Recently clients asked me to consider using an LLP as an onshore vehicle for pooling funds for investment purposes.
Perhaps I missed some research but I was unable to find any sensible writings on the use of an LLP for such a purpose.
I thought it might be useful to share my analysis of the position.
(a) wish to invest in companies in a sector where individual investments can be high risk but if the investments are spread across a number of such companies then the risk profile becomes attractive;
(b) consider that it is difficult to arrange a sufficient spread of risk in such investments on one's own;
(c) consider that pooling resources with a few like-minded individuals would help the spread of risk and improve information flow in the decision-making;
(d) need a tax-efficient vehicle preferably incorporated in the UK which could be operated on a tight budget.
2. Vehicles to consider using for the fund include:
- Limited partnerships. These are tax transparent. However, the limited partner loses his limited liability if he involves himself in management and so it is not an appropriate vehicle to use for the present purpose.
- Limited company. An onshore limited liability company is not really a tax efficient vehicle for a fund. Tax on profits is paid by the company and then when funds are distributed to the shareholders tax is paid again (the 'double whammy'). An offshore limited liability company is a possibility but has extra cost and management implications.
- General partnership. This is a tax-efficient vehicle. However, it does not provide limited liability for the partners. We live in a more litigious age where investment is concerned and it seems silly to expose the whole of your personal wealth if an alternative can be found.
- Limited liability partnership. An LLP is also a tax-efficient vehicle but not commonly used as a fund vehicle. The rest of this note is designed to consider the implications of using an LLP as a fund vehicle.
3. Collective investment scheme?
If individuals pool their funds in an LLP are they creating a collective investment scheme? Establishing or operating a collective investment scheme is a regulated activity requiring authorisation from the FSA.
It might take, say, eight months to get authorisation from the FSA and external costs might be, say, £40,000 while on-going costs are significant.
For the purposes of the client this is not an option worth considering. If the vehicle needs to be regulated then they would use an offshore solution.
4. Day-to-day control
However, when one looks at s235 of the Financial Services and Markets Act 2000 it states that to be a collective investment scheme, 'the arrangements must be such that the persons who are to participate ("participants") do not have [a] day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions'.
There are a couple of cases giving guidance on this language. However they are not fully on point.
In the case of Russell-Cooke Trust Co v Elliott's  Mr Justice Laddie stated: 'In colloquial terms, what the subsection is directed towards is identifying who is or will be "minding the shop" on a day-to-day basis.
'It may be that the person who is involved in a day to day basis is answerable to someone higher up the chain on whose behalf he is acting. But it is the former, not the latter, who has day-to-day control.
'If the investors have day-to-day control, then the investment is not a CIS.'
There is also the case of Financial Services Authority v Fradley  where Mr John Martin QC sitting as deputy judge of the High Court the judge stated: 'It seems to me essential if the scheme is to fall outside the subsection that all the contributors should have day-to-day control: if some do and some do not, the scheme is within the subsection.
'That is because the application of subsection (2) to a scheme requires an answer to the question "Do the participants have day-to-day control?" and if the answer is "no"- as it will be if some participants have control and others do not - the scheme is within the subsection… I do not think it possible to have one scheme which is partly a collective investment scheme and partly not; so that as soon as one participant chooses the services of TBPS he relinquished control and the scheme became a collective investment scheme as regards all its members.'
This case was also considered by the Court of Appeal where Arden LJJ reversed part of the decision but not I believe the words quoted above.
Rather unhelpfully for my purposes Mary Arden stated: 'In the circumstances, it is not necessary to consider how regularly a client must actually exercise control for his control to constitute "day-to-the control" for the purposes of s235 (2).'
There is, however, a useful paper from the Financial Markets Law Committee issue 86 - Operating a Collective Investment Scheme.
This paper makes the point that 'it appears that as a minimum the participant should be in a position to tell the person who is actually managing the property what to do on a continuing day-to-day basis'.
The issue 86 paper indicates it is unclear whether the participants collectively or individually must have day-to-day control.
I believe that their fears are based on the fact that the Interpretation Act 1978 allows that unless the contrary intention appears the plural can include the singular.
Personally after a long career in the law I have faith in the common sense of our judges.
It would make nonsense of the wording at s235 (2) if each single participant actually had to have day-to-day control over the management of the property.
Common sense tells us that it can only mean the participants as a group must have that day-to-day control.
The paper also states: 'It is very unclear where the boundary lies between giving directions and having day-to-day control.
'To be in a position to give directions necessarily involves control, so the key is what is meant by "day-to-day". What of participants who give directions on a regular basis, perhaps daily or at least on many days?
'Is that giving directions or is that day-to-day control?
It may be that section 235 (2) is drawing a distinction between the right to exercise control and the actual exercise of such rights.
'The mere right to give directions, even on a daily basis, does not constitute day-to-day control, but if the right is actually exercised on a regular basis it may do so.
'Once again, one cannot have any confidence in the correct answer to the question.'
Personally, while the wording may not be entirely clear, I am not as pessimistic as the authors of the paper and I believe we can see the intent behind the subsection.
5. FSA's perimeter guidance
I also examined the FSA's perimeter guidance.
I normally find this very useful and over the years have been enormously impressed by the helpfulness of a certain member of the FSA who deals with the perimeter guidance.
On this occasion the guidance was unusually unhelpful as it seemed to forget that an LLP was a body corporate.
I then had a very useful e-mail from the FSA clarifying their view: 'On the general principle of regulation of LLPs, it was the government's specific intention that partnership rights under an LLP would not be excluded from being CISs purely because they are a form of body corporate.
'I believe this was based largely on the fact that there was no body of law equivalent to that of Company law such as to justify treating LLPs on a par with corporate bodies that are subject to the Companies Act.
'Government recognised that many LLPs would be vehicles for commercial business operations and would avoid being CISs because, for example, all the partners shared day-to-day control or otherwise that the exemption for commercial enterprises (paragraph 9 of the Schedule to the CIS Order) applied.
'However, it was recognised that LLPs could be used as an alternative form of investment vehicle with a significant number of investor partners who may be required to cede day-to-day control to a managing partner.
'Hence, an LLP may be a CIS but it is likely that many will not be.'
While it is up to the courts to decide the actual meaning of the subsection the FSA's statement looks sensible.
6. ProShare Investment Clubs Manual
I also had a look at the ProShare Investment Clubs Manual.
They advocate an unincorporated association and as this does not allow for liability to be limited this is not an attractive approach for riskier investments.
Also ProShare is exceedingly cautious in its approach to the FSA perimeter fence.
This is to be expected as they are trying to appeal to a wide audience which will include widows and orphans.
My problem concerns high net worth sophisticated investors who can better understand the subtleties of regulation and so can go nearer the perimeter.
7. Drafting points for the LLP agreement
Based on my research I reach the conclusion that LLPs can be used as a fund vehicle provided the members (or partners as they tend to be defined in the LLP agreement) have day-to-day control over the management of the property.
Drafting points for the LLP agreement include:
- How do the partners exercise day-to-day control? I am not sure if it is common but in one law partnership to which I belong whenever a decision is to be taken there may or may not be a meeting but there is an e-mail where partners are invited to either vote in favour or oppose the resolution. We are told if the management committee opposes the resolution. It is a simple and quick mechanism for taking decisions. Thus the LLP agreement could simply say that all decisions relating to the day-to-day control over the management of the property shall be subject to email requests asking each partner to indicate whether he or she is in favour or oppose and that no irrevocable action to implement such a decision shall be taken without such a vote. Even where there is a meeting it is probably best also to circulate an email asking for votes.
- How many partners can you have in such an LLP? It is easy to imagine five or 10 but it must get more difficult to ensure day-to-day control is with the participants the higher you go and I guess beyond 20 systems will tend to break down. Admittedly my law partnership is not a fund but we operate the email voting system quite easily with well over 50 partners. However, for a fund I suspect I would be cautious about going beyond 20 and I suspect I would be more comfortable with a maximum of say 15.
- Partners group together not only to pool money but also to pool their knowledge and experience. Some of the partners may contribute more than others. The question arises as to whether the arrangements could encompass some form of bonus pool at the centre which could then be distributed to certain partners who contributed more time and effort than others. You could have two or three of the partners who are more active in doing due diligence on the company in which they wish to invest, negotiating the deal and generally managing the process through to completion. This can be very time-consuming. At the end of the year could you award such partners say 20% of the profits over an 8% return? It is possible that this might cause the FSA to consider looking more closely at the arrangements but of itself this is not, as I understand the law, a regulated activity.
- Can you structure the LLP agreement so that the originators of the project retain control over the administration of the LLP? For instance if someone is not voting (i.e. failing to participate in the day-to-day control over the management of property and thereby jeopardising the whole LLP) there needs to be someone in authority able to speak to that person and if appropriate enforce that partner to resign. Also if the partners decide to invest in a particular company then there needs to be a mechanism whereby the decision is implemented. I do not see a legal problem with the concept of having all participants involved in the day-to-day control but one or two or three members carrying out administrative functions.
- There also needs to be mechanisms to determine net asset value.
- A question also arises about redemptions in the LLP and whether it is an open ended collective investment scheme.However, providing there is a competent mechanism in place to ensure that partners have day-to-day control over the management of the property it ought not to be treated as a collective investment scheme and so any questions about open ended or close ended funds are irrelevant.
- Do we have problems with the Regulated Activities Order (RAO)? The obvious point to start is to look at 'arranging deals in investments'. However, there are excluded any arrangements where the person making the arrangements enters or is to enter the transaction as principal or as agent. Thus if one of the partners is negotiating a deal with the investee company then I believe an appropriate exclusion applies for that regulated activity. There is also the fact that the LLP - being a corporate body - will be dealing in the investments it makes as principal (RAO 14) but should be able to avail itself of non-holding out exclusion (RAO 15). Also the MiFID override in RAO 4(4) should not apply as the LLP would be exempt from MiFID under article 2.1(d). I am not aware of other problems with the RAO.
- What about the financial promotion order? This is only relevant when taking on board new partners. The idea behind these LLPs is that there might be an initial group of four or five who will know each other well and they in turn might know one or two other people who want to group together. Thus the one-off exemption should normally apply.
A full discussion on tax is beyond the scope of this note. However, an important question is whether an individual can hold an asset through an LLP and still qualify for EIS relief (which presupposes that the asset in question is a holding of shares in an EIS qualifying company).
An LLP is tax transparent for as long as it carries on a trade, profession or business with a view to a profit, and in those circumstances its assets are treated for tax purposes as held by its members in partnership: each member holds a fractional share of all the assets rather than holding an undivided share of a fraction of its assets – S863 ITTOIA 2005 and S59A TCGA 1992.
S157(1) Income Tax Act (ITA) 2007 provides that an individual (‘the investor’) is eligible for EIS relief in respect of an amount which he subscribes on his own behalf for an issue of shares in a company, if those shares are issued to the investor.
So as a starting point, that requirement is not met in respect of shares held as partnership property and for that reason HMRC consider that EIS relief is not available on assets held via an LLP or any other type of partnership.
S250 ITA does modify S157 by allowing EIS shares which are subscribed for, issued to, held by or disposed of for an individual by a nominee to be treated for EIS purposes as though subscribed for, issued to, held by or disposed of by the individual.
S250 also provides that if shares have been issued to a bare trust for two or more beneficiaries, the EIS legislation has effect (with the necessary modifications) as if each beneficiary had subscribed as an individual for all of those shares, and the amount subscribed by each beneficiary was equal to the total amount subscribed on the issue of those shares divided by the number of beneficiaries.
So the EIS legislation allows shares to be held by a nominee or bare trustee whilst still allowing relief to the individual investor.
But HMRC does not consider that that goes so far as to allow an LLP to subscribe on behalf of its members jointly.
S250 predates the Limited Liability Partnership Act, and whilst it might accommodate spouses and other family members jointly holding shares via a bare trustee, it would not appear to work in relation to an LLP which might have partners entitled to varying shares of the partnership assets.
Moreover, HMRC argue that an LLP would be prevented from acting as a trustee in relation to its members by virtue of a conjunction of S6 of the Limited Liability Partnership Act 2000 and S12 of the Trustee Act 2000 which state, respectively, that each member of an LLP is the agent of the LLP; and that a beneficiary of a trust may not be an agent of the trustee.
There is nothing in the EIS legislation which prevents a syndicate of investors from investing collectively in one or more EIS qualifying companies, and this happens frequently.
There exist a number of professionally-managed EIS Funds in which investors’ funds are pooled and invested on their behalf by fund managers; there also exist a number of business angel networks where individuals invest in syndicates in order to spread their investment over a range of companies along with others.
In all cases, the individual investor holds shares in the EIS company beneficially, quite often via a nominee.
These funds are not distinct legal entities, but they do in some cases constitute collective investment schemes.
These mechanisms either do not give the benefit of limited liability or require using a firm authorised by the FSA.
This reminds me of the wealthy broker who once told me he did not understand the motivation of our politicians who demand that investment by sophisticated investors must normally be made through intermediaries.
My own experience is that sophisticated investors:
a) do not want to invest all of their money through FSA authorised intermediaries;
b) want limited liability and greater anonymity in riskier investments;
c) often want to group together to spread risk and share experience.
I reach the conclusion that LLPs ought to be considered seriously as fund vehicles by high net worth and sophisticated investors who are seeking to pool their funds to spread the risks and cooperate on finding suitable investment opportunities.
There is a problem in that the law relating to EIS relief and the use of LLPs is badly thought through and needs a policy review to find a more appropriate balance between the competing needs of tax, trust and LLP law.
I hope this note can in some small way encourage the policy review on EIS to take place soon particularly given the apparent inability of our banks to help smaller companies.
Tom Mackay is partner at Mackay Carter Shaw