Business of Law

Loans and Moans

Past firm failures mean tougher credit rules

Posted Sep 1, 2009 9:00 PM CDT
By Susan A. Berson

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In January, access to cash was a panic-button issue for law firms both big and small. Cratering credit markets and sinking firm revenues had lenders closing their vaults or impos­ing stringent terms and restrictions for the trickle of funds for which firms could qualify.

Now the good news is that bankers view law firms as a good bet again. But the bad news is that firm manage­ment still has challenges to avoiding the headache-inducing finance terms accrued from the mistakes of law firms past.

Heller Ehrman, Thelen, Wolf­Block and Thacher Proffitt & Wood are much-publicized examples of defunct law firms whose long-term debt or credit-line issues contributed to their downfalls. The continuing jettison of lawyers and unprofitable practice groups, delays in associate start dates, and salary cuts are only some of the steps law firms are taking in hopes of satisfying lenders.

When a firm has dwindling revenues, the steps to a reduced risk profile may include “turning to fairly aggressive measures to re­duce costs, improve cash positions and shore up capital base,” says Brad Hildebrandt of Somerset, N.J., founder of the professional services management firm Hildebrandt, which claims to represent 80 percent of the top law firms around the world.

His firm and Citibank have prepared a report detailing a laundry list of changes firms have had to institute before getting credit. They include placing strict internal controls on discretionary spending, cutting bonuses, freezing associate salaries, postponing new hires or initiatives, laying off professional and administrative staff, and revamping partner compensation schedules to slow distributions and improve cash positions.

“Insufficient partner capital, expanding in questionable economic environments, unproductive offices and overcommitting on real estate” are the top mistakes that can bring a firm trouble, Hildebrandt says.

While a lot of loan paperwork is standardized, liquidity and debt structure limitations are covenants that lenders tailor according to a firm. Cur­rently, the provisions that have the potential to frustrate partners are the ones lenders have found necessary in the wake of law firm closings.

Citibank and JPMorgan Chase & Co. have been betting on law firms for decades. To secure favorable financing from these top players, as well as other lenders, firms should provide reassurance that good management is steering the financial helm.

“That means we’ll see that collections are actively managed, and it’s clear that management has an understanding of cash flow, including where it’s going and where it’s needed,” says Sharon Weinberg, managing director of JPMorgan Chase’s law firm group. The group provides financing to 60 percent of the Am Law 100 firms.

“Lenders also may look to whether there is a diversification of practice areas. ... We’ll look to see that management has contingencies planned to adapt firm operations to possible market changes,” Weinberg says. “And, of course, management needs to watch overall compensation carefully in declining markets.”
The departure of partners or a practice group has been shown to be a sign that a firm may be in trouble, Weinberg says, so “covenants concerning the mandatory number of partners are generally necessary.”

Also, requiring future years’ partner profit distributions as security may be a lender’s response to a systematic problem of putting up with slow-paying clients. Distrib­uting big bonuses with declining revenues may also raise questions, as well as lenders’ limitations on partner draws.

Though lenders can’t discuss customers and their loan information, the consensus is that a firm that hesitates to institute stricter controls on spending, blows through the line of credit to pay big bonuses in bad times, and lacks contingency plans to combat the exodus of a revenue-generating practice group will cause lenders concern. And for firms that are unresponsive to those concerns, borrowing against next year’s partner profit distributions or deferring payouts to ex-partners may be required.

SEVEN STEPS

Because Moody’s economy.com predicts financial belt-tightening won’t end until early 2011, firms teeing up for the best credit terms should be mindful of these seven business-minded suggestions.

1. Borrow with a purpose. “Seek­ing credit without a defined business purpose ... or increasing debt for abstract business development for an arbitrary few without tying to a defined target, market or client base can quickly deplete funds with no return,” cautions Weinberg.

2. Balance credit needs with partner capital. For example, tapping a line of credit at the beginning of the year to pay bonuses of the previous year is common. But borrowing to pay bo­nuses when the future looks grim can lead to too much reliance on debt.

3. Do your research. Small and medium-size firms, as well as large firms having contingency and nonbillable-hour business models, should include community and regional banks in their financing search. Shop around.

“Get three or four offers on the table,” says Mark McAfee, chief lending officer for Esquire Bank, which is focused in the New York City area.

“We’ve seen lawyers who get stuck with terms and arrangements that don’t work for their particular type of firm, such as plaintiff attorneys,” explains Andrew C. Sagliocca, Esquire Bank president and CEO. “From lines of credit that assist attorneys with case financing to online IOLTA account management, ...  lawyers should ask what financial package can be tailored to their firm.”

Also, assess the financial strength, capital, asset quality, liquidity and growth prospects of a lender. “It’s understandable that you want to lock in a good rate,” Weinberg cautions, “but ... there is no free money.”

4. Choose lenders that understand your business. “Law firms are unique,” says Dan DiPietro, managing director of Citi Private Bank’s law firm group, which counts more than 600 law firms as customers. “They’re more conservative than other industry sectors, in general. They tend toward bet­ter capitalization and are less inclined toward financial leveraging.” 

5. Talk it out. “If a firm experiences financial problems, address it with your lender earlier rather than later,” advises DiPietro.

6. Select management with a business sense. Perhaps John Murphy, chair of Shook, Hardy & Bacon in Kansas City, Mo., captures management fundamentals best: “There has to be someone in charge who has the courage and stamina to say no to a partner, regardless of stature, when he or she wants to spend ridiculous sums of money.”

7. Innovate. An early proponent of firms revamping the traditional lockstep compensation model, DiPietro applauds Orrick, Herrington & Sutcliffe’s decision to abandon that model in favor of a productivity-driven associate compensation system, a move also taken by Squire Sanders & Dempsey and Morgan Lewis & Bockius. Both DiPietro and Hildebrandt expect other firms to announce new measures before 2009 ends.

As DiPietro says, “Implementing innovation can be a challenge for firm leadership, but it’s one that can improve a firm’s bottom line.”

Susan A. Berson is a partner with the Banking & Tax Law Group of Leawood, Kan. She is the author of The Modern Rules of Personal Finance for Professionals. She can be reached at .(JavaScript must be enabled to view this email address).

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