WHEN A LAW FIRM IS ON ITS KNEES AND BANKRUPTCY LOOMS, WHAT CAN BE DONE TO RESURRECT ITS FORTUNES? CHRIS BAKER EXAMINES THE CAUSES AND THE PROCESSES TO HEAD OFF FINANCIAL RUIN

Following the euphoria of the Christmas and new year celebrations comes the festive financial hangover as a nation checks its credit card statements and mourns.

Solicitors received advance warning of this last year when the head of the Inland Revenue's voluntary arrangement service, Dick Ivory, told lawyers at the Solicitors Assistance Scheme's annual conference that negotiating repayment deals with debtors is far more efficient for the Revenue than issuing formal court proceedings.

He added that this applied as much to solicitors as to other individuals (see [2003] Gazette, 4 December, 4).

Fortunately, law firms and solicitors seem to be able to balance their books better than the average denizen of the January sales.

Bankruptcy would appear to be rarer in the profession than it is in other sectors.

According to a spokesman for the Office for the Supervision of Solicitors (OSS), the Law Society does not keep records of firms that have gone belly up.

But, of roughly 400 OSS interventions that have taken place since 2000, bankruptcy was cited in only 25 cases.

'However, usually bankruptcy is not the sole reason for intervention - usually there are several others such as abandonment and breaches of the accounts rules,' the spokesman adds.

These were cases of solicitors going bankrupt, but entire firms can suffer a similar fate.

Most leading insolvency practitioners say it is pretty uncommon, but it does happen.

'I suspect that some legal aid firms have gone bankrupt, but so have some small non-legal aid firms as well - it is a tough market out there,' says Legal Aid Practitioners Group director Richard Miller.

Sometimes it will be a bolt from the blue.

Mark Sterling, a partner at City firm Allen & Overy, says: 'The sort of case we all worry about is the cover-busting negligence claim.

I'm not sure that it has happened much but it's the sort of thing that gives you nightmares.'

But more often than not, financial woe can be brought about by changes in the market.

Mr Sterling points to the rapid growth that took place in the profession just before the last major recession in the late 1980s and early 1990s.

'Some firms over-expanded and were over-exposed,' he says.

'They had a small number of clients in a small sector of business which itself saw bankruptcy.'

As clients in property development and small private equity businesses went bust, the law firms that relied on them for work followed suit.

Concentrating too heavily on one area of business can be fatal.

One insolvency practitioner, who did not wish to be named, says: 'I have come across law firms getting into difficulty.

Generally, it's because their area of business has just become less profitable.

Larger firms can ride it out but with smaller or medium-sized firms, there is too much risk in having just one or two large clients or concentrating on one area of business.'

He highlights convey-ancing as an area that may feel a squeeze in the near future as a result of e-conveyancing.

Then there is the spending - shiny new offices and pay hikes for all may seem good at the time, but have to be considered carefully.

'Bankruptcy usually follows an over-commitment on outgoings such as premises and salaries,' says John Verrill, a partner at City firm Lawrence Graham and president of R3, the Association of Business Recovery Professionals.

'And in a tightening economic climate, people pay more slowly so the cash doesn't flow.'

In such a situation, firms will also find it hard to bag transactions on which they can charge a fee.

'Over-reliance on a flawed business plan or over-ambition will lead to financial difficulty,' Mr Verrill says.

When a firm, or an individual solicitor, gets into difficulty, the Law Society will step in.

'When a solicitor goes bankrupt, his or her practising certificate is automatically suspended,' the OSS spokesman says.

'However, it is possible to apply for a termination of the suspension and this may be done even before a formal declaration of bankruptcy.'

If the suspension is terminated, it is common for the Society to impose conditions on the solicitor's practising certificate to protect clients and the wider public.

Almost certainly, the solicitor will be required to work only in partnership or in employment approved by the Society.

Usually, conditions are imposed to protect client funds, such as banning the solicitor from signing cheques.

The Society can intervene in and close down a firm if a solicitor there is made bankrupt.

If all the principals are bankrupt, an intervention is almost inevitable.

The banks have a big say in the firm's finances.

'The banks pay the salaries and the rental as most firms lease their premises,' says Mr Verrill.

'Short of cutting the payroll and reducing unnecessary expenses such as IT and marketing, there is very little you can do.'

It is a hard slog that can lead to a 'degree of business paralysis', as Mr Verrill puts it.

A compromise has to be worked out between the firm and its creditors, which will involve a close examination of which partners were involved at the time.

'You may have to restrict the admission of new partners,' he says.

'And new partners will not want to take the blame for something that happened before they worked there.'

The firm could then enter into a partnership voluntary arrangement (PVA) or insolvent partnership order to reschedule the debts.

If three-quarters of the creditors agree with the new arrangements, the rest will have to go along with it.

Mr Sterling points out what he calls a 'wrinkle'.

Such arrangements will require an administrator to be brought in, and if that person is not a solicitor then the firm falls foul of the Law Society's fee-sharing rules.

'If you have a joint appointment with an accountant and a solicitor who is an insolvency practitioner, the Law Society will go along with it,' he adds.

'There is a reasonable history of that.'

Mr Verrill adds that R3 is always happy to help on a formal or informal basis.

There are a lot of kindred spirits out there who will be happy to listen and offer advice, he says.

There also need to be connected arrangements where a partner's personal assets fit around the needs of the creditors and the shortfall, which can be rather complicated, Mr Sterling warns.

It is generally agreed that the lenders are more willing to work out these compromises than they once were, as closing the firm down means they will see little return.

But another insolvency partner at a City firm, who also did not wish to be named, argues that formal arrangements are a headache.

'If the firm doesn't do anything or doesn't have the support of its bankers, the only thing it can do is dissolve and go out of business,' he says.

'But they do tend to form some informal arrangement with the partners and creditors.

That is frequently the better solution, rather than a formal insolvent partnership order - once you apply a formal order to a service provider, it becomes difficult to provide that service.'

Often the solution is looking - using secret consultation with specialists - at the equity and how much partners are allowed to draw down.

'The decision is easier to take with the benefit of outside counsel,' he continues.

'Discreet outside counsel is helpful in predicting and taking early steps to reduce outflow of cash and to reduce costs incumbent in the business, such as losing people or reducing expenditure on IT or marketing - it seems painful in the short term but it makes sense.'

Mr Sterling says that going for limited liability partnership status is another good form of protection.

'But I believe, just from idle conversation, that the take-up has not been that great,' he adds.

The enhanced disclosure requirements may be a reason, according to Mr Sterling.

However, there is a growing number of larger firms seeking to limit their liability.

The best way to avoid financial nightmares is prudent financial planning, says Mr Verrill.

Being sensible about budgeting and what partners can draw down - especially if a firm is overdrawn - will always be the key.

'You have to wield the scalpel quickly,' he adds.

'It may be painful at the time but it's a lot easier and better than doing it when the cash has already been spent.

'The best way to avoid a slow-burning bankruptcy is to take advice and take it early.

It may seem expensive but it's better than losing everything.'

Chris Baker is a freelance journalist