If there is one sector bound to produce more work for the insolvency and rescue profession in 2014, it’s the world of legal practice. Examples of law firms becoming insolvent have been rife over the past year, with the last two quarters proving particularly intense for the sector, and it seems things will get worse before they get better, finds Fred Crawley
At the time of writing, in early December, both EOS Law and Hilliers HRW have just gone under, and countless other firms teeter on the edge. Inefficient management in the long term has put a great number of firms in a position of chronic financial weakness, and for many, the challenge of securing professional indemnity insurance (PII) for the year ahead has been enough to precipitate commercial failure.
PII renewal occurs in October, and for many firms, the cover is financed by a third party which is repaid over the following 12 months.
However, premiums have increased, some insurers are refusing to offer policies based on adverse regulatory decisions against firms or unacceptable commercial risk, and some specialist funders involved in financing cover have withdrawn from the market.
All this means that insurance has been a significant hurdle for a lot of firms, and as of 12 December, the Solicitors Regulation Authority (SRA), the regulatory body for solicitors in England and Wales, confirmed that some 141 were still without cover, having entered the 90-day extended policy period (EPP) for failing to secure cover by 1 October. A further pool of firms, the size of which the SRA would not confirm, are yet to declare their insurance position to the regulator.
While 136 of the 277 firms that entered the EPP have now secured insurance (although only 12 did so after 1 November), if the remainder have not acquired cover by 29 December, they will be in line for enforcement action. Many of this cohort will now be in the midst of winding down or attempting
to find a purchaser for their business, but no doubt some will hold on too long in the
hope of finding an insurer, and be closed down in the new year.
PII renewal time usually causes a spike in law firm closures – the SRA confirms that around 100 more tend to close during September than in any other month – but this year appears to be different.
Christina Fitzgerald, partner at Matthew Arnold Baldwin and one of the leading voices in the field of law firm insolvency work, says the problem is not going away any time soon. One of the key indicators, she says, is that the long-term trend of higher levels of firm failure in the North and North West has now begun expanding to encompass the South and London – a situation she says is largely unprecedented.
“This is not an annual spike” says Fitzgerald, “but the start of a period of a high and sustained level of corporate distress.”
The final straw
Fitzgerald and other practitioners specialising in working in turnaround and insolvency situations with law firms are at pains to point out that the epidemic of closures building in the industry is not solely a result of the PII renewal situation; it is more a case that insurance renewal has been the straw that broke the camel’s back after years of financial weakness.
George Bull, chair of the professional practices group at professional services firm Baker Tilly, said the following about law firm failures in a communication with clients at the end of November:
“Financial stability – or a lack of it – has been a factor in each of these failures. The introduction of entity-based regulation by the Solicitors Regulation Authority has emphasised the importance of financial stability.
“With high-profile law firm failures running at unprecedented levels, certain common features
are beginning to emerge. Property liabilities taken on in the good times have proved unsupportable in an economic downturn. Excessive distributions to partners have left firms weakened to the point of collapse. Tax arrears where the cash to fund these – VAT collected on client bills, for example – has been spent elsewhere. Excessive reliance on secondary lenders may leave firms feeling they can survive, only to discover that they cannot. And, worst of all, a lack of awareness on the part of both fixed and non-fixed share equity partners as to what exactly is going on in their business.”
Supply and demand
The oversupply of legal services in the UK market is universally recognised, and the current spasm of business closures – not to mention the large number of distress- induced takeovers disguised as mergers in media reports – is easy to see as the mechanism that will correct the balance between supply and demand.
But what will the endgame be? Inevitably, it seems the legal market will go the same way as accountancy, leaving a less fragmented market with a much smaller tail of small businesses headed by a few larger consolidators. Indeed, there are consolidators currently active which, aided by the new business options presented by the introduction of alternative business structures, are proving adept at picking up the practices of experience- rich yet commercially non-viable firms.
It’s not just big firms that will survive, however. Smaller and medium-sized firms with specialist practices, which can market themselves well enough to enjoy a national reputation, will survive by transcending their regional limitations through demand for their sectoral expertise.
“Traditional” local firms without specialisms, however, may well find themselves in hot water, as a lot of their mainstay work – such as conveyancing – becomes increasingly commoditised and provided by larger competitors which can offer these services with greater efficiency and at a lower price point.
For law firms going into 2014 the options seem to be, as the marketing adage has it, “Go big, go niche, or go home”.
Best of a bad situation
For those firms for which the only remaining option is “go home”, how can the situation be improved in order to allow the most productive intervention of insolvency and turnaround specialists?
Fitzgerald has a number of ideas for creating better links between the worlds of legal practice and insolvency and turnaround work. First, she would like to see it made more possible to achieve a trading administration of a law firm.
At present, the requirement to have a solicitor-licensed insolvency practitioner take a joint appointment which attracts personal liability for any breach of undertaking of that practice makes a pre-pack virtually the only option in insolvency.
By relaxing these conditions, she feels that insolvent law firms could more easily enter a formal administration, finding more time for an appropriate and stable merger or negotiated sale to be arranged (if desired), and ultimately presenting more value to stakeholders.
Fitzgerald would also like to see a clarification and expansion of the role of special manager. A special manager – invoked, for example, in the case of Cobbetts early in 2013 – is not an official office holder, and oversees the management of archiving and redistribution of client monies after a firm is closed down. At present there is no legislation, nor even any guidelines, offered for the parameters of this role.
Furthermore, Fitzgerald is in discussion with the SRA, with a view to proposing that the conditions under which the authority intervenes in a firm be limited to those involving fraud or other dishonest conduct, rather than simple commercial failure.
She is also working with SRA relationship managers to spot the warning signs of commercial distress in law firms and point them towards turnaround options. While it would not be appropriate
for the SRA to recommend individual practitioners, Fitzgerald says “it may be that the law society is prepared to be involved in that part of the process. Firms in financial distress need to be directed to experienced professional advisers”.
She adds: “The SRA has been extremely helpful and proactive in interacting with specialists in this area.”
The SRA is more proactive than most trade associations in the work it does with its members. Nevertheless, whatever action it takes to alleviate legal firms’ distress, it is clear there are some serious structural faults running throughout the UK legal sector. And while help is increasingly at hand from turnaround specialists, collections experts and others, it remains the obligation of
the partners in charge of troubled firms to get their houses in order.
The large players and the niche specialists may have secured their places in the market, but for those who insist on maintaining a traditional approach to legal services, and especially for those whose decisions have meant they have yet to secure PII cover, it may just be time to pack up and go home.