2011 was always going to be a turbulent year, but the arrival of several new challenges has put risk teams under greater pressure than ever.
There’s never been a more important – or perhaps a more stressful – time to be a risk manager at a law firm. Previous Legal Business and Marsh risk management and professional indemnity reports have dealt with the need to properly establish a risk culture and gain effective buy-in from the wider firm in anticipation of major changes that were just around the corner.
This time around, risk teams are in the thick of this change and are working flat out.
‘Consideration needs to be given towards how to achieve earlier identification of significant risk issues with firms. This would be to the benefit of all.’
Emma Dowden, Burges Salmon
With regulatory changes coming into force during 2011 and countless more being proposed, risk managers at law firms can be excused for thinking that they are trying to hit constantly moving targets. Just when firms may have thought they had everything covered, the targets shifted again.
Regulatory upheaval has been continuous since the summer of 2007. First there was an entirely new handbook on professional conduct, which was a departure from the old guide, followed less than six months later by an entirely new money laundering regime. Add to the mix structural changes to the regulators, a swathe of industry reviews, such as Clementi and Jackson, and the bullet-proofing that firms have needed to undertake during the recession and you have a perfect storm. ‘It really does feel you’re on shifting sands all the time,’ says Annette Fritze-Shanks, head of risk management at Taylor Wessing.
For Tony Cherry, partner and chair of Beachcroft’s internal committee for governance and risk, it’s a simple case of adapt or die for many law firms. ‘Most law firms are definitely foreseeing problems and are taking measures to prepare themselves,’ he says. ‘Law firms fall into two categories. There are those that are resourced up and ready to go and there are those that aren’t. This period is a challenge for compliance departments.’
Assessing outcomes
One of the most significant changes to happen to the legal market is the Solicitors Regulation Authority’s (SRA) move towards outcomes-focused regulation (OFR) in October 2011. The aim is to concentrate on the high-level principles governing practice and the quality of outcomes for clients, rather than tick-box compliance with rules. This new approach is designed to coincide with the SRA’s new powers as regulator of firms operating through alternative business structures (ABS).
‘Law firms fall into two categories. There are those that are resourced up and ready to go and there are those that aren’t.’
Tony Cherry, Beachcroft
One of the most significant changes is the overhaul of the Solicitors’ Code of Conduct to reflect this new approach, designed to give flexibility by avoiding unnecessarily prescriptive rules on process, while giving clear guidance on what firms must achieve for their client. Consultation on the draft Code closed on 13 January, with the final set of rules to be published in April.
We discuss some of the effects that OFR will have directly on risk teams’ resources in Part III of this report. However, while the intent of the SRA to move away from a box-ticking approach to regulating the legal profession has been widely welcomed, the prospect of adapting to the unknown has law firms in a flap. The SRA has chosen to embrace the spirit of the new regime of self-regulation by not providing detailed guidance to law firms. But this has caused some consternation among firms, who thrive on clear guidance and strict rules. As one respondent to the survey commented: ‘The decision not to include guidance in the handbook will not help even the willing to comply. A separate user manual will be awkward.’
Sandra Neilson-Moore, European practice leader for law firm professional indemnity at Marsh, believes that many law firms see the potential for subjectivity in the application of OFR as a particular problem. ‘The concept of outcomes-focused regulation seems to suggest that the actions of a firm can be judged retrospectively, based completely on the outcome of those actions,’ she comments. ‘This implies that actions may be adjudged correct in one situation while identical actions are deemed incorrect in another, completely dependent on the outcome of those actions for the firm’s client. Most of the firms feel (and I tend to agree) that it is far more practical to set out a series of simple rules to be followed and then to judge the firm on whether or not those rules were followed. The reality is that it is not impossible for there to be a poor outcome, even when the firm has followed all such rules correctly.’
But for John Verry, director of risk for TLT Solicitors, the most significant challenge will not be the strain on resources at firms as they strive to train staff and update their rulebooks in line with OFR, but rather the cultural shift that firms will have to make to adopt those changes. The big cultural shift in moving away from a rules-based approach, he argues, will be that firms are moving into a situation where more risk assessments will have to be made by individual fee-earners.
‘We’re not just talking about swapping systems here,’ he says. ‘I think there’s going to be a real cultural shift and I’m not sure how we’re going to be ready to do that by 6 October 2011. I think, unfairly, this will lead to more animosity with the SRA. We need to get out of the trenches and deal with this rather than find fault with everything that happens.’
ABS rejected
The move to OFR and changes to the Code of Conduct are a direct consequence of the SRA readying itself as oversight regulator for ABS. However, one of the surprising results of this survey is that appetite for ABS, or at least taking on outside investment as a means of raising capital, has waned since last year’s report. Just 24% said that their firm would consider outside investment, down from 36% last year, and nearly half said they would not.
‘I think the percentage of firms that will explore outside investment will be relatively low, in fact, as a percentage of the overall legal community, even lower than our survey response suggests,’ says Neilson-Moore. ‘In my opinion, while there will be some firms that will actually pursue this course, it will be a very small number indeed when compared to the profession as a whole. If I am correct, this would be consistent with what has happened in other jurisdictions that already permit outside investment (Australia for example) where very few firms have actually gone down this route.’
One theory for this drop in enthusiasm is that in previous years firms’ thinking on this subject was purely hypothetical. With the October 2011 start date for ABS seemingly a long way off in 2009 and early 2010, firms perhaps felt able to entertain the possibility of raising external capital in the distant future. In this year’s survey, the opportunity is far more proximate: if firms are going to take on outside investment around October, then plans will need to be in place already. From the results of this year’s survey, it seems that few firms can see the merits of turning to external investors. Comments such as ‘we value our independence/self-determination’ were typical, while one respondent was refreshingly honest and pointed to a reason why many firms will not have a free choice in taking on third-party money in the future: ‘We doubt we will attract investors.’
‘It is unsurprising that the figures have gone down,’ says Cherry. ‘People are starting to develop a wider understanding of the concept. First, they are starting to understand what exactly investors will be looking for from a law firm in terms of capital, and they are also starting to understand what investors will want in return in terms of control.’ It seems few firms can see this as a viable option, at least right now. A handful of firms did provide comments such as ‘not for the foreseeable future’.
Bill Richards, the former senior partner of LG and now the firm’s head of risk and compliance, says he doesn’t expect the move to alternative funding sources to happen overnight. He doesn’t expect legions of firms touting their wares to would-be investors come October. ‘Anecdotally there seems to be more interest in external funding than there has been for a while but most firms don’t seem to be seriously considering it at the moment,’ he says. ‘But remember when LLPs came out there was only a trickle of interest and now we’re all LLPs, apart from Slaughter and May. Potentially there’s scope for the legal landscape to shift dramatically in the next few years, but I doubt it will be in October 2011.’
Jonathan Westwell, general counsel and head of risk and compliance at Baker & McKenzie in London, believes the drop in interest is more likely due to the easing of the economic climate. ‘In my view, firms are generally wary of the idea of introducing outside capital and losing autonomy,’ he says. ‘If there has been a drop in interest it is probably due to the change in the financial environment. I don’t think many larger firms are considering outside capital – they don’t see a need for it.’
Targeting failure
It is a sad irony that arguably the firms most in need of white knights in the shape of external investors are the least viable investment options. It is this gulf between need and suitability that could see a slow take up of alternative sources of investment come October.
‘I think the percentage of firms that will explore outside investment will be relatively low.’
Sandra Neilson-Moore, Marsh
Since the collapse of Lehman Brothers and, closer to home, the demise of Halliwells, firms struggling with debt and financial mismanagement have raised the awareness of financial risks, as we discuss in Part II of this report. With tax rates going up and bank funding becoming harder to find, a number of firms are very thinly capitalised. Anecdotal evidence from risk managers suggests that a good handful of firms are currently on the critical list with their creditors. The question then emerges as to whether the market, which some commentators insist has too many law firms in it, should squeeze out weaker firms by virtue of natural selection. In Part IV we report on the knock-on effect of smaller firms failing to find insurance and going into the assigned risks pool (ARP), meaning that insurers are passing their exposure to this onto larger firms in their professional indemnity insurance premiums. As one firm responded, ‘We are told by our PI insurer that it accounts for up to 20% of our premium.’ Not an insignificant cost.
It seems that the SRA intends to take a tougher stance with financially unsound firms and was keen to include financial stability as a key outcome under OFR. It has also prohibited start-up firms from falling into the ARP and plans to restrict the amount of time any firm can spend in this safety net. On the evidence of our survey, commercial law firms would be highly supportive of this stance. 74% of respondents agree that more law firms should be allowed to fail. As one firm put it: ‘They are insured businesses in a capitalistic environment. The market should determine if a firm fails.’
‘Not all firms should be allowed to fail but more should,’ says Fritze-Shanks. ‘If a firm is unable to be insured, is it right that it should be practising? There’s a professional standards and consumer protection issue there which is more important, in our view, than any effect on insurance premiums. If a firm is providing a useful social service it may be right that other firms should support it through the ARP but otherwise, firms should be allowed to fail.’
Emma Dowden, director of operations and best practice at Burges Salmon in Bristol, says the question needs to be asked as to why a firm is struggling to get insurance from the ‘normal market’. If insurers perceive the risks to be too great, she argues, then surely there is a risk to that firm’s clients and, ultimately, how those clients’ interests can best be served. ‘We agree that a tougher stance with the ARP is needed and that firms should be allowed to fail where that is the most appropriate option,’ she says. ‘In my view, consideration needs to be given towards how to achieve earlier identification of significant risk issues with firms. This would be to the benefit of all, and for those firms in question may be able to prevent the need for intervention by the regulator and/or ARP cover down the line.’
One survey response to this question echoes the sentiment that clients’ interests should determine whether a firm should be allowed to go under: ‘Yes – if the firm poses a risk to clients; no – if it’s not in clients’ best interests.’
Westwell is sceptical of the actual effect failing firms are having on those firms at the top of the market and argues that failing to find insurance shouldn’t be the only symptom of a failed firm. ‘Yes, a firm should be allowed to fail but a failure to get insurance shouldn’t be the only reason why a firm has failed,’ he says. ‘There could be many different reasons why a law firm can’t get insurance, for example operating in a niche area in which the risks are not well understood. I think there should be a tough stance when it comes to the ARP but I don’t think many larger firms see it as a major problem.’
But even talk of firms failing adds to the general nervousness that pervades risk teams now. When you combine economic instability with wholesale changes in the regulatory make-up of the profession, then it’s time for law firm managers to really listen to their risk and compliance heads and take heed of the things they don’t really want to hear.
mark.mcateer@legalease.co.uk
georgina.bennett-warner@legalease.co.uk
Legal Business would like to thank Marsh for its sponsorship of this survey.