The Solicitors Regulation Authority (SRA) has outlined the three key financial ‘warning signs’ against which it will assess firms’ financial stability as a key element of its supervisory work over the next year.

It also announced that in an effort to “focus on the issues that really matter”, law firm compliance officers will soon no longer have to make an annual report of non-material rule breaches – but they will still have to collect the information.

Speaking at the Law Society’s risk and compliance conference on Friday, SRA executive director Samantha Barrass explained “the real and present danger” to firms of all sizes of financial failure.

She said the SRA’s role was not to stop firms failing but to help “put things back on a sound footing and thus perhaps improve their attractiveness to buyers or to ensure an orderly wind-down”.

The key indicators, which will form the basis of the SRA’s risk assessment, are: drawings exceeding profits (“It may sound obvious… but we see this all too often”); borrowing exceeding net assets; and borrowing over a certain level – “quite simply, are you borrowing too much?”

Firms showing two or three of these will be given a red rating, those with one amber and those with none green.

Ms Barrass said: “Red-rated firms are therefore identified as high-impact firms in serious financial difficulties, with the potential to collapse. These firms will receive intensive supervision. Such firms will be required to prepare detailed contingency plans and obtain professional insolvency advice.

“These firms will also be required to regularly provide detailed financial information and will be subject to regulatory action if they fail to change poor behaviours.”

Amber firms are defined as those with financial difficulties which “may, with appropriate financial management, be overcome so that the firm is able to continue trading in its own right.

“Such firms will have regular financial assurance engagement visits, on a monthly basis, and be required to provide monthly detailed financial information. These firms will be subject to close monitoring and review so we can ascertain whether their overall financial position is improving or whether they need to be moved into intensive level supervision.

“For those low-impact firms, the green firms, where we are not aware of financial issues, firms will receive minimal supervision.”

Ms Barrass said the SRA recognised that the requirement to record and report non-material breaches has not been popular with firms, “many of whom have told us that this is a burden that is simply not proportionate to risks”.

She said the main issue has always been about identifying patterns of non-material breaches, “that combined may amount to a material breach because of the systemic underlying issues”.

As a result, the SRA will look is to remove the requirement for firms to report non-material breaches, but they will still need to record such breaches so patterns can be identified. “We believe that patterns of non-material breaches are in themselves material, and will need to be However, Ms Barrass cautioned that the SRA may still require firms to provide details of non-material breaches and that if they cannot do this, “it will be seen as a key indicator that firms are failing to manage their risks effectively”.

The change will be consulted on in the next stage of the SRA’s red-tape initiative, and it is likely to come into force in October.

Alternative business structures (ABSs) will still have to report all non-material breaches annually because the Legal Services Act 2007 requires the SRA to collect this information. “Consistent regulation of all kinds of firms we regulate is extremely important, and this is something we will be progressing with the Ministry of Justice. But requiring this information from 10,000 firms simply because the Legal Services Act requires us to impose the requirements on 100 or so ABSs is unsustainable, and we think unjustifiable.

“We do not think the requirement is proportionate to the risks and we believe that, in this instance, the unnecessarily precise requirements of the Legal Services Act is acting as a barrier to proportionate and risk-based regulation.”

Tags: ABS, Alternative business structures, Solicitors Regulation Authority