A City law firm that advises bailed-out insurance giant AIG has been rescued from administration by its partners.

Insurance and personal injury specialist Hextalls has entered into a pre-pack arrangement, which will see a small group of partners buy the firm.

The top-200 firm is the first of any scale to come close to collapse, fuelling fears for the health of the legal sector. The recession has already forced London's leading firms - including the Magic Circle - to axe staff or freeze pay.

Hextalls, whose clients include rugby union prop Matt Stevens, has been hit by problems with its debt and cash-flow. The firm also suffered from its recent move into commercial and property law, where business has slowed because of the downturn.

The pre-pack deal, arranged by corporate rescue firm Begbies Traynor, is one of the first of its kind to be used by a UK law firm. The arrangement allows Hextalls to set up a new business to collect payments from clients, enabling it to pay its creditors.

Insurance partner Alex Padfield is believed to be leading the new outfit, a slimmed down version of the firm which will focus on insurance and litigation.

But a number of its staff, right up to partner level, have already deserted Hextalls for its rivals.