The Solicitors Regulation Authority has warned of the increasing threat of ‘group contagion’ as struggling firms in a group structure hinder the entire business.
In a report to the regulator’s Risk Outlook, the SRA said the trend was relatively new to the legal services market but is increasingly seen as a problem for complicated group structures.
The report noted two types of contagion: direct contagion involving a financial shock to one firm in the group spreading to the rest of the group through direct financial links, and indirect contagion, where outsiders respond to an event causing a knock-on effect to the rest of the group.
‘Firms that are part of a group will need to control their exposure to this risk,’ said the report. ‘The primary defence against contagion is for individual firms within a group to have adequate financial and reputational risk management processes so as to prevent or mitigate shocks that could spread through the overall business.
The creation of ‘firewalls’ between firms in a group is a common control for this risk, particularly where the contagion is direct.
‘However, where branding is common throughout the group, a firewall will not be effective against indirect contagion.’
The SRA said it was most concerned about the potential for group contagion with conglomerate and larger corporate structures.
The regulator said problems could exist in alternative business structures, chains of firms linked through a marketing hub or corporate structures involving one or more holding companies.
The report said group contagion can cause financial loss and increase the threat of disorderly closure or misuse of client money.
It added that if firms want to gain the benefits of a single identifiable brand, the possibility of indirect contagion must be controlled and subsidiary companies dropped if the risk is too great.
The SRA added that it did not wish to inhibit law firms from making use of different types of business structure, but warned of the risk of excessive complexity being used to reduce transparency between the firm and its clients and regulator.