Desperate solicitors are pillaging their VAT receipts, inner circles of managers are sitting on bad financial results, and firms are borrowing heavily to maintain drawings, according to a bleak risk assessment by the Solicitors Regulation Authority (SRA).
Financial instability will be made worse by a “market correction” following recent high-profile law firm collapses, including lenders being increasingly unwilling to maintain agreed borrowing facilities, the authority predicted.
In the most alarming analysis yet of the financial stability of the profession, senior SRA officials delivered a report to the monthly board meeting in London that suggested there would be a rising number of regulatory interventions in the coming year – in part due to competition from new entrants to the legal market. The report came just two days after the collapse of 12-partner midlands firm Blakemores, with the loss of 250 jobs.
Relationship manager Samantha Palmer told the board that poor financial practice was taking place in firms “across the piece”, including those currently evaluated by the authority as at low risk of instability.
She said reasons firms were unstable included “triple dip” recession and the “flatlining of turnover, combined with decreasing levels of profitability”. Instability exists in all law firm sectors, she added, but highlighted the weak conveyancing market and competition from new entrants in probate.
One blow some firms are experiencing is “really high premises commitments” that they entered into at the top of the market. The benefit of initial arrangements such as leaseback had expired, exacerbating firms’ financial woes.
Ms Palmer said the SRA has detected an increasing incidence of “poor behaviours”, that include: drawings exceeding net profits and growing indebtedness to continue drawings levels; firms controlled by an “inner circle” of senior managers who do not share financial information with “rank and file” partners; VAT receipts used as ‘cash received’, leading to further borrowing to fund VAT due to HMRC; and heavy reliance on high overdrafts.
However, while these behaviours made firms more vulnerable to SRA interventions – nine of which took place in January and February alone, when 30 were anticipated across the whole of 2013 – there was also a “direct correlation between firms that exhibit good behaviours” and those which maintained a “secure financial footing” despite the difficult market, she said.
Following cases such as the ‘pre-pack’ takeover of Cobbetts by DWF, a “market correction” would see lenders reduce their exposure in the legal sector, she warned. Overdrafts and other agreed borrowing would come under pressure and lenders may be unwilling to fund partners’ tax liabilities in the July “spike” in demand for funds. Working capital loans may become unattainable.
Also at the board meeting, executive member Richard Collins highlighted the SRA’s concern that it had already spent 10% of its annual budget on interventions. So far its has spent some £2.2m, of which £1m and £800,000 respectively was spent last month on Yorkshire firm Atteys, and this month on Blakemores.
It had originally forecast it would spend £1.3m on interventions in the whole of 2013. If the SRA had intervened in Cobbetts – which it did not need to because of the pre-pack sale – the cost would have been around £6m.
There have been no suggestions of impropriety at Blakemores, Cobbetts or Atteys.
Mr Collins said the SRA would consult with the Law Society over using the Compensation Fund to meet the costs of intervention, which he said was more suitable to cover “one-off peaks” in spending than the “internal administration budget”. Intervention powers were originally devised to protect the fund and the Legal Services Act 2007 provided that it could pay for the cost.
He said the SRA would consider seeking powers that were short of last-resort intervention to direct law firm managers, and possibly which would also require firms to set up a ring-fenced fund to pay wind down and file storage costs – although he acknowledged that doing so would further weaken firms’ financial position.
Executive director Samantha Barrass stressed the importance of firms having contingency plans. She said the SRA’s strategic approach included issuing “an early wake-up call” to firms identified at risk, involving placing conditions on them to seek consultancy advice. “Sooner rather than later the firms… are properly getting to grips with the situation and aren’t letting it drag out to the bitter end,” she said.