Why Greater Pain for Creditors When Legal

Legal sector analysis highlights expected outcome significantly worse for legal firms than any other sector when an insolvency process is required. David Johnstone, managing director at Recovery First, explains why.

Recent analysis published has indicated that unsecured creditors of firms of solicitors can expect an average dividend of two pence in the pound compared to an average across all industries/sectors of five pence – why would this be?

Well, there are many factors influencing the recent experience.

First and foremost, historically there have been few failures in the legal sector and the phenomena has really only been gathering pace over the last eight years, so experience of dealing with such situations is limited. As with all things new, it is rarely possible to get it right first time and although a small number of restructuring businesses have built experience and expert knowledge of the sector, which is unique in many respects to all others, often Insolvency Practitioners (IPs) find themselves dealing with a situation for the first time.

The second principal reason is that by nature, solicitors are providers of advice as opposed to seekers of it. It is fact that advice is almost always sought late regardless of sector and the later it is left, the fewer options that remain. While a general statement, the nature of the solicitor owned business is such that it would appear acknowledging the situation they find themselves in is left even later than the average.

The combination of these two factors creates a situation where the IP approached has little time to invest in understanding the options; traditional methodology is utilised as opposed to looking at more innovative and sector specific tools to avoid a sale at an undervalue and improve the outcome for the firm and the creditors. While that is changing, time will tell as to whether the pace of change is sufficient to impact on the overall experience.

The above is exacerbated by a whole host of factors:

  1. Regulation

    The legal sector is, by necessity, a heavily regulated sector, likewise insolvency. Insolvency regulation and solicitor regulation is most definitely not joined up. A lack of appreciation of the sector specific regulation on behalf of the IP can give rise to problems. Similarly the legal firm is regulated by the Solicitors Regulatory Authority (SRA), whose primary focus is directed at the consumer, the firm’s client, and not the outcome for the creditor or the market forces imposed by the legislators. For those involved, the lack of engagement between or above the various regulators is extremely frustrating, but the impact on the firms, their clients and creditors does not appear to justify resource at the correct levels to improve the outcomes.

    The use of a Solicitor Manager in conjunction with the IP is growing, improving the lines of communication with the SRA and ensuring solicitor regulatory matters are dealt with in a compliant manner, albeit it doesn’t address improvements that could be achieved were the SRA’s tool box extended or amended.

    Indeed it is assumed that the analysis takes into account situations where the SRA intervenes in the firm concerned and where that occurs, it is an inevitable consequence that this will have a detrimental impact on the outcome for creditors. Intervention is additionally galling where the firm has a meaningful exposure to claimant personal injury (PI), as their own objective of ensuring the best outcome for existing clients with ongoing matters is unlikely to be achieved.

  2. Lack of financial management within small to medium (SME) firms

    While smaller businesses have a tendency to operate on a cash basis, nowhere is it more prevalent than law firms.

    The firms that flourish have been proactive and invested in accurate and timely management information and operational key performance indicators. This gives them the maximum sight lines in terms of identifying issues that may be arising or looming, which affect the viability of their business, giving them the ability to plan for change.

    Too many SME firms still operate predominately on a cash basis and when cash flow patterns change, the problem that should have been foreseen and mitigated is upon them.

    Additionally, shortfalls in working capital can be papered over by the use of secondary or short term funding products, as opposed to addressing the underlying issue, resulting in a worsening of the position for creditors if the business subsequently fails. Away from the legal sector, additional funding will often be secured by bricks and mortar or will be specific asset funding, providing some tangible security. Within the legal service sector it will inevitably be leveraged off the back of WIP, something easily manipulated by the firm in question and often not fully understood by the lender, with comfort taken from a personal guarantee. Unfortunately given the traditional acceptance of personal liability within the legal sector, this is something solicitors are all too quick to agree to.

  3. Lack of input from existing professional relationships, particularly their banker

    Leading on from the lack of financial management is a reluctance for the principle banker to insist upon what should in fact be readily available. This is perhaps changing as the main banks operating in the sector have all invested in one form or another of sector specific knowledge and things are improving. At the coal face, however, there still appears to be a politically driven motivation not to rock the boat. When combined with a respect for the profession that can lead to the specific relationship manager not wishing to change the dynamics of the relationship, through asking for or insisting upon something not previously requested, it remains the case that often robust financial information is only insisted on if the customer is looking to change or increase their facilities. This need to discuss with the incumbent banker can be circumvented by approaching a new secondary lender who is perhaps naive about the changes taking place in the legal market

    Banks are best placed to spot changes in cash activity and the use of secondary funding. Although we cannot expect banks to assume responsibility for their customers’ activity, many of their customers have no experience of the situation they find themselves in. More proactive and dynamic management of the relationship by the bank may lead to issues being addressed earlier and at a time when much more could be salvaged.

  4. Lack of awareness across all participants in the ownership of the firm

    Lawyers are not necessarily lovers of financial detail. While this is not a prerequisite for business ownership, once they are part of that ownership structure it can be surprising how much trust or faith is placed in one particular partner or director in respect of all things financial. This can place all burden on one set of shoulders, likewise for sole traders. Pride, denial or something else kicks in when things do not go well, bad news is not shared either with co-owners or advisers until matters are often terminal.

  5. Nature of the entity

    The legal profession often remains fiercely protective of its partnership status and the privacy of its financial position this allows. Recent times have seen an increasing use of limited companies or limited liability partnerships, however many remain in sole trader or partnership status. This can delay a bank or a creditor taking action to liquidate their exposure.

  6. Costs litigation over fees once matters are settled

    Liability insurers continue to seek a windfall through the avoidance of fees where a transfer from solicitor to solicitor has arisen through challenges over the methodology of transfer. This creates uncertainty over what value actually exists in WIP if an insolvency event arises. Looking at claimant personal injury in particular, the lack of robust transitional arrangements when introducing LASPO put the vendor on the back foot and plays into the hands of the purchasing entity. This makes what is already a challenge for the IP even more difficult in respect of achieving value from existing WIP. While it was legislation introduced in 2000, which created the opportunity to grow many of the businesses affected, no responsibility for outcome appears to have been taken by the legislators to create a secure exit path when pulling the rug out from under the majority.

  7. Ever changing legislative landscape

    It is a not so much a merry go round as that goes up as well as down, but a slippery slope for firms and the ever changing landscape does not appear to stopping anytime soon. The Chancellors Autumn Statement, highlighting an increase to small claims limit and potentially restricting claimable events suggests further change on the horizon. This has been followed swiftly with the release of the Briggs review suggesting an online claims court up to £25K to avoid the involvement of a solicitor. This will hopefully take much longer to impact and be properly thought through, not least the whole process of training up additional judges etc. However history suggests it will eventually lead to further change.

Change is no doubt necessary and indeed without it nothing will improve. It is difficult to see how many competing objectives with a diverse range of stakeholders will work together to initiate positive change. In the interim, from the perspective of an IP attempting to maximise value for creditors though, it creates significant additional challenges when trying to deal with the distressed law firm.