Banks will look more closely at law firms, post-downturn

RECENT trading results published by a number of the large law firms might suggest they have weathered the economic turmoil pretty well. However, much of this robust performance has been achieved through cost-cutting. This is likely to worry banks and other potential backers of law firms.

Difficult trading conditions have put financial management under the spotlight in the legal sector – fee rates are under pressure and cash collection is a higher priority than ever before. The high-profile collapse of Halliwells and accountant Vantis have heightened worries for lawyers and bankers. Such scrutiny comes at a time when we are also witnessing significant change in the legal marketplace: mid-sized firms are subject to increasing competition and the challenge of true differentiation; the problems of the high street firm are well documented, not least with the annual renewal of professional indemnity insurance; and we are less than a year away from the “big bang“ of the Legal Services Act, when new investors will be able to enter the sector and make a play for an all commoditised legal service.

It is no surprise that rumours continue to circulate about the number of law firms in financial difficulty and the level of scrutiny they are being placed under by their banks, with talk of some being in “intensive care”. This leads to the big question for many in the legal sector – will banks become more reluctant to lend to law firms?

Traditionally, individual partners were jointly and severally liable for the firm’s borrowing (and all other liabilities) and banks had recourse to the personal assets of those individuals, with the result that law firms enjoyed favourable banking terms. But that was before the advent of the limited liability partnership (LLP). Many firms converted to LLP status at a time when trading conditions were benign and banks did not typically require security from the business or guarantees from the partners.

Market conditions are no longer so favourable and, like most other businesses, many law firms have experienced an increase in the cost of borrowing and the introduction of arrangement fees. For some smaller practices the concern will be whether unsecured credit will continue to be available, as banks look to require personal guarantees from individuals where the firm has incorporated as an LLP or a company, or seek security over the firm’s assets. At the same time, banks are looking for firms to provide more regular financial information on their performance and projections and more protection by way of financial covenants in their facility arrangements. Lenders may have expected that firms will address any hard core debt and at the same time bring overheads under much tighter control.

Some firms have a little respite in the form of an increasing number of alternative sources of short-term funding for specific areas such as professional indemnity insurance, tax and VAT. But the consequences of a tougher attitude from the banks include the possibility that individuals may be more reluctant to become partners or join firms where there is any personal liability for borrowing. It is likely that all individual partners, and prospective partners, will become more concerned that they have access to regular financial information from the firm’s management team.

The legal sector – and particularly well managed and profitable firms – is still attractive to lenders, but it faces challenges. Having seen a major firm collapse owing a significant amount to its bankers, if banks are to be persuaded not to impose far tougher regimes on law firms, management teams will have to give greater priority to internal financial discipline than ever before.

Fergus Payne is partner and joint head of the partnerships and LLPs group at Lewis Silkin LLP