Ghosts in the balance sheet: the liabilities lurking behind your LLP

This article examines the protection the LLP structure offers, the circumstances in which that protection may prove misleading and the practical steps members can take to safeguard their position.

Partnership versus LLP: where the risk sits

In a general partnership governed by the Partnership Act 1890, the firm has no separate legal personality. Every partner is jointly liable for the debts and obligations of the firm incurred while they are a partner, and jointly and severally liable for wrongs committed by fellow partners acting in the ordinary course of business. In short, personal assets are exposed to the firm’s liabilities, including those caused by someone else.

The Limited Liability Partnerships Act 2000 changed the picture. An LLP is a body corporate with a legal personality separate from its members. It contracts in its own name, owns its own assets and is primarily liable for its own debts. A member’s exposure is, in principle, limited to what they have invested in the business.

Signing away the shield: personal guarantees

The most common way in which limited liability is circumvented is also the most voluntary. Banks, landlords and key suppliers frequently require members to give personal guarantees in support of the LLP’s borrowing, lease or trading obligations.

A guarantee is a separate contract between the member and the creditor. If the LLP defaults, the creditor can pursue the guarantor directly, regardless of the corporate structure. Guarantees are often signed at the outset of a lease or facility and then forgotten, but they can survive changes in membership and, unless properly released, may follow a member long after they have left the firm.

When the cloak is pierced: insolvency claims

The LLP’s separate legal personality offers little comfort where the business fails and a liquidator starts asking questions. Key provisions of the Insolvency Act 1986 apply to LLPs, with modifications, including:

• Fraudulent trading, where business has been carried on with intent to defraud creditors, exposing those knowingly party to it to a personal contribution order
• Wrongful trading, where a member knew, or ought to have concluded, that there was no reasonable prospect of avoiding insolvent liquidation and failed to take every step to minimise loss to creditors
• The LLP-specific clawback of withdrawals, which allows a liquidator to recover drawings, profit shares and capital repayments taken in the two years before winding up where the member knew, or had reasonable grounds to believe, that the LLP was or would become unable to pay its debts.

That last provision is the true ghost in the balance sheet. Drawings taken in good faith during a difficult trading period can be recovered years later, often when the money has long since been spent.

Personal responsibility: negligence and fiduciary duties

Limited liability doesn’t protect a member from the consequences of their own wrongdoing. A member who assumes personal responsibility for advice to a client may be personally liable alongside the LLP.

Notably, the courts have confirmed that members don’t automatically owe fiduciary duties to each other merely by virtue of membership, so the members’ agreement will often determine the scope of what is owed.

However, members do act as agents of the LLP and may owe the LLP fiduciary duties in this capacity. By way of example, in Hosking v Marathon Asset Management LLP [2016], a member was ordered to forfeit half his profit share of £10.38m for breach of fiduciary duty.

Practical guidance: laying the ghosts to rest

Protection begins with the members’ agreement and good governance. Members should consider the following:

• Structure capital contributions deliberately, distinguishing between capital, current accounts and loans, and set clear rules on when capital may be withdrawn or repaid
• Adopt a prudent drawings policy linked to cash flow and solvency, with retentions for tax and contingencies, to reduce clawback risk
• Keep an up-to-date register of personal guarantees and negotiate releases, caps or time limits, particularly on retirement
• Include indemnities in the members’ agreement under which the LLP indemnifies members for liabilities properly incurred in the course of the business, while carving out fraud, wilful default and breach of duty
• Define the duties members owe to the LLP and to each other expressly, rather than leaving them to implication
• Review professional indemnity and management liability insurance to ensure cover extends to individual members
• Take early advice when financial difficulties arise and document decisions carefully, as contemporaneous evidence is often the best defence to a wrongful trading or clawback claim.

Conclusion

The LLP remains an effective vehicle for limiting personal exposure, but it’s not an impenetrable fortress. Liability can creep back in through guarantees signed years ago, drawings taken in the wrong period and individual conduct that falls short of the standards expected.

Members who understand where the shield ends and plan accordingly are far less likely to be haunted by liabilities they thought they had left behind.