CHAPTER TWO – WHY PARTNERSHIP DISPUTES ARISE
Many years ago I advised some professionals on buying a practice together. The costs of buying a practice are never low and the final piece of the jigsaw in my advice was that they needed a partnership agreement. They decided that they had spent enough money and besides, they were old school friends and had known each other for years, so what could possibly go wrong?
This next paragraph is probably unnecessary. You will have guessed that all was not sweetness and light in their partnership and the saved £1,000 or so on a partnership agreement was replaced by tens of thousands of pounds of legal costs in a very messy partnership dispute. Their professional regulator was unimpressed by the fist fight in reception.
This was a scenario that even the best drafted of partnership agreements would not necessarily have solved. It would of course have provided a simpler and cheaper process for resolving the underlying dispute.
The best time to avoid a partnership dispute is when you’re getting on. In the honeymoon stages of a business relationship, when you are setting up the business, it makes sense to have the difficult conversations because they are all hypothetical. We are not going to fall out, but if we did how would we resolve it?
Once I have drafted a partnership or LLP agreement for a professional practice, my advice is always to lock it in a drawer and leave it there gathering dust. The minute anyone is tempted to take it out from the drawer and see what it says, then there is a potential partnership dispute brewing.
At that point, it is best to leave the drawer locked and go to the pub or coffee shop (or wherever) and to have a frank and possibly difficult conversation. Get to the bottom of the issues and decide what you’re going to do about it. Record what you’ve decided and move on.
Once you start checking what the partnership agreement says, you are possibly at the top of a potentially slippery slope.
As you will have seen from the paragraph above, a well drafted partnership or LLP agreement is the basis for avoiding disputes. Those early discussions setting out what happens in what situations are key.
I remember my history tutor at university stating that the key to understanding ancient history was to remember “land, money, power.” In many respects, that is equally the case in partnership disputes. Land is probably less important, but money and power are the key drivers in partnership disputes.
The two major areas of dispute that arise within partnerships are around profit sharing and decision-making. Who gets how much of the profits and who gets to take the important decisions? If you can resolve those two matters, then a partnership dispute is unlikely to arise. Hence the need to have honest discussions early on and to tackle issues when they arise or even when they might arise.
The key elements that need to go into a good Partnership or LLP Agreement, and which can cause friction are:
Capital – how much is the partner required to put in and when. Are there situations when additional capital will be required and what happens if a partner cannot afford or does not wish to put more capital into the firm? How and when will that capital be returned? See below on retirement.
Profits and losses -how will they be divided? This can run on a continuum from equality to “eat what you kill”. In equality, the profits are divided equally between the partners, irrespective of how much effort or success (however you define success) each one has put in or achieved. At the other end of the spectrum, “eat what you kill” sees partners taking only that share of profits which they have generated, billed and – hopefully – collected. Yet another argument can arise around how expenses are allocated in this scenario. Some partners share an administrative assistant, and others demand their own, and possibly more than one! And certain partners demand a lot more central support than others.
There are many options in the middle of this continuum. I personally like a partner’s profit share to have an element reflecting the salary due to them for the work that they do as a senior professional, a performance related element based on how they have performed against an agreed set of SMART1 objectives and a final dividend element based on their capital, to reflect their investment in the firm. Without a clear definition, which may include an element of give-and-take for good and bad years, or an averaging calculation, resentment can arise. Those contributing more to the firm can resent those contributing less. Similar discussions can be had regarding losses, although note that it is best practice to allocate losses in an LLP into a Loss Reserve Account, where they remain in the LLP until needed for tax purposes.
Drawings Policy – who gets to take out how much and when? Again, if this is not agreed, disputes can easily arise. It is usual to agree a monthly draw so that partners know that they can pay their mortgages and monthly bills. Addition profit shares can then be taken as agreed, often after the annual accounts have been finalised and the profits agreed. Some firms have additional draws quarterly or semi-annually.
Decision making – who gets to make what decisions? Is there a management committee to whom powers have been delegated or is it by a simple or weighted majority? If so, is it a majority based purely on numbers, or by percentage of capital or points? Are there tiers of partner with different voting rights? All partners need to understand how decisions will be made. The 2021 case of Tribe v Elborne Mitchell LLP the judge found that he allocation of profit had been ‘within the range of proposals that it was reasonable for the senior partner to make’. What is in the Partnership of LLP Agreement will stand unless it is perverse.
It is good practice, wherever possible, to avoid taking votes on matters at partners’ meetings. The minute you take a vote, there is somebody who has “lost” and who may feel resentful at that decision. It is preferable, if it is clear that there is a minority strongly against a particular decision, to adjourn the meeting and for a senior partner to try to resolve the issue before bringing it back to the table, or to reach a compromise. If you have to take a vote leaving a minority disgruntled, careful management will be required to ensure that this does not turn into a full blown dispute.
Retirement and expulsion – it needs to be clear how these clauses work and partners need to feel that they cannot be unfairly ganged-up on and forced out. The majority of partners need a mechanism to deal with poorly performing partners. The mechanisms need to be appropriate to the size and culture of the firm. In a large firm with a corporate culture, the mechanism can be quite brutal. If the management committee decides that partner A is to retire, partner A will retire. In a firm with five or fewer partners, such a brutal mechanism will not be appropriate, but nonetheless the firm needs a mechanism to deal with poor performance or, more likely, poor behaviours.
There is usually a debate about whether an agreement should have a no-fault expulsion clause. We often call this a “red socks clause” because it allows the partners to remove a partner because he or she wears red socks. The issue with fault expulsion clauses is that the non-performing partner’s performance or behaviour is not quite bad enough to force a fault expulsion, but there is a general acknowledgement in the firm that it would be a better place without him or her. I mention above performance or behaviour, and in my experience it is often the behaviour that is the issue.
If your agreement contains a well drafted no-fault expulsion clause, you probably don’t need to read further!
Restrictive covenants – again you can go off and read many learned tomes on the tricky subject of restrictive covenants. The key in partnership disputes is to have them as a negotiating tool; partners need to appreciate what they can and cannot do. As we will see later, they can be a vital negotiation tool as a partner may be desperate to take some of his or her clients with them.
Dispute resolution – you need to decide whether or not your partnership agreement has either mediation and or arbitration in it. There are pros and cons to both. When it comes to a dispute, it is vital to know whether mediation and arbitration is in the partnership agreement and whether it prohibits the disgruntled partner, or the firm, from starting a claim before going through the alternative dispute procedures.
It is useful, especially in larger firms where there is a management committee, to have a clause in the agreement that allows that management committee to take legal advice in the event of a dispute, which can be paid for by the by the firm and – crucially – cannot be seen by the partner whose potential removal or sanction is being contemplated. Without such a clause, there is a risk that a partner can claim access to all documents and advice provided to the firm. If such a clause is not in the agreement, it is safer for the individual partners to take advice in their own names. They will not be able to claim back the VAT on this.
For some reason, it is not uncommon for partners in professional practices not to want to tackle poor performers, be that in terms of billing, technical competence or interpersonal behaviours. This may be because people get to become partners in firms because they are technically competent at accountancy, law, surveying, medicine, etc and then are expected to manage a team, generate business and run a practice – all of which are skills they have never been taught. Additionally, people (even aggressive litigators) often do not like confrontation with people close to them on a face to face basis.
The ostrich approach to management never yields good results. A problem ignored does not improve. In fact, a problem tackled may well improve. A recently promoted partner, new in the role, who is taken aside by a trusted more senior and experienced partner, may well listen to advice and change their ways before their behaviour becomes so destructive that they are asked to leave.
Trying to persuade a head of department partner who has been in role for 20 years that he or she should alter their approach is not going to be an easy conversation, especially if they are a big biller. A well drafted partnership agreement may help, as well as good performance reviews and a well-managed HR function.
Given the issue identified above – that people are made partners because they are technically proficient at whatever the firm’s specialism is, rather than because they have the appropriate skill set to manage a team, win new business and develop a firm – it is key that new partners are given a thorough induction programme to being a partner, possibly a mentor to help them develop as a partner and regular feedback to prevent them getting bad habits early on.
This must be an ongoing process and a good appraisal system is key.
Where a problem is tackled well and sensitively as soon as it arises, is less likely to lead to a fully-blown partnership dispute.
1 Specific, Measurable, Achievable, Relevant and Timebound.