The Key Considerations for Professional Services Firms Contemplating a Demerger

26 November 2020

During these economically turbulent and uncertain times, many Professional Services Firms will be seeking to insulate themselves from short-term financial difficulties and position themselves for longer-term growth. For some Firms, who may have expanded and diversified into varying practice areas in more buoyant years, this may involve scaling back and divesting non-core practices through a demerger. We consider that demergers are likely to be a growing trend and in this news alert, Associate Wonu Sanda and Partner Zulon Begum discuss some key reasons for and implications of a demerger.

Why a demerger?

Demergers involve part of a business breaking away from a larger Firm (Divesting Firm) to form a new Firm (Demerged Firm), usually by way of a transfer of business, assets and people. Often, Divesting Firms see demergers as an opportunity to strategically re-align their focus on their core business competencies and strengths and to streamline expenditure and operations. For the Demerged Firm, financial and management independence and the ability to potentially unlock untapped value for partners and employees in that part of the business can be a compelling driver to break away from the Divesting Firm.

The implications of a demerger: the break-up

There are many issues for Professional Services Firms to consider in a demerger. As a starting point Firms will need to factor into the timetable and commercial terms of the deal any constitutional provisions which are relevant to the demerger, including the requisite partner approval for the transaction and notice requirements, payment of outstanding capital and current account balances, restrictive covenants and other provisions affecting those partners who are transferring to the Demerged Firm.

Many Firms’ constitutional agreements will set out the specific voting thresholds and procedures to approve a divestiture of part of the business. The threshold required may be more than a simple majority and, depending on the specific agreement, could require as much as 90%, or unanimous partner, approval. It is, therefore, vital for the Firm to engage in advanced planning and consultation with the affected partners and wider partner body to ensure that the requisite buy-in can be obtained. Even once partner approval is secured, it may be that not all the partners who form part of the proposed Demerged Firm are on board with the demerger for professional or personal reasons. In these circumstances, the Divesting Firm will need to consider how to treat these partners going forward; if the demerger went ahead without the dissenting partners, the partners who are left behind may need to be re-deployed to other parts of the business or, if that is not possible, the Divesting Firm may need to agree exit terms with those partners.

Pre-completion, both the Divesting Firm and the Demerged Firm will want to ensure that a fair and balanced approach is taken to determining and valuing the assets and liabilities transferred, such as the work in progress and book debts of the transferred business and agreeing how these are dealt with going forward. This can be complicated for Professional Services Firms, especially in relation to valuing work in progress, book debts and apportioning liability/responsibility for recovery and credit control.

Carving up client engagements for transfer to the Demerged Firm needs to be dealt with carefully to ensure that professional duties to the clients are met and they feel well looked after. Both Firms will need to agree a managed approach to notifying affected clients and obtaining consent to transfer their files and confidential information and novate (or renegotiate) any terms of engagement.

Additionally, the Divesting Firm will be keen to ensure that professional indemnity and successor practice liabilities (if they are a law firm) are transferred to the Demerged Firm.

A demerger may also trigger the application of Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE), such that the employees and possibly LLP members (if the Divesting Firm is an LLP) may transfer to the Demerged Firm with preserved employment rights. If TUPE applies, then obligations to inform and consult and specific timescales will apply and will require careful forward planning.

The implications of a demerger: looking ahead

Much of the substantive preparation for a demerger will need to be undertaken before completion to ensure an efficient process. This will likely include the Demerged Firm seeking and obtaining authorisation by its applicable professional regulator, if necessary (for example, the Solicitors Regulation Authority in the case of law firms) – this can sometimes be a lengthy process and should be initiated at an early stage to avoid delays. The Demerged Firm will also need to put in place the necessary infrastructure to ensure that it can carry on business as usual from day one; this will include matters such as office space, appropriate professional indemnity insurance and employee benefit schemes etc.For the Demerged Firm, it would be wise to consider, with specialist advice, how any partner’s or senior employee’s restrictive covenants will be treated and potentially varied (including in respect of any TUPE connected issues and variations potentially being rendered void) to ensure that the restrictions remain relevant and enforceable by the Demerged Firm and the newly transferred business’ clients can be protected.Equally, the Divesting Firm will be thinking about how to secure its future and will likely have post-demerger issues to address, including updating any business and market plans, downsizing its office space, and bedding in the remaining business of any clients who may now be obtaining separate professional services from both the Divesting and Demerged Firm.

We expect to see more Firms choosing to demerge in order to streamline their operations in the coming months and it will be important that they ensure the right advice and steps are taken so that the process is smooth and the demerger is ultimately successful for both parties.

If your Firm is considering a demerger or if you have any questions on the issues covered above, please contact Partner Zulon Begum or Associates Wonu Sanda and Wendy Chung, all of whom advise partnerships and LLPs in all sectors (including law firms) on a range of legal matters, including partnership structures, profit sharing arrangements, partnership mergers and de-mergers, partner disputes and legal risk management.