Out-Law / Your Daily Need-To-Know

Why professional services firms are failing, and what administrators need to know

Out-Law Analysis | 18 Sep 2017 | 10:58 am | 8 min. read

ANALYSIS: Why are large professional practices entering into insolvency and what do restructuring advisors and lenders need to look out for when they are dealing with a professional practice in financial difficulty?

In January King & Wood Mallesons, formerly SJ Berwin, become the largest UK law firm to be placed into administration. The firm had 163 partners, over 900 staff and a turnover in 2016 of £177 million.

In May this year Cluttons LLP, a firm of chartered surveyors and property consultants established back in 1765, was also placed into administration. The firm had a strong presence in the UK and the Middle East, with approximately 450 employees and 36 partners.

The legal profession in the UK is currently going through a period of unprecedented change due to:

•           market consolidation;

•           the impact of technology;

•           competition from accountancy firms with legal arms;

•           relatively poor cash flow management when compared to other businesses;

•           legislative change for personal injury and legal aid firms; and

•           often outdated business models that are built on expensive offices and large numbers of fee-earners and support staff.

For chartered surveyors, property consultants and architects, the UK property market is already starting to show signs of a significant slowing down of activity and stamp duty rises have hit the higher end of the London property market.

Professional practices are essentially highly regulated people businesses and there are a number of common areas that restructuring professionals and lenders will need to be familiar with when dealing with professional practices in financial difficulty.

It seems inevitable that many professional practices large or small will find this year to be even more challenging than ever before and as result there will be opportunities for the restructuring community to help unlock value and protect client interest. Dealing with such situations can often be demanding, however an understanding of the common themes that will often occur can help achieve a more positive outcome for all stakeholders.

Structure and governance

Ascertaining the structure is very important as it will impact any restructuring.

Many professional practices are now limited liability partnerships; only a few are still traditional partnerships. A traditional partnership structure will help ensure that the partners stick together during financial difficulty because of the personal liability that will attach to partners if the practice fails. With a traditional partnership the status of the partners and whether they are equity, fixed or salaried partners may give rise to complicated questions in relation to whether partners are true partners and whether they have been held out as partners and whether creditors have placed reliance on such holding out.

Having an LLP structure can often make it difficult to ensure that partners stay during a period of financial difficulty as the partners will not be personally liable for the firm’s debts. It is more difficult to drive the collegiate behaviour that may be essential for any restructure if there is an LLP structure in place and not a traditional partnership.

The most important document for any restructuring advisor to understand early on is the members agreement. The provisions to look out for will include the period of notice partners will need to give before leaving the practice. The existence and strength of any restrictive covenants will also be important to help prevent the risk of key partner departures.

A sensibly drafted waiting room provision in the members agreement which provides that only a certain number of partners can leave in any financial year may help prevent a run on the firm where large numbers of partners look to leave at the same time. However it needs to be understood that professional practices are people businesses and if partners wish to leave it is practically difficult to force them not to.

Any restructuring advisor will need to ascertain how much capital individual partners have invested in the LLP and also understand how much of that is borrowed externally in the form of a partner capital loan. It will need to be understood whether partners’ capital is at a level that is sufficient to make it difficult for partners to leave and risk losing that capital, when weighed against other offers they may receive.

It is important to understand that when a partner leaves, the firm not only loses the income that partner generates but the firm but will have to pay back capital owed to the partner. This can be a double-whammy for firms in financial difficulty. It is vital to understand from the members agreement when capital is repayable after a partner leaves – the longer the period, the better it is from a restructuring perspective. The terms of any partner capital loan will also need to be understood particularly when such a loan needs to be repaid and whether this ties in with the repayment period under the members agreement.

A firm operating internationally is likely to made up of different legal entities in different jurisdictions because of differing local laws and regulations, and this will complicate the position. Whilst the UK business may operate as an LLP, there may be overseas partnerships where partners retain personal liability or other corporate vehicles. So overseas partners may have different liabilities and risks in an insolvency.

Overdrawn current accounts and Insolvency Act claims

An officeholder of a professional practice will need to consider whether they have claw back claims under section 214A of the 1986 Insolvency Act, known as s214A IA86 claims, for wrongful trading against former partners for money they have withdrawn from the firm. There have been no reported cases in relation to s214A IA86 and in practice the claims are difficult to bring for a significant period of drawings. The claw back period is two years but the administrator has to show that at the time of the withdrawal the partners knew or had reasonable ground for concluding that the firm was unable to pay its debts as they fell due and there was no reasonable prospect of avoiding going into insolvent liquidation. This considerably limits the amount that can be claimed.

A bigger potential claim will usually arise in relation to partners’ overdrawn current accounts. An overdrawn current account position will often arise on the administration of a professional practice as the firm, by virtue of the insolvency, will have made no profits in the last financial year of trading and therefore as drawings are only a payment on account of profits, then the absence of profit may well trigger a large overdrawn current account liability for individual partners.

Difficult questions may arise as to whether capital account balances can be set off against such claims and again the provisions of the members agreement can be crucial in helping establish whether claims can be pursued by a subsequently appointed officeholder. Often a purchaser will be keen to ensure that any partner that comes across to them following an administration sale is protected from the risk of bankruptcy and therefore the purchaser will often look to acquire any overdrawn current account claims against former partners at a considerable discount.

Terminal loss relief

On the cessation of a partnership, including an LLP, the partners may be entitled to make certain tax relief claims including:

•           terminal loss relief under section 89 of the 2007 Income Tax Act. This relief permits losses that have arisen in the final 12 months of the trade or business of the partnership to be carried back three accounting periods. This often gives rise to a significant tax refund for partners who have paid tax on prior year profits.

•           overlap relief under section 205 of the Income Tax (Trading and Other Income) Act 2005. A partner that does not have an accounting date ending on 31 March or 5 April will usually have an element of profits in the opening years which have been taxed twice. This is as a result of the HMRC rules on accounting periods. However, this double taxation is then recoverable by the partner on the cessation of the trade or business of the partnership.

Since these tax reliefs can be significant, it will be important early on to understand whether the members agreement properly provides for the allocation of losses amongst members. It will be important to ensure any terminal loss relief and overlap relief claims are fully utilised. These claims may be vital to help ensure that partners’ capital loans are discharged in full following any administration process. Lenders may also consider taking an assignment of any terminal loss relief and overlap relief claims from individual partners as the money received from such claims will go to partners directly and not via the LLP where the lender may have security.

Work in progress and debtors

The main asset of any professional practice will be the work in progress (WIP) and the debtor book. It is important to ascertain exactly what WIP is likely to lead to payments and to understand the age of debts.

It is not uncommon in law firm insolvencies for 'good' WIP and debtors to achieve a blended rate of 30p in the pound. Higher values may be achieved for firms with a stronger client base and less contingent work, though lower values will often be achieved for volume claimant personal injury firms. The question of whether files with a success fee element can be validly assigned to any purchaser will also have an impact on value. The value of WIP for law firms who carry out legal aid work can also evaporate if the legal aid agency does not consent to an assignment of the legal aid contract; which will be its standard position if monies are owed to HMRC. A thorough knowledge of the sector and the likely purchasers is vital to help achieve higher WIP and debtor realisations.

Regulation

Professional practices are highly regulated and can often hold very large amounts of client money and significant numbers of client files including deeds and wills for law firms. The Solicitors Regulation Authority (SRA) has strict codes of conduct dealing with the use of client money and client files.

The SRA has statutory powers to intervene in a legal practice either before or after an insolvency if it feels that client money and client interests are not being protected. The costs of an intervention are likely to rank ahead of a secured lender and also ahead of the costs of an officeholder. It is therefore vital to engage in dialogue with the SRA at a very early stage to ensure that an intervention in the legal practice is avoided. The appointment of a solicitor manager alongside an officeholder is important to ensure that client confidentiality and client interests are protected and an intervention is avoided.

In relation to chartered surveyors, the Royal Institute of Chartered Surveyors (RICS) protects client accounts and governs the registration of firms. RICS registered firms need to ensure their finances are properly managed and client money is protected. RICS can suspend a firm’s registration which will mean that the firm is unable to continue to trade. Again an early dialogue will need to be opened up with RICS if there is going to be an administration of a RICS registered firm and suitable processes will need to be put in place for ensuring client money is protected post administration.

On a restructure of a professional practice the relevant regulator will need to be treated as an additional stakeholder who needs to be brought into the process early on and managed properly as it will often have considerable powers that can negatively impact the future viability of the practice. It cannot be ignored and the partners themselves will also be keen to ensure that the relevant regulator is being properly managed and work will need to be done to ensure that any restructure seeks to protect the interests of clients as well as creditors.

Steven Cottee is a restructuring expert at Pinsent Masons, the law firm behind Out-Law.com