Law firm mergers: an overview of liability issues

Mergers and acquisitions (M&A) activity among law firms is rebounding following a subdued period during the pandemic. There are broadly six reasons why law firm acquisitions occur: going global, going national, entering new markets, practice expansion, financial pressures and the desire to be acquired as a way to exit the profession. Whatever the rationale, how liabilities are dealt with after the completion of an acquisition, and the potential impact this may have on Professional Indemnity Insurance, are issues that warrant special attention. And now so more than ever, with continued low appetite to insure many firms, the increased selectiveness by insurers in who they are prepared to insure, and of course the steep rise in PII premiums over the past few years.

For the purposes of this article, we use the term “acquisition” to refer to a merger, acquisition or the absorption of at least a part of another legal practice. We refer to the acquiror as the “acquiring firm” and the practice (or part thereof) that is being acquired as the “prior practice”.

Run-off cover or successor practice? How the liabilities of a practice prior to acquisition are dealt with post-acquisition

The intention of the insurance terms that the SRA requires solicitors to have in place is for there to be seamless protection for clients whenever firms merge or are taken over. In other words, someone will always be responsible. In the context of prospective mergers and acquisitions, this is a scary prospect and so needs very careful consideration before firms take on any historic liabilities, not least because there is usually a time delay between the occurrence of an alleged breach of duty and the subsequent intimation of a claim for damages. For an acquiring firm, such a delay may mean they are confronted with a claim for historic alleged failures perpetrated by the prior practice, sometimes going back several years pre-acquisition.

Given this potential nasty surprise, it is pivotal for an acquiring firm to carry out effective due diligence before committing to a transaction to establish the likely extent of any potential problems. The acquiring firm must consider very carefully whether, for ongoing insurance purposes:

  • It is prepared to become a successor practice to the prior practice, and therefore be responsible under its own cover for any claims that might be intimated against the prior practice into the future; or

  • It is to ask the prior practice to trigger – and pay for – elective run-off cover under its own existing PII policy (or potentially pay for this cover itself) so as to keep any future claims ‘ringfenced’ within the prior practice.

These two options are often not easy to decide between; run-off cover typically costs anything up to 4x the annual cost of the prior practice’s insurance cover, so is a very hefty commitment. It also only covers the six years post-acquisition, whereas it is possible (albeit relatively rare) for claims to emerge against the prior practice beyond that period (which, absent any other effective run-off cover for such claims, should fall to the Solicitors Indemnity Fund (opens a new window)).

Weighed against the above, however, is the benefit of a run-off arrangement in ensuring that any claims that arise sit against the prior practice’s claims record, not that of the acquiring firm. This can be hugely beneficial to the acquiring firm if any claims do materialise, as it hedges their own claims record against the effects on future premiums that a poor record might bring.

Which option to go down is very much a matter for discussion in each case. However, it is worth mentioning that any contractual agreement as between the acquiring firm and the prior practice in relation to which will deal with future claims is irrelevant for the purpose of determining whether or not the acquiring firm has become a successor practice. What matters is whether an election is made to put the prior practice’s arrangements into run-off and whether, if such an election is made, the premium is paid. In all other cases, it is likely that succession issues will become relevant.

It should also be noted that the SRA’s Minimum Terms & Conditions (MTC) (opens a new window) only require cover of £2m or £3m, depending on whether it is a partnership or LLP/ABS etc. Liability to claimants remains with the prior practice and its members so, if an elected run off is insufficient, they remain exposed.

Just taking this a little further, for those familiar with the SRA’s MTC, you will know that there is a hugely convoluted mechanism for determining successor practice issues, and this will prevail over any private arrangements. The SRA’s minimum terms define a “prior practice” as “each practice to which the insured firm's practice [i.e. the acquiring firm] is ultimately a successor practice by way of one or more mergers, acquisitions, absorptions or other transitions, but does not include any such practice which has elected to be insured under run-off cover in accordance with clause 5.5 of the MTC.” Clause 5.5 provides that if a firm fails to make an election to be insured under run-off cover and/or fails to pay any premium due under the terms of its PII policy before its cessation, it will be insured as a prior practice under the insurance of the successor practice (i.e. the acquiring firm).

Therefore, if an acquiring firm does not want to become a successor practice (with responsibility for future claims against the prior practice), then one of the most obvious preventative steps it can take is to ensure that elective run-off cover for the prior practice is taken out and paid for prior to completion of the acquisition (which is when the prior practice will typically cease to exist).

As mentioned above, depending on the circumstances the acquiring firm may wish to assist the prior practice in funding the run-off premium to avoid the potential downside of it being deemed a successor practice.

However, it is also important to note the other criteria set out by the MTC regarding the definition of a “prior practice” and what therefore constitutes a successor practice.

We have seen several cases where the MTC rules produced unintended and undesired outcomes for the acquiring firm (and consequently for its PI insurer) due to a failure to proceed with adequate caution during an acquisition. Let’s look at an example of such a cautionary tale.

  • Firm A acquired parts of the partnership of Firm B. Firm B ceased to exist after the acquisition transaction completion date (“the completion date”). It had been contractually agreed prior to the completion date that Firm B would take out elective run-off cover for liabilities that may arise out of legal work it had carried out prior to the completion date. This was also aligned with the wishes of Firm A’s PI insurer, who had made it clear that it was not prepared to provide cover for Firm B’s liabilities. Several months after the completion date, Firm A received a letter of claim from a former client of Firm B, claiming substantial damages for various historic alleged failures perpetrated by the now former practice of Firm B. Contrary to what had been intended and contractually agreed between the representatives of Firms A and B, Firm A was automatically deemed to be the successor practice of Firm B with effect from the completion date as a result of having met the following criteria set out in the MTC’s definition of successor practice:

    • It transpired that Firms A and B had failed to ensure that elective run-off cover was timeously taken out for Firm B’s historic liabilities;

    • Firm A held itself out to the outside world as the successor practice of Firm B. Holding out can be expressly or by implication. It often occurs by way of information contained in a firm’s notepaper, business cards, electronic communications, publications and statements and declarations made to regulatory authorities etc.;

    • Firm A incorporated part of Firm B’s name as its new trading name. The MTC rules provide that a firm will be deemed a successor practice if it is carried out under the same name, or a name that substantially incorporates the name of the practice which it succeeds; and

    • Firm A acquired the goodwill and/or assets of Firm B.

  • Firm A’s PI insurer therefore, at the time a claim was first made against the former practice of Firm B, became liable to deal with the claim against the prior practice of Firm B. The insurer that had made it clear that it did not want to provide cover for any of Firm B’s liabilities found itself doing just that; with the consequent impact on the relationship between Firm A and the insurer.

Some of the other criteria contained in the MTC’s definition of successor practice that will lead to a practice being deemed a successor practice, are:

  • If the owner of the prior practice was a partnership and the majority of its principals became principals of the acquiring firm;

  • If the owner of the prior practice was a partnership and the majority of its principals did not become principals of another legal practice, but one or more of its principals became principals of another practice, that practice will be deemed to be a successor practice if: (a) it has met any of criteria that were met by Firm A in the example above; and/or (b) it has assumed the liabilities of the prior practice; and/or (c) the majority of staff employed by the prior practice became employees of its practice;

  • If the prior practice was a limited liability partnership or an incorporated practice, the acquiring firm will be deemed a successor practice if either the LLP or the limited company have become a principal in the acquiring firm and/or if the acquiring firm holds itself out as the successor practice.

The determination whether there has been a succession is always very fact specific and can be highly unpredictable, being dominated by the SRA’s overriding aim to ensure that ‘someone always pays’.

Conclusion and recommendations

The SRA’s minimum terms relating to succession and cessation are complicated, contrived and unpredictable in their application. It will no doubt continue to be a minefield for the uninitiated and those who do not proceed with caution when seeking to acquire at least a part of another firm.

Remember, once a successor practice always a successor practice. If the acquisition does not work out and you agree to go your separate ways, the clock cannot be turned back. Having become the successor practice of a prior practice you will retain responsibility for that prior practice’s historic liabilities. This is when those from the prior practice that have demerged from your firm are free to apply to the SRA as a new firm and to start with a clean slate.

With underwriters adopting increasingly enhanced risk selection, it is imperative that law firms do not expose themselves to unnecessary risk. Doing so is likely to make them less attractive to insure.

The SRA’s minimum terms and issues of law firm succession are well understood by specialist solicitors, brokers and insurers in the solicitors’ PII market. We recommend that you turn to them for guidance before making a binding decision on completing an acquisition or any PII matters generally.

Joe Bryant is a Partner at Beale & Co and also provides a PII risk auditing and advisory service to law firms aimed at making them a more attractive risk to prospective PI insurers.

Brian Balkin is a Senior Vice President at Lockton providing insurance and risk advice to law firms.

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