The Solicitors Regulation Authority (SRA) is contemplating whether to contact thousands more law firms about their financial position after this summer’s exercise involving 2,000 practices “confirmed our view that financial difficulty is a widespread current risk”.
The regulator revealed this week that 5% of the initial sample showed a “very high risk of being in financial difficulty”.
Half were found to be a low risk, with the remaining firms falling on a spectrum between the two.
Firms with a low-risk rating are being sent an e-mail reminding them of their self-reporting obligations, while those with a medium rating will be required to re-submit their information for analysis at a “to-be-decided point in the future”. High-risk firms are being contacted by phone or receiving a face-to-face visit.
“We are now considering our next steps in terms of collecting data from a wider selection of firms,” the SRA said. “This may be necessary because the data collection exercise has confirmed our view that financial difficulty is a widespread current risk.”
The SRA’s latest report on financial stability said its engagement with firms found poor financial management that ranged from “naïve to reckless”, such as over-reliance on borrowing, partners drawing more than the firm’s profits and over-commitment to high fixed costs, such as premises and vehicles.
“We have also seen poor practice in the management of client accounts. For example, some firms have held large amounts of client money in their office account by receiving payments containing both office and client money,” it said. Better practice is to pay it first into client account, the SRA advised.
Looking at poor business management, the regulator highlighted failures to bill and collect revenue for completed work, and over-reliance on a single type of legal work. Whilst genuine specialism in a particular area of work is a “significant business advantage”, it said, many firms have a very narrow focus without a unique selling point for their services.
“This has made these firms vulnerable to changes in demand from clients or to competition from other firms,” the SRA explained.
While diversification can be part of the solution, “we have seen situations where financial difficulty has been worsened by firms entering new legal markets without a clear business plan or the necessary skills to make this a success. Similar lessons can be learnt from the experience of firms that have acquired other firms to gain market share or diversify their services”.
The other main characteristics of financially failing firms were poor leadership and a failure to work constructively with the SRA, it said.
- The firms’ risk rating was calculated through a three-stage process. First they were asked to provide basic financial information, including their profit and loss, total drawings, borrowings and overdraft facilities. This was then inserted into pre-defined financial formulas and analysed using a combination of “academic and qualitative insights”. This analysis provided an assessment of the likelihood that the firm was experiencing financial difficulty.
Finally this was combined with the existing ‘impact’ scores for the firms concerned – ie, the potential impact their failure would have on the regulatory objectives – to reach the risk rating.