Buying or Merging with Another Law Firm? Proceed with Care
28 October 2020
Many law firms are struggling as a result of the fallout from the pandemic and increasing PII costs. They need to find a solution or a way to exit the profession.
Others have had enough of dealing with the ever increasing regulation and compliance, managing employees and the various concerns of running a business. They want to join another firm that will take over their responsibilities, releasing them to get back to fee earning and "the law".
At the other end of the spectrum there are firms that are looking to grow and develop. The above scenarios are presenting opportunities for them and consolidation is currently moving at pace across the legal services market.
For those firms that are looking to buy, merge or otherwise acquire a firm it is important to proceed with care. The potential impact on your Professional Indemnity Insurance (PII) should be a major consideration as there have been some disasters. While you might see significant advantages in an opportunity, do not discount the potential pitfalls. Remember….due diligence is key. In this article we aim to identify some of the issues you need to consider.
Successor practice or run-off cover?
The most important question from a professional indemnity perspective is whether you are going to become a successor practice and be responsible for claims against the acquired firm, or whether they are going to proceed with run-off cover under their existing PII policy.
When addressing this issue you need to consider the definition of “Successor Practice” in the SRA’s Minimum Terms and Conditions (MTCs). It is not straight forward and sometimes the definition will deliver a result that you had not expected. The good news is that after twenty years the rules are well understood by specialist brokers and insurers in the solicitors’ PII market, who you can turn to for advice and guidance. The answer to whether there is a succession is always very “fact specific”, so you should ensure that you are able to give a clear outline of what is proposed when you take advice. Some of the more important issues to keep in mind are as follows:
- If you do not want to become a successor, then a fail-safe solution is for the firm you are acquiring to purchase run-off cover – even if you assist them to fund this. It is important to ensure that the premium for the run-off is paid before the merger. This is essential or the election will fail. Once payment is made and the cover is confirmed, you can relax in the knowledge that you are not going to become embroiled in a successor practice argument.
It is important to note that as of 1 October 2022 SIF will no longer provide the free run-off extension at the end of the six year run-off cover provided by insurers. The wording of the MTCs (and in particular the glossary definition of “prior practice”) currently ensures that the liability does not revert to the acquiring firm at the end of the run-off period. However, for clarity, it would be prudent to make this clear in any negotiations or documentation regarding the acquisition.
The above is of course subject to any contractual obligations you might assume, which we address under Due diligence, i. Partners/Associates/Staff below.
If you are the firm that is being acquired then you need to carefully consider what your strategy will be once the six year run-off period has ended. It is not unusual for claims to be made after six years, with the standard limitation periods in contract and tort being successfully extended up to the fifteen year-long stop date.
When we get to 2022 some insurers might be prepared to consider offering an extension to a run-off policy, but as yet there is no certainty of this. If cover is offered, it is likely that it will not be on the same basis as the MTCs and it will be strictly subject to payment of premium.
- If you are acquiring a firm owned by a sole practitioner and the sole practitioner is joining your firm then, unless run-off cover is purchased in advance of the acquisition, or another SRA - regulated practice holds itself out as successor (which is unlikely), you cannot avoid becoming a successor. Even if the sole practitioner joins your firm as an employed solicitor or a consultant, you will still be the successor. This has caught many firms out over the years.
- If a firm that is a partnership ceases and the majority of the partners are joining your firm as principals, then you will automatically be the successor, unless run-off is purchased by the partnership prior to the principals joining your firm.
- If you are acquiring a firm that is a limited liability partnership or an incorporated practice, then a succession will only occur if either the LLP or the limited company becomes a principal in the acquiring practice, or if the acquiring firm holds itself out as the successor.
- If you are acquiring principals or files from an LLP or incorporated practice that is ceasing and you want to avoid becoming a successor, then it is critical that you do not do anything that could be considered as “holding out” unless run-off has been purchased prior to the cessation.
- “Holding out” is where things can go very wrong unless run-off has been purchased and paid for prior to the cessation. If you want to avoid “holding out” then the detail is important and everyone in the firm needs to be fully briefed including reception and support staff. There must be no reference to “having taken a firm over” in correspondence, documentation, external or client meetings or telephone communication. Letterhead, the website or signage referring to your firm as “incorporating” the other practice will see insurers from the former firm argue that there has been a succession and they are not obliged to provide run-off cover. This is an argument insurers are very keen to pursue if the former firm is insolvent and cannot afford to pay for run-off cover, or if they have a poor claims history with further notifications expected. We encourage firms to take advice on this issue to ensure that they have a clear plan of what they need to do – and that this is shared with everyone in the firm. Even a careless tweet could cause you problems – and do not underestimate the potential for the insurer of the former practice to make a “mystery shopping call” to test whether or not your firm is “holding out”.
- You can have more than one successor to a firm. This will occur where, for example, two firms have held themselves out as being the successor to a particular practice, or where a four partner firm ceases with two partners going to one firm and two going to a different firm. Each successor firm succeeds to the whole of the firm – you will each be 50% liable for all claims. We have seen scenarios where the successor firms agree to each take responsibility for claims arising from different areas of practice within a firm, but this is a separate “commercial arrangement” that would need to be separately agreed with the insurers of both firms and the consent of the SRA would need to be obtained.
- If you are acquiring the majority of partners from a firm that is a partnership in the expectation that their old firm will continue and you will not be a successor practice, then you must still beware. The potential departure of top fee earners can cause those who will be remaining in the firm to review their position. If the announcement of a departure causes the existing firm to implode and the remaining partner(s) shut the doors on the day that the partners you are taking into your practice leave the firm – then you will be the successor practice. Do not discount the potential for this scenario.
- Once a successor practice always a successor practice. If the merger does not work out and you agree to go your separate ways, you cannot rewrite history. If you are the successor then you will retain responsibility for all the future claims (arising from past work) of the firm you succeeded to. The practice that was succeeded to will need to apply to the SRA as a new firm, but it will have a “clean slate” as far as past liabilities are concerned.
Depending on how the transaction is structured, firms sometimes agree to take on additional liabilities or obligations to effect insurance. This may arise, for example, if they acquire the shares in the prior practice, or if they agree to take out and maintain top up insurance covering the prior practice. Any future reduction in the scope or limits of SRA compulsory cover could also have an impact.
Before you make a decision on whether to proceed with the purchase or acquisition of another practice, due diligence is critical. All too often we see firms that are not sufficiently thorough or considered in their approach. Many leave it until the last minute, or proceed on the basis that everything will be fine because they have known the partners in the firm for years “and they have lots of great clients”. In contrast you should always heed the advice you would give your own client in this situation – undertake your due diligence carefully and thoroughly.
The following list is by no means exhaustive, but it does detail some of the more important areas to investigate:
a. Previously completed PII proposal forms
Providing these have been completed accurately in the past, these forms will help you see how the firm has represented their business to insurers. The gross fee information and breakdown of areas of practice will help to confirm (or inform) your understanding of their business. If you intend to become a successor practice your current insurer will also want to review at least the last proposal form.
b. Claims history
This is absolutely critical. Remember, their claims record will become part of your claims record upon succession. Our recommendation is that you obtain up-to-date insurer claim summaries confirming the claims history for at least the last six years, ten years if possible. While ten years is a longer period than will be required by most insurers, it will give you a better view of the firm and their approach to risk historically. If there are any sizeable payments or reserves disclosed, then get chapter and verse on the background to the claim. This should include an explanation of what action the firm has taken to prevent recurrence. Your insurers will want to know this if you are going to be the successor practice.
You should always take advice from your broker as to the potential impact that the merger of the claims history with your own could have on your premium. It is also best practice for your current insurer to be engaged in that discussion. Even if the firm you are acquiring is purchasing run off cover, a review of the firm’s claims history (together with complaints and disciplinary history) will give you a good overview of the risk management culture within the firm, the challenges of integration and potential risks for the newly merged firm.
If the firm is not purchasing run-off cover then it is important to ensure that you impress upon them the need to notify their insurers of any outstanding issues, and particularly any precautionary matters (known in policies as “circumstances”), in advance of the succession. This will ensure that you and your insurer do not have to take responsibility for these matters if a claim develops at a later date. Furthermore, to the extent that client confidentiality permits, it would be prudent to review the notifications that have been made to ensure that all possible claimants or potential claimants have been included within the notification. This is particularly important if there is a systemic issue and a “block” notification needs to be made.
c. Complaints history
Again this will inform you regarding the culture that exists in the firm. In addition to the nature of the complaints, consider how the firm responds in this situation. Is their approach to clients compatible with yours?
d. SRA/Disciplinary issues
A firm’s most recent insurance proposal form will generally provide you with a good overview of any SRA or other disciplinary related matters. Ensure that you have asked if there are any updates or new issues since the proposal form was completed.
e. SRA Accounts Rules compliance
As well as the disciplinary aspects of accounts compliance, it is important to note that in some circumstances the SRA may assert that an acquiring firm is responsible for shortages on the prior firm’s client account. Be alert to this possibility.
f. Risk management
Undertake a comprehensive review of risk management within the firm including related systems and processes. Is the firm’s risk management culture compatible with your own? If it is not as strong, then accept that there could be challenges integrating the practices and you will need to plan how you will achieve that. Some particular areas to review include client selection procedures, supervision arrangements, conduct and frequency of file audits, the process for dealing with conflicts of interest, in-house training and professional development programmes.
g. Areas of Practice
Make sure you understand the areas of practice that the firm undertakes and the percentage spilt by gross fees. This information will be evident from their last PII proposal form. Understand how this will affect the split of your areas of practice and whether this will impact your own insurer’s appetite. For example, some insurers have an upper limit on the percentage of conveyancing they are comfortable with. Also seek information on any historic areas of practice that have been abandoned in more recent years. If any high risk work has been undertaken in recent years, then you should be asking more questions regarding the nature and scope of that work, the expertise of those involved and whether there have been any claims or other issues arising from it.
If the firm undertakes any areas of practice that you do not engage in, then you also need to challenge whether you have the knowledge and experience within your firm to supervise this activity if it is to continue. This issue will be important to your insurer.
A poor financial position will often be a catalyst for a firm looking for opportunities to merge or be acquired. Ask for the accounts and understand what the pressures are. Does the firm pay attention to billing work in progress and bad debtors? What are the chances of the firm ever being paid for outstanding billed work? Is the firm too dependent on a single client, a small number of clients or a fee earner who might not remain following the merger? If premises are to be retained, understand the lease arrangements and potential future liabilities.
Are you going to inherit any HR issues? Are there potential redundancies? It is important to identify this and take appropriate advice as early as possible in the process. Decisions here need to be based on sound business sense and not sentiment.
j. Details of prior practices
Take care to identify whether the firm you are acquiring is itself a successor to any other practice. If it is, then you should make enquiries regarding the due diligence that was undertaken prior to the succession and obtain the claims history of that practice prior to merger if it falls within the last 10 years. This will help you to avoid unfortunate surprises that could arise if there were shortcomings in the earlier due diligence.
k. IT systems
It is important to understand the compatibility, or otherwise, of IT systems. What will be the challenges and cost of integration and how quickly can this realistically be achieved?
l. Impact on your PII
If you are going to be the successor practice or assume additional contractual liabilities, ensure that you have communicated with your broker at a very early stage to ascertain the position of your current insurer. Will the profile of the firm still fall within their appetite and underwriting criteria? What additional premium will they charge and what will their position be on renewal? Are there any “show stoppers” from their perspective and will there be any changes as far as the self-insured excess and limit of indemnity is concerned? On the flip side it could be that the addition of a particular firm changes the profile of your firm in a positive way and opens up the possibility of additional markets at renewal. The point is to ensure that you understand just what the potential scenarios could be.
If you carry excess layer PII, you will need to decide if this also needs to be endorsed prior to acquisition to confirm cover for the acquired firm’s activities. In any event, becoming a successor practice is a good opportunity to review whether you need to increase your overall limit of indemnity going forward.
Never under-estimate the time, cost and energy that will be expended to successfully integrate with another firm. In terms of best practice we suggest the following:
- Ensure that there is a clear vision for the new firm and that this is communicated to all staff in advance of the merger.
- Identify what you need to do pre and post-merger including combining or transferring systems, training and social integration. Make sure you have a clear plan that you share with others in the firm as appropriate.
- An increased focus on risk awareness and supervision during the integration phase will pay dividends and identify areas where extra work is required.
- Leadership is important at all levels, but especially from those at the top.
When finalising documentation regarding your acquisition, we suggest that you also consider who will be responsible for:
- Payment of the self-insured excess on matters that have been notified prior to the acquisition but are yet to be settled.
- Payment of the self-insured excess on matters notified to insurers after the acquisition, but arising from work done by the prior practice before it was acquired.
- Any increase in future PII premiums arising as a direct result of notifications made to insurers after the acquisition, but arising from work done by the prior practice before it was acquired.
We have seen disputes arise over the issues listed above. It is therefore important that there is clarity – particularly given that the financial impact can be considerable.
In conclusion, be cautious and always take advice. As one of the leading Solicitors’ Professional Indemnity Insurance brokers, Howden has seen many mergers and acquisitions in the legal sector over the years. There have been some spectacular successes - and we can help you to navigate your way clear of the disasters.
Neil has been a broker for over 30 years, specialising in helping UK solicitors find the insurance they need. His team works with law firms large and small to ensure that they are covered for every eventuality.