Challenges Facing Law Firms

11th November 2013

For as long as most of us can remember, law firms did not hit the insolvency headlines other than perhaps for acting for Administrators or Receivers on high profile cases.  However, as with many sectors, in the last 5 years the world has changed, such that the insolvency of a high profile law firm doesn’t now even make the headlines.

Halliwells,Challinors Cobbetts, Manches and Harris Cartier are but a few of the recent casualties and the general concern is that other well known brands will follow.  A recent survey by our trade body R3 estimated that 31% of all law firms (2,556 practices) are at risk of failure, with the situation worse in London.  In this article we look at the combination of factors which have contributed to this worrying state of affairs.

Changes in availability of funding

Banks traditionally have been very willing to lend to law firms, often on an unsecured basis, in order to attract substantial deposit balances and spin off customers from the firms clients.  In addition there were historically no larger firm failures and the lending was considered to be  low risk.  The parameters have changed and law practices are now assessed on the same basis as every other business, focussing on profitability, serviceability and security.

Alternative Business Structures (“ABS’s”)

The Co-op, SAGA and the AA are the first major consumer brands to announce that they will start offering legal services following the approval of ABS licences by the Solicitors Regulation Authority (“SRA”).  The AA, a breakdown, recovery and insurance specialist, has entered into a joint venture agreement with law firm Lyon Davidson to create AA Law.  New substantial entrants into a market already suffering from oversupply will inevitably result in fallout.

Market changes

Significant changes to the legal aid system in England and Wales came into effect on 1 April 2013, as part of a plan to reform the system and save £350 million a year.  Also effective from April 2013 is the banning of referral fees in relation to personal injury claims, as well as changes in the recoverability of conditional fee arrangement (“CFA”) fees.  These changes will have substantial short and medium term impact upon many specialist practices.

PI Insurance

The insolvencies of PI insurers Balva Lemma and Quinn between June 2012 and January 2013 left over 2,000 firms seeking alternative PI insurance.  This is compounded by the 1 October 2013 deadline for law firms to renew insurance in a very wary market.  Insurers are required by the SRA to provide 6 years run off cover to law firms, irrespective of whether the firm is able to pay the premium.  Typically this is 3-3.5 times the annual premium.

The consequences of this are that on 1 October the SRA were notified by 263 firms that they had been unable to obtain PI insurance.  Firms have until 31 October to obtain cover failing which they must not take on further clients and take action to close the business by 31 December.  As at 31 October 2013 there were still 175 law firms without PI cover who are now either frantically seeking cover at any cost or taking steps to cease to trade.

Whilst commentators were predicting significantly higher numbers, there is the hidden issue of significantly higher premiums (some up to 40% increases) which may not be sustainable.

Outdated operating structures

The ratio of fee earners to support staff will vary significantly, a major factor being the type of work undertaken by the practice.  Company commercial work tends to require very low levels of support staff, compared to the higher levels required for residential conveyancing and personal wills trusts and probate.  However many practices have support level ratios of between 2 and 3 to every fee earner and it is often senior partners reluctance to engage charge which prevent inefficiencies being eradicated.

Restrictions on restructuring

There are certain barriers unique to the legal profession which prevent traditional insolvency restructuring, such as;

i)  An acquiring firm runs the risk of being deemed to be a “successor practice” and as such will inherit any legacy claims against the firm being acquired.  This can be so prohibitive as to render the practice unsalable;

ii) Law firms cannot be traded in Administration by an Administrator who is not a qualified solicitor; and

iii)Client confidentiality in relation to client files is prohibitive to extensive due diligence by a potential purchaser.

The Future

The top 10 largest UK law firms reported average profit per partner of £1 million, up 6.1% on 2012.  There is an increasing gap of the so called top tier and mid tier firms – average profit per partner within the top 11-25 fell to £448,000 from £481,000, despite fee income rising by almost 9.7% as smaller firms rushed to consolidate.  The gap between the best and worst performing firms is widening further and the clear message is that unless these firms can radically restructure their businesses, the trend of law firm failures is likely to continue.