Growing pains

Firms must beware of the insurance implications of any mergers or lateral hires, says Frank Maher

Hundreds of thousands of pounds are probably being wasted each year by law firms who fail to plan insurance issues on mergers and lateral hires.

For example, an additional, avoidable annual cost of nearly £100,000 in extra insurance premiums was notched up by one firm after taking on part of another practice. And that was only a four-partner firm who could ill afford the expense. But large firms, too, have found themselves exposed to high financial penalties. And it does not take a full-blown merger or takeover to achieve this disastrous situation, either – one ill-advised lateral hire is enough to reek financial havoc.

The ultimate sanction is consignment to the assigned risks pool ‘sin-bin’ for the commercially uninsurable, with real difficulty obtaining more than the bare minimum cover.

There are many opportunities for saving money, including the chance to steer claims away from your firm’s policies.

The scenario

The deal is done, the press release has been sent out: the firm has raided a competitor, picked up a team with some key players and clients who, together, will enhance the core business by developing synergies between the respective client bases and practice areas. It looks good and the Champagne is flowing.

As an afterthought, the management asks the professional indemnity partner, previously unaware of the pending deal, to confirm the details to the insurance brokers. And that’s when the trouble starts.

The firm’s insurers may be entitled to charge an additional premium if there is a significant change in the practice during the policy year, but still they are less than delighted. They are not keen on insuring the new practice area as it is not within their normal risk profile. One of their staff has recently joined from another insurer where he knew about a claim brought against one of the new team when he was a partner in the target firm, and he did not like what he saw: the claim included allegations of fraud. The extra premium will not come cheaply.

But there is more to come. The rest of the target firm, mortally wounded by the departures, joined up with another firm on the same day, leaving nothing of the original practice.

The now-dissolved firm had a serious claims problem hanging over it. And the way the deal has been done, both these new firms are deemed, under the Law Society’s ‘minimum terms and conditions’, to be the ‘successor practice’ – for all time. In this case, it could easily have been avoided. They had expected to be responsible for any claims against the team they took on, but that is not how the rules work. Instead, the way the deal has been structured means both firms who took on teams are considered to be successor practices.

Two firms’ insurers will now be involved in handling every claim. Two firms’ excesses will be payable. Each has to obtain full information on notifiable circumstances relating to the whole of the old firm, not just the teams they took on, when filling out proposal forms each year.

The firm should have thought about its due diligence on the partners it was acquiring, too. Three years ago, Legal Risk’s annual survey of the top 100 law firms’ insurance arrangements found that many firms were failing to make quite basic checks on lateral hires. Simple matters, such as practising certificates, CVs, disciplinary records and the like were going unchecked, although the latest survey showed a significant improvement.

Successor practice issues are fraught with difficulty and are not for the uninitiated. Particularly complex are cases where firms are splitting. Bear in mind that when launching a bid for a team, it may not be the intention that the target firm splits, but it can be the result, and this is hard to control. Great care is needed, because it can be possible in some cases to control the outcome, much like tax planning.

Particularly important is how the publicity is managed, because that can heavily influence the outcome, which is even more complex when a firm is splitting – as one firm found to its cost when an arbitrator determined that it was the successor with a multi-million-pound claim against its policy. To make matters worse, + continuedarbitrations on the point are between insurers and the insured firm is not even a party.

Even firms that thought they were doing their due diligence have fallen foul of the rules. For example, there have been two cases of top 100 law firms that took on partners from other firms, carefully avoiding taking those they did not trust and who were later struck off. But the firms still ended up with insurers contending they were successor practices, and faced eight-figure claims for fraud and money-laundering.

Topping-up

Remember, too, that not all claims are insured. Insurers are universally denying coverage for the (alleged) referral fee element of claims arising from the Accident Group, with some firms exposed to six-figure claims or more. One firm took on a small personal injury practice only to find it had £500,000 in liabilities that had not been revealed by due diligence, a large proportion of which was Accident Group-related.

Thought must be given to the risk that is being taken on. Insurers use ever more detailed risk-management questionnaires, though even they fail to address critical issues.

Changes in the firm – be it to personnel, client bases or practice areas – can have a significant effect on the level of premium required and may even affect the insurer’s decision to cover you at all. If you are changing any of these, you need to find out what the impact will be before committing to the deal. And exciting areas of practice are all very well, but insurers are not looking for excitement. So the niche Ukrainian mining company may appeal rather less to your insurers than it would to some law firms.

Incorporation, whether as a limited-liability partnership or limited company, and the alternative business structures proposed by the Legal Services Bill also raises important considerations on professional indemnity that need to be addressed carefully, particularly in relation to personal liability.

So, the key question is, do you really understand how your insurance premium is calculated and how it may alter if you make changes to your practice? Because you should before you commit to the deal.

Frank Maher is a partner at Legal Riskcontinued