Decision to allocate partnership profits had to be taken rationally

26 July 2021

The High Court has held that, when deciding how to allocate profits to the members of a limited liability partnership under the terms of the partnership deed, the management needed to act rationally.

What happened?

Tribe v Elborne Mitchell LLP [2021] EWHC 1863 (Ch) concerned a limited liability partnership (LLP) incorporated in the UK which operated as a law firm.

As is common, the firm’s governance and constitution, including the allocation and distribution of any profits it made, were governed by a members’ agreement (sometimes called a “partnership deed”).

Under the members’ agreement, partners in the firm would first be allocated a “fixed share” – that is, a specific, identified amount – from the firm’s profits (assuming sufficient profits to pay those amounts).

After the fixed shares had been paid, up to 40% of the firm’s profits would be allocated to a “discretionary fund”. These funds would be allocated and paid according to a two-step procedure:

  • The firm’s senior partner would make recommendations to the partners as to how profits within the discretionary fund should be allocated. The senior partner was required to “have substantial regard for financial performance” but otherwise was entitled to determine recommendations (in the words of the members’ agreement) “at his discretion”.
  • If required, the partners would approve the allocation of funds by an “ordinary resolution”.

Following the allocation of the discretionary fund for the 2015 and 2016 financial years, one of the firm’s former partners complained that the funds had not been allocated properly.

In particular, the former partner claimed that the senior partner’s decision when making a recommendation and the partners’ decision to pass an ordinary resolution approving that allocation were both exercises of a contractual discretion and so subject to the so-called “Braganza duty”, and that both decisions had been made in breach of that duty.

What is the Braganza duty?

The Braganza duty is named after a recent case in which the duty was explored and summarised, although it has existed for some time now. It states that, when exercising a “contractual discretion”, a person must not act irrationally, arbitrarily, capriciously, perversely or for an improper purpose. This is often described as a duty to exercise a contractual discretion “in good faith”.

The duty applies when exercising a contractual discretion, not an absolute right. It is not always clear whether something is an absolute right or a discretion. For example, a right to terminate a contract is almost invariably an “absolute right”, but a right to vary payments or contractual terms may well amount to a contractual discretion.

The duty does not require someone to reach a particular decision, but it does require them to take into account relevant matters, disregard any irrelevant matters and avoid a conclusion that no reasonable decision-maker could ever reach. This includes taking all relevant factors into account and not acting on the basis of irrelevant factors or ulterior motives. However, as we have seen in recent cases, such as Watson v Ltd [2017] EWHC 1275 (Comm), sometimes the range of decisions is so limited that the court effectively remakes the decision for the parties (see our previous Corporate Law Update).

Interestingly, the former partner also argued that, in making these decisions, the firm’s partners had to have regard to the principles set out in Re Charterhouse Capital Ltd [2015] EWCA Civ 356.

That case summarised a principle more commonly known to lawyers as the rule in Allen v Gold Reefs of West Africa Ltd, which states that, when the members of a company resolve to amend the company’s constitution, they must comply with various conditions. These include (among other things) that they act in good faith in the interests of the company.

Although similar to the Braganza duty, the rule in Allen v Gold Reefs is framed less in terms of exercising a contractual discretion and more as a protection to prevent the majority of a group of persons abusing their power to the disadvantage of the minority. It is usually pled and treated separately, as it relates specifically to amending a company’s articles of association, although in recent years the principle has also been considered in the context of amendments to loan notes.

What did the court say?

The court agreed that the Braganza duty applied to the senior partner’s decision to make recommendations as to allocations among the partners. This meant that, in making his recommendations, the senior partner had been duty-bound not to “take into account irrelevant matters or ignore relevant ones”. His recommendations could not be “outside the range of reasonable proposals that might be made in the circumstances”.

However, the senior partner had complied with that duty. In the judge’s view, his recommendations did not need to be perfect or include all possible analyses. They merely needed to be full enough to allow for a debate between the partners. They could address non-financial matters, provided that the senior partner paid “substantial attention” to financial performance (which itself went merely beyond billings).

Separately, and interestingly, the judge also said that the rule in Allen v Gold Reefs and Re Charterhouse applied to the partners’ decision to ratify or modify the proposed allocation by way of ordinary resolution. The effect of this was similar. That 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”.

Having decided that the senior partner’s recommendations were reasonable, it was fairly straightforward for the judge to conclude that the partners’ decision to adopt those recommendations was also reasonable.

What does this mean for me?

LLPs and partnerships are commonly used in a variety of circumstances to provide professional services. These include legal, accountancy and medical services, as well as within the private equity and venture capital industry.

In some ways, the decision on the Braganza duty is not surprising. The duty has previously arisen in relation to bonus allocations and payments under employment-related insurance policies. Profit allocation is a logical area in which the rule would apply.

Importantly, the decision shows that, when allocating profits in these circumstances, partners will be held to a particular standard and cannot act capriciously or irrationally. However, provided they follow a basic, reasonable and explicable process, it should be difficult to challenge any ultimate decision as to profit allocation. This might include the following.

  • Consider the basis of previous decisions. Although the decision-maker will not be required to follow the same procedure each time, the route by which previous decisions have been made and whether all relevant parties have acquiesced in them may be informative.
  • Document the decision and its basis. Generally, the courts will not interfere with the commercial merits of a decision, but they will assess the level of scrutiny applied. It will be easier to demonstrate to a judge that a decision was made properly if the decision-maker can point to the factors they took into account.
  • Consider setting out the parameters for the decision in the contract. If at the drafting stage, it may be worth stating explicitly in the relevant contract what factors the decision-maker can (or must) take into account and which they can (or must) ignore. However, it would be important not to straitjacket the decision-maker, and any factors should probably be expressed to be non-exhaustive. The contract should also state explicitly that any decision is or remains at the decision-maker’s discretion.

The court’s decision on the rule in Allen v Gold Reefs is an interesting development. The point was not argued before the court, and so it is important not to place undue reliance on the judge’s comments. However, if upheld, this could be a significant development.

Historically, the rationale for this rule was to prevent the majority of a group of persons from using its power to oppress the minority. Scenarios in which this might happen include where the majority of a company’s shareholders amend its articles in a way that favours only their own interests and not those of the company, or where a majority of the holders of a series of loan notes agrees amendments to the terms of the notes that favours only that majority. In these scenarios, if the decision is not taken in good faith, the court can effectively unwind it.

This decision here shows that the courts might be prepared to apply the rule to a wider range of decisions by the economic owners of a business. In this case, the decision was one through which the majority, if so inclined, could oppress the minority: the members’ agreement effectively gave the majority of the LLP’s members the power to enhance their own remuneration at the expense of the minority, even if this did not involve an amendment to the members’ agreement.

It is not clear whether the courts would be prepared to apply the rule more broadly to other kinds of decision. An obvious parallel is a decision by a company’s shareholders to approve a final dividend, although generally the shareholders in that situation will not be able to vary dividend entitlements as between individual shareholders (as these will be set by the company’s articles).

But other decisions by members of a company, LLP or partnership may involve more qualitative judgments. Examples might include approving the terms of a share buy-back, director’s service contract or capital reduction, or the sale of the principal assets of a fund. Should the courts apply the rule in Allen v Gold Reefs to these kinds of decision, this would represent a significant in-road into the concept that an economic participant is generally free to vote in a way that protects their own interests.

For the time being, members of an LLP, partnership or company should bear in mind, when taking a decision that affects all members, that they should act in the best interests of the business and the membership as a whole and not in a way that unduly places their interests above others’.