From bad debts to bad mergers – SRA study pinpoints key features of firms in financial difficulty

Failed: some partners refuse to see the problems in front of them until it’s too late

A failure to pay debts – and the increasing willingness of creditors to pursue solicitors for their money – is the most common feature of law firms in financial difficulty, Solicitors Regulation Authority (SRA) research has found.

It also highlighted the dangers of firms undertaking mergers and acquisitions without sufficient due diligence, and of a growing trend of firms agreeing loans from clients out of money in client account.

The study looked at 76 firms that had suffered financial difficulty, and the SRA said it “uncovered a clear correlation between financial instability and the misuse of client monies”, which was found in more than a quarter of those firms studied.

Failing to pay debts was a feature of 82% of the firms, however, and the SRA said that sustaining high levels of debt from borrowing is becoming more difficult, despite low interest rates. “We have observed a shift in the chasing of debt, with companies and organisations pursuing solicitor firms more vigorously for ever-decreasing sums of money,” it said.

The adverse economic circumstances was a feature of half of the firms, manifesting in reductions in particular markets, reliance on a single work category or single funding source, and diversification into unfamiliar markets.

Poor financial and business management was seen in 39% of cases, such as autocratic management and failing to control cash flow associated with work in progress.

The study added: “There were also several examples of senior managers and partners who were in denial as to the severity of the firm’ s financial position, either because they appeared unable to recognise the situation or because they carried on regardless in the hope that a resolution would be found. This often led to partners continuing to draw money whilst the firm was in significant debt.

“Although excessive partner drawings were identified as a key issue in the file review, there were also incidences highlighted of managing partners being unable or unwilling to draw a salary from their firm due a lack of available funds. This demonstrates a responsible approach, but one that is clearly unsustainable for those involved.”

Though well-managed mergers and acquisitions could help firms diversify and expand, the SRA found examples where they had been taken without proper due diligence. This was a particular issue amongst some of the larger firms studied.

In one case, a firm had borrowed significant amounts to pay for several acquisitions. The study recounted: “However, this rapid, debt-based expansion left the firm vulnerable to changes in some of its key markets – conveyancing and legal aid. The firm was not able to adjust to these changes in market conditions.

“In another example, a merger took place to allow a firm to diversify into a new area of legal services. In doing so, the firm inherited a significant amount of debt, which it had not planned properly for dealing with.”

A quarter of cases saw the misuse and misappropriation of client funds – aside from the obvious plundering of client account, “a recently identified practice has been the creation of loan agreements between partners and clients”, the SRA said.

“In these instances, partners may ‘take advantage’ of a strong relationship with clients, usually those holding the most money in the account. The solicitor will make a written request to the client to use their monies for other costs and, in some cases, will draw up a more formal written agreement. This practice can lead to conflicts of interest and has also led to instances where the client has needed to access their funds and they have not been available.”

Other features highlighted included key partners leaving the practice – mostly innocently but in some cases to escape the mess they created – failing to obtain professional indemnity insurance or a practising certificate, and poor service quality.

The SRA said the research showed that although firms have a responsibility under principle 8 to run their business “effectively and in accordance with proper governance and sound financial and risk management principles”, it does not follow that a practice running into financial difficulty is because it has failed to uphold this.

Mike Haley, SRA director of supervision, said: “Tough economic times can sometimes lead ethical and upstanding solicitors to stray from the straight and narrow. They think that because they are breaking the rules for the best of intentions – to keep the firm afloat – that this is somehow acceptable. That is simply not the case.

“It is not our job to tell solicitors how to run their firms, but we do need to be kept informed if there are financial difficulties so we can make sure client interests are not put at risk. Our concern is to ensure that when a firm is in financial difficulty that client monies are not misused, and to oversee the orderly transfer or closure of a firm in a way that means client matters are dealt with properly.

“We’d urge all firms to seek a regular financial health check and get financial advice as soon as they believe they are in trouble.”

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