How Healthy is Your Law Firm? Time for a Stress Test

It’s been four years since the financial crisis, and the legal industry is still facing significant economic challenges.  Although revenues are up in 2012, margins have not kept pace due to expense growth and a continuing productivity gap as firms are under pressure to discount fees or offer alternative fee arrangements.  On top of that, the profession is aging and is entering a period of capital drain from retiring senior partners.  These challenges may result in more of the law firm failures that we have seen over the past few years.  In our experience, law firm failures typically have a common thread: breakdown or lack of appropriate governance, inaccurate financial reporting and/or excessive leverage.

In addition to external threats, internal threats pose just as serious a risk to the health of a law firm if not properly managed.  Your firm may be vulnerable if risk is not properly managed and the firm’s financial position is not properly evaluated.  Appropriate governance, including management oversight and reporting structures, is necessary to meet the myriad of challenges facing the industry.

Partners, prospective partners (including laterals), lenders and clients are increasingly aware of and concerned about these risks, and whether or not a law firm is prepared to deal with them.

Conducting what we like to refer to as a “stress test” is an excellent tool to measure a law firm’s ability to deal with existing threats and assure partners and clients that they are appropriately managing the organization for long-term success.

We have helped our law firm clients perform such evaluations and have broken down the components to the following key areas:

• Firm Governance
• Financial Reporting
• Risk Management
• Fiduciary Practices
• Evaluation of Financial Health

The test results should be viewed as a report card that grades the firm on its performance in each area.

Firm Governance

The governance structure forms the backbone of every law firm.  In an appropriate, well-functioning governance structure, the management oversight and risk management process is necessary to deal with “stress” to the firm.  The appropriate governance structure depends on firm size and specific needs.  As firm needs change over time due to mergers, growth, changes of leadership, strategic initiatives and other factors, the governance structure should evolve and be flexible enough to embrace these changes.  The governance structure should be aligned to the firm’s strategy and business needs while allowing for accountability.

Every firm has unique governance needs, but key principles and practices can provide guidance to implement the most appropriate structure.  A governance structure that consists of a partnership board, executive board, and practice leaders with well-defined roles and goals is a template that can be modified to suit individual firm needs.  A strong partnership agreement and clear and direct lines of reporting both contribute to good governance.

The stress test scores firm governance in three main areas: governance structure, dispute resolution and succession planning.

Financial Reporting

Effectively managing a law firm requires accurate, detailed financial reporting.  An assessment of the firm’s financial reporting should analyze the accounting reporting methods employed as well as the competency of accounting and finance personnel.

You should carefully consider your options when choosing an appropriate accounting basis for financial reporting.  Many small- and medium- sized firms choose to report on a cash or modified cash basis.  These firms still need to have a strong understanding of their financial position on an accrual basis, including work in process, accounts receivable and payables, to be able to make informed management decisions.

Weak internal controls or management override of controls could result in manipulated financial reporting.  Although internal controls over financial reporting should be appropriate for the organization’s size, a strong control environment, adequate segregation of duties, and close review and monitoring of critical areas is necessary to prevent inaccurate or fraudulent financial reporting.

While a strong emphasis on financial reporting is generally graded positively, putting excessive pressure on meeting financial targets could backfire.

The stress test assesses the level of transparency and adequacy of financial reporting at a firm.

Risk Management

Adequate risk management includes evaluating client acceptance procedures, insurance coverage, lines of reporting and general counsel’s access to information. The goal is to prevent the destructive effects of reputation damage, credit risk, regulation violations and large uninsured financial losses.

Appropriate lines of reporting between the individuals responsible for risk management and/or general counsel to management keep the channel of communication open and help prevent mismanagement. The firm’s general counsel needs to have timely, open access to all relevant information relating to the firm’s ongoing legal issues and potential claims.

Fiduciary Practices

A breach of fiduciary duties is a serious act and is a common cause of professional penalties and disbarment.  Bar association rules of professional conduct promulgate basic fiduciary standards, including responsibilities related to record keeping and the handling of funds and property.  However, we often find significant exposure from inadequate controls surrounding trust activities, especially when trust activities occur at multiple offices.

An evaluation of internal controls surrounding trust accounting could expose potential threats to the firm that are often ignored until a material event occurs.

Evaluation of Financial Health

The final key area that the stress test evaluates is the overall financial health of the law firm, including cash flow, capital structure, degrees of leverage, and key financial metrics.

The firm should project and monitor its short-term and long-term cash flow needs to ensure working capital commensurate with its needs.  There are several factors firms should take into account when determining the appropriate capital structure, including firm size, type of entity, partnership agreement, firm culture, and consistency in earnings.

Excess leverage can put the financial health of the organization at risk.  Firms should carefully monitor their use of debt which varies based on a variety of factors, including firm size, culture, expansion cycle, seasonality or cyclical practice areas.

Analyzing various metrics can help determine if an organization might be overleveraged with debt and/or over-committed on its financial obligations.  A stress test includes a comparison of your law firm to its peer group by benchmarking key financial metrics, including measure profitability, productivity, cash flow, pipeline and balance sheet.

Valuable Tool

Performing an annual stress test can help your law firm assess the key areas of firm governance, financial reporting, risk management, fiduciary practices and financial health and prepare your law firm to weather both internal and external threats.  This assessment can be a valuable tool to identify potential weaknesses and avoid the pitfalls that caused the downfall of so many prominent law firms.  A clean bill of health goes a long way to relieve anxiety, for both existing and potential partners, about the ability for a firm to remain a viable organization for the long-term.