Collective ownership: sound management is the responsibility of all partners

12 Dec 2013Feature

Firms should introduce a culture where risk management and financial stability are ongoing processes and behaviours rather than simply something to be looked at in the run up to renewal of insurance or bank facilities, says Jennifer Harren

Firms should introduce a culture where risk management and financial stability are ongoing processes and behaviours rather than simply something to be looked at in the run up to renewal of insurance or bank facilities, says Jennifer Harren

Sound financial management is a matter of professional conduct. Firms are now expected to run their business in accordance with proper governance and according to sound financial and risk management principles (see principle 8 of the SRA Code of Conduct). All firms have an obligation under outcome 10.3 of the code to report serious financial difficulty to the regulator. Poor financial planning and performance coupled with a failure to report may, in certain circumstances, be a matter of professional conduct - or misconduct - which may make a firm's relationship with its insurer very difficult. There was initially great concern about all of this in the profession.

Insurers have, in recent times, adopted a similar approach and now ask questions about a firm's finances, which forms part of their criteria for assessing risk. For example, firms are asked a series of questions at renewal relating to income generation - including a forecast for the forthcoming year - and how fees are broken down by department or client i.e. details of the top five clients by fees billed within the last financial year is often requested.

So it is not just the bank and creditors that firms need to be aware of when considering the impact of financial issues or difficulties. It is clear that insurers now equate good financial management with good risk management and take a keen interest in what firms are doing to reduce their risk profile.

Chastening experience

The reports on the case of Manches and Challinors are worth studying in these respects. There is usually little reporting on law firm debt but there is an awareness in the profession that there are problems with liquidity and changes of attitude within banks. It is usually only when firms are in terminal dire straits that these issues become publicly known.

In the case of Manches the firm had the following issues: behind on its £715,000 VAT bill; unable to fund the partners' tax liabilities; insured by way of an extension on its PII cover to 31 October; at the limit of its overdraft. That is a lot of pressure for a firm to withstand in financial and psychological terms.

It is clear that insurers were watching the firm's position very carefully presumably concerned about the firm's exit strategy and the potential need for run-off cover. As were the bank and creditors concerned at the firm's ability to discharge its debt. No doubt the SRA had a keen interest too, concerned at the significant cost of intervention. In this particular case there seems to have been a reasonably favourable outcome following the firm's merger with Penningtons.

Favourable outcomes are not always the case and banks are often left with large debts following a firm's failure. Challinors owed £4m to Allied Irish when they went into administration. These are chastening experiences for banks.

It is unlikely that finance will become any easier when you consider developments in the profession at the moment: the pressure on publicly funded work; the changes in the personal injury market; reduction in the volumes of employment claims, to name but three factors having an effect in the context of an over-subscribed profession and new entrants to the market. April's package of reforms is starting to have an impact with the SRA engaging with firms, predominantly those undertaking work in the personal injury market, and asking what they are doing to manage any loss of income from the referral fee ban.

Limiting exposure

Many firms were nervous when the SRA said that it would be making financial management a major issue and it was, at that time, investigating thousands of firms. More recently the SRA announced that it would not be testing thousands of other firms despite the suggestion that targeting firms' financial stability remains top of the SRA's agenda. It would be naïve to think that firms can now relax. Banks and insurers will continue to be far more diligent and demanding and for good reason - limit their exposure to risk.

One of the practical steps a firm can take is to raise awareness about finance. In the Manches case it was reported that few partners knew the extent of the firm's financial problems. Awareness of problems and collective ownership of dealing with them is essential if a sustainable plan is to be put in place.

Despite the move to outcomes-focused regulation the SRA has pointed to a lack of engagement by firms on the subject of financial stability. There is an apparent "fear" of "regulation by entrapment" and a lack of knowledge about what constitutes a serious, reportable matter. Firms are asking for guidance on what constitutes a material breach. There are no hard and fast guidelines: if it is keeping you awake at night, report it.

The message from the SRA is not to let fear of self-incrimination prevent reporting. The SRA has said that it will work in partnership with firms looking to resolve financial issues.

Missed payment

So when do you know when you are in financial trouble? It is not always obvious although some of the figures would tend to suggest that there was trouble long before the matters were reported in the legal or other press. The SRA has referred to a missed payment to the HMRC as a key indicator of when a firm is in financial difficulty. Usually there is a trend long before this which reveals a developing situation, such as client losses leading to falls in income, rising costs including insurance, or loss of staff leading to holes in income.

The SRA expects early notifications by firms experiencing difficulties paying bills, relying on short term borrowings and breaching overdraft limits. Firms should maintain a risk register identifying the financial risks facing the practice and the steps which will manage and mitigate those risks. It will assist if financial decision making is documented. So record your partners' meetings and discussions with your accountants and bank manager; it will help to show your insurer on renewal.

Firms need to be able to demonstrate to insurers that the practice is sustainable so they should produce a business plan evidencing how the firm will deal with changes in the market and show that the plans are reviewed and strategic decisions leading to consolidation, diversification or expansion, are being actively considered.

Firms should prepare an annual budget and conduct regular variance analyses to monitor expenditure and cash flow. Budgets should ensure that seasonal disruptions and annual payments, such as professional indemnity renewal, are taken into account in financial forecasting.

Insurers will be attracted to the firm that invests in internal processes and structures, and external support from good accountants and other advisers. This demonstrates a commitment to sustainability, compliance and effective risk management.

Monitoring profitability

Structures should be implemented to monitor and assess profitability of the firm and fee earners on an ongoing basis. Hourly rates and fixed fees should be periodically reviewed to determine profitability and efficiency in order to gauge performance levels. Also, interim billing and credit control procedures should be implemented to reduce lock-up days.

Law firms should not fear interest from the SRA, the bank, or their insurers in their accounts. Firms should strive to improve their finances on an ongoing basis, reviewing WIP, monitoring cash flow, aiming to make the cash position better each period and setting targets for cash as well as revenue and profit. Although unpopular among fees earners these measures, which may appear short term, have long term benefits.

The point in all of this is obvious: every firm should be striving to get to a position where its finances are going in the right direction; where they show the firm is clearly sustainable and is a reasonable investment in terms of debt and insurance risk. It should be a matter of pride for the partners and part of the firm's brand and value.

Jennifer Haren, Weightmans Jennifer Haren is a solicitor in the professional risk team at Weightmans