The High Court held last year that when deciding how to allocate profits to the members of an LLP (limited liability partnership), the management of the LLP must act rationally in doing so.
The case concerned an LLP in the UK which was operating as a law firm. The firm’s constitution (including how it distributed any profits) were set out in a Members’ Agreement (often called a “Partnership Agreement”).
Under the Members’ Agreement, partners were allocated an initial fixed share (i.e. a specific identified amount from the firm’s profits), and after this had been distributed, up to 40% of the firm’s profits would end up in a discretionary fund (i.e. a fund set up for things that are not considered necessary as such but may be useful). The Members’ Agreement stated that the funds within that discretionary fund would be subject to the following procedure:
- the senior partner would make recommendations to the partners as to how profits within the discretionary fund should be allocated and the senior partner was required to have substantial regard for financial performance but was otherwise was entitled to use his discretion; and
- if required the partners would approve the allocation of funds by an ordinary resolution (i.e. more than 50% of a vote).
One of the firm’s former partners complained that the funds had not been allocated in accordance with the Members’ Agreement for the years 2015 & 2016. The partner claimed that the senior partner’s decision, and the partners’ decision to pass an ordinary resolution generally as detailed above were examples of exercising contractual discretion, and therefore subject to the “Braganza duty”. He subsequently claimed that such decisions were in breach of that duty.
What is the Braganza duty?
The Braganza duty is an implied obligation that qualifies the manner in which contractual provisions (i.e. the provisions contained in the Members’ Agreement) providing a right to exercise discretion should be effected, and requires such discretion to be exercised in a rational and good faith manner.
The former partner in this case also contended that the firm’s partners had to have regard to the principles set out in Re Charterhouse Capital Ltd  EWCA Civ 356. That particular case summarised a principle known as the rule in Allen v Gold Reefs of West Africa Ltd, which states that when members of a company resolve to amend its constitution, they must comply with various conditions, which include acting in good faith and in the interests of the company.
Whilst being similar to the Braganza duty, the rule in Allen v Gold Reefs of West Africa Ltd is more so to protect those minority members, rather than focusing on how such discretion should be carried out.
The Court’s decision
The Court agreed that the Braganza duty applied to the senior partner’s decision to make recommendations as to allocations, which ultimately meant that the senior partner had been bound by a particular duty not to consider irrelevant matters or ignore relevant ones. Such recommendations could not be outside the range of reasonable proposals that might be made in the circumstances at hand.
It was commented that the senior partner had in fact complied with the above duty. The Court’s stated that the recommendations did not need to be perfect or include all possible considerations. Rather, they needed to be full enough to permit a debate amongst the partners to allow them to address non-financial matters so long as they pay substantial attention to financial performance.
The Court also held that the rule in Allen v Gold Reefs of West Africa Ltd and Re Charterhouse Capital Ltd applied in this case in terms of the partners’ decision to ratify or modify any proposed allocation by way of an ordinary resolution. That lead the Court to further determine that such decision could not take into account irrelevant matters or ignore relevant ones, and it could not be outside the range of reasonable decisions that might be made in the circumstances of allocating the discretionary fund.
It was therefore somewhat clear and simple to the Court that the partners’ decisions in these circumstances were reasonable.
How does this affect businesses going forwards?
You may find that you are set up as a partnership or an LLP, and as such, the decision in this case provides a logical and sensible view on how profits should be allocated. The decision shows that when allocating profits, partners will be held to a particular standard and cannot act irrationally. Provided you follow a reasonable process, it should be difficult for someone to challenge a decision on profit allocation.
Important take away notes for businesses going forwards are to:
- consider previous decisions and how they have been made;
- document the decision so that if it is challenged, it will be far easier for a Court to determine if a decision was made properly, as it’ll be clear what factors have been taken into account; and
- consider setting out the requirements for allocation in an agreement with factors clearly expressed as to how discretion is exercised.
Important to note however, is that it is not clear whether the Courts would be prepared to apply the rule more broadly to other kinds of decisions, or indeed, other business set-ups (such as a private limited company by shares). We may find this year that the rule is applied to other cases. It may be that other decisions by members of a company, LLP or partnership could be scrutinised in the same way, examples include declaring dividends, approving the terms of a share buy-back, a capital reduction, or the sale of particular assets. Is it right for the Courts to interfere in such circumstances? It would seem that in doing so it restricts a business from operating freely.
What is clear is that members of an LLP, partnership or company should, when taking decisions that affect all members, act in the best interests of the business and the membership as a whole.
If you require any advice or assistance relating to an LLP, partnership or company, or perhaps want to know how to exercise a particular right, whilst at the same time reducing the risk of it being challenged, then please get in touch with Elizabeth Clazie (Solicitor in the Corporate Department at Edmondson Hall Solicitors) who can be contacted on firstname.lastname@example.org / 01638 560556.
Author: Elizabeth Clazie, Corporate and Commercial Solicitor | Edmondson Hall Solicitors & Sports Lawyers