Risk and regulation in the changing legal sector
16 April 2012
The legal industry is changing fast. Firms that fail to adapt will be left behind
The legal sector is, of course, undergoing seismic change and the associated opportunities are being embraced by more than many had anticipated. This is a brave new world and firms are understandably concerned about the regulatory minefield ahead of them. Compliance, risk and regulation are central to law firms’ planning and will be core to survival in an ever more competitive legal market.
In this article, we will tackle some of the key aspects of regulatory change that have demanded the attention of the profession over recent months, explaining their significance and showing how your firm can work to overcome the challenges they present and grasp the opportunities they create.
Outcomes-focused regulation (OFR)
We have all heard about the Solicitors Regulation Authority’s (SRA) drive to overhaul the focus of its regulatory regime involving a move away from a rules-based approach to a principles-based one, enforcing compliance with the spirit rather than the letter of the law. The reasoning behind this is simple: hard and fast rules cannot give guidance for every situation that might arise, especially in a sector as complex as legal services. The SRA therefore believes that by encouraging adherence to certain principles of good practice, the quality of risk management will increase across the board.
This will require up-to-date knowledge and understanding of what the SRA expects. One aspect of this is that the profession is required to comply with mandatory principles and deliver mandatory outcomes. Although this sounds suspiciously like the rules-based regulation the SRA now shuns, we are assured that this is not the case and that firms can prove their compliance in a number of ways beyond the ’indicative behaviours’ defined by the regulators. Guidelines on this are loose, and SRA literature can sometimes seem contradictory, meaning that interpretations of the new regime can vary wildly.
How the SRA will choose to manage, interpret and enforce its new system is also up in the air, making finding out what compliance will actually mean on a practical level a difficult task for law firms.
Under the new rules, all law firms will eventually have to appoint compliance officers for legal practice (COLPs) and for finance and administration (COFAs) to ensure that new regulatory challenges are met. These COLPs and COFAs will be required to take responsibility for statutory compliance by ensuring that their firms have the right systems and processes in place and reporting failures to the SRA.
This role is to be filled by a competent member of the firm, but problems are already arising in choosing individuals with enough experience, influence and access to do the job, but also with enough time to ensure that it is done properly.
Another aspect is their potential culpability. We suspect that the number of candidates for these posts will begin to thin when the extent of individual liability for non-compliance issues and regulatory breaches the job entails becomes clear.
Beyond the practical problems presented by these changes though, law firms will be challenged in being forced to look at their practices in an entirely new way. The SRA suggests that compliance will require consideration of key but often complicated issues. Ensuring that a firm acted within an established set of rules (as was hitherto the case) was never simple, but promoting compliance through subscription to a set of often unclear guidelines and reporting on performance against them will seem daunting and, unfortunately, firms that fail to seek understanding
of these new requirements will ultimately suffer.
Alternative business structures
The Legal Services Act is also presenting a whole new raft of challenges to the profession in the form of alternative business structures (ABS). Law firms can now undergo ABS conversion, following which they will continue to provide legal services, but with some element of non-legal involvement such as management, investment or the provision of additional professional services.
Well over 100 entities - not all of them law firms - have now applied for ABS status, which is already considerably more than most commentators at first predicted.
Potential applicants will want to consider carefully the risks attached to becoming an ABS before applying. Law firms looking at conversion will face a series of challenging questions: what impact will non-lawyer managers have on the firm’s values and the way in which it operates? Will the involvement of outside capital and management heighten the perceived risk for potential clients thinking about instructing the firm? Will the firm be able to operate in overseas jurisdictions and open foreign offices as an ABS?
Once a firm has thoroughly considered the operational implications of this change and decided the ABS route is the right one for them, they will have to tackle the conversion process. Registering your firm’s interest is easy enough, but clearing the hurdles to achieving ABS status is a different question altogether. The proposed managers and interest holders will have to satisfy the SRA of their suitability, appropriate COLPs and COFAs will need to be appointed and the firm will be expected to demonstrate its suitability for external investment.
With new regimes come new risks. Firms will need to adapt to deal with the new risks presented by ABS and OFR, but in some cases wholesale culture change will be needed for complete implementation and risk mitigation to take place. We understand and insist on the need for strategy and compliance from law firms, but we also heavily emphasise the influence of culture. Without a risk-aware culture that pervades every element of the firm, all the planning in the world cannot avert a failure. When a law firm fails in its compliance and regulatory duties, the absence of a culture of risk-awareness is more often than not the culprit.
Recent KPMG figures show that more than 58 per cent of board members said their employees had little or no understanding of risk exposure. It also suggested that although we often believe ’tone at the top’ is important, many staff take their lead from their immediate line manager. These findings show that there is work to be done, not just in law firms but throughout the professional services environment in understanding and transforming risk culture as well as improving the risk-awareness of staff.
While nobody would dispute the need for systems and processes to manage risk, firms need to work hard to instil this culture above and beyond the existing structures. For this to happen, a process of education and training must take place in which staff are made aware of the risks potentially facing both the firm and them personally.
In the current business environment law firms need to make sure that they are up to scratch in terms of regulatory compliance in order to maintain reputation, win new work and grow. The legal sector is changing fast and the rules and conditions governing it are changing too, with OFR and ABS creating potentially some of the biggest transformations the profession has seen. Being on top of these changes and, if possible, ahead of them will be key to your firm’s future.
Managing risk in litigation
Litigation funding is a market in its infancy, and one that should make potential litigants reconsider the financial risks involved
Historically, if you wanted to use a lawyer the position was clear. Both you and the lawyer expected you to pay for it. Yes, there may be circumstances where litigation costs came back in part from the other side, but access to the law required money.
This changed in the aftermath of World War II, with the report of the Rushcliffe Committee which led to the Legal Aid and Advice Act 1949. Legal aid was the first step on the road away from a direct and almost umbilical link from the client’s wallet to the lawyer.
It is remarkable to think of the changes that have occurred in what is only a little over 60 years since.
Legal aid provided a partial solution, but only that; it did nothing for businesses, nor did it cater for the needs of an upwardly mobile middle class in a world of consumer rights, health and safety, and industrial tribunals. Other solutions were required and, at least in the area of contentious cases, have come forward.
Before-the-event (BTE) insurance is the oldest alternative method of funding. It has a long history in Continental Europe, particularly Germany, but began to be sold in the UK in the 1970s. The idea is simple and elegant - for an annual premium an insured will be covered for legal eventualities arising in the period.
In practice, of course, BTE’s path has not been so straightforward. The thorny issue of panel solicitors and freedom of choice continues to be a battleground between BTE providers and law firms. It is easy to understand both sides’ positions. Lawyers resent having ’their’ clients taken away and given to a faceless panel firm operating in a business park miles away. Insurers crave certainty and guaranteed service levels that do not sit well with professionals unable to work to (effectively) fixed fees.
Different BTE distribution methods have found themselves plagued by selection against insurers and minimal customer awareness. A significant number of individuals (those who don’t buy insurance) have never been able to access the product. Now, thanks to the influence of market aggregators and the drive for a low headline price, BTE penetration is falling in the personal lines market.
In the commercial market, BTE has always been of minimal impact outside the SME and charity sectors. Cover to risk manage and mitigate employment risks is attractive to small businesses, but what use is £100,000 of limited contract cover to a multimillion-pound turnover business?
Even by the 1990s, when legal aid was seen as an increasingly unaffordable drain on the public purse, it seemed, for the reasons given above, that BTE could not be a full answer to the problem and alternatives were sought.
When the 1999 Access to Justice Act came into force the current system of conditional fee agreements (CFAs) and after-the-event (ATE) insurance was born. An entrepreneurial lawyer could run cases without having to charge their client if the case lost, and earn success fees to recompense them for that risk in won cases. ATE allowed the client to insure the risk of paying adverse costs and disbursements in unsuccessful cases. And because this was about allowing claimants to bring their claims without suffering reduced damages, all the extra costs went back to be paid by the defendant.
Of course, CFAs and ATE were not limited to simple personal injury cases. Other legal areas brought additional difficulties - but all this meant was that lawyers took longer to adapt to them.
The dynamics of commercial cases are different, particularly because there is less spread of risk and less certainty of merits. A personal injury lawyer can have a caseload of many files at one time and, if risk assessment processes are good, should have reasonable confidence there will be a steady flow of winners. At the other extreme, a commercial lawyer may only have one or two cases taking the vast majority of his time in a year. A case may take a lot longer to get an accurate view of merits, and the pressure on fees in a settlement can be intense.
But entrepreneurship will find a way and lawyers have come up with the hybrid (or partial) CFA. Half (perhaps) of your fees are paid by the client on an ongoing basis. Win and a full fee (and success fee) is due from the other side. Lose and you seek nothing more. This gives a solicitor a genuine incentive to run strong cases, but does mean there will be money to pay the bills, come what may. It also gives the client a genuine financial stake in the litigation - one of the things lacking from personal injury cases that causes Lord Justice Jackson so much disquiet.
The ATE market has also evolved. We now see large numbers of significantly sized commercial cases, often on a hybrid basis, where ATE is seen as a necessary part of the financial package.
With the Jackson reforms on the horizon it seems the ability to recover success fees and ATE premiums from the other side in a case will go. Not all lawyers have grasped that this does not mean the end of CFAs. There will be cases in a post-Jackson world that will not work because the price of CFA and ATE is too much of the damages pot, but the principle will remain a key method of funding cases.
And so to a yet more recent arrival, litigation funding. Litigation (or third-party) funding involves an unrelated party providing some of the money to finance a case and, in return, taking a share of the proceeds. It is not that long ago that such an approach would have been downright illegal, and even after that there was a view that public policy should prevent such interactions. Then along came Arkin v Borchard Lines & Ors. With safeguards, the Arkin view was that there was nothing wrong with sharing the benefits, provided that such a funder could be liable for adverse costs up to the value of its investment. Key among the safeguards is the need for a funder to act on what amounts to an ’arms-length’ basis; the funder can provide advice and require notification/information on what happens, but public policy still prevents interference in the handling of the case.
Seven years on, and funding has stepped into the litigation mainstream. Jackson LJ’s report endorsed the principle, and safeguards he endorses have been incorporated into the voluntary code launched by the new Association of Litigation Funders.
It can be hard to know exactly how much funding is going on in the market. There will always be individuals prepared to help with a case for people they know. There is then a handful of businesses with a pot of cash ready to fund cases. There are many more who may describe themselves as funders, but whose role seems to be much more to match cases and cash. The code is likely to give increased visibility to who has money and is able to fulfil, for example, capital adequacy provisions, and so will help to provide transparency in this area.
Most people’s idea of litigation funding is that it exists to support a person who, as the then Master of the Rolls described Mr Arkin, “is and was a man without means”. In this guise funding fills a gap where commercial CFAs and ATE often struggle - with clients who cannot pay half their solicitors’ costs on an ongoing basis. ATE should sit alongside the funding in such a package - it protects the impecunious client against a downside risk and the funder against an Arkin costs liability.
The funding market is also developing in a more interesting direction. It has become a ’hedging’ tool - allowing businesses that can afford the costs of litigation to better control their expenditure. Potential claims can be explored and, if merited, brought in a way that minimises the client’s financial outlay. When finances are under scrutiny and making best use of the cash available is vital, a package of funding and ATE cover allows such a client to minimise the room for unexpected financial expenditure. If the case wins the client has an upside - yes, a share in the damages will be paid to the funding partners, but this is the price for removing much of the financial risk from the legal action.
And in the near future we have the prospect of what will be known as damages-based agreements (DBAs) but look to the uninitiated pretty much like contingency fees. A DBA will allow the lawyer to act as a litigation funder - taking a share of the damages. Much of the detail around DBAs is yet to be published. The funders’ code provides a good idea of some of the pitfalls DBAs will need to resolve - conflict of interest, unbiased advice and capital adequacy to name a few. For a commercial lawyer who is in the thick of the action and does not have the diversified portfolio of a funder, these may be a lot harder to resolve than for the funder.
Case funding has developed considerably in the range and sophistication of offerings available.
In no way has this evolution finished - markets are too young to have reached an ideal level of competitiveness, and may yet in some areas prove too fragile to withstand the pruning that the Jackson reforms threaten to give them. That excepted, tomorrow’s solutions are likely to be even more wideranging and sophisticated than today’s.
What every potential claimant should bear in mind is that “how much do I have to pay?” should no longer be the first question when contemplating litigation.
Get your house in order
Law firms have a huge amount of data that must be put to better use in risk management
Today’s top law firms are walking in increasingly hot waters. The globalisation of the legal market, consolidation, expansion ambitions and increasing competition all bring challenges and opportunities - and a huge compliance and risk map.
On top of that, UK firms have outcomes-focused regulation (OFR) to deal with. The only way to deal with these challenges - and simultaneously add to the bottom line - is to see the world in terms of information, not manual processes.
“The volume of business data that sits within a firm’s system that’s completely unleveraged is huge,” says IntApp’s Pat Archbold. “Law firms do a great job of getting the information they need to get the client on board and to get bills out, but for everything else there’s plenty of room for improvement. And firms are going to keep getting bigger so their compliance issues are going to become more complex.”
The web of risk
Managing this web of risk has to be done with integrated technology, says Archbold - humans simply cannot cope with the complexity and cannot be relied upon to remember all the things they have to do. Even basic compliance elements such as conflict-checking cannot be scaled if they are being done manually, Archbold says.
The answer - workflows and automation - means getting in with IT, but that’s not always easy; risk, beyond the essentials, can be a difficult sell when IT often has a long list of other matters in the queue.
“Until a client or insurer makes a point about where the market trends are going, firms often resist change,” Archbold says. “But don’t wait for insurer and client pressure to create a fire drill - take the proactive steps now.”
So, what can risk people do? Start by building forums for engagement, says Archbold. Working towards ISO 27001 can help this happen, he says, because it is in the standard to set up security forums, and risk can piggyback on their creation to make more proactive, risk-focused forums.
OFR will also drive the connection between risk and IT (and other departments), Archbold adds.
“It’s an executive management issue,” he says.
“OFR is a different beast, because it asks that you demonstrate you have the systems and controls in place to meet the outcomes. It’s not a tick-box system.”
But what happens if you’re just not big enough to handle big business standards like ISO 27001? If you’re Clifford Chance and Allen & Overy this is not a big problem. A 200-lawyer firm, however, may not have the resources, points out Archbold. This is why, he says, IntApp is working to create a venue for this dialogue and deliver more than just software.
Getting proactive with IT
“The real shift that has to take place is a more proactive relationship between risk and IT,” Archbold explains.
One way IntApp is helping this change happen is by sponsoring the Law Firm Risk Roundtable initiative. This includes a working group of law firm risk and IT leaders collaborating to develop risk response guidelines in response to evolving industry, client and regulatory pressures.
But in terms of what IT can do for risk management at a firm, that is thinking ahead of the pack, Archbold says. First, a firm has to get better at binding all its information together.
“Understanding who’s worked on which matter, what administrative staff has been assigned, who has been pitched to as well as core data like the consistent updating of practice groups and certifications, are all going to be increasingly important moving forward,” he says. “Humans can’t possibly track and update this information manually.”
Doing this delivers value in profit-creating areas. For example, Firm X might want to be the bestenergy firm in the world, but if it isn’t checking carefully and at many stages - prior to client set-up or matter intake - who in the firm is speaking to who, it could end up killing its chances of winning the best client it could have simply because of conflicts or information barriers.
“That’s when I say: ’get that underlying data organised now to avoid headaches later’,” adds Archbold.
This is the mission, should they choose to accept it, of modern-day risk chiefs, he says, “because it’s not just an IT issue and it’s not just a risk issue - it’s a business issue”.