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FRP Advisory looks at the issues facing lenders and advisers when dealing with insolvent Limited Liability Partnerships

Authors: Charles Turner, Philip Watkins
15 March 2011

In the following news article, Charles Turner and Philip Watkins, partners at FRP Advisory, provide a brief introduction to some of the issues that lenders and their advisers can face, when dealing with an insolvent, or potentially insolvent, partnership.

Over the last 2 years, we have seen the dramatic effects of the credit crunch in the corporate world. Bank lending has been under severe pressure for a number of reasons, from a requirement to improve their balance sheets,  lack of liquidity and falling security values.

Professional partnerships have not been immune to the general state of the economy, and many are finding life very tough in times when borrowing is difficult to obtain, deal flow is much reduced and clients are increasingly looking to reduce costs.

Partnerships generally take two forms; the traditional unlimited liability partnership and a partnership created after the introduction of the Limited Liability Partnerships Act in 2000.

Increasingly, over the last few years, partnerships have sought to limit the liability of their individual partners by becoming limited liability partnerships (LLPs). In the LLP regime, the liability of the partner is just that - limited to the value of their membership share. Whilst they share in profits, they are not liable for the debts of the partnership, which is treated like a limited company in having a legal identity separate to its owners. But on insolvency they can be liable for repaying drawings to the Administrator that are taken in excess of profits.

Whilst things are going well and the business is successful, this all seems very straightforward and, the partners (or members as they are legally referred to) simply take their drawings and profit share in the normal way. However, when things start to go badly and the business needs restructuring or, in a worst case scenario, an insolvency process, things start to get a little more complicated. Lenders and advisers need to be aware of the pitfalls that can lie in wait for the unwary.

LLPs are able to grant security over their assets. By far the most valuable assets in most partnerships will normally be the Work In Progress (WIP) and debtors that can be secured by a normal debenture.

Many professional practices will operate client accounts. These are accounts into which funds belonging to clients of the firm are paid, thereby keeping them separate from the practices' own funds. There are detailed rules relating to the conduct of client accounts, which are designed to ensure that "mixing" of client and practice funds is avoided. It is important, therefore, when contemplating an insolvency process, that the operation of the client account is considered. In the case of a legal practice only a solicitor is allowed to operate the client account and a non-solicitor insolvency practitioner is precluded from doing so. It is, therefore, difficult to envisage a situation where an Insolvency Practitioner could trade a solicitors practice through an insolvency process. This position is compounded as it is highly unlikely that a client would be happy dealing with a practice in administration as medium and longer term client care will not be guaranteed. Our old friend, the "pre-pack," therefore rears its head once again. A pre-pack is simply the process whereby a sale of the business is agreed prior to the insolvency event and the sale is completed by the insolvency practitioner shortly after his or her appointment.

Practically, the only way to achieve a realisation from an insolvent legal practice is through a pre-pack. This can ensure that an alternative firm takes over conduct of all live matters, to ensure an income stream from the WIP that can be used by the administrator to pay creditors. Detailed advice, however, is also needed in relation to how the WIP is dealt with, either through sale or work-out arrangement, which may well depend on the nature of any security held in respect of it. It must also be borne in mind that legal practices, in particular, do not "own" the files which represent their WIP. Rather, they own the right to receive payment in respect of that WIP when the matter is completed.

Whilst liquidation, receivership (in rare circumstances) and company voluntary arrangements are also available for use by such practices, it is likely that administration will be the most often used process.

As well as the client account issue, it will be important for anyone involved with an insolvent partnership to consider the issue of professional indemnity insurance (PII) and, it is this that also pre-disposes professional partnerships to the pre-pack regime. PII is expensive anyway but, in the event of insolvency, it can become prohibitive. In the case of an insolvent legal practice, this can present a liability of over 30% of gross fee income, clearly a number which makes its payment virtually impossible. In addition, it should be borne in mind that run-off cover for up to six years will be needed in cases where no successor practice (which is a whole topic in itself) is in place. That additional premium may double the amount to be paid.

Six points for a lender to look out for in relation to professional practices:

1. Growing Work in Progress (WIP) consumes cash and could conceal losses in the event it is not recoverable, so it is important for lenders to understand the partnerships WIP and debtor provisioning policies. WIP and debtor reviews should be carried out on a monthly basis.
   
   
   
2. Quite often partnerships will pass management information to a bank that will show profit before drawings. However, it is important that management information also contains the profit net of drawings, to understand the impact of drawings on net profitability and cashflow. It is also important to know that partners are not drawing more than their profits.
   
   
   
3. A standard thirteen week cashflow forecast is a great model for a partnership to use to monitor their short term cashflow, so that they can anticipate problems and plan accordingly.
   
   
   
4. It is important for a funder to understand how partners' income tax is allowed for in the accounts and how it will be paid. Although, a liability of the individual partner income tax is quite often paid by the firm.
   
   
   
5. Quite often poor performing departments are masked by the profits of the overall firm. It is important for partners and funders to understand profit and working capital consumption on both a department and regional basis.
   
   
   
6. Generally speaking, revenue levels may be lower at a time of recession. All things being equal, the cyclical fall in revenues will automatically reduce working capital which, itself, will generate cash and reduce bank borrowings. It is important that firms understand the impact on increased working capital funding in the event of an upturn in revenues, as it at this stage of the economic cycle that business failures have historically peaked. Integrated profit and loss, balance sheet and cashflow forecasts are an essential tool for a partnership to plan their medium and long term funding requirements.

At FRP Advisory, we have a wide range of experience in dealing with insolvent partners and partnerships. It cannot be stressed enough how important it is to obtain the best possible advice in these situations – we are available to provide that advice, whenever and wherever you need it.

To find out more about how FRP Advisory can help you and your business, please contact us using the online form below.