Cap happy

The trend for capping law firms’ liabilities is catching on. Martin Ellis reports on the level of limits required to keep all parties on-side

Figures from PricewaterhouseCoopers (PwC) demonstrate an increasing acceptance of liability capping in the legal profession. Financial exposure can be capped above the minimum compulsory level of professional indemnity cover – £2m for partnerships and £3m for limited-liability partnerships (LLPs) from October 2005.

PwC’s 2004 ‘Financial Management in Law Firms’ survey revealed a significant decrease in partner resistance to capping liabilities. Among the top 25 law firms in the UK, 29 per cent reported that they “routinely” limited their liability in 2004, compared with just 12 per cent in 2003. The perceived need for limiting liability also rose in the same period from just over 50 per cent to 75 per cent of firms. This year’s figures are expected to reveal a continuation of this trend.

Case law has developed since Clark Boyce v Mouat (1994), which found that lawyers should not have a duty to go beyond their retainer and provide unsought advice on the risks of a transaction. Indeed, problems arising out of inadequate engagement procedures have resulted in a number of recent cases. Unless there is very good reason for divergence, judicial expectation is that: each file will have an engagement letter (Hurlingham Estates v Wilde & Partners (1997)); if a solicitor becomes aware, or ought to have become aware, of a risk in carrying out their instructions, then they must warn the client (Credit Lyonnais SA v Russell Jones and Walker (2003)); and that a greater degree of care will have to be exercised by the solicitor when acting for an inexperienced client (Carradine Properties Ltd v DJ Freeman (1999)).

Care needs to be taken by fee-earners not to inadvertently drift outside their retainer. To do so will, on the face of it, extend the duty of care. If the original parameters of a retainer are exceeded, the original engagement letter will need to be amended to reflect this and to advise the client.

It is also important when considering the financial capping of liability what the appropriate level of professional indemnity cover is and that it remains in force. If contractual terms are agreed with clients that stipulate a required level of professional indemnity cover, then law firms must remember not to fall foul of such terms in the future. Professional indemnity insurance is underwritten on a ‘claims made’ basis, being the policy in force at the time the claim is made and not the policy in force at the time the negligent act was actually committed. If a negligence claim is made against the firm long after the original terms were agreed and entered into, and the firm’s level of professional indemnity cover has been subsequently reduced, then the firm will face a difficult experience with its client. It is therefore imperative that the past, as well as the future, is considered when selecting an appropriate level of professional indemnity cover.

This obviously raises the issue of how much professional indemnity cover a firm should take. Should professional indemnity cover be set at the limit of the firm’s total liability, or should it hold more cover to provide an element of comfort? Many firms reduced their cover a few years ago when premium rates were at their peak. However, it is envisaged that many will take the opportunity in this year’s softening market to increase their professional indemnity cover to provide a buffer against potentially large claims.

While a limit to a firm’s financial liability will not automatically result in lower professional indemnity premiums, underwriters are increasingly looking for examples of consistent capping of firms’ exposure and clear guidelines within their terms of engagement. If practised, this definitely sends a positive message about a firm’s risk management culture and procedures; it can also be used as a powerful tool for the broker in the negotiation process with underwriters.

Since the move to the commercial insurance market, firms have been required to demonstrate to their professional indemnity insurers that effective risk management procedures have been put in place. Managing the risk of exposure to higher value negligence claims is a key element in the overall management of risk within the business. Perhaps over time, if the level of awards for negligence claims falls, this could have a positive impact on a firm’s professional indemnity cover. In a hard market, high-quality risk management procedures could make a real difference as to whether an underwriter will offer renewal terms.

The legal profession has long considered ways in which it could limit its liabilities. However, resistance from partners and fear over client reaction have caused firms to hold back. PwC found that, among those firms not routinely limiting their liability, partner resistance was perceived to be the main barrier (67 per cent of the top 25), followed by client resistance at 50 per cent.

However, research suggests that the barrier is more psychological than real – when partners have opened a dialogue with their clients about capping their exposure, the general response has been: “We’re surprised you hadn’t done this earlier.” Some financial institutions remain wary, but the general consensus from clients has been positive, as long as the capping is at a reasonable level.

The Unfair Contract Terms Act 1977 (UCTA) requires firms to cap their liabilities at sensible levels, according to the risk of the projects they are handling. Any judge will fail a test of reasonableness if a disparity is apparent and the risk far outweighs the cap on financial exposure.

It is therefore very important that careful thought is given to any cap figure. There is a danger to having a blanket cap limited to the minimum level of cover that firms are obliged to carry. If it is the firm’s intention to rely on a cap, it will most likely have to demonstrate to a judge the factors taken into account in deciding whether such a cap was reasonable. A fee-earner should therefore carry out a brief risk analysis of each new matter, including the likelihood of something going wrong and the potential cost, so as to ensure that any cap bears some resemblance to the risk attached to the matter.

There is no benefit in trying to cap your exposure if it does not give you a decent defence. However, if it is set at a reasonable level it is a very prudent strategy to adopt as part of a firm’s risk management procedures. Underwriters are increasingly looking at methods used by law firms to reduce the number of negligence claims they face. At the very least, limiting liability by financial capping and specifying the scope of the retainer provides a clear message as to the firm’s attitude towards the acceptance of risk and is a tick in the right box for any underwriter assessing the professional indemnity renewal.

Martin Ellis is a director at Alexander Forbes Professions