Risk Outlook 2013/2014

The SRA's assessment of key risks to the regulatory objectives

  • Risk Outlook 2013/2014

    The Risk Outlook sets out our current view of the key risks to the regulatory objectives in the Legal Services Act (LSA) 2007 over the next twelve months. To identify these risks we have drawn on a wide range of evidence and our own experience of regulating law firms.

 
 

Foreword

Antony Townsend - Chief Executive

Antony TownsendRegulation should not be a mystery: why and how regulation works should be based upon a shared understanding between the regulator, the regulated, and consumers of services. It therefore gives me great pleasure to introduce the SRA's first Risk Outlook, which shares our developing thinking as we become a more mature outcomes focused, risk-based regulator, as set out in the Strategic Plan we published at the end of last year.

Our regulatory objectives are clear – we are focused upon protecting the public interest and clients of legal services. To do this effectively, making the best use of our resources, we have to identify and control risks to those objectives. Risk is central to everything we do at the SRA. Our day-to-day regulatory activities are guided by risk, focusing our attention and activities on issues, firms and risks that pose the greatest threat to protecting the public. From authorising individuals, supervising firms and taking enforcement action, risk shapes each and every decision we take.

In December 2012 we communicated how we would put risk at the heart of our operations by publishing our Regulatory Risk Framework, alongside our Risk Index which categorised the risks to the regulatory objectives we had identified within the legal services market. This Risk Outlook is the final piece in the jigsaw, and should be read as a companion piece to the framework and index, completing the risk picture with our assessment of the most significant risks we expect to have to manage over the next 12 months. It is key to delivering the SRA's Strategic Plan which we published at the end of last year.

This assessment is based largely on our experiences of working with firms in the sector. It brings together evidence from a number of sources to provide an accurate and balanced assessment of the significant areas of risks. The evidence includes case studies, those working in law firms of all sizes, SRA frontline staff experience, media reports and Solicitors Disciplinary Tribunal (SDT) findings.

I would like to take this opportunity to thank all those who gave constructive and valuable feedback during the writing of the outlook. Progress always involves risks, and to avoid all risk is to stagnate. However, risk taking is not the same as recklessness. We don't want firms to become risk averse, but we do want firms to become risk aware. We hope this Outlook will help that process by explaining what the SRA has assessed as the biggest risks now and those that have the potential to cause us concern in the future. Understanding our concerns, and the actions we will take to manage risks will help firms to innovate and respond to the changes in the market, but to do so responsibly and in a way that safeguards the public interest.

This Outlook is not just of interest to those delivering legal services. We hope that it will have a wider audience amongst our stakeholders, including consumers and those who represent them, and other regulators. We hope, too, that those who read this Outlook will provide us with their thoughts, so that we can continually improve as we publish further editions. Although we will publish a Risk Outlook annually, we will support that annual assessment with more frequent risk assessments throughout the year.

Finally, we have already made public the way we risk assess the events that are reported to us, and this will be followed shortly by the publication of the way in which we risk assess individual firms – a further step in improving transparency, and reducing mystery.

Antony Townsend - Chief Executive

Executive summary

The Risk Outlook sets out our current view of the key risks to the regulatory objectives in the Legal Services Act (LSA) 2007 1 over the next twelve months. To identify these risks we have drawn on a wide range of evidence and our own experience of regulating law firms.

The Risk Outlook will:  

  • communicate our view of regulatory risk, from the perspective of the largest regulator of legal services in England and Wales

  • explain how we control the key risks

  • demonstrate the priorities to which we expect to allocate our resources

  • provide an aid to law firms' management of risk.

Part A of the Outlook sets out our assessment of the characteristics of the legal services market that are driving change. Changes in the market mean that levels of risk also change and new risks will emerge.

Part B profiles our key current, emerging and potential risks. We explain what we mean by each risk, why it is significant and the controls we use to manage the risk.

Structure of Risk Outlook  

Drivers of change

The rapid pace of change in the legal services market means that risk analysis and management are dynamic processes. Our market assessment has identified four main groups of drivers of change.

Economic trends and outlook

  • Weak economic growth is contributing to a reduction of demand for a wide range of legal services
  • Low demand results from reduced turnover in many key markets, ranging from the residential property market to corporate mergers and acquisitions
  • Prospects for future economic growth remain weak, and so trading conditions for law firms are set to remain challenging
  • Despite historically low rates of interest, availability of credit is limited and many firms face challenges securing finance
  • Low interest rates reduce income generated from capital held in bank accounts
  • Globalisation and internationalisation are increasingly driving up competition for all types of firm.

Political and regulatory background

  • Legal Aid changes have reduced a key source of revenue for many law firms, and additional reforms, such as Price Competitive Tendering, are being considered.
  • The ban on referral fees for personal injury and other legislative changes are making a significant impact on this market for legal services
  • Other civil litigation reforms are affecting sources of revenue for firms
  • Alternative Business Structures are entering the market at an increased rate. This is starting to lead to additional competition and new methods of delivering legal services to consumers
  • Regulatory reforms are still being embedded, such as establishing new ways of working with the regulator through compliance officers
  • The Legal Education and Training Review (LETR) is considering new approaches to improving competences and access to legal careers.

Market and firm level trends

  • Many law firms have a relatively narrow focus on a single type of legal work. These firms may face greater challenges adapting to changes in demand for legal services
  • A growing trend of mergers and the growth of larger law firms may lead to consolidation and a less fragmented market structure
  • Firms are increasingly looking to commoditise the services they provide, which presents both risks and opportunities
  • Use of legal process outsourcing and technology is also increasing.

Consumer behaviour and expectations

  • There is evidence of increased 'price awareness' from private consumers and a growing demand for 'fixed-price' products and 'unbundling' of services
  • Levels of consumer empowerment are lower than in other sectors, but there is some indication that this may be changing
  • Many consumers use the internet to find a law firm and increasingly receive their legal services over the internet
  • Demographic changes, in terms of age and ethnicity, will have an impact on demand for legal services and how they are provided.

Profile of the key risks

The key risks are grouped into three categories:

Current risks

current risk pyramid top
Financial difficulty

We are seeing an increased number of firms in financial difficulty. The growing scale of this problem is a significant factor in our view of this as a key risk. This trend is driven by a wide range of economic and commercial pressures.

While our role is not to prevent financial failure, it can lead to other significant risks, such as disorderly closure, poor standards of service, criminal association and the misuse of client money.

Read more

Dishonest misuse of client money or assets

We have seen a large increase in the number of reports received about this risk over the past two years. The economic downturn has created an environment where dishonest misuse of client money is more likely to materialise. This increase and the significant effect it has on the public and consumer interests make it one of our key current risks.

Read more

Lack of diverse and representative profession

Although the legal profession as a whole is very diverse, there is a lack of diversity in more senior roles in many law firms. This indicates that there are barriers to progression, particularly for women, ethnic minorities and people from less affluent socio-economic backgrounds.

Barriers to progression reduce the likelihood of a strong, talented legal workforce able to provide services to a diverse population.

Read more

Failure to co-operate or comply with notification and information requirements

We expect firms and individuals to deal with us openly and honestly. The recent appointment of compliance officers revealed an unexpectedly high degree of non-compliance by regulated firms and highlighted the issue of firms failing to operate transparently.

Firms' failure to co-operate or comply can have a negative effect on our ability to conduct effective risk management.

Read more

Emerging risks

emerging risk pyramid
Lack of adequate succession or exit planning

We are seeing an increased number of firms becoming unable to continue trading with no viable exit or succession plan in place. When this happens there is an increased risk that a firm will not be able to effectively manage financial difficulty or it can lead to disorderly closure, placing consumers' interests at risk.

With the increase in the number of firms facing financial difficulty and closure, this risk is of growing concern for us.

Read more

Poor standard of service or advice – particularly where this involves vulnerable consumers

While levels of consumer satisfaction are relatively high, there is concern about the standards of service and quality of legal advice provided to consumers. In particular there is increasing evidence that the needs of a number of potentially vulnerable groups are not being met.

The negative effects of this include barriers to access to justice and detriment to the interests of consumers.

Read more

Inadequate systems and controls over the transfer of money

The legal services industry handles large sums of money in confidential circumstances making it a target for criminal activity laundering the proceeds of crime.

The proceeds of money laundering are often used in organised crime or terrorist funding, and so preventing it is clearly in the public interest. The effect of this crime can be also financially destabilising for the firm involved and damaging to the public's confidence in the delivery of legal services.

The growing evidence that firms do not recognise the likelihood of this risk affecting them makes this an emerging risk.

Read more

Potential risks

potential risk pyramid
Improper or abusive litigation

We have seen a number of cases where the misuse of legal proceedings (or the threat to bring proceedings) has been used to gain money unethically by exploiting a client or third party's lack of knowledge or resources.

While this risk occurs relatively infrequently, when it takes place it is often on a large scale and has a significant negative impact. In particular, it can cause widespread harm to the interests of consumers, especially when more vulnerable individuals are targeted. Improper or abusive litigation often attracts a high profile and has a detrimental effect on the public's confidence in the delivery of legal services.

While difficult economic conditions and more competition continue to pressurise firms to find new sources of income, there is increased potential for this risk to occur.

Read more

Lack of due diligence over outsourcing arrangements

The combination of commercial changes and market opportunities has encouraged many law firms to look for ways to increase efficiency and reduce costs. This has led to increased outsourcing of business activities and basic legal processes.

Failure to effectively manage outsourcing arrangements can result in significant risks to consumers, in particular conflicts of interest, confidentiality and independence.

Read more

Group Contagion

Group contagion is the risk that liabilities, losses or events affecting one part of a group will affect a regulated law firm within another part of the group. The trend of consolidation of firms in the legal services market, and the emergence and increasing complexity of new structures, have led us to identify the potential risk of group contagion.

Although we have limited evidence of this risk occurring in the legal services market, evidence from other markets has demonstrated that group contagion can lead to firms facing financial difficulty or other reputational problems.

Read more

Lack of transparency in complex business structures

We are concerned about the excessive complexity of many new entities which may reduce the transparency of a firm's operations or hide problems from us or their clients. A lack of transparency reduces our ability to manage risks to the regulatory objectives.

Read more

Introduction

The Risk Outlook sets out our assessment of the key risks to the regulatory objectives in the Legal Services Act (LSA) 2007 2 over the next twelve months.

The scope of the Risk Outlook is the legal services market that we regulate. Our analysis has not stretched to cover risks related to the wider legal services market.

LSA regulatory objectives

  • protect and promote the public interest
  • support the constitutional principle of the rule of law
  • improve access to justice
  • protect and promote the interests of consumers
  • promote competition in the provision of legal services
  • encourage an independent, strong, diverse and effective legal profession
  • increase public understanding of the citizen's legal rights and duties
  • promote and maintain the SRA Principles
 

The Risk Outlook will play a key role:

  • communicating our view of legal services, from the perspective of the largest regulator of legal services in England and Wales

  • explaining how we control the key risks to the regulatory objectives

  • demonstrating the priorities to which we expect to allocate our resources

  • aiding law firms to manage risk.

Our analysis is based on available evidence and experience as of Spring 2013; we will publish further Risk Outlooks on an annual basis to refresh our assessment of key risks.

We have carried out our analysis at an aggregated market level. We have not carried out detailed analysis of different sub-sectors of the legal services market.

The Risk Outlook is relevant to all individuals and entities that we regulate, including partnerships, Alternative Business Structures (ABSs) and solicitors that work in-house for unregulated entities. When referring to regulated entities we have used the term 'law firm' or 'firm' as shorthand.

The evidence

The analysis presented in the Risk Outlook is based on a wide range of sources of information, drawn from both external sources and internally from SRA data and case files. As shown in Figure 3, we have aimed to bring these sources of evidence together to provide a balanced assessment of the most significant areas of risk.

Evidence Base

Structure

The Risk Outlook is presented in two main parts:

Part A: Market assessment – trends and drivers of change: This section looks at the changing nature of the legal services market and how it drives levels of risk.

Part B: Profiles of key risks: This section sets out the key risks, grouped into current, emerging and potential risks. We explain why these risks are important and the controls that we use to manage them.

A separate section provides case studies and a final section sets out a summary of the links between each risk and the regulatory objectives that they affect.

Part A: Market assessment – trends and drivers of change

Our market assessment of drivers of change has four components:  

  • 1. Economic trends and outlook
  • 2. Regulatory and political background
  • 3. Market and firm level trends
  • 4. Consumer behaviour and expectations.

The topics covered in this section often overlap and interconnect with each other.

Economic trends and outlook

The wider economy is a key driver of change in the legal services market. This has a range of effects, including the availability of credit and a reduction in levels of demand for key services.

Gross fixed capital formation7

Difficult economic conditions

The UK is in a period of slow and uncertain economic recovery and is facing a number of challenges to growth. This has created a tough operating environment for many businesses.

The economy remained stagnant in 2012 with Gross Domestic Product (GDP) growth of only 0.2% 3 . There was significant variation across regions, with London and the South East achieving the highest rates of growth 4 .

In March 2013, the British Chambers of Commerce downgraded its forecast for UK economic growth for 2013 from 1.0% to 0.6%. This was in response to the unexpected decline in GDP in the final quarter of 2012 and deteriorating prospects for growth globally and particularly in the Euro zone 5 .

Recovering from this recession is taking longer than it took the UK to recover from previous recessions. Figure A.1 tracks the impact of the 2008 economic downturn on 'gross fixed capital formation', an indicator of the level of demand in an economy 6 . This is compared against recessions in the 1970s, 80s and 90s. The data shows a more severe reduction in demand during the recent recession and the subsequent weak recovery.

Impact on demand for services

Economic conditions are having a negative impact on demand for many types of legal services. Key factors include:

  • lack of confidence of businesses to invest and carry out corporate mergers and acquisitions
  • inflation running higher than growth in average real incomes and therefore reducing households' purchasing power 8 (in the year to April 2013, the rate of inflation was 2.4%) 9
  • consumers' increased propensity to save and reduced income from savings
  • the high rate of unemployment and stagnating levels of household income.

Deficit reduction

A key economic policy of the Coalition Government is to reduce the budget deficit with the intention of bringing national debt under control 10 . This has been approached using a variety of tactics, including reducing public spending and making changes to the tax system. The prioritisation of deficit reduction has also influenced the strategy of HM Revenue and Customs to take a firmer approach to recovery of debt from firms in arrears 11 . This has had an impact on law firms facing financial difficulty, who are under pressure to pay outstanding debts 12 .

Housing market

Transaction volume in the housing market is a key economic indicator for the legal services market, due to its impact on demand for conveyancing services. At its peak, transaction volume was 400,000 per quarter 20 . This fell to a low of 126,000 in quarter one of 2009 and has not been followed by a substantial recovery. This has significantly reduced the market for conveyancing services.

Interest rates and availability of credit

The recession has resulted in reduced access to lending for businesses 13 . Since 2009, the Bank of England has set interest rates at the historically low level of 0.5%. Although this has reduced the costs of borrowing for some, there are still significant barriers to credit for businesses and households. One of the key reasons for this is that many banks are attempting to increase their capital reserves 14 , a requirement designed to improve the financial stability of institutions that provide credit 15 .

Current low interest rates are beneficial to businesses with high levels of debt, but when interest rates start to increase this could have an adverse impact on firms' ability to borrow and to pay back what they owe. Our engagement with firms has also shown that reduced interest rates have meant that firms are making less money through interest earned on capital balances.

Difficulties obtaining credit through traditional routes is leading to more law firms accessing non-mainstream finance such as:

  • private equity funds

  • high cost sub-prime business loans 16

  • complex loans

  • debt consolidation or restructuring.

An independent lender reported in 2011 that their lending to law firms had almost doubled, mainly due to the need for quick financing to pay tax bills 17 . This could point to a wider trend of law firms using alternative sources of credit. Non-mainstream finance can also involve more high-risk borrowing, which may include links with individuals or entities in countries with a high risk of money laundering 18 and cash loans from unregulated providers 19 .

Globalisation

The legal services market in England and Wales has a positive international reputation and a high degree of influence as a result of the worldwide influence of English Law. This has helped make London, in particular, an international hub for legal services 21 .

The effect of globalisation is not confined to large city law firms with offices in multiple jurisdictions. It is making the legal services market more complex and more competitive and this is having an effect across the entire market. Smaller firms may be able to benefit from opportunities, such as using offshore legal process outsourcing providers. However, they must also contend with the higher levels of competition that are also driven by globalisation.

Political and regulatory background

Political and regulatory changes are contributing to a significant amount of change.

Legal Aid, Sentencing and Punishment of Offenders Act (LASPO) 2012

LASPO 2012 22 is making a significant impact on the legal services market. As set out below, it includes Legal Aid changes and implements many of the recommendations made by Lord Justice Jackson in his review of civil litigation costs.

Legal Aid changes

From April 2013, the Legal Aid budget has been reduced by £350m from £2.2bn through a combination of changes to the areas of work covered by legal aid and changes to client eligibility 23 .

For law firms that carry out a lot of legal aid work these cuts pose a significant challenge. In a comprehensive survey conducted in mid-2012 of over 2,000 solicitors' firms in England and Wales, it was revealed that 31% were considering withdrawing from one or more areas of legal aid work over the next three years. This trend was particularly significant in firms undertaking work in family legal aid 24 . It is important that the impact of these market changes on access to justice is monitored.

Price-competitive tendering

Further changes to Legal Aid have been proposed, with plans to introduce price-competitive tendering (PCT) for criminal defence services. This will mean that defendants will lose the right to choose their lawyer and instead be allocated a representative. The proposed PCT model may result in the 1,600 firms that currently provide these services reduced to approximately 400 25 . This is intended to lead to more cost effective services but concerns have been raised about a possible negative effect on access to justice 26 .

Referral fee ban

The government ban on the payment and receipt of referral fees in personal injury cases came in response to concerns about the high overall cost of litigation, rising motor insurance premiums, increasing numbers of claims and the perception of a 'compensation culture' which encourages people to make claims for minor injuries 27 .

Despite SRA concern as to whether the ban is an effective way to mitigate these risks, we have developed a workable regulatory framework to ensure the ban is enforced. Prior to the introduction of the ban, we contacted Compliance Officers for Legal Practice (COLPs) and key contacts in firms we understand to be involved in personal injury work to raise the issue of these changes and highlight the key points we expect firms to address 28 .

Firms that can no longer obtain clients from referrals will need to develop new strategies to attract clients. If firms cannot do this in a cost effective way it may present risks to their financial viability. Firms must also ensure that the approaches they take to obtaining clients are compliant with the ban 29 .

Other reforms related to personal injury

Other reforms affecting the personal injury market include:

  • fixed legal fees for Road Traffic Accident claims under £10,000 reduced from £1,200 to £500

  • a cap on success fees for lawyers at 25% of damages

  • a ban on lawyers recovering success fees and after-the-event insurance premiums from the losing party 30 .

This is set against a backdrop of falling overall numbers of road accidents 31 and the longer term prospect of advances in driver assistance technologies further improving road safety. As Road Traffic Accident claims represent the majority of all personal injury claims 32 this points to a longer-term trend of decline in the value of this specific legal sector.

Legal Services Act 2007

As illustrated below, the Legal Services Act (LSA) 2007 opened the market to ABSs 33 and required modernisation of regulatory practices.

Alternative business structures (ABSs)

ABSs allow non-lawyers to own and manage law firms and enable existing firms to accept external investment. This is intended to promote competition in the provision of legal services and drive market efficiency as existing firms change to adapt to the entry of new businesses. This may lead to increased quality, diversity and choice in services, increased capital investment, new approaches in the management of law firms and lower costs for consumers.

We have now authorised over 150 ABSs 34 , ranging from large brands to bodies backed by private equity, through to smaller specialist practices. It will take time for the full market impact of ABSs to emerge, but the range of different structures we are seeing is indicative of a more diverse approach to provision of legal services.

In March of this year, we combined individual authorisation teams for ABSs and recognised bodies into a single firm authorisation unit, Firm-Based Authorisation. All applications for authorisation – ABSs, recognised bodies and sole practitioners – are now dealt with under the same process.

Regulatory reform

The LSA 2007 began a period of regulatory reform, leading to the introduction of risk-based OFR and the new SRA Handbook 2011. The aim of this reform is to make regulation more cost effective, targeted and proportionate to risks. However, any period of significant change creates challenges as those involved get used to new ways of doing things. Other notable regulatory developments include:

  • Compliance officers – Firms we regulate have appointed Compliance Officers for Legal Practice (COLPs) and Compliance Officers for Finance and Administration (COFAs). The COLPs and COFAs will play a significant role in embedding the new practices and culture required to make risk-based OFR
    effective. 35

  • Legal Education and Training Review (LETR) – In response to the need for legal education and training to reflect the major changes taking place in the legal services sector, we are collaborating with the Bar Standards Board (BSB) and the Institute of Legal Executives (ILEX) Professional Standards (IPS) to carry out LETR. This is a review of education and training needs across both regulated and non-regulated legal services in England and Wales. Following completion of the research phase, each of the three sponsoring regulators will consult on a proposal for addressing the recommendations 36 .

Market and firm-level trends

This section reviews trends related to the structure of the legal services market and the strategies and activities of law firms.

Market structure

The legal services market is highly fragmented, with the majority of law firms having a small number of partners. 44% of firms are sole practitioners and 41% have between two and four partners 37 .

A recent survey showed that 27% of firms carry out at least 90% of their work in a single category of legal practice 38 . This indicates that a significant proportion of firms have a relatively narrow focus to the activities that generate their turnover. Some of these firms may be specialist or niche providers of certain legal services, but it is likely that for many of these firms, this narrow focus is not a commercial strength. Over-reliance on a category of legal work places a firm at risk if factors reduce the revenue that can be generated from that source.

Diversification into new areas of work is often necessary for law firms to remain commercially viable. This process needs to be well managed to ensure that new business models are realistic and that new services are delivered effectively.

Mergers and consolidation

Market pressures are leading many law firms to seek mergers in order to boost market share and make cost efficiencies 39 . In the long-run, this may re-shape the legal services industry with a less fragmented market emerging. We have limited data on merger activity, but available evidence demonstrates that it is a significant trend. For example, a small-scale survey indicated that 76% of law firms have considered the possibility of a merger over a six-month period and 20% of firms with more than ten partners completed a merger in 2012, compared to 14% of smaller firms 40 .

There was an increase of 25% in merger deals among top-100 UK law firms in 2012 compared with 2011 41 . We have also seen an increased number of UK law firms seeking to merge with large international firms 42 .

Consolidation is taking place at different rates across the legal services market. Having faced a difficult business environment since 2007, conveyancing is showing the highest rate of consolidation, with the largest ten conveyancers handling 28% more of the total property transactions in 2012 than was the case in 2010 43 .

Effective mergers can lead to innovative and more efficient new business models for the law firms involved. To ensure that the new structures are viable, this process also requires careful management, due diligence and planning. Poorly executed mergers and acquisitions are a key driver of risk.

Commoditisation

Commoditisation is the process of breaking down legal services into component steps in order to find efficiencies and make services more profitable.

Firms are increasingly shifting less complex tasks from qualified solicitors to paralegals. This allows firms to leverage more legal work from the solicitors they employ. There are currently over 300,000 paralegals working in England and Wales 44 and this number is likely to rise 45 .

Another form of commoditisation is the trend in outsourcing basic legal work to external providers in order to make efficiency savings. This practice is usually applied to lower-value activities but has the potential to encompass an increased range and complexity of legal activities 46 .

Increased commoditisation, use of paralegals, outsourcing and the introduction of ABS are all part of a trend which is reducing the proportion of legal work carried out by solicitors. We are aware that there is a wider debate about the longer-term effect of legal services being provided by people who have not had formal training in legal professional ethics.

Technology

Many law firms have also invested in technology to drive down costs and improve the quality of services they deliver. This has included use of on-line libraries, automated document production and flexible templates 47 .

A key trend has been the move towards cloud computing, which allows data to be held remotely. Law firms' use of websites for marketing has also increased 48 .

However, benchmarking against other industries and countries has found that even the largest law firms are not yet maximising the use of technology to acquire clients 49 .

Obtaining professional indemnity insurance (PII)

Firms must hold a minimum level of PII, which must be obtained from a qualifying/participating insurer 50 . Qualifying insurers must be authorised to offer the relevant insurance contracts under the Financial Services and Markets Act 2000 (FSMA), whether from the Prudential Regulation Authority (PRA) or the equivalent regulator in another European Economic Area (EEA) Member State under 'passporting' 51 arrangements. We do not vet or approve insurers, and so the process of obtaining insurance still involves the exercise of due diligence on the part of the firm.

We are seeing an increasing number of law firms taking out insurance with 'unrated' providers, that is, insurers that have not been assessed by a rating agency. In 2012/13 16% of firms used an unrated provider, up from 9% a year before 52 .

In recent years, there have been two high profile insolvencies from unrated insurers, Lemma in 2012 and Quinn in 2011. Insolvency of an insurer has an impact on the protection of consumers and can also have a commercial impact on the law firms involved.

Consumer behaviour and expectations

The behaviour and changing expectations of consumers are also a key driver of change.

Price awareness and expectations of lower cost services

A reasonable price is key to many consumers' decision-making when purchasing legal services. However, the nature of legal services makes it difficult for consumers to assess what represents good value for money. Research found that many consumers believed that legal services are prohibitively expensive 53 . This perception may itself act as a barrier to access to justice for many potential consumers.

Many businesses are responding to consumers' concerns by offering more services at a fixed price. It is estimated that fixed price services currently account for around 40% of legal service transactions and this is a trend that appears set to continue 54 .

When consumers have limited ability to judge quality, the potential negative side of competition driven by costs is the risk of a so-called 'race to the bottom' 55 , with standards falling to achieve cheaper prices. Some parallels can be drawn with the recent scandal of horsemeat being found unlabelled in certain food products. An element of this included pressure to supply products for very low costs combined with a major failure of quality controls.

Consumer empowerment

In the legal services market, consumer empowerment may be less developed than in many other consumer sectors 56 . For example:

  • in recent years, there has been progress in the financial services industry in terms of empowering consumers to make decisions and access redress. The scale of the Payment Protection Insurance (PPI) claim back by consumers has raised many people's awareness of their power and rights as a consumer.

  • in the utilities industry, consumer empowerment has led to increased 'switching' of energy providers to get a better deal and the emergence of 'collective switching' that allows consumers to band together and make a real impact on the market 57 .

In legal services, there are many reasons why these trends will not be mirrored precisely. However, it is likely that consumer empowerment will become a more significant driver of change, as it has done in other sectors. This process will drive further change in the ways that law firms and consumers interact 58 .

Consumer empowerment may lead to more 'unbundling' of legal services. This involves a firm agreeing to limit the scope of their work on a legal matter to allow the consumer to carry out some of the work themselves. This can improve cost effectiveness by giving the consumer a more active role in dealing with their legal matter 59 .

Branding and consumer confidence

A recent survey found that 59% of consumers 'would potentially be interested in legal services from well-known brands' 60 . Previous research found that when buying legal services, consumers valued quality of service and fixed prices over the 'reassurance' of a brand name, but that consumers did often use a trusted brand name as a proxy for quality 61 .

Surveys frequently show that consumer confidence in lawyers and legal services is lower than in many other professions, and the level of trust in most professions is currently decreasing 62 . This has implications for our regulatory objectives as trust is an important component in both access to justice and upholding the rule of law.

On-line consumers

In other sectors, many consumers are now using the internet to buy and use services, two prominent examples being internet banking and online shopping. This trend is less well developed in legal services, but its influence is starting to emerge. Already, around one in five legal services consumers now uses the internet to find their lawyer 63 .

An increased number of legal business models are moving beyond this, towards greater internet-based provision of services. This includes allowing consumers to adapt simple legal documents or track their case online 64 . Consumer demand for internet-based services is unlikely to diminish and needs to be taken into account when assessing regulatory risks, through consideration of issues such as data protection, client confidentiality and access to justice.

It is also worth highlighting that there are around five million UK households who do not have access to the internet 65 . These households are potentially at risk of barriers to accessing justice as the provision of legal services increasingly moves online.

Demographic shift

Demographic changes are also likely to shape trends in the profile of consumers of legal services. As the population of England and Wales continues to age 66 , demand for certain services such as divorce 67 , will writing and probate can be expected to grow in the long term.

Another significant demographic shift is increased ethnic diversity. The 2011 National Census showed that 19.5% of the population of England and Wales are from an ethnic group other than White British, an increase from 12.5% in 2001 68 . This demographic shift is changing the client base for legal services and may have an impact on the types of service demanded.

Part B: Profile of the key risks

This section of the Risk Outlook profiles each of the key risks. Although presented separately, in reality, many of the risks will have a degree of interconnectivity and are unlikely to happen in isolation.

The key risks have been prioritised by grouping the risks into three categories:

  • Current risks: where we have evidence of a widespread negative effect on the regulatory objectives.

  • Emerging risks: where we have some evidence, but limited to date, of a widespread negative effect. These risks are a growing concern.

  • Potential risks: where we have limited, clear evidence of a negative effect to date but, given current trends, these risks have the potential to have a negative effect.

 

Current risks

Current Risk

The following risks are categorised as 'current':

Financial difficulty

Financial difficulty presents the most significant current risk to our regulatory objectives. All firms will go through periods where they face challenging market conditions. However, this risk is greatest when firms fail to recognise and take action to meet these challenges.

The LSA 2007 requires us to promote competition in the legal services market. An unavoidable characteristic of any competitive market will be firm failure and it is not our objective to prevent this. Our responsibility is to encourage firms to make sensible commercial decisions so they can avoid financial difficulties and, when financial difficulties do arise, to regulate the behaviour of the affected firms to minimise any negative effects. Key characteristics of firms at risk of financial difficulty include 69 :

  • management weaknesses – e.g. excessive concentration of power, limited sharing of financial information and inexperienced management below senior partner level

  • accounting weaknesses – e.g. inadequate budgetary controls, weak cash flow planning and an inability to understand profit generated by different types of work

  • change handling – e.g. failure to adapt to a changing market or to the changing needs of employees and customers.

Negative effects

Financial difficulty is significant because firms that do not manage the challenges that result from it, present a risk of:

  • disorderly closure – this scenario can cause delays in clients accessing their files and funds. It may also affect other parties to transactions or litigation and so impact more widely, including on the courts and the administration of justice

  • poor standards of service – financial difficulties also often lead to a detrimental effect on the quality and standard of legal services received by consumers

  • criminal association – past investigations show that firms in financial difficulty are also more vulnerable to criminal involvement

  • breaches of the SRA Principles – firms in financial difficulty are also more likely to breach the SRA Principles or present other significant risks, such as dishonest misuse of client money or assets. An example of this taking place is provided in case study one (see the following section).

All of these issues affect the regulatory objectives, and in particular the interests of consumers. These negative effects have significant potential to cause major harm to the public's perception of legal services. If there are several firm failures in a particular geographic area, or related to a particular type of legal service, this may also have a negative impact on access to justice.

When a firm becomes insolvent then creditors also face loss. The failure of Cobbetts left total unsecured debts of over £91m, more than £75m 70 of which was owed to landlords. Protecting the interests of these creditors is not within our remit, but it is important that those we regulate act with integrity, even in the context of the closure of their firm. Demonstrating integrity will assist in retaining the confidence of lenders in providing finance to law firms.

Good businesses may face higher borrowing costs if they are unable to distinguish themselves from badly managed firms. As firms' financial positions deteriorate, we are finding that they are increasingly turning to non-mainstream lenders. This can exacerbate financial difficulties by exposing law firms to high rates of interest and restrictive loan conditions. We are also alert to the potential risk that a non-mainstream lender may exercise significant influence in the firm that amounts to a pre-emptive ABS arrangement.

Trends

We are receiving increasing numbers of reports of financial difficulty. We are currently engaging with 51 firms who have a high likelihood of intervention and have identified approximately 2,000 firms we believe have an increased susceptibility to financial difficulty due to factors such as reliance on legal aid or work type 71 .

The drivers of financial difficulty are diverse and include, but are not limited to, the changes to the personal injury sector, legal aid changes and the difficult economic conditions. Case studies in the following section demonstrate that financial difficulty is a major issue across all sizes of firm and types of work and is not confined to a specific segment of the legal services market.

SRA controls

We require firms to face up to financial problems to achieve an orderly resolution. Our preference is for firms to deal with the issues early, adapt their business model and establish a commercial future for themselves. When a firm must close, effective management should lead to an orderly closure without the need for us to intervene. This requires exit or succession planning, which is covered in more detail under the section on emerging risks.

We are taking a proactive approach to the regulatory management of financial difficulty. We are actively engaging with the firms that we have identified as being susceptible to financial difficulty to gauge their financial position and allocate our resources in a way that is appropriate to the severity of any identified issues. This may include encouraging firms with unrecoverable difficulties to wind down in an orderly manner and engaging with firms on how they can recover and continue trading, if appropriate.

Managers that do not properly address financial difficulty, or who take steps to cover up problems, will be in breach of the professional principles. This includes misrepresentation of their financial position or knowingly trading while insolvent.

Our controls are based on the following principles:

  • Principle 2 which requires that regulated persons act with integrity

  • Principle 8 which states that those we regulate must run their business, or carry out their role in the business, effectively and in accordance with proper governance and sound financial and risk management principles.

In addition, Chapter 7 of the Code of Conduct sets out ten mandatory outcomes and four indicative behaviours about ensuring proper checks and balances are in place for effective management of the firm. Specifically, Outcome 7.4 states that firms 'must maintain systems and controls for monitoring the financial stability of your firm and risks to money and assets entrusted to you by clients and others, and you take steps to address issues identified'.

Dishonest misuse of client money or assets

The factors that may lead to client money or assets being misused are wide ranging and case specific. However, there are some common characteristics which we have observed in a large proportion of cases, as shown below 72 :

Triangle showing the following text link as common charateristics

opportunity - the presence of a client account creates the main opportunity for this risk to materialise. This highlights the need for strong systems and controls to manage and mitigate risks related to those who have access to a client account

financial pressure - poor financial performance or cash flow problems are often factors present at firms where this risk materialises. Financial pressure may not relate just to the firm; there are many examples of managers and employees with unmanageable levels of personal debt also resorting to accessing money from a client account

rationalisation - although less tangible than the first two factors, the scope for the perpetrator to rationalise their actions is also a key feature of previous cases of misuse of client money. This varies on a case-bycase basis, but usually involves those involved finding a justification to explain their actions, for example, by telling themselves that money will be returned as soon as possible.

Negative effects

This risk continues to be a high priority because of the significant effect it has on the public's and consumer's interests. Although the Compensation Fund provides redress, and firms are required to remedy shortfalls that arise, it may lead to a negative effect on the legal matter being dealt with as well as causing distress and alarm to consumers. Dishonesty is also highly damaging to the public's confidence in the delivery of legal services.

Over the last five years, 30% of all interventions involved suspected dishonesty and nearly half included accounts rule breaches amongst their grounds. When costs of intervention cannot be recovered in full from the intervened firm, they fall on those we regulate and eventually get passed on to consumers in the form of higher fees.

Trends

The number of SRA receipts reporting concern about this risk has almost doubled over the last two years, up from 649 in 2011 to 1,107 in 2012. Receipts for 2013 reflect this increased trend, with 285 receipts received between January and March.

While some of this increase may be due to reporting changes in October 2011, this trend remains a concern. We are also concerned that increased risk of financial difficulty will further drive up levels of this risk.

SRA controls

Our supervision of those we regulate is designed to detect indicators of this risk and create an environment where suspicious activity can be easily reported to us. We have a whistle-blowing policy 73 and operate a 'Red Alert' hotline which allows us to take urgent action if there is an immediate threat to client money or assets.

The introduction of the role of COFA is intended to provide an additional control. This will ensure that there is a responsible individual within the firm with financial oversight and a direct duty to report breaches to us.

Those we regulate are subject to professional obligations of integrity, specifically:

  • Principle 2: 'Act with integrity'

  • Principle 6: 'Behave in a way that maintains the trust the public places in you and in the provision of legal services'

  • Principle 10: 'Protect client money and assets'.

When we have concern that these principles have been breached, this will result in an investigation. We can intervene into a firm on reasonable suspicion of dishonesty alone. Save for exceptional circumstances, where dishonesty is found this will lead to the solicitor responsible being struck off the roll 74 .

In addition, the Solicitors' Accounts Rules 2011 exist to ensure that regulated firms maintain a minimum standard of systems and controls necessary to prevent financial dishonesty. When we introduced risk-based OFR, detailed accounts rules were retained in the SRA handbook. Keeping prescriptive rules is a proportionate response to the risks related to client money and assets.

We also intend to review our policies about the ways that firms should be allowed to hold client money. The review will consider many options for strengthening the protections in this area, including giving solicitors positive permission to hold client money.

Lack of a diverse and representative profession

Although an increasingly diverse range of people are entering the legal profession in England and Wales 75 , there is still a lack of diversity at senior positions in many firms.

Direct discrimination is not thought to be the main cause of this lack of progression 76 and a wide range of underlying contributory societal factors have been identified.

People from some backgrounds, or with certain characteristics, may suffer from:

  • a lack of information, from an early age, on career options

  • a lack of role models working in legal careers

  • barriers to higher education, particularly at 'redbrick universities'

  • a lack of personal contacts working in legal services 77 .

All of these factors have a bearing on access to legal careers and the type of legal career that is pursued.

Negative effects

This represents a risk to the regulatory objective of encouraging an independent, strong, diverse and effective legal profession. When there are barriers to entry and progression in the legal profession, this reduces the likelihood of a strong, talented legal workforce, able to provide services to a diverse population 78 .

Trends

Workforce statistics show a relatively diverse range of people working in legal careers 79 . In 2011:

  • 14% of Practising Certificate (PC) holders were from a black or minority ethnic (BME) group, compared to 19.5% 80 of the population of England and Wales – which indicates a slight under-representation

  • 46% of PC holders were female, which is proportionate to the 46% of people in employment in England and Wales 81 .

Research has demonstrated a number of key career barriers faced by solicitors in relation to the following characteristics 82 :

  • ethnicity (solicitors from black and minority (BME) backgrounds) – there is evidence of a pay gap of 17% between White British and BME solicitors. The disparity is often a reflection that BME solicitors are based in small high street firms, sole practices, and work in areas of law that are less well paid, such as legal aid, personal injury and immigration 83

  • socio-economic background – although this is a complex area to define statistically, workforce data showed that 30% of solicitors who were educated in the UK, had attended a fee-paying school 84 . This indicates that this group is disproportionately over-represented amongst those we regulate 85

  • gender (women solicitors) – we also have concerns that women face barriers to progression in legal careers. For example, 20% of women solicitors working in private practice in England and Wales are at partner level or equivalent (excluding sole practitioners), compared to 46% of men. In addition, women are less likely to secure a highly paid training contract 86 .

SRA controls

Principle 9 states that firms and individuals should 'promote equality of opportunity and encourage respect for diversity'. To promote the delivery of this, we are undertaking the following activities:

  • LETR is exploring how to widen access to qualification as a solicitor through a more diverse range of routes to qualification 87 . This is a major review of qualification routes and is intended to make a significant impact on access to the profession

  • we have collected and published workforce data on those we regulate 88 . Through monitoring and publishing this data, we are highlighting areas for improvement and showing those we regulate where they are now and where they need to be with regard to a diverse workforce

  • we have published the findings of a thematic review which provides examples of how firms deliver equality and diversity outcomes in practice 89 .

Failure to co-operate or comply with notification and information requirements

Negative effects

We require regulated firms and individuals to deal openly and honestly with us. The success of this approach depends on reliable engagement and a constructive working relationship with those we regulate. Similarly the Legal Ombudsman (LeO) relies on this co-operation and compliance to investigate whether it is appropriate to order redress to consumers who have received a poor legal service.

Firms that fail to deal openly with the LeO and us have a negative impact on the interests of the consumers affected by these cases. This also has the potential to harm the public's confidence in the delivery of legal services.

Trends

LeO make referrals to us on cases classified as conduct matters. In 2012, 78% of these referrals were in relation to 'Failure to co-operate with LeO or other regulators'.

This demonstrates that co-operation and compliance with these duties are a widespread problem. This assessment is reinforced by 621 reports directly to us in 2011/12 that related to firms' 'failure to co-operate or comply with notification and information requirements' 90 .

The recent appointment of compliance officers revealed an unexpectedly high degree of non-compliance by regulated firms and highlighted the risk of firms failing to comply with their regulatory obligations and to co-operate with us openly and transparently.

As a central part of the risk controls under OFR, regulated firms were required to appoint COLPs and COFAs, however:

  • 1,200 firms failed to meet the deadline for nominating their appointed compliance officers

  • over 500 regulated firms or individuals failed to disclose material information to us concerning their proposed compliance officers

  • 300 firms did not make any applications at all despite being sent a number of reminders about their obligation to do so.

SRA controls

Our key control is based on Principle 7, which states that those we regulate must 'comply with their legal and regulatory obligations and deal with your regulators and ombudsmen in an open, timely and co-operative manner'.

Firms without approved compliance officers in place are weakening their ability to control risks. In the worst instances, those firms that failed to provide material information about their nominated compliance officers, were involved in actively misleading us. This is a serious breach of the SRA Principle requiring those we regulate to act with integrity.

We have adopted a robust approach to enforcement in order to establish a credible deterrent to future non-co-operation and non-disclosure. We have identified 547 individuals who have failed to disclose material information to us about their suitability to be compliance officers and 434 cases where firms have failed to co-operate with the nomination process. Enforcement action has been considered against all of these firms/individuals and in the most serious cases reports are being prepared which recommend either an internal sanction, revocation of recognition or a referral to the SDT 91 .

We have invested a significant amount of resource into training and recruitment to ensure we have the skills to build constructive working relationships with the firms we regulate. We will respond proportionately to breaches of the Handbook and firms that have genuinely tried to comply should not have concerns about being open and honest in their dealings with us.

Emerging risks

Emerging Risk

The following risks are categorised as 'emerging':

Lack of adequate succession or exit planning

Succession planning refers to a strategy that allows owners to leave the business while allowing it to continue trading under new ownership. Our experience has shown that a lack of succession planning is often associated with retirement of partners in law firms.

Our expectation is that firms will have an exit plan that will allow the firm to be wound down in an orderly manner or taken over by new owners. For some firms, exiting the market in a way that delivers profits for existing owners will be a central objective of their business plan. However, an exit strategy should also be in place in case a firm is no longer able to continue trading. This could be a result of:

  • the firm no longer being economically viable

  • death or serious illness of a managing partner or key member of staff

  • failure to obtain professional indemnity insurance

  • regulatory requirements (e.g. sole practitioner has practising certificate suspended or removed).

The recent intervention into Blakemores 92 happened because there was no viable exit strategy to respond to its severe financial difficulties. This action was taken to protect the interests of consumers.

Negative effects

A lack of succession and exit planning creates a risk to the continuing commercial viability of a firm. This becomes a regulatory concern because it undermines a firm's ability to deal with financial difficulties and other risks. This can lead to a range of scenarios with the potential to have a negative effect, including disorderly closure, poor standards of service and fraud and dishonesty.

Trends

The current financial climate has led to an increasing number of firms becoming unable to continue trading as a result of financial difficulty and our engagement with these firms has revealed no succession or exit plan in place 93 .

The situation these firms face is exacerbated by the limited opportunities to sell their businesses due to time pressure, as successful business sales often take years to plan 94 .

Just over one in five solicitors on the roll is aged over fifty, giving an indication of the number of retirements likely to take place over the coming decades 95 . In firms where owners, senior managers or large proportions of staff are approaching retirement, it will be important to form succession plans.

SRA controls

Principle 8 requires those we regulate to 'run their business or carry out their role in the business effectively and in accordance with proper governance and sound financial and risk management principles'. Part of good business management is having contingencies in place, such as an exit or succession strategy.

Having plans in place does not mean that a firm will necessarily have to use them, but it reassures us that abandonment and other types of negative effect are unlikely. If a firm does not have credible plans in place for succession or exit, and we have evidence that the firm may close in a disorderly way, it may be necessary for us to intervene into the practice.

To protect consumers when a firm closes without a successor practice, our minimum terms and conditions of compulsory professional indemnity insurance (MTC) 96 require the qualifying insurer 'on risk' at the date of the closure to provide run-off cover for the balance of the period of insurance and for a further six years thereafter. This protects consumers who need to make a claim after the closure of the firm.

In circumstances where a firm closes due to a succession by a successor practice then any future claims arising from the ceased firm will be covered by the qualifying insurer on risk for the successor practice at the date the claim is made. This fact can deter firms from acquiring other practices as they may not want to take on the responsibility for potential run-off claims.

Where there would otherwise be a successor practice, the MTC allows a closing firm to elect before its cessation to trigger the run-off cover under its existing policy, rather than through the mechanism of the successor practice's insurance. This can help facilitate the sale of a practice and the successor practice benefits from not having to worry about possible future run-off claims. if the closing firm does not elect and/or fails to pay the run-off premium due before its cessation, then the situation reverts back to the default successor practice position.

From October 2013 insurers will have to offer a three-month policy extension to any firm that cannot obtain PII at renewal to give the firm an opportunity to obtain replacement cover or conduct an orderly closure of its practice in the case that insurance is not obtained.

Poor standard of service and legal advice, particularly where this involves more vulnerable consumers

Defining vulnerable consumers

There is no single definition of a vulnerable client, but it is useful to consider characteristics of the individual client as well as the circumstances in which they have a legal need:

  • Characteristic-based vulnerability - higher levels of vulnerability are associated with clients with specific characteristics. Under the Equality Act 2012, we are responsible for promoting equality for women, BME groups, people with disabilities and other specific characteristics 98
  • Circumstance-based vulnerability - although people with certain characteristics may be more likely to be vulnerable, almost any consumer could be vulnerable given a specific set of circumstances.

For example:  

many types of legal service are used at times of stress, such as during a divorce or while involved in an employment dispute. The influence of stress affects consumers' decision-making and may make them more vulnerable some consumers of legal services may also face an especially high impact if they do not get the right legal advice. In extreme cases this could include life changing outcomes, such as deportation in immigration cases 99 . Where the potential impact of a legal matter is this important, the consumer may also be viewed as more vulnerable.

There is evidence that standards of service and quality of legal advice are sometimes below the level that can reasonably be expected by consumers. This is a particular concern because consumers may find it difficult to identify a good provider of legal services from a bad one 97 .

While delivering a poor standard of service or legal advice is an important issue in its own right, the risks can be exacerbated where they affect vulnerable consumers.

Negative effects

Poor standards of service and quality of legal advice have a negative impact on:

  • the interests of consumers

  • the public interest

  • access to justice, and

  • the rule of law.

Trends

It is difficult to make an accurate estimate of the exact incidence of poor standards of service and legal advice, however, a number of consumer surveys provide useful insights. These indicate that the majority of consumers are satisfied with the service they receive, but there is still a relatively high proportion that are not. While we recognise that consumer satisfaction is not a perfect indicator, there are good reasons to pay attention to these findings:

  • a Legal Services Board (LSB) survey of consumers showed that 55% of solicitors' clients were very satisfied with the service they received from solicitors 100 , with 7% of clients dissatisfied, and further 9% neither satisfied or dissatisfied 101

  • a YouGov consumer survey showed that 15% of people were not satisfied the last time they used legal services 102

  • the 2012 Legal Service Consumer Panel (LSCP) Tracker Survey indicated that although overall satisfaction with legal services has remained constant, at 79%, there has been a decline in satisfaction with 'personalised service and empathy' to 70% from 75% in 2011, and a decline in satisfaction with 'transparency of costs information' from 80% in 2011 to 70% in 2012 103 .

A 2013 report from the LSCP 104 also indicates that the way firms handle complaints from consumers is limiting evidence of poor service. The report finds that:

  • 42% of people do nothing when dissatisfied with the service they receive from a lawyer

  • 23% of consumers decide not to complain to their lawyer because they have no confidence that their complaint would be resolved fairly

  • 70% of consumers who are dissatisfied with how their lawyer handles their complaint abandon their complaint without referring to the Leo.

There is some support for the findings of the LSCP report from the SRA's experiences of supervision in this area. An SRA study of first-tier complaints handling in 2012 105 found:

  • a reluctance amongst firms to formally record complaints

  • perceptions that the majority of complaints are unjustified and/or vexatious.

There is also evidence of poor quality in relation to specific types of legal service, for example the quality of will-writing 106 . Research has demonstrated that the experience of using legal services, and the outcomes achieved, are often worse for consumers that could be viewed as vulnerable. For example:

  • research found evidence that people with disabilities experience more problems than others when they use a lawyer 107 . For example, 32% of disabled people surveyed felt they were charged by their lawyer for costs incurred by the lawyer relating to their disability

  • consumers who do not speak the same language as their provider may have more problems communicating their needs and getting these needs met. Research into specific groups, such as asylum seekers and those with hearing loss, has shown that language and communication barriers are a significant issue for some consumers 108

  • a report by the LeO identified the need for improvements in quality and service required by some providers of divorce work. A divorce is an example of a stressful situation where a consumer of a legal service may be more vulnerable 109 . LeO has pointed out a number of common complaints are caused by substandard service by lawyers in divorce matters; for example around one in five lawyers not giving an estimate of expected costs of a divorce at the start of the case.

SRA controls

Our controls are based on:

  • Principle 4: 'Act in the best interests of each client'

  • Principle 5: 'Provide a proper standard of service to your clients'.

Chapter 1 of the Handbook provides 16 outcomes related to client care and 28 indicative behaviours. These emphasise the need for firms to consider the individual circumstances of their client, which should help them meet individual clients' needs, rather than using a 'one size fits all' approach.

Outcome 1.12 places an emphasis on those we regulate to ensure that 'clients are in a position to make informed decisions about the services they need, how their matter will be handled and the options available to them' 110 .

We work with LeO to identify themes in complaints, and then have the ability to provide guidance around these areas. We also receive referrals from LeO when service complaints cross over into being a conduct issue, so we can investigate whether conduct amounts to a breach of the Principles or failure to deliver the right outcomes. Where conduct is an issue, we can put conditions on an individual's practising certificate to undertake training around client care or discrimination.

We are also carrying out LETR which will identify ways in which education, training and Continuous Professional Development (CPD) can play a more effective role in reducing risks resulting from poor competence.

Inadequate systems and controls over the transfer of money

Law firms transfer large sums of money in highly confidential circumstances and so are attractive to those who wish to launder the proceeds of crime or otherwise hide transfers.

It is rare to be able to prove that a law firm has handled the proceeds of crime and both legislative and regulatory controls focus on requiring systems that make laundering difficult. Failure to adhere to such systems does not mean that laundering is taking place but it increases the risk of serious impropriety.

Inadequate systems and controls also increase the risk of other financial frauds being facilitated through law firms, ranging from mortgage frauds to high-yield investment fraud.

Negative effects

Money laundering is financially destabilising and can lead to financial difficulty and the risks associated with it. An association between law firms and money laundering is damaging to the public's confidence in the delivery of legal services. This is also a risk to 'upholding the rule of law', as the public should be confident that the law will be upheld by trustworthy professionals.

Ensuring adherence to money laundering prevention controls is also in the public interest as it helps protect the public from harm caused by organised crime and terrorist financing.

Anti-money laundering systems and controls are not just a priority for us, there is international focus on combating money laundering as a key part of fighting organised crime and terrorist financing. This is evident in the recently proposed EU Anti-Money Laundering Directive, which aims to strengthen existing legislation relating to systems and controls 111 .

Trends

The Financial Action Task Force (FATF) has identified property transactions as a particularly high risk area for money laundering 112 , however it is always difficult to accurately predict true levels. There are some indications of an upward trend, as money laundering reports and prosecutions in the UK have risen substantially over the last decade 113 . In this context, our main concern is that the level of suspicious activity reports (SARs) seems lower than we would expect.

We have recently explored how firms are managing risks around money laundering and fraud in relation to conveyancing 114 . Through a thematic review we visited 100 firms carrying out varying levels of conveyancing activity. One in four of these firms had experienced actual or attempted money laundering or fraud, but the majority of firms did not feel it was a risk that affected them 115 . This indicates a potential underestimation of the risk of clients attempting to launder money through legal transactions.

SRA controls

We do not prescribe the complete internal systems and controls a firm should have in place. However, all firms must comply with the Money Laundering Regulations (2007) as a matter of law 116 . Outcome 7.5 is relevant here, requiring that those we regulate 'comply with legislation applicable to your business, including anti-money laundering and data protection legislation'.

We provide guidance to firms on how to meet their anti-money laundering responsibilities as required by anti-money laundering legislation, as does the Law Society 117 . We are involved in national anti-money laundering groups, through which we keep up-to-date with the latest developments in anti-money laundering and adjust our risk tolerance and risk management processes accordingly. Our Forensic Investigation team also includes staff who are specialists in this area. Their skills and knowledge are used to identify and investigate firms where suspicious activity is taking place.

We will take active enforcement action against solicitors involved in money laundering and sanctions can be extremely serious. Aside from criminal convictions under the Proceeds of Crime Act, which may result in significant custodial sentences, individuals may be struck off the roll of solicitors for convictions of this type 118 .

Breaching anti-money laundering regulations may also result in serious sanctions such as suspensions and fines 119 .

Potential risks

Potential Risk

The following risks are categorised as 'potential':

Improper or abusive litigation

Improper or abusive litigation is the misuse of legal proceedings (or the threat to bring proceedings) to gain money unethically by exploiting a client or third party's lack of knowledge or resources. This is an emerging risk with the potential to cause harm to the public interest and the rule of law. The negative effects are particularly severe when more vulnerable individuals are targeted.

Negative effects

Such litigation falls broadly into two categories, relating to whether the target is the client or a third party:

  • Client exploiting litigation – induces vulnerable consumers to become involved in claims either at excessive cost or where there was no need for the consumer to be charged.

    The Miners' Compensation Scheme provides an example of client exploiting litigation.

    In 1999 the government set up a scheme to provide compensation for former miners affected by industrial diseases. Solicitors were paid direct by the scheme. However, some firms also charged their clients separately, such as by calling these extra costs 'success fees'. Some firms were found to have acted in circumstances of conflict of interest by preferring the interests of referrers to their clients' interests.

    Vulnerable consumers were exploited, demonstrating a lack of integrity. The consumer and public interest were being put behind firms' profits and vulnerable clients faced additional barriers to accessing justice. The scandal generated much publicity, damaging public confidence in legal services.

  • Third party exploiting litigation – uses the threat of costly litigation to extract payment that is not due or to intimidate and stifle defence of the claim.

    Third party exploiting litigation can be seen in the unethical practices of some law firms regarding file-sharing litigation.

    This practice involved sending out letters to those whose internet protocol address had been associated with illegal downloading of materials produced by a client, a supplier of online pornography. Letters were sent out in large numbers and gave the explicit name of the allegedly downloaded material and threatened public revelation and litigation if the alleged downloader did not pay several hundred pounds.

    At one point, regulatory reports about this practice made up over 15% of all reports to us from members of the public.

    These practices led to successful cases being brought by us to the SDT. The activities of the firms involved were damaging to the public interest, the rule of law and the public's confidence in the delivery of legal services.

Trends

Trends are hard to identify as serious cases tend to take place infrequently, usually when an opportunity emerges to take advantage of a particular situation. Although these cases are infrequent, when they occur they have a significant negative impact.

SRA controls

Principle 2 requires that those we regulate act with integrity and Principle 4 requires them to act in the best interests of each client. Where Principles conflict with one another, it is the public interest that must determine which prevails. Third party exploiting litigation, placing the client interest above integrity and the public interest, is therefore contrary to the SRA Principles.

Lack of due diligence over outsourcing arrangements

The increasing use of outsourcing, in particular Legal Process Outsourcing (LPO) by regulated firms provides benefits to consumers in terms of lower costs and alternative ways of accessing legal services. However, outsourcing poses risks if it is not subject to the appropriate controls and due diligence.

Negative effects  

There are three main areas of concern, which may place consumer interests at risk or lead to financial difficulties:

  • ensuring confidentiality of client information – with confidential material being handled by another party, the regulated firm must still ensure that information is not disclosed beyond the scope of the client's consent. Firms using outsource providers may face significant limitations in assessing and assuring the effectiveness of the controls that are in place at an outsource provider

  • avoiding conflicts of interest – the growth of large firms specialising in handling outsourced legal work also presents a potential risk of conflicts of interest. For example, when entering into these arrangements an individual law firm may not be able to ensure that their provider is not also handling materials for the other side in a litigation case

  • risk of financial difficulty/structural stability – outsourcing may also present a commercial risk if the outsource provider goes out of business. This could have a significant negative impact on the clients and could have a widespread effect if the outsource provider served a large number of law firms.

Trends

A combination of commercial challenges and market opportunities has encouraged many law firms to look for ways to make cost savings and use more efficient processes. This has led to increased outsourcing of business and basic legal processes such as cloud computing, research and drafting of contracts 120 121 .

The growth of LPO has been rapid and can be seen in the growth of the market providing LPO services. It has been estimated that from 2008 to 2012 the global LPO market increased in size by 50% and now represents 0.25% 122 of the global legal sector 123 .

SRA controls

We do not intend to hinder the use of such services and the benefits they bring to consumers when well managed. Our focus is on ensuring that associated risks are well managed.

Outcome 7.10(b) sets out certain provisions where processes are outsourced. These include clear contractual arrangements and accessibility of data and other information.

Group contagion

The risk arising from group contagion is that liabilities, losses or events affecting one part of a group of firms affect a regulated legal firm within the group.

Group contagion could place a law firm in financial difficulty even if it was effectively managing its own direct business activities. Group contagion might also be reputational, for example a scandal involving a firm in one part of the group could damage the brand of the whole group.

The risk of group contagion will be greatest when members of a group are less integrated in terms of systems, controls, finances and decision-making, but are still taking on the risks of the rest of the group 124 i.e. they are taking on the liabilities with no control over behaviour of the other parts of the group.

Negative effects

Group contagion can result in financial difficulty which is directly associated with a large number of negative impacts. Negative impacts could also be reputational, which could damage the public's confidence in the delivery of legal services.

Trends

Group contagion has become a potential risk because of:

  • increasing consolidation, which includes mergers between firms 125 and the formation of businesses structured into groups of firms

  • the emergence of new types of group structure amongst recognised bodies and ABSs

  • increasing complexity in the business structures used by groups including law firms.

SRA controls
Contagion Risk

When a business is going through our authorisation process, group contagion may be identified as a risk. If this is the case we conduct further investigation into controls used by the firm to manage this risk. We also continue to monitor firms at risk from group contagion, and require further assurance and adaptations to policies if we feel the risk has increased at a specific firm.

The risk of group contagion can be effectively managed if individual firms within a structure have appropriate financial and reputational risk management. This can involve creating separation (known as 'firewalls') between the finances and management structures of different parts of the group 126 .

Having controls to manage group contagion is consistent with:

  • Principle 8: which requires firms to 'Run your business or carry out your role in the business effectively and in accordance with proper governance and sound financial and risk management principles'

  • Principle 3: 'Not allow your independence to be compromised'.

Lack of transparency in complex business structures

There is an emerging risk of a lack of transparency in the complexity of some business structures used to deliver legal services. This creates the potential for serious problems such as financial difficulties or fraud to be 'hidden' within the complexity of these businesses.

The structures of some legal services firms are very complex, and involve:

  • trusts, nominee or similar arrangements

  • shadow or de facto director arrangements or similar

  • overseas interests

  • complex ownership arrangements.

Complex structures can be found in both recognised bodies and ABSs. However, where complex structures are used, there must also be transparency between these businesses and their consumers, regulators and other third parties.

Negative effects

The negative effects associated with a lack of transparency in complex business structures, include:

  • financial difficulty and risk of disorderly closure

  • criminal association

  • intentional misleading

  • acting outside regulatory permissions

  • tax avoidance

  • group contagion.

These are risks to the public interest and interests of consumers.

Trends

Inappropriate use of complex business structures is already a widely recognised risk. The 2013 Budget made a commitment to tackling tax evasion through the Limited Liability Partnership (LLP) structure 127 and the World Bank has published a report on use of complex legal structures to hide corruption 128 .

SRA controls

We do not wish to restrict innovation or discourage complexity if it is beneficial to consumers and is appropriate for the firm. However, complex business structures must ensure that ownership, influence, management and control are not opaque, intentionally or otherwise. The SRA Principles require those we regulate to:

  • Principle 7: 'Comply with their legal and regulatory obligations and deal with their regulators and ombudsmen in an open, timely and co-operative manner'

  • Principle 8: 'Run their business, or carry out their role in the business, effectively and in accordance with proper governance and sound financial and risk management principles'.

Adherence to both of these Principles is consistent with not allowing the complexity of a firm's business structure to have a negative effect on transparency.

Firms that apply for authorisation, whether as a recognised body or ABS, and are overly complex, with no sufficient reason why they are this complex, will at the very least be given close and continuous supervision, and may require restructuring before they are authorised. We also assess the fitness and propriety of non-lawyer managers and/or owners of an ABS by applying the SRA Suitability Test 2011.

Case studies

This section provides a series of case studies which demonstrate how failure to manage the key risks can lead to negative impact on the regulatory objectives. Names and other details have been changed to protect identities, but the overall narratives of the case studies reflect real events.

Case study 1: Misuse of client money at small firm

Mr Smith and Mrs Brown were senior partners at ABIC Solicitors, a small property firm. The financial crisis affected ABIC Solicitors significantly, reducing its turnover by about half. This resulted in serious financial difficulties. In response, the partners chose to decrease the number of staff and reduce the firm's overheads. However, the situation was exacerbated when ABIC's overdraft facility was substantially reduced, and a lender recalled a significant outstanding loan. Some months later, ABIC's office account was nearing the new overdraft limit and, soon after, the firm found itself unable to meet its ongoing liabilities.

The partners, driven by a desire to keep the firm running and ensure the continued employment of their remaining staff, started transferring funds from client accounts to their office account to cover the firm's operating costs and repay debts. This misappropriation of client funds was intended to be a short-term measure. Mr Smith enjoyed substantial personal wealth from other sources and it had been his intention to use this to repay the shortage on the client accounts and secure the future of the firm. This misuse of client money continued for around a year and, by the time the SRA intervened, the partners had accumulated a shortfall in excess of £1 million.

The case was brought before the SDT and the allegations were upheld. The SDT acknowledged that Mr Smith had the intention to repay the money, and that Mrs Brown had trusted him to do so. However, their actions were unacceptable and contrary to the public interest, and Mrs Brown should have blown the whistle as soon as she began to doubt Mr Smith's conduct.

As the instigator of the fraud, Mr Smith was struck off the Roll of Solicitors, and had to cover the substantial costs of the investigation. Mrs Brown was also struck off and ordered to pay costs. However, the costs were lower to reflect the fact that she had not initiated the fraud but had assisted it due to a misguided sense of loyalty and the firm belief that Mr Smith would be able to rectify the situation by realising his personal investments. Both also received custodial sentences following a criminal trial.

Case study 2: High street firm trading insolvent

This is the summary of the voluntary liquidation of a five-partner law firm which had mainly acted for local clients and used an incorporated business structure.

Two of the partners had been equity partners prior to incorporation and they also owned the office premises from which the firm traded. These partners had both made substantial loans to the business but neither was taking significant repayments on these loans or rent on the premises.

One of the partners, Mr Sample, also had a much higher case holding than the others and was responsible for bringing in a significant proportion of the firm's work.

As a result of a conduct matter, Mr Sample was struck off the Roll of Solicitors. We also began questioning the remaining partners about firm's finances, as it seemed likely that Mr Sample would need to ask for rent and repayments from the firm. At the same time the firm needed to find a way to deal with the loss of the income Mr Sample had been bringing in.

The firm was not sure how to deal with the resulting shortfalls, but was clear that they needed to close their largest office and reduce their business. They also considered a merger.

Discussions with the SRA revealed that the firm owed substantial sums to HMRC and had a large overdraft. The bank had confirmed their willingness to support the firm during an orderly closure in order to see their debt satisfied from the sale of assets, and HMRC had stated their intention to petition to wind up the business.

We prepared for a possible intervention should the firm collapse and arranged for daily updates from the partners on their progress on winding down the firm's affairs. This included daily cash flow forecasts and information on any discussions on a merger or sale of the business.

The firm sought to enter administration before HMRC issued their petition, but were unable to achieve this. The priority became to engage constructively with the firm to ensure that client files were all forwarded on to other firms, which included liaison with the Legal Services Commission (LSC) to ensure that legal aid clients were taken on.

Case study 3: Bankruptcy of a large firm and orderly closure

The closure of the large firm May Dower LLP demonstrates that size does not protect a firm from the risk of financial difficulty.

May Dower LLP was a large firm operating in several cities, specialising in a number of different areas of corporate work. The firm was profitable prior to the recession, had a history of growth, and had leased expensive new premises in the years before the recession.

However, work began to decline as economic conditions started to bite, and May Dower found its profits reducing substantially. The expensive leases made the problem worse.

Over the following few years, the firm systematically paid out more to partners than it took in profits, amounting to millions more than had been earned. The firm was characterised by a very poor style of management, with limited financial information provided to partners and a divisive culture.

A few years after the start of the recession, May Dower was burdened with rent, debt and remuneration expectations that meant that shortfalls in meeting expected profits caused significant financial difficulties. The firm resorted to deferring payments to partners and to its creditors.

Having failed to prepare for adverse economic conditions, the firm was not able to adapt to a change in market conditions. Parts of the business had been profitable, but had guaranteed the debts of other parts of the firm and was liable for the leases.

The firm's bank agreed to continue to lend to cover the next month's wages only if a plan for wind down was confirmed, and the SRA wanted assurance that the firm's thousands of clients would be protected, otherwise we would be looking to intervene into the firm to protect client files and assets.

The firm successfully undertook an orderly closure and there was no need to intervene.

Case study 4: Difficulties at a time of transition

Ms Jones set up a sole practice specialising in clinical negligence and personal injury work.

Her firm was successful to start with; however, she had failed to give enough consideration to business development and long-term sustainability. When the LSC introduced plans for preferred suppliers of clinical negligence work, she felt unable to meet the requirements and stopped doing this type of work.

No longer receiving income from clinical negligence work, Ms Jones diversified into new areas of work to keep her business profitable. However, she did little planning around how to manage this diversification.

Some months later, Ms Jones had six part-time staff supporting her on the new areas of work, but these staff lacked sufficient experience. The firm also lacked an effective case management system. As a result, Ms Jones had to double-check all work, which impacted on her ability to manage her own cases and on the success of her personal injury cases. Her insurers were not happy with the impact this was having on the financial success of the firm, and would not renew her indemnity premium. This resulted in having to obtain cover from the assigned risk pool at ten times the cost of her previous premium.

The firm ended up in serious financial difficulty as a result of mismanagement of the diversification. Ms Jones abandoned her practice without making any arrangements for the future of her current clients' affairs. Her clients started contacting us, anxious about being unable to contact the firm.

We tried to contact Ms Jones on a number of times for an explanation, but she failed to respond. We had to intervene into the practice in order to protect her clients, and Ms Jones was referred to the SDT.

Whilst having sympathy for her situation, the SDT agreed that Ms Jones had abandoned her practice, and upheld all the allegations against her.

The SDT suspended Ms Jones from practising as a solicitor for two years, recommended that she not be permitted to practise other than as an employed solicitor on returning to the profession, and ordered her to pay costs.

Case study 5: Weak anti-money laundering controls

Mr Arche practised in partnership as Arche Solicitors, a firm that predominantly supplied conveyancing services. The firm was successful until the collapse of the housing market, when it started to experience financial problems.

To cut costs, Mr Arche made his bookkeeper redundant and took over the role himself. Despite having an insufficient understanding of the Accounts Rules and money laundering regulations, Mr Arche took sole responsibility for maintaining the firm's books and undertaking monthly client account reconciliations.

During this time Miss Layton, a successful businesswoman and personal friend, instructed Mr Arche on a number of matters and introduced other clients to the firm.

Shortly afterwards, Mr Arche started making unauthorised transfers from client accounts. In one case, he transferred funds from two client accounts, without the clients' knowledge, to Miss Layton's account. This, in effect, meant that he was allowing the firm's client accounts to be used as a banking facility. Although the shortage on one of the client accounts was rectified within a few months, the shortage on the second account remained for over a year and was corrected only after the SRA drew Mr Arche's attention to it.

There were other cases where a number of receipts and payments occurred that were not supported by appropriate documentation and did not correspond to the work that had taken place. These transactions had characteristics similar to the warning signs contained within the Blue Warning Cards on money laundering issued by both the Law Society and the SRA. Mr Arche, however, failed to notice these signs.

Following an investigation by the SRA, the matter was referred to the SDT. The SDT heard that all the breaches had occurred as a result of Mr Arche's dealings with Miss Layton and her associates. Mr Arche had allowed his friendship with Miss Layton and the desire to retain her as a client to lead him into giving her priority over other clients. This resulted in detriment to other clients. Mr Arche's legal counsel asked that the stress and anxiety he had been experiencing at the time due to his struggle to keep the firm afloat be taken into account.

Taking the evidence into account, the SDT upheld all allegations made against Mr Arche, who was suspended from practice for a set number of years and ordered to pay costs.

Conclusions

The Risk Outlook sets out our analysis of the key risks to the regulatory objectives. The risks we have identified cut across all of the regulatory objectives, however many of the risks highlighted above may be most likely to have a negative effect on the public interest, the interests of consumers and the professional principles.


Notes