Law firms are tricky to restructure, but there are solutions for those that are struggling, says Clare Boardman (pictured)

The unfortunate demise of law firms such as Cobbetts, Brooke North and Rowlands Field Cunningham highlights the significant challenges that many in the sector, particularly mid-tier practices, are facing. 

For some time, the market has been experiencing the perfect storm: a combination of sluggish trading conditions in a difficult economic climate, alongside significant regulatory change, including the Legal Services Act, which allows new players with deep pockets to enter the sector. 

Despite the myriad merger activity, the UK market remains oversupplied. However, law firms are some of the most challenging businesses to restructure for several reasons.

People businesses

Law firms' most valuable assets are their people. However, during a restructuring this asset can complicate processes. Often in stressed scenarios, businesses need to make quick, sound decisions at an executive level. When firms do not have a robust, collegiate board structure in place, consultation with all partners is often needed, making the decision-making process cumbersome and ineffective. 

Furthermore, firms often have few tangible assets. Consequently, the balance sheet can offer little comfort to a lender and limited means with which to leverage and raise further funds.  

Partner drawings

Partner drawings for an underperforming law firm will immediately be subject to scrutiny. There are often claims that the partners must have taken too much out of the business, not adjusting earnings to current financial performance.

While this may sometimes be the case, drawings can be challenging to adjust. Ill-managed adjustments to earnings can result in the departure of the better partners and subsequently lost revenues as clients stay loyal to the individual, not the firm. 

Lumpy cashflows

Law firm cashflows are lumpy owing to large one-off payments such as partner tax, rent, annual practice certificates and professional indemnity insurance premiums. This can create 'pinch points' if sufficient cash headroom is not built up, which can quickly lead to breaches of banking facilities and cash shortfalls. 

Increasingly, law firms are turning to funders to provide short-term unsecured loans that allow payments to be spread over several months. But if a firm is considered to be a weaker covenant or as having trading issues, funders may refuse to renew a loan just weeks before payments are due. Therefore, law firms can be immediately faced with a cashflow issue if they operate with minimal headroom.

SRA and compliance roles

The Solicitors Regulation Authority (SRA) introduced the role of compliance officer for finance and administration (COFA) on 1 January. One of the requirements for the COFA is to assess the current financial position of the firm and notify "a material change in financial stability" to the SRA. 

The SRA is keen to ensure struggling firms are properly advised on their options. It wants regular communication and visibility of the strategy. If engagement with the SRA does not occur, it may be forced to intervene at a later, more critical, stage, which can often prove terminal for the firm and expensive for creditors. It is therefore important that any nervousness from the market to engage with the SRA is dispelled. 

In Q1 2013, there were eight interventions by the SRA due to financial difficulties and they estimate this number could increase to 30 by the end of the year. But these are a last resort for the SRA.

Possible solutions

While there certainly isn't an 'off the shelf' solution, there are certain approaches that underperforming firms should consider.

A one-off issue, such as a significant bad debt, may result in a short-term cash difficulty that needs bridging. The business must be confident that any issue isn't symptomatic of a more fundamental problem.

A 13-week rolling cashflow forecast is essential when there are cash issues, alongside a medium-term strategy. Short-term solutions include driving the cash collection cycle and gaining support from creditors, landlords, partners and third-party funders.

Nevertheless, some fundamental issues require more than just short-term cash management. The greatest challenge for firms is to acknowledge the severity of the problem. We have seen optimistic revenue forecasts since 2010, and yet the market remains tough.   

A solvent solution will usually be better than insolvency, so this should be the board's Plan A. Firms should work towards a turnaround of the business, with an operational improvement drive, reducing costs, improving margins and focusing on working capital efficiencies to generate cash headroom.

Unfortunately, Plan A will not be achievable in all cases. Failures occur for many reasons, including lack of third-party support, lack of underlying trading performance or lack of partner support. Alternate options include a sale, a merger or perhaps a sale of a division or subsidiary that may be non-core or loss-making.

Insolvency options

If all solvent avenues for restructuring have been exhausted, the best way to preserve value for all creditors is for a sale of the business and assets to occur on day one of the insolvency – ie a prepack.

While prepacks have previously come under scrutiny, the insolvency world has responded with the introduction of new guidelines. Law firms cannot be traded in insolvency, so the options are either an immediate sale of the business or an immediate closure and full job losses. 

Halliwells was sold via prepacks to three purchasers. More recent prepacks have included Marsden Rawsthorn and Cobbetts. An insolvency practitioner needs to demonstrate that such a deal is the most favourable option for all creditors. Lining up such deals confidentially, before insolvency, can be extremely challenging. 

Tax issues are complex and, if not structured properly, these deals can prove ruinous for individual partners.

Ultimately, law firms must not bury their heads in the sand where there are signs of underperformance. They must be proactive, get advice, engage with the SRA, work in a collegiate manner and seek out the best solution for all stakeholders.

Clare Boardman is a restructuring services partner at Deloitte.