Risk Dimensions Newsletter Issue 7: October 2022

In the latest edition of our Risk Dimensions newsletter for solicitors we focus on Environmental, Social, and Governance (ESG) issues. The recent publication of the Legal Business Risk Management Professional Indemnity Survey 2022, sponsored by Marsh, emphasises the focus of law firms on this topic, with 73% of respondents saying that ESG is now firmly part of their firm’s risk management agenda. John Kunzler from Marsh’s Risk and Error Management team discusses conflict of interest and ESG for law firms focussing on the struggles firms face in terms of processes and controls to guard against the types of conflict failures more recently observed. There is also an article from Dr David Kelly, Climate Resilience Lead and ESG Specialist at Marsh Advisory UK, considering how firms can approach ESG and develop a strategy that is reflective of their business and ambition, taking into account the challenges firms face.

Conflict of interest and ESG (environmental, social, and governance) for law firms

Authors: John Kunzler, Marsh

The ESG agenda and the increasingly wide requirement that businesses have enterprise risk management (ERM) frameworks combine to create significant opportunity for professional advisers, (including law firms) to advise businesses on legal requirements and implications. However, a focus on ESG also brings with it significant challenges and risks to be considered, including the following:

Law firms may be expected to identify their own ESG risks and/or (depending on their instructions) failings in ERM approaches by clients, especially for regulated clients.
Governance of law firms themselves is likely to be examined. The expectation that auditable processes exist, and can be demonstrated as embedded and working, and create assurance and action where necessary, all combine to create significant administrative burdens.

Critical internal processes that law firms operate include identification and management of conflict of own and client interests, and ensuring independence. Our 2021 and 2022 law firm surveys with Legal Business suggest firms are becoming less concerned about this risk than they were in 2021:

Mean score out of 5 and ranking out of 27	Impact on scale of 1 (low) to 5 (high) /ranking		Likelihood on scale of 1 (low) to 5 (high) /ranking
	2021	2022	2021	2022
Acting where there is a conflict of interest	3.4 / 6^th of 27	2.6 / 13^th of 28	2/ 23^rd of 27	1.4/ 17^th of 28

It seems that many firms consider the risk of acting where there is a conflict of interest as a significant risk to their business with a lower likelihood but higher severity. Our view of the claim experience suggests the risk impact is high, and likelihood does not seem to be decreasing.

An ERM approach might well be to seek evidence that the current controls provide assurance that the risk is managed to the accepted risk appetite. At Marsh, our Risk and Error Management Team invest considerable time and effort in reviewing claims with a view to reducing their incidence. Over the last 10 years we believe we have detected a pattern relating to conflict of interest between clients and independence, particularly in commercial transactions. The severity of this risk is such that firms may wish to review their processes and controls against the general types of failures seen, which are discussed below.

The pattern of failure in management of conflict of interest is not new, and claims are not high frequency, but often generate severe losses. We have also noticed that conflict of interest is generally well handled at the identification stage, but often it is ongoing review of the conflict, when focus is on the transaction, that goes awry. The quote below from 2002 explains this well:

“As new parties in the matter appear, and as the interests of the client, attorneys, and the firm change, the potential for conflicts of interest must be addressed again. This continuing need to address potential conflicts of interest is manifested in all types of representation, litigation or transactional.”

_{Fortney, Susan Saab and Hanna, Jett,” Fortifying a Law Firm's Ethical Infrastructure: Avoiding Legal Malpractice Claims Based on Conflicts of Interest” (October 16, 2002). St. Mary's Law Journal, Vol. 33, No. 4, 2002. Available at SSRN:}_{https://ssrn.com/abstract=1490171}

The conflict of interest process is deceptively simple, but it displays persistent areas of weakness which often surface in claims of significant value.

Pattern/common themes

Partner in charge of matter is longstanding at the firm and senior, often generating sizeable income and is subject to little oversight.

The scenario is often sale of a private family business or a significant investment driven by a founder/entrepreneur.

Client is longstanding and valued, and there is significant reluctance to send them elsewhere.

Client has a high degree of control over the actions of the companies involved, often a quasi-partnership.

Individuals are involved in various capacities e.g. director, individual, or trustee.

Record keeping and justification for the decision about conflict is often absent.

Partner independence is eroded by client relationship and commerciality.

Seniority and actual and claimed expertise may deflect or suppress questioning in this area.

The necessity for ongoing review is overlooked or is cursory and unrecorded

There is rarely directly unethical behaviour. The influence of the client and the partner on the firm’s approach and the independence of the conflict process creates an environment where the process of ongoing independent review does not occur.

Some firms have no procedures at all, but even for those that do, when a significant piece of work and a longstanding client combine with a senior figure in the firm, conflict procedures sometimes get sidelined:

The clouds in the diagram represent the lack of clarity introduced, and overall influence that the client and conducting partner can have, on the conflict process. Over the past three to four years, we have seen a number of such scenarios, ending up as significant claims.

Perhaps most tellingly, few solicitors would advise a client (for example a client who was a Trustee or Company Director) to attempt to exercise a discretion or make an independent decision, in the scenario in which the partner conducting a matter often finds themselves. From a regulatory perspective almost all the Principles the Solicitors Regulations Authority (SRA) expect to be upheld, can appear compromised: “The SRA Principles comprise the fundamental tenets of ethical behaviour that we expect all those that we regulate to uphold.

in a way that upholds the constitutional principle of the rule of law, and the proper administration of justice.
in a way that upholds public trust and confidence in the solicitors' profession and in legal services provided by authorised persons.
with independence.
with honesty.
with integrity.
in a way that encourages equality, diversity and inclusion.
in the best interests of each client.”

The outcomes from these situations are severe and difficult for firms to manage.

Potential Outcomes
The claims which develop are large and painful for the firm to manage.	Claims are commonly £1 million+.
Reputation can suffer.	Given the exercise of judgement and ethics are involved, inevitably there is reputational risk to the firm.
The firm’s Governance is questioned.	What processes exist to prevent this known risk?
Internal culture is re-assessed.	Internal doubt about the professionalism of senior members of the firm may create a credibility gap, as the culture exposed internally and potentially externally is at odds with the messaging of assurance/high ethical standards.

Independence and integrity are crucial elements supporting the social licence that solicitors hold to act as agents of clients. While conflict scenarios are not generally driving up claims frequency, in our view those that feature in claims follow familiar patterns. The scenarios may even be occurring relatively often, however if the client and the other party to the commercial contract both view the transaction as successful, such judgements never come into question.

Now more than ever, and knowing how these situations emerge, good governance as well as regulations require that lessons are learned and firms guard against this risk – so what can firms realistically do?

Key actions to consider:

Establish a conflict process which captures all identified conflicts, and their ongoing management.
Create a rolling register of conflicts, identify who is overseeing them and ensure all ongoing matters are reviewed every quarter at least.
Appoint an independent conflict manager (potentially the COLP [Compliance Officer for Legal Practice]) to monitor ongoing cases which have been identified, but where a decision to continue acting has been taken.
Appoint a conflict committee (potentially three standing members such as the senior partner and COLP/COFA (Compliance Officer for Finance and Administration) and two floating members) to make the decisions.
Consider a materiality threshold which results in continuing independent review (perhaps the top 5% or 10 % of matters by value) where:
- a potential conflict has been identified and
- the firm is continuing to act (this is unlikely to involve many cases a year).

The required steps are not significant in themselves, and the frequency with which conflicts arise is likely to correspond to the size of the firm and its work area. This should not require additional resources to manage. Small firms might not be able to create structures to manage these concerns independently, but could bear in mind the risk features identified and discuss with SRA ethics helpline on an ongoing basis.

In larger firms sometimes resourcing is not the issue, but instead politics and power play a part as such procedures impinge on the ability to exercise sole and independent judgement, which some will find uncomfortable.

Clearly good governance and regulations require independence to be maintained and bias, or the appearance of bias has to be avoided at all costs in exercising ethical judgement. Law firms and solicitors need to be trusted to operate similar standards to those which they would advise clients to adopt. While that has always been the case, the good governance agenda, and the known claims suggest that an auditable process is required to create assurance to a greater degree than in the past. Apart from a review procedure and a register, suggested actions are as follows:

DO	DON’T
Review existing cases for emerging conflicts and changes in retainer.	Treat conflict as a one-time decision.
Engage in peer or challenge team review on these and other issues for at least 30 minutes a week.	Work in silos at partner level.
Raise awareness of this kind of risk and promote partners discussion of conflict scenarios.	Ignore partners who keep themselves to themselves.
Check actual knowledge of conflicts around the firm and update where necessary.	Think conflict rules are simple and well understood, or that the effort to operate procedures outweighs the risk of getting a conflict decision wrong.

Making ESG work for your firm

Authors: Dr. David Kelly, Marsh

The Risk Management and Professional Indemnity Survey 2022 illustrates that awareness of environmental, social, and corporate governance (ESG) principles exists within the legal profession, and that there is an appetite to increase engagement with ESG within firms and with respect to clients.

Define your ESG approach and strategy

With knowledge and integration of ESG gathering pace, it’s important to reflect upon its definition and purpose. ESG is a measure of the sustainability and resilience of an organisation in the face of a spectrum of risks that can emerge due to environmental, regulatory, or market pressures.

Consequently, when considering how to approach ESG and develop a strategy that is reflective of your business and ambition, it’s important to have visibility on what is material to your business today and in the future, including the risks that could emerge and affect operations and reputation. It’s also important to consider what working environment and culture you want to provide for staff, and how this will be perceived by the public, clients, and stakeholders.

As with the development of any business strategy, and as a prerequisite for successful integration, the involvement of staff across all areas is a positive approach to setting long-term ambitions and ESG policy. Individuals use their own morals and ethics to make informed decisions on every aspect of their lives. Businesses that can reflect a similar and visible approach to strategies governing their activity are more likely to derive positive outcomes in relation to staff retention, recruitment, and reputation.

Overcoming challenges in your journey

When embarking on your ESG journey, challenges may include which framework to follow, what metrics to measure, how to measure them, and what and when to disclose relevant information. You may also be challenged by ‘what does good look like’ within your sector, and for organisations of a similar size and operation. Over the years, different ESG frameworks and reporting mechanisms have evolved, allowing ESG to become established within the business community. Arguably, there has been a lack of consistency in the application of these various frameworks, which has led to some uncertainty in the data being reported, its accuracy, and its transferability across sectors.

In September 2020, the World Economic Forum (WEF) published its white paper, Measuring Stakeholder Capitalism, which sought to establish a framework for the identification and assessment of ESG that aligned with existing business reporting standards. The WEF identified 18 themes across the ESG spectrum, each containing a number of reporting/disclosure requirements. This provided a mechanism for accurately and consistently measuring and reporting against ESG targets. The WEF’s approach has proven to be relevant across all industry sectors and has formed the backbone of Marsh’s ESG Risk Rating tool.

So where to start? Before jumping headlong into the development of an ESG strategy, it can be useful to understand how your organisation’s current policies and procedures align with WEF thematic areas, for example. This measure of your current positioning will undoubtedly identify areas of strength and weakness, and is useful information to help shape your ESG strategy. However, this in itself is not enough. Consideration should also be given to internal and external factors. Internal factors could include ambition to grow and/or retain the team, staff motivation and support for ESG, diversity and inclusion policies, and staff promotion and incentives. How are these represented on the current appraisal of ESG and how material are they to the organisation going forward? Similarly, external factors that could influence the approach to ESG are: pressures emerging through the supply chain or from customers, the need for investment or finance in future years, the reputation of the organisation, and requests from shareholders or stakeholders.

Make ESG strategy core to your organisation

Crucially, the ESG strategy needs to sit at the heart of your organisation. It should not be a side-of-desk project or the sole responsibility of a sub-committee or individual. It will be increasingly important for an organisation to demonstrate how ESG touches on every aspect of its business. This includes procurement and how you communicate your ESG ambition through your supply chain.

You should challenge your supply chains to provide support in meeting ESG objectives, in turn influencing other businesses to adopt ESG approaches, and causing a ripple effect across industries. Organisations that can surround themselves with a supply chain that is collaborative and supportive are on the path to ESG success. Consequently, early, frequent, and consistent communication across the supply chain is important.

You should take a sense of pride in stating your ambition and the need for your supply chain’s support. This provides a great foundation for innovation in the delivery of products and services — protecting your business and identifying early indicators within the market.

The importance of data and metrics

Finally, data is critical. Give credibility to your ESG strategy by stating what you will measure, why it’s important to measure, and what metrics you will use. Organisations that are unsure of what data and metrics are relevant to them can seek assistance or look across the market to learn from peers. Avoid, however, a copy-and-paste approach to this. Data relevant to one organisation may not be suitable for another — even if in the same sector.

Align your data gathering requirements with your current position, level of ambition, and mandatory requirements. Look at what you are measuring today — do you need to do more? Don’t be afraid to publish your metrics externally — your ESG journey will take time and improvement should be consistent and credible, supported by a detailed strategy and robust data. It’s more of a marathon than a sprint.

Marsh is well-placed to support clients with their ESG strategy efforts — ask your usual contact if you want to know more about how we can help.

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Risk Dimensions Newsletter Issue 7: October 2022