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Slater and Gordon

The Rise and Demise of Slater and Gordon The company In early 2015 Andrew Grech, Managing Director of Slater and Gordon, was at the peak of his professional success. Grech had come from a very modest working-class background to head up what was described as “the world’s biggest listed law firm” (Fyfe, 2016). The success of Grech was reflected in his earnings which in 2008 were $375,000 and by the end of 2017 had jumped to more than $866,000 per annum. This was a far cry from the humble beginnings of Slater and Gordon in 1935 when the two founding partners, Bill Slater and Hugh Gordon, commenced the business working primarily on workers’ compensation cases in the offices of the Australian Railway Union. They soon developed a name for themselves in battling for the underdog. Back in 2001, after changes to the Legal Professions Act allowing law firms to structure themselves as limited liability companies, Slater and Gordon incorporated their business to become Slater and Gordon Ltd. Prior to this, most law firms including Slater and Gordon, typically operated as partnerships. Throughout the years Slater and Gordon (SGH) had enjoyed several successes on very high-profile cases involving workers’ rights, negligence and product liability claims. These cases included long, drawn out battles against Australian and multinational companies such as British American Tobacco, BHP Billiton, CSR and James Hardie Industries just to name a few. Whilst these high-profile class actions were very positive for the firm’s brand and marketing they were said to provide ‘lumpy revenue’ (Shapiro and Eyers, 2015). By 2005, SGH had put their ‘growth by acquisition’ strategy into high gear. Such was the extent of this strategy, coupled with a booming share market, SGH decided to float the company in 2007. By this time much of the SGH profits came from much smaller litigation cases predominantly in the areas of personal injury and workers’ compensation claims. This area of the practice accounted for approximately 65 per cent of the total revenue. The firm was indeed continuing to prosper. SGH was a household name in Australia. This was primarily due to a concentrated media campaign promoting their ‘No win, No fee’ business model. Under this type of agreement, the law firm took on a plaintiff’s case, and if unsuccessful, then no fee was charged to the client. Whilst this may seem attractive to the client, the underlying issues of billing and revenue recognition can be problematic for the firm. As the firm worked on individual cases, it increased its Work in Process (WIP) account and credit to Revenue. Accounting challenges for professional services firms and billing include the need for considerable estimation, and at times, gazing into the crystal ball. This is further exacerbated as cases for personal injury and the like, can often take years to settle. (A similar example of problems with revenue recognition was seen in the administration of Knights Insolvency Administration, an accounting firm, which required a write-down of nearly $7million to Work in Progress in the 2005 financial year (Perret and Askew, 2005). After listing on the ASX just two years earlier, Knights Insolvency Administration itself became insolvent). 1 Slater and Gordon

The applicable accounting standard AASB118 Revenue, in hindsight at least, appears to have allowed flexibility in the interpretation of the recognition of revenue. Back to the Float The float of Slater and Gordon Holdings Ltd in 2007 signalled warning signs to some potential investors surrounding conflicts of interest, particularly with respect to the company’s duty to act in the best interests of the shareholders. To this end, SGH included a specific clause in their prospectus: “Lawyers have a primary duty to the courts and a secondary duty to their clients. These duties are paramount given the nature of the Company’s business as an Incorporated Legal Practice. There could be circumstances in which the lawyers of Slater & Gordon are required to act in accordance with these duties and contrary to other corporate responsibilities and against the interests of Shareholders or the short-term profitability of the Company.” (SGH Prospectus 2007, p9). The above clause effectively meant that after the duty to the courts first, then to the clients, that a duty to shareholders would rank third. In May 2007 the $35 million capital raising by SGH made international business headlines. SGH was the first law firm in the world to list on a securities exchange. On the back of glowing forecasts from Managing Director, Grech, the market embraced the listing with the $1 shares opening at $1.32. SGH advised via its prospectus and presentations to the market that nearly $15.5 million of the capital raised would be used to fund an acquisition program together with increased advertising and promotion. Over the next few years SGH continued with its acquisition strategy. Grech continued to be held out as a ‘market darling’ with investors happy and encouraged by the continual upward forecasts. Between the years of 2007-2011 SGH acquired in excess of twenty firms across Australia. In 2012 SGH commenced their foray into the United Kingdom where they acquired 7 law firms by the end of 2013 (Shapiro and Eyers, 2015). In 2013 SGH was the best performing stock in the top 200 in Australia. The transformative deal This insatiable hunger for growth however was to be the beginning of the end of their moment in the sun1. Whilst some analysts working quietly behind closed doors of various investment firms suspected some issues were brewing with the SGH accounts and forecasts (Fyfe, 2016), the company was on the cusp of launching its biggest acquisition yet – a firm by the name of Quindell, operating in the United Kingdom. Quindell was a professional services firm essentially offering a one-stop shop for vehicle accident claims, and subsequently, personal injury claims. Prior to the April 2015 takeover, SGH undertook intense due diligence of Quindell’s operations, sending tens and tens of its Australian-based lawyers to the UK. A small army of auditors were also seconded for the project. SGH was satisfied with its investigation of Quindell and subsequently on Monday 30 th March made an announcement to the market. The deal, which Grech described as ‘transformative’ was to acquire a major part of Quindell Professional Services for $1.2 billion. The deal did prove to be transformative but not in the way SGH had envisioned. Grech and SGH convinced the market of the wisdom of the 1

A brief period of time where one enjoys success or accolades.

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deal and had a successful capital raising of $890 million to fund the acquisition, which resulted in a market capitalisation catapulting SGH into the ASX100. The key group of senior executives at SGH, known as the ‘gang of four’, all experienced significant growth in their own personal wealth, which on paper had soared to over $30 million each. Staff at SGH were not immune to the excitement and anticipation of further promised success. The majority all had faith in and trusted Grech to the extent where some staff even mortgaged their own homes to purchase shares in SGH. But not all staff were so caught up in this perceived fast lane of fortunes. A number of senior staff who had been with SGH several years were not as star struck with the self-beliefs of the gang of four. However it appeared that there was no longer anyone at senior executive level that would stand up to Grech, let alone say “No”. The last person known to stand up to Grech, a former partner of the firm and subsequent director, left the company some years earlier. But from the outside not all were convinced this was such a great deal for SGH and this was not limited to Australian observers and analysts. In response to the publication of a scathing report into Quindell written by a young analyst David Yu in April 2014, Dan McCrum of the Financial Times in the United Kingdom, raised several questions regarding the deal. He noted that there was to be a review into what was described as Quindell’s aggressive accounting policies by PwC. These questionable accounting policies, similarly to SGH, related to WIP and revenue recognition. Of particular interest to McCrum was the 53,000 Quindell cases of industrial deafness being taken on by SGH. These cases for personal injury damages were made against (past) employers for hearing damage sustained in the workplace, predominately manufacturing, industrial or construction related work environments. These types of cases are very lengthy coupled with significant challenges in establishing the extent of injury and ultimate liability of the employer. The firm recognised revenue on a 70 per cent success rate. Many advisors described these claims as dubious. The industry average for revenue recognition of legal cases was 40 per cent (Fyfe, 2016). Further issues associated with the Quindell acquisition were the legal reforms put in place by the UK government, which made the success of smaller personal injury cases much, much harder to achieve. Just weeks after the SGH and Quindell deal announcement, SGH share price rose to near high of $8, giving the company a market value of $2.7 billion. But the old adage of ‘what goes up must come down’ held water where SGH is concerned. The decline was evident within a few short months. Back in the UK, the PwC review into Quindell accounting practices was conducted into the December 31, 2013 accounts. The review revealed that former auditors KPMG, had failed in two areas of the audit, one being revenue recognition for legal services. 2 By September 2015, ASIC were investigating SGH. The focus of their investigations was on not only the Quindell acquisition, but also, much closer to home, into their policies and valuation methods of revenue recognition and valuation of WIP. 2

In 2018 KPMG were subsequently fined GBP4.5 million by the Financial Reporting Council for failures of the audit.

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November 2015 saw SGH share price fall by 50%. This reaction by the market was in response to an announcement by Grech at the 2015 AGM that no additional UK law reforms were forthcoming. Just six days later the UK government did in fact announce additional reforms which would result in further excluding lawyers access to previously high-volume compensation cases. By the end of February 2016 SGH revealed a first-half loss of $958 million. Approximately $800 million related to the impairment of the Quindell-related goodwill arising from the $1.2 billion Quindell acquisition. In apparent response to ASIC’s investigations, another $118 million of WIP was also written off. SGH did its best to window-dress the write-down of the WIP, publicly claiming to adopt a more conservative approach to valuing WIP and the early adoption of AASB15 Revenue Recognition (Exhibit 1). The final 2016 accounts of SGH reported Net Cash from Operating Activities of ($104,244) million (Slater and Gordon Holdings Ltd, 2016). In defence of the SGH acquisition of Quindell, Grech maintained that they had acquired only the professional and legal services divisions, these being the standout divisions of the company. However it was these divisions that were riddled with suspect accounting practices and declining profitability due to the UK government reforms. The UK had the highest level in Europe of compensation claims for injuries such as whiplash. The government’s aim was to curb, or reduce this inordinately high volume of litigious activity by raising the bar on establishing liability in such cases. These facts alone raise doubts as to the depth of the due diligence undertaken, and whether Grech had in fact read the ‘scathing’ report by Daniel Yu. McCrum of the Financial Times had also asked the question “Why would anyone buy this company outside of bankruptcy.” It was widely known that Quindell was definitely in serious decline. The 2016 calendar year did not improve for SGH. In a market update the Chairman reported that the company had syndicated debt facilities of GBP375 million (equivalent to approximately $670,000,000 Australian dollars) and $90 million. Lenders such as Westpac and National Australia Bank were becoming increasingly nervous. By mid-November 2016 the share price of SGH had plummeted from its March 2015 high of $7.85, to just 31 cents. By this time, it was not only shareholders predicting doom and gloom for SGH, but lenders too. In March 2017 one of the syndicated lenders Barclays sold off its debt exposure of over $100 million in SGH for just 22 cents in the dollar. This was shortly after SGH had reported an interim loss of over $425 million (Thompson, 2017). The start of 2017 revealed SGH shares to be nothing more than a penny stock. Negotiations between SGH and their primary lenders, Westpac and the National Australia Bank were seemingly at a stalemate. The banks could either send in the liquidator or become the owners of a law firm; neither of which appealed. By mid-year the banks subsequently agreed to sell off their debt to a hedge fund collective Anchorage Capital Group. The rescue package Anchorage and SGH then proceeded to negotiate a deal to save the company, the details of which were announced in late August 2017. SGH later announced a full year after tax loss for 2017 of $547 million (Exhibit 4) 4 Slater and Gordon

Anchorage Capital is a private equity group. They are not new to Australia. Another recent high profile Australian acquisition was that of Dick Smith Electronics from Woolworths Limited. Private equity firms typically re-package and dress the acquired company as an attractive investment which they later list on the stock exchange. 3 The deal with SGH, announced in late August 2017, would see Anchorage Capital take control of SGH, holding 95 per cent of the issued shares. The capital restructure was finalised in November and if agreed to by existing shareholders would result in the consolidation of a 1 share for 100 shares (see Exhibit 2). SGH’s 347.2 million issued shares, would be consolidated down to 35 million. With the share price (prior to the restructure) trading at approximately 35 cents, the effect of the restructure would render their value to around 0.3 cents. The reconstruction also saw many of SGH senior executive’s wealth plunge. Grech whose portfolio peaked at approximately $50 million was, after the reconstruction valued at a mere $180,000 or so. Anchorage agreed to remain with SGH for at least three years. As part of the agreement, the Board was also spilled, and new directors, chief financial officer and chief executive officer were appointed. Bob Wilson – a shareholder Bob thought of himself as a reasonably astute investor and was initially very optimistic about the prospects for SGH. Bob’s son, as a result of an accident, was severely disabled and Bob managed his son’s modest investments with the aim of providing him with long term financial security. In early 2015 shortly after the announcement of the ‘transformative’ deal, Bob purchased shares in SGH. He was confident as to the wisdom of the investment, as, after all, they were the world’s biggest law firm. He also believed in the firm’s history of standing up for the little guy. However, by November 2015, Bob, like many others, was having doubts about his share investment in SGH. So, on a November morning in 2015 Bob decided to attend the SGH Annual General Meeting. Managing Director, Grech, once again managed to woo the crowd, confidently advising the forum that he estimated group revenue to be in excess of $1 billion for the financial year ending 30 June 2016. Buoyed by Grech’s presentation, Wilson purchased several thousand additional shares in the few days following the AGM. Unfortunately for Bob, and his son, a week after the AGM, and Grech’s positive outlook for SGH, damaging announcements relating to the UK arm of the business saw the share price fall by 50 per cent. Mid December, only weeks later, SGH revised their profit forecasts on a massive scale. So much so, in February the firm declared a $958 million loss for the half year ending 31 December 2015. Bob could not believe this course of events and the staggering hit the share price had taken. Surely the managers or directors of SGH should have seen this coming? Later in 2016 Wilson had to make another decision regarding his share-holding in SGH. Maurice Blackburn, a long-time combatant competitor of SGH, was bringing a class action against SGH on behalf of shareholders. The irony, that it was indeed Maurice Blackburn bringing the action, was not lost on Bob. The action 3

Such was the case with Dick Smith (DSE). Anchorage acquired DSE from Woolworths Limited for approximately $115 million, and later raised approximately $520 million from the IPO of Dick Smith Electronics Limited (Vaz, 2016).

Maurice Blackburn commenced was a class action against Slater & Gordon

Holdings Ltd on behalf of the Applicant, Matthew Hall, and all persons who acquired an interest in

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fully paid ordinary SGH shares between 30 March 2015 and 24 February 2016 (Hall Class Action)

(Maurice Blackburn)

In response, SGH advised the market that if the Maurice Blackburn class action was successful, the company would not have assets to settle the claim. SGH’s now auditors, Ernst and Young, expressed concern in the 2017 audit report as to SGH’s ability to remain a going concern (Exhibit 3). Bob was frustrated with this possible outcome, given where shareholders rank in a winding up. As further details emerged, Bob realised that if shareholders did not vote in favour of the Anchorage bailout, the only option was to wind up the company. Reluctantly he, like the majority of shareholders, had no other choice but to vote in favour of the proposal and see their investment reduced to one hundredth of its value. After the events of December 2017, Bob recalls the clause added to the initial prospectus. With the benefit of hindsight, Bob now questions whether this ‘conflict of interest’ as he sees it, could have ever worked out any differently. Bob’s last hope of any financial compensation lies with two legal firms, Maurice Blackburn and Johnson Winter and Slattery. These firms have launched class actions on behalf of shareholders, against SGH’s former auditors Pitcher Partners. Maurice Blackburn alleges that in the 2015 financial statements of SGH assets relating the Quindell acquisition were overstated by more than $700 million. The firm further alleges that by signing off on these statements, Pitcher Partners

misled shareholders and should be liable. The action brought by Johnson Winter and Slattery alleges that WIP was overstated by more than $130 million in the years 2014 and 2015 and should not have been signed off by Pitcher Partners. Pitcher Partners are defending the matters. Jess Lentini – an employee Shortly after graduating with a bachelor’s in commerce/law, majoring in accounting, Jess was successful in securing a graduate position with SGH. Commencing in early 2013, Jess was very excited and enthusiastic about her new role where she could utilise both her accounting and law qualifications, and with such a large and well-known company. As a graduate, Jess was rotated through many different departments within the company. It was not until she was in the accounting department that she started to have doubts about some of the accounting practices within the organisation. Her main concern was regarding the ASIC investigation and the major write-down of WIP. During her time at university Jess had studied AASB118 Revenue. She could not understand how the adoption of AASB15 Revenue Recognition could have such an impact on the valuation of WIP. Jess recalls the excitement around the office when the ‘transformative deal’ was announced. Yet in just over twelve months the impairment losses relating to the goodwill of the acquisition have crippled the firm. How could Slater and Gordon’s fortunes have reversed so quickly? In her relatively short time at SGH, Jess had experienced a complete change in the culture of the firm. There seemed to be a divide between many of the ...