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September 15, 2008

Experts warn integration of firms heightens liability risk

As the Big Four reveal plans to integrate or more closely align member firms, insurance and litigation experts warn that presenting networks of firms as a single entity in pursuit of commercial benefits also carries with it enhanced litigation risk.

This year, Ernst & Young announced plans to integrate 87 firms in Europe, the Middle East, India and Africa into a single business unit. KPMG Europe is now comprised of UK, German, Swiss and Spanish firms. Recently, PricewaterhouseCoopers re-structured its network, aligning firms into regional clusters. Deloitte, too, has clusters in Latin America, Southeast Asia and the Caribbean.

Though the nature and level of integration within these networks varies, clarity is needed on the true relationship between member firms, according to Jane Howard, a partner at London law firm Reynolds Porter Chamberlain.

“If people are branding themselves under a common name and offering a global service, they need to ensure that adequate global standards and quality control regimes are in place to effectively manage the risks,” she said.

“Common quality control can, however, be double edged. It will be used by plaintiff lawyers, as in Parmalat and other cases, to argue that one firm should be responsible for the acts and defaults of another firm even in circumstances where, in reality, the quality control is fairly superficial and the firms are in fact independent.”

Howard, whose firm has been involved in a number of high profile liability cases, warns the more integrated a network becomes the greater the threat of vicarious liability claims.

Anthony Calder-Smith, a UK executive director of insurance company Aon, said the recent integration moves by the Big Four will heighten the risk of vicarious liability.

“The firms, I am fairly sure, will maintain individuality to the extent they are able to and, from a legal perspective, entities will remain local.

“But I think any move towards centralisation of risk controls, systems and finances of any sorts will bring with it a risk of vicarious liability,” he said.

Managing the threat

E&Y said the integration of its firms into regional units will allow it to better manage risk, off-setting the threat of vicarious liability. This is a point that Calder-Smith agrees.

“I think the market will see that there is a bit of a downside to this in return for an awful lot of good upside, which is an improvement in the risk management systems,” he said.

The threat of vicarious liability is polarising the profession between those global entities that wish to be known as networks or even partnerships and those that wish to be defined as associations or alliances of independent firms.

Smaller associations are becoming risk adverse and dismantling key network characteristics in order to help reduce not only the threat of liabilities passing but also the regulatory burdens inherent in ‘network’ status. For example, some associations have asked member firms to remove common branding and are outsourcing quality control measures to regulators and independent third parties.

“They are trying to avoid enhanced liability because they recognise that they haven’t got the resources or aren’t sufficiently integrated to be able to deliver the quality control that global branding might suggest at this point in time,” Howard said.

Clarity is key

Firms that belong to mid-tier networks are sometimes stuck in the middle, trying to market themselves as members of bona fide networks while remaining independent.

Howard said it is important these firms make it clear they are truly independent and incorporate this message into contractual arrangements with clients. ‘Sole recourse’ clauses are becoming more common and a legal safeguard.

“These require the client to agree that in the event of the claim it will only sue the local firm and that it recognises that other network firms and umbrella organisation aren’t responsible,” Howard said. “Whilst these clauses haven’t been tested in court, such contractual protections give some comfort.”

There is little doubt the integration/re-structure trend is here to stay. Major networks believe it makes a lot of commercial sense to more closely align the operations of firms and leverage the power of a global brand. Equally, wily claimant lawyers are waiting in the wings. As firms come closer together, opportunities will develop for lawyers to link the pockets of wealthier partners to the hands of smaller ones. The key will be the ability of networks to manage the liability risk.

What lawyers look for

Jane Howard, a defence lawyer who regularly advises ‘networks’ and international associations on liability issues, reveals a list of factors that plaintiff lawyers seek to demonstrate that ‘umbrella’ organisations and other member firms should share responsibility for the actions of a culpable local member firm.

• Overlapping executives at senior level between local firm and umbrella organisation;

• Sharing of common office space between local firms and umbrella organisation;

• Regular cross-checking of one another’s work/common system of quality control;

• Sharing common audit methodologies and manuals;

• Sharing of a common name or logo, particularly when an audit report is signed off in the name of the global umbrella organisation;

• Network wide marketing as a single entity;

• Reporting member firms’ revenues on a combined basis;

• Allegations of profit sharing between members (perhaps arising from referral fee arrangements).

Source: Jane Howard, Reynolds Porter Chamberlain

Integration does not equal higher cost

Closer integration within accountancy networks is likely to increase the risk of vicarious liability but it should have minimal affect on insurance.

Aon UK executive director Anthony Calder-Smith said the cost or availability of insurance is not closely linked to quality and risk management, or to the potential liability due to integration.

“Unless there are truly dramatic changes to the risk profile of a firm it is a consideration as to whether you would want to insure a firm or not but it is not really a consideration in the actual value of the insurance policy, the cost of the insurance,” he said.

“The cost of insurance is really to do with the willingness of markets to write this business because it is a complex and high risk business in the first place. It is to do with evidence of profitability at current rated premiums, which is really the last ten or 15 years of losses. So, this will only have an impact on price if in five or six years’ time we can find evidence that [integration] had an impact on losses.”

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