UK: Professional Practices News: A Briefing On Topical Issues

Floating Down Under

In this issue, we look at changing attitudes to outside investment with the listing of Slater & Gordon. We also examine how to protect your firm from the loss of a key partner, and other topical issues.

In the last Professional Practices News, we discussed alternatives to traditional partnerships and changing attitudes to outside investment. Giles Murphy looks at how Australian law firm Slater & Gordon is blazing the trail.

Over the years, the partnership structure enshrined in law by the 1890 Partnership Act has served the professions well.

In recent times, however, we have seen traditional businesses with a partnership structure incorporate their organisations as limited companies in order to list their shares on the stock exchange.

The reasons for listing a professional business are varied but, often, the justification is to realise the capital value of the business which, in most cases, is not recognised in a traditional partnership structure.

Many types of traditional professions have floated their businesses. These have included surveying practices such as DTZ, Savills and Fletcher King, accountants Tenon and Vantis, engineering consultants Scott Wilson, and recruitment firms Michael Page and Robert Walters. But this has not been possible for UK law firms because the Solicitors Act prevents the sharing of profits with non-lawyers. However, once the Legal Services Bill is enacted and becomes operative in the UK, this restriction will be lifted.

With the advent of the new Bill, there has been much press debate about whether law firms will take advantage of the ability to list. There have also been questions about whether it would be possible to list a legal fi rm successfully, given the nature of the services provided. But this debate has now been superseded by events in Australia.

On 21 May 2007, Slater & Gordon became the world’s first listed law firm. The business chose to list on the Australian Stock Exchange following a change in Australian legislation that allows for nonlawyer investors. This legislation is similar to changes that will come into force in the UK with the Legal Services Bill.

The relatively modest size of Slater & Gordon (it wouldn’t appear in the league table of the top 80 UK law firms) may surprise some, as it has been assumed that critical mass is key to the successful fl oat of a UK fi rm. Look closer though, and it becomes clear how the nature of the practice perhaps makes the business more appropriate for listing.

A consumer law firm, Slater & Gordon employs over 400 staff in private client, employment and litigation work. The latter includes asbestos and personal injury litigation, and the firm has earned a strong reputation for winning landmark litigation cases.

Slater & Gordon’s annualised results for the period up to 31 December 2006 show a fee revenue of £24m, and its profit before tax was £5.3m or 22% of fee revenue. The firm issued 35 million shares at the equivalent of 42p, approximately 32% of the enlarged share capital of the business.

With a strong position in Victoria’s personal injury market, one of the rationales for Slater & Gordon’s listing was the opportunity to pursue an acquisition programme. On 28 May 2007, the firm announced its first post-float acquisition with the purchase of a Brisbane-based specialist military compensation firm for the equivalent of £1.15m (payable in cash and, crucially, shares).

Of perhaps more interest to some will be the performance of Slater & Gordon’s share price over the coming months. For instance, having issued shares at AU$1, the price closed on 18 July 2007 at AU$1.72, placing the company’s value at the equivalent of £77m. This equates to over three times Slater & Gordon’s fee revenue over 14 times profit before tax.

Once the Legal Services Bill is enacted in the UK, it is conceivable that Slater & Gordon’s flotation could inspire a number of law firms to explore alternative business models and the idea of outside investment. As discussions with some of our clients would suggest, it’s worth watching developments over the next few years and their effects upon the UK’s law profession.

With a partnership protection strategy, it is possible to reduce the impact of the loss of a key partner on a firm, says Matt Haswell.

If a business partner dies or becomes ill, failure to protect a firm and its partners could have dire consequences.

The death or critical illness of a business partner can cause considerable disruption to a firm. In addition to the emotional turmoil and potential knowledge gap triggered by a death, there are the financial implications to consider.

A partnership may have debts repayable upon the death or critical illness of a partner, including bank overdrafts, hire purchase agreements, bank loans and a partner’s capital account. Therefore the remaining partners will need to decide what happens to the deceased’s share of the business and resolve any problems relating to the deceased’s spouse or estate.

A suitably structured partnership protection strategy can ensure that the business remains in the control of the active partners while assisting the deceased’s dependants. Partnership protection allows business continuity by ensuring that a commercial purchase price is obtained for the deceased partner’s share of the business, payable to his/her spouse or estate, without undue delay.

What happens if a partner dies?

Most conventional situations of this type are dealt with under the Partnership Act 1890, whereby, on a partner’s death or retirement, the partnership must be dissolved unless the partnership agreement advises to the contrary.

The deceased partner’s share will pass to his/her estate, which could mean the partnership share going to the deceased partner’s spouse. This might present some serious problems. For example, the spouse could end up owning a share in a business that he/she does not want. In turn, the continuing partners will have a partner who cannot or does not want to participate in the business. Another likely scenario is that the spouse needs income and wants to sell the inherited share. The surviving partners could then face the possibility of a replacement partner who they did not choose. So, ideally, the remaining partners need to acquire the deceased partner’s share.

What should a partnership agreement include?

A partnership agreement should detail how the firm’s profits are to be shared, the duties allocated to the various partners, and how to treat intangible assets and goodwill. Consideration should also be given to what would happen to a partner’s capital account and share in the business if he/she leaves or dies. If it is not already in place, a partnership agreement should be drafted under the direction of a solicitor.

It is important to assess the current provisions of the partnership agreement to understand the clauses that would operate in the event of the death of a partner, particularly regarding any restrictions on the disposal of shares in the business. There are various methods that could apply, namely automatic accrual, a buy and sell agreement or a double option agreement.

Under this type of arrangement the partners agree that in the event of one of them dying, his/her interest in the business will pass automatically to the remaining partners. This ensures that control of the business is retained by those people with the necessary skills and experience to continue to manage it as before.

However, it is important that the deceased’s heirs are financially compensated as, in many cases, the value of the late partner’s share may form a major part of his/her estate and the value of this inheritance could be lost to the heirs.

This is a written agreement stating that the deceased’s share of the business must be sold to the surviving partners who must purchase it. Although this is a relatively simple agreement, it should be borne in mind that business property relief available for inheritance tax purposes will be lost if such an agreement is used as it constitutes a binding agreement of sale.

This is generally accepted as the most appropriate arrangement in normal circumstances. It is similar to a buy and sell agreement in that an agreement exists, but as an option rather than a legal obligation.

In the event of either the surviving partners or the heirs wishing to exercise their buy and sell option, the other party must comply. HM Revenue and Customs (HMRC) does not see a double option agreement as a binding contract for sale, so there is no loss of business property relief for inheritance tax purposes.

Adequate cash resources must be available to allow remaining partners to purchase a deceased partner’s share in the business. The most effective way of doing this is for each partner to take out a life assurance policy on his/her own life and for the policy to be placed into a specially designed partnership trust arrangement that favours the remaining partners.

In the event of a partner’s death, the policy proceeds would be made immediately available to the trust’s beneficiaries, free of any inheritance tax liability. The trust deed must be drafted to allow the monies to pass to the partners in proportion to their interest at the time of the death. This means that the trust will automatically adapt to take account of new or retiring partners and any changes in the partnership structure.

The types of policies normally used in connection with such agreements are level term assurance policies or whole of life policies. The level term assurance option provides low-cost life cover and is normally written to the partner’s expected retirement date. Naturally, it is important for such provisions to be reviewed frequently throughout the term of the policy to ensure that the cover represents a realistic valuation of the partner’s interest.

A whole of life policy provides cover throughout the partner’s life. On retirement the terms of the trust allow the policy to revert to the partner and may form part of the provision for the partner’s dependants.

Another aspect of this type of policy is the provision of benefits in the event of a partner suffering a critical illness, which could mean that the partner is unable to work or may no longer wish to participate in the running of the business. Such a policy would enable the remaining partners to buy that partner out and retain effective control of the business. It would also relieve the critically ill partner of some of the financial worry. This type of cover is available as an extra benefit to a whole of life policy or on a temporary basis as a policy in its own right.

Great care should be taken in selecting a suitable product and provider. When selecting the most suitable policy for partnership protection, partners should make sure that:

• sums assured are indexed

• cover increase and extension options are available

• the premium basis is guaranteed or reviewable

• there is availability of critical illness cover

• competitive premiums are secured

• taxation of policy proceeds is efficient

• the term and level of cover required is sufficient.

All businesses have key people whose particular skills, knowledge, leadership or experience contribute to their continued financial success. This is why it’s essential to have a well-defined partnership protection strategy in place to guard your company’s profitability.

Following the revised SORP for LLPs, Clare Copeman surveys how larger firms are interpreting the rule changes in their members’ agreements and annual accounts.

The introduction of new accounting rules for Limited Liability Partnerships (LLPs) has changed the way many professional firms present their annual accounts, notably in the treatment of members’ balances and remuneration. These changes are due to the revised Statement of Recommended Practice (SORP) for LLPs, which applies for periods ending after 31 March 2006. The revised SORP not only impacts the way firms must deal with their accounts but, for some practices, has also led firms to review their members’ agreements. Given that the filing deadline for April 2006 year-ends has now passed, a number of annual accounts have been published that allow us to examine how different firms have been affected.

Although we don’t have access to all members’ agreements, a review of a number of larger firms’ accounts suggests some significant differences, both in the rights of the members relative to the firm and in the way that the recent accounting developments have been interpreted.

Early commentators were concerned that the new SORP required members’ capital balances to be treated as a liability of the LLP to the member, unless the LLP has the unconditional right to refuse repayment.

Attention was centred on those firms where members’ capital is repayable on retirement. This is because those practices would be required to treat members’ capital as a liability, even when capital withdrawn by a retiring member would normally be replaced by new or existing members.

Firms that want their capital balances to be classified as equity might include a clause in the members’ agreement that the LLP would not be required to repay the capital of a retiring member where this would cause total capital to fall below a base level. This approach allows the base level of capital to be treated as equity rather than a liability.

In practice, the provisions of the SORP relating to members’ capital appear to have been something of a non-event. This is probably because, in the recommended presentation, the balance sheet divides at ‘net assets attributable to members’. All members’ balances, whether equity or liability, are shown in the bottom half of the balance sheet.

Of the accounts reviewed, the majority show all capital balances as a liability. Firms seem to conclude that neither their bankers nor readers of their accounts will mind whether their capital is categorised as equity or liability. Furthermore, the possibility of classifying members’ capital accounts as a liability rather than equity – perhaps providing the member with additional protection over these balances in the case of insolvency – has been a factor in some firms’ decisions.

Where LLPs have paid members from current-year profits which cannot be reclaimed, the revised SORP requires that these payments should be treated as an expense in the current year’s profit and loss account. Furthermore, current-year profit that has not been paid at the year-end, which the LLP does not have the unconditional right to withhold from members, should also be treated as an expense, creating a liability in the balance sheet.

Profit available for discretionary distribution among members (treated as equity in the balance sheet) should only arise where the LLP has the unconditional right to withhold undrawn profit from the members (or the unconditional right to reclaim drawn profit).

Treatment of payments to members as an expense was initially worrying, in that firms that make full distribution might find themselves with a zero balance on their profit and loss account – as well as potentially having zero equity in the balance sheet. However, these early concerns appear to have been unfounded, although, compared to members’ capital, there is a much wider variance between the firms in our sample.

The split was fairly even between the number of firms for which materially all amounts paid or payable to members were treated as an expense, those for which materially all amounts were treated as available for discretionary distribution, and those for which there was a mixture of the two.

While there is no choice regarding amounts paid under an employment contract or non-discretionary fixed shares, there has been some pragmatism in determining the rights attached to residual profit shares. In determining these rights, firms have looked at the accounting impact on reported profit and equity. They have also considered what other firms might be doing and the rights of members over undrawn balances in an insolvent situation.

Prior to the revised SORP, there was a greater presentational incentive for undrawn profit to meet the criteria of equity. In such cases, amounts treated as liabilities were deducted in the top half of the balance sheet, reducing the apparent strength of the firm’s balance sheet. It seems that firms whose existing members’ agreement required post year-end approval for the division of profit have, in many cases, not amended their members’ agreement. In contrast, newer LLPs have been more inclined to draft a members’ agreement that allows for the automatic division of profit.

There have been some differences in accounting treatment between firms. Under the revised SORP, all members’ balances – whether equity or debt – can be shown in the bottom half of the balance sheet as part of net assets attributable to members. Yet there have been cases where members’ liability balances were deducted from net assets. Also, while most firms matched the treatment in the profit and loss account with that in the balance sheet (for instance, expense giving rise to a liability and amounts available for discretionary distribution giving rise to equity), not all practices have followed this approach.

It has been a time of significant change for LLP financial reporting and we suggest that there is not yet a consistent view on all of the judgemental areas of the revised SORP. Whether the differences remain or interpretations converge in the coming periods remains to be seen.

Barbara Hamilton looks at how firms are getting useful client feedback.

Client service is a key differentiator for professional practices and something on which firms increasingly compete. To get it right, they need to be sure they know where they stand and devote resources where needed. We look here at how firms are obtaining competitive advantage through feedback, and how we can be better at obtaining feedback as a sector.

Eversheds partner and head of client relationship management, Geoff Harrison, says: "We can tell ourselves we have the best possible approach to client care and service but unless we ask our clients how they rate our service delivery such thinking has no practical value."

Resistance and barriers

Ideally, client feedback is ongoing, with fee earners obtaining comments directly, supported by independent processes that fit each client.

Yet many firms are still not seeking comment from their own clients on how well they are performing. Jo Summers, director of researchers Acritas, says: "In our experience some professional firms still fear the dreaded ‘client feedback’ programme as it is tantamount to the 360 degree appraisal."

Acritas’ research, carried out with over 800 in-house heads of legal in the early part of 2007, revealed that an overwhelming 60% had not been asked for their feedback. This is surprising considering that when Acritas conducts client feedback for professional practices, it typically achieves more than a 75% participation rate – suggesting that clients want to take part.

The main barriers to obtaining feedback are time, resources and cultural resistance. If the firm and its partners are busy or stretched, undertaking client feedback seems like a luxury. And no-one likes having the finger pointed at them. While it is only human to find fault, this does no good in the long term and certainly does not reward the client’s honesty. Instead, whoever is responsible for feedback should agree with the client as to how he/she wishes the news to be passed on and then deliver it appropriately, focussing on actions.

Feedback can be used for everything from improving profitability and matter management to cross-selling and service improvements. Firms undertake client feedback to:

• listen to the client and adapt services

• raise their profile with their clients

• address service and performance issues

• identify opportunities for new business

• find out how well the firm and its partners are doing

• pick up training needs

• increase profitability and improve efficiencies

• manage risk

• identify rising stars

• identify rogue partners

• manage reward and recognition for fee earners

• meet initial promises made to client

• protect clients from predators

• match client-service teams to the client

• introduce new people to the client.

Approaches to client feedback are as diverse as firms themselves. It can be conducted in-house or externally, face to face, by telephone, online or on paper, and via rolling listening programmes or annual feedback.

Furthermore, feedback can be formal or informal, matter or transaction-related, individual or group, quick and dirty or indepth, firmwide or individual. It may take the form of a post-secondment/fieldwork debrief, or be topic-related such as on brand or tenders.

Traditionally, feedback has been client to firm, but more recently, two-way feedback has evolved, such as service level agreements.

Figure 1 illustrates who might undertake client feedback. An in-house researcher in a law firm might be a professional support lawyer and an in-house consultant might be a semi-retired partner.

Some firms only use partners to undertake feedback, but use a different one each year. This maintains independence, creates cross-selling opportunities, and spreads the relationship – especially useful in transactional or project-based environments.

However, doing something internally does not always represent better value for money. Taking time-costs into consideration, it is often more cost effective to use external agencies than to take up partner time. And, arguably, an independent point of view is more valuable. "Who is asking more often than not affects the answer," says Joe Bell, a director at market intelligence firm Winmark. "Clients tend to be more forthcoming with people they don’t already know."

Using external providers can also deliver skill benefits and objective opinions. Partners cannot claim to be expert interviewers, and their time could well be spent better elsewhere. "Any perception that a firm has of how clients perceive them is all conjecture unless validated by people outside the firm. Only the client really knows," comments Dr Jim Hever of Addleshaw Goddard LLP’s client development centre.

Alternatively, incorporating feedback into the way firms work helps if you can’t outsource it. Most transactions or other compliance projects provide plenty of opportunities for feedback.

Feedback needs to combine qualitative opinions along with hard data. It is then possible to analyse and benchmark the results.

Figure 2 illustrates the results of a client feedback survey undertaken by researchers Resolve Marketing. Ideally, a firm’s performance should sit close to the diagonal line so that it matches the importance a client places on it. Too far over or under the diagonal and the firm is either wasting resources and energy or not meeting expectations.

What is learnt from client feedback needs to be responded to, as feedback is very visible to a client and he/she will expect to see his/her comments acknowledged. "Client feedback can be a negative experience for the client if the information is not acted upon or if the actions taken are not communicated back to the client," says Liz Bostock of Resolve Marketing. For feedback to be useful, it has to be properly planned and delivered within the context of the strategic objectives of your firm. Before undertaking any feedback, firms should determine why they are doing it and what they hope to achieve. This is as important as who and what you ask.

Peter Maher considers the various strategies firms can employ to help them manage their pension liabilities.

Although some firms have closed their final salary pension schemes to new entrants, deficits persist. And while the strength of equity investment over the long term is well reported, the inevitable volatility of the stock market has an immediate effect which impacts on the size of a firm’s pension deficit.

This uncertainty is clearly unwelcome, so many businesses wisely look to a variety of strategies to help smooth this volatility, and, in so doing, demonstrate to the outside world that they are managing the situation.

Leveraged buy-out bonds can be particularly helpful. The use of such vehicles allows the employer to crystallise the full buy-out liability by transferring all of the assets of the scheme to an insurance company which will secure deferred annuities for scheme members. The deficit that exists between the value of assets transferred and the cost of purchasing the deferred annuities becomes a loan to the sponsoring employer afforded by the insurance company. The trustees are discharged of their liability and the employer has a fixed target to fund, i.e. the loan from the insurance company.

The use of structured investment products has also gained ground recently, whereby the conventional 80% equity/20% bond portfolio is turned around so that 80% of the funds are put into AA-rated bonds, with the remaining 20% used to buy call options on, say, the FTSE-100 total return index for ten years. This time horizon enables longterm exposure to equities while protecting the downside.

This approach also helps reduce volatility since the fund value is not determined by stock market levels, but by the total value of the bond holding (plus income accrued), the cash received from maturing options and the present value of the unexpired options. Additionally, since funds are less actively managed, ongoing running costs should fall.

A rather more recent introduction to the market is a product issued and underwritten by one of the largest banking institutions in the world. It potentially provides for a minimum of a deposit-based return and an upside of 20% per annum, subject to a basket of blue chip shares remaining at a higher value than a pre-determined floor price, typically around 75% of its original value. The product has a ten-year lifespan (though it can be traded in between times at the prevailing market price) with an undertaking that the capital will be returned (less charges) at the end of the term, and returns of up to 200% of the original investment are possible.

Further, if any of the fixed annual returns do not become payable because the fl oor price is breached, then they can be reclaimed so long as all the stocks remain above the floor price in the final year, in what could be thought of as a ‘second chance’. While any firm should carefully review financial products such as these, considering both their upsides and downsides, this product could be useful to many businesses.

Finally, it may also be worth looking at deficit insurance. Typically the funding deficit, either full buy-out or FRS 17, can be insured, so that an insurance company extinguishes the debt upon the principal employer going into liquidation or certain other notifiable events.

We look at HMRC’s stance on salary payments to partners’ spouses and tax concessions on late night taxis.

The commerciality of salary payments to the spouse of a partner in a professional firm has recently come under attack by HMRC. This type of payment is typically of a level similar to the annual personal allowance, so if the partner’s spouse does not have any other assessable income, there will be no tax or National Insurance liability arising on this income.

HMRC’s view is that the payment is an appropriation of the partner’s income that would otherwise be subject to tax at 41%. The debate is whether the partner’s spouse does in fact carry out any role for the firm, and some of the duties questioned by HMRC are:

• secretarial duties, including answering the telephone and making appointments
• hosting occasional dinners at a partner’s private residence

• attending corporate functions.

There are additional concerns about the flexibility of partners’ spouses’ roles and their availability at the firm’s request. HMRC also questioned the fact that such employees are not required to keep detailed diaries of their movements.

We understand from HMRC that there is a national review currently being undertaken in relation to this matter. If your firm pays a salary to partners’ spouses or has recently had an enquiry, we can advise you on this matter.

We have seen a worrying change in HM Revenue & Customs’ (HMRC) interpretation of the exemption for the provision of a taxi to get home when an employee is required to work late. For the exemption to apply, HMRC must be satisfied that:

• the employee is occasionally required to work late, i.e. until after 9pm, but

• those occasions are neither frequent, i.e. no more than 60 occasions in a tax year, nor regular, i.e. there is no predictable pattern, and

• at the time of travel, public transport has stopped, or it would not be reasonable to expect the employee to use public transport.

We have clients being challenged on the basis that the exemption is not available after the first occasion on which a late night taxi has been provided. HMRC is taking the stance that if, say, the employee works late every night for a week on a specific project, then only the taxi on the first night falls within the exemption. This does not seem to be in line with HMRC’s 490 Booklet (Employee Travel), which gives examples of workers for whom late night working is a regular feature, such as "people employed in restaurants, clubs and pubs whether on a shift basis or not, or those on regular call-out duty".

HMRC is also challenging that public transport is available after 9pm, although this is not a condition of the exemption. If the employer considers that, for some other reason, it would not be reasonable for the employee to use public transport, the exemption should still apply.

If you are challenged on your late night taxi policy, do not just accept HMRC’s view, as its current approach is not free from doubt.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.