Directors' duties: What do they mean for LLP members?

When deciding how best to structure a new venture, many choose to use incorporated entities such as companies in order to benefit from the limited liability offered to members. For further detail on different business structures, please see our article here.

Recognising that companies act through their directors, English law has historically imposed various duties on directors to reflect the trust and responsibility placed on them by shareholders and the unique fiduciary position they are in.

These duties were codified under the Companies Act 2006 (the Act), but the extent to which they apply to members of an LLP has not always been clear.

The recent case of Re A&C Restoration LLP (Manolete Partners plc v Riches) [2020] EWHC 1404 (Ch) has reconfirmed that directors’ duties can be applied to designated members of LLPs, and also serves as a useful reminder of how these duties are altered in the event of insolvency.

The Case

Mr Riches was a designated member of A&C Restoration LLP (the LLP) and was paid drawings from the LLP in anticipation of his profit share. When he retired as a member, a retirement deed was entered into by him and another member on behalf of the LLP, which included an express waiver by the LLP of any sums Mr Riches might owe the LLP in respect of drawings paid to him in excess of his actual profit share.

The LLP subsequently went into creditors' voluntary liquidation and a misfeasance application was brought by the assignee of the liquidator's claim.

Mr Riches argued that he had no liability to repay the excess drawings (which the LLP's account recorded as being in excess of £120,000) due to the express waiver of such sums in the retirement deed.

The Judgement

The Court considered the provisions of the retirement deed, and it was agreed that it was within the LLP's gift to choose to waive such debts. However, in this case, the waiver was entered into when it was clear from the accounts that the LLP was insolvent, and in those circumstances, the interests of third party creditors would undoubtedly be prejudiced. It was noted that in such circumstances, creditors were entitled to expect the designated members (arguably the equivalent of the directors) to recover the LLP’s debts, rather than release them.

Designated members of an LLP were subject to the codified statutory duties set out in the Act, and as the LLP was insolvent, they were actually obliged to consider the interests of creditors when considering whether to agree to a waiver of the debt on behalf of the LLP. The Court opined that "Plainly it was a breach of duty, a misfeasance, to cause the LLP to agree to the waiver in the circumstances of insolvency”.

This breach of fiduciary duty meant that Mr Riches was prevented from relying on the waiver of the debt and that a damages claim against him existed, which would be calculated by reference to the amount of the debt.

The Court considered whether Mr Riches was entitled, under the Act, to rely on a defence that he acted “honestly” and “reasonably” but determined that it was clearly not a reasonable decision to "waive one's own liabilities in the context of insolvency" and therefore, it wasn’t even necessary to consider the application of the honesty test.

Earlier Case Law

To add further credence to the findings of the Court in Re A&C Restoration LLP, the earlier case of McTear v Eade [2019] EWHC 1673 (Ch) noted that members of an LLP were potentially subject to the original common law and equitable principles upon which the codified duties of directors of companies were based.

Furthermore, when considering the application of these principles, regard had to be had to the function being undertaken by the relevant member. In the McTear case, the designated members were regarded as operating as directors of a company and so it was deemed appropriate for the codified duties to be deemed to apply to them.

Directors’ Duties

The codified duties of directors, which are now set out in the Act, comprise:

1. Act within powers - Directors must only use their powers for the purpose for which they were given and act in accordance with the company's constitution.
2. Promote the success of the company - Directors must promote the success of the company for the benefit of its members as a whole. This includes considering the long term consequences of any decisions, employees’ interests, the fostering of broader business relationships and the need to act fairly between members of the company.
3. Exercise independent judgement - Directors must make their own decisions, although this does not prevent them from complying with the terms of any agreement entered into by the company, or in accordance with the company's constitution.
4. Exercise reasonable care, skill and diligence - This is tested on both a subjective and an objective basis, considering (a) the knowledge, skill and experience actually possessed by a particular director and (b) the knowledge, skill and experience to be reasonably expected of a person carrying out the same function.
5. Avoid conflicts of interest - Whether or not a conflict exists or could potentially exist has to be considered based on the particular facts of a situation. However, there will not be a breach of this duty where the conflict has been pre-authorised (by the members, other directors or under the company's constitution), or where an analysis of the circumstances concludes that the situation cannot reasonably be regarded as giving rise to a conflict of interest.
6. Not to accept benefits from third parties - This duty covers benefits offered in connection with any action taken/not taken by a director in their capacity as such, or any benefit given because an individual is a director.
7. To declare an interest in a transaction or arrangement - Both the nature and extent of such interests must be declared, and the duty applies to both proposed and existing transactions.

The Interests of Creditors

Under section 172(1) of the Act, the duty to promote the success of a company requires a director to act in a way that he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. However, under section 172(3), this duty is modified in the event of insolvency, at which point directors are obliged to consider the interests of creditors.

There continues to be debate about what the relevant insolvency "trigger" is for these purposes. Potential options include:

1. When the company is technically insolvent (using a balance sheet or cash-flow test).
2. When a company is "on the verge" of insolvency.
3. When a company is of "dubious solvency".
4. When there is a "real" (and not just remote) risk of insolvency.

Until there is certainty as to when insolvency occurs for these purposes, directors and designated members should tread carefully if there is any concern about the solvency of the business.

Conclusions

Directors need to continue to be mindful of their codified duties under the Act and the framework within which they are required to make decisions but designated members of LLPs need to appreciate that these duties will also apply to them. Both directors and designated members need to be aware that failure to adhere to such duties can result in certain consequences, including personal liability.

With the continuing economic uncertainty and resulting ongoing challenges faced by many businesses, the rationale for decisions needs to be sound in all cases, and both directors and LLP members must consider their position especially carefully if there is any question as to the underlying solvency of the business.

Christine Dubignon is a Partner in the Corporate team.

Disclaimer

This note reflects our opinion and views as of 11 August 2020 and is a general summary of the legal position in England and Wales. It does not constitute legal advice.