Entity-Based Regulation Means Stormy Weather Ahead for Law Firms

By Steve Carter,Head of Professional Practices Group North, Baker Tilly

Steve Carter

One of the radical changes in the regulation of legal services has been the introduction of entity-based regulation. The change allowed the SRA to regulate the firm itself as well as the solicitors and other individuals operating within the firm. This change is monumental but its significance is often overlooked.

Entity-based regulation affects you personally more than you think and it could put you and your firm on a collision course with the SRA if you aren’t thinking about the firm’s financial stability.

Individual partners in firms might think of their role as being a good lawyer and that they only need to excel at providing legal advice to clients but, with the change to entity based regulation, the operation and management of a firm are now equally important. Individuals in law firms can no longer be confident that abiding by the rules themselves is enough; they may ultimately carry the can as a result of the firm breaching new regulations that only apply to the firm itself.

In December 2012 the SRA published its Regulatory Risk Index (RRI). The RRI provides an insight into the mindset of the regulator and how it will be approaching entity based regulation. The SRA said about the RRI,”the Index is intended to be a ‘living document’ which provides a structure for risk information. This will then extend to incorporate new risks if and when identified. All of the risks associated with the Index are enshrined within the requirement for reporting and all regulation and regulatory activity will ultimately come back to this core index”.

At the beginning of July 2013 the SRA also published its Risk Outlook which showed its view of current and emerging risks. Many of these are risks of the firm rather than risks of individuals breaching the regulations.

Two of the risk categories that feature prominently in both the RRI and Risk Outlook which are specifically entity-based rather than focused on the individual are:

1. Firm viability and structure
Risks arising from firm instability due to events relating to the firm’s financial viability and/or structural composition

2. Firm operational risks
Risk arising from the inadequacy of firm’s policies, processes, people or systems

In the past solicitors have often been accused of not running their firms like businesses, having poor business management skills and even of making money despite themselves. After reading the RRI and 2013 Risk Outlook partners should satisfy themselves that their firm is meeting its regulatory obligations in full. Many partnerships suffer basic business problems that are taboo subjects. Under entity-based regulation, these must be addressed. This could give partners the opportunity they need to make sure changes happen that were hitherto not open for discussion. The key issues of succession and sound financial management are common examples. This also envisages partners taking an active interest in, and raising questions about, the whole firm not just their specific area of work.

Using a selection of the Level 1 risk headings and the examples given by the SRA in the RRI we end this briefing with some key questions for partners to ask:

Baker Tilly

Management competence/financial difficulty
1. Does the firm have the adequate business planning and succession planning in place now?
2. Is there a risk that the firm may experience difficulty in meeting its ongoing financial liabilities?

In the Risk Outlook the SRA put “financial difficulty” at the top of its list of current risks with “lack of adequate succession or exit planning” at the top of its list of emerging risks.

In the Risk Outlook the SRA stated:
“The recent intervention into Blakemores 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.

Key characteristics of firms at risk of financial difficulty include:
• 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”

Supply chain risks
• Is the firm vulnerable due to instability or failure of its insurance company, instability or unsuitability of an outsource provider, or over-reliance on a referral arrangement?

Structural instability
• Is excessive merging or buying-in of expertise or seniority creating instability?

Inappropriate firm structure
• Is the organisational setup completely clear or does it hide non-compliance?
• Is the firm set up in a way which avoids tax liabilities?

Firms which the SRA consider high impact will, by now, have received a questionnaire concerning financial stability. This is the first stage of the SRA’s information gathering in this new area of regulation. Firms need to fill this in carefully and truthfully. While the SRA fully expect that there will be firms who now find themselves in financial difficulties, the SRA have told us that they will try to help firms in this situation. However, if they subsequently find that firms have tried to hide their true financial position from their regulators they will not be so amenable.

By Steve Carter,Head of Professional Practices Group North, Baker Tilly

Steve Carter

One of the radical changes in the regulation of legal services has been the introduction of entity-based regulation. The change allowed the SRA to regulate the firm itself as well as the solicitors and other individuals operating within the firm. This change is monumental but its significance is often overlooked.

Entity-based regulation affects you personally more than you think and it could put you and your firm on a collision course with the SRA if you aren’t thinking about the firm’s financial stability.

Individual partners in firms might think of their role as being a good lawyer and that they only need to excel at providing legal advice to clients but, with the change to entity based regulation, the operation and management of a firm are now equally important. Individuals in law firms can no longer be confident that abiding by the rules themselves is enough; they may ultimately carry the can as a result of the firm breaching new regulations that only apply to the firm itself.

In December 2012 the SRA published its Regulatory Risk Index (RRI). The RRI provides an insight into the mindset of the regulator and how it will be approaching entity based regulation. The SRA said about the RRI,”the Index is intended to be a ‘living document’ which provides a structure for risk information. This will then extend to incorporate new risks if and when identified. All of the risks associated with the Index are enshrined within the requirement for reporting and all regulation and regulatory activity will ultimately come back to this core index”.

At the beginning of July 2013 the SRA also published its Risk Outlook which showed its view of current and emerging risks. Many of these are risks of the firm rather than risks of individuals breaching the regulations.

Two of the risk categories that feature prominently in both the RRI and Risk Outlook which are specifically entity-based rather than focused on the individual are:

1. Firm viability and structure
Risks arising from firm instability due to events relating to the firm’s financial viability and/or structural composition

2. Firm operational risks
Risk arising from the inadequacy of firm’s policies, processes, people or systems

In the past solicitors have often been accused of not running their firms like businesses, having poor business management skills and even of making money despite themselves. After reading the RRI and 2013 Risk Outlook partners should satisfy themselves that their firm is meeting its regulatory obligations in full. Many partnerships suffer basic business problems that are taboo subjects. Under entity-based regulation, these must be addressed. This could give partners the opportunity they need to make sure changes happen that were hitherto not open for discussion. The key issues of succession and sound financial management are common examples. This also envisages partners taking an active interest in, and raising questions about, the whole firm not just their specific area of work.

Using a selection of the Level 1 risk headings and the examples given by the SRA in the RRI we end this briefing with some key questions for partners to ask:

Baker Tilly

Management competence/financial difficulty
1. Does the firm have the adequate business planning and succession planning in place now?
2. Is there a risk that the firm may experience difficulty in meeting its ongoing financial liabilities?

In the Risk Outlook the SRA put “financial difficulty” at the top of its list of current risks with “lack of adequate succession or exit planning” at the top of its list of emerging risks.

In the Risk Outlook the SRA stated:
“The recent intervention into Blakemores 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.

Key characteristics of firms at risk of financial difficulty include:
• 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”

Supply chain risks
• Is the firm vulnerable due to instability or failure of its insurance company, instability or unsuitability of an outsource provider, or over-reliance on a referral arrangement?

Structural instability
• Is excessive merging or buying-in of expertise or seniority creating instability?

Inappropriate firm structure
• Is the organisational setup completely clear or does it hide non-compliance?
• Is the firm set up in a way which avoids tax liabilities?

Firms which the SRA consider high impact will, by now, have received a questionnaire concerning financial stability. This is the first stage of the SRA’s information gathering in this new area of regulation. Firms need to fill this in carefully and truthfully. While the SRA fully expect that there will be firms who now find themselves in financial difficulties, the SRA have told us that they will try to help firms in this situation. However, if they subsequently find that firms have tried to hide their true financial position from their regulators they will not be so amenable.