Successor practice rules – “marry in haste; repent at leisure”

There can be few law firms of any size who, over the fifteen years of the open insurance market, haven’t considered a merger or acquisition. Organic growth can be elusive in a fluctuating economy, and joining hands with a local competitor can result in a new force stronger than the sum of its parts. The new firm can sweep all before it, providing a well-funded retirement strategy for older partners and giving the younger ones a boost in enthusiasm and an improved career path. Sounds ideal – what could possibly go wrong?

Sadly, there have been disastrous mergers – multiple claims arising from unexpected quarters; efforts to avoid taking on legacy issues foundering on the reef of the Successor Practice Rules; insurers inferring (rightly or wrongly) that they’ve been taken advantage of and walking away at the following renewal.

There are many business reasons why a merger could be a good idea for you: growth, expansion geographically or in skillsets, economies of scale, succession planning or cultural fit. These notes highlight a few areas, relating to professional indemnity insurance, to consider during the M&A process.

There’s an old saying – marry in haste, repent at leisure. As with many proverbs, there’s another with an exactly opposing bent: you snooze, you lose. Business involves calculated risk and sometimes stealing a march on your rivals. Caution is still needed to avoid latent disaster.

In the early years of the open insurance market, acquisitions sometimes happened with an apparent minimum of background work, perhaps fuelled by a rush to embrace the new millennium and re-invent what might have been a traditional old partnership. There used to be no option to deflect legacy liabilities into a stand-alone run off policy, so the successor firm could assume all manner of baggage without a proper understanding of the risk.

In more recent years, the target firm has been able to purchase six years’ worth of run off cover from their incumbent insurer. This ring fences their legacy risk and protects the acquiring practice from anything that may emerge from the woodwork following the merger. However, questions remain. What if they fail to pay for the run off cover? What if the insurer providing the run off cover goes out of business within the six years? What if a claim arises after the six year cover has expired? What if a claim arises in excess of the run off limit? Would it make a difference if the acquired firm were a partnership with £2 million of cover, but the acquiring firm were a limited company with a £3 million limit?

The Successor Practice Rules are formulated to maximise the chance of finding a successor. Whilst the acquiring firm may – repeat, may – be protected in all but the very first example in the previous paragraph, there are always areas of doubt that could be exploited to land their insurer with an issue. It suits the regulator for liability to rest with an active practice and their insurer if at all possible, rather than expose the public to a shortfall in a negligence settlement. Early discussion with your broker is recommended.

If the target firm elects to buy run off cover, the amount to be paid will be clear from their PII policy, probably ranging from 200% to 350%, over the course of the six year period, of the last annual premium. On the other hand, if the acquiring practice decides to absorb the successor practice’s liabilities, their insurer will need to see in effect a full underwriting submission to give them sufficient data to be able to price the new risk. The broker may have to combine the latest renewal submissions from both legacy firms to show the new split of work and the total claims loss ratio to allow the underwriter to arrive at a suitable additional premium. All future renewal declarations will also have to combine the sets of figures. If you take on the past liabilities, the target’s record instantly becomes yours.

And don’t forget a potentially crucial question: who will pay the excess for claims arising from pre-acquisition work?

Regardless of whether elective run off is taken, an element of due diligence needs to take place. We’re not going to dwell on the details here – there’s a Law Society checklist that details dozens of points to note as part of a merger or acquisition – but one item in particular can catch you out. If the target firm made any acquisitions themselves, how much due diligence was carried out at the time? Could there be disasters waiting to happen resulting from an earlier botched merger that aren’t apparent from the initial investigation?

Your insurer will be less interested in this aspect if the target firm’s run off legacy is being insured by the outgoing insurer, but that’s not to say that you should go in blind.

How will your insurer react at the next renewal? In basic terms, the underwriter has no option but to provide cover for the merged practice for the rest of the year. Come renewal, however, and regardless of whether run off cover had been taken by the target firm, the insurer may be faced with an animal of a different stripe from the last renewal.

If a firm majoring in low risk work takes on a personal injury or conveyancing specialist firm, the insurer may decide that the new firm is no longer within appetite. If their underwriting criteria are now breached, will they continue to provide cover or walk away? Your broker might be able to provide some guidance pre-merger on this. Does the new firm have more offices than partners? That might influence the premium or even acceptance of the risk at renewal.

Conversely, because insurers tend to segment law firms by numbers of principals, the higher the number of principals, the more choice of insurers who might be interested in providing cover.

All this harks back to an important tenet: the proposal form should provide no surprises for the insurer. The answers on the renewal proposal form should simply back up what the underwriter already knows from disclosure during the year.

A few words on team lifts. If you see a firm failing and you want to swoop in and take a group of individuals, you will need specialist advice to maximise the chance of leaving the liability behind. It might be better to wait for the inevitable and then cherry-pick the staff and/or work. (If the firm is local, you might pick up some of the work anyway.)

Finally, a warning about “holding out”. If you give the general public the impression, however fleetingly, that you are acting like a successor practice, the regulator might find that appealingly persuasive. As stated earlier, the rules will hunt out an insured successor whenever possible. A careless phrase in a letter or a tweet, or to a business reporter for a local paper, might leave you and your hapless insurer susceptible to inheriting successor practice liabilities.

A perfectly executed merger or acquisition, where all parties benefit and where there are no latent issues, where the computer software integrates and extends reassuringly over all offices, and where the insurers involved, never at any stage wonder if they should charge a bit extra “just to be on the safe side”, may at some time over the past 15 years have actually happened. We recommend that you seek specialist legal advice to aspire to this when considering any M&A transaction.

This article was submitted to be published by Howden Group UK Limited as part of their advertising agreement with Today’s Conveyancer. The views expressed in this article are those of the submitter and not those of Today’s Conveyancer.

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