Risky business

As the economy slows, claims against lawyers are set to rise. But risk management is as essential in the good times as in the bad.

Even at this early stage, 2008 is already looking as though it is going to be a difficult year for law firms. The much-talked-about slowdown looks as though it has finally arrived.

The credit crunch, volatile stock markets, a slowing housing market and businesses pulling in the purse strings to weather out the financial storms is bad enough in itself. In addition to this, however, law firms find themselves struggling to comply with an ever growing burden of regulatory and compliance obligations.

If that were not enough, recession poses another very real threat to law firms: claims. It is a fact that professional negligence claims are recession-led. Through their liquidators, failed businesses look to place the cost of failure with the lawyers and other professional advisers. The harder the recession, the greater the number of claims generated.

Falling house prices and a growing number of repossessions cause lenders to look very closely at the advice they were given and the steps taken by the lawyers at the time of the mortgage advance. Failings are quickly identified and steps taken to obtain recompense from the lawyers’ professional indemnity insurance providers.

The real problem is that there is little that law firms can do to avoid being caught in the spiral of recession-led claims because the mistakes have already been made. The claims time bomb is ticking away in the archives of closed files, or for the less organised firms, the files scattered on the floor and on the window sills where the lawyer has still not quite got round to closing the file, clearing balances, getting the stamp duty land tax paid and archiving.

So why does recession lead to an increase in the number of claims? One of the reasons is that during the good times everyone is too busy making money to take a careful look at the way the work is being done.

A key component of reducing the risk attached to a file is to ensure that there is adequate supervision of the fee-earner, whatever level they are. Senior partners are just as likely to make mistakes as the newly admitted lawyer.

The client pressures of immediate delivery linked to ever demanding fee targets often results in the work being done as quickly as possible by an overworked, under pressure and stressed fee-earner. Not a good recipe for making sure the risk of error is kept to a minimum.

Another problem is that in the good times, when professional negligence cover is cheap and claims few and far between, risk management tends to be the last thing on most lawyers’ minds.

“I have not been sued so I must doing it right” is a short-sighted approach. Mistakes are most likely being made, but solicitors’ claims tend to be long-tailed – that is, there is usually a relatively long period between the mistake and the claim – and it takes a good dose of recession to make the claims come bubbling to the surface.

This reinforces the point that good risk management is an ongoing process, with firms collectively and fee-earners individually identifying the risks attached to the work they are doing, analysing them, and then taking steps to reduce the risk of error. Managing your risk is as important in the good times as it is in the bad times.

However, are there any particular risks that are greater in times of recession? Most certainly. When times get hard, it tends to be the non-contentious side of the business that suffers most. The litigators are too busy on insolvency matters and suing other solicitors for negligence to feel the same level of impact.

When work dries up there is a tendency for lawyers to start looking for work in areas outside their normal practice. Dabbling and wandering through fields of law armed with no more than a precedent book is a dangerous business, both from an insurance perspective as well as regulatory. Remember that a solicitor is under a regulatory obligation not to take on work unless he or she has the necessary skill, expertise and time to do it.

Unstable stock markets and fluctuating house prices cause problems for those lawyers who draft agreements based on current valuations. Matrimonial lawyers are at particular risk here. A consent order based on a valuation from six months previously in a falling housing market can result in a client losing out quite substantially. Likewise, sitting on a share portfolio with instructions to sell in a rapidly falling stock market can again cause considerable loss to a client.

To compound the potential problems, solicitors who have been negligent face considerable financial loss at a time when they can least afford it. Claims and complaints cost a great deal of money. Paying the excess, lost management time investigating and reporting the claim, increased insurance premiums and loss of future business from the client are all costs that a law firm can ill afford to lose on a shrinking fee income.

So what of the professional indemnity insurers? How will they fare in a recession? Increased claims will mean greater losses. Currently, professional indemnity insurance premiums are at unsustainably low levels. The correction, when it comes, will be sudden and swift and upward.

It is difficult to be precise, but rating increases are certain, and may lead to increased premiums of up to 30 per cent for the poorest-performing firms. It will be interesting to see how the underwriters react in recession. Mortgage fraud has made a comeback and the claim payments that will inevitably follow will have a considerable impact on the insurers.

The danger to the profession is that if insurers are caught out, they have the option to withdraw from the market, thereby reducing capacity, and if that happens then rates will rise.

Risk management must always be at the top of the firm’s and the individual’s agenda. The well-run firms with good risk management systems will have seen the problems coming and will have made contingency plans, which will already be in effect. Those who choose to turn a blind eye to the need to manage their risk, both professional and strategic, may well pay the price.

John Verry is director of risk at TLT Solicitors