Changes to Preference and the impact on law firms

Law firms may well need to look at the impact of this change on their business because, if you have borrowings of almost any nature, they might affect your ability to borrow from your bank or other lender: or the price you must pay for that borrowing.

Banks, typically, have to secure their lending to law firms using floating charges because of the nature of the assets law firms hold. While some firms have assets that lend themselves to a fixed charge, such as property or significant IT equipment, most of the big assets on balance sheets comprise Debtors, (unpaid bills) or Work-in-Progress (unbilled time). These assets are constantly shifting and being replaced with assets of a similar nature, which is why a floating charge is used.

The change in December 2020 was that HMRC’s Preference, which had been abolished in 2003, has been restored. At the same time, the maximum “prescribed part” of realisations, which was introduced as a quid pro quo in 2003 for losing that preference, is being increased to £800,000. The “prescribed part” is a percentage, (but subject to that maximum of £800,000), of the value of assets subject to a floating charge, which is instead of being paid out to floating charge holders, is payable to unsecured creditors.

If you are with me so far, then great: if not the table below should help.

Example Law firm Balance Sheet and values
Asset/(Liability)	Security	£’000
Freehold Land & Building	Fixed (Bank)	1,000
Plant & machinery	Floating (Bank)	500
Work-in-Progress	Floating (Bank)	1,500
Debtors	Floating (Bank)	750
Total Assets		3,750
Less:
Bank Loans and Overdraft		(2,000)
Other loans		(500)
HMRC, (VAT, PAYE, Student Loans deductions)		(750)
Trade Creditors and other unsecured creditors		(1,500)
Owners’ capital (overdrawn)		1,000
Total Liabilities		3,750

If this firm was to be wound up, then, (ignoring the complexity of the prescribed part and the possibilities of Personal Guarantees), the allocation of preference under the old and new rules would be as follows:

Asset/(Liability)	Paid to	Realised under Old Rules	Realised under New Rules
		£’000	£’000
Freehold Land & Building	Bank (Fixed charge)	1,000	1,000
HMRC	Crown (Preference)	-	750
Plant & machinery	Bank (Floating Charge)	750	750
Work-in-Progress	Bank (Floating Charge)	1,500	500
Debtors	Bank (Floating Charge)	500	-
Total assets realised		3,750	3,750
Paid to Bank		3,750	3,000
Paid to HMRC		Nil	750

The bank’s risk of not recovering its lending has increased as result of this change in the law. They will be more careful about how much they lend to this firm and on the face of it would either reduce their lending by £750k or they will price their risk much higher. Neither option is attractive to the firm.

With the impacts of the pandemic, this change, (which was already deferred from 6 April 2020), comes at a difficult time for law firms. It makes it even more important that they practice rigorous financial discipline. The messages are old but remain true:

• bill more quickly;

• collect debts more quickly;

• pay creditors more slowly;

• manage your budget and

• manage your cashflow.

By doing so, you will reduce the need for bank facilities and that must be better for everyone.

Smaller firms rarely have the support to enable them to do this. The obvious source is their accountant, or an experienced law firm finance expert, either of whom should be able to understand the nature of the business and can prepare the budgets and cashflows that will be needed when having those discussions with the Bank.

In the meantime, be prepared for tricky negotiations with your law firm’s bank over the next few months as the facility renewal discussions take place.

^{*The views expressed are the author’s and not ICAEW}

An experienced Legal Finance specialist, Richard joined Baskerville Drummond in 2019 and has helped grow the consultancy to be one of the leading providers of independent strategic advice to UK Law Firms. He can be contacted on 01908 595 575 or by email.