Official secrets

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17 June 2013

Posted by Allison Wooddisse, head of practice compliance at Legal Futures Associate LexisNexis

Do you truly understand your financial position?

Your COFA should live, sleep, eat and breathe financial management. This isn’t optional; rule 1 of the Accounts Rules demands compliance with the SRA principles and Code of Conduct in relation to effective financial management of the firm.

So what is effective financial management? Outcomes-focused regulation usually means you have to guess what the SRA expects; however, in a rare moment of clarity, the SRA has explained exactly what good and bad financial management looks like.

The basic stuff

Before we look at best practice, let’s first consider the basic regulatory requirements.

You have to run your business in accordance with proper financial management principles (principle 8). You’re also required to actively monitor financial stability and viability (Code of Conduct). This includes:

  • Maintaining systems and controls for monitoring:
    • risks to money and assets entrusted to you by clients and others; and
    • the financial stability of your firm.
  • Having processes for:
    • controlling budgets, expenditure and cash flow; and
    • identifying and monitoring financial risks including credit risks and exposure.

Usually, this is as much information as you’d ever expect to get from the SRA, but the financial failure of Cobbetts and other firms has served as a wake-up call.

According to the SRA, a significant number of firms are facing financial difficulty across the sector. This isn’t suprising; it’s a huge challenge for firms to keep their head above water in the most challenging market conditions the legal sector has faced for many decades: an entrenched recession combined with legal aid cuts, the personal injury referral fee ban, civil costs reforms, professional indemnity insurance pressures, plus new competition from within and outside the traditional legal market.

The SRA exceeded its entire 2013 budget for interventions within the first three months. Clearly, something needs to be done and, in a recent speech, SRA executive director Samantha Barrass told us what.

The bad stuff

The SRA doesn’t buy into the theory that many firms’ financial problems are solely down to the economic and political environment. How well a firm is run, its ability to spot and manage early warning signs, its financial management, approach to risk taking and willingness to engage with the SRA have a major bearing on its success or failure.

Poor practice

In the SRA’s eyes, these practices can be seen as critical indicators of financial instability:

  • Payments made to partners irrespective of cash in the bank;
  • All net profits drawn with no reserve pot retained;
  • Short-term borrowings to fund partners’ tax;
  • VAT received used as cash received, resulting in further borrowings to fund VAT due to HM Revenue & Customs;
  • Partners out of touch with office account bank balances;
  • Heavy dependence on high overdraft borrowings; and
  • Partners’ capital injection is 100% borrowed.

Poor behaviours

Combining these practices with poor behaviours can result in an especially toxic combination. The SRA gives examples of:

  • Firms continuing to take on financial commitments that they cannot afford, eg long office leases and new staff;
  • Senior managers who bury their heads in the sand, thinking they can weather the storm without having to make major changes and/or believe their financial situation will rectify itself; and
  • Failing to provide the SRA with key information.

Poor governance

‘Governance’ is one of the SRA’s favourite words, so it’s no surprise it features here. In the context of financial management, examples of poor governance include:

  • The over-dominant senior partner or small inner circle of senior managers (where few people in the firm feeling able to appropriately challenge);
  • Most of the partners being simply unaware of the true situation of their firm; and
  • Failing to stress test profitability and/or share key financial information with rank and file partners.

The good stuff

The SRA has taken the somewhat unusual step of telling firms what they should be doing, rather than just focusing on what they shouldn’t do.

Good corporate governance is at the top of the list. This means senior individuals collectively have:

  • A clear understanding of the risks the firm faces and is prepared to take; and
  • The appropriate oversight and controls they need to manage that risk effectively across the firm.

Good governance will not remove all financial risk, but the SRA wants to be assured firms are well run, recognise the risks they face and implement appropriate strategies, systems and controls.

From governance, we move onto general good practice and examples given by the SRA include:

  • Sending bank statement details to every partner at the start of every day – ensuring financial matters are always at the forefront of their minds;
  • Not paying out partner drawings unless partners achieve tight key performance indicators on lock-up and cash collection;
  • Ensuring all partners regularly receiving full financial information including:
    • Office account bank balances;
    • Profitability levels tested and unprofitable work shed (we presume this refers to write-offs); and
    • Premises costs contained.
  • Where appropriate:
    • Renegotiating the terms of the firm’s leases, relinquishing unnecessary space and reducing rental obligations; and
    • Reducing partner drawings – not just in line with reducing profitability, but also to build up cash reserves.

Not all of these measure may be appropriate for your firm, but they give the heads up on the type of behaviour the SRA is likely to view favourably.

The stuff that gives you away

As well as telling you how to behave, the SRA gives three key indicators, where warning signs should really start to be ringing:

  • Drawings exceed profits;
  • Borrowings exceed net assets, ie the firm is borrowing more than it is worth; and
  • The firm is simply borrowing too much

The SRA has RAG rated (red-amber-green) the top 600 firms for financial stability risks and the intensity of SRA supervision will depend on how the firm is rated:

  • Firms showing no evidence of any of these warning signs are rated green;
  • Firms with one warning sign are given an amber rating;
  • Firms with two or more warning signs are rated as red – these are high-impact firms in serious financial difficulties, with the potential to collapse.

You cannot assume you will escape SRA scrutiny if you’re not a top-600 firm. There is a positive duty on you to notify the SRA promptly:

  • of serious financial difficulty;
  • of any indicators of serious financial difficulty – as well as the indicators above, the SRA code gives the following examples: breach of bank covenants or inability to pay your professional indemnity insurance premium, rent or salaries;
  • when you become aware your business may not be financially viable to continue trading as a going concern, eg because of difficult trading conditions, poor cash flow, increasing overheads or loss of key staff or sources of revenue; or
  • of any serious issues identified as a result of your financial monitoring

The right stuff

At the end of the day, no-one can tell you how to manage the finances of your business and what works for one firm could be completely unsuitable for another. There are, however, some key pointers you can take from the recent SRA guidance and you should ignore it at your peril. Why not take our quick test to see how you measure up against the SRA’s expectations?

Financial management test

Tick all that apply to your firm

  1. You do NOT make payments to partners irrespective of cash in the bank.
  2. You reserve some of your net profits each year (ie you do NOT draw all net profits).
  3. You are building up your cash reserves.
  4. You do NOT use short-term borrowings to fund partners’ tax.
  5. You do NOT use VAT received as cash received.
  6. Your partners have a good grasp of office account bank balances, eg they receive copy bank statements on a regular basis.
  7. You do NOT depend heavily on high overdraft borrowings.
  8. Your partners’ capital injection is NOT 100% borrowed.
  9. You do NOT take on financial commitments you can’t afford, eg long office leases, new staff.
  10. You deal promptly with requests for information from regulators (including the SRA’s annual information report).
  11. You have a balanced senior management team who feel able to challenge the firm’s decisions and actions.
  12. Your senior managers do NOT bury their heads in the sand about the financial status of the firm.
  13. Your senior management team collectively have: a clear understanding of the risks the firm faces and is prepared to take; and the appropriate oversight and controls needed to manage risk effectively across the firm.
  14. All partners/senior managers are aware of the true financial position of your firm.
  15. You share key financial information with rank and file partners/senior managers on a regular basis.
  16. You regularly stress test profitability.
  17. Partner drawings are dependent on the partner achieving key performance indicators, which include tight financial indicators.
  18. You have reviewed and, if appropriate, reduced overheads.
  19. Your net assets exceed borrowing.
  20. You do not borrow more than you can afford.

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