Uncharted waters: The practical implications of the Legal Services Act 2007

We will shortly be seeing the first real consequence of the Legal Services Act 2007 (LSA) following the introduction of the legal disciplinary practice (LDP) concept – LDPs were formally approved by the Solicitors Regulation Authority (SRA) on 31 March 2009. For the first time in English legal history, ownership of solicitors’ practices is extended to those that are not qualified as solicitors.

This is, of course, only the prelude to further extensive changes brought about by the new legislation. The legal profession is entering uncharted waters and the purpose of this article is to explore the practical effects of the LSA and what it means for those engaged in running the financial and operational aspects of law firms.

The LSA is being implemented at a time when many firms are suffering significant declines in revenue after a period of strong growth. Many practices are consequently in passive-defensive mode, focusing on cash flow, reducing head count and worrying about their banking relationships.

Against this background, many law firm leaders do not believe that they need to worry about the implications of the LSA. Phrases like ‘I’m not worried about competition from supermarkets – clients will always want quality service’ and ‘I like the partnership culture, I don’t want to change’ are typical of the comments that I have recently received.

Some firms may remain untouched over the next few years, but they will be in the minority. The legislative changes, combined with the uncertainties of the economic recession, will create a climate in which complacency is not an option. Those firms that ignore how the legal marketplace is going to be transformed will face a serious battle for survival; those that refuse to embrace the new world will inevitably be overtaken by competitors that exploit the new legal environment.

The LSA

First, the LSA has created a whole new class of acronyms that will become commonplace, and so I include a glossary of terms that will enter common usage (see the glossary below).

Second, the legislation is going to be introduced piecemeal, and the time scale of the reforms is as follows:

March 2009 – LDPs (see below) can operate;
March 2009 – firm-based regulation began;
November 2009 – new procedure for the issues of practising certificates;
Late 2009 – the LSB starts to operate;
2010 – the OLC becomes fully operational;
Late 2011/early 2012 – the first licences for ABSs are granted; and,
2012 – all aspects of the LSA will be in place.

The most widely publicised part of the LSA relates to the introduction of ABSs, which will probably not be allowed until early 2012. In the meantime, however, there will be plenty of activity provided by the LSA.

LDPs

LDPs can be owned and managed by a combination of different types of lawyer – solicitors, licensed conveyancers, barristers, notaries public, legal executives, and patent and trademark agents – and up to 25 per cent non-lawyers. Any individual that is not legally qualified is now able to apply to be a manager, provided they are approved by the SRA and provided there is not more than 25 per cent non-lawyer ownership of the firm. The restriction on the extent of non-lawyer ownership is by proportion rather than number – non-lawyers must not make up more than 25 per cent of the ownership of the firm.

Only a handful of applications have been received for approval as an LDP. The slow take-up is due to a number of factors. Many firms were waiting for the LDP system to be finally approved before making an application.

Equally, many non-lawyer professionals, who would perhaps have been keener to become recognised as a full partner in a solicitor’s practice, will now want to wait for a better economic climate before taking on that level of responsibility. Large firms with international offices may find that there are current difficulties in accommodating the LDP regime with regulation in other jurisdictions. Finally, it was always expected that most law firms that want to extend their ownership beyond solicitors would wait until the introduction of the full ABS structures in 2011/2012: the LDPs are quite narrowly structured and do not give the same flexibility as an ABS.

Regulation

As of 31 March 2009, all partnerships automatically become recognised bodies (see glossary). This is part of the somewhat understated part of the LSA that is going to lead to widespread changes to the regulation of the profession. The SRA is firmly committed to the process of ‘firm-based regulation’, meaning that regulatory powers will focus on the law firm as an entity rather than on individual solicitors. In other words, both firm and individual must be authorised.

All recognised bodies will need to apply for renewal of their (automatic) recognition in November 2009.

This will effectively mark the start of a licensing regime for law firms (and LDPs/ABSs) giving the SRA increasingly wide powers over law firms. From November 2010, the SRA will introduce a new regime for licence fees: it is quite possible that the SRA will start to impose significant fees for licence renewals. In addition, the new regulatory regime will lead to greater demands for knowledge about the internal affairs of law firms by the SRA who, through the new renewal forms, may start to ask for information about sources of income, complaints received, proof of compliance with codes of conduct, details of training activities, (more questions on) diversity and employee/management misconduct.

This sort of information will give the SRA a much greater insight into the records of law firms who are going to be under greater scrutiny that ever before. The legal profession is accordingly, if slowly, becoming aware that the cosy days of regulation by the Law Society are disappearing. The SRA, armed with new powers and knowledge, is set to become a potentially powerful and intrusive regulator – one that is unlikely to be timid about using its extensive powers. The SRA will also have the power to discipline managers in LDPs/ABSs as well as employees in all businesses undertaking restricted legal activities.

Solicitors’ Accounts Rules 1998 – changes

On 31 March 2009, the SRA introduced changes to the Solicitors’ Accounts Rules 1998 (SAR) as a result of the LSA. These changes are relatively minor and include:

Changes in the authority to withdraw monies from
client account;
Abolition of controlled trusts;
Rules for the delivery of accountant’s reports; and,
The removal of interest certificates, with all complaints about interest calculations now being dealt with by the Legal Complaints Service.

Most importantly, there is one substantial change – whistle-blowing obligations are now imposed on accountants. The letter of authority given by all law firms to their reporting accountants, in accordance with Rule 38 of SAR, used to provide that, where accountants found information of “material significance” about the fitness of solicitors to hold client monies, they were “encouraged” to report the matter to the law Society. Now, the amended Rule 38 provides that such information “must immediately” be reported to the SRA. So, reporting accountants no longer have the option of a discrete/off-the-record chat with their solicitor clients about material breaches. They are obliged to make a direct referral to the SRA, adding to the potential tension of relationships with external auditors.

ABSs

The most widely-trumpeted reform of the LSA is, of course, the ability for law firms to obtain external investment and for ownership to be held by non-solicitors. The LSB will not have the resources to set up the approval processes for any ABS applications before late 2011 (the actual approval will be undertaken by an approved regulator, for instance the SRA). From that date, however, ABSs will be able to offer reserved legal activities in direct competition with the traditional legal practice. They can be multi-disciplinary professional practices with a controlling interest held by non-lawyers.

They will, on the other hand, be subject to controls that do not affect a purely solicitors practice. The licensing bodies, such as the SRA, will keep a close eye on those holding outside interests. Those who wish to own a ‘restricted interest’ (typically more than ten per cent) of a licensed body will need approval from a regulator, which will primarily investigate whether the ownership of the restricted interest will affect the independence of the legal services to be provided. There have, for example, been concerns that people or organisations with dubious records or associations could buy a law firm and use it as a cover for money laundering activities.

Additionally, ABSs must have two appointed senior people responsible for professional activities – a ‘head of legal practice’ and a ‘head of finance’ – that have clear obligations to report to the licensing authorities on breaches of the terms of the licence, including breaches of the Solicitors’ Code of Conduct 2007 and breaches of the SAR. These will be more onerous duties than currently exist in the ordinary solicitors practice.

Forecasts

So, what do all these changes actually mean and will they have any real affect on the structure of the legal profession?

The take-up on applying for LDPs has so far been weak. Lawyers are highly cautious and conservative, and surely most firms will adopt a ‘wait and see’ approach. Whatever happens in terms of competition, one aspect of the reforms is certain to have a real affect on the operation of law firms – regulation will become tighter. The SRA has been given wide powers and will not hesitate to use them. Licensing fees are set to rise and may partially replace individual practising certificate fees. The fees may vary across firms, depending on size of firm and claims/complaints records. Information demands will increase. The number of firms is set to halve according to the views of many commentators, making the regulators’ lives easier. Increased regulation of the legal sector is just a reflection of the demands for greater supervision in many finance-related markets. FDs will often hold a key role in dealing with the increased regulation.

The interest that many outside investors had shown in the legal sector may have cooled in the light of the recent downturn in the fortunes of many law firms. In particular, investors will be wary of firms that have a heavy focus on cyclical-linked work, instead looking for steady cash flow and consistent profit streams. Those law firms that can demonstrate regular profitability and that would focus on, say, personal injury or medical negligence may prove attractive. Even criminal legal aid may attract attention for, although it has very low hourly rates, it can be run with low overheads, on a mass volume basis and has guaranteed payment.

Even though interest may have cooled, it is inevitable that there will be some new entrants into the legal sector with deep pockets and new ideas. They will transform the retail legal sector. They will introduce concepts currently largely unknown to the legal market. They will seek high national market shares and may use practices such as predatory pricing to achieve their goals. They will have often big marketing spends and, crucially, will be able to invest heavily in IT. The loosening of competitive restrictions in the opticians’ profession is illustrative of what can happen in the legal sector. From a highly fragmented industry in the mid 1980s, the sector is now dominated by just four players who have 70 per cent of the market. Specsavers alone reportedly spent £27m on advertising in 2007.

If the high street law firm is under dire threat, what is the future for firms providing commercial legal services? What will be the effect of external competition in this part of the sector?

Some commercial firms will certainly attract outside investment – although they will need to show how they are going to use the money to create more value. Some will take the investment (either from venture capitalists or by floating on the AIM market) to expand regionally or overseas, or to gain market dominance in certain markets. Their cultures will become more hierarchical and entrepreneurial. External investors may well seek more dedicated and professional management, with CEOs and FDs becoming the two most dominant members of the firm, replacing the part-time senior and managing partners, who have never been trained or groomed to run large businesses. The businesses that opt for this route will be much more focused on developing long-term capital value. The firm’s management may be as interested in their share options/profit linked bonuses as their yearly salary.

Those who stay on more traditional paths (and this will probably be the majority) will need to respond to the new competitors. My view is that the present economic and legislative changes will lead the profession away from using the partnership structure as its most common form of business model. The partnership model is outdated – a relic of 19th century business activities. It hampers swift decision-making and encourages risk averse models. There is nothing now to prevent law firms from being run like ordinary, if highly regulated, businesses.

Further, in the future, law firms will not need as many partners: legal work will increasingly be undertaken by specialist non-qualified lawyers with a much greater use of technology; for example, by using artificial intelligence and document management tools. With greater challenges to profitability through more competition and more sophisticated clients, law firms may well become leaner, dominated by directors operating in a more pyramidal environment. If I am right in my predictions, the LSA is likely to bring about an enhanced role for many FDs, who will function centre stage in a more regulated and competitive market.

Nigel McEwen is a partner at SSG Legal. He can be contacted at nigel.mcewen@ssglegal.com

GLOSSARY

Alternative business structures (ABSs)

New types of law firm will be permitted from around 2012; for example, firms with more than 25 per cent non-lawyer managers, a company taken over by a non-lawyer enterprise, a company floated on the stock exchange or a firm that provides both solicitor and non-legal services.

Approved regulator

A regulatory body approved under the LSA to authorise individuals or firms to undertake reserved legal activities; the approved regulators include the Law Society (acting through its independent regulatory body, the SRA), the Bar Council, the Institute of Legal Executives and the Chartered Institute of Patent Attorneys.

Front-line regulator

An approved regulator – the term ‘front-line regulator’ is used to contrast with the LSB (below), which will be the over-arching regulator for legal services.

Legal Services Board (LSB)

An independent body established under the LSA to be the over-arching regulator for the legal profession as a whole, and which will authorise organisations like the Law Society to carry out ‘on the ground’ regulation.

Office for Legal Complaints (OLC)

The OLC will take over all complaints handling against lawyers, at present handled by the complaints services of the various professional bodies.

Recognised body

An LLP or company recognised by the SRA as suitable for the provision of legal services. As of 31 March 2009, partnerships are required to be recognised.

Reserved legal activities

Specified in the LSA as the exercise of a right of audience, the conduct of litigation, reserved instrument activities, probate activities, notarial activities and the administration of oaths. Accordingly, those businesses that provide non-reserved legal activities will not be regulated under the LSA – so firms offering employment, unlitigated personal injury claims, immigration or even corporate legal advice will have the ‘advantage’ of a lack of regulation.