COFA conundrums: How do you know if your firm is in trouble?

Richard Hill By Richard Hill
from Stepien Lake and chair, ILFM

The ultimate role of the COFA (as set out in the SRA Authorisation Rules) is to ensure compliance with the SRA Accounts Rules 2011, and to record any failures of compliance.

But the SRA’s Quick Guide to OFR implies that the COFA has a duty to report to the SRA when the practice is in serious financial difficulty. Yes, you guessed it: there is no definition of serious financial difficulty given.

This is obviously open to interpretation and can be quite an emotive subject. Too little knowledge or confidence in this area might lead to unnecessary reports being made to the SRA as a knee jerk reaction at the first signs of cash flow difficulties or reports not being made at all when they might be necessary.

The disclosure of financial instability appears to be the SRA’s attempt to address the impact on the profession and clients when firms close suddenly due to financial difficulties with no prior warning; the SRA wants to ensure the orderly closing of a practice to minimise the effect on clients (eg greater risk to client money and assets).

There has been some debate and confusion over who should report to the SRA when the firm is in financial trouble. It is obviously a commercial concern that affects the entire practice, and you would expect the onus to fall on managers. With the financial expertise and seniority of compliance officers this would also make sense, although it is a sensitive and challenging situation to deal with individually. The COFA must ensure they have access to all finance and business information to be able to assess this on a fully informed basis. In other words, the COFA should always be in full possession of the facts to make a reasonable judgement.

Still don’t know if you're in trouble?

It is sensible to assume a cash problem that is imminent will be immediately reportable. However, let’s say the latest cash flow projections predict the overdraft will go above the facility level in three months, and the bank has said it will not increase the facility. How would you deal with this situation?

Your concerns must be addressed to other senior management or partners immediately, explaining the situation at hand and the obligations on the firm to report the matter, should it be deemed as being in serious financial difficulty.

To overcome the ensuing debate at partner/management meetings, the COFA might set predefined parameters that, if reached, would trigger a report. This could reduce the subjective nature of the issue.

It would be prudent to analyse the ratios and banking covenants that the bank sets for your overdraft facility. These should be discussed to identify the ratio limits that would prompt a report.

The use of liquidity, profitability and working capital ratios are also worthwhile when documenting your thought process in demonstrating to the SRA that you have considered the situation and will show your reasoning behind any decision, particularly when that is not to report.

The requirement on the COFA to report places greater emphasis on good working capital management and cash flow projections - which all firms should be doing anyway. I was recently asked at an ILFM COFA workshop what the point is in doing cash flows, when fees fluctuate and are so uncertain? Well, though fees may fluctuate, you must be aware of what your outgoings are so that you understand the underlying cost base of the firm and can predict cash flow shortages.

Simple techniques can assist, such as reviewing alternative funding for key operational costs such as VAT, professional indemnity insurance, rent and salaries. Any trouble in paying these could immediately require an SRA report - but therein lies another hurdle: the internal resistance to reporting the SRA in times of trouble...

Are the SRA's rules just too vague? How could they be clearer? Or is the problem just the result of poor financial hygiene in legal? Let us know what you think in the comments below. Image credit: Henkster

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Firms will be reluctant to report problems if they think involving the SRA will just add to them, and I see no reason to think otherwise. The SRA does not have the resources or expertise to form a judgement about whether a firm will fail, but it is quite capable of pushing it over the edge. An orderly insolvency should be no threat to client money and is likely to involve less disruption to client service than intervention. Apart from looking out for cases of fraud or abandonment, I don't see what role the SRA can usefully play. My blog on the subject is at Chris
The collapse of Blakemores/Lawyers2you is interesting in this context, as it ended in SRA intervention, rather than administration. No details are yet public enabling us to judge whether that just means that there were no funds for a rescue through an insolvency process, or perhaps other good reasons for intervention, but it would be very worrying if the SRA had intervened and cut short what might otherwise have been a managed insolvency and transfer to another practice. Clients' interests cannot be best served by intervention if there is a chance of the files and staff transferring to another firm in an orderly fashion. I would even go further and suggest the SRA should review its policy on not letting firms trade in administration. The assumption that insolvency equals fraud and a threat to client money is long outdated.

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