Warning signs: managing financial stability

Law firms should always manage their finances so as to not fail financially, although even in benign economic times many still did not achieve a particularly high level of financial performance.

Too many law firms have for too long not been run as businesses.

Firm failures

It was perhaps inevitable then that a combination of a difficult economy, government legislation impacting on certain parts of the legal profession and a lack of financial disciplines, skills and knowledge, would lead to the rash of law firm failures which we have seen over the past
12 months.

And, just as financial times were getting tougher for law firms, financial management became subject to the compliance obligations
in the SRA Handbook following the introduction of Outcomes Focused Regulation (OFR) on
6 October 2011.

Principle 8 in the SRA Handbook provides that you: “Run your business or carry out your role in the business effectively and in accordance with proper governance and sound financial and risk management principles.”

And Outcome O(7.4) in the SRA Code of Conduct requires firms to: “Maintain systems and controls for monitoring the financial stability of your firm… and take steps to address issues identified.”

These regulatory obligations are perfectly sensible because ensuring a firm’s financial position is on a solid footing, as stability requires, is something which, quite apart from compliance obligations, law firms should always be doing as part of good business practice.

However, what is the SRA’s view of what firms should be doing?

In 2013, the SRA set out in a note a list of ‘poor behaviours to avoid’ in relation to financial stability as follows:

• drawings exceeding net profits;

• high borrowing to net asset ratios;

• increasing firm indebtedness by maintaining drawing levels;

• firms controlled by an ‘inner circle’ of senior management;

• key financial information not shared with ‘rank and file’ partners;

• payments made to partners irrespective of ‘cash at the bank’;

• all net profits drawn, no ‘reserve capital pot’ retained;

• short-term borrowings to fund partners’ ?tax bills;

• VAT receipts used as ‘cash received’ resulting in further borrowings to fund VAT due to HMRC;

• partners out of touch with office account ?bank balances;

• heavy dependence on high overdraft borrowings.

Effective action

While the SRA list may be sensible insofar as it goes, it does not focus on the underlying reasons why law firms are failing to generate healthy cash flow, and which need to be identified before effective remedial action can be taken.

For example, causes of poor cash generation are likely to include:

• a downturn in the value of business, caused by fewer instructions or lower prices or both, which will lead to less work in progress being available to be billed and leading in turn to less cash being received to pay overheads. Unless this cycle of paying out more cash than is being received is stopped by taking action to cut overheads and generate more revenue, a firm will at some point run out of cash.

• areas of work which are a drain on cash because of the length of time between instructions and payment, work having to be financed in the meantime. Identifying which parts of a firm are haemorrhaging cash because of excessive ‘lock up’ and cutting them out will be necessary to ensure survival, if it is not already too late.

Further financial stability compliance requirements under OFR include: outcome O(10.3): you notify the SRA promptly of any material changes to relevant information about you, including serious financial difficulty.

‘Serious financial difficulty’ is not defined, but some indications of SRA thinking are contained in indicative behaviour IB(10.3) which provides that acting in the following way may tend to show that you have achieved outcomes in chapter 10: “Notifying the SRA promptly of any indicators of serious
financial difficulty, such as inability to pay your professional indemnity insurance premium, or rent or salaries or breach of
bank covenants.”

And this is backed up by other indicative behaviours, such as indicative behaviour IB(10.2): actively monitoring your financial stability and viability in order to identify and mitigate any risks to the public; indicative behaviour IB(10.4): notifying the SRA promptly when you become aware that your business may not be financially viable to continue trading as a going concern, for example because of difficult trading conditions, poor cash flow, increasing overheads, loss of managers or employees and/or loss of sources of revenue; and, indicative behaviour IB(10.5): notifying the SRA of any serious issues identified as a result of monitoring referred to in IB(10.1)
and IB(10.2), and producing a plan for remedying issues that have been identified.

Cash flow

Given the above, if a law firm has cash flow problems, what should
it do?

The SRA in its note ‘Financial stability’ on its website urges firms to seek help from the SRA, but it is also clear that it does not provide financial advice: “Your first port of call may be your assigned member of our supervision team. They will talk through your problems from a regulatory perspective and consider what can be done. Bear in mind that the SRA’s concern is to protect clients ?and the wider public interest and we cannot provide legal or financial advice.”

Given those final words, should a firm’s ‘first port of call’ be to the SRA, or to a firm of experienced accountants who may be able to turn matters around?

If any circumstances arise which could affect the financial stability of a firm, then the firm would be well advised to take advice from its accountants to establish the extent of the problem and, if possible, arrive at a course of action to remedy matters.

The advice provided and the actions agreed to be taken on the basis of that advice will need to be carefully recorded to be able to justify the firm’s conduct, if challenged, and how and why the issues were resolved in the particular manner adopted.

The following statement in particular, made by the executive director of the SRA in April 2013, will need to be heeded: “We ?will not tolerate the reckless trading of firms into insolvency and where this happens we will pursue enforcement action under principle 8, including referral to the Solicitors Disciplinary Tribunal where appropriate.”

The profession has been warned.

Building blocks

Given the tough conditions which many law firms are currently experiencing, what are some of the financial stability building blocks that should be put in place to provide a more solid financial foundation?

1. Decide who should have responsibility for financial management.
Financial management should be seen not only as the responsibility of a finance professional of experience and quality.

Managing partners will need to make it their business to ensure that they can more than hold their own with their finance directors because financial management should be intrinsic to and inseparable from everything else that requires managing in a law firm.

2. Review financial measurement and reporting.
In order to be able to ‘maintain systems and controls to monitor financial stability and to take steps to address issues identified’ (outcome O(7.3)), financial performance needs to be capable of being accurately measured, assessed and reported on.

Financial measurement and reporting should aim to obtain accurate information of what is happening/will happen in a business and to provide clear information to those managing the business as to actions they need to take to optimise financial performance. Without accurate measurement, no valid analysis of financial stability is possible.

3. Financial education and training.  
However, financial reports will not improve financial stability if there is no explanation of what people are supposed to do with them. As a lawyer said to me recently: “I don’t have a clue about the financial reports I receive.”

How much better off would firms be if their lawyers were taught to better evaluate financial reports to improve their financial performance?

4. Take control of your cash management.     
 ‘Cash is king’ and of paramount importance to maintaining financial stability, as the examples used in the indicative behaviours make clear.

 

• Taking instructions. The process begins when instructions are taken from clients. If essential matters are not agreed with clients at that stage, then it is more likely that there will be cash issues throughout the matter, impacting on financial stability.
• Managing work in progress and debtors. Work in progress and debtors are risk factors and will require constant monitoring and setting of targets, designed to minimise the level of ‘work done but not billed/not paid for’.

5. Establish an audit trail.
Under OFR it is not sufficient just to be compliant. Firms must be able to demonstrate that they are achieving outcomes and principles.

How will firms be able to demonstrate, if challenged, that they are maintaining financial stability?

Having in place disciplines and procedures as outlined above, which are adequately documented, can be a starting point.  However, controls and procedures which firms put in place can only be tested for their effectiveness by continuous monitoring and this will require firms to ‘measure what matters’ and to record outcomes.

SJ

Peter Scott is a former managing partner of Eversheds London and now runs his own professional consulting practice Peter Scott Consulting www.peterscottconsult.co.uk. Contact pscott@peterscottconsult.co.uk