Legal issues for law firm M&As Deal types and navigating the issues that arise

The Solicitors Regulation Authority (SRA) has oversight of law firm mergers and acquisitions. It is necessary to notify the SRA of all sales and purchases. In addition, certain mergers of law firms require more formal SRA approval, which can take several months to obtain.

SRA approval requires extensive input from buyers and sellers alike, and timescales should be accounted for at the initial stages of deal preparation.

Buyers and sellers should take note of two situations in particular where SRA approval is required and where they can expect intense regulatory scrutiny:

• Where the merger of two law firms is effected through a share purchase, approval is required regardless of whether both firms already have SRA authorisation. The regulator will want to assess the new ownership structure and, in particular, approve future mangers and compliance officers
• Alternative Business Structures (ABS) – where non-lawyers will own the new firm, or be involved in its management, regulatory approval is more complex. This is particularly relevant where private equity investment plays a part in the deal. A separate approval application must be made to the SRA – a process that can take 4-6 months. Buyers and sellers must provide detailed financial forecasts and business plans for the ABS as well as carry out a detailed risk analysis. In addition, new owners must satisfy the SRA’s detailed Assessment of Character and Suitability Rules.

In recent years, the SRA has been forced to take regulatory action against law firms with increasing regularity. High profile cases of missing client money and consumer harm arising from poor performance by law firms mean that protecting clients’ interests is firmly on the SRA’s radar. For merging firms, this has significant consequences.

The SRA is clear that, in law firm M&As, client files must not be treated as a commodity. Clients of law firms are not, from the regulator’s perspective, assets in the traditional sense. During due diligence, the parties should ensure that client interests are the primary consideration. A failure to protect interests as required can result in significant and reputationally damaging regulatory sanctions.

In addition, sellers must obtain properly informed consent from individual clients for the transfer of files to the new entity, and clients should be given options to find alternative solicitors if they wish. This can be managed so as not to be unduly disruptive, but careful planning is needed not to damage goodwill.

Post completion, urgent client matters must be addressed swiftly so that any case deadlines are met. Of course, buyers will be aware that protecting the interests of existing clients is an opportunity to foster good and profitable relationships with clients over the long term.

An exhaustive investigation into the complaints history of the target firm must be carried out as part of the due diligence process. The Legal Ombudsman has the authority to hold buyers responsible for historic complaints even though the complained-of-conduct occurred pre-sale and was not linked in any way to advice given by the buyer firm.

Buyers should, therefore, analyse historical complaints and establish if there may be future liability arising from any unresolved complaints. Where there are ongoing complaints that have reached the Legal Ombudsman, or are being handled by the target entity’s professional indemnity insurers, the level of risk associated with these claims should be carefully assessed.

Deal price (or the deals for equity partners post deal) and the extent of any indemnities required from the seller will depend on the risk exposure linked to any outstanding or potential complaints. For sellers, there is always a risk that significant historical liabilities or existing complaints could undermine the deal entirely. At an early stage, therefore, buyers should carry out an audit of complaints and close those it can as early as possible. Buyers will expect to see complaints handling policies in place and will seek warranties and indemnities against future liability where appropriate.

Any sale or purchase of a law firm must comply with all relevant TUPE requirements. These include consulting existing staff and maintaining existing working terms and conditions. Sellers must also supply the buyer with detailed staff records, including details of any disciplinary matters.

In addition to TUPE compliance matters, complexities may arise in law firm mergers depending on how the target entity is legally structured.  Like many professional services firms, law firms are often run as partnerships, limited liability partnerships, or limited companies.

On the sale of a business, questions may arise around obtaining consent to the transaction from equity partners, for example. In addition, the buyer will want to know the extent of any restrictive covenants that are in place to prevent departing partners or senior staff taking clients with them.

Finally, with senior, specialist solicitors in high demand, the buyer should, early on in the deal process, address how to retain key staff, particularly those with a large client following.

SRA rules prohibit law firms from acting for two or more clients where there is a conflict, or significant risk of conflict, regarding a matter or even a specific aspect of a matter. These tightly drawn regulations are rigorously enforced and must always be considered when law firms merge.

Buyers will need some degree of access to client details and current cases to gauge the potential for conflicts. This may be to establish whether the merged entity might end up acting for both sides in a particular dispute, for example, or to understand whether the merger could mean the new firm has access to information that could have a negative impact on an existing client.

Where conflicts are discovered, it is up to the buyers and sellers to establish how these are to be managed, and whether, in fact, the new firm can continue to act in a particular matter.

The due diligence process around conflict of interest itself presents another possible issue concerning client confidentiality. Great care must be taken by the seller when deciding the precise nature of existing client/case information to provide to the buyer. SRA rules mean that, in principle, client information cannot be disclosed to a third party, including a potential acquirer of the business, without getting the client’s consent. This process of getting individual consent from multiple clients can be expensive and time consuming, and it should be factored into the deal timetable.

It is important to make clear that, even where there are strong reasons justifying a merger, deals may ultimately fail if the acquirer and target firm are not a good cultural match. It is imperative, therefore, that both parties are open about their motivations for embarking on the deal in the first place, are clear about their working practices, and explain their approach to decision making and shouldering risk during day to day operations.

Anyone thinking of buying or selling a legal practice in the UK should recognise the investment in time and money the process will take. Even where both sides are highly motivated to complete the deal, and there has been a realistic valuation of the target entity, the process can take up to nine months or more.

We have highlighted a selection of the legal issues buyers and sellers of law practices in the UK need to be aware of. Other matters to consider include assessing compliance with strict client money and accounts rules, UK GDPR, viability of IT processes and systems, and dealing with any commercial real estate owned by the target firm.

At DMH Stallard, our solicitors in all commercial practice areas work as a team to support your M&A transaction. 

For an initial conversation please get in touch.