Is the Compensation Fund a luxury in times of austerity?

The Legal Services Consumer Panel has just announced, in its work programme for 2012-13, that it intends to examine the adequacy of regulators’ financial protection arrangements. This comes at a time when the SRA board is setting the levels of contribution to the fund for the coming year. Many solicitors, if the contributions are at a similar level to those demanded in 2011-12, will be asking whether the Compensation Fund is a Rolls Royce which might adequately be replaced by a Ford Focus.

Given that the Consumer Panel does not have a long history of recommending reduced levels of consumer protection, it is unlikely that its report will view current arrangements as more than adequate. It says that the capacity of financial protection regimes has “come under scrutiny in the solicitors’ profession due to unprecedented levels of claims on the Compensation Fund, escalating insurance premiums and rising numbers of businesses in financial distress”. The panel’s study will look at finding an appropriate balance of risk and will look at the experience of other sectors, including financial services.

The methodology used by the SRA to calculate contributions to the Compensation Fund, which is approved by the Legal Services Board (LSB), has been the same for the last two years. Fifty per cent of the funding comes from a fixed contribution by regulated individual solicitors and 50 per cent from a fixed contribution by firms. For 2011-12, these figures were £60 and £772, a massive increase on the previous year, when the contributions were £10 and £120. The SRA is required by statute to provide a Compensation Fund to compensate consumers who lose money because of the dishonesty or failure of solicitors. The LSB would not allow it to walk away from its obligations, even if the SRA was inclined to do so. The SRA has recently completed a review of its financial protection arrangements, including the fund, but no radical changes are expected in the way in which the current process operates.

The fund can pay out as much as £2m per claim, which is more generous than any equivalent scheme.

So, what are the current levels of claims against the fund and are things really that bad? Analysis of the claims against it is notoriously difficult, but at the end of 2011 there were 1,735 claims under investigation and the value of open claims was £226m, a rise of 16 per cent since September 2010. However, the amounts actually paid out are much less than the value of the claims; in 2011 £92.85m was claimed from the fund but only £24.69m actually paid out in respect of those claims – some 27 per cent of the total. Mortgage fraud is the largest single type of claim in financial terms and 179 new claims on the fund of this type were made in 2011.

Historic data shows that claims are always high at this stage in a recession. Nevertheless, it is clear that by any analysis the Compensation Fund is expensive and under great pressure. From the SRA’s perspective, the implications of large corporations entering the legal services market via ABS structures can only exacerbate the situation.

The financial services experience

The Consumer Panel intends to look at the financial services sector in its assessment. The Financial Services Compensation Scheme (FSCS) pays out to cover financial loss, rather than being based on dishonesty, and its maximum levels of payout vary between £50k and £85k, depending upon the type of product involved – rather less than the £2m possible under the Compensation Fund. However, financial services firms also have to comply with capital adequacy requirements. Small independent advisers (similar in size to most firms of solicitors) currently have to find £10,000 and PI cover of £1.2m, although this is set to double by 2015. Most independent financial advisers deal well with capital adequacy but are unhappy with the FSCS, which regularly asks for additional large contributions during the year. They would doubt that their grass ?was greener.

Financial protection is an expensive business and works best in times of relative stability. The legal services sector is not in a stable situation and the LSB is keen to see all manner of new business models in operation over the next few years. The twin aims of better financial protection and constant business innovation may be difficult to achieve

Perhaps a Ford Focus is sometimes ?better than a Rolls Royce.