Mergers: risk or opportunity for law firms in 2015?

The Law Society Gazette reported in 2014 that: “At the top end, consolidation is a key priority with 42 per cent of the top-50 firms considering a merger to be very or fairly likely by 2016”.

As commercial clients innovate, shrink their legal panels and search for law firms offering a full service for less, the competition to retain and win legal services work has become increasingly fierce. Consolidation of law firms to pool expertise and market share through merger has been one response in recent years. The trend is slowing but is consolidation still a good idea for the law firms and their PII insurers going forward?

Firms’ perspective

The SRA believes that effective mergers can, with careful management, due diligence and planning, lead to innovative and more efficient business models and, in the long-term, contribute to a less fragmented legal services market.

For the largest UK firms, merger is an opportunity to extend their footprint in key and emerging international markets. For mid-tier firms, merger can be a short-cut to geographic and practice area expansion in UK (with perhaps a foothold overseas); a greater economy of scale to enable more work to be done for less. For smaller firms, merger can achieve a diversification of practice that encourages growth where certain practice areas are no longer attractive. It can also ward away the threat of insolvency. In its 2014 annual report, PwC cites consolidation/merger and the recovery of the economy as the key factors in UK law firms’ recent return to financial health.

However, in embracing the possible benefit of merger there must also be a recognition that a poorly executed merger is a key driver of risk. It can compound existing financial difficulties, produce a clash of cultural differences leading to instability, give rise to greater instances of commercial conflicts of interest and create challenges in adapting systems and controls to suit the new risk profile of the firm. Undoubtedly a lack of proper due diligence is a problem. This seems particularly so among the larger firms that might hastily enter into a merger under the pressure of trying to make up “lost ground” as the economy begins to get back on track.

Insurers’ perspective

Can consolidation lead to a bigger and better quality risk for insurers? Certainly there can be an increased premium income for the insurer that retains the business of the emerging firm, and in circumstances where 19 mergers took place last year among just the top 100 firms, there is the opportunity via mergers to seize a greater slice of the upper mid-tier and top-tier market.

However, a merged firm is a rather different animal to that of its predecessors and presents a new risk for insurers on renewal – with the possibility of upsetting of an otherwise long and happy relationship, and the need for greater focus on carrying out good due diligence. Careless or hasty investigation of the new firm can underplay or fail to uncover the nature and extent of a poor claims record of one of the predecessor firms or of the real potential for further claims.

Against this background, it is unsurprising that insurers are increasingly taking an active interest in their insureds’ proposed mergers, and their involvement is being sought much earlier in the process. Insurers’ views can be an important ingredient in determining whether the merger goes ahead.

An obligation to remain bound by the operation of the Minimum Terms and Conditions (MTC) means that insurers have to tread carefully in carrying a merged firm into its first full policy year. A poor claims history for one of the component firms can generally be addressed pragmatically, for example by applying a higher policy excess for claims arising from a particular component prior to the merger. Run-off cover for one or both of the predecessor firms is an alternative to avoid having to seek cover for predecessor liabilities of the merged firm, though this can be prohibitively expensive.

A potential situation also arises in the year of merger itself. That is “double insurance” by two or more insurers of the prior practices. The MTC suggest that the insurance may provide that the contribution is determined in accordance with the relative numbers of principals of the owners of the constituent firms immediately prior to succession. An alternative point of reference might be each prior firm’s turnover.

Conclusions

Mergers are now part of the legal services landscape. This is unlikely to change in the near future since few firms have the time and resources to build their empires from scratch, even if the trend appears to be slowing. However, to merge without thought, too quickly or without undertaking proper due diligence can undermine an otherwise solid practice and present risks and uncertainties for both the law firms and their insurers – the sum of the merged firm might not be greater than its constituent parts.