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Lending to Law Firms: Credit Investigations Revisited

Article excerpt

For a lender evaluating a loan request from a law firm, some elements of the credit investigation can be very familiar. After all, lending to law firms is not unlike extending credits to other collections of professionals--such as groups of health-care providers or partnerships of accountants. The creditworthiness of the individuals involved in the practice is what is important because these professionals generate cash flow, which is vital to repayment ability.

Special Aspects of Law Firm Lending

But there are also special aspects to lending to a law firm that, if handled improperly, could be troublesome. This article is intended to address these issues. It will concentrate on the following aspects of a loan to a law firm.

1. Purpose.

2. Legal issues.

3. Accounting issues.

4. Concentration issues.

5. Margins and operating leverage.

6. Capital.

7. Collateral.

8. Liability management.

9. Covenants.

10. Information requirements.

Purpose

Loans to law firms are typically to finance working capital, to bridge gaps in the collection of accounts receivable, or for capital expenditures associated with a move or leasehold improvements. Also, letters of credit may be provided for rent security.

The bank should not finance distributions in excess of net income. A strong firm will use lines of credit to finance the growth in working accounts and bridge seasonal timing differences in collections and expenditures, meeting or exceeding all requirements to retire short-term bank debt while increasing capital. A weak firm may attempt to use lines to maintain partner distributions in the face of falling collections, evidenced by uninterrupted use of short-term bank debt and diminishing capital.

The bank should not finance activities outside the practice of law unless the firm obtains the prior approval of its partners.

Legal Issues

Most law firms are structured as general partnerships. Each partner, as a general partner, is personally liable under partnership law for all the obligations of the partnership. In structuring credit facilities, personal liability as a general partner should be assumed to apply only after the liquidation of all partnership assets. Therefore, personal liability as a general partner should not be viewed as comparable to, or an acceptable substitute for, a personal guaranty allowing immediate recourse.

The method of legal recourse to partners for credit facilities will vary in relation to the relative size and strength of the firm. Credit facilities to the largest, most profitable, and best-capitalized firms may rely on recourse through partners' liability as general partners; however, that liability may be limited. Credit facilities to smaller law firms should have the unlimited, joint and several, personal guaranty of all the partners.

The lender must review the partnership agreement to understand the business, its organization, and its governing process and operating procedures.

Any provision in the partnership agreement for releasing individual partners from liability upon retirement or withdrawal should be addressed, even if superseded by the bank's loan or guaranty documents. The intent of this recommendation is to establish a mutually acceptable understanding with the partners regarding their individual obligations at the initiation of any credit relationship.

If the partnership has been incorporated as a professional corporation (PC), the individual partners must guarantee their PC's obligations to the bank.

The bank should be notified of any changes to the partnership agreement, particularly those reflecting additions or withdrawals of partners. New partners should be required to execute whatever documents are necessary to assume their liability for all existing and future bank obligations.

As much as possible, bankers should deal directly with the senior partners of the firm, as outlined in the partnership agreement, including members of the management or executive committee or the managing or financial partner. …