There has been a lot of talk of late about the “embattled” sector of the listed law firm (or in the words of Slater & Gordon’s Managing Director Andrew Grech “ink spilt”. Slater & Gordon recently posted a loss of $958.3m for the half year ending 31 December 2015.
Slater & Gordon’s share price has fallen more than 95% since April 2015 from a high of $8.07 to a current price of 38.7 cents which represents a reduction in the market value of the firm of more than $1.3 billion.
The fate of plaintiff law firm Shine has been similar, with it recently posting a 90% reduction in its interim earnings to $1.3m and announcing that it will not declare an interim dividend.
The dramatic fall from grace of these two listed law firms do have some similarities.
The downfall of Slater & Gordon is said to be attributable to firstly, its bad acquisition of the professional services division of the UK firm, Quindell for $1.23b which has now been written down by $814.2m.
Secondly, the value of Slater & Gordon has been affected by how the company has accounted for goodwill and work in progress which has been the subject of scrutiny by ASIC. The single biggest asset on the Slater & Gordon balance sheet is “work in progress” which as at 31 December was listed as $662m. “Work in Progress” represent the fees incurred to that date which a firm expects to make if it wins a case. As a law firm (as opposed to a litigation funder), Slater & Gordon is not permitted to charge clients a percentage of the damages achieved; rather, it may only charge them the fees incurred, plus an uplift which must not exceed 25%. The uplift is allowed so as to compensate the law firm for acting on a contingency (“no win no fee”) basis. The problem is that since its listing in 2006, Slater & Gordon has demonstrated that it is unable to convert the whole (or even a substantial part) of this work in progress into cash. Since listing, its entire profit generated sits at $313m.
Similarly, at the end of January this year, Shine adjusted its expected earnings for the financial year from $54m to $26m following a review of its work in progress and disbursement provisioning and the downgrade resulted in a one off provision of $17.5 million for work in progress recovery rates for existing personal injury cases. Work in progress assets account for the majority of Shine’s asset pool of $316m. Shine has also attributed its income decline to greater than expected write offs and competition in Queensland.
The common thread between the downgrades of both Shine and Slater & Gordon is their overstatement of their work in progress assets and a failure to achieve as profit this asset.
These firms recognise this WIP as revenue at the time that the services are delivered but this is revenue which will never be realised if the case is ultimately unsuccessful. Slater & Gordon have now adopted (on a retrospective basis from 1 July 2014) accounting standard AASB 15 for revenue recognition which requires that work in progress may only be recognised as revenue when it is “highly probable that a significant reversal of revenue recognised will not occur”. The reliance by plaintiff law firms on work in progress also causes cash flow problems for these firms with the firms carrying the cost of the legal work and disbursements until the completion of the case. This cash flow pressure was likely a motivation for the ASX listing of these firms in the first place.
The business model of litigation funders is fundamentally different to that of these listed law firms. Litigation funders also carry the costs of a piece of litigation until the completion of the case but typically do not treat these costs as revenue. Generally, the market does not measure the value of litigation funders based on the amount of these funded costs. Rather litigation funders are valued either on a cash basis (as a multiple of their earnings) or based on the aggregate of the expected size of the damages awards from the cases being funded by the funder.
In addition, the expected profit which will be realised by a litigation funder from a case is not linked to the amount of costs funded; rather funders are entitled to a percentage of the damages from a case which in substantial cases can be a significant amount. IMF Bentham announced recently that it expects to make a net profit (before tax) of $47m in respect to its funded class action against the ratings agency S&P. These are profits of a magnitude that plaintiff law firms (who are restricted to recovering their fees plus an uplift) are unlikely to achieve. It is true of course that a litigation funder may lose a case and not realise its expected profit, however, if a funder has a pool of large cases such losses will not have as dramatic an impact on overall performance.
Litigation funders are wary of concentration risk. That is, they avoid having too many of their cases in one area which would increase the likelihood of multiple losses. The focus by both Slater & Gordon and Shine on personal injury matters is also a form of concentration risk. These are typically lower value cases (personal injury claims are subject to caps on general damages in Australia) in respect of which a large volume is required in order to generate profits. The concentration in personal injury cases is one of the reasons Slater & Gordon suffered a profit downgrade following the announcement in November last year that the British government intends to restrict the amount and the nature of damages which can be acquired in motor accident claims.
The requirement for a high volume of cases makes this type of work particularly susceptible to the threat posed by competition (identified by Shine) and is also prone to a less rigorous risk assessment process given that high volumes are key to profitability. It is telling that Shine has confirmed that its downgrade due to cases which are now considered unlikely to success are limited to the personal injury business and do not include class actions.
Litigation funders in Australia have typically focussed on funding a spread of cases comprised by class actions, commercial claims and claims arising out of insolvency. This spread seeks to avoid the concentration risk which plaintiff law firms are prone to. Litigation funders also do not treat as revenue the expenses funded towards a case, nor are their profits linked to the recovery of these expenses in the same way that is the case for plaintiff law firms. As such, litigation funders are unlikely to fall victim to the large downgrades which have plagued the listed law firm sector in Australia.