Salaried and fixed share partners could both be liable if their firm comes into financial trouble. Fergus Paine and Miguel Pereira urge partners to take steps to secure their assets

Over the last few months, we have seen a number of professional practices of varying sizes forced into dissolution or insolvency proceedings. Times are extremely tough and it is very possible we can expect to see the failure and collapse of several more law firms in the coming months.

Salaried partners (SPs) or fixed share partners (FPs) in traditional partnerships will be largely unaware of the personal liabilities they may face in such circumstances. It is not necessarily the case that only equity partners will face such risks.

Holding out

Before we explore the potential risks, it is worth summarising a few of the basics. The law does not recognise SPs or FPs: either one is a partner, or not. Most SPs, depending on how their employment contracts are drafted, are not in fact partners at all and will be treated as employees. FPs will be recognised as partners if they fulfil the necessary criteria to be a partner, namely, participation in management, contribution of capital and the sharing of some risk (i.e. sharing in losses as well as profits).

Notwithstanding whether SPs or FPs fulfil such criteria, given that they are held as partners of a partnership, it is implicit that they are also held liable for the partnership's debts. In theory, this means that if a firm were to become insolvent, SP and FPs would be equally liable alongside the equity partners for the debts owed by the firm. The Partnership Act 1890 is very clear on this point; it provides that:

"Everyone who by words, spoken or written, or by conduct represents himself, or who knowingly offers himself to be represented, as a partner in a particular firm, is liable as a partner to anyone who has on the faith of any such representation given credit to the firm."

Insolvency

Given that partners of a firm are individually and jointly liable for the debts of the firm, they will all be contributories with unlimited liability, if it winds up. In insolvency, the affairs of the partnership will be wound up by a liquidator who has the power to pursue the partners' assets in order to pay off the firm's creditors.

It is normal for SPs and FPs to obtain indemnities from the equity partners in respect of any liabilities of the firm brought against the SPs or FPs (except for any liabilities resulting from claims arising from their personal fraud, dishonesty or wilful misconduct). These may be implied or express indemnities.

This is all well and good if the estates of the equity partners are sufficient to cover such indemnity claims. Whether the indemnities are of value to an SP or FP will depend on whether the equity partners have any assets on which the claim may be enforced against. Indeed, given that a liquidator is likely to pursue the assets of the equity partners first, it is very probable such assets would have been used by the time the liquidator decides to pursue any SPs or FPs. It is also entirely possible that equity partners would face bankruptcy as a result of the liquidator making such claims.

Options

What can FPs or SPs do to limit the above risks? There are four possibilities.

First, seek to change their title so that they are no longer held as partner. The immediate drawback is that such a step may be perceived as a demotion in the eyes of clients. The loss of title may be difficult for partners to accept given the hard work usually involved in achieving it in the first place. Another drawback is that the firm may have to start making national insurance contributions in relation to the FPs, an additional cost at a time when the business is under pressure to keep overheads down.

Also, the Partnership Act 1890 provides that every partner is jointly liable for the debts and obligations of the firm incurred while he is a partner. This means that even if SPs or FPs change their role, this would not affect their liability for debts and obligations accrued previously. Whether an SP or FP is well advised to change role now will largely depend on what the accrued liability is at present and whether that situation is likely to deteriorate.

Second, it is entirely possible that major creditors of the firm, such as the landlord or the bank, may not have placed any reliance on the fact that the SPs and FPs are held out as partners. It is clear from the provisions of the Partnership Act that, in addition to the holding out itself, reliance on such representation is also necessary. Where there is no reliance, the SPs and FPs will not face any liability. Whether any reliance was placed will be a question of fact. It is therefore open to the firm, unless it has already done so, to clarify the status of its SPs and FPs with creditors by making it clear that it is not intended that they be jointly and severally liable for the debts of the firm and to request a letter from any major creditors confirming this.

The value of such a letter will depend upon its terms and how explicit and unconditional its provisions are. In reality, however, a firm may be reluctant to approach a creditor with such a request, as it may not wish to cause alarm or alert them to possible financial problems ahead. In such circumstances, it is doubtful whether a creditor would be content to narrow or limit its potential recourse should it be concerned about recovering amounts owed to it.

The third option is to convert the partnership to an LLP. In general terms, all members of an LLP enjoy the same protection of limited liability as do members of a limited liability company. This means that any claims for outstanding debts would be made against the LLP's assets, not the personal assets of an individual member. In practice, this should protect the members in the event of an armageddon insurance claim, which is in excess of the firm's PI cover. It is possible that if a firm has not already converted to an LLP there are very good reasons why, particularly as costs for converting are now relatively small given that conversions are tried and tested.

However, SPs may wish to highlight to the equity partners that in addition to the advantages of limiting liability, there are financial benefits when converting to an LLP. For instance, at the moment, the current practice of HMRC is to treat all members of an LLP, employed or otherwise, as self-employed for tax purposes. This may lead to potential tax savings as the LLP would not be required to make any national insurance contributions in relation to the FPs and SPs remuneration. Interestingly, this does raise the question as to whether, on a conversion of a partnership to an LLP, those salaried partners that have become salaried members, and who are subsequently taxed as self-employed, would be treated as self-employed by an industrial tribunal even though they have the characteristics of employees.

This would deprive the person of all statutory employment protection where perhaps both the salaried member and the employing LLP intended and believed him to have that protection. The loss of employment protection may be a small price worth paying in order to ensure limited liability status.

Finally, a further option is for the firm to take out supplementary bespoke insurance protection for the benefit of the SPs or FPs that will provide protection in the event of a huge loss that could wipe out the firm's assets and professional indemnity cover, potentially leaving the SPs or FPs personally exposed. Such insurance cover would be unusual, but it would be interesting to see whether difficult economic times will lead some firms to bolster insurance protections. The cost of such insurance cover is likely to be prohibitive.

Depending on the leverage which the SPs or FPs may yield, another option would be to convince the equity partners that the future of the firm lies in merging with a compatible firm. Although the reasons for merging would lead to the equity partners' negotiating position being significantly weakened, consolidation may be a way of securing new capital into the firm. In order to attract potential merger partners, the firm will need to show that some of the departments within the firm have goodwill which can be sustained in the larger firm. Notwithstanding this, it will be difficult to find a firm that would be happy for the new merged entity to absorb the liabilities of the partnership.

Depending on the size of the FP and SP pool in a firm, and the importance of such pool to the future success of the firm, at the very least, the FPs and SPs as a collective unit may approach the equity partners in order to obtain detailed financial information about the firm, and, if necessary, to negotiate the introduction of possible measures to protect their own personal assets. The firm may have no choice but to listen to their requests.

Fergus Paine is joint head of partnerships and LLPs and Miguel Pereira an associate at Lewis Silkin.