Quindell lessons: Is the legal profession compatible with capital markets?
Colin Gibson explores whether the situations which arose at Quindell and Slater and Gordon point to deep-rooted challenges for the future of the legal services market
There is no doubt that in the decade since the Legal Services Act 2007 was introduced, the increased investment in alternative business structures has benefitted clients by driving competition, innovation and efficiency.
But confidence in this brave new world of external investment has been shaken by the tale of Quindell and Slater and Gordon, two legal services firms where hubris and overreach resulted in significant investor losses and the possibility of insolvency that could have put thousands of live cases at risk.
In both situations, listed status enabled and arguably drove behaviours that are not best suited to legal business models or client interests. It appears that serious issues were caused by management's need to demonstrate a relentlessly positive growth narrative and to support this with aggressive approaches to funding, acquisition, and accounting.
The Quindell scandal and struggles at Slater and Gordon raise a number of important questions for investors and the legal profession.
Clear as mud?
Arguably the two businesses may have been viewed more critically by analysts and investors if they had been operating in a sector that is better understood, with a wealth of historic performance data and transparent accounting practices.
Those of us that look after the financials in legal practices deal every day with the complexity of income recognition and forecasting. With caseload quality and settlement timelines often subject to significant uncertainty and variability, it is a tough ask for those unfamiliar with the detail to accurately assess the health, performance and value of an individual organisation.
This is a real problem for investors focused on future value and one that is further compounded when a legal business' accounting is either optimistic or creative.
Quindell and Slater and Gordon both adopted aggressive accounting approaches in response to the need to present a strong growth narrative to investors. In Quindell's case, at least, some of those approaches significantly over-stepped the limits of what is recognised as acceptable.
In both examples, this was linked to extremely ambitious M&A programmes with financial projections for the acquired businesses that proved to be hopelessly optimistic.
In Slater and Gordon's case, the accounting choices were not as aggressive and these two factors on their own would not have had such a dramatic impact were it not for their extraordinarily misjudged and highly leveraged acquisition of the Quindell Legal Services business in 2015. This turned the financial 'car crash' that was Quindell in 2014 into a 'three car shunt' that has now brought Slater and Gordon to its knees, leaving it in the hands of its debt-holders.
The extent to which these practices and the resulting stock market communications represented a knowing or reckless attempt to mislead, is currently the subject of separate investor group litigation actions in the UK and Australia.
While most ABS firms will have appropriate accounting practices, in the case of publicly-quoted professional services firms, it could be argued that much more needs to be done to strengthen corporate governance in this area.
While Slater and Gordon's public statements may have made it clear that the financial interest of its shareholders was secondary to its clients and the courts, many find it hard to see how statutory and professional duties can ever sit easily alongside shareholder expectations and pressure.
The concept of slow and steady growth, with shareholder interests not necessarily at the front of the queue, is unlikely to get investors excited enough to generate significant investment. Ambitious, innovative, or highly-leveraged growth strategies are more attractive, but the fundamental flipside of greater rewards is increased risk.
Additionally, for both firms, when you consider the pace and scale of legislative change affecting personal injury litigation firms, their highly concentrated market consolidation strategies in that sector added a further major source of risk.
Although volatility is acceptable to most general businesses and investors, these examples demonstrate that external investment models for legal businesses, particularly those based on public capital markets, create a completely new set of risks for the protection of client interests.
Can the SRA adapt?
Quindell and Slater and Gordon have also drawn attention to whether the current self-regulatory structure run by the Solicitors Regulation Authority is capable of dealing with the risks posed by capital markets. It is highly likely that when the SRA was established it didn't ever foresee a situation on this scale or this complexity.
This raises questions around whether the regulator should have the capability and capacity to identify and intervene early. Arguably there is a need for additional external regulation to fully protect client interests and ensure the situation never arises where a large insolvency swamps the Solicitors' Compensation Fund.
The jury's out
Gateley was the first law firm in the UK to float on AIM in June 2015 and it appears to have made a solid start based on a considered, long-term growth strategy. It has focused on diversification '“ spreading risk by acquiring organisations in complementary sectors including Capitus (a tax advisory business) and Hamer Associates (a property consultancy).
Clearly capital markets are currently working for them, but the lack of other IPOs in the sector may already speak volumes around the fundamental challenges not yet addressed. What's clear is that Quindell and Slater and Gordon will remain a cautionary tale for both legal services regulation and investors. Lessons will be learned and I am sure any future IPOs will be watched keenly and treated cautiously.
Colin Gibson is chief executive officer at Your Legal Friend