October 23, 2012

RISK MANAGEMENT: A Systematic Approach for Law Firms

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July/August 2010 Issue | Volume 36 Number 4 | Page 46


RISK MANAGEMENT: A Systematic Approach for Law Firms

Many of the factors involved in law firm risk management are reasonably obvious. However, some of what is reasonably obvious may, on reflection, be contrary to the perceived self-interests of individual lawyers. Taking a structured approach to risk management helps overcome the self-interests, makes for better risk mitigation and leads to a more productive, profitable firm.

Not all risks are of equal concern in law firms. Some risks are very common and relatively insignificant. Some are rare but have a huge impact when they occur. Other risks may be rare but also inconsequential. When underwriting insurance policies, insurers distinguish between risks that are “frequent” and risks that are “severe.” Firms that seek to properly approach risk management should likewise assess their different relevant types of risk so they can understand what strategies to implement in response.

Ultimately, there are a range of ways that a firm’s risks may be mitigated. For example, work in some areas of the law can be avoided, preventative procedures can be established, and education or training can help. Mitigation measures will be of varying effectiveness and cost, and some measures may have unintended consequences, whether for the better or worse. Given all these factors, there is scope for creativity and need for a pragmatic assessment.

Invariably, though, looking at the source of a risk is key to understanding and mitigating that risk. For law firms, the two principal sources of risk are the firm’s clients and the firm’s lawyers—and, not coincidentally, these sources are also a firm’s principal assets. The risks associated with these sources can be further subdivided, so let’s begin there.

Risks Associated with Clients

Essentially, the risks associated with clients fall into four categories: claims, departures, credit and conflicts. Let’s look at each, noting that these categories overlap to an extent.

• Claims risk. All law firms face the risk that clients will assert professional negligence or fiduciary duty claims seeking compensation. Lawyers also face the risk of client complaints to their regulators. The consequences can be direct or indirect. The law firm may be obliged to pay an award of damages and can suffer other litigation costs, and its future insurance costs may be affected as well. Indirect consequences can include damage to the firm’s reputation and morale.

Clients are also a source of claims risks from another perspective. One of the two principal sources of major claims is said to be “dangerous clients.” In fact, upon an examination of major (i.e., severe) claims against law firms, there is a significant association between major claims and situations in which “dangerous” clients face legal scrutiny relating to matters with which their lawyers assisted. These types of claims often fall in the high severity category—not so common but very ugly when they occur.

• Departure risk. While not usually considered a part of law firm risk management, the risk that a good client will leave can be quite important in terms of revenue, reputation and the professional cohesion of the firm. But beyond that, this risk is tightly connected with claims risks, since dissatisfied clients are more likely to leave and more likely to make claims.

• Credit risk. This is closely related to the first two categories of client risks. Dissatisfied or unhappy clients are much less likely to pay their bills, and some will also depart as well as make claims against their lawyers. So-called dangerous clients add another aspect to this problem as well. Just as dangerous clients are a greater source of claims risk, they also present a greater risk of nonpayment to the firm.

• Conflicts risk. This is perhaps the most common risk associated with clients. Whether it comes down to a matter of legal conflicts or simply business reality, the fact is that every client carries the risk that acting for that client means another prospective retainer is not available to the firm.

Risks Associated with Lawyers

Current lawyers, arriving lawyers and departing lawyers are all potentially sources of risk for their firms. Not surprisingly, lawyer and client risks are closely connected, being essentially flip sides of the same coin.

• Current lawyers. Even the most experienced lawyers can present performance risks, since all lawyers sometimes fail to practice at the level required. Sometimes we are too busy or not well organized. Other times we act outside of our area of expertise or experience. Some lawyers simply prefer to do everything themselves rather than delegate or refer work to other, more appropriate lawyers. Current lawyers can also pose misconduct risks. While less common than performance failures, some lawyers act improperly. Sometimes it is an injudicious response to stress or the opportunity of “the moment.” Other times misconduct is a matter of character. It is not uncommon for the risk associated with a dangerous client to be magnified by the involvement of a lawyer who does not have the strength of character to “do the right thing.”

In addition, current lawyers are the source of conflicts risks, especially lawyers who wear “multiple hats,” such as holding a director, trustee, executor or other fiduciary role, or who have a direct or indirect personal interest in the matter at hand.

• Arriving lawyers. Lawyers who are newly arrived carry two principal risks. The first is that the new lawyer may not be what he or she appears to be in terms of character or expertise. Also, some lawyers leave their previous firms for reasons that are not self-evident, and the reason for that departure may have consequences for the new firm. Plus, arriving lawyers bear conflicts risks as well—specifically, the risk that the new lawyer’s presence may interfere with the firm’s ability to continue acting for an existing client or in an existing matter.

• Departing lawyers. Lawyer departures create two main risks. The first involves the loss of a valuable lawyer, including the potential that gaps in expertise may be created by the departure and that client relationships may suffer. The second is the potential compromise of confidential client and firm information and property.

Risk Mitigation Strategies

How can firms mitigate the various types of risk just discussed? Here are client-focused and lawyer-focused strategies to consider.

• Client-focus ED mitigation. Strategic client management is invaluable in reducing a variety of risks. It is critical, however, that the firm acts as a whole in this process. Unfortunately, some firms still continue to operate as a collection of solo practitioners rather than as a cohesive entity. While that mind-set raises other broad strategic issues, it definitely contributes to client risks and must be overcome for effective mitigation.

To begin, the firm should be involved in deciding which clients and matters to take on to make it possible to consider the various current and future implications for the firm as a business entity. In other words, acting as a firm permits deliberate choice as to the best work to take on, versus just taking whatever walks through the door—the usual result of an individual making the choice. Acting as a firm also permits more dispassionate consideration of the legal conflicts that may arise and the type and character of the prospective client. For whatever reason, individual lawyers find it harder to say no, when sometimes saying no is the best answer.

In addition, firm-oriented intake helps ensure that proper retainer letters are required for all new clients and matters, and that client conflicts are better managed with proper disclosure and agreement at the outset. Clear identification of the scope of the matter at the outset and over the course of the representation mitigates performance risks as well. Of course, acting as a firm in this regard can be difficult. It is necessary that the people making the decisions are properly informed, motivated and trusted by others to act in the best interests of the firm. When this doesn’t happen, lawyers are simply sharing space.

Client teams can also reduce performance risk by delivering more breadth of experience and expertise to a given client. Client teams also reduce the risk that individual lawyers will be beholden to or “captured” by a difficult client. Moreover, they increase the odds that client concerns will be recognized and dealt with positively before it is too late. Plus, client teams decrease the risks attendant on the departure of any one lawyer.

Communication between the client and firm, rather than just the lawyers involved, can likewise mitigate risk. Client audits by a representative of the firm, for example, can help uncover issues that clients might not want to raise with the lawyers concerned. Such audits also allow clients to advise what the law firm is doing right and, if asked, how the firm may assist the client in other areas.

Lastly, proper financial management mitigates risk. While it is clearly important that the firm get paid, vigilance with respect to accounts receivable and work-in-progress can also surface client dissatisfaction before it is too late. It can also provide evidence that a client is under financial stress, which can lead to “dangerous client” behavior.

• Lawyer-focus ED mitigation. Obviously, continuing professional development and training is important in mitigating performance risks. However, this needs to involve more than keeping up-to-date on legal developments. It should cover practice management and professional responsibility, too. In firms with internal professional development programs, encouragement of legal excellence and intellectual interest in the law further mitigates performance risks—and it can mitigate departure risk by increasing collegiality and professional satisfaction.

For incoming lawyers, proper diligence in interviewing, reference and background checking, and the candidate selection processes can mitigate the risk of making a bad hire. This is more important than it sometimes appears, since the risk of an unsuccessful lateral hire is significant and the direct and indirect costs can be significant, too.

For departing lawyers, proper procedures and protocols for protection of client and firm confidential information and property and the proper transfer of client files are critical. In addition, diligent and thoughtful exit interviews can mitigate the risk of subsequent departures by giving the firm a better understanding of internal problems.

Policies and Systems

Along with the client-focused and lawyer-focused strategies just discussed, having proper errors and omission insurance is, of course, a very important aspect of risk mitigation. Coverage needs to be properly assessed in terms of both the scope and quantity appropriate for the firm. The nature and attitude of the insurer may also be important when it comes to claims processing.

In addition, proper internal reporting of claims and potential claims helps preserve insurance coverage. At the same time, it facilitates proactive approaches to identified claims risks, and it allows for proper disclosure to the client when a potential problem is identified. The internal culture should be that the greater sin is in failing to report and seek help.

There are also various firm policies and systems that are critical in risk management—and once they are implemented, they can result in lower insurance costs as well. Here are key ones:

• Standard policies with respect to audit inquiries, client confidentiality, conflicts, opinions and retainer letters

• An up-to-date conflicts database and proper conflicts searching procedures, which extends to the new entities that become involved during the course of a matter, whether as clients or adverse parties

• A system for properly screening confidential client information and clearing conflicts on a confidential basis

• The involvement of “un-conflicted” experienced lawyers to manage and clear conflicts, which also mitigates the risk of “tainting“ the lawyer doing the client work

As noted at the outset, most of what has been discussed here should be entirely self-evident to law firms. And many of the topics mentioned could be the subject of much further and deeper discussion. However, the essential point is that a structured approach to identifying the sources of risk and the corresponding mitigation strategies leads to better risk management and the prevention of claims.

About the Author

Malcolm M. Mercer is a partner and General Counsel at McCarthy Tétrault in Toronto, ONT.