Shunning the risk
20 November 2006
Failing to prepare is preparing to fail. The wisdom of this adage was never made plainer than in the wake of Arthur Andersen's spectacular demise. Partnerships need to not only wake up to the danger of a catastrophic event but, moreover, take active steps to limit the potential fallout.
The development of limited-liability partnerships (LLPs) has increased security for members by protecting their personal assets from the clutches of the creditor - unless they were personally liable for the negligence. While LLP status is valuable for individuals, limiting liability does not protect the firm itself from failure in the event of a successful negligence claim or the ensuing reputational damage, nor does it protect the individual negligent partner from the spectre of financial ruin.
Firms have traditionally protected themselves against professional liability risks by buying professional indemnity (PI) insurance, which has a limit of indemnity above those set by the Law Society, which are £2m for a partnership and £3m for an LLP. There is no hard-and-fast rule as to an adequate limit of indemnity and many factors need to be taken into account by the firm, including the complexity of the law in which they are involved, the value of transactions and the size of litigation the firm undertakes. Cost of cover also plays its part and firms have taken advantage of the current soft market to buy more cover with the savings achieved at the last 1 October renewal. The larger law firms will buy whatever capacity is available, which does enable firms worldwide to buy upwards of £250m-£300m.
A dilemma faced by many firms is the prospect of taking on large commercial transactions that far exceeds the levels of their PI cover. The cost of arranging one-off cover - very similar to the cost of maintaining cover for all of the firm's work - is not an attractive option. While the temptation of additional fees is great, the profit from undertaking such a job rapidly disappears when the additional cost of the PI cover the firm thinks it needs to buy is factored in - especially when it realises that the policy will need to be renewed annually for as long as it feels it is exposed to a negligence claim.
The insurance market is developing innovative insurance solutions to help firms manage the liability exposures, such as asset-protection insurance, which provides funds to dependants of partners should the partnership be made insolvent from a PI claim. The dependants are able to use these funds to protect the family home and remain financially secure.
This type of policy has been seen as an alternative to converting to an LLP. The majority of solicitors still prefer the benefits of partnership status, but the downside of unlimited joint and several liability has become an increasing concern.
Additional coverFirms now recognise that no limit of PI cover is sufficient to protect them against an 'Armageddon' event. The recent litigation against Edge Ellison (now Hammonds) by the Football League has added to the sense of unease. The lawsuit, if successful, could have led to a claim of £140m.
Recent research shows that lawyers are aware that LLP status is not the panacea for total protection. More than 40 per cent of solicitors questioned believe firms require an extra layer of insurance to provide the ability to defend a negligent partner - or to relaunch the firm should a claim threaten its existence.
In response to the demand for an insurance-led solution, new products have been designed to help LLPs fight a catastrophic claim or, if incapable of settlement, to be used by members to restart the firm or help the dependants of a negligent partner to keep the family home. The policy provides two coverage levels.
The first is triggered should a claim exceed the total limit of PI insurance, threatening a firm with insolvency. The total value of this policy can be used by members to settle such a claim on the proviso that the claimant waives any further actions against the firm and any of the members. This cover serves as a valuable negotiating tool when settling a major negligence claim. The second level of cover becomes available should a claimant refuse to settle and the LLP becomes insolvent. The policy then pays in full to the members to recreate the insolvent partnership, start a new business or even fund retirement. The payment is also available to the negligent partner as part of their protection against being pursued personally. This cover provides the partners with a cash payment to relaunch their practice in the event of bankruptcy and serves as a life support should a partnership ever flatline.
The hope is that a firm never has to suffer the misfortune of exercising its additional insurance cover. However, should disaster strike, contingency plans should be employable immediately. Sometimes it pays to be pessimistic.
Risk managementThe best solution to avoiding a catastrophic claim is to have effective risk management procedures in place. Firms need to ensure that clients are taken on in a structured manner; risk management amounts to much more than adding layer upon layer of supplementary insurance. An increasing number of firms are now taking risk management to the front line, dealing with issues before they become a problem by scoping out the extent of the work to be undertaken within the retainer and that which is not.
There is an array of risk management strategies that can be deployed, such as:#Engagement letters. It is possible to limit the firm's exposure for both non-contentious and contentious work, subject to certain limitations for contentious business agreements. Firms need to take a long and careful look at their risk management policies. Limiting the risk of negligence claims makes solid business sense; evidence of properly instituted risk management initiatives also inspires confidence among PI insurers. Some underwriters will discount 30 per cent from premiums if they are convinced the firm has good systems and procedures in place.
Firms must recognise that an unexpected event can affect even the best-managed practice. Implementing additional levels of insurance against professional negligence claims is far from an indictment on the failings of a firm. An awareness of the liabilities, and consideration of how to protect against them, should be integral to any risk management strategy.
The LLP, as evidenced by its very name, does not and will not cover every eventuality. There are holes that even supplementary PI insurance cannot plug. The potential problems facing partnerships and LLPs alike are genuine and it would be imprudent to ignore these risks. The Andersen experience and subsequent Goliath professional negligence claims have sounded the alarm. To ignore the call would be tantamount to sticking one's head in the sand.
Steve Holland is director at Alexander Forbes Professions