Managing risk in law firms

The sharp increase in insurance costs in September 2002, in terms of both higher premiums and larger excesses, has led to an increased emphasis upon risk management in law firms. This article looks at a number of the practical steps which solicitors can take to try and reduce the level of liability and reputational risks which all firms face in an increasingly demanding and competitive environment.

Client Vetting

When accepting instructions to act on behalf of new clients, solicitors are obliged to comply with the requirements of the money laundering legislation, which are now primarily contained in Part 7 of the Proceeds of Crime Act 2002. Part 7 of the Act became effective on 24th February 2003 and the Money Laundering Regulations 2003 are due to come into force within the next few months.

The acceptance of certain prospective clients may present a number of risks for a firm, namely:

• Reputational Risks: dishonest clients who are engaged in money laundering or other illegal activities and who seek to use solicitors to provide a cloak of legitimacy and respectability for their activities.
• Liability Risks: for example, high risk clients who seek, in effect, to pass the commercial risks of an assignment on to their solicitors by attempting to undermine their advisers’ professional independence or by otherwise laying the ground for a potential claim (e.g. by providing inadequate or inconsistent instructions).
• Credit Risks: clients who either cannot pay the fees due from them or who will look for other means of avoiding their obligations (e.g. by making allegations of professional negligence).

Money Laundering/Client Vetting checklists can be completed and signed by the proposing partner in relation to each prospective client. Such checklists can include:

• details of the proposed client.
• the details required for money laundering checks.
• how and why the firm has been approached to act.
• details of previous solicitors, if known. It may, in this respect, be possible to make some discreet enquiries, subject to considerations of confidentiality. If the prospective client has retained a significant number of solicitors recently, the solicitors should ask himself why.
• whether there is anything unusual about the proposed assignment (for example, the formation of companies, particularly overseas, the purchase of property using a corporate vehicle or the formation of trusts where there is no apparent commercial or other purpose).
• confirmation that a credit assessment has been undertaken where the level of fees is likely to exceed a specified amount.

As well as satisfying the mandatory requirements of the money laundering legislation, checklists of this type will help to direct solicitors’ minds to the type of reputational, liability and credit risks referred to above.

The Use of Printed General Terms and Conditions of Business (“Terms and Conditions”)

The use of standard Terms and Conditions is common practice in most areas of commerce, including (increasingly) in the engagement of professional service firms. Accountants, IFAs and construction professionals have utilised such Terms and Conditions for many years and larger law firms are now increasingly introducing similar provisions into their dealings with clients.

There are a number of perceived advantages in adopting this approach:

• it is sound business practice – and very much in the interests of all parties – to have a clear and mutually accepted understanding of the terms of the retainer on any given assignment;
• the Terms and Conditions can state that, once agreed, they will apply to all future work for the client, save where otherwise agreed (i.e. incorporation is a “one off” exercise);
• it is, in both commercial and risk management terms, now more important than ever for solicitors to ensure that their contractual arrangements with clients are tightly managed;
• the use of printed Terms and Conditions will enable firms to reduce the length of their present retainer letters;
• partners and fee earners are more likely to send printed material out to clients;
• in general terms, there is much to be said for standardising the basis upon which business is conducted, as solicitors seek to inculcate a common approach across their respective firms;
• the introduction of such Terms and Conditions is likely to be viewed as a positive feature of a firm’s risk profile by its professional indemnity insurers.

The solicitor’s retainer letter will prevail in the event of any inconsistency and, as well as complying with the requirements of the Solicitors’ Cost Information Client Care Code 1999, the retainer letter should set out the scope and limits of the work which the firm is and, more importantly, is not, undertaking for the client. By definition, printed Terms and Conditions cannot address any such limitations.

As to content, any Terms and Conditions can include the following type of provisions:

• the scope of services – e.g. that there will be no responsibility to advise on tax related issues, save where otherwise agreed. Note, however, the need for a client’s informed consent to agree such a limitation where there are material tax issues;
• that the services are provided solely for the benefit of the client and the firm accepts no responsibility to anyone else;
• a statement of the client’s responsibilities;
• general provisions relating to charges, expenses and billing arrangements;
• a proportionate liability clause – designed to cover situations where other advisers limit their liability to the client, in consequence of which, the solicitor’s ability to claim contribution may be prejudiced. Such a provision is very important in the transactional context where other advisers (notably accountants) routinely limit their liability.

It may, in this respect, be appropriate to consider specifying a minimum limitation of liability (plus legal costs), both to provide a degree of comfort to clients and to enhance the prospects of satisfying the “reasonableness” test under the Unfair Contracts Terms Act 1977;

• that the solicitor accepts no responsibility for the acts or omissions of experts, consultants or foreign lawyers (or, indeed, any responsibility for their fees);
• the solicitor’s obligations in relation to the retention and storage of documents;
• internet based dealrooms/datarooms – the use of this medium carries an inherent risk of third party access to confidential information and it is prudent to obtain the client’s informed consent to this;
• force majeure – a provision that the firm will not be liable if it is unable to perform its services as a result of any cause beyond its reasonable control. Note that the relevance of such clauses has been increased by the introduction of terrorist exclusions into solicitors’ excess layer professional indemnity policies;
• an arbitration clause – subject to the agreement of insurers, solicitors could reserve the right to refer any dispute to arbitration in order to minimise the reputational impact of any claims which are made against them.

Limiting Liability

In contrast to the attitude of major firms of accountants, solicitors have been generally reluctant to seek to agree limitations of liability with their clients (such limitations being permissible under the professional conduct rules, provided that they are not less than the minimum level of £1 million cover required by the Law Society).

Some research into this issue was undertaken in 1999 by the Commercial Law Sub-Committee of the City of London Law Society. This was prompted by steps which had been taken by the “Big Six” accountants (as they then were) to limit their liability in a manner which could be prejudicial to clients’ other professional advisers, including solicitors. A comprehensive questionnaire was sent to the 101 firms practising in the City of London and 42 replies were received (of which 11 were from corporate/commercial firms). Although one quarter of all the respondent firms stated that they included provisions to limit their liability, most did so only rarely and concern was expressed by many firms that they might become uncompetitive if they sought to impose limitations in circumstances where other firms had no such policy. Whilst those concerns remain, the significant reduction in insurance capacity during the last two years is likely to lead many City firms to revisit the issue.

In broad terms, solicitors have a number of options:

• where other advisers (e.g. accountants) are proposing to limit their liability, the solicitor could seek to agree a similar limitation, although it may be difficult to ascertain the existence and terms of any such limitation. Accordingly, the better (and safer) option is for the solicitor to seek to agree a proportionate liability clause with the client;
• the solicitor could seek to limit his liability to the available insurance cover.

In that event, the firm would probably need to accept the risk of insurer insolvency and of the policy being vitiated or any claim for indemnity being repudiated for breach of policy terms and conditions;

• the solicitor could seek to agree a maximum and minimum limitation of liability, with the former taking account of the available insurance;
• the solicitor could seek a specific monetary amount or “liability cap.”

Note, however, the need for some objective justification for the figure chosen. In this regard, it needs to be borne in mind that, in view of the “claims made” nature of professional indemnity insurance, the level of excess layer cover currently available to the solicitor may not be available should a claim materialise some years later.

Any limitation of liability will need to satisfy the requirements of the “reasonableness” test of Section 11 of the Unfair Contracts Terms Act 1977 (“UCTA”). It follows that detailed consideration needs to be given to any proposed limitation of liability, having regard to the circumstances of the particular case.

In this respect, there are a number of points to bear in mind:

• a Judge will test the clause at its weakest point. If it fails at that point, it may well fail in its entirety as the court has no power of severance;
• the test is ultimately a discretionary one which depends on all the facts and the courts have not been wholly consistent in their approach;
• a Judge will apply the contra proferentem rule and construe any ambiguity against the party seeking to limit their liability;
• the burden of establishing the reasonableness of the limitation will be on the solicitor. The court will have “regard to the circumstances which were, or ought reasonably to have been, known to or in the contemplation of the parties when the contract was made” (see Section 11). Thus, the reasonableness of the limitation is to be judged at the time the contract was made and the circumstances of the loss which the client ultimately suffers are not directly relevant.

Section 11(4) of UCTA specifies two particular matters to which regard must be had where a person seeks, by reference to a contract term, to limit his liability (as to which, see 2 and 3 below). Schedule 2 of UCTA also sets out five guidelines for the application of the reasonableness test.

In the context of a solicitor’s limitation of liability, the principal factors which a court is likely to take into account are:

1. the client’s likely level of loss.

See the approach adopted by Dyson J in Moores –v- Yakeley Associates Limited, 28th October 1998. In the case of a specific monetary limit/”liability cap”, can an objective justification be offered for the figure agreed with the client?

2. the insurance cover available to the firm.

What is relevant, for present purposes, is the availability of insurance cover, rather than the actual insurance position. Hence, the fact that a solicitor had chosen to insure himself for substantially more than the limitation does not, in itself, establish that the limitation was unreasonable (although this may be a factor to take into consideration).

Having regard to the “claims made” basis of cover, a firm is also entitled to take into account the fact that the current level of cover may not be available in the future, at the time when a claim might be made against it (or when a circumstance is notified to insurers). This should, where relevant, be reflected in the definition of the “available insurance” in any limitation of liability;

3. any other resources available to the firm.

Although this is also one of the specific considerations mentioned in Section 11(4), in the context of larger limitations running into tens of millions of pounds, it is less likely to be a major factor;

4. the bargaining position of the parties.

In many cases, the client will have substantial bargaining power, e.g. because of its corporate size and financial strength or its ability to instruct the firm’s competitors if it dislikes the firm’s proposed terms. There may, however, be particular circumstances where such apparent bargaining power may be diminished, e.g. where most firms with the relevant expertise and resources to undertake the work are conflicted out. Time pressures may also leave the client in a weak position, e.g. where the firm had previously acted for the client in circumstances where it would now be difficult or time consuming for the client to change solicitors in respect of a new matter. Hence, in St Albans City Council –v- International Computers (1995) FSR 686, Scott Baker J was prepared to take account of the suggestion that the Claimants were “over a barrel” because of the tight timescale;

5. alternative opportunities available to the client to instruct another firm of solicitors without having to accept a similar limitation of liability clause;

6. the client’s knowledge of the term.

This factor is very important and it will always assist the firm to show that the client was made fully aware of the existence, scope and terms of the limitation clause. The firm should also endeavour to ensure that appropriate representatives of the client were made aware of the term, i.e. directors or senior representatives, rather than subordinate employees.

In the event of a subsequent challenge to the reasonableness of a clause, the firm’s position will also be strengthened if it is able to demonstrate that the reason for the introduction of the limitation was explained to the client in relatively simple terms;

7. the practice of the profession.

It will assist the firm to show that other firms of solicitors incorporate similar types of limitation clauses.

Future Developments

Notwithstanding the anticipated increase in the number of limited liability partnerships (“LLPs”) during the next few years, solicitors will need to continue purchasing substantial levels of cover for their practices for two reasons: first, to ensure that the LLP has adequate insurance resources to meet any claim; and, second, to provide adequate run-off cover for former partners of unincorporated partnerships, who will remain jointly and severally liable for the former firm’s breaches of duty. Accordingly, whilst an LLP offers protection for the personal assets of the vast majority of its members, it is not a panacea for all the liability risks currently facing firms.

Larger firms of solicitors may respond to the significant reduction in excess layer capacity by seeking to introduce limitations of liability on a more regular basis. Limitations based upon a firm’s available insurance are more likely to be commercially acceptable to clients, whilst proportionate liability clauses are likely to become relatively commonplace, as accountants and other advisers respond to current market conditions by limiting their liability in a manner which may prejudice the solicitor’s ability to obtain contribution from them.

Risk Management Training and Compliance

There are a number of incentives for firms to implement and drive forward effective risk management programmes. They include:

a) commercial benefits:

• improving levels of client service and satisfaction;
• attempting to inculcate a common approach across the firm; and
• the fact that an effective risk management programme will be a positive feature of any firm’s risk profile. This will become increasingly important if the insurance market continues to harden and insurers are in a position to become highly selective about the risks which they accept and the price at which they are prepared to underwrite business;

b) avoiding the adverse consequences of claims, e.g.:

• funding the self-insured excess;
• increases in future premiums;
• dissatisfied clients and loss of business (potentially the largest cost to firms);
• irrecoverable fees whilst the quality of work is being disputed;
• loss of fee-earning time (both of the individual partners and fee-earners involved and those handling the claims internally);
• anxiety for those directly involved; and
• reputational issues.

The implementation of an effective risk management compliance programme comprises, in broad terms, three steps.

1. Drawing together existing rules, procedures and guidance.

This material needs to be collated in one document, such as a firmwide manual. The purpose of any such manual should be to provide common-sense guidance to help all members of the firm avoid mistakes, work more efficiently and provide a better service to clients.

The objective should be to provide simple, practical advice which is applicable to all departments in the firm on issues such as: conflicts, money laundering, retainer letters, professional independence, knowledge and expertise, recording of advice, outside appointments and the steps to take when things go wrong. It is also useful for the manual to include material such as specimen retainer letters and checklists of issues to consider in relation to new instructions.

By the same measure, no matter how comprehensive a manual is, its impact will be limited unless it is supported by a firmwide training programme.

2. Training

An alternative approach to arranging a series of lectures is to adopt a “workshop” format in each department in order to:

• try and ensure that everyone reads the manual and is familiar with its contents;
• encourage all partners and fee-earners to consider the risks which they face in their particular areas of work;
• produce a note following the training sessions, summarising the key areas of risk within each department and offering practical guidance as to how problems can be avoided. These notes can be included as additional appendices to any manual and also placed on any firmwide intranet. Apart from distilling and reiterating the key points to emerge from the sessions, such notes will reinforce the active status of any manual as a “living document”, rather than something which is placed on the shelf and forgotten about.
• Consideration does, however, need to be given as to how compliance with the key provisions of the firm’s internal procedures can be monitored in an efficient and cost-effective way. If there is no such system in place, there is a real risk that a number of fee-earners will not comply with the relevant rules and guidance.

3. Compliance

There are a number of options available to firms, including the possibility of instructing outside consultants or nominating a small number of fee-earners to undertake compliance reviews or audits. An alternative is to adopt a system of sample peer reviews under which (over a period of time) all partners and fee-earners will conduct, and be subject to, a file review.

There are two perceived advantages in adopting a peer review approach: first, it will spread the burden throughout all fee-earners in each department; and, second, the review should prove to be an extremely useful training exercise for those involved. In this respect, any checklist can contain cross-references to the firm’s manual and these will, in turn, serve to underline the key rules and guidance.

The exercise should not be an attempt to “second guess” the legal advice which has been provided, but rather to assess whether the firm has got the basics right – the simple but important steps that need to be taken during the course of any assignment.

In terms of the mechanics, a random selection of reviewers and current files can be made on an annual sample basis and, once the exercise has been completed for each period, an overview of the key issues and trends can be circulated to all members of the relevant department.

In addition to issues of training and compliance, it is also very important for firms to analyse the underlying causes of claims and circumstances notified to insurers. By doing so, lessons can be learnt from past and current claims, as well as “near misses”.

Whilst the approach outlined above will involve an investment of time and resources, the majority of claims against solicitors continue to arise out of avoidable administrative errors or matters such as a failure properly to establish the scope and limits of the retainer. It follows that, if firms are prepared to make the necessary commitment in order to try and get the basics right, the number and severity of claims against them should reduce over a period of time.