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Covid-19 and the tough questions law firms are now asking

Jeremy Callman, a barrister at Ten Old Square, considers the legal challenges facing law firm management amid the coronavirus pandemic and a financially-damaged world

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The financial scars of the Covid-19 pandemic run deep. The new harsh financial reality means those who manage law firms face some tough legal questions. In my partnership practice, I have already seen the following questions arising as part of the ‘fallout’ from the coronavirus pandemic:

Profit share: can we cut partner share and adjust what fixed-share partners are entitled to?

As is so often the case with questions of partnership law, the starting point is to look carefully at the terms of the partnership/LLP agreement (‘the Agreement’). For equity partners, the Agreement will usually feature a carefully worked through, often points-based, profit distribution system. Usually, for equity partners, the answer should be relatively simple, if harsh. If there are lower profits, then the value of each point will fall. A smaller pie leads to smaller slices. 

Drawings will often be contentious. Whilst partners frequently perceive drawings as the equivalent of a monthly salary, they are not. Drawings are a payment on account of profits. Usually, there will be a clause in the Agreement which addresses how drawings are determined and provide the partnership/LLP with the ability to reduce drawings. Sometimes there is no such clause and drawings are simply fixed by management. It is likely then to follow, as a matter of the exercise of management powers, that if annual profits are falling, drawings can be adjusted downwards too. The alternative would likely be to pay drawings at ‘normal’ levels and then claw back payments of drawings made at the end of the year when (reduced) profits are known. Many firms are spreading the pain and reducing, or even withholding entirely, drawings. 

The position for so-called ‘fixed-share partners’ is more complex. The first thing to ascertain is the legal status of the person concerned. As the law stands, you cannot be both a partner and an employee of the same firm (see Ellis v Ellis & Co [1905] 1 KB 324; Cowell v Quilter Goodison Co Ltd [1989] IRLR 392) nor – rather curiously – can you be both a member of an LLP and an employee of the same LLP (Reinhard v Ondra LLP [2016] 2 BCLC 571). So, you need to analyse whether the fixed-share partner is in law (a) a partner/member or (b) an employee. One (but not the only) pointer will be whether the fixed share is actually a cap on profits. If so, this will be a strong indicator that the individual is a partner/member. If the fixed share is, rather, a guaranteed fixed sum, this will be tantamount to salary, and a strong pointer to the individual being employed. 

If the fixed share is a cap (i.e. the individual is entitled to a share of profits of up to say £150,000 pa), then if overall profits do not allow payment of the fixed shares, fixed share payments would usually fall pro-rata. Usually, fixed-share partners have first claim on profits before any equity partners take profits. Again, though, it depends on the wording of the Agreement.

What if management wants to reduce the cap on fixed-share partners, perhaps in line with the ‘hit’ that equity partners are taking? You need to look carefully at the Agreement and see if there is a review mechanism or some other power to reduce fixed shares. Often any reduction will start from a fixed point in time (typically the accounting year-end). Fixed-share partners are created by the Agreement and usually the answer to whether, and if so, how and when such fixed shares can be revised or reviewed, lies in that same agreement.

De-equitisation: can we transform some of our equity partners into non-equity partners or even employees? Can management force through those sort of changes?

This is usually a hard ask. There are many instances where equity partners are simply not paying their way. The most egregious example I have dealt with over my many years of advising on partnership matters was an equity partner in a large global firm who billed 11 billable hours in a year! Why should such individuals remain in equity?

It is rare to find clauses built into an Agreement expressly including a power to transform an equity partner, against their will into, for example, a fixed-share partner or an employee. I have drafted such clauses for agreements and, if there is such a clause, then it can be used in accordance with its terms.

Absent such a clause, things are more difficult. There is no inherent right to de-equitise. Any point-reduction options can be pursued as discussed above. If, after cutting equity points, the equity granted to that person still does not make economic sense, then it is usually sensible to have a ‘full and frank’ discussion about performance and whether the equity partner is paying their way. Often agreement can be reached for the poor performer to leave equity in a ‘face-saving’ way. Partners are often, but not always, as concerned about avoiding embarrassment as they are about keeping equity. 

If a negotiated solution fails, then it may be necessary to consider using compulsory retirement powers (see below) to terminate the individual on notice and offer the individual (if the firm wishes) the option to return as an employee, fixed-share partner, or consultant. That route often results in a deal being done before the firm actually has to pull the trigger on the compulsory retirement.

Poor performers: if we need to shed poor performers to become more streamlined and financially ‘fit for purpose’, can we do so?

You need to be sure you are dealing with a partner/member and not an employee. If the person is an employee, then you need to consider all the rules and strictures applying to terminate employment. Assuming you are dealing with a partner/member, then the first question is whether there is a power to terminate their partnership/membership in the Agreement? 

If there is no power to terminate, you cannot do it (see Partnership Act 1890: s 25 and LLP Regs 2001 (SI 2001/1090) Reg 8 and Eaton v Caulfield [2011] BCC 386). In those circumstances, you may well want to consider whether the firm wishes to amend its agreement to introduce a power if doing so is in the best interests of the firm (and not merely a way of removing a particular partner). 

If you cannot get agreement to add a power, your only likely options are to negotiate a retirement of the individual on agreed terms or to contemplate dissolving and re-forming. Be warned, however, that dissolution is not a silver bullet and would likely have hugely complex and detrimental consequences. Such a poison-pill approach is really only a last resort.

If there is a clause allowing termination, it will usually be either an expulsion clause providing for termination for cause (e.g. serious breach of the Agreement or bringing the firm into disrepute etc) or a compulsory retirement clause, providing for deemed retirement after a fixed period of notice, often six months. As these termination powers are contractual, you need to consider the terms of the clauses with care. Often, trying to terminate a poor performer by expulsion is squeezing a round peg into a square hole. It can be better to proceed down the compulsory retirement route, even if paying the poor performer their profit share for the notice period sticks in the throat.

Even compulsory retirement is open to challenge. The procedure set out in the Agreement (and any other governance documents) must be properly followed. Was notice given? Was the meeting quorate? Was the meeting validly held? See further below. 

Some agreements provide for a right to be heard. Even if they do not, it is often sensible to give the partner/member whose termination is proposed a right to circulate a memo and/or address colleagues. See the recent case of Dymoke v Association for Dance Movement Psychotherapy UK Ltd [2019] EWHC 94 (albeit that it is not a partnership case). 

The decision to terminate needs to be taken carefully. It can be struck down if it is discriminatory (sections 44 and 45 of the Equality Act 2010) or in bad faith (see Blisset v Daniel (1853) 10 Hare 493 Ch). It may also be the case that, following the Supreme Court’s decision in Braganza v BP Shipping [2015] 1 WLR 1661, the two limbs of Wednesbury will apply (this is an evolving and important area of law). If so, then the decision to impose compulsory retirement (a) must not be one that no reasonable group of decision-makers could ever have reached (the ‘outcome limb’) nor (b) must it take into account matters that ought not to have been taken into account or fail to take into account matters that should have been considered (the ‘process limb’). Even though it may be a matter of debate whether so-called ‘Braganza duties’ apply, it is sensible to assume they may well, and proceed accordingly.

So, if the Agreement contains the power to do so then poor performers can usually be removed (most often using a compulsory retirement clause) but with great care, so that litigation risk is minimised.

Merger: if we want to merge to become more financially stable and to secure economies of scale, can management make it happen?

Many firms are currently considering defensive mergers. Size may provide economic stability (although bigger is not always better). Managing a merger is not easy and forcing one through is even harder. Sometimes Agreements contain express clauses allowing a vote (usually at a high percentage) to agree to a merger. However, the mechanics of a merger often make forcing it through difficult. It will often depend on the way the deal is to be structured and the warranties needed. If one firm ‘swallows another whole’, then in the LLP context, it is more likely that it can be made to happen, as the LLP owns its assets and the LLP can, therefore, be transferred along with its assets. Even then warranties and practicalities (e.g. signing up to new LLP agreements) may make this unworkable. For partnerships, where partners own the net assets personally, they will usually have to agree to sell.

Other forms of structure would make forcing through a merger even more difficult. It is hard to see that anyone could be forced to sign up to new LLP terms or to become partners in a new firm or structure. Often what has to happen is that dissenting partners or members need to be exited first. That may sometimes make timings difficult. In those circumstances, negotiation to deal with dissenters may be the only viable route. In practical terms, trying to force people into a merged firm is not likely to create an effective or harmonious merged business.

The Practicalities: can we make decisions and hold meetings? Are quorum and voting requirements met by joining meetings by video conference or telephone?

In these times, in which so much is being done virtually, management needs to check with care whether the terms of the Agreement allow for meetings to be held by video conference and/or by telephone. If they do not, consider whether the wording of the meeting clauses expressly require physical attendance at a meeting for it to be valid. Quorum provisions will need to be observed and it is hard to see how the use of proxies will easily overcome such requirements. 

If the agreement does not allow remote attendance, a practical solution will need to be found, even if social distancing rules remain in place (perhaps it is time for outdoor meetings?). Alternatively, and perhaps as a learning point for future flexibility, firms could consider amending the Agreement to allow remote attendance or online meetings. An amendment must be passed in good faith in the best interests of the firm (see by analogy Re Charterhouse Capital Ltd [2015] 2 BCLC 627).

In order to amend the Agreement, most agreements require a resolution to be passed in a valid meeting. To overcome the obvious ‘catch 22’, a deed of variation signed by all partners/members, if appropriately worded, should work to amend the Agreement.

These issues have already started to bubble to the surface. As firms adjust to a financially damaged world, these challenges will become more and more of a reality.

Jeremy Callman is a barrister at Ten Old Square specialising in partnership and LLP matters