Financially challenged law firms - what are the options?

I don’t want to be unduly negative, but there is no guarantee that firms that are currently struggling will be able to bounce back as the economy improves. There isn’t even a guarantee that the economy will improve in the short- to medium-term. So, for the principals of firms that find themselves in financial difficulty and are contemplating closure in the near future, closing down now might be a better and far cheaper option than PII renewal.

Chair of the Law Society PII Committee, Nick Gurney-Champion (Law Gazette 17 September 2020)

This advice from the Law Society highlights both the reality and extent of the financial challenges currently facing many law firms. The rationale for closure was the run-off costs (based on a multiplier of the expiring premium) would be less prior to renewal given the expected premium increases.

The 1 October 2020 renewal did indeed see significant increases in premium and we anticipate that the upward trend will continue into 2021. As the next major renewal date of 1 April 2021 approaches, it is likely there will be even more firms facing financial challenges as a result of the pandemic. Many will struggle to afford PII premiums at higher rates.

We encourage firms to start considering this issue, engaging in open dialogue and taking advice now. It is important to understand the options in the unfortunate event that your firm does not have a viable future. The more matters are allowed to drift and the more extreme the position becomes, then the more difficult it will be and the greater the risk of a chaotic closure that is not in the interests of those involved in the firm or their clients.

In this article we aim to provide an overview of the options and alternatives for those firms that are concerned about what lies ahead.

Take advice

There are a number of professionals who specialise in advising law firms and can provide a “health check” and advice on the future viability of the business. Getting an independent and expert view is useful.

In our experience, engaging with another professional for advice is a step that many firms leave too late, labouring under the mistaken view that they know what is best for their business. We challenge firms to reconsider such thinking.

Change the model

If the advice is that the business is not sustainable, you might be able to make changes to the business plan that will move the firm forward in a more positive and profitable way. Again, this is something that can be considered with an advisor who has a track record of assisting law firms to make changes to return to profitability. A change in direction and focus, that is timely and considered, could save your firm.

Can you reduce or control your PII spend or other overheads?

A review and reduction of overheads might be the difference between survival and closure. Given changes in working arrangements as a result of Covid-19, many firms will be reassessing what is needed in terms of office space in particular.

PII premiums are also a significant expense item. While it is unlikely that firms will achieve substantial savings on their PII premium in the current hard market, you should nonetheless consider what you can do to control this spend or keep it as low as possible. Are you providing the best possible presentation of your firm to underwriters? Does your broker have direct access to a range of markets? Are you satisfied that your broker is providing you with the best possible representation? For more on these issues we refer you to our recent article: “Representation and presentation – key to successful renewal of your PII” 

We are aware that some firms have contemplated reducing their limit of indemnity or increasing their self-insured excess as a strategy to reduce their PII premium. We advise caution on this issue.

As far as the limit of indemnity is concerned there is a regulatory obligation in clause 3.1 of the SRA Indemnity Insurance Rules to “take out and maintain professional indemnity insurance that provides adequate and appropriate cover in respect of your current or past practice taking into account and alternative arrangements [you] or [your] clients may have”. For more discussion on this we refer you to the following article "The problem with reducing your indemnity limits"

Likewise we advise firms to take care when considering the extent of any increase in the self-insured excess. You need to ensure that the firm will be able to fund the increased amount if one or more claims are made during the policy year. Inability to pay a self-insured excess will irritate underwriters and can have significant adverse consequences. The following article provides further discussion on this "Beware increasing your self-insured excess on your PII"

Orderly closure

There will unfortunately be some scenarios where closing the firm is the best or only realistic option. If that is the case, then it is better to have a closure that is planned and orderly as opposed to one that is a chaotic, knee-jerk response to the unavailability or unaffordability of PII, or worse still the intervention of the SRA. A well-managed closure, with a close eye on the interests and needs of clients, will help to ensure that reputations remain intact. This is particularly important for those solicitors who intend to continue practising in another firm or business structure in the same area.

If you close your practice without a successor, then the run-off provisions in the policy will be triggered and a run-off premium will be payable. This varies between insurers and is generally a multiplier of 2.5 to 3.5 times the last annual premium. Meeting this cost can be a problem for many law firms that are closing, particularly where they are financially challenged already.

Insurers are required to provide run-off cover whether they receive the payment or not. However, we predict that in the coming months the SRA are going to take a greater interest in ensuring that payment is made. The reason for this is that the SRA have recently rejected a plea from insurers to change the rules so that they are only required to provide run-off cover if they receive the premium. The SRA took the view that such a change would not be in the interests of consumers, but they did commit to working with insurers. They have indicated that they may be willing to carry out regulatory prosecutions against the principals of firms that close without making such payments. This is something that solicitors need to be aware of as any such action could impact on your future ability to practise.

There is an extended period of cover available upon expiry of your last PII policy. We caution using this as “extra time” if your firm is going to continue, but it can be useful for firms needing more time prior to closure. There is an initial Extended Policy Period (EPP) of 30 days, during which a firm can continue to practice as usual. This is followed by a Cessation Period (CP) of up to 60 days. During this time a firm cannot take on any new work, but it can continue to complete existing matters as it works towards closure by the end of the 60 day period. Upon closure of the firm, the start of the run-off cover is then backdated to the expiry of the last annual policy.

You can read more detail on this issue (and in particular warnings of the dangers of using it if you are not closing the firm) in our article "Extended Policy Period: A "safety net" for law firms - or is it?" 

For any firms contemplating closure, there is helpful guidance available from both the SRA and the Law Society:

• https://www.sra.org.uk/solicitors/guidance/closing-down-your-practice/
• https://www.lawsociety.org.uk/en/topics/business-management/closing-down-your-practice-regulatory-requirements

Find a successor practice

Finding a successor practice is not always easy, however it does provide a “tidy” solution for a firm that is struggling. Consider the positives that you could offer to a potential successor – it might be a strong client base and local following, a will bank, or a niche practice area that would fit well with the profile of another firm. Again we encourage firms to start the dialogue. Engage with a firm that might be interested. Alternatively, the same professionals who can advise you on your business, might be able to suggest where an opportunity exists.

A succession under the SRA’s Minimum Terms and Conditions (MTCs) will proceed in one of two ways as far as PII is concerned. Either:

1. Your firm is insured under the PII policy for the successor practice in respect of any claims made or matters notified following succession; or
2. Your firm “elects” and pays for run-off cover prior to the succession.

The first option has the advantage that you will not need to fund a run-off premium. Under the second option, the run-off must be paid in full prior to your firm ceasing and affordability can be an issue.

Many successor practices prefer the second option as it means that your firm’s past and future claims are ring-fenced and there is no risk of the successor’s claims history being compromised. In some instances a successor practice will fund the run-off as part of the acquisition deal. This can be a practical solution and it is also useful for firms looking to acquire other practices to keep this option in mind.

Succession is a complex issue and we always recommend firms consider taking advice before they proceed with any arrangements – either as the successor or the firm being acquired. We provide a more detailed overview of the issues relating to succession in our article entitled “Buying or merging with another law firm – proceed with care”. 

Switch regulator

In 2017 the SRA introduced new rules enabling law firms to “switch” regulator without the need to purchase run-off cover. In our experience to date, switching to regulation by the Council for Licensed Conveyancers is the most common scenario that firms contact us to discuss. However, regulation by other bodies such as Chartered Institute of Legal Executives (CiLex) and the Bar Standards Board (BSB) is also possible.

Obviously a “switch” is not going to solve financial challenges and it is important to remember that the new regulator will want to assess the firm prior to granting authorisation. Financial instability could be a barrier. Firms should likewise expect a very cautious approach will be taken if they close their SRA-authorised business and apply to establish a new “phoenix firm” under a different regulator.

In our experience, firms that have switched to the CLC usually cite the desire to be governed by a regulator specialising in their practice area as one of the most significant drivers of the change. For most it is part of a plan to move the business forward in a more focused and profitable direction.

As far as PII is concerned there are bespoke schemes available to CLC regulated firms and Howden is the broker for one of these. The CLC has its own Minimum Terms and Conditions and there are some differences to the SRA version. The most significant is that the 6 year run-off cover required upon closure of a firm is currently free, albeit subject to an aggregated limit of £2 million.

Care is also required if your firm has carried out work that cannot be regulated by the CLC or other regulator. It would not be possible to undertake this going forward and PII to cover any claims arising from this past work would need to be arranged.  Once again it is a matter of seeking advice and considering the options.

The following links provide further information:

• https://www.sra.org.uk/globalassets/documents/sra/mou/mou-switching-clc.pdf?version=4a1ac4
• https://www.cilex.org.uk/employers/regulating_your_legal_firm/switching_regulator
• https://www.clc-uk.org/lawyers/switching-to-clc-regulation/

Alternative practice arrangements

In November 2019 the SRA introduced a complete re-write of the rule books including two new Codes of Conduct. This change facilitated the introduction of new practising structures that were intended to provide an opportunity for “solicitors” to deliver legal services without the expense of establishing and maintaining an SRA-authorised practice. As a result “solicitors” are now able to:

1. offer legal services to the public as “freelance solicitors”; and
2. offer unreserved legal services to the public from entities that are not SRA-regulated.

Freelance solicitors must have “adequate and appropriate” insurance if they undertake reserved legal activities, but otherwise there is no requirement for PII if the above practising arrangements are adopted. Obviously we would caution solicitors on this point. Even if your work is low risk and you have never had a claim before, things can go wrong. We always advocate that professionals should ensure they have appropriate PII cover. At the present time there are also questions as to what amounts to “adequate and appropriate” insurance in these circumstances and the extent to which that is available in the current market.

There are various requirements and restrictions if these alternative practising arrangements are adopted. In particular a freelance solicitor cannot hold client monies (save for receiving costs and disbursements on account) or employ staff. For anyone considering this option we would recommend reading the Law Society Practice Note, “Freelance Solicitors” available here:

The following guidance, both published by the SRA, also provides more detail:

• https://www.sra.org.uk/solicitors/firm-based-authorisation/freelancers/
• https://www.sra.org.uk/solicitors/guidance/preparing-sole-practitioner-regulated-independent-solicitor/

An important point to note when considering this option is that it will necessarily involve the closure of your SRA-authorised practice. This will trigger the requirement for run-off, unless it is possible to find a successor practice willing to take responsibility for past liabilities as discussed above.

A final word

We want to conclude this note by emphasising the importance of addressing issues early and taking advice if your firm is financially challenged. Do not leave it too late. There are professionals with a wealth of experience in assisting law firms in this situation. As far as the PII implications are concerned, the team at Howden have the knowledge and expertise to assist you navigate your way through the relevant issues.