By Ed Connell

15th November 2023

How law firms can avoid financial distress

There are several ways a law firm can find itself in financial distress. Knowing how a firm might fail and how this can be avoided will ensure you identify issues and take appropriate action to improve your business’s financial performance.

Why are firms failing?

1. Lack of PII cover

This issue continues to be a factor. PII firms have to be mindful of the economic stability of their clients as, where an intervention is made by the Solicitors Regulation Authority (SRA), they are bound to provide six years of run-off cover even when premiums are not paid.

Insurance premiums have soared and law firms need to be aware that the size of their firm and the type of work that they undertake can affect the cost of their PII premiums. The cost of insurance is becoming an increasing problem for smaller law firms which may not have the same risk management processes as large law firms. Those working in the property conveyancing sector have been particularly hard hit by higher premiums because of the perceived risk of high-value transactions, with claims arising from increased mortgage rates and a slump in sales prices.

2. Shrinking of profit margins

A recent survey found that revenue growth in the legal sector last year averaged 8% while salaries in the same period have increased by 10%. Energy costs have also increased exponentially and interest rates are at 15-year high. Firms must react swiftly to adjust charge-out rates in order to maintain profits per partner.

3. Poor cashflow management

The current cost of living pressures is adversely affecting lock-up levels. Effective cash collection is becoming more of a challenge but is vital in maintaining the working capital of a firm. Equity partners must be realistic when setting drawings levels, despite their own financial pressures resulting from high inflation levels.

4. Fraud

Axiom Ince was shut down recently by the regulator, some six weeks after the SRA suspended former managing partner Pragnesh Modhwadia over suspected dishonesty. The firm secured a freezing order for £64m against Modhwadia, and his lawyers confirmed in court that the client account money was gone. It was spent on purchasing and renovating properties and buying the larger firms Ince & Co and Plexus Legal. This failure is not only giving the SRA a huge headache. It could affect every firm in the UK as they may all have to make a one-off payment to cover the shortfall in the compensation fund, created by the collapse of Axiom Ince.

5. Cyber risk

Clients trust law firms to safeguard their highly confidential, commercially sensitive, and often personal information. In many areas, legal firms handle large funds on behalf of their clients. This is why cybercrime is such a threat to the legal profession. Phishing is the most common cyber threat. ‘Phishing’ is when criminals use scam emails, text messages or phone calls to trick their victims. The aim is often to make recipients visit a website, which will then download malware (such as ransomware or a virus) onto your computer, or steal bank details or other personal information, such as login details. Just recently the Information Commissioner’s Office reprimanded a County Durham law firm after a cyber-attack led to a data breach and four fraudulent payments being made on a probate matter.

How can these problems be avoided?

1. Know where you are

Having access to accurate and timely financial information has to be a top priority. This will allow you to see which parts of your business are most profitable. In these times of inflation and high interest rates, it is not possible to stand still. Increased costs are inevitable and efficient firms are constantly asking how these costs can be kept under control. Having reliable forecasting tools can assist in developing strategies for the future, allowing you to stress test the effect of changes in working practices.

2. Be brave when looking at charge-out rates

Some consider that maintaining charge-out rates reduces the stress of confronting clients with price rises. In the long run, this approach is unsustainable. A new mindset is required. An increase in charge-out rates gives you an opportunity to communicate with your client. By understanding their needs, you can illustrate how you can help to attain these, shifting the focus from price to clients recognising the value of your services. It gives your fee earners the scope to be creative in dealing with client problems. Their job satisfaction will rise when they get positive client feedback on a job well done.

3. Keep up to date with technology

Generally, most legal firms will use some sort of case management software. Also, billing and tracking software is commonplace. This ensures that firms are compliant with regulations as well as speeding up the billing process and tracking time spent with clients. This process can be extended to online payment solutions. The right software ensures that clients can quickly and easily pay their bills in the ways that feel most comfortable and secure to them.

Additionally, keeping your firm protected from cybercrime is essential. The National Cyber Security Centre, a part of GCHQ, produced a very useful document in June 2023. This cyber threat report highlights risk areas and gives useful, practical advice on how to protect your firm.

Using AI-based automation tools, legal firms can take repetitive, time-consuming tasks from human employees’ hands and turn them over to computer programs. This both eliminates the risk of human error and streamlines workflows that would otherwise eat up a large chunk of a lawyer’s daily employment. This technology is in its infancy, and it will be interesting to see how it develops.