Rewriting the rulebook

The regulation of legal services has been hotly debated in recent years, including calls for a modified approach for the larger, most corporate-focused firms. Hazel Ryan, risk director at Eversheds LLP, brings us right up to date.

The journey since the enactment of the Legal Services Act 2007 has had a number of twists and turns and we are not at the end of the road yet.

The Solicitors Regulation Authority (SRA) now regulates both individuals and entities. Legal disciplinary partnerships (LDPs), allowing 25 per cent non-lawyer participation, have been introduced and alternative business structures (allowing 100 per cent non-lawyer participation) should be with us by October 2011.

To go back a stage, however, in October 2008 the Law Society commissioned a report from Nick Smedley on the regulation of corporate law firms. The question was whether or not it was preferable to establish a separate regime for some or all of the regulatory functions for firms undertaking largely corporate work. The report was published in March 2009, and Smedley identified some key issues of substance around some rules being unsuited for the particular work and clients of the corporate legal sector, and that there had been a breakdown in trust between the sector and its regulator. He recommended the creation of a new corporate regulation group at the SRA, headed by a very senior level group director. He recommended that the group be based in London, have sufficient expertise to deal with the corporate sector, focusing on strategic, system-level issues. The aspiration would be that the group could act as a source of expert advice in difficult matters.

At the same time Lord Hunt of Wirral MBE was commissioned to report on the regulation of the legal sector as a whole. His report was published in October 2009, and he welcomed Nick Smedley’s report, with its focus on internal governance and compliance.

Hunt went one step further and proposed a system of ‘authorised internal regulation’ (AIR); a sophisticated system, under which firms must be able to show robust governance and risk processes, with checks and balances giving comfort to the regulator. For Hunt, however, although such a system might begin at the top end of the profession, it should be available to all. There should be no dividing line across the profession.

How has the SRA responded?

Since those reports, there have been a number of changes at the SRA, including a new chairman, Charles Plant, a former partner at law firm Herbert Smith.

The SRA has taken on board the comments in the Smedley/Hunt reviews, and is currently setting up a corporate team based in London with the aim of gaining specialist understanding of City/corporate work and to build greater trust and understanding with that sector of the profession. This should facilitate conversations around difficult issues such as conflicts, as well as making actual inspections easier. If the group works as anticipated, the knowledge gained through working with firms with sophisticated internal controls and processes can be shared. It is not, however, adopting the view of Smedley that a separate wing of the SRA is necessary.

Rather the SRA has reiterated the view that the rule one principles that cover the solicitors’ profession in the Code of Conduct are common to all (see box, page 48), and that supervision and monitoring should reflect the risks involved, with the sophistication of the firm being a key part of that. Its new approach to regulation is firmly based on what it describes as ‘outcomes focused regulation’ (OFR). Such regulation will not be ‘light touch’, but rather will be proportionate to the risks involved. There will still be tough sanctions for those unwilling to engage with the SRA.

Outcomes focused regulation

There will be a number of broadly stated principles, likely around ten, covering areas presently set out in rule one and other key aspects of legal practice, such as the need to protect client money and assets. The outcomes expected for clients will then be described. These will be the mandatory aspects of the new code, against which enforcement action will be judged.

There will also then be guidance and examples of “indicative behaviour” (both non-mandatory), which will supplement these mandatory requirements. The concept of indicative behaviour is an interesting one. If the SRA were to become aware that a firm is exhibiting behaviour showing that achieving the outcomes set out in the handbook is at risk, the SRA will approach supervision of that firm from that viewpoint. Clearly it is open to the firm to demonstrate that it is, in fact, satisfying the requirements.

It is intended that the new code of conduct, the ‘handbook’, will encompass all of the existing code, together with all other rules such as accounts rules, disciplinary procedures and indemnity rules. For an example of the model being suggested, see the consultation paper, Solicitors Regulation Authority, Achieving the right outcomes (January 2010).

The vision for OFR set out above may also include some detailed rules in appropriate limited cases.

Supervision

The SRA has also indicated that it will develop its approach to supervision looking at firms’ own management processes, and flex that approach according to the size of the firm, its risk profile and the sophistication of its risk-management systems.

This is intended to be a collaborative exercise, not focusing on looking for detailed breaches of the rules. It is designed to help firms show how they are achieving the ‘outcomes’ detailed in the handbook.

The SRA has indicated that it needs more information on firms and is also intending to set up a desk-based research and analysis function, which will gather information such as complaints, market research, information from firms and consumer research. It will then be able to assess the risks of particular firms, gather evidence and decide whether outcomes are at risk.

Issues with the new approach

Lawyers are familiar and comfortable with the concept of rules and there is some concern that OFR will not deliver certainty, particular in situations where someone’s livelihood or professional reputation is at risk. The paper on the SRA’s enforcement strategy (due at the end of 2010) is therefore eagerly awaited.

For many firms, the ability to be more flexible in how the principles are satisfied must be welcome, however. The existing rule two has been criticised by both firms and clients as being inappropriate in many commercial situations involving sophisticated clients.

OFR will require a mind shift in both the regulator and the profession. The firm will have to think through how principles might be applied to a particular set of circumstances. The regulator must not take a punitive approach or be seen to be point scoring, but support those who want to improve their standards.

Early guidance would be welcome on whether firms are going to need to change all their existing procedures. The thought of extensive rewriting of existing policies and procedures, and retraining of employees, is causing concern. Such costs should not be underestimated in these resource-constrained times.

What next?

It is too early to say what steps firms will need to take to ensure their systems will be appropriate in this new world. There are still a few more key stages along the way (see table, previous page).

Throughout May and June 2010, the SRA will hold a series of roadshows to help the profession understand the impact of the change in practice. These will be backed up by an interactive website area with an opportunity for solicitors to put their questions to the SRA. More details about this “Freedom in Practice” campaign are also available on the SRA website.

What is clear is that the role of a strong finance director is vital. The role will be at the centre in this new marketplace, where firms will have to tackle client demands head on, with more efficiency, innovation and investment in the relationship. Changing business models, outsourcing, alternative business structures then all add spice to the mix.

– hazelRyan@eversheds.com