What happens when law firms go under – and how can they stay afloat in choppy waters? Paul Rogerson consults Quantuma’s ‘specialists in failure’.

To spend an hour with Quantuma is to walk among the tombstones. The boutique insolvency specialist was created as recently as 2013 by Carl Jackson, former head of restructuring at accountancy outfit RSM Tenon, just a few months before Tenon’s high-profile demise and sale to Baker Tilly. Yet in the four years since, fast-growing Quantuma has seemingly set about dominating the market in high-profile law firm failures.

Formal appointments so far include Challinors, Davenport Lyons, Prolegal, Maitland Hudson and – of course – the European arm of King & Wood Mallesons, the legacy SJ Berwin business. So who better to quiz on the often enigmatic subject of how law firms get into bother than – with apologies to Arsène Wenger – the ‘specialists in failure’?

One big clue to Quantuma’s growing profile is sitting in the firm’s Holborn, London office as I arrive. I had asked to meet Andy Hosking, the one-time Grant Thornton partner who is now head of Quantuma’s professional services team; and Sean Bucknall, a director at Quantuma who specialises in distressed legal practices. But also there to observe is Sam Palmer, partner and head of professional and financial risks at solicitors Ashfords.

It is soon clear that Palmer’s contribution cannot be overstated – for she is Quantuma’s conduit to the regulator. The former head of regulatory management at the Solicitors Regulation Authority, Palmer joined Ashfords in 2015 with a brief to provide law firms with regulatory guidance and support, including business structure planning. When IPs are formally appointed, she is parachuted in as solicitor manager.

I touch on the role of the SRA immediately in assessing why law firm insolvencies often generate controversy. Here is the now cliched scenario: a law firm gets into trouble below the radar; partners decamp elsewhere or draw too much ahead of a collapse; rump assets are sold off at a heavy discount through covert pre-pack deals; and unsecured creditors are left swinging in the wind.

Meanwhile, the regulator looks on complacently amid calls for a formal intervention.

Hosking, however, stresses that a distressed law firm cannot be compared with a struggling manufacturer of ‘widgets’ when it enters recovery mode. ‘When a bank puts us into a factory, we’ll do an options analysis and consider a quick disposal or whether the business needs to go into administration or some other [insolvency] process. You can’t do that with a law firm. It’s heavily regulated: there are clients’ interests to consider; there is a client account. It is a “people” business. So at all times when you are trying to do a refinancing, or a sale, or even a breakup, you are seeking to ensure that no intervention issues arise.’

That means ensuring the SRA is hauled inside the tent at the start of a recovery process that can take months – seven months in the case of Davenport Lyons, for example.

‘So much of the work gets done pre-appointment,’ Hosking says. ‘From day one of our assignment, we tell the client to bring in specialist regulatory communications. Sam [Palmer] will sit down with the COLP and help initiate an exchange of correspondence with the SRA so they know what is happening. The regulator will want to know if wages are being paid, so we’re not going to see a migration of staff. They will want to confirm that client interests are being protected correctly. And then they will want to know the strategy.’

Palmer, who is perhaps uniquely qualified to know, observes: ‘It is absolutely key to provide that detailed contingency planning from a regulatory perspective, evidencing how protection of clients’ interests is actually going to be achieved. So it is always useful to have a “refresher” conversation about that with the partner group. Given that reassurance, the regulator will be more confident that this is a managed wind-down, merger, acquisition, sale – whether as a whole or in parts – and not a crash that requires the ultimate action available, an intervention.’

Hosking adds: ‘Unless there has been misappropriation of client funds, or exceptionally poor partner behaviour which breaches SRA standards, [our job] is about explaining to the partners their responsibilities both to the SRA and to creditors. If they were to migrate in droves, for example, then intervention could see them become personally liable for the costs involved, their practising certificates withdrawn and creditor value evaporating.

‘We respect the SRA and accept that the client account is sacrosanct. As an IP I don’t want to deal with it, I want a solicitor brought in.’

On the question of managing disposals, Hosking continues: ‘Some people seem to think that a sale is simple – it’s not.’

He cites as an example the 2013 sale of top-100 firm Manches to rival Penningtons: ‘There were many competing interests in that firm and they had to be brought into line to agree to the one disposal. A number of those partners were quite keen on leaving, and we had to explain to them that if they were to leave in significant numbers, then intervention was a very real risk. Fortunately, those partners were bright and could see the risks. And therefore the idea of doing a sale to another firm and accepting – or enduring – a two- or three-year lock-in all of a sudden [became] less difficult.’

But what of KWM, whose death throes have been accompanied by lurid media tales of discarded files strewn across abandoned desks, partners fleeing in droves and acerbic email exchanges apportioning blame? While clearly an unedifying episode, this can hardly be blamed on Quantuma, which got involved very late in the day. The first earmarked administrator, AlixPartners, pulled out citing funding concerns.

Hosking says: ‘Choosing my words carefully, I would like to say that KWM is currently a successful administration, though for me that is an oxymoron. It is unfortunate we were brought in so late. I do feel more could have been done. I’m very careful about making comments on partners’ behaviours, but some of them should have considered abdicating some of their own needs in favour of general creditors and clients’ interests.’

An investigation into the circumstances surrounding KWM Europe’s failure remains ongoing, though Quantuma has stressed that a final verdict is a ‘long way down the line’. There is no suggestion of impropriety.

As an insight into the everyday practicalities of dealing with the biggest UK law firm collapse, however, Hosking offers this vignette: ‘Sam is walking the floors to ensure that when the building gets vacated it will be tidy. As solicitor manager she has had to call back partners and say: “You wouldn’t leave your house in this state, get it tidied up. Put stuff in archiving, get the client files or it gets shredded”.’

KWM Europe’s demise has also renewed debate about the controversial use in many distressed law firm sales of opaque pre-pack buyout deals. These deals leave creditors out of the loop and allow debts to be conveniently dumped, critics allege.

At KWM, some work in progress and accounts receivable have been sold at a heavy discount to departing partners and other firms, as part of what Quantuma describes as a ‘pre-pack strategy’. The administrator will not confirm this, but unsecured creditors will almost certainly recoup nothing.

What critics fail to realise is that it is impossible to run a law firm in administration for anything but the shortest of periods, making a pre-pack or liquidation the only options for a firm in serious trouble. Rules designed to support ‘stability’ can thus have unintended consequences.

Sean Bucknall explains: ‘As we (administrators) are not regulated lawyers, we cannot trade a law firm. So there has to be a disposal, either through a breakup or sale.

‘When we talk of the value (of the sales) this is not cognisant of the liabilities of the business at the time. Typically, there are significant creditors and significant bank debt too. We have to follow the parameters of the insolvency process in respect of distributions to secured and unsecured creditors, and so on. We can only deal with the assets that are available.’

Hosking expands on this point: ‘It’s not like a factory or hotel, where even if you had a prospective purchaser prior to your appointment you can trade in the short term to try and assess whether you are getting real value.

‘And invariably you’re dealing with a wasting asset. So your ability to maximise [realisations] is often a matter of speed and whether you have a willing purchaser.’

As for allegations that pre-packs are akin to ‘phoenixing’, Hosking is dismissive: ‘Partners may go, it’s a people business and they will move to new firms. That doesn’t mean they have escaped their personal obligations. They will invariably have suffered losses and will need to relay capital loans.

‘People are quick to judge: “oh look, it’s another collapse and the creditors get burnt”. No they don’t. Well, they do, but it’s not done deliberately. It’s not an engineered collapse.

‘No purchaser will acquire a work in progress or debtors of another law firm without there being a huge amount of due diligence. And there will always be a discount.’

Quickfire sales – or indeed quick firesales – can rely on the external advisers Quantuma calls in to help, which can include CMS, Ashfords and Pinsent Masons. They retain comprehensive databases of law firms who may be looking for strategic acquisitions of entire firms or of work within specific sectors.

Law firms fail for many reasons, of course, with Quantuma alluding to the ‘perfect storm’ lashing small and medium-sized practices. Jackson LJ’s costs reforms, the emasculation of legal aid and curbs on small claims (see p1) could almost have been designed to deny solicitors a decent living, notwithstanding their access to justice implications.

But according to Hosking, the profession itself also needs to change. Honourable and esteemed they may be, but too often firms remain sclerotic and old-fashioned when it comes to paring costs. He gives one anonymised example: ‘We ended up administrator of a firm which downsized offices. The managing partner wanted to halve the space following a time and motion study which showed that six out of 10 partners were not in the office at any one time. With wifi and so on enabling homeworking, the space plan was focused on meeting rooms, hot-desking and much smaller work areas.

‘When he unveiled the plan to fellow partners, there was outrage. They were not prepared to give up their own offices. As soon as the partners saw their own offices were under threat, they started to come in more. So he was forced to source 50% more space than first envisaged, at premium rates.

‘And of course, once the crisis was over – the partners stopped using their rooms again.’

That is just one example of a firm tied in to occupying premium space for up to 25 years on a fixed overhead, where partners will continue to require minimum drawings regardless of trading fluctuations. Drawings which, says Hosking, may ultimately be funded by taking on more debt in what becomes a vicious cycle.

Lease obligations have proved a millstone for many a law firm. Another dead weight can be professional indemnity insurance, notwithstanding the relatively benign market for premiums.

Hosking explains: ‘Premiums are linked to the management of the firm. So one firm we’re aware of was keen to grow turnover in a shrinking market. That meant their appetite for risk grew. But they didn’t have a particularly strong compliance department, so the level of PI claims rose dramatically. And that in turn saw the premium rise from £400,000 to £1.3m in the space of five years. That’s £900,000 that would have been available for distribution.’

Firms may be more inclined to take risks as their traditional sources of income dry up through no fault of their own. So what can they do?

More can do what might appear obvious, according to Hosking: ‘Firms need to ramp up their regulatory compliance. If the insurer sees that the law firm is proactive in managing risk, and is meeting them on a regular basis, that will be reflected in [lower premiums] in due course.

‘Listen to your accountant within the firm. Actually look at the management accounts, assess the cash collections and do consider moderating your drawings where there is difficulty. And ask whether you can downsize the office space, keeping overheads down while still meeting clients’ needs.

‘Are you reporting appropriately to your institutional investors, such as banks, so there is some comfort if difficulties arise? And you need properly to report your income – not turnover, income. I’m not interested in how much you’ve banked today in the way of client disbursements, because that’s not going to be available to defray the firm’s overheads, staff costs or partner drawings.’

Like ‘vanity’ property plays, expanding through lateral hires can also entail long-term commitments that can come back to bite, Hosking counsels. ‘Firms have encountered major financial difficulties as a result of the belief that lateral hires are the way forward. They’ll offer two- to three-year lock-in deals to incoming partners  at guaranteed income levels when the client following isn’t there. They’ve committed to paying out money in a situation where they are not making profits.’

As a route to better decision-making Hosking is a fan of alternative business structures, which enable non-lawyers – including finance directors – to take a stake while sharing executive responsibility. Yet their impact so far, while significant, has not been transformative. Why is that?

‘Historically, as you know, some of the SRA waiting [times] for authorising ABSs were quite substantial,’ Bucknall interjects. ‘They have now shortened significantly. I would certainly say to a business seeking to incorporate a law firm that the flexibility of the ABS model is something they would want to have available.’

I mention in passing that a Deloitte partner recently asked me why accountancy and law firms are not yet jumping into bed to form fully fledged multidisciplinary partnerships. SRA chief executive Paul Philip has admitted ABSs ‘haven’t worked’ as expected, urging solicitors to take advantage of rule changes enabling them to team up with accountants in ‘one-stop shop’ advisory firms.

Surprisingly, perhaps, Hosking thinks this is a non-starter – certainly among the bigger commercial practices. ‘It sounds like a no-brainer and conceptually it would make eminent sense,’ he concedes. ‘But in the current marketplace, it would be economic suicide, frankly. Lawyers, accountants and banks work independently and engage the specialist skillsets they feel they need at any one time. An MDP’s ability to attract referral work from other firms, clients and institutions would be seriously compromised.’

Strenuous efforts by Big Four accountancy firms to make inroads in the law will be circumscribed for similar reasons, he predicts. ‘[Their] idea is do transactional work and perform other legal services almost in servitude to the accountancy practice. Conceptually, that’s great. But I wonder how many top-25 legal practices in the UK would refer work to such a firm’s accountants knowing they will have their own law practice work on it. The referral could lose them fee income.’

The ABS revolution, it would seem, is indefinitely postponed.