LLPs and the Good Faith obligation

13 October, 2008
by: Cripps

An article exploring the whether LLP members’ agreements should include an obligation of good faith as between the members.

 

Partners in a traditional partnership who are planning to become a limited liability partnership may be surprised to be asked whether they wish to include an obligation of good faith in the LLP members’ agreement that will replace their old partnership agreement.  As all partners are aware, however dimly, the duty of good faith is a fundamental aspect of partnership.  They might therefore assume that the same holds true for LLPs.

 

If so, they would be wrong, because partnership law does not have general application to LLPs .  Although certain good faith-type obligations are implied by virtue of each LLP member being an agent of the LLP, these are limited in scope and govern each member’s relationship with the LLP and not with his fellow members.  LLPs are a species of company  and so the absence of a general good faith obligation is consistent with the position for company shareholders.  However, there is nothing to prevent LLP members choosing to adopt such a duty as a matter of contract, hence the need to make a decision on the point.

 

Prospective LLP members therefore need to consider something that they will almost certainly have taken for granted until now.  So what does this duty actually entail? 

 

There is no explicit good faith obligation as such in the Partnership Act 1890, but the closest general statement of the principle appears in section 28, which provides that “Partners are bound to render true accounts and full information of all things affecting the partnership to any partner or his legal representatives.”  Section 29 goes on to provide that a partner must account to the partnership for any benefit derived by him, without the other partners’ consent, from any transaction concerning the partnership or its assets or business connection.

 

Classic examples are the partner who conceals that he is one of the purchasers of a partnership asset, which is then on-sold at a considerably higher price.  Or the partner who is responsible for purchasing partnership goods but who does not disclose that he is actually the vendor, supplying at a price that is favourable to him personally.  Fundamentally, this is a duty of honesty.

 

But the implications go much wider than this and the duty can impact on any conduct of a partner or group of partners.  The above examples concerned rogue individual partners, but an individual partner may equally be the victim of action taken in bad faith by a majority of the other partners.  Any decision in which a majority exercises the right to outvote a minority is liable to challenge if there was some improper motive.  An obvious example in this context is a decision to expel a partner from the partnership.

 

So what arguments are there for retaining the duty of good faith?  One reason often given is the preservation of the partnership ethos.  But there may be limits to this, because once the members’ agreement is signed it is likely to be put and away and forgotten.  Ethos is surely something that runs deeper and determines how the members will act in any given situation, both individually and collectively.  It is likely to reflect the personalities of the individual partners and may have been built up over many years.  Nevertheless, having an explicit good faith obligation may focus minds if major decisions need to be made which could adversely affect individuals.

 

On that basis, a good faith obligation may be seen to promote fairness, because it means that the majority cannot act in an arbitrary way simply because they are in a majority.  Many partnerships have sophisticated decision making processes, which may include requiring an enhanced majority for resolutions involving matters of particular importance.  This provides a valuable safeguard but may not be sufficient to protect individuals who are being dealt with unfairly.  In such circumstances, a good faith obligation can provide a possible remedy to the individuals concerned.

 

Of course the same reasoning can be an argument against.  A good faith obligation may allow an unscrupulous individual or minority to “muddy the waters” in what may in truth be a perfectly fair and reasonable decision of the majority.  The threat of proceedings for breach of the duty could be used to delay legitimate decision-making processes and may lead to considerable uncertainty.  It also involves the possibility of legal proceedings as between individual members, which might be considered to run counter to the principle of limiting personal liability that inspired LLPs in the first place.

 

Another concern is that having personal duties of good faith owed by members to one another may expose them to increased risk of unlimited personal liability for negligence.  Although LLP members are not personally liable for the debts and other obligations of the LLP itself, they may nevertheless be personally liable for negligence claims arising out of their own mistakes.  A member facing a significant personal loss (or his trustee in bankruptcy) may be tempted to seek a contribution from all or some of his fellow members if he considers that they were in some way to blame for the circumstances giving rise to the claim.  For example, a claim that the member concerned was overworked, or required to work in an unfamiliar practice area or was otherwise given inadequate support could be characterised as bad faith on the part of the other members.

 

This risk should not be overstated and it may be considered that the circumstances giving rise to a genuine claim of this nature are likely to be rare.  Nevertheless, the risk cannot be entirely discounted and even an unmeritorious claim could provide an anxious time for the members.

 

Experience suggests that many partners in professional partnerships value the duty of good faith highly and would like to retain it in some way if they convert to an LLP.  Even within the protection of an LLP, the risks of professional practice are still such that having faith and trust in one’s fellow members remains of paramount importance.  There is evidently a balance to be struck between the legitimate interests of the majority and protection of the minority.  Partners should be encouraged to consider the question carefully from both possible viewpoints, since they can never be certain on which side they might find themselves in the future.

Reviewed in 2015