21 December 2015

The invitation to accept an offer of partnership is typically the culmination of years of hard work, stress and sacrifice. It is normally grabbed with both hands by the happy recipient, in the expectation that remuneration will soar; peer respect will be enhanced; and strategic contributions will be welcomed by his new colleagues. But all is not quite as it seems and, in reality, a partnership can be a poisoned chalice – or worse.

Unlike membership of an LLP or a shareholding in a limited company, a partnership under the Partnership Act of 1890 brings with it unlimited personal liability on a joint and several basis with the other partners. The theory is that the “privilege” of being entitled to keep the partnership’s financial affairs entirely private is to be balanced by the acceptance of personal liability. In reality, that balance is damagingly skewed as exposure of personal assets to creditors (and the accompanying prospect of sequestration) is a very heavy price to pay for privacy.

An incoming partner will often carry out thorough due diligence on the firm to satisfy himself about the full extent of its financial position. That is a sensible step. A view will normally be taken that liability for all the debts arising during his period of tenure is appropriate – in short, the risk is acceptable in the context of the anticipated rewards. This approach is rational and sophisticated but it is also deeply flawed. That is because of the nasty sting in the partnership law tail: namely the potentially alarming extent of an incoming partner’s exposure to claims for the historic debts and liabilities of the firm. These can often be hidden and will come out of “left field”.

Why should an incoming partner have to carry the can for liabilities incurred when he was perhaps working elsewhere, or his status was that of an employee in the firm? It all seems very unfair.

The starting point for assessing the extent of an incoming partner's liability is Section 17(1) of the Partnership Act 1890 which states that: “A person who is admitted as a partner into an existing firm does not thereby become liable to the creditors of the firm for anything done before he became a partner.”

This innocuous proposition seems straightforward and comforting. Sadly, the evolution of the applicable case law has transformed Section 17(1) into a trap for the unwary. That Section should therefore not lull an incoming partner into a false sense of security. The unexpected and unwelcome conclusion that can be drawn from the emerging case law is that, more often than not, an incoming partner will be liable for past debts. That seems to stand Section 17(1) on its head.

The key decision is Sim v Howat [2011] [CSOH115] in which Lord Hodge rehearsed in great detail the circumstances where an incoming partner will be held to have accepted liability for prior debts. Apart from the unusual situation where an incoming partner expressly accepts liability, Lord Hodge suggested that if the new partner simply “slots” into the firm (which technically becomes a new entity) and there is no change in the outward facing nature of its business, then there will be a presumption that liability has been accepted. Lord Hodge indicated that the presumption can be rebutted if:

• substantial capital is injected into the firm by the incoming partner;
• there is a material change in the business profile of the firm - perhaps by the opening of a new service line or where the incoming partner contributes a substantial client base to the firm; and/or
• wholly separate books of account are maintained so that the “new” firm is not involved in settling the debts of the “old” firm. In reality, that distinction will be very hard to achieve.

As is obvious, the bar for avoiding the assumption of liability is set very high by Lord Hodge. Everything depends on the specific facts and circumstances but the odds are stacked against the incoming partner.

In Heather Capital Limited v Levy & McRae & Others [2015] [CSOH115], Lord Woolman reiterated that the burden of proof is on the creditor to demonstrate that an incoming partner has accepted liability. That is some succour for him but it is a very minor piece of good news.

So, the moral of this story is that not everything that glitters is gold. The offer of a partnership could in reality mask a Pandora’s box of horrible legacy problems which, in the worst case, could wipe out the financial position of the incoming partner. No wonder LLP status is increasingly embraced by professional firms. At the very least, an incoming partner should ensure that the assumption documentation clearly states that he is not liable for prior debts and an indemnity should be obtained from the existing partners to back up that statement. Yet even that might not be enough… So take care, incoming partner!

Andrew Sleigh, Corporate Partner, afs@bto.co.uk T: 0141 221 8012