Distressed law firms - the challenge for insolvency practitioners

This article was first published by RECOVERY News and the full article can be found online here

This article was jointly written by Partners Alan Bennett and Sam Palmer

Three recent law firm administrations (McClure Naismith, First Stop Legal Services and Jeffrey Green Russell) and one intervention (Blavo & Co) have brought into sharp focus the difficulties the legal sector continues to face. 

The Solicitors Regulatory Authority (SRA) has previously engaged with law firms so as to understand the reasons for financial instability. The reasons they found included:

  • Overdrawing by partners who did not understand the difference between profit and cash at bank, often maintaining drawings from previous years profit despite cash flow pressures; 
  • Heavy borrowing from second and third tier lenders, in more extreme cases to fund VAT and rent; 
  • and Lack of forward cash flow planning often categorised by a weak or non-assertive finance director.

At first blush the above issues could describe financial instability facing any professional services firm that IPs deal with on a day-to-day basis. Why are law firms different? The interaction with stakeholders, particularly the SRA, is a major difference. 

The SRA has statutory powers of intervention. An intervention can be without notice, resulting in frozen client and office accounts, immediate office closure with staff dismissed and clients' files retrieved by intervention agents. The SRA will seek to recover those intervention costs from the partners personally. 

These costs can be eye watering; for example, the estimated intervention costs for Cobbetts was £6m, Manches £2.5m and Challinors £4m. The SRA maintains that their Statutory Charge trumps the bank's security. While this has not yet been tested through the courts in practical terms, the bank's security is undermined and insolvency costs are in uncertain territory. 

Transparency and openness with stakeholders is key. This can be difficult as a common theme in law firms with financial difficulties is that visibility on financial information is often restricted to a small group of partners. Often when advising, the IP may tell some partners for the very first time about the true extent of the law firm's financial difficulties. 

This brings its own difficulties as rumours tend to circulate and partners, perhaps mistakenly, fear the worst and look to leave the law firm. This further adds to the instability and, unless managed effectively, increases the likelihood of an intervention.

Managing the stakeholders continues once a formal appointment of the IP takes place and continued close liaison with the SRA is vital. In particular, the IP will need to appoint a solicitor manager and present a Regulatory Framework Agreement for SRA approval so as to ensure that clients' interests are protected. 

The role of the solicitor manager is to principally ensure the safe transfer of client files and client funds, in accordance with informed client consent. In addition, the solicitor manager will also provide regular reports to the SRA on the progress of the administration or liquidation. 

It is likely that further law firm insolvencies will take place and IPs should bear in mind the above issues before considering taking an appointment.

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