share in the capital of the LLP (ie: over and above the amount of their own capital contribution). Individual members will also be subject to certain notice provisions, garden leave obligations during notice and restrictive covenants that govern what they can do once they cease to be a member (e.g. non-compete, non-solicitation of and non-dealing with clients of the LLP).

Up until now, disgruntled members who claimed that the LLP (and sometimes other members) had committed a repudiatory breach of the LLP Agreement have asserted that the breach discharges the member and the LLP from any further performance of the contract (ie: the LLP Agreement). In accordance with the doctrine of repudiatory breach, rights that have already accrued continue unaffected. However, and here is the mischief from an LLP's perspective, the discharge from further performance under the LLP Agreement extends to: notice provisions (the disgruntled member can walk away immediately), the post termination restrictive covenants (the disgruntled member is not bound by them, so is free to compete with, solicit and act for the LLP's clients) andallows the disgruntled member to rely on Regulation 7 of the default provisions in the LLP Regulations (LLPR) to gain a (very) substantially increased share in both the capital and profits of the LLP – the argument being that a repudiatory breach of the LLP Agreement means that that agreement falls away so there is "no agreement" for the purposes of the LLP Act 2000 (LLPA).  In those circumstances, the default provisions in Regulation 7 of the LLPR apply to give that member an equal share in the capital and profits of the LLP.  Allowing repudiatory breach to operate in this way can result in a minority member who, for example, may, under the LLP Agreement, only have an entitlement to 1% of the profits of the LLP and no entitlement to the capital, suddenly sharing equally with, say, 10 other members in both the capital and profits. Such a minority member would get a huge windfall – an extra 9% of the profits plus 10% of the capital. Such a scenario makes the use of LLPs potentially very unattractive and could result in businesses deciding not to operate in England.

Flanagan v Liontrust Investment Partners LLP and Others [2015] EWHC 2171 (Ch) cures the mischief.

Facts

Mr Flanagan was a member of Liontrust, an LLP that ran a hedge fund.  Under the terms of the LLP Agreement,  he was entitled to a fixed "profit share" of £125,000 per annum, plus a variable share, the amount of which depended on his own performance and the contribution of his team.  He had no entitlement to any interest in the capital of Liontrust, beyond the return of his own capital contribution. The default provisions in Regulations 7 and 8 LLPR were expressly excluded.

In addition, under the terms of a side letter, Mr Flanagan was entitled to an initial period of engagement by Liontrust of 24 months. He had a six months' notice period but that could not expire prior to the end of the 24 months, which meant that the earliest notice could be served was after 18 months service with Liontrust.  Liontrust served Mr Flanagan with notice to terminate his membership before this time. The notice also purported to remove him from the Management Committee and place him on garden leave (thus depriving him of his ability to earn any additional profit share over and above his fixed share of £125,000). 

After careful analysis of the law and the facts, the Judge concluded that Liontrust were in repudiatory breach of the LLP Agreement. Liontrust had, by the terms of and the words used in its letter serving notice on Mr Flanagan, renounced its intention to perform its obligations that it owed to Mr Flanagan. The Judge also found that Liontrust had, by purporting to exclude Mr Flanagan from the Management Committee, acted in such a way as to deprive Mr Flanagan of "substantially the whole benefit which he was objectively intended to obtain under the LLP Agreement" and so the notice also amounted to a repudiatory breach that went to the root of the contract (i.e. the LLP Agreement).

The £8 million Question – is the common law doctrine of repudiatory breach ("the doctrine") excluded in relation to LLPs?

Having found Liontrust to be in repudiatory breach, the Judge went on to consider whether the doctrine is excluded, as Liontrust submitted, because of the LLPA and the fact that LLPs are creatures of statute. If the doctrine was not excluded, Mr Flanagan stood to make £8 million, being his valuation of his equal share in the profits and capital of the Liontrust LLP.

The Judge started with an analysis of Hurst v Bryk, which held that the doctrine could not be used to bring about the dissolution of an ordinary (Partnership Act 1890) partnership. The court reached this conclusion mainly because of Section 35(d) of the Partnership Act 1890 which gives the Court discretionary, not mandatory, powers to order the dissolution of a partnership under the Act. This discretion would be rendered otiose if a partner could accept a repudiatory breach and, by doing so, invoke the doctrine to bring about the dissolution of the partnership.

Even though there is no equivalent to s35(d) in the LLP Act, the Judge in Flanagan agreed with the court's analysis in Hurst that, if the doctrine could apply to partnerships (and hence to LLPs), you could get "three camps" within a multiparty partnership:

  1. those partners who are guilty of repudiatory conduct;
  2. those innocent partners who have accepted the breach; and
  3. those partners who have not.

In the context of an LLP, if the doctrine applied, then:

  1. the LLP would be in repudiatory breach of the  LLPA Agreement (the Liontrust LLP Agreement) and Mr Flanagan, by accepting the breach, would have his relationship with the LLP governed by the default rules and Regulation 7 LLPR above;
  2. the relationship between the LLP and the other members would continue in accordance with the terms of the Liontrust LLP Agreement; and
  3. Mr Flanagan's relationship with the other members of the Liontrust LLP Agreement (but not the LLP itself) would be governed by that agreement.

Furthermore, the judge observed that matters could become more complicated if the other members, or at least some of them, had participated in, or had adopted the breach by the LLP and, if their breaches were accepted by Mr Flanagan, then his relations with those "guilty members" would be governed by the default provisions as well.  You would then have a situation in which, as between the members of the LLP, Mr Flanagan would have different and contradictory relations with the other members – some governed by the LLP Agreement and some governed by the default provisions.

In the Judge's view, such a situation was untenable, against what Parliament could have intended and so self-evidently "the co-existence of two different contractual regimes governing the same LLP is likely to lead to results which are legally incoherent and could only be resolved by further agreement between all the members".  In his view, the statutory scheme for LLPs, as set out in the LLP Act, should and could be construed to avoid this "incoherence".  Accordingly, he concluded that the doctrine of repudiatory breach is implicitly excluded from the statutory scheme governing LLPs, namely the Limited Liability Partnership Act 2000, at least where there are more than two members of the LLP.   Indeed, the Judge went on to say that he was fortified in reaching his conclusion by a number of further considerations, including the fact that "it would in my judgment be offensive to commence sense, and contrary to the reasonable commercial expectations of the parties, if the effect of the doctrine were to permit Mr Flanagan to share in the profits of the LLP on a basis of notional equality with the other members, when the LLP Agreement itself gave him only a fixed allocation of income profits and no entitlement to any capital profits...the appropriate remedy for a member in Mr Flanagan's position is a declaration as to his continuing membership of the LLP and a right to damages, if he can establish that he has suffered any loss as a result of his exclusion [from the management of the LLP]".

Comment

This is the first case that has considered the application of the doctrine of repudiatory breach of contract in the context of a multiparty LLP Agreement; the decision contradicts a number of leading text books that had argued that a repudiatory breach could bring an LLP Agreement to an end.

The decision does prevent outgoing members from obtaining an unintended and unfair financial windfall (by relying on the default provisions to argue an entitlement to share income and capital profits equally) and also avoids the impractical situation arising whereby the relationship between the members themselves and between the members and the LLP is governed by two different contractual regimes – one, being the terms of the LLP Agreement itself and the other, being the default provisions set out in Regulations 7 and 8 LLPR.

The decision and clarification of the law is to be welcomed by multiparty LLPs which go to the trouble and expense of drafting comprehensive LLP Agreements that specifically exclude the default provisions as it is now clear that, in relation to an outgoing member, his or her entitlements will be governed by the LLP Agreement that they originally signed up to, rather than having that agreement displaced by the default provisions.  A victory for common sense – and for the continued attraction for businesses to use the flexible LLP structure.

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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