In Industry Insights

(This is a guest post by Fiona de Feu aka ‘My Compliance Colleague’. Thanks, Fiona!)

Spoiler alert!

You will not enjoy this article. There’s nothing “feel good” about it, and it’s uncomfortable, but read it anyway. That’s because it’s about that gut-clenching topic: financial stability.

We know where we should be, as SRA Code for Firms 2.4 makes starkly clear. A practice’s regulatory duty is to “…actively monitor your financial stability and business viability”.

The bit that’s not made clear of course is the how….How do we know we are financially stable? How do we know our business is still viable? At what point would, or should, it be evident to us that we are not, and that we need to take steps to wind down?

We warned you this is uncomfortable stuff, but take heart: if we can calibrate what we mean as lawyers by financial stability, we can measure ourselves objectively.  Realistically, we will need discipline to do that consistently, sidestepping any (entirely natural, but inexcusable) inertia, and overcoming any tendency to take the rosy-tinted view. Can we design the equivalent of a calibrated flask (think of test tubes in a chemistry lab) which will tell us all is well?

How do we measure financial stability?

So, if we assemble a list of factors which indicate stability or otherwise, and set a threshold, we can then objectively measure the risk of instability and track it over time. Some typical internal factors might be:

  • Failure to pay creditors when falling due
  • Office account cheque dishonoured
  • (Over-)reliance on overdraft
  • Loss of key fee earning staff
  • Lock-up increasing
  • Over reliance on a single client
  • Insider fraud affecting office or client account
  • Cash flow forecasts (or reconciliations) delayed or not being done

External factors might include:

  • Global pandemic
  • Bank refuses further borrowing
  • Hack or cyber theft affecting client account

There’s a discussion of further early warning indicators in the Law Society’s Financial Stability Toolkit.

As every practice is unique, the factors you select and measure will vary from firm to firm. For example, some practices live in overdraft and are not necessarily unstable.

Factors may have to be weighted, as some risks will be graver than others. For example, failure to observe bank covenants attached to a loan facility, like caps on expenditure or drawings, requirements to send financial information, or for the firm to stay within certain financial benchmarks to ensure they can service the debt. If you break these there’s a good chance there’s a problem. Consistent failure to pay the office milk bill is likely to have less serious consequences but may still be a relevant factor.

I’m a busy COLP/COFA, is there a model I can adapt?

Have a look at Jonathon Bray’s financial stability reporting tool, which encourages firms to develop an objective framework for deciding when they become ‘unstable’.

Paul McCluskey’s Gemstone Legal Financial Stability Scorecard takes more of a gap analysis approach. Firms can use this free online tool to proactively identify where they might have weak points and take steps to fix them before they become an issue. The important next step will be to measure the tangible changes in performance and there’s also a Financial Benchmarking Scorecard, which will allow a law firm to periodically check their progress against their own metrics plus their wider peer group.

The tools aim to get you started and promote healthy discussion on a difficult and often emotive subject. That discussion should enable you to refine the questions to ensure a good fit for your business. If the finished tool is then built into your regular management meetings, so that it is consistently analysing and tracking stability and viability, you have system that meets the SRA’s requirement.

Deciding where the threshold is

The SRA rules have a built-in reporting requirement where there are ‘indicators of serious financial difficulty’. Since this reporting threshold is not defined by the regulator, it becomes a judgement call.

The natural temptation may be to delay or avoid reporting. That’s the point though: the stability analysis is fact-based and takes no account of paralysing emotion or denial.  Others may ask, exactly how will that confession be received by the SRA? Well it’s a valid question, but the SRA seems to be extending the hand of empathy in its Guidance on the subject.

Astute law firm leaders will avoid that temptation by acting objectively and promptly, otherwise, what started as commercial difficulty could easily escalate into a conduct issue.

So, in summing up, as a matter of good governance, firms should have already thought about what these ‘indicators’ look like in the context of their practice. Those thoughts of course, helpful as a starting point, then need to be translated into actions and recorded, if they are to be of operational use. Using the resources above could help take the emotion out of the stability-reporting decision and avoid getting there in the first place.

2021 is likely to be another turbulent year: the financial effects of the pandemic may become more apparent and law practices are not immune. There will be law firm failures. COLPs and COFAs, you either have a working system financially-speaking, or an elephant in the room.

As to which one, that’s down to you.

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