Report written by Neena Patel:  this report briefly covers some of the interesting issues discussed in an APP workshop entitled “Insolvency & winding up of a law firm” given by Matt Haw, partner at Baker Tilly and James Mather barrister at Serle Court and chaired by Caroline Field of Fox on 6 February 2014.

The high profile demise of Halliwells in 2010 sent shock waves through the legal profession.  Manches, Challinors and Cobbetts are just a few examples of firms that have since followed suit and disappeared, leaving behind a legacy of cautionary tales.  These collapses demonstrate just how radically the legal profession has changed in recent years and how susceptible law firms are to running into financial difficulties.

The profession faces a number of challenges.  There has been a significant increase in regulatory burden, which is constantly changing.  Solicitors are answerable in various ways to the SRA, the Legal Ombudsman, the Legal Services Board, the Law Society and the Court.  Which other profession has to cope with that scale of regulation? There have also been significant changes to the rules relating to legal aid funding and conditional fee arrangements which mean that there is less work available for some firms, especially those specialising in family and criminal law.  Law firms tend to operate on traditional models and have high cost bases which can mean they have a limited ability to adapt.  The legal profession is also a highly saturated market which has seen a decline in instructions during the difficult economic climate.  With these struggles, banks may adopt a cautious approach in their lending to law firms and some firms are finding it harder to secure professional indemnity insurance at a reasonable cost, or at all.  Against this challenging back-drop it is no wonder that we are seeing an increasing number of law firms encountering financial difficulties.

Inevitably, when things go wrong for a firm blame is cast on its members, particularly those on the board or management committee. Members of an LLP (unlike partners in a traditional partnership) can draw some comfort from the fact that their liability will usually be limited to the capital they have contributed to the firm.  However, there will also be the questions of whether they have i) given personal guarantees to landlords and banks; ii) potential liability for run-off cover for insurance premiums and excess; and iii) personal tax liabilities which are not met by the tax reserve accounts of their firm.  There will also be the question of whether they will be required to foot the bill for any SRA intervention costs.

Additionally, the statutory insolvency regime applies to members in broadly the same way as directors so that they can be required to contribute financially to a winding-up of the LLP if they allowed the LLP to continue trading when they knew, or ought to have concluded that there was no reasonable prospect that the LLP would avoid going into liquidation.  Even more worryingly, there is a specific “claw back” provision in the Insolvency Act 1986 which applies only to LLPs.  Members can be asked to repay drawings and other payments received from the LLP during the two year period prior to the liquidation of the LLP if they knew or had reasonable grounds for believing that the LLP was unable to pay its debts or would become unable to pay its debts as a result of those withdrawals.

Larger firms will typically delegate key financial decisions to a board or management committee comprising of a small number of members. It is these members who are likely to be subject to more rigorous scrutiny.  However, this does not mean other members should simply disregard the risk of claw back or wrongful trading. Until the Courts provide some guidance, it cannot be assumed that it will be a defence to simply argue that one was not privy to the financial information. For now, the risk remains that the Courts may determine that any member ought to have known the financial condition of the LLP.

Members should also check the terms of their members’ agreement to see how trading losses are dealt with. Most agreements will either allocate losses to a reserve account in the balance sheet or allocate the losses between members up to a capped amount. The allocation of unlimited losses between members will, however, undermine the limited liability of the LLP.

It is crucial that firms take appropriate steps to spot early warning signs of financial difficulty, identify problems and take corrective measures.  These might be carrying out a full operational review of their practice which includes a comparison of profitable departments against unprofitable ones, reviewing their cash cycles, making a capital call and decreasing member drawings.   If there are any doubts about the solvency of the LLP, the management committee should get an independent review from experienced professional advisers.  Members should also keep a close eye on the LLP’s financial health and request financial information and answers to questions where matters are unclear.