Planned changes regarding the ownership of law firms, combined with recent accounting developments, make it essential for practices to review and update their partnership agreements, says Clare Copeman


Many partnerships do not have a partnership agreement in place. In some cases there may be an agreement in draft, but it has not been finalised and signed. And for those firms with an agreement, many have not revised it in years, except for the occasional change on the admission and retirement of partners.

Limited liability partnerships (LLPs) fare somewhat better, as firms usually set up a members' agreement on conversion. However, the agreement may not have been reviewed since incorporation.


Old reasons


While a partnership or LLP is running happily, healthily and without contention, a partnership agreement may not seem important. However, issues can easily arise in the case of a disagreement or dispute.

In the absence of an agreement to the contrary, the provisions of the Partnership Act 1890 (or LLP regulations 6 and 7) apply, and these may not always have the desired effect. For example, under the terms of the Act, the expulsion of a partner requires the unanimous agreement of the other partners. But what if a firm wishes to force out two partners? Each can veto the expulsion of the other, in which case the firm could have no choice but to dissolve.


The Act also provides for the equal division of profits between partners. However, this could be bad news for a firm if a partner or member's performance does not merit an equal share and they contest this.


Another advantage of regularly reviewing the agreement is that it causes partners or members to focus on how their firm is managed, and their rights and obligations to each other and the firm. These issues are all connected and tend to alter over time, whether in response to changes in the firm's size or the commercial and regulatory environment. For example, as a firm grows, partners may prefer a stronger management structure that allows decisions to be made quickly and effectively and partner performance to be better managed, even if this means a slightly weaker partnership culture.


New reasons


Recent changes to the business environment are making it increasingly important for partners and members to revisit their firm's agreement.

One issue revolves around the rights of a partner to profit and capital. Historically, partners' accounts have been accounted for as part of the firm's net assets, similar to share capital and retained profit in a company.


New accounting standards mean that in a company, LLP or partnership, balances due to the shareholder, member or partner are treated as a liability of that business, unless the organisation has the unconditional right not to pay them out. Therefore, where, for example, capital accounts are repayable on retirement, these balances are treated as a liability for accounting purposes.


However, broader considerations regarding the terms and conditions of partners' accounts can be more important than the accounting implications. For example, some firms have made the return of capital to retiring members conditional on the firm maintaining a minimum level of capital in the business to ensure that the minimum level of capital is not treated as a liability.


In so doing, this may have raised wider considerations regarding the rights and obligations that members are prepared to undertake with respect to each other and the firm. By signing an agreement where there is a minimum level of capital, a member is taking the risk that he may not get his capital back on retirement. However, as an upside to this risk, in the event that the firm suffers a wave of partner defections, the entitlement to retain a minimum level of capital protects the firm from a sudden withdrawal of its funding.


In reality, the risks surrounding minimum funding levels are rarely serious in a thriving partnership as new or existing partners replenish the capital of retiring partners. The 'right answer' for any firm would depend on the extent to which partners wished to commit to 'one for all and all for one'.


The new accounting rules have also caused profit distributions to be reconsidered. For example, should the firm be obliged to divide all its profit each year between the partners, or should it be entitled to retain profits in the business? In what circumstances, if any, may partners be required to repay drawings?


UK generally accepted accounting practice aside, these are questions on which most partners have a view, and which they would want their firm's agreement to address clearly.


Who owns what?


The ownership of appreciating assets, such as property, has always been an important area of a partnership agreement. However, until recently - as fewer modern firms own their premises - it may have been slipping down the agenda.
The impending Clementi reforms and the opportunity for firms to raise external capital are focusing minds on how to realise capital value.


A traditional agreement simply entitles partners to the return of their capital when they retire. Some consider this in keeping with the spirit of partnership but, increasingly, firms are considering whether or not retiring partners should be entitled to realise a share in the goodwill.


Previously, continuing partners might have made a one-off payment or provided an annuity to a retiring partner who had contributed to building the business. However, some firms are now considering more sophisticated ways to recognise goodwill. This could involve a 'share ownership' system, where the 'price' of a unit of ownership can vary over time and partners may 'buy in' and 'sell out' at different prices.


Even prior to Clementi, entitlement to goodwill was a frequent topic for dispute. As the concept of capital value in professional firms moves to the fore, partners should review their position and make sure their agreement reflects this.


Clare Copeman is a director in the professional practices division at Smith & Williamson, the accountancy and financial advisory group