Risk and restructuring: Law firm insolvencies

The legal sector continues to go through a period of unprecedented change, with new challenges and risks alongside a host of new competitors. Firms are actively adopting new approaches to ensure they remain ahead of the game but, for some, financial distress and, indeed, insolvency are real threats.

With a number of recent and high-profile failures, fresh light is being shone on those factors which are significantly affecting the resilience of law firms.

A buyers’ market

Professional services clients are becoming increasingly price sensitive. It’s relatively rare now for firms to have the ability to ratchet up their fees in line with inflation, with any increases requiring clear value-adds to pass muster with clients. For those that don’t have the resources to deliver new service offerings at a competitive price point, it is a real challenge to increase revenue and mitigate rising operational costs.

Sizing up the competition

With that in mind, law firms are seeing new competitors enter the market, presenting a significant challenge to attracting and retaining business and talent. The impact of ABSs and the launch of legal services by traditionally non-legal professional services firms is driving down prices, particularly where services can be commoditised, packaged, and sold at ever lower rates. This is being driven in many cases by technological disruption, with AI continuing to be perceived as a threat to legal services roles.

While more complex work will inevitably require human action and interaction, generally consumers will willingly substitute personal contact for cost cutting where the service is largely functional. Firms, therefore, which can articulate their advisory credentials, both legal and commercial, will be better placed to maintain and enhance current client relationships and more effectively pursue prospects.

A helping hand from the government

On top of this upward pressure, there has also been considerable downward political pressure on the market – most strikingly with regard to legal aid. While not having an effect right across the industry, the changes to legal aid policy have hit many firms hard. Further, Michael Gove may have shelved some of the Ministry of Justice’s planned reforms in early 2016 but the proposals, which in their original guise would have seen the number of firms awarded contracts reduced, remain on the agenda. In the meantime, the ongoing wrangling over legal aid payments is posing further challenges for criminal firms and practitioners and contributing to uncertainty in the market.

The peculiar case of law firm administrations

It is very much hoped that responding in a timely and effective way to these challenges will stave off the prospect of insolvency. If the pendulum has swung too far, however, then law firms face a specific set of potential pitfalls which require careful navigation.

First, the SRA has a very clear role to protect client interests and client monies, and can issue an intervention notice. This can mean immediate closure, with the SRA taking possession of the practice’s documents, client files, and office account monies.

In insolvency proceedings more broadly, the SRA has a stringent set of rules that must be abided by, including on client files and client monies. For client files, for instance, a fully realisable plan for their safe relocation to a new provider must be signed off by the regulator.

Meanwhile, the nature of a partnership structure brings its own millstone. As any firm will know, achieving a consensus is a difficult task and one which makes the pursuit of restructuring solutions which require a majority vote of all partners and support of creditors difficult to achieve.

Perhaps the most important factor, but one which often passes under the radar, is the impact of a firm’s insolvency on the individual partners where there are potentially grave personal implications and obligations they perhaps did not know they had.

For instance, failing to proactively review and scrutinise accounts can mean that partners continue to draw the same amounts as they did in previous (perhaps more profitable) years, which can result in a severe cash-flow problem for the firm. If a firm subsequently fails, partners can be pursued for profits that they have ‘overdrawn’, which has a substantial personal and professional impact.

Further, in the event of an SRA intervention, solicitors may have their practising certificate or registration suspended.

All this adds up to an environment with a distinct set of challenges. With some large failures hitting the headlines, it’s easy to forget that it is often the small and medium-sized firms that are most at risk. Those practices with ten to 15 partners (usually less than 50 employees) that are trying to provide a broad spectrum of services to an often regional clientele generally do not have the economies of scale needed to weather the storm.

For those finding it tough, the only practical solution is often to conduct a full-throated cost-cutting exercise, or to go in search of a like-minded organisation to merge with. If the situation has already deteriorated to such an extent that insolvency looks like a real possibility, then an accelerated sale or merger might well be the best course of action. Critically, though, any firm beginning to face difficulties must ensure effective financial and information management and record keeping.

Martha Thompson is a business restructuring partner at BDO

@bdoaccountant

www.bdo.co.uk