Carnage – is it avoidable?

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6 March 2015


By David Johnstone, managing director at Legal Futures Associate PI-Solutions

Johnstone: the SRA and the Law Society are best placed to prevent firms going under

Johnstone: the SRA and the Law Society are best placed to prevent firms going under

Many commentators are voicing their opinion and there does appear to be a growing consensus that 2015 is the year the devastating side of LASPO will fully show its face. Legal Futures last month reported a prediction of impending carnage in the personal injury (PI) market and it may well be true, but are there avenues that can be taken to mitigate the destructive nature of cash drying up on small-to-medium sized PI practices, the principals of those businesses and the claimants currently being serviced by the firms affected.

The process of consolidation in the claimant PI sector that is an inevitable consequence of LASPO has been occurring over the last two years. That said, the pace of consolidation has perhaps been slower than expected to date – with the carnage set to come from that pace increasing significantly and the consolidation that results being neither controlled nor managed.

The danger for the profession and those individuals involved is that traditional methodology for dealing with firms that fail, as a result of hitting a cash crisis, is not pretty, no doubt the thinking behind the use of ‘carnage’.

The reason for this is that claimant PI locks significant value into work in progress (WIP) and traditional methodology means that regardless of how an end to one entity is achieved, it will result in a massive proportion of the value built by that entity being handed over to another.

Subconsciously or consciously, owners of businesses that know they have a significant asset are reluctant to realise that asset when it involves discounting it by potentially 60% plus to transfer the work to another firm in a solvent trade sale. Not all firms can afford to write off 60% of their WIP and remain solvent and therefore, rather than face that dilemma, continue to trade.

A significant proportion of the consolidation to date has been achieved through strategic decisions to merge or sell via a trade acquisition either the whole practice, a department or simply the WIP incumbent in a pool of cases, and that will continue to be part of the consolidation process. By way of example, Slater & Gordon recently confirmed the acquisition of a further two firms. This, though, isn’t where the ‘carnage’ is seen.

Failing law firms
The other element of the consolidation seen to date has arisen through firms that have already failed and either gone through a formal insolvency process involving administration, liquidation or bankruptcy or had the Solicitors Regulatory Authority (SRA) intervene. Regardless of the process, this does create carnage on all sorts of levels and the fact that insolvency and intervention are not a joined-up event does not help matters.

For the individual solicitors who own the business, allowing matters to get to this stage can be devastating on a personal level. If left this late it can involve the loss of the ability to practise and the potential for disciplinary action by the SRA, whether or not an intervention has taken place.

From the profession’s point of view, the additional financial burden created by the SRA intervening is one aspect of the harm, with no real prospect of the cost being recovered from the existing assets within the firm. This tends to be the WIP and the likelihood is that the act of intervention will ultimately lead to this asset being wasted.

The other aspect is the light in which the legal profession is seen generally. While there may be few high-profile, large-scale failures, every failure impacts on the clients of that firm. If, as predicted by some, this year sees a growing number of firms failing to take action early enough to avoid a formal process, collectively a significant number of claimants are going to have a very bad experience of the client care, whether it’s delivered by the interventions process or pre pack arrangements delivered by the insolvency practitioner.

The problem is exacerbated by the potential of it happening to an individual claimant on more than one occasion. We have already seen this on a number of occasions, where a firm that fails is pre-packed into another that then goes on to fail itself, resulting in the clients having to move yet again.

If the pace of consolidation accelerates, it becomes harder for insolvency practitioners (IPs) to ensure the credibility of purchasers and, if they take a short-sighted view and sell at an undervalue for a cash deal, it is arguably not their concern.

In an intervention, the likelihood is that the intervening agent will offer no customer care or support beyond advising existing claimants to find another firm. This puts all the emphasis on the claimant to identify a firm that is likely to survive the consolidation process – the information required to make an informed choice simply isn’t available, even if the claimants were to understand the transition that is currently taking place in the market. It still remains the case that more firms will go than will remain, therefore it becomes a complete lottery for those set adrift by the intervening agent.

Additionally banks and other creditors are viewing the sector with ever-increasing concern. Banks in particular are seeing an increasing pattern of firms repeatedly failing to meet their own projections, undermining the banks’ confidence in the firms’ ability to manage themselves. Subject to how quickly individual relationship directors react, this may assist in bringing those firms in need of advice to those accountancy and restructuring firms best placed to give it.

The dangers of internal run-off
The only alternative to a discounted trade sale has historically been internal run-off. In other words, keeping the firm going and winding down over time by working the existing matters through to a conclusion. This is where a number of the businesses that either could not afford the discounts involved in a trade sale or were actually continuing in the hope that business picked up have found themselves.

It is these businesses, who have to some extent been in enforced internal run-off, which are at the highest risk of being part of the envisaged carnage.

Unfortunately, internal run-off is an extremely inefficient mechanism for liquidating the value locked into WIP for all but the most sophisticated businesses and it becomes more inefficient as the process progresses.

As caseloads reduce and value is liquidated generally, settlement patterns will stretch, creating additional cost with no improvement in revenue. Levels of cash receipts start to get spikey and overall cash receipts drop off rapidly at a point within the process. Rarely do the associated costs come down in line with the reduction in revenue, as all too often the projections regarding receipts are not met whilst cost projected are fairly accurate. Some costs are step costs and, by their nature, must remain while being absorbed by an ever-reducing number of settlements.

The full extent of the challenges of managing an internal run-off could take up a whole paper in its own right, but it is not difficult to imagine the challenges of managing a graveyard.

So what, if anything, can be done to avoid the waste, loss of value and devastation that arises when cash runs out without any contingency plan – ie, the carnage.

The last two years have seen the implementation and growth of an alternative, third option to add to the trade sale or internal run-off. A number of firms have opted for outsourcing the run-off of their cases and have, or are, in the process of turning into cash 100% of the value incumbent in their WIP.

This model was developed to avoid the discounts applied by those with deep pockets taking up the opportunities LASPO presented and at the same time address the inefficiencies of an internal run-off. By spreading the work across a number of the firms remaining in the sector, experience has shown that the settlement periods are accelerated.

Properly managed, the attrition during the transfer process is negligible and by ensuring ongoing monitoring, independent accounting and bill drafting the realised value is directed to the relevant parties in a timely fashion.

This has the potential to transform the outcome statement for an exiting party, as the realisations may well exceed the WIP value on the balance sheet, when prepared on a going concern basis. Additionally, the other significant barrier to stepping back from claimant PI is that professional indemnity insurance run-off cover can be mitigated and aligned with the process.

The key to avoiding or mitigating the negative aspects of the transitory period is control. If firms take steps early enough and remain in control of their own exit, all aspects associated with carnage will potentially be removed and the proprietors will, in all likelihood, retain value on a personal level to invest in their own transition.

One step later than that and the ‘control’ shifts, but again, if the whole process is carefully managed and investment is made by the engaging parties (the restructuring and accountancy professions) in understanding the market, the majority, if not quite all, of the factors associated with carnage will be mitigated.

There are a small number that have already handled multiple solicitor appointments and gained valuable experience. The banks are playing their part in directing firms to appropriate advisers, but firms themselves can play their own part by properly researching their choice of adviser if concerned about broaching the subject with their bank.

The SRA challenge
The final and most significant factor lies with the SRA, and to some extent the Law Society. This is possibly the most challenging aspect of carnage mitigation. It is all too easy to say that firms or solicitors should take advice early; the reality for small practices and, in particular, sole practitioners, is that the environment created in 2000 that allowed so many to prosper, has been pulled out from under them 13 years later.

It is seriously difficult to deal with that on a personal level and accept the change. Those that do and proactively look to deal with the situation they find themselves in are not, as stated above, where the carnage is going to come from.

It is also fair to say that when engaged, the SRA will make every effort to accommodate the best possible outcome and avoid the need to intervene whenever the existing framework allows. To ensure the carnage is reduced as much as possible though, there needs to be more effort to accommodate solutions that place the clients centre stage, regardless of the existing framework.

To achieve this, further consultation with the accountancy and restructuring professions is necessary to create best practice, which allows the SRA to initiate the transfer in a controlled and managed manner that minimises waste and inefficiency on.

That said, on the basis that prevention is better than cure, the SRA and the Law Society are best placed to minimise the numbers of firms that leave it so late that intervention within the existing framework is the only option left. Getting those who have no appetite to engage to do just that is an unenviable task, however.

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