Wiped out if the winner takes all

Roger Trapp looks at how a judgment against one firm could lead to its partners going bust

The past few days have been as momentous as it gets in the accountancy world - and we are not talking about the decisions by the Institute of Chartered Accountants and the Chartered Institute of Management Accountants to press ahead with a prospectus for merger.

No, the issue is - once again - law suits for negligence and the reaction to them. Last week's pounds 105m High Court judgment against Binder Hamlyn was shocking in part because only a few within the profession even knew the case was going on. But the real drama arose because - in what is believed to be the first instance - the firm admitted that it did not have enough insurance cover to meet the award. This meant there was a real prospect of the partners - even those who have been absorbed into the immensely successful Arthur Anderson - being forced into bankruptcy.

It put into focus the week's other groundbreaking event: the emergence of plans by Ernst & Young, headed by Nick Land, and Price Waterhouse, headed by Ian Brindle, for registering their businesses in Jersey in order to obtain limited liability partnership status, and so, they hope, avoid the risk of being obliterated by a claim. Since even the firms themselves can see that going offshore has negative connotations, this is clearly a desperate measure for desperate times.

Because KPMG has already opted to seek greater protection from the spiralling claims for redress for negligent work by turning its audit practice into a limited company, KPMG Audit, observers have a chance to weigh up the pros and cons of each approach to liability limitation. Which would you choose?

Incorporation

KPMG's move amounts to only partial incorporation. Since turning the whole firm into a company would have cost a lot more in terms of lost tax advantages, senior partners have chosen to ring-fence the most vulnerable bit: the part that audits public companies. Though changes to the tax system will cancel out some of these benefits, partners will continue to enjoy lower National Insurance costs as a result of being self-employed, rather than company directors on PAYE.

Becoming a company brings a requirement of greater financial disclosure. Because it is only incorporating part of its operation, KPMG is not obliged to publish accounts for the whole organisation. But it is doing so, as a marketing ploy.

It is sometimes said that adopting company status makes management more streamlined than is possible with several hundred partners. In fact, the days of all partners sitting around a table to decide on business decisions went when restrictions on the number of possible partners were lifted a couple of decades ago. Partnerships already ape the ways of companies, with all partners voting only on really big issues, and day-to-day running delegated to a team that does little client work.

So what difference does it make in the event of a legal claim? First, the organisation can be put out of business if it lacks sufficient assets to meet a claim. Second, the individual partner responsible can still be ruined. But partners unconnected with the case do not lose all their worldly goods because of the actions of someone who, in the modern firm, they have possibly never met.

Some rivals of KPMG have suggested that its partial incorporation might not provide this protection, since it could be possible for a determined litigant to involve the partnership in an action against the audit arm. If this proves to be so, it is likely that some leading legal advisers could find themselves in a situation with which accountants have become all too familiar.

Limited liability partnership

The concept has existed for some time in Britain, but has been of little help because of the requirement that those seeking to use it not take any part in the running of the business. What Jersey is planning is something like the system the US state of Delaware introduced last year. In return for a deposit of a few million pounds (to meet routine claims), a large professional firm will be able to obtain for all its partners the same sort of limited liability available to companies without giving up the ethos of being a partnership.

This is important because, although proponents of incorporation insist that the partnership culture is not lost with the mere change of name, others say they are deeply attached to such partnership fundamentals as co-operation and sharing - except when it comes to colleagues' law suits.

A limited liability partnership is an attempt to have the best of both worlds, since partners will continue to have the same sort of tax advantages as members of traditional partnerships while at least partially protecting themselves from the prospect of being ruined by a large claim. The firms looking at going offshore insist they are not being drawn by the tax breaks for which places such as Jersey are noted but will continue to pay taxes as if they were registered in Britain.

So what is the bottom line? Much the same as for incorporated bodies. The whole body can be knocked out by an aggrieved litigant, while the individual partner found to be at fault can also be ruined. But other partners' assets are protected.

There is a third option, strongly defended by Touche Ross: stay as you are. This firm is not the only one to see the partnership culture as special. Others point out that - even with the moves towards more modern management styles - partnerships encourage ideas of not wanting to let one another down. Furthermore, says one managing partner, they aid recruitment, since the urge to gain the recognition that being a partner brings is greater than the desire to be a manager.

But that leaves everyone exposed to legal action, regardless of their involvement - which is where we came in. Touche's stance, if it represents the firm's true attitudes (and not everyone is sure it does), could be a brave one. And not only because it will look isolated if, as seems likely, Anderson and Coopers & Lybrand announced plans to take one route or other. Rather, if it becomes the only surviving partnership, it will be that much more vulnerable to the wipe-out claim of which insiders fear the Binder case is just a harbinger.