The claims outlook in an economic downturn

With the severity of the recession beginning to bite across the profession, most law firms would probably accept that the downturn has exacerbated the liability risks that they now face. For their part, armed with statistics from the last collapse of the property market and its role in the demise of the Solicitors Indemnity Fund (SIF), insurers are understandably concerned about the losses that may be coming their way.

This article looks at some of the factors that are likely to shape the claims experience of the profession over the next few years and offers a view on their overall impact.

Impact of the economic downturn

Although there has inevitably been a degree of ‘scaremongering’ about the claims environment generally (some of it self-serving), history tells us that the level of claims does generally reflect the state of the economy.

Losses (a prerequisite for any claim) are incurred, financial distress abounds and clients may be unable to trade out of their problems. All this tends to lead to a greater scrutiny of the advice offered by professionals, such as solicitors. Hence, in a buoyant economy, an unfortunate piece of drafting may be disguised if the underlying investment is still making money; the reverse is true when the economy goes into recession – clients then tend to pour over the advice they have received and are more likely to take a robust view if there have been errors. In this environment, breaches are more likely to be detected and are far more likely to be causative of actionable loss.

Increase in insolvencies

The latest figures from the Insolvency Service and Companies House, released in February, confirm that the number of liquidations was up by 24 per cent in 2008 from 2007. Insolvency experts predict a further increase in 2010 and it is difficult to argue with that analysis in the current economic climate.

If that is correct, what are the implications for the claims profile of solicitors?

One factor that has driven the move towards LLP conversion in recent years has been the fear of being caught up in a major insolvency or corporate scandal. These sorts of problems inevitably generate litigation and lawyers may be at risk, not least because of the ‘deep pocket’ syndrome. Thus far, such problems have been confined to firms in the US.

In more general terms, an insolvency, by definition, involves the loss of an often close solicitor-client relationship. Claims are less likely to be made and pursued where there is a strong and long-standing relationship with a client and, while difficulties can (and obviously do) arise from time to time, they are far more likely to be resolved constructively without the parties resorting to litigation. In contrast, one of the liquidator’s primary duties is to realise the company’s assets to good effect and those assets include rights of action against third parties. Accordingly, liquidators will review loss-making transactions and, if there are apparent shortcomings in the advice, explore potential recoveries.

The disposal of assets may bring problems to light in relation to the law firm’s earlier work, while liquidators are also now starting to utilise third-party funding to pursue actions (see below).

The banking/capital markets crisis – potential fall-out?

Major litigation between financial institutions has yet to ensue. It is now a little over 18 months since the problems at Northern Rock surfaced and many banks and institutions are still working through their positions in an attempt to reduce or close out their exposures. Whether such behind-the-scenes activity will culminate in major, intra-market litigation, only time will tell.

The problems in the banking market have given rise to speculation in some quarters that firms could be exposed to claims from clients in the sector, whether directly or via Part 20 proceedings, should defendants seek to ‘share the pain’.

The starting point for any analysis is the solicitor’s core duty – namely, to negotiate an agreement that reflects and gives legal effect to the client’s instructions and its understanding of the commercial deal. A solicitor’s scope of duty does not extend to giving advice to competent and experienced clients on the commercial wisdom of a transaction; the point being that the client operating in the relevant market is in the best position to assess the viability of the proposed deal. This is particularly so in the capital markets, where the transactions (such as collaterised debt obligations and structured investment vehicles) were large and complex. It will, therefore, be very difficult for such sophisticated clients to substantiate a ‘failure to warn’ argument.

Nor can clients credibly contend that their lawyers should have sought and obtained more extensive protection for them, in circumstances where clients were driven by competitive pressures to accept a dilution of the traditional rights of recourse; for example, the prevalence, until 2007, of covenant-lite loans.

Likewise, while some disputes may give rise to issues of valuation, this is a matter for the banks and the relevant financial advisers/accountants – it is not something that can be laid at the door of the lawyers.

In contrast, where there has been a failure to properly implement and give effect to the terms and structure of an agreement, a client will have legitimate cause for complaint. In a highly competitive and fast moving market, transactions were completed within very severe constraints of time, with the risk of errors and oversights being exacerbated by the inherent complexity of the transactions. Thus, while lack of time is a factor to be taken into account, it is not a licence to be negligent.

Finally, claims of this nature may give rise to significant issues of causation. Accordingly, even if a breach of duty can be established, the claim will fail if the link between the breach and the loss is too tenuous (for instance, it is not a dominant or effective cause). Causation is often a pivotal issue in solicitors’ cases and it is one that will be keenly contested should any attempt be made to involve firms in the fallout from the current liquidity problems.

Commercial property

Problems arising out of the commercial property sector have long been a regular source of claims for large law firms, and the concern is that such claims will increase in frequency and quantum during the recession. Take, for example, a case where a solicitor acting for a tenant fails to serve an effective break clause on the landlord. In a buoyant market, where the landlord has a queue of other prospective tenants, this is unlikely to result in a significant loss. In the current climate, however, where there are no alternative tenants, and landlords are offering all manner of incentives to retain existing tenants, landlords will take every point available to them on the validity of such notices. An ineffective break clause will, therefore, result in the tenant being ‘locked into’ the lease, with the result that a large reverse premium will probably have to be paid to the landlord in order to buy him out. This will, in turn, be passed on to the law firm and its insurers.

In a rising market, this type of negligence would not have been causative of a major loss; the position today is very different. To illustrate the point, Chancery Court statistics illustrate that, in 2002 and 2003, a total of 906 landlord and tenant actions were commenced (Judicial and Courts Statistics 2007, Ministry of Justice, September 2008). Between 2005 and 2007, that figure had fallen to only ten. Suffice it to say that the figures for 2008 and 2009 are likely to show a sharp upward trend.

General commercial work

In general terms, clients who are in financial trouble may seek ways to extricate themselves from their contractual obligations and the same applies to counterparties who are in financial difficulty. This presents fertile ground for contractual disputes, with one or both parties alleging breach of contract, misrepresentation or other causes of action. Where a law firm has been involved in drafting the contract that is the subject matter of the dispute, there may be a question as to whether any ambiguities in the agreement can be laid at its door. In those circumstances, other lawyers are likely to become involved and if they can point to any such ambiguities or other defects in the original drafting, the result may be a claim against its original firm for extrication costs, loss of chance and the costs of any litigation with the counter-party.

Counterclaims in response to fee claims

Claims for outstanding fees have always been a significant catalyst for professional indemnity claims and the problems they create for both firms and their insurers are well understood. The current economic difficulties are likely to result in an increase in the number of high-risk and financially distressed clients, both in terms of existing clients and new ones. To compound matters, all this is occurring at a time when the economic downturn is intensifying pressure on individual partners to generate additional business and (of necessity) to collect existing debt.

There are many tried and tested practical steps that firms take in order to avoid these sorts of problems. They include:

Proper client vetting and credit checks;
Adherence to Rule 2.03 of the Solicitors’ Code of Conduct 2007 (information about the cost) in retainer letters and regular updates to clients;
Regular billing; and,
An independent review before commencing any legal action.

The reference to an ‘independent’ review is to an objective assessment by someone else within the firm, other than the matter partner. Three key questions to be addressed are:

Will the client be able to satisfy any judgment or award against it?
Is the firm’s position on the documentary and other evidence sufficiently strong?
Is there any chance of negotiating a satisfactory settlement and payment plan in appropriate cases (rather than resorting to ‘knee jerk’ litigation in the face of internal pressures)?

Redundancies and redeployment of staff

In addition to a general reduction in resources, any substantial downsizing will lead to a loss of continuity in personnel and the need to avoid problems with the handover of work. This may manifest itself in a number of ways: fee-earners and staff may become demotivated or, in some cases, their performance may be affected by stress; standards of supervision may slip; and, fee-earners may omit to prepare full and proper handover notes or to take all necessary steps to protect the position of clients (for example, in relation to registration).

A loss of business is also likely to increase the risk of solicitors ‘dabbling’ in areas outside their expertise. Inevitably, when firms are struggling for survival, some of them will cast around for other work and take on business that they are not, in truth, equipped to handle. This may include, for example, entering into high-risk conditional fee agreements and accepting instructions in specialist areas in which they do not have the requisite expertise. Likewise, where staff are being redeployed to other areas, it is critical that they are properly trained and supervised.

Third-party funding of claims

Third-party funding is likely to be relevant to a small number of high-value claims. Although the law historically frowned upon such arrangements as unlawful, they are now accepted by the courts as permissible in the public interest and a legitimate means of funding.

There have recently been mixed messages about the market for third-party funding. An Australian funder, IMF, recently pulled out of the UK market, while a survey by Addleshaw Goddard of the FTSE 350 companies suggested that third party funding was of relatively little interest (on the grounds that the funders wanted too big a slice of the damages)1. Against that, a US$173 million claim by the liquidator of Stone Rolls against Moore Stephens was funded by a third-party lender and the liquidator’s appeal against a strike out of the claim was recently heard by the House of Lords2. It has also been reported that a large claim is being pursued against Collyer Bristow by over 500 investors in respect of tax deferment schemes3. Those investors are reported to be proceeding with the assistance of £5m of litigation funding.

In practice, third-party funding is likely to help a small number of claims get off the ground in circumstances where they would not otherwise have done so. Commercial funders are looking for investment opportunities, while such funding presents an attractive option for liquidators, who might not otherwise have had the available funds to pursue large and difficult claims.

Conclusion

Where do all these factors leave us in terms of the claims outlook for the profession?

Although any conclusions are, of necessity, tentative, given that these type of problems inevitably take two years or so to filter through, the reality is that the overall level of claims will increase. It is, however, still too early to say what the scale of the impact will be. Much will depend upon how long the recession lasts and, in terms of property related claims, how willing lenders are to pursue their claims in circumstances where their own lending practices are open to criticism.

Most law firms will find themselves with declining or static turnover over the next year or two. Their natural response may be to suggest to insurers that, as less business is being undertaken, the firm’s premium should be reduced. While each firm will need to be assessed on its own merits, insurers’ responses may be to point to two factors: first, the long-tail nature of claims, which means that payments made are traditionally in respect of work undertaken some years ago; and, secondly, that a reduction is not appropriate in circumstances where levels of premia have not reflected substantial increases in turnover during the past five years.

Is the profession facing an imminent ‘claims tsunami’ as some have suggested? The answer is a resounding ‘no’ – but activity will certainly increase over the next couple of years.

Footnotes

Peter Maguire is a partner in the insurance and reinsurance group of CMS Cameron McKenna LLP. He can be contacted at peter.maguire@cms-cmck.com