Scotland feature: Saltire in the wounds

While Scottish banks prospered law firms lived like lairds, moving into modern, high-end premises. But then came the crash

When Glasgow-headquartered Semple Fraser called in the administrators on 8 March the reaction from Scotland’s legal fraternity was one of knowing surprise: they knew something like this was going to happen at some point, they just did not know when or to whom.

Such certainty in a time of recession is a rare thing, even when it comes to bad news, but with the near-collapse of Scottish banking giants RBS and HBoS casting a long shadow over the nation’s legal sector, the knock-on effect on its law firms was inevitable. Last year’s financials showed the tough time Scottish firms were having. This year’s results could see the worst figures posted in years.

RBS

Banking on growth

Oil, whisky and tartan-themed tourism may be key elements of the Scottish economy, but it is the country’s banks that have been the authors of its modern history.

Many historians argue that the 1707 Act of Union with England was driven by a crisis in the Scottish banking sector, while the foundations of SNP leader Alex Salmond’s independence bid were built on RBS’s perceived strength – and could yet falter thanks to the question of monetary union with the Bank of England.

It was perhaps inevitable, then, that the country’s law firms would become reliant on its banks, which provided a steady stream of work across a range of practice areas.

“A huge amount of work was instructed by the banks prior to 2008 and firms north of the border probably benefited disproportionately,” says Morton Fraser chief executive Chris Harte. “There were very few things around that time that HBoS and RBS weren’t involved in. It was nuts.”

Burness chairman Philip Rodney agrees. “Scotland had a disproportionately large financial services sector and looking back it’s quite amazing how important RBS and HBoS were,” he says. “A lot of property work was related to bank lending, but if you think about how colossal the banks were back then there was a complex mix of work that included transactions, litigation and employment.”

Pride

For firms across the market this was good news, with turnover walking through the door without much effort needed to attract it (see table, below).

Indeed, before the recession, firms were happy to crow about their relationships with RBS and HBoS, with firm submissions for The Lawyer UK 100 in 2004, 2005 and 2006 seeing Brodies, Burness, Dundas & Wilson, Maclay Murray & Spens, McGrigors, Shepherd & Wedderburn and Tods Murray all name one or both of the banks as key clients.

In 2005 Tods Murray claimed to The Herald that its six-year-old banking practice was on course for “another record year” after handling work for the likes of Bank of Scotland, Allied Irish Bank and Northern Rock.

Similarly, in June 2008 Morton Fraser issued a press release in which it listed its major achievements for the year, including “retaining major clients such as […] RBS and Bank of Scotland”.

Before the fall

As the work flowed in firms began to reassess their accommodation needs, signing up to move from Victorian and Edwardian terraces to large business-district developments. Although the standard cash incentives and rent-free periods applied, firms did not realise they were taking on extra liabilities at a time when turnover was about to collapse.

“In terms of identifying risks, many law firms thought the gravy train with banks would continue indefinitely and they moved themselves from B-class office accommodation to A-class,” says a source in the Scottish market.

“I was at a Lloyds cricket match in 2008 and a surveyor told me there were problems on the way because surveyors and lawyers were moving into the most expensive space – when they do that you know you’re heading to a recession. That’s when you’ve hit the top of the market [because firms have the additional resources to spend on property].”

Semple Fraser is a case in point. Riding high on its 2006/07 turnover of £15m, the firm signed a deal on 1 November 2007 to take on 30,500sq ft of office space in a development on Glasgow’s St Vincent Street that commercial property partner Paul Haniford described at the time as being “right in the heart of Glasgow’s buzzing business community, with great social amenities and easy access to good transport links”.

The firm moved in in July 2008, taking up a 15-year lease with a break option for 2018.

Although the terms of the off-market deal were not made public, the firm’s LLP accounts reveal its impact. In 2006/07, when turnover was £15m and the highest-earning partner took home £739,000, the firm’s leases on land and buildings with a term of up to five years totalled £394,000, the equivalent of 2.5 per cent of turnover. In 2008/09, when turnover had dropped to £12m and the highest-paid member received £414,000, the firm’s property commitments had jumped to £804,000 – the equivalent of nearly 7 per cent of turnover – with almost £500,000 of that on leases with a term of more than five years.

By the year to April 2011, the last year for which the firm filed accounts, turnover stood at £12.2m and the highest profit share was £218,000. Lease commitments, however, had risen to £1.24m – 10 per cent of turnover – with £865,000 of that being long-term. Throughout the period the firm’s annual wage bill remained relatively static at around the £4m mark.

Crunch time

While there is no suggestion that others will follow the same path as Semple Fraser, LLP accounts show that a number of other Scottish firms are grappling with drastically increased property costs at a time when revenue is stubbornly refusing to come back (see Moving Costs below).

The problem is multi-layered, but it all comes back to one source: the banks.

It is no secret that a swathe of work dried up overnight when RBS and HBoS were bailed out by the Government, with the big-ticket mandates for breaking up the banks going to magic circle firms such as Linklaters, which advised RBS on its demerger with ABM Amro in 2010, and Allen & Overy, which acted on the bank’s 2012 flotation of Direct Line Insurance. Having never really got a look-in on that kind of work anyway, it was the withdrawal of lower level, bread and butter work that really hurt in Scotland.

“Anything that was debt-financed – which was a big part of the Scottish market – dried up,” says Anderson Strathern managing partner Andrew Lothian. “It’s pretty clear the domestic market in Scotland began to contract around 2008 and has contracted by about 20 per cent since. The majority of firms have lost revenue.”

There was then something of a rebound, when the banks turned to lawyers to find out exactly how exposed they were to their customer bases, lulling firms into a false sense of security.

“When the banks became bad banks the fees firms were charging were astronomical and that kept turnover levels up,” says Harper Macleod chief executive Martin Darroch. “They lost multi-matter work, but replaced it with big matters and that resulted in a bit of a rebound.

“What a lot of firms got wrong when they saw some work turn off and then got big fees for bad bank work, was thinking the market was on the turn, and they moved into palaces.”

This could have been okay for firms if the recession had not lasted far longer than anyone predicted, although Brodies managing partner Bill Drummond does not believe firms should be judged too severely for not being able to predict the way the economy would turn.

“Everyone was caught by surprise by the credit crunch and the length of the recession,” he says. “I don’t think it’s right to criticise firms for that.”

But, as Rodney says about firms that took on new lease commitments in the belief that the market would have bounced back before their rent-free periods came to an end, “people entered into deals with their fingers crossed and that’s bitten them”.

This has all been compounded by the fact that, while there is still banking work to be had, one consequence of Scotland’s largest banks being bailed out by the taxpayer is that there is now far less being instructed out of Edinburgh. For Scotland’s firms this creates a double negative: they are forced to take their chances in the ultra-competitive whole-of-UK market, while their old lines of contact with banks no longer exist.

“All the power in the banks has shifted to London and the work is now procured properly – it doesn’t just go to the old school tie,” says Darroch.

Feature Table 010413

Strength in specialisation

Not all Scottish firms are struggling. There is a small group – Brodies, Burness, Dickson Minto, Harper Macleod and Turcan Connell – that has weathered the recession, if not unscathed, then at least with both top and bottom lines in as good a position as when it began.

All very different businesses, what sets them apart from the rest of the Scottish firms is that they have all focused on specific areas rather than taking on every piece of work that comes their way. For Brodies and Burness that has meant positioning themselves as high-end Scotland-only commercial businesses. This has paid off, with both firms enjoying a steady stream of lucrative referrals from the City.

Harper Macleod has positioned itself at the more value end of the market and has proved itself quick to take advantage of opportunities, recently launching a renewable energy practice with a team from McClure Naismith and redeploying lawyers to other areas as soon as the recession hit rather than waiting to see how things panned out.

Dickson Minto and Turcan Connell have remained wedded to their private equity and private client cores, even when that meant a tough couple of years in the post-2008 world.

Each business has also enjoyed strong continuous leadership from managing partners and chief executives who have steered a course through smooth and choppy waters and become synonymous with their firms in the process.

Drummond and Rodney have run their firms since 1998 while Harper Macleod’s Darroch, an accountant, has led his since 2006, having been its finance director from 2002. Dickson Minto and Turcan Connell are still run by the partner duos that set up the firms in 1985 and 1997 respectively.

“We’ve all been clear about what we’re doing and we’ve gone after it,” says Darroch. “A lot of firms chase the top line, but don’t work out what it’s doing for them.”

This sentiment is echoed by Rodney. “A strategy’s not a strategy unless you’re prepared to say no to certain types of business,” he says.

Emergency mergers

Part of the issue for firms outside this grouping is that even at its largest, the Scottish market occupies the middle ground of the UK profession.

And the middle of the middle of a market that is being squeezed from all directions is not a comfortable place to be. For some in Scotland the only way to survive in such a situation is to add turnover, and that inevitably means merger.

The past two years have seen unprecedented change in Scotland in this regard. Erstwhile Scottish leader McGrigors, which along with Dundas, Maclays and Shepherds expanded into the City in a bid to capitalise on the banking relationships it enjoyed north of the border, has been taken over by UK firm Pinsent Masons, while the other three are all in the market for a similar deal.

Burness has merged with Aberdeen firm Paull & Williamsons, Anderson Strathern has taken over property boutique Bell & Scott, Morton Fraser has bolted on Glasgow’s Macdonalds and Biggart Baillie has been swallowed up by DWF.

The rationale, according to Morton Fraser’s Harte, is simple.

“At the end of the day, it’s not all about turnover, although for us turnover is important,” he says. “It’s difficult to prosper as a legal business in the present environment if you don’t have a certain level of turnover, but it’s about adding the right turnover and making sure that’s adding profit too.”

Lothian agrees. “Adding revenue is our main strategic objective just now as it means you can spread fixed costs across a broader base,” he says, adding: “It’s my job to make that growth profitable.”

On the face of it, bulking up may not be such a bad idea, especially following a long period of little change in the Scottish legal sector. Certainly, Drummond believes being open to change can be the key to success.

“We had to change in the late 1990s because we had high debt-to-turnover ratios,” he says. “Darwinism is a part of the legal sector, and if you don’t adapt and change you won’t survive.”

But is merging really the answer?

“Some firms are running for cover,” says Rodney. “They’re huddling up and I’m not convinced that solves problems. If you put two weak firms together you just get one bigger weak firm – the sheer fact of a combination won’t save them.”

Even getting a combination off the ground can be tricky. According to one source, Semple Fraser began merger talks with a number of firms, but could not seal a deal due to its property liabilities, something that could prove a stumbling block for other firms in the market for a merger.

“Semple Fraser was Scotland’s Halliwells and it’s made banks and lenders look more closely at the legal sector,” says the source.

Perhaps the greatest irony of all, then, is that the banks that provided the work that spurred the office moves that are now crippling the firms could ultimately seal their fate.

Moving costs

The trend for costly office moves among Scottish firms started in 2005, when Tods Murray took on 41,000sq ft in Edinburgh’s Fountainbridge development, where Bank of Scotland was already based.

The deal, agreed the previous year for an annual cost of just over £1m, came at a time of renewed activity for Edinburgh city centre’s office market, which had seen annual take-up in 2003 rise 42 per cent on the previous year to 920,000sq ft, according to real estate consultancy Knight Frank.

The move, which saw the firm end its 100-year tenancy in the city’s Queen Street, was followed in 2006 by McClure Naismith’s relocation to purpose-built offices in Edinburgh’s Ponton Street. The firm took a 16-year lease on almost 16,000sq ft, moving from two New Town offices after what then senior partner Kenneth Chrystie described as a “very busy” year for the firm.

“The growth in turnover over the past few years and the significant jump in partner numbers reflects the underlying strength of the business. Our new, larger offices in Edinburgh have been well-timed,” he told Scottish legal pubication The Firm in May 2006.

When in 2009 Morton Fraser took on a 15-year lease on more than 36,000sq ft in Edinburgh’s £20m Quartermile development, its then chief executive Linda Urquhart hailed the firm’s “bold move from a traditional Edinburgh property into one of the most contemporary buildings in the new business district”.

And in 2010, when MacRoberts began a 15-year lease on 33,500sq ft at Glasgow’s Atlantic Quay development, thought to cost between £24 and £27 per sq ft, then managing partner Michael Murphy said it signalled the “ambition for the future of the firm and also of our desire to provide MacRoberts’ staff with modern, attractive and comfortable office accommodation that enhances the efficiency of the way we work together”.

However, behind the flashy moves were high price tags revealed in the firms’ LLP accounts.

Though the terms of any rent-free or cash incentive deals are not known, all four firms are now allocating a much higher proportion of their income to cover property costs – at a time when turnover has fallen across the board.

In the 2007/08 financial year, MacRoberts and Morton Fraser allocated 4 per cent of turnover to rent, at £740,000 and £626,190 respectively. At McClures and Tods Murray, the figure was 5 per cent, the equivalent of £795,570 and £1.04m.

By 2011/12 the proportions had risen considerably, to 7 per cent at McClures and Morton Fraser, 9 per cent at MacRoberts and 11 per cent at Tods Murray, with respective rents standing at £939,416, £945,315, £1.5m and £1.3m.

To put that into context, magic circle firm Allen & Overy, which has the highest proportional property costs of all firms in The Lawyer’s UK 200, spends £100m per year on rent. In 2011/12, when turnover stood at £1.14bn, that equated to 9 per cent of turnover.

In the same period, Burness’s rent was 6 per cent of turnover and Harper Macleod’s was 2 per cent.

As a source in the market says: “If you’re servicing debt there’s a real fine line when you’re only a £15-20m business between success and failure and being able to meet obligations.”