The economic downturn – new risks and challenges

The current economic downturn has had a dramatic effect on firms of all sizes. ‘Consolidation’ is the watch word for most managing partners up and down the country. Redundancies are becoming depressingly familiar as firms struggle to cope with reduced work streams and a much harder market. It is no surprise that professional advisers are not immune to the difficulties faced by their clients, when approximately 65 businesses a day are failing and 2,500 employees per day are also being faced with redundancy. For those who have been involved in firm management for some years, the speed and severity of the slump caught them unawares. There are, however, a whole generation of people, including managers, coming through who have never experienced a real downturn.

All of this presents considerable challenges, but at the heart of these is the changing profile of risk. In reality, the new risks now being considered are not really new risks at all, but ones previously identified as being very unlikely to occur, and therefore ones that businesses (consciously or otherwise) were prepared to accept.

An example of this would be the unprecedented level of concern around the failure of a major clearing bank. While, in theory, law firms have always been aware that there were risks on loss of client funds and on being held liable for undertakings given despite such a failure, the likelihood of such a risk occurring was felt to be very remote. There was, however, a period last year where this looked to be a very real possibility; and the risk remains much higher than before. Similarly, law firms spending substantial sums to buy professional indemnity cover were faced with what appeared to be a real risk of a major insurer failing in the run up to renewal in October 2008.

The good news is that lawyers are better placed to face these challenges than ever before. For years, lawyers regarded insurance as being their main risk-management tool. Now law firms have grown to recognise and embrace the benefits of risk management, and an unprecedented number are employing professionals with specific responsibility for risk management and compliance. Firms have never been more aware of the need to protect their business, its reputation and the reputation of their partners from unnecessary or unforeseen risk.

So, what are the risks that firms currently face?

In the current climate, firms of all sizes inevitably have to be vigilant of the risks associated with their clients. At a time when some lawyers and teams are struggling to find work, and are aware of the potential for redundancies, there is an inevitable temptation for lawyers to ‘lower the bar’ on client acceptance. This can mean that people turn a blind eye to factors that would otherwise persuade them not to take on a new client, such as the ability to pay or a track record of suing their previous lawyers. Clients who cannot pay will always look for reasons to criticise the firm’s work to avoid payment. Why are you more likely to meet the demanding expectations of a difficult client than his previous firm (that you are instructed to sue)? There is also a much greater temptation for people to dabble since, once again, under-utilised lawyers fear they may be vulnerable to redundancy.

The pressure that already exists in conflict situations will also be heightened. Leaving aside the acquisition of new clients, lawyers are very reluctant to send their existing clients to other firms. Information barriers do not cure actual conflicts of interest and it is important that those managing law firms take the increased risks on client selection and conflict very seriously.

There is also an inevitable need for firms to get better at managing their billing and cash collection. The measure of ‘investment in client’ is commonly used in firms, but, in the current climate, should more accurately be seen as ‘fees at risk’. Depressingly, there are still many lawyers who fail to attend to this most basic of business requirements. Late delivery of bills reduces the likelihood of payment. To the extent that action is necessary to recover these bills, it is widely recognised that suing clients for fees is a sure-fire way of triggering a complaint (at the very least) and counterclaims in professional negligence (at worst). Real judgment is required as to whether it is sensible and appropriate to sue a client who does not pay you. The absence, for example, of an engagement letter or a fee estimate is likely to make recovery much harder, and increases the likelihood of a complaint being brought and upheld against your firm as part of the process.

The risk associated with the main asset of law firms – their staff – also increases. Against a background where redundancies have either been made or are being considered, lawyers no longer feel as secure. The risk then is that people you need leave and, despite other distractions, it is essential to ensure your high performers continue to feel valued by the business. Equally, are you happy that the restrictive covenants in your partnership deed or LLP members agreement adequately protect your business?

Examples of the redundancy criteria applied by law firms are relatively widely known, and, unsurprisingly, many are derived from chargeable time and financial performance. It must, therefore, be recognised as a significant risk that people will seek to ‘pad’ their time or raise bills and subsequently write them off, since in both cases such action may artificially improve their financial performance on paper. Are your systems and controls robust enough to pick this up? Do you effectively deal with such behaviour?

For years, many law firms have talked about their ‘open door’ policy to ensure that all notifiable circumstances for insurers are brought to their attention. Against a background of people’s jobs feeling less secure, will they still be as inclined to come forward and admit to mistakes? Firms need to carefully consider whether their systems properly detect complaints at the earliest opportunity, and give them an opportunity to then take appropriate action to resolve the complaint or notify their insurers. Now that the insurance market is also hardening, professional indemnity insurers will be looking at appropriate policy points, and ‘failure to notify in due time’ is one of the main reason why insurers decline to cover or later seek recompense.

Of course, the current climate also provides opportunities for firms, and there are recruitment opportunities for those firms prepared to invest in the long-term. Having said that, while there are many people that have been displaced through no fault of their own, you must ensure employment processes pick up on those who have been encouraged to leave by their previous business because they were seen as poor performers. No business wants to inherit somebody else’s problem. You should properly follow up all references sought and check with the SRA to see if there are any disciplinary records held against anyone who is being taken on.

Whether dealing with new clients (with whom the firm has not previously dealt) or its own employees, vigilance for fraud is key in times of recession. Mortgage fraud was endemic in the booming property market of the past ten years and incidences of fraud involving professionals are sadly becoming commonplace. It is important to look carefully at the work that is being put to you by new clients to make sure you are happy that it is work your firm feels comfortable in doing. Also, make sure that all of your lawyers understand the obligations they are under regarding reporting suspicious transactions.

Closer to home, while you may feel that you know the staff working around you, away from work you have no awareness of the pressures they may be under, particularly if spouses have lost their jobs and money is tight. The instances of fraud perpetrated by employees on law firms have increased. Now is the time to be carefully reviewing the processes in place within your finance and other firm functions so as to ensure that client’s money and client’s data too is properly protected.

In a recession, the activities of regulators do not reduce. The SRA are very active and anxious to raise standards in the profession. There is a much greater likelihood of a lawyer’s work being subject to third-party scrutiny than ever before. It is difficult when there are so many other competing pressures to keep staff focused on regulation, but it is equally essential that firms find a way to do this. The Law Society is issuing guidance notes on a very regular basis, and it is important that firms ensure their fee-earners are aware of the existence of these and their contents. It is also important that firms ensure complaints are dealt with sympathetically, approached with an objective view and resolved; otherwise you will be faced with involvement from the Legal Complaints Service or the Solicitors Regulation Authority (SRA).

Firms cannot afford to be distracted from maintaining, and preferably increasing, their spending on risk and compliance. The legal profession is a long way behind the accountancy profession in the steps taken to monitor and require compliance from lawyers. Anyone who has dealt with a large firm of accountants will know that the client selection, client engagement and conflict procedures adopted are far more robust than those applied by law firms. This is clearly the future for the legal profession, and the sooner firms embrace this, the sooner they (and their insurers) will start enjoying the benefits.

Is risk-management business prevention? Busy lawyers doing what their firms asked them to do, and seeking new sources of work, can find risk management to be a barrier at times. Do productivity and profit-making inevitably find conflict with risk management? I don’t believe so. Good risk management increases, but also helps, retain profit to be available to distribute to those for whom it is being earned. Good risk managers need to have empathy with the lawyers that they are working with, and also a degree of commercial pragmatism if they are to be successful at what they do. Firms can support them by sending out a clear message that risk management matters, for example ensuring that rewards are not purely based on financial performance, but that there is more of a ‘balanced score card’ approach rewarding compliance as well as good fee-earning. It is also essential that there are good supervision techniques in place within firms, and this is a key area that the SRA have identified as being a failing in many law firms. Good supervision will spot the warning signs of a person’s overtrading, which, if unchecked, will lead to complaints (at best) and claims (at worst).

Firms, now more than ever, need to be satisfied that steps are in place to ensure that the risks of the business are managed and that compliance is achieved with, among other things, the requirements of Rule 5 of the Solicitors Code of Conduct regarding the management of the business. In many firms, the appropriate way to take this forward will be to appoint an audit committee, and for the audit committee to review the work been undertaken on risk and challenge those involved to make sure they are satisfied that appropriate steps are being taken.

There is also an increased drive towards firms seeking quality accreditations, such as ISO 9001 or Lexcel. While in one way a good measure of the health of business, it is important that firms focus not just on obtaining a standard of this kind, but also how their business will improve as a result of it. It is therefore important that firms do not simply create policies for the sake of it, but make sure that the procedures work for their business, that people understand them and then that people follow them. As such, proper auditing or file review is key. As Nick Leeson ably demonstrated, policies and procedures alone do not protect an organisation.

In summary

Undoubtedly, in the next few years the management of law firms will be tested more than it has been for many years. The fittest businesses will survive and prosper, and there is no reason why firms should approach the current situation with trepidation. Rather, there is a gilt-edged opportunity to take advantage of the increased awareness of compliance and risk issues, and build upon and improve the way risk is identified, managed and accepted by your business. The current climate creates the perfect environment for firms to embed the necessary compliance culture among their lawyers, so that your firm will be secure and profitable for the next generation of partners and staff.

John Marshall is risk and compliance partner at Dickinson Dees LLP. He can be contacted at john.marshall@dickinson-dees.com