SME struggles – challenges and prospects
Amid an economic squeeze, professor Rebecca Parry of Nottingham Law School, Nottingham Trent University, details the insolvency processes for SME law firms of various shapes and sizes.
There are tough times ahead for SME law firms. Many will have weathered the pandemic through nimble shifts to remote working and helping clients to navigate government assistance schemes. Still, many are now struggling with the downturn in the economy, increases in cost of living and a looming recession and repayment of liabilities accrued during the pandemic, with the restrictions on insolvency procedures that applied during this time also now being lifted. This article will review current challenges, options for law firms to survive, as well as insolvency options, with some brief international comparisons.
Staff retention, tech upgrades, the ending of covid relief and generating new client business are all top challenges on the SME law firms agenda this year. Together with a worsening financial climate, these may tip the balance for some firms. A drop in business can lead to cash flow problems and there may be demands from creditors including HMRC. The repayment of government backed covid loans has started and bounce back loans to small and medium businesses must be repaid within 6 years. Rental arrears will have accumulated during the pandemic, although they are subject to a code of practice under the Commercial Rent (Coronavirus) Act 2022, including negotiation and arbitration.
Lenders may raise concerns around overdrafts and may request further security and/or the provision of a surety or guarantor. Under the Insolvency Act 1986, insolvency arises where the firm becomes unable to pay its debts or if its balance sheet shows a deficit. Not only current liabilities but also prospective ones should be considered in assessing the ability of the firm to pay its debts or the state of its balance sheet, as highlighted by the Supreme Court’s judgment of BNY Corporate Trustee Services Ltd v Eurosail (2013) UKSC 28.
Cybersecurity risks also loom large. A shift to home working and hybrid working can potentially increase cybersecurity risks and incidents can be financially damaging and can compromise the security of client data. Staff training in good practices is essential, as humans are often the weakest link in cybersecurity arrangements. Good technical infrastructure is also needed to prevent damage to productivity caused by outages.
Talent retention can be another major challenge. John Morley of Yale University has found that where remuneration is linked to profits, declining profits can cause partners to depart and seek better opportunities elsewhere while others may retire. Retention problems can cause firms to deteriorate rapidly. The loss of key fee earners can be damaging and can lead to others leaving. As the position deteriorates, thought should be given to the possibility of insolvency proceedings as wrongful trading liability can arise in cases where filing for insolvency is delayed by a partnership/LLP in circumstances where the partner/member knows or ought to know that insolvent liquidation is an inevitability. It is worth referring to the Insolvency Act 1986, s 214, which is applied by relevant legislation to both insolvent partnerships and LLPs. Run-off cover should also be considered.
There are various possible solutions, including insolvency procedures, available for sole practitioners, partnerships and LLPs and the options will depend on the form that the firm takes. Only a brief overview of the options can be given here but for further detail please refer to a specialist text such as Elsepth Berry and Rebecca Parry, Law of Insolvent Partnerships and Limited Liability Partnerships (2015).
Sole practitioners will be liable with respect to the debts of the firm. A merger or amalgamation with another firm might be one possibility. Alternatively, some progress may be made in negotiating with major creditors, who may be willing to compromise rather than take their chances in a bankruptcy. However, it may be difficult to take this approach with a dispersed body of creditors or, for instance, if one large claim creditor will not compromise. Formal insolvency laws have the advantage of collectiveness. A bankruptcy under Insolvency Act 1986, Part IX can bring a fresh start for a practitioner within one year but brings with it some conditions and limited property can be retained. An individual voluntary arrangement, ‘IVA’, under IA 1986, Part VIII enables terms to be agreed for repayment of the debts over a longer period and solicitors will find the regulatory considerations of an IVA less onerous than that of a bankruptcy. The IVA will be voted on by creditors and 75% voting in person or by proxy must vote in favour and thereafter the performance of the agreement will be supervised by an insolvency practitioner.
If the firm operates as a partnership, the options – beyond the merger and contractual negotiation options discussed above, are the partnership voluntary arrangement – a partnership administration order or liquidation of the firm as an unregistered company. The Insolvent Partnerships Order 1994 applies. A PVA will enable an agreement to be reached with creditors regarding the debts of the firm but not those of the individual partners, who may need to enter into linked IVAs. A partnership administration order enables the firm to have the protection of a moratorium but it normally entails the appointment of an administrator and it may be an expensive option. An administration order can be used to transfer the firm’s business to another firm, including a new firm, and an expedited version of this is a prepack. A firm which operates as an LLP will again have the option of a voluntary arrangement or administration, as well as a compromise or arrangement, liquidation and receivership, all of which are closely modelled on the companies regime. The legislation is complex as Limited Liability Partnerships Act 2000, s 14 applies provisions from other statutes with modifications and so cross references to different instruments are needed.
The problems faced by UK firms are not unique and smaller firms across the US, Canada and Australia have reported similar problems of staff retention, rising costs, as well as other issues. Covid support measures were common in many countries and liabilities to repay state assistance will now weigh heavily for many. As for insolvency laws, SMEs generally have been the focus for reforms such as in the US, where a simplified Chapter 11 process is available for small business debtors and Spain is enacting a simplified law for micro business insolvencies. In some countries, the reform focus has often been on incorporated businesses, presumably since procedures for unincorporated firms are inherently simplified. In Australia for example, under their Corporations Act 2001, s 500AE, law firms can be incorporated and they can now benefit from the simplified winding up procedures, whereas unincorporated firms will have similar options to those in the UK.
