Law firms were once the darlings in the portfolio of any bank manager. Those days are over. The recent near melt-down of the banking system has resulted in banks themselves seeking to remain as liquid as possible. Accordingly, they have massively scaled back their lending in many areas. They are no longer falling over themselves to lend to law firms seeking new or increased facilities, but are adopting a much more cautious approach. Further, banks have been stung by criticism that their attitude to risk was, at best, cavalier. They now wish to be, and to be perceived as being, prudent lenders. The conversion of many law firm partnerships to LLP’s has also caused a shift in banks’ perception of the risk of lending to the legal sector. This is because they tend now to have recourse only to the assets of the LLP and not to the personal wealth (perceived or real) of its members. Most significantly, however, the unheard of has now become a reality: major international law firms have very publicly failed in the recent past (Heller Ehrman, Altheimer & Gray, Coudert Brothers, Brobeck Phleger & Harrsison, Thelen Reid, to name but a few). Some of these have left banks and other creditors licking their wounds.
In the UK, while law firms still operated as partnerships and before the current recession hit, facilities at reasonable rates were readily available. Banks relied for their security on the fact that the partners were jointly and severally liable for all debts of the business. Many banks chose to ignore the technical issue that, often, partners had taken steps to protect their personal assets against the possibility of loans being called, because they rarely were. Nor was there much evidence of close monitoring by the banks of maintenance within firms of a minimum level of capital. That environment encouraged law firms to indulge in over-generous drawings policies since the sole result of firms continuing to increase drawings to partners whether or not the firm’s cash position justified it was an increase in the firm’s overdraft, to which partners individually often paid scant regard.
A recent trend has been noted that banks, as a condition and alongside the granting of facilities to a law firm which carries on business as an LLP, are now insisting on lending to partners individually to enable them to maintain a minimum level of capital in the firm. Whilst perceived in many quarters as an unwelcome reintroduction of personal liability, this trend may ultimately benefit firms themselves as well as the banks. Partners will be forced to recognise the importance of cash to their business when they personally have to cover additional interest payments for capital loans. This, in turn, will focus attention on lax management control over lock-up (the amount and age of a firm’s work in progress and debtors). Firms will more readily appreciate that the injection of additional capital by partners individually can often be avoided by more regular billing and more efficient debt collection. Tighter credit control can be predicted, a huge benefit at a time when many law firm clients, even those which are household names, are financially vulnerable.
Banks are also more likely than hitherto to keep a close eye on how law firms are being managed financially, by requiring regular financial reporting. Management will need to keep its finger on the pulse. Firms can be certain that significant and imprudent distributions of cash to partners are more likely to be spotted and questioned, potentially causing the bank to review its own exposure to the firm.
The common use of LLP’s has given banks the possibility of an alternative source of security, in that LLPs are able to grant debentures over their assets. Whilst the taking of a debenture is still out of the ordinary (those granted by Halliwells and Bird & Bird attracting significant publicity), this practice could prove beneficial to both banks and law firm partners. A debenture can sensibly be used as an alternative to requiring partners to build up capital in the firm from their personal resources or through the retention of profits. It should be recognised, however, that, in cases where firms are not perceived to be financially strong, it can safely be predicted that a practice will inevitably evolve over time whereby a debenture will be required as a matter of course as additional rather than alternative security.
A further interesting development in law firm finance will come about when the Legal Services Act is brought into force. This will for the first time enable law firms to raise finance through the sale of equity to persons other than the partners themselves. It is tempting to see this as a panacea to law firms’ dependence on banks, although the general consensus is that, in most cases, bank borrowing will remain a cheaper source of finance than parting with equity. Moreover, external financiers such as private equity houses, who have shown a particular interest in entering the legal practice arena, will, as one of their funding requirements, generally wish to be satisfied that they have an exit route open, often via a public offering of shares in the business. Firms intending to raise finance in this way are accordingly already planning to restructure their operations to facilitate this. A typical structure might involve the introduction of a limited liability company (whose shareholders would be the partners and the external financier) as a partner in the partnership. A common feature of these restructurings is that the revenue generating activities of the practice (out of which the partners continue to receive their income) are separated from the entity (often a limited liability company) in which capital value is to be built and into which an outside financier will be introduced.
Restructurings of this type may also be encouraged by the unprecedented gap which exists currently between the tax rates applicable to income and to capital. Partners will be tempted to seek to commute at least some part of their earnings into interests in an entity which, on realisation, will be taxed as capital rather than income.
Such restructurings will present their own challenges for the lending banks. In some cases, they will lose significant lending opportunities entirely. In other cases, where banks lend alongside capital injections by external financiers, they will need to look to where the true value of the business really is. Inevitably, the assets of the law firm will still be available for charging under a debenture, but partners’ shares in a company which may at some future time be sold or publicly floated will also present an interesting possibility for further collateral. For the law firms themselves, it can only be beneficial to have at least the potential to raise significant finance from sources other than the traditional banks. The increased competition should result in banks putting their best foot forward in the lending terms they offer, insofar as competition between themselves has not so far achieved this.
There is no experience of how the change in lending conditions will pan out for banks and, consequently, law firms. It is common knowledge that, once a law firm reaches the stage where it can no longer trade, the value of its work in progress and debtors (often its only significant assets) dramatically reduces. Will banks find themselves as well secured by a debenture as they thought they were? If they choose the route of lending to partners personally, will they find that old habits of personal asset protection die hard? If they lend to a law firm, will they keep abreast of the implications for the value of their security of new structures and even new contracts adopted by that law firm?
Of one thing we may be certain that banks will be increasingly discriminating in their lending. And law firms will have to impress with their sound financial management, from whomever they are seeking to borrow. Everyone’s a winner.
How to impress your bank manager
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