There is a fine line between being a harbinger of doom and a realist. Being objective, however, the signs are not good.

It is undoubtedly the case that insolvency practitioners are becoming increasingly busy preparing reports on law firms for their creditor banks.

Furthermore, consider the January 2011 headlines:

  • Firms seek to consolidate in 2011, following release of Winmark’s Network for Managing Partners (NMP) annual benchmarking survey. Apparently, half of the law firms surveyed anticipated stagnation or worse in the UK economy during 2011.
  • The profession’s growth 'defies gravity', following the announcement that the number of practising solicitors is now in excess of 120,000.
  • Small firms seek to consolidate, was the headline following the publication of a survey by Law Consultancy Network showing that 82% of the firms surveyed had considered the possibility of merger, takeover or amalgamation in the first half of 2010.

Hilderbrandt Baker Robbins and Citi Private Bank recently released their 2011 client advisory report highlighting trends in the legal market in 2010 and 2011.

It makes interesting reading and even though it focussed on the US market, the themes are familiar.

After beginning with an apt quote from Lewis Carroll’s Through the Looking Glass the preface concludes: 'Anticipating a protracted period of sluggish demand and mounting client pressures for enhanced value in the delivery of legal services with only modest rate increases, many firms are racing hard just to stay even – i.e. to maintain an acceptable level of profitability to satisfy their partners and to maintain stability.'

The report states that the demand for legal services has shrunk in the past seven quarters.

The predictions for 2011 are not particularly encouraging. The expectation is 'to see the legal business stabilizing, though at a lower level than in the years prior to 2008'.

It is fair to say that the legal profession (on both sides of the pond) faces a number of challenges over the next few years.

Testing times

In May 2010, the Solicitors Regulation Authority (SRA) published a guidance note on Closing down your practice.

Further, the SRA wrote to the Managing Partners of the top 50 UK law firms following the administration of Halliwells and a Law Society Gazette article with the headline, five firms ‘put in intensive care’ by banks.

The letter (without making any assumptions about the firms’ solvency) states that 'there are significant advantages of engaging with [the SRA] early' if firms experience a serious deterioration in their financial circumstances which might threaten their ability to continue in business.

The SRA is clearly taking the situation seriously.

It seems likely, if nothing else, that there will be a rationalisation in the market for legal services in an environment of over-supply together with downward pressure on salaries and partner profits.

What issues should managing partners and individual members of law firm LLPs therefore be addressing?

Stress test your LLP

The members of an LLP have a fiduciary duty to act in the best in interests of the LLP.

Further, where an LLP encounters solvency issues, the members of the LLP must take appropriate steps to protect the interests of its creditors.

One of the main complaints made by insolvency practitioners in the UK is that businesses do not seek advice early enough and this significantly limits the options ultimately available.

Furthermore taking advice early is one of the best ways of protecting members from attack should the LLP ultimately end up in a formal insolvency procedure.

Take independent advice from third party advisers; don’t be tempted to rely on "in house" expertise, competent though it may be, it may lack objectivity.

Members should realise that they cannot necessarily hide behind their management structure and should ensure that they are fully informed in terms of seeing regular management accounts and being aware of the representations being made on their behalf to third parties about the LLP’s ability to pay its debts.

Members can be liable for offences under section 206- 211 Insolvency Act 1986 ("IA1986") and are subject to the Company Directors Disqualification Act 1986.

It needs to be remembered that although the word "partnership" is used, LLPs are much more like companies.

The LLP has a separate legal personality and although the liability of the members is limited, the price for limited liability is that much of the law relating to companies and corporate insolvency will apply in a modified form.

Unfortunately for members of an LLP, unlike companies, the liability of members is not limited to those with titles and responsibilities.

This makes things really difficult in larger firms where the members have agreed to empower certain members or groups of members to run the firm.

Members should, however, be under no illusions that in theory at least they are not excluded from liabilities in the event of insolvency.

This would include liability for wrongful trading under section 214 IA1986 and other sections that give office holders (and potentially creditors) legal remedies through the courts.

Of particular note is the possibility of an administrator or liquidator seeking to claw back drawings in circumstances where a member’s current account is overdrawn.

The general practice is to pay members’ monthly drawings based on theoretical profit forecast.

If the business sustains losses, however, it is likely that members’ current accounts will be overdrawn.

The availability of set-off against capital account balances may be limited, both by operation of law and through the effect of commercial indemnities given as part of a firm’s funding arrangements.

It could additionally be argued that over payment of monies in the form of drawings should be regarded as a capital repayment and therefore a preference under section 239 IA1986.

It will, however, be vital in circumstances of merger or sale (whether through an insolvency procedure or otherwise) to preserve value and that means keeping client engagement partners on side and incentivised.

This could include setting up some protections from financial distress but this would need careful commercial negotiation and specialist advice should be taken before attempting to implement any such measures.

It may be worth revisiting the conversion documentation just to confirm what was transferred into the LLP and what was not.

Of course the major issue for many LLPs is the property from which the LLP trades.

Professional landlords capitalised on the LLP 'boom' by charging hefty fees for transferring property into an LLP in many cases with separate guarantees still in place.

Some firms were not prepared to pay that price and left their office properties outside the LLP.

The partners whose names are on the lease may feel that a sense of collegiality is required but in tough times this is not always forthcoming.

Retiring partners may be well advised to insist on their lease liabilities being extinguished and not simply indemnified.

Effective financial management should be simple but it rarely is.

In times of reduced turnover, effective management of costs, effective invoicing of work in progress and effective debt collection can be the difference between success and failure.

Insolvency law judges actions retrospectively so it is important to be able to point to a cogent and documented decision making process showing that appropriate action was taken to protect creditors’ interests.

It is worth remembering that the section 123 IA1986 sets out two tests of insolvency, a balance sheet test and a cash flow test (ability to pay debts as they fall due) and firms must demonstrate that they are compliant on both counts.

Partnership?

The concept of salaried and fixed share membership still exists within the ambit of many LLPs.

Equally, there are also ways in which creditors may pursue LLP members directly or through a liquidator or administrator.

Salaried and fixed share members are not immune from attack. HM Revenue and Customs is not quick to make distinctions when Crown money is at stake.

This may not necessarily be fatal but it could result in considerable stress and expense.

Special insurance to protect salaried and fixed share members is likely to be extremely expensive and indemnities from named members may not be worth the paper they are written on.

This is food for thought for younger lawyers eager for the accolade of partnership.

The correct advice, however unpalatable, is to ensure awareness of the firm’s financial position and to ensure that you are regularly updated with financial information.

It may be beneficial to ensure that individual members’ borrowing is spread widely so that no one bank has a pre-eminent position of influence over the LLP but this may not be possible given the cross-indemnities between the lender, the LLP and the members which is common in many funding agreements.

Creditor driven rationalisation

Law firms were once regarded as the jewels in the banks’ crowns because of the levels of clients’ monies held. A more sober analysis is now prevailing.

If the predicted rise in interest rates occurs during 2011 (and commentators are divided on this) pressure will be brought to bear on struggling businesses including law firms from their banks and other creditors.

Law firm customers of the main clearing banks may therefore come under pressure to rationalise and/or merge and the banks may even see themselves facilitating mergers or restructurings.

Distressed mergers may therefore be the result of bank interventions but this is a difficult process and there may be few willing suitors.

The size of the funding requirement needed to stabilise the businesses may be unpalatable without adding the reputational risk that institutional and corporate clients may need to be convinced of the standing of the new firm.

The 'holding out' rule creates a further difficulty in terms of the level of 'run-off' insurance cover needed.

In a recent administration sale, the asset purchase agreements expressly referred to the sale of only part of the business and the acquisition of certain assets.

One of the purchasing parties required an express exclusion of any right it might have acquired to hold itself out as the successor practice.

As with all distressed sales within or without an insolvency process while there is protection from creditor action in the initial stages, but there is no guarantee or obligation upon creditors to support the "rescued" business going forward.

It will be important, as it always is, to ensure that key suppliers and landlords, not to mention clients are on-side going forward.

Taxation is an important consideration too.

An LLP is transparent for taxation purposes.

This means that the profits of the firm, whether from income or capital, are taxable in the hands of the individual members.

Liquidation would trigger a change in the status of the LLP such that it will be treated for taxation purposes as a limited company.

The consequence of this is that any loss arising in the liquidation would be attributable to the LLP and would not be available to members to use to set off against personal income in the current or preceding years.

Maximising the tax losses attributable to members may allow members to minimise their personal tax liabilities and could in some cases create tax repayments although prudent financial lenders will often seek an assignment of these rights as a part of their security portfolio.

Mergers and acquisitions outside the administration process, while ostensibly attractive, require considerable thought and time to put in place and are not without risk.

The demise and pre-packed administration sale of Halliwells has been widely discussed elsewhere and it is apparent that lengthy negotiations were needed to achieve the sales that took place within a tight time scale.

It appears that the process resulted in a better outcome for the secured lenders, the ongoing employment of the staff, continuity of service for clients and minimal intervention by the SRA.

Of course, given the nature of insolvency, there were also those who were unable to benefit from the administration process.

Alternative business structures – the answer or not?

Charles Plant, the SRA chair recently said that '6 October 2011 will be [an] historic day for legal services in England and Wales'.

Will the ability to raise capital from external sources relieve managing partners of their headaches?

Raising capital to reduce debts is obviously not particularly attractive to a third party investor just as converting debt to equity is not attractive to the existing business owners.

The market for investment in law firms is not likely to be large and such investments if completed would result in huge cultural adjustments for lawyers.

It may of course be extremely beneficial to have third party involvement and experience but it will be interesting to see just how many firms take the plunge.

It will also be interesting to see what EBITDA multiples the market may offer for controlling interests in law firms. EBITDA is the usual measure adopted to describe the earnings of a business before an account is taken of interest, taxation or depreciation.

Some analysts suggest that this may be as low as 4.

If this were to generate less cash than the level of secured debt on the balance sheet then the transaction is unlikely to proceed.

Equally, it is evident that law firms are particularly vulnerable to the due diligence process with work in progress being a particular target.

Conclusion

There is undoubtedly going to be rationalisation and contraction in the legal profession in the short to medium term.

The key is to take advice and manage your business in appropriate detail so that any signs of deterioration are picked up early.

Document your decision-making process carefully having regard to the fiduciary duties owed to the LLP - and where needed statutory duties to the LLP’s creditors.

Revisit your members’ agreement to ensure that the LLP has all the powers it needs to regulate the practice effectively.

It is always easier to make reforms in periods of calm so the provisions on expulsion and compensation and the restrictive covenants should be regularly reviewed.

Whether the market for legal services will ever return to its former position is moot.

With that in mind the profession’s challenge going forward will be to create new business models and business practices that will stand the test of time if the current economic reality becomes the norm.

Ian Williams, a solicitor, and Andy Beckingham, an accountant, have written this article in a personal capacity.