Smaller firms that identify themselves early and take professional advice when struggling will have a better chance of survival.
Many articles have been written recently in this journal and elsewhere about the challenges facing the legal profession following the changes brought about by the Legal Services Act and a number of other developments. Some speculate over the future of the profession and comment on the emergence of new players with interesting backers. Others adopt a pessimistic and foreboding line, understandably highlighting the likely rationalisation and subsequent insolvencies that might arise. Most have commented on the reported larger failures in terms of how the mighty have fallen. We are looking to take a different perspective in this article - about the impact on the smaller practice, the real (rather than perceived) position of the Solicitors Regulation Authority and how the smaller practices can be assisted to steer the right course as the winds of change sweep through the profession.
Changes in the wind
It’s a given that the winds of change are already blowing. Some changes were brought in with the good intentions of encouraging competition that should ultimately benefit clients. Other issues that the profession faces arise indirectly from decisions taken by a government with an agenda of austerity. Sadly, the coming together of all these changes at the same time will, for some, create the perfect storm.
Some firms will embrace the changes entrepreneurially, including smaller practices, for with all threats come opportunities. There will, however, inevitably be casualties as firms close – some solvently, some not. There will be some larger firm failures amongst those, particularly amongst the larger regionals still carrying high levels of debt. Yet the numbers will inevitably come disproportionately from the smaller ‘high street’ practices who are unable or who cannot afford to change and who are likely to face the full force of the winds of change.
It is on the high street that the combined effect of alternative business structure initiatives by retail brands, changes to legal aid, changes to PI work, the costs of implementing new regulatory requirements, the Jackson reforms, and professional indemnity premium increases, will inevitably hit hardest.
Commentators seem generally motivated by being able to demonstrate their expertise to their chosen audience and to that extent we are no different here (as a solicitor and insolvency practitioner both with considerable experience in advising small and medium-sized businesses (SMEs)). Some are writing for external stakeholders like lenders, who undoubtedly are watching this sector closely. No one though, yet, seems to be addressing the position of the partners of smaller firms and sole practitioners, who are likely to be the most affected.
Alternatives to the downward spiral
The key point that we want to stress is that there is always an alternative, infinitely preferable to soldiering on alone, available to smaller firms facing difficulty – yet one which many are hesitant to take… obtaining proper independent external assistance early , and before things deteriorate. We wanted to shine a light on the issues that may prevent firms from engaging early and identify whether these concerns are justified, in addition to looking at possible solutions from such action.
In the world of SMEs, when trading conditions are difficult and future projections are frightening, options available to address the issues slip away with increasing speed the longer that they are not grasped. If addressed in good time, causes for poor trading performance can be remedied. Typical options include:
- Unviable services or business units can be sold or closed;
- Management and management information can be enhanced;
- Individuals can be trained (or re-trained);
- Recruitment and redundancy can be implemented to improve the workforce efficacy;
- Cost savings can be implemented.
Ideally, these steps would be done and profitability restored before external stakeholders intervene - but as they can take some months to complete, these steps need to be addressed in good time and (depending on the skill-set of existing management) overseen by specialists. Sometimes it is necessary to raise fresh capital, which is no longer as quick to obtain as it once was.
Failure to act – The downward spiral
If not remedied, then losses will start to impact on the business’s funding, which mean that borrowing facilities become extended, tax is paid late (attracting penalties) and suppliers are not paid on time. Management inevitably focuses more on cash generation by any means rather than underlying profitability, or winning and servicing client work, the quality of which starts to fall causing a spiral of decline. For professional services firms, the lack of focus on client work can also lead to a higher incidence of negligence claims.
Eventually, the business runs out of spare cash, tax arrears accumulate and it cannot secure supplies. Then external stakeholders start to intervene: bank managers insist on independent reports and meetings, HM Revenue & Customs threatens distraint or bankruptcy/winding-up and suppliers start to issue recovery proceedings.
The business owner is now much less in control and increasingly is working to others’ agendas – so it is even harder to focus on what the business owner knows he needs to do. He is constantly fire-fighting creditors, begging for supplies, hiding from HMRC and seeking to borrow short-term money at usurious rates. Before long he will need to plead for extra time to pay the debts that the business owes. By this stage, the external stakeholders have lost confidence in his ability and integrity, taking a dim view about the procrastination. And goodwill has evaporated. He hasn’t then given the time to manoeuvre.
Seeking early advice does not equate to failure
It is, though, very hard to come to a decision to engage insolvency practitioners or turnaround professionals. It is often viewed by the management as a step that is tantamount to an admission of failure, and one that will almost inevitably lead to liquidation of the business, bankruptcy of the directors and loss of livelihood for those involved. These concerns are not, however, the reality of the role of, or the typical outcome facilitated by, these professionals in the 21st century.
With law firms the same entrenched views about bringing in business recovery professionals will exist. However, there is much greater concern (unique to law firms) acting in the back of the minds of many practitioners considering such an option – the attitude of the SRA to such a step and the perceived threat of intervention.
The approach of the SRA
It used to be the prevailing view, based on what was seen to play out in the legal press, that when law firms got themselves into financial trouble, the Law Society (as the regulator at the time) would simply press the intervention button and the all of the concerns the management of any SME would have (liquidation of the business, bankruptcy of the directors and loss of livelihood for those involved) would instantly come to pass.
Intervention is a blunt instrument, from a different time, aimed solely at protecting client files and client money. It effectively trumps any attempt to rescue the practice due to the imposition of a statutory trust on the firm’s assets and the huge costs of the intervening solicitors (which become a joint liability of the firm and its partners).
But simply because this may have been the historical approach to firms in financial trouble, is the same really true now? A lot has changed since the introduction of the intervention regime in the Solicitors Act 1974:
- Law firm structures have changed hugely with the ability to trade as LLPs and limited companies and for lenders to take debentures by way of security;
- There is now a completely new set of ‘outcome focused’ regulations administered by a new regulator – the SRA;
- Business rescue professionals are no longer the undertakers of the business world and are now highly trained, experienced and equipped with deep sector expertise;
- The cost of interventions in modern firms is massive compared to previous eras – due in part to the new law firm structures and the size of some modern firms.
Previous writers have sought to champion a new and better way to deal with firms in financial trouble than intervention, but the reality is that this new and better way is already here and being utilised – although it is in its infancy and some specific changes by the SRA could see it work much better. The SRA has no wish to intervene in firms facing financial difficulty, and will only do so where it has to. A careful look at the firms that have hit the press recently in relation to their financial problems (several of which the writers were involved with) shows this to be the case and shows that a more harmonised approach catering for both a rescue of the firm and the protection of its clients (without the need for intervention) is now emerging. In many recent situations, including Manches, the SRA has worked pro-actively with the business rescue professionals to avoid intervention.
The SRA has stressed repeatedly its desire to use intervention only as a last resort. It knows that the practitioners in most of these firms are not delinquent directors or fraudsters. They have essentially not done anything wrong. They came into the profession in a previous age expecting to have a career for life after hard training and the unpredictable has worked against them. They are now facing an unprecedented period of change and many have proved unable to adapt and respond quickly enough.
At a recent conference the SRA’s director of supervision, Mike Haley, set out three key messages to firms facing financial difficulty:
1. The need to be open with the SRA – a lack of engagement was likely to lead to trouble further down the line.
2. To self-report in a timely manner – the need to be mindful of the relevant regulations and fact the ultimate responsibility for compliance that rests with the compliance officer for legal practice.
3. To prepare for the worst – to have contingency plan, now, for various potential outcomes.
It is the first two of these that seem to be the biggest concerns for many law firms – ‘when do I need to report?’ and ‘what will happen when I do report?’.
Under the new regulations, SRA Principle 8 requires firms to ‘…run your business… effectively and in accordance with proper governance and sound financial and risk management principles’. Outcome 7.4 requires firms to ‘maintain systems and controls for monitoring the financial stability of your firm … and take steps to address issues identified’. Indicative behaviours include controlling budgets, expenditure and cashflow (IB 7.2) and identifying and monitoring financial risks including credit risks and exposure (IB 7.3).
The point at which firms are required to report financial problems is set out in Outcome 10.3 which requires firms to ‘… notify the SRA promptly of any material changes to relevant information about you including serious financial difficulty…’.
This is clarified by IB 10.3 which confirms indicative behaviours including ‘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’.
Mike Haley recently added to that list by suggesting that breach of authorised overdraft limits and time-to-pay agreements with HMRC might also constitute notifiable events.
But can firms obtain independent professional advice before contacting the SRA? The answer to this in most cases, if advice is taken early enough, will be yes . Again this was confirmed by Mike Haley recently, although he pointed out that firms would have to consider carefully their obligation to report after they had taken such advice.
And what happens after firms report? Much will depend on their situation, but if they have engaged early enough and are working with professionals to resolve their problems Mike Haley explained the SRA’s position as follows: ‘If firms are aware of their problems and are taking steps to deal with the situation, we just need to be sighted on what they are doing.’ Examples of good behaviours exhibited by firms in difficulty specifically included taking advice from insolvency practitioners – on occasions the SRA has sought undertakings from partners to do this. The same message was spelt out by the SRA board chairman, Charles Plant, in a recent interview with The Times, when he said that intervention was ‘the last resort’ and that the SRA would always prefer active engagement.
If practitioners doubt that the SRA’s approach is as set out above, they only need to look at the SRA’s underlying financial issues. For 2013, the SRA had an intervention budget of £1.3m. It is now anticipated that the SRA’s actual intervention spend for 2013 is likely to be £8-10m, with the immediate shortfall coming from the Compensation Fund. Against a backdrop of such figures, commercial reality alone dictates that avoiding intervention where possible must be the objective.
The SRA is looking for engagement, action to address financial problems and transparency. Inevitably, those who identify themselves, take professional advice and enter into an ongoing dialogue with the SRA about how they are going to address their financial issues will be of significantly less concern than those who leave disclosure and seeking assistance until the last minute, when the problem is inevitably worse and the impact on others greater.
It is the latter situations that are most likely to lead to action by the SRA and potential intervention where, due to the lack of time, there is no longer the ability for a rescue. It is the former that the SRA will, if satisfied with the arrangements, be able to leave in the hands of the firms and their professional advisers.
Viv Williams is chief executive 360 Legal Group, James Tickell is director at Portland Business & Financial Solutions and Nick Oliver is solicitor and director at Verisona Law