Many criminal law firms will have to merge, or enter into joint ventures, or form alternative business structures (ABS), to survive, after the government announced yesterday that it would push ahead with legal aid reforms that are predicated on market consolidation.
However, a report by KPMG, commissioned by the Ministry of Justice (MoJ), raised a raft of concerns about consolidation on the scale envisaged as being necessary once solicitors’ fees are slashed by 17.5% by 2015, including a cut of 8.75% for cases starting on or after 20 March 2014.
Regulatory approval for new structures, conflicts of interest, and sourcing investment funds were among the concerns.
A separate report by Andrew Otterburn and Vicky Ling, commissioned by the MoJ and the Law Society and also published yesterday, found the appetite among criminal firms for merger to be low and concluded that implementing cuts before consolidation had been give a chance to occur threatened to weaken the profitability of firms that were already financially fragile.
The government’s decision to implement its headline legal aid reforms, despite several concessions, is likely to reawaken the controversy that led to a narrow vote of no confidence  at a special general meeting called to consider the Law Society’s ‘constructive engagement’ approach to resisting funding cuts.
The number of duty solicitor contracts will be set at 525, the top end of the range suggested by Otterburn and KPMG, as against the current 1,600.
Stimulating a dash for market consolidation has been a bedrock of the government’s position, on the assumption it will deliver economies of scale and new efficiencies that will mitigate the effects of swingeing fee reductions. One of the government’s concessions involves a support package that Mr Grayling said “offers government guarantees to commercial funding for law firms that seek to scale up”.
In addition to allowing ABSs to enter the criminal legal aid procurement process, the government has encouraged consortiums in which a “lead contractor… will hold the contract and be responsible for delivery of all services under the contract” together with up to three law firm “delivery partners”. In urban areas such arrangements will be limited to two partners. The MoJ said: “This, we believe, would mitigate the pace and scale of the change while facilitating the longer term efficiencies offered by competition.”
The Otterburn and KPMG reports put the median net margin of crime fee income at 5%. KPMG observed some room for efficiencies around staff costs but said: “The potential for significant efficiencies within overheads appears limited. The main overhead appears to be property costs associated with offices. As some firms are locked into lease contracts, it may be difficult to achieve savings in the short term.”
The Otterburn report found firms thought they would need at least nine months to develop mergers or consortium arrangements, whereas the government’s plans envisaged a rapid expansion of some firms to compensate for a reduction in the overall number of suppliers. Even larger firms with experience of acquisition or rapid expansion would find it hard to cope with the size of firm required to achieve a viable contract consisting of duty and own client work, Otterburn concluded.
KPMG said the level of consolidation that could be achieved through acquisitions, mergers, joint ventures or ABSs would face various hurdles, including how the Solicitors Regulation Authority (SRA) “will seek to regulate and approve these organisations”, which it said was “unclear”. It raised the spectre that individuals might be unwilling to act as compliance officers for “such disaggregated entities”.
Other issues that firms linking together would face included “the extent of conflicts of interest that arise as a result of combining client bases into one firm”. Also, investment costs would be incurred by structural changes within firms. KPMG declined to estimate what the scale of the costs might be, but pointed out that Otterburn’s analysis “demonstrates that providers have limited reserves to fund these costs”.
A cultural preference for independence among criminal firms and a lack of management capability were other possible barriers to consolidation, KPMG said. It also speculated that by the time the MoJ announced its third generation procurement, in about eight years’ time, the market might no longer have enough providers to produce “competitive tension”.
Still looking ahead, KPMG warned that trainee solicitors could be discouraged from specialising in criminal law. Although in the short term this might deal with any overcapacity in the market, “in the longer term this has the potential to jeopardise the future strength of the profession”.
Asked about its strategy for regulating joint ventures, an SRA spokesman said: “We will be studying the [MoJ’s] proposals carefully and will consider how best we can facilitate a competitive market that gives consumers of legal services and the public appropriate protection and confidence. This includes the authorisation of joint venture firms, the details of which we had not seen until the proposals were released today.”
Bill Waddington, chairman of the Criminal Law Solicitors Association, told Legal Futures the initial 8.75% fee cut was the “death knell for a number of firms… that have held on to see what was going to happen and are financially on the brink.”
He continued: “You cannot force consolidation in this particular way, against the clock. Any firm will tell you if they have decided to merge over the last few years or take over another firm… from the day they start the talks to the day they actually complete the deal will never be much less than about 12 months.”
He said the outlook was “extremely bleak”, adding: “It’s so disappointing after such a long, hard-fought campaign – meetings, consultations, masses of responses, masses of positive ideas being put forward for savings that can be made… And why?
“What is the urgency for consolidation? Consolidation does not bring about a cheaper service; the cheaper service is being imposed upon you with the cut, so what is consolidation actually doing apart from putting a lot of firms out of business?”