Diamond and dust: financial stability, the new management touchstone

12 Dec 2013Feature

With growing financial pressure on traditional partnership structures, risk management should be top of the agenda for law firms, but could 2014 also be the year of alternative models, asks Joanne Staphnill

According to David Simon, veteran of over 40 years' private practice and now chairman of our newly-minted alternative business structure (ABS), there has never been so much doom and gloom about the legal services sector as now, with a flurry of reports about traditional firms and LLPs being forced into administration or merger.

As clients jump on the 'more for less' bandwagon, the SRA piles on the pressure by opining that there are hundreds of firms at risk of financial failure. To top the lot, difficulties in obtaining professional indemnity insurance could put a swathe of firms out of business.

Often firms get into difficulty because of events outside their control. But at least some must have failed because of the short-termism that their ownership structures implicitly encourage. It is difficult to see how some of the current crop of mergers can be anything other than a short-term fix.

The same structural weaknesses exist, but with the added pressure of more mouths to feed. There is no such thing as a law firm that is too big to fail, so financial stability has become the new touchstone. Will this hail the advent of new structures for the delivery of legal services?

Disadvantageous tax regime

HM Treasury's March 2013 Budget could bring the certainty of death and taxes to law firms, with proposals that could sound the death knell for limited liability partnerships (LLPs) and prompt a widespread review of law firm structures.

LLPs have been popular and advantageous; a creature of the Companies Act yet taxed as a partnership. However, the Budget aims to prevent companies and individuals from using LLPs to disguise employment, and from benefitting from certain arrangements involving profits and losses among LLP members.

HMRC has commented that "individuals who would normally be regarded as employees in high-salaried professional areas such as the legal and financial services sectors are benefitting from self-employed status for tax purposes".

Among the proposed changes is the removal of the presumption of self-employment for some members of LLPs. HMRC said the proposed changes "are not intended to affect those entering into arrangements that are not tax-motivated…" but admitted somewhat ominously that, the proposals "will give rise to a degree of complexity…".

These proposals are expected to come into force in April 2014, leaving some firms stuck with an LLP status which no longer benefits them. A regime under which profit is scrutinised and taxed means LLPs will have even less scope to retain profits for investment. Having to live for the moment even more, and without benefits such as those provided by service companies, some less well-funded LLPs could tip over the edge.

Alternative structure

What can be done? In such a highly regulated sector, changing a law firm's structure is difficult, expensive and time-consuming. But for firms that manage to adapt, there could be significant advantages. Some firms are obtaining ABS status to seek outside investment, accessing capital out of the reach of traditional structures.

Many firms might become an ABS with a complementary service provider and go on to out-perform their traditionally structured competitors. 2014 could well be the 'big bang' year for multi-disciplinary ABSs, even as other firms are forced into mergers or fail altogether.

Traditional partnerships or LLPs create an inherent tension between the desire of the partners to maximise profits, and the need to reward and motivate employees. By moving to a corporate structure, legal services providers have novel opportunities to remove this tension such as by acquiring employee ownership status.

Employee ownership enjoys strong government support and the Department of Business, Innovation and Skills aims to increase the sector's contribution to the GDP from 3 to 10 per cent by 2020.

Our own business, from the start of our planning for the ABS, aspired to create a business wholly owned by its employees. This will happen in 2014. We are putting into practice our belief that the best way to create a truly forward-thinking company full of highly motivated professionals is to involve everyone in ownership.

Indemnity forces

What else can be done? The PII renewal process has unwittingly become a market force with the power to determine which firms survive and which fail, especially now the assigned risks pool (ARP) has closed and been replaced by a three-month grace period within which to secure insurance or close down.

In fairness, the ARP rarely functioned as a safety net for firms. Entry typically meant that a firm was in the process of closing for good, and only a few ever managed to pay the ARP premium, secure open market insurance and leave.

However, the plight of the 150 odd firms that failed to obtain acceptable terms from the open market before 30 September 2013 - and their struggle to obtain insurance in that crucial month while they could still accept new instructions - hammers home the importance of excellent risk management.

A firm can be viable in all other respects - financially stable, solid client base, loyal staff - but too many of the wrong type of negligence claims can leave them unattractive. In the cyclical PII market there will always be hard years when insurers can afford to be very selective. Unless firms make risk management a day-to-day priority, they are vulnerable to closure simply because no insurer will take them on.

Spotting claims risk

Weak procedures for accepting new clients or instructions are often a root cause of negligence claims. While there is understandable pressure on lawyers to get new work in, some react by accepting instructions in areas of law they know little about, acting in blatant conflict of interest, or even ignoring 'know your customer' (KYC) checks to take on fraudulent clients.

Firms that are more selective, perhaps insisting on a peer review stage in the process, have a much better insurance record. They have a healthier bottom line because they don't have to write so much off in fees. These are ordinary firms that simply accept that the good returns come from good clients, and bad clients cost them money.

However, things will sometimes go wrong. If your firm does only one thing to improve its risk profile, it should be to train all staff (fee-earning or otherwise) to recognise a potential "circumstance" or "claim" as defined by the firm's PII policy, and to report problems to management immediately. Circumstances or claims reported to PII insurers promptly are usually easier and cheaper to resolve or mitigate.

PII insurers generally prefer a firm to notify dozens of 'circumstances' that turn out to be simple to manage, than be notified of only one 'claim' that has been 'festering' and costs huge amounts to defend and settle. Making precautionary notifications demonstrates that the firm pro-actively addresses problems, but notifying only one 'bad' notification makes one wonder what else might be lurking.

So, what can we expect in 2014? There will be no let-up in the pressure on law firms, but lawyers are good at adapting, once they put their minds to it, so we may well see more diamonds emerging from dust amid take up of new structures.

Joanne Staphnill is a senior solicitor with Robin Simon, part of Triton Global Limited, licensed as an ABS