The Application of the Default Provisions in the LLP Regulations 2001

APP Article Article

Jeremy Callman, Ten Old Square

Gavin Foggo, Fox Williams LLP

THE APPLICATION OF THE DEFAULT PROVISIONS IN THE LIMITED LIABILITY PARTNERSHIPS REGULATIONS 2001

By Jeremy Callman, Gavin Foggo and Molly Ahmed As recently as 2009 Sir Michael Briggs characterised: “a feature of the arrival and success of the LLP [as being] that it has yet to give rise to any serious or expensive litigation about how it works… [and] that users of LLPs and those who deal with them have yet to get bogged down in any real legal controversy about them.” 1 However, the recent case of Eaton v Caulfield (1) Holloway (2) Caulfield Search (Legal) LLP (3) [2011] EWHC 173 (Ch), [2011] All ER (D) 63 (Feb) is a noteworthy development in the area of the law on LLPs. So far as the authors are aware, Eaton is the only reported case dealing with: • t he expulsion of a member from an LLP where there is no written members’ agreement; • t he application of the default provisions in relation to the sharing of capital and profits; and • t he unfairly prejudicial treatment of one member by the other members

Molly Ahmed, Fox Williams LLP

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under the Companies Act 2006.

It also applies section 122(1)(e) of the Insolvency Act 1986 (just and equitable winding up) in the LLP context.

The facts Caulfield Search (Legal) LLP (the “LLP”) was a legal recruitment/headhunting firm, incorporated by Mr Eaton, Mr Caulfield and Mr Holloway in 2007. The rationale behind the incorporation of the LLP was to formalise the members’ relationship, since prior to 2007 the three of them had been working together, and marketing themselves under a common brand to the outside world. Crucially, there was never a written LLP members’ agreement.

The relationship between Mr Eaton and Mr Caulfield deteriorated over time. In 2008, matters came to a head and Mr Caulfield sought summarily to expel Mr Eaton from the LLP. Mr Caulfield effected this purported expulsion in a number of ways. Mr Caulfield locked Mr Eaton

1 Whittaker, John and Machell, John (2009) The Law of Liability Partnerships, 3rd edition, Bloomsbury Professional, the foreword.

THE DEFAULT PROVISIONS CONTINUED... out of the office, blocked his access to the IT system, removed his profile from the LLP’s website, and informed clients and candidates that Mr Eaton no longer worked at the LLP. In the days following the purported expulsion, Mr Eaton made various attempts to assert his position that he remained a member of the LLP and to resolve the situation without recourse to legal action; this culminated in a letter from Mr Eaton making an open offer before proceedings were commenced for the Respondents to buy out his share of the LLP. If he were bought out for fair value, he would agree to retire from the LLP.

Whilst there was no written members’ agreement, there were oral agreements as to a number of terms of the LLP, although there was a fundamental difference between the members as to what the orally agreed terms were.

Throughout the proceedings, Mr Eaton’s consistent position was that the only (orally) agreed terms of the LLP were as to the profit sharing arrangement referred to above, the sharing of costs and that the 25 per cent payments to the LLP from each fee were to be treated as capital contributions to be returned, at some stage, to the respective member, less any deduction made for the LLP’s expenses.

There was no onus upon Mr Eaton to make such an offer as the usual position is that the remaining members of an LLP protect themselves in respect of the costs of litigation by making an offer of a buyout under the principles set out by Lord Hoffmann in the case of O’Neill v Phillips [1999] 1 WLR 1092 (a buy-out of the petitioner’s share of the LLP at fair market value). Mr Eaton’s offer was rejected. He therefore presented an unfair prejudice petition pursuant to section 994 of the Companies Act 2006, which also sought relief under section 122(1)(e) of the Insolvency Act 1986 (a just and equitable winding-up of the LLP).

The Respondents’ case on what terms of the LLP were agreed shifted constantly (at least six different versions were put before the Court). In essence, the Respondents’ case was that Mr Caulfield had the power to expel any member of the LLP in his absolute discretion, provided that it was in the best interests of the LLP. In terms of the 25 per cent contributions, the Respondents asserted that these sums were to be retained in the LLP and that, upon dissolution, they would belong to Mr Caulfield on the basis that the 25 per cent contributions were a fee due to him for using the Caulfield brand.

What were the terms of the LLP?

The Default Provisions

The business was run on an ‘eat what you kill’ basis. Each member of the LLP was entitled to the entire fee for each assignment he had successfully completed, less a contribution of 25 per cent which was paid to the LLP to cover operating costs. If another member had assisted either with winning the assignment or carrying it out, an agreement would be reached in relation to the splitting of that particular fee.

When considering the terms governing the LLP, the default provisions under Regulations 7 and 8 of the Limited Liability Partnership Regulations 2001 also had to be considered by the Court.

Those Regulations apply unless the members have agreed otherwise. The default provisions include the following:

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• a ll members are entitled to share equally in the capital and profits of the

limited liability partnership (regulation 7(1)); • e very member may take part in the management of the limited liability partnership (regulation 7(3)); • n o majority of the members can expel any member unless a power to do so has been conferred by express agreement between the members (regulation 8).

Eaton v Caulfield is a trial of the issues as to liability: whether there was a power to expel; if so, whether Mr Eaton was validly expelled from the LLP; and if not, whether the expulsion was unfairly prejudicial and/or the LLP should be wound up on just and equitable grounds.

Was the expulsion valid?

Mrs Justice Proudman found that the expulsion was invalid because there was no power of expulsion. The basis for this decision was that there was no written members’ agreement and that the members had not reached any express agreement as to expulsion. Regulation 8 of the Regulations, therefore, applied, which states that: “no majority of the members can expel any member unless a power to do so has been conferred by express agreement between the members.”

The Respondents had to show that a power of expulsion was expressly agreed and the circumstances in which such a power could be exercised. Since the power to expel is expropriatory in nature, it is always strictly construed.

“The Respondents’ difficulty in this regard…[was] that their case on this fundamental point..constantly shifted and it was very hard to pin them down as to its precise nature.” The Respondents’ pleaded case was abandoned at trial.

THE DEFAULT PROVISIONS CONTINUED...

One of the arguments advanced by the Respondents in support of Mr Caulfield’s power to expel was that all the members of the LLP understood that one of the terms on which they were joining the LLP was that Mr Caulfield was the “boss”, which included a power that he could expel any other member at his discretion and that they could “take it or leave it”.

Taken at its highest, the Respondents contended that by signing Companies House Form 288A (appointment of a member), each member was indicating that he had agreed to Mr Caulfield’s power to expel.

This argument did not persuade the Judge who held that the operative part of Regulation 8 is that the power to expel must be conferred by express agreement. Proudman J held that acceptance by conduct in signing Form 288A would have been equivocal and would not in any event have amounted to express, as opposed to implied, agreement for the purposes of Regulation 8. Proudman J also held that “there is no concept of a member in name only”.

Finding of unfair prejudice An unlawful expulsion and exclusion from the business was a clear example of unfairly prejudicial conduct. Accordingly, the Court has the discretion to order the Respondents to buy out Mr Eaton’s interest in the LLP. In addition, the Judge found that there had been a complete breakdown in the relationship between the members and that Mr Eaton would be entitled to have the LLP wound up on a just and equitable basis, pursuant to section 122(1)(e) of the Insolvency Act 1986.

The Judge did not agree with Mr Eaton that there was an express agreement

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that each individual member’s capital contributions would be returned to him on departing the LLP. No such term should be implied under contractual principles. However, she made the finding that Mr Eaton was entitled to a third share of the total capital contributions on the basis that, in default of agreement as to what would happen to the capital contributions, Regulation 7(1) applies, which states that all members are entitled to share equally in the capital and profits of the LLP.

by the LLP to its members).

Exclude section 994

Lessons to be learned

A novel point which arose from Eaton is the costs advantage of the petitioner making an open offer (or a part 36 or other without prejudice save as to costs offer) at the beginning of proceedings, following the guidance of the House of Lords in O’Neill v Phillips [1999] 1 WLR 1092. The usual position is that the remaining members can protect their position in respect of the costs of litigation by making an offer of a buy-out. Because Mr Eaton had made an open offer for the Respondents to buy-out his share of the LLP prior to proceedings being commenced and because this offer was rejected, Mr Eaton had achieved a result at trial at least as good as this offer. Indemnity costs (which could work out in practice at around 90 per cent of the legal fees, as opposed to around 70 per cent on the standard basis) were awarded against the Respondents for a large percentage of the trial costs.

Written members’ agreements Most professional services firms are aware of the desirability of having a welldrafted written members’ agreement.

Eaton v Caulfield highlights the need for an expressly agreed and carefully drafted expulsion clause, otherwise there is no power of expulsion. Absent such an agreed power, under section 4(3) of LLP Act 2000, unless and until a member gives (reasonable) notice himself that he wishes to cease to be a member, he remains a member. It also highlights the need for agreement as to the mechanism for the departing member’s profits and capital contributions to be distributed to him; otherwise the default provisions apply (which provide for equal entitlement to capital and profits).

An LLP members’ agreement should also cover matters which are not addressed by the default provisions, including: provisions relating to the return of capital, how management decisions are to be taken (for example, whether decisions require unanimous consent or only a simple majority), whether a member is a ‘contributory’ in relation to the winding up of the LLP, and the duties owed by the members to the LLP and each other (and

Members can, by agreement in writing, exclude the operation of section 994 of the Companies Act 2006, and most LLPs would be well advised to do so in the members’ agreement to avoid the uncertainty of litigation. However, section 122(1)(e) of the Insolvency Act 1986 cannot be excluded.

Buying out the departing members’ interest

Jeremy Callman is a barrister at Ten Old Square. Gavin Foggo is a partner and Molly Ahmed is an associate at Fox Williams LLP. They all represented the Petitioner.

© Fox Williams LLP and Jeremy Callman 2011