Insolvency in the legal sector can be caused by a number of factors that pose unique problems for the firm’s partners and the insolvency practitioners.

No industry is fully protected from the pushes and pulls of economic movement, but while some sectors consistently feature at the top of the breakdown of insolvencies by industry, such as construction and manufacturing, others seem to live a more sheltered life.

The legal sector is protected from downturns in economic conditions to a certain degree thanks to the scarcity of the skills and knowledge in question. But, like any other business, all it takes is the loss of a major client, a law suit, or a missed payment for it all to ‘come tumbling down’.

When things do go wrong in the legal sector and firms become insolvent, there are complexities specific to this industry that can make the process particularly problematic for insolvency practitioners and the partners of the firm involved.

In this article, we’re going to look at some of the challenges associated with the insolvency of a limited liability partnership (LLP) law firm. We’ll also look more closely at the potential causes of financial difficulties in the legal sector and the implications of regulation by the Solicitors Regulation Authority (SRA).

Common causes of insolvency in the legal sector

The factors that lead to financial instability in the legal sector are much the same as you would expect to see elsewhere. Increased competition, lack of demand, missed and late payments, and the insolvency of clients all feature prominently. This is in addition to:

• Overdrawing by partners who do not understand the difference between profit and cash in the bank. Partners will often maintain the same levels of drawings despite cash-flow pressures;
• High levels of tier 2 and tier 3 lending to fund expenses such as rent and VAT payments;
• A lack of proper cash-flow planning.
• Increasing cost of Professional Indemnity insurance.

These issues could similarly be cited as the causes of financial stability in any number of professional services firms. However, there are also a number of other contributory factors that are specific to this sector. That includes capital adequacy requirements, professional indemnity insurance and the presence of a major stakeholder in the form of the SRA.

Capital adequacy requirements

One driver of insolvency unique to law firms is the high level of capital adequacy requirements. Capital adequacy is the amount of cash a law firm needs to keep in reserve to ensure it can meet its financial commitments at any given moment, but also to survive and thrive in the future.

Fixed rules have not been imposed by the SRA in England and Wales, so the onus is on law firms to implement a self-regulatory regime of the highest standards. The financial failure of a law firm presents the greatest risk to its clients, so it’s essential steps are taken to protect them by putting sufficient levels of capital in place. However, this can put a significant strain on a law firm’s cash-flow, and potentially lead to failure further down the line.

We have had calls from many professionals agonising about their future trying to decide ‘is it all worth it?’ Should they simply merge with another practice; sell out the practice and become an employee? Of course there is no simple answer and there is a lot of pride and professional standing to be lost by the wrong decision.

Professional indemnity insurance

Firms operating in the legal sector must also provide the right level of protection to their customers in the form of professional indemnity insurance. This is a significant additional expense that drives up the costs of the legal firm, and therefore the prices for customers.

There is no doubt in my mind this has been a major contributing factor in pushing otherwise solid professional business models to the financial limit. However with conveyancing for example in some areas using a good old fashioned lawyer for selling your home has almost been wiped out.

For small firms, this additional burden can push prices to such a level that they are unable to compete with larger firms with more proportionate professional indemnity costs. The result is that an increasing number of legal firms, particularly conveyancing lawyers, are being put at risk.

Online Competition

The move online for the likes of Rightmove and Zoopla amongst others in finding a house to buy is worryingly more and more eyeing up conveyancing. To be fair to Zoopla and Rightmove providing information about conveyancing is a logical next step. Even providing leads to conveyancing lawyers will eat into already squeezed margins.

Conveyancing is not the only where margins are getting squeezed. Barristers and lawyer networks may generate leads but can also reduce profit margins. Unfortunately the mentality of the online buyer means the buyer usually wants something for nothing or at very little cost.

Specialisation may provide an answer, but for those who have no specialism to fall back on, time may be running out.

The impact of SRA regulation

The SRA has statutory powers to intervene in insolvency matters. Client and office accounts can be frozen, offices can be closed, employees can be dismissed and the clients’ files can be retrieved. The SRA will then seek to recover the cost of making the intervention from the firm’s partners personally. And as you’d probably expect, these amounts can be frightening.

Although it has yet to be tested in the courts, the SRA maintains that its statutory charge should be settled ahead of a bank’s security and before the insolvency practitioners are paid. This also puts the costs of administering the insolvency process in question and leaves the firm’s creditors with little chance of seeing any meaningful return.

The insolvency practitioner appointed to administer the process must also maintain close contact with the SRA throughout. Unlike insolvencies in other sectors, the insolvency practitioner has to appoint a ‘solicitor manager’ who will report to the SRA on the progress of the administration or liquidation. The insolvency practitioner must also present a Regulatory Framework Agreement for SRA approval, the purpose of which is to ensure clients’ interests are being protected.

There’s no doubt that insolvencies will continue in the legal sector. As well as seemingly ever-present economic uncertainty, partners also have to deal with the high costs associated with professional indemnity insurance and capital adequacy requirements. There’s also a powerful regulator that can step in to protect clients from a struggling firm. Thankfully however, despite the worry over future failures, the current outlook in the industry is generally considered to be bright.

Written by: Mike Smith, Senior Consultant, Company Debt www.companydebt.com

Mike Smith is Senior Consultant and Managing Director of Company Debt (www.companydebt.com) and has been advising small, medium and large companies for over 37 years. Company Debt is a leading Turnaround and Insolvency Consultancy firm. Mike has acted as trouble shooter for the board of Sun Alliance, Business Development Director for Legal & General and Head of Develoment for Laser UK (BNP Pariba).