Structural challenges – Risk Management Round Table 2012

The fifth LB/Marsh round table brought together a group of risk experts to discuss the practical effects of alternative business structures and who to appoint in key management roles created by the SRA.

The timing could not have been better – the fifth risk round table hosted by LB and Marsh took place at the end of March, just a day after the Solicitors Regulation Authority (SRA) issued its first three licences for alternative business structures (ABS) under the Legal Services Act. Unsurprisingly, then, the topic of ABS and commercial law firms taking on external capital was high on the agenda.

With a few notable exceptions, it appears that very few of the top 100 firms in the UK will be looking to complete a major strategic overhaul using ABS now. However, quite a few are looking to use the new rules to allow non-lawyers in senior positions to take ownership in the firm, while others are mulling over external financial investment.

Sandra Neilson-Moore, European practice leader for law firms’ professional indemnity at Marsh, sums up the current position: ‘The really big law firms, in the main, are not doing a lot with ABS. With the exception of a few that are very public – Irwin Mitchell and one or two others – they are looking at potentially bringing people into the equity who are not solicitors.’

Simon Callander, general counsel (GC) and partnership secretary at Olswang, says that it’s too early to be talking about material effects on commercial law firms just yet: ‘There are people knocking on your door all the time wanting to talk about things but I think the current focus of ABS has to be the consumer end of the market, because that is where the opportunity is; where you can create scale; where you can standardise; where you can harmonise; where you can turn it into a process function.’

For a firm such as DWF, where insurance accounts for roughly half of the firm’s turnover and various competitors have announced a range of ABS-related initiatives, there is a need to keep a close eye on what is happening. ‘There is talk out there about firms looking to go into joint ventures with insurance companies,’ says Deborah Abraham, DWF’s head of risk and compliance. ‘We are watching very closely what is going on out there, but from the firm’s point of view we do not feel pressured to do anything quickly. Obviously, because of the competition that may arise, we must be prepared if we need to move in any which way.’

Tony Cherry is chair of DAC Beachcroft’s internal committee for governance and risk, another firm that has a significant insurance business. He agrees with Abraham’s viewpoint: ‘There does not seem to be an enormous and immediate motivation to do anything too quickly. Certainly what I have heard on a number of occasions is, “Well we want to keep an eye on it ourselves, but we do not really want to be the first mover here”.’

But changes to structure aside, for those present the real issue is taking on external investment, particularly from private equity investors. Andrew Carpenter, managing director at Marsh, says his impression is that there is quite a lot of capital out there that the venture capitalists are looking to use and some people think ABS is an opportunity to get access to that. ‘But doing something with it is still a challenge for some of them,’ he says. ‘They have this idea and they are trying to work out where it ends up. In that scenario, you half wonder whether they end up with half of what they want.’

‘The really big law firms, in the main, are not doing a lot with ABS. With the exception of a few that are very public – Irwin Mitchell and one or two others – they are looking at potentially bringing people into the equity who are not solicitors.’ Sandra Neilson-Moore, European practice leader for law firms’ professional indemnity at Marsh

Mark Jones, who, as the head of Addleshaw Goddard’s professional practices consultancy, regularly advises law firms on strategy, management and organisational development, says any firm contemplating taking on external investment should be honest with itself. He says: ‘My first questions as adviser to anyone considering external investment are: “What are you going to do with the money? Do you have a plan? Are you confident that you can beat the expected rate of return of the investor? What’s the exit?” If you do not have an answer to those questions, do not do it.’

According to the panellists, the key barrier to law firms taking on external capital from a private equity investor is having to adapt to a more corporate environment. As Jones says: ‘Partners in private practice law firms are not used to operating in what a private equity provider would describe as an accountable commercial environment. There is a behavioural discomfort element to it.’

Martin Bakes, a partner and general counsel at Herbert Smith, echoes this viewpoint. ‘It is a generalisation, but lawyers are trained to be risk averse and that makes many of them inherently bad entrepreneurs. Entrepreneurs should be about taking risks,’ he says. ‘Taking capital and doing something with it involves taking more risk than most lawyersare comfortable with.’

Callander says it will probably take one firm to stick its neck out: ‘It may be that a firm emerges from a particular sector of the market and says, “Actually, we are going to do this,” and it will outplay everyone else in the market because it will simply be able to outgun them. Yes, there will be a trade-off as a result, because the people who back that are going to want a return.’

From a risk perspective, compromising professional standards in pursuit of new money causes particular concern. Neilson-Moore suggests that the commercial imperatives of a private equity company adding pressure to a firm as it looks to get a return on investment could affect professional ethics. However, much of this depends on what is driving the business. ‘It will depend very much, as it always does, on the drivers,’ she says. ‘If the compensation and reward structures are such that they drive bad behaviours, bad behaviours will follow.’

For Jo Riddick, compliance officer for legal practice at Macfarlanes, proper ring-fencing can protect professional standards. ‘If the professional part of the business is ring-fenced from the investors, then potentially it can work,’ she says. ‘But I think there has to be that sense that the professional people in the business may need to take specific ethical considerations into account and are, in that sense, different from the management and the pure investors. It is going to be interesting to see if that divide gets blurred.’

‘The reality is that some law firms will think they are taking a good opportunity and behave unwisely, and that may then reflect on the rest of the profession,’ says Bakes. ‘The vast majority, no doubt, will deploy this sensibly.’

But most of the round table participants broadly agree that the recent circus around ABS is something of a red herring. David Whitney recently became senior risk and compliance manager at Bird & Bird, but before that was a relationship manager at the SRA. As such, he has an insider’s perspective on the recent rule changes. Noting that two of the first three organisations to receive ABS licences recently are effectively law firms that have just brought in practice managers, he queries whether in many instances there will be much difference between ABS under the new rules and organisations that are already ‘recognised bodies’ under previous SRA rules.

‘In many cases the change to ABS may just be organisational, with one or two people already associated with the firm – such as accountants or HR professionals – becoming owners,’ he says. ‘I do not think on the face of it that such ABS represent much of a different risk. What you also have is one or two fairly large organisations that are staffed with hundreds of non-qualified people doing work which is not reserved, with a few lawyers supervising them. Such firms are there already and are recognised by the SRA; they are not ABS. In that respect, I find it very difficult to differentiate between them.’

COLPs and COFAs

The discussion then turned to a subject arguably closer to the hearts of the guests: nominating individuals for the new roles brought in by the SRA, the compliance officer for legal practice (COLP) and the compliance officer for financial administration (COFA). The make-up of teams should be overhauled by 31 October 2012, the date by which the SRA should have approved firms’ nominated COLP and COFA.

There was much amusement at first about the recent extension of the 31 March deadline for firms to nominate individuals for these roles for SRA approval. Participants widely agree this extension has less to do with giving more time to firms struggling to find the right person to fill these roles, and more to do with the SRA’s IT systems letting it down. Firms generally are comfortable with identifying the right individuals. Indeed, Riddick and Callander have already been identified as the COLPs at their respective firms.

‘My sense is that initially there was a lot of concern,’ says Bakes. ‘People wondered who was going to be foolish enough to put their hands up to do this role. But I think, over the months, firms and individuals have become more comfortable with the notions and I am not aware of difficulties that the larger firms have had in terms of identifying COLPs and COFAs.’

However, residual concerns remain over the COLP role, as Neilson-Moore points out. She says there is concern because the COLP has a duty to record and report breaches of
SRA rules, which may not sit well with an open-door policy at firms where people feel they can talk to risk managers about circumstances that might give rise to claims.
‘I know at least one firm that decided the person who is in charge of the professional indemnity (PI) claims within the firm will not be the COLP,’ she says. ‘The COLP will be someone else.’

As someone who acts as both COLP and money laundering reporting officer at her firm, Riddick finds this attitude hard to fathom. ‘I find that really difficult to understand, because I think that relationship of trust is really integral to the head of risk role. It is something which goes right across the board. You would not be doing your job properly, as PI partner or as COLP, if you did not record what was coming in to you. We have had external reporting duties on us, for example to the Serious Organised Crime Agency and our insurers as well as the SRA, for a long time. I am not sure that the COLP takes us into a different world.’

‘If you put certain bits of the compliance regime out of the COLP’s reach – perhaps they do not deal with complaints or insurance claims, but they do deal with other bits – they will not get that holistic view and joined-up approach.’ – Jo Riddick, compliance officer for legal practice at Macfarlanes

However, she adds that the responsible COLP in the outcomes-focused world will still offer that open door and ability to consult, without running off to the SRA immediately, before it is clear a report duty has crystallised. ‘I think there are real benefits for the COLP in having a holistic role,’ she says. ‘If you put certain bits of the compliance regime out of the COLP’s reach – perhaps they do not deal with complaints or insurance claims, but they do deal with other bits – they will not get that holistic view and joined-up approach.’

Callander agrees that keeping a claims manager/GC role separate from the COLP role to avoid creating a culture of nervousness about talking about potential problems would be a mistake. ‘Whether you go to your complaints manger, claims partner or GC, let us not forget that the SRA is very clear that, while the COLP holds the role, it does not diminish the role of the other managers in the firm, who are under exactly the same obligations,’ he says. ‘To my mind there is nothing to be achieved other than to invite question from the SRA as to why you are doing that. I understand the point about motivation of people and that people fear going to talk to you, but I just do not see what the split of function achieves. If you perform the COLP role in the right way you will be equally trusted by partners in the firm as by the SRA.’

Neilson-Moore points out that the real problem with the COLP role may lie with the duty to record breaches, particularly if over-enthusiastic compliance directives and/or the regulators require the recording of ‘minor’ breaches. In its role as a risk adviser and in its own compliance and regulation experiences, Marsh is aware of such situations, where a requirement to record every breach, however minor, becomes time consuming and frustrating. Neilson-Moore hopes that the SRA’s ‘outcomes-focused’ approach to regulation will not result in a similarly painful process for law firms. She says: ‘In some cases, the stuff compliance officers are told they have to produce in order to prove to the regulator that the organisation is adhering to the principles they say they are adhering to is really quite horrendous. The regulator says, “You say you are doing this. Prove to us you are doing this”. Collecting the “proof” in a format that the regulator finds useful for its purposes; that is the problem.’

For George Brown, litigation partner at Reed Smith, his recent dealings with the SRA on that front have been positive. He says: ‘The meeting that we organised with the SRA adviser was such that his starting point was: “You are sophisticated, well-run businesses and that is how you stay in existence”. As sophisticated, well-run businesses, how each business complies with the rules is going to be different.’

Callander does not think the future of regulation is about spotting breaches after the fact and issuing fines, rather more identifying problems and asking firms what they intend to do to rectify the problem. ‘Certainly, in our discussions with the relationship managers, they have been keen to stress that what they are going to be looking for is the future and what you are doing to sort problems out, rather than the past,’ he says.

Another issue is that under the SRA guidelines, rather bizarrely, the COLP has to be a qualified lawyer, which will prohibit some existing heads of risk from taking the COLP role. In those cases the managing partner will often be the individual taking the responsibility.

Abraham at DWF says the firm’s managing partner, Andrew Leaitherland, will assume the COLP role. But putting the managing partner in that position has its own problems. ‘We have worked with the SRA for over 12 months,’ she says. ‘They can see the structure and the way that it would work, but they are still saying, “We will look very closely at the corporate governance of all firms. It is all about whether a managing partner will have enough time to really put into this role what we expect to see”. It is going to be our job, when we go through the application and nomination, to show just why he thinks he is the right person for the role.’

Brown argues in this case that the amount of time spent by a managing partner in a COLP role should be largely irrelevant because if the managing partner is at a firm with few problems, then not much of the managing partner’s time will be needed, as others could do routine work. ‘I am presuming that this requirement that there be this chunk of the managing partner’s time devoted to the COLP role is because the SRA is expecting some form of proactive regular review of systems and control or discussion to be actually undertaken by the managing partner,’ he says.

‘I think it is perhaps a mistake to think of it as time that necessarily has to be spent on risk and compliance,’ says Whitney. ‘Somebody in the role of a managing partner of a large firm already has very limited time to deal with everything that comes his or her way, and to give them the additional oversight role of all of the risk and compliance is a big ask. It is not a question of them expecting X hours a week; it is, “Do you really have a handle on everything that is reporting into you, as well as the duty of making sure the firm operates and is profitable?”’

International standards

As for other challenges for the future, the discussion turned to the SRA’s consultation on regulation of international practice. The consultation sought opinions on how UK-based firms operating outside the UK might be regulated in the future, and ended on 15 February. The SRA is currently looking at the responses. The fact that the SRA is looking at how firms are regulated beyond Dover is welcomed – to a degree.

Whitney, as a former employee of the SRA and now risk manager at an international firm, has a particular interest in this. He has read responses to the consultation from the Law Society and the City of London Law Society, and says there appears to be a lot of support for the general concept of enterprise regulation for the international firms.
‘That would certainly simplify my job and would simplify risk and compliance for a lot of people,’ he says. ‘But I think there are a number of caveats that go with that, primarily that the detail of the blueprint has not been properly thought through and there are likely to be difficulties trying to operate it. The concept is that there will be principle-based regulation for those parts of an enterprise outside of England and Wales, but it is difficult to decouple principles from the outcomes. So I think the message that has gone back is, “Look, we like the big picture, but do some more work about what this will mean in practice, because we are not convinced that in its current state it is workable”.’

He adds that other suggestions of alternatives to using the SRA’s principles include moving towards some globally accepted standards that could apply to the non-England and Wales businesses that are not associated with outcomes.

Martin Bakes is a partner at international firm Herbert Smith and sees the need for some cross-border standardisation. ‘We just need the present position to be clarified because at the moment the regulatory position in terms of how you structure yourselves and where you do business is very complicated,’ he says. ‘So it would be good for that to be sorted out.’

Reed Smith is another large global firm and George Brown warns against comparing apples with pears. ‘Trying to say the standard in one jurisdiction is higher than another is nonsensical because they are different,’ he argues. ‘The way in which law is practised in France is different from the way in which you would practise law in America. The standard is no higher or lower; it is just different.’

And it is because of different approaches worldwide to the rule of law and different ideas about what constitutes proper conduct that Callander believes the SRA is going beyond its remit. He argues there are issues over differing standards but it is for the law firms to manage the problems themselves. ‘I do not think they are for the SRA to regulate. That is the key point. I do not have a problem talking to the SRA about our overseas operations, because I think it is legitimate for them in terms of regulating our UK business to understand that, whether we are headquartered here or not. To me, they are a territorial regulator and should stay territorial. I would love for them to go and create some international apparatus under which you could have a one-stop shop for international regulation, but I feel that is in the “too difficult” pile. I think the profession is in danger of going along with something that is ill-thought through.’

And it is this idea of self-regulation and applying a common-sense approach to what is right for your firm that has run through the entire discussion. Whether the issue is changing the firm’s structure, taking on external capital, appointing the right people for crucial risk-related roles or ensuring that professional standards in one overseas office do not fall below a common threshold that is right for your individual firm, the message is simple: firms are perfectly capable of doing all that themselves. LB

mark.mcateer@legalease.co.uk