UK Legal Practices. Legal Upheaval. Industry Insights Spring Inside

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1 Industry Insights Spring 2012 UK Legal Practices Many law firms are struggling. The legal sector has been subject to a number of recent high profile failures and plenty of distressed merger activity in recent months. What does the future hold and what are the major areas of concern for practices, members and lenders? Traditionally a difficult sector for lenders to manage, the landscape for lawyers is changing. Reeling from a number of high profile mainstream failures, lenders now routinely demand detailed financial information from law firms, something which was unheard of in the good old days. The traditional overdraft is now only part of the capital intensive funding requirement of these legal practices and more complex products such as disbursement funding lines require more robust financial controls. Accurately measuring and reporting work in progress (WIP) is inconsistent across the industry but with WIP lock up averaging 5 months, understanding it is key to understanding the performance of the firm. Whilst financial performance is picking up from the low point immediately after the last official recession and average net profit per equity partner figures suggest an increase from 89k in 2009 to 106k in , this largely derives from cost cutting measures. Average fee income per equity partner did in fact fall during the same period 2. Project Merlin (the Government s lending target for major banks) will broadly be achieved for 2011, but targets for lending to small to medium sized enterprises has not been met 3 and in any event, meeting onerous lending criteria in the current economic climate is far from a given. Without additional finance to fund growth i.e. taking on new cases, many practices have for all intents and purposes become zombie firms in parallel with their corporate cousins. Major changes to legislation and the global economic downturn have created a perfect storm of adverse conditions which is leading to a race to consolidate. There will be an intense period of merger and acquisition activity. This could well lead to polarisation of the sector with mid-tier firms having to think carefully about their market position. If these challenges are not addressed now, inevitably there will be more failures down the line. Personal Injury Pain Personal injury and clinical negligence work accounts for around 18% 4 of total fee income in the sector. Although once a lucrative market, there is no doubt that law firms handling slip and trip or personal injury (PI) claims have found conditions difficult in recent years. Increasing competition, rising referral fees from claims management companies and more aggressive tactics from insurance companies have meant diminishing margins and cash flow difficulties. Added to this, the mop up of historic claims in the early years of the PI boom has been and gone. Anecdotally, the economic downturn saw a small surge in PI claims as people looked for other opportunities to bolster dwindling finances, but this now appears to have peaked. (1) The Law Society s Law Management Section Financial Benchmarking Survey 2010; (2) The Law Society s Law Management Section Financial Benchmarking Survey 2010; (3) Bank of England Data published 13 Feb 2012; (4) The Law Society s Law Management Section Financial Benchmarking Survey 2010 Inside 1 5 Summary: Factors to review 6 Summary: Possible formal restructuring opinions

2 Whilst standard road traffic accident claims can be quicker to settle via fast track procedures; and lawyers costs are recovered based upon a predictive fee matrix, actual profit costs are low. Many PI firms rely heavily on the litigated cases which are not subject to fixed fees. Cynically, some firms have in the past sought to drive claimants to litigate in order to recover the much higher fee. A fee which isn t formulaic, but based on costs incurred and historically is far higher than via the fast track predictive costs. Litigated cases tend to take much longer to settle sometimes taking years as opposed to fast track claims which are usually settled within 7-9 months. The funding required to support this type of case portfolio and the associated upfront costs such as medical fees and referral costs, has driven lenders to demand increasingly robust and meaningful financial management information, not traditionally a lawyer s top priority. It is fair to say that for many firms, cash is managed by the office manager or the cashier rather than the partners, who often do not appreciate the importance of cash as their focus remains solely on winning new work and the profitability of ongoing assignments. Conditional Fee Agreements (CFAs) The Government has announced that it is to implement the recommendations made by Lord Justice Jackson in his proposals to reform civil litigation funding. These reforms are expected to become law in the Autumn of Litigation has always been both costly and risky putting civil justice out of reach for those on low incomes. An attempt to remedy this was made in the Justice Act 1999 which allowed solicitors to enter into CFAs which spawned the no win, no fee culture we see today. A CFA arrangement allows a claimant s lawyer to claim their success fee and After the Event (ATE) insurance premiums from the losing defendants in many cases either insurance companies or the NHS. Success fees can be up to 100% of the lawyers base costs and they are only payable for successfully bringing a claim. A claimant therefore currently has no interest in negotiating fee terms with their solicitor. Typically, in a no win, no fee situation, if the case is lost, the lawyer will write off his costs. If it is won, the lawyer will claim his base costs, the success fee and ATE premium from the losing party. The claimant still receives 100% of the compensation, a phrase very familiar to those who watch daytime TV. This is great news for the winning side but it is the Government s opinion that we are all losing out in the long run. The best example is the annually bemoaned car insurance premium. According to the statistics released by insurers, costs as a percentage of damages awarded have increased from 56% in 1999 to a staggering 142% in This is why our insurance premiums have only been going one way over the last number of years. For cases with damages of up to 15,000 the costs paid out to successful parties, as a percentage of damages, can now average 218% 6 this should be no surprise when only the losing side has any interest in restricting the costs. The Jackson proposal is to abolish CFAs in favour of contingency or Damages Based Agreements (DBAs). Put simply, the lawyer s success fee will be deducted from the damages awarded. The proposal is to establish a success fee cap of 25% of damages on PI cases. Additionally, the ATE premium will no longer be recoverable from the defendant. As a minor concession the Government is proposing a small increase in general damages awarded. (5) Clarke Stamping Out Compensation Culture Fears Ministry of Justice Press Release 29 March 2011; (6) Jackson Review of Civil Litigation Costs - Final Report 14 January 2010 Duff & Phelps 2

3 This firmly puts the agreement of any success fee at the forefront of the mind of the claimant and will undoubtedly lead to both a reduction in success fees across the board and even greater competition. Costs paid out by insurance companies will reduce accordingly and theoretically, everybody s insurance premiums should reduce. Regardless, the introduction of DBAs will have a big impact on law firms reliant upon PI and must be planned for now. Payment Protection Insurance (PPI) The last 18 months have seen a number of firms traditionally geared up to deal with volume PI cases shifting their attention to the mis-selling of payment protection insurance (PPI). Claims for PPI mis-selling required a similar infrastructure as PI claims and were expected to offer a lifeline for firms who were struggling in a declining PI sector. The results of last year s judicial review and well publicised climb down by the British Bankers Association mean that the bank s own cheque books are now wide open to claimants. Does this mean that laywers can profit from this area of work? There is no certainty that claimants will seek to pursue their claims using lawyers, when the banks are willing to settle without legal involvement and there is a proliferation of unregulated claims handling companies in existence, so legal representation would appear to be largely unnecessary, much to the chagrin of many firms in this sector. That s not to say that there will not be some opportunities that present themselves in the PPI arena, but it certainly isn t a panacea. Conveyancing The current inertia of the UK housing market is no secret. At the outset of the recession there were swingeing cuts across the property teams in legal firms nationwide. Almost daily we are subjected to conflicting forecasts about anticipated movements in house prices; but without any real certainty or consistent recovery in the housing market it is a difficult decision for legal firms to increase staffing numbers to meet what could turn out to be only a short term increase in demand. The Legal Aid and Sentencing Bill Described by the Law Society of England and Wales as the single biggest attack on state-funded legal advice for the poor and vulnerable since the legal aid system was introduced the stated intention of the Government is to substantially reduce the amount spent by it, on payment of solicitors fees and expenses via the legal aid system....without any real certainty or consistent recovery in the housing market it is a difficult decision for legal firms to increase staffing numbers to meet what could turn out to be only a short term increase in demand. The Government s intention is to reduce its expenditure on the Legal Aid programme by upwards of 300m. The Law Society mounted its Sound off for Justice campaign to lobby against the proposals but in the present economic climate it is considered the campaign is unlikely to gather substantial public or parliamentary support. The impact of this proposed legislation will be significant for those firms who are partially or in some cases, wholly reliant upon legal aid funded cases for their fee income. Alternative Business Structures Colloquially known as the Tesco Law reforms, Alternative Business Structures (ABS) brought in by the Legal Services Act were introduced in October This means that non-lawyers can now own a Duff & Phelps 3

4 law firm, potentially meaning an influx of new entrants into an already crowded marketplace. It is expected that Co-Op s legal offering will now jump straight into the top 50 legal practices in terms of size. Increased competition means more pressure on fees and legal practices will need to sharpen their acts accordingly. With new players such as private equity and even supermarkets waiting in the wings, many existing law firms will not relish the increase in competition which will follow the inevitable commoditisation of many legal services. Perhaps as a reaction to these conditions and as an alternative to full merger, some smaller firms are now banding together under umbrella brands and one such collective, part funded by private equity, is due to lavish 15m on a TV and radio advertising blitz in the first quarter of Smaller practices Of particular concern to smaller practices and sole practitioners, is succession planning. According to Syscap 8, the number of single partner law firms fell by 9% in the 12 months to March 2011 from 4,050 to 3,700. One reason for this statistic is lack of access to funding to allow buy in from lawyers wishing to step up to equity partnership. Another reason is widespread consolidation. With these testing conditions in the profession and the wider economy, it is difficult to introduce new partners to smaller practices and a telling statistic is that the average age of sole practitioners is 52 as opposed to those lawyers in the profession generally where it is albeit that lifestyle choices will also partly explain this difference. Compliance with latest Solicitors Regulation Authority (SRA) regulations (the new Handbook came into effective on 6 October 2011) add further costs and obligations to firms operating on thin margins. To compound matters further, over the last 10 years many lawyers invested personal monies into property. This leaves lenders with potentially worthless personal guarantees, as figures suggest that 1 out of 4 legal practices now include partners who have provided personal guarantees 10. Should a sole practitioner choose to wind down operations, they still require run off cover - specialist professional indemnity insurance for 6 years following closure for which premiums can be as high as 350% of the usual annual premium. This means many practitioners simply cannot afford to retire. As an aside, it should also be noted that a number of professional indemnity insurers have exited the marketplace and compounding this, the assigned risk pool for practices which cannot renew their insurance is also being phased out by October Although there will still be some measures available, these are far weaker than the current arrangements and could see some firms being forced to cease trading within a few months if they cannot secure the required cover. So a solution for many practices may be to merge with another firm. The general absence of capital across the sector means there are few acquisitive parties out there but if a willing partner can be found, there must be both a strategic merit and an alignment of personalities to ensure a happy union. Failing this, and with no light on the horizon, a number of lawyers have simply walked away from their struggling practices leaving the SRA to pick up the pieces. These lawyers would be well advised to seek professional restructuring advice before simply taking such drastic action as there may be the opportunity to avoid potential pitfalls and mitigate personal liability. (7) QualitySolicitors recruits in run-up to 15m ad campaign Law Society Gazette 19 January 2012; (8) Number of sole practitioner law firms suffers steepest fall since the credit crunch Syscap Limited 18 July; (9) The Law Society s Law Management Section Financial Benchmarking Survey 2010; (10) The Law Society s Law Management Section Financial Benchmarking Survey 2010 Duff & Phelps 4

5 Summary In summary, the legal sector and lawyers themselves face unsettling times. The key asset of a legal practice is very often its WIP. The only way to preserve the value in the WIP is via an orderly process whether this is by merger, acquisition or via a restructuring process. Duff & Phelps can advise and guide both lawyers and lenders through these options and be on hand for discussions and negotiations with all major stakeholders, including the SRA. How can Duff & Phelps Help? y We are happy to discuss any issues in complete confidence, with no obligation. y We will advise you as to the options available and have a worldwide network of acquisitive parties generally and also in the legal sector. y We can assist with analysis of projections, understanding WIP and we have a dedicated HMRC team to assist with any tax arrears. y We have acted on a large number of advisory and formal insolvency assignments for members of LLPs and Partnerships. y We regularly advise lenders to LLPs and Partnerships. y We advised on the first pre packaged sale in administration under the new outcomes focussed regulations issued by the SRA effective from 6 October Factors to review: Legal structure Business model Type and mix of work Financial Information WIP Cash flow and funding requirement Sector benchmarking y Is the business a traditional partnership or an LLP? y Does the lender have security over the assets of the partnership and can they be enforced? y Does the LLP itself require separate advice to the partners? y Does it work? y Do the Partners understand it? y Do the Partners measure performance? y Does each revenue stream generate profit or contribution? y Could resources be re-allocated? y Are the Partners all contributing to the Business? y Does the financial information show true performance? y Is it used as a decision making tool by Management? y Are forecasts being met? y What is the WIP lock up? What does WIP comprise of? y Is the WIP ledger regularly cleansed and WIP written off? y Does the practice record WIP for all matters enabling it to be used as a management tool? y Do the Partners understand the funding requirement of the business? y Is the business able to meet its liabilities as they fall due? y Is debt being repaid? y How does the business perform compared to its peers? y A number of relevant metrics must be applied from the financial to the non-financial. y Sales mix of different specialisms within the practice. Duff & Phelps 5

6 Summary Red Flag obvious signs of distress y Difficulty paying landlords, wages, drawings or professional costs. y HMRC arrears or Time to Pay Arrangements in place. y CCJs and threats of other enforcement action. y Overdraft not being used properly hard core debt. y Short term, high cost borrowing (often personally guaranteed by the partners). y Turnover falling. y Ageing or declining WIP profile. y High turnover of staff. y De-motivated workforce. y Inability to fund new work. Possible formal restructuring options: Legal structure Formal restructuring options for the firm Voluntary arrangement LLP Administration Creditors voluntary liquidation Legal structure Formal restructuring options for the firm Insolvency options for the firm Partnership voluntary arrangement With interlocking IVAs Partnership Administration Winding up Partner bankruptcy With bankruptcy petitions Without bankruptcy petitions Duff & Phelps 6

7 Investment banking services in the United States are provided by Duff & Phelps Securities, LLC; Pagemill Partners; and GCP Securities, LLC. Member FINRA/SIPC. M&A advisory services in the United Kingdom and Germany are provided by Duff & Phelps Securities Ltd. Duff & Phelps Securities Ltd. is authorized and regulated by the Financial Services Authority. Investment banking services in France are provided by Duff & Phelps SAS. For more information, visit (NYSE: DUF)

8 For more information about our industry expertise or to subscribe to Industry Insights, visit: Contact Sarah Bell Tel: Jimmy Saunders Tel: About Duff & Phelps As a leading global financial advisory and investment banking firm, Duff & Phelps balances analytical skills, deep market insight and independence to help clients make sound decisions. The firm provides expertise in the areas of valuation, transactions, financial restructuring, alternative assets, disputes and taxation, with more than 1,000 employees serving clients from offices in North America, Europe and Asia. Investment banking services in the United States are provided by Duff & Phelps Securities, LLC; Pagemill Partners; and GCP Securities, LLC. Member FINRA/SIPC. M&A advisory services in the United Kingdom and Germany are provided by Duff & Phelps Securities Ltd. Duff & Phelps Securities Ltd. is authorised and regulated by the Financial Services Authority. Investment banking services in France are provided by Duff & Phelps SAS. For more information, visit (NYSE: DUF) Copyright 2012 Duff & Phelps Corporation. All rights reserved. DP122002