There are many circumstances in which an LLP member can end up with personal liability for either individual liabilities of the LLP or a share of the LLP’s losses over a particular period. This article examines just a couple of related examples as to how LLP members can end up bearing very substantial LLP losses.
The default position is that an LLP member has no obligation to make good the losses of the LLP. A typical scenario would be where an LLP has traded at a loss, or has suffered a catastrophic loss such as an insured claim, and the members put the LLP into liquidation.
In such a case the members will lose their capital (to the extent of the losses and the costs and expenses of the liquidation). Depending on the extent of the LLP’s debts they will also probably lose undrawn profits from the previous period, and might not (depending on the precise circumstances) even be able to prove for a proportion of those undrawn profits alongside other creditors.
But the position can be even worse than that. Some LLP agreements I have seen provide that each member must bear a share of the LLP’s losses. Sometimes that is simply a dreadful drafting error, in some cases arising from a misunderstanding as to what is appropriate when carrying over agreement terms from a partnership agreement governing the partnership that preceded the LLP. Clearly, if members must bear their share of the LLP’s losses without any reservation then their position is not much better than if they had been in a general partnership where they would have unlimited personal liability. The only saving grace might be (depending on the drafting) that they would only be liable for their share of the losses, not jointly and severally liable for the entirety of the LLP’s losses, which would be the position of each partner in a general partnership.
In other cases the inclusion of such a clause is deliberate, but usually with an important reservation/limitation as to the circumstances in which liability can arise. However, even with well-thought-out reservations/limitations, these clauses can have an unintended sting in the tail.
When an LLP suffers a loss but continues to trade, then that loss has to be allocated amongst the members, usually in their profit-sharing proportions. The loss cannot simply disappear into thin air. One way or another it has to be dealt with. The LLP may continue to trade but it has less assets. One way or another this has to be reflected in the members’ accounts, as there is no-one else to bear the loss/shortfall of assets. There are only three ways this can be done, either a debit against each member’s capital account, and/or a debit against each member’s current account, and/or the creation of a loss reserve account. The latter can only be a temporary measure. It is just window-dressing putting off the evil day when members’ accounts are debited.
LLP agreement clauses dealing with this scenario, if well drafted, make it clear that members will not have to contribute to losses in the event that the LLP goes into liquidation. Clearly it is very important to get this reservation right.
A distinction must be made between on the one hand an obligation to contribute to a loss out of undrawn profits or future profits, and on the other hand an obligation to put new money into the LLP.
Even where such clauses are properly drafted, difficulties for individual members can arise. The may be a difference of opinion between members as to whether to put a loss-making LLP into liquidation or not. Provided that it is more likely than not that the LLP will avoid insolvent liquidation (for example because of improving trading conditions), so that there is no risk of wrongful trading, the majority of members may wish to carry on trading, whereas the minority might prefer to put the LLP into liquidation, but they would be out-voted. The particular reason why some members might prefer liquidation would be so that they can take their labour elsewhere and earn a living out of which they would not have to contribute to the losses that have just been incurred by the LLP.
Unfortunately for such members, any LLP that has an LLP agreement is likely to have provisions in that agreement requiring members to give notice before they leave, with the result that members can in effect be trapped in an LLP, having to contribute to a previous year’s LLP losses out of income in the new financial year. Potentially, depending on the extent of the losses and the performance of the LLP in the new financial year, such involuntary ongoing participation by a member can be financially crippling. Drawings may be considerably reduced, and even then, if the LLP does not perform as expected, members may end up overdrawing and having to repay at the end of the new financial year, even if the LLP is then put into liquidation. A liquidator will always be able to recover overdrawings.
Members in this position cannot escape the trap simply by physically walking out and finding another job. If they have not given the correct notice they will still be members, and by walking out contrary to their obligations they will almost certainly make their position worse rather than better, at least if the LLP/the other members have the resolve to pursue the claims that would arise against the absent member. Modern notice clauses can often require more than a year’s notice, for example six months’ notice to a financial year end can mean that in reality notice of up to 18 months has to be given if notice is given less than six months before a financial year end.
This article identifies just one of many reasons why potential members considering joining an LLP should carefully analyse what their position would be in the event that the LLP started to make losses. No business is immune to adversity. Intending LLP members need to have an exit strategy before they join.