Legal Services Review - Report

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Report of the Review of the Regulatory Framework for Legal Services in England and Wales

Appendix 3

Ernst & Young LLP
1 More London Place
London
SE1 2AF

December 2004

Sir David Clementi
Review of the Regulatory Framework for Legal Services in England and Wales
2nd Floor, Selborne House
54-60 Victoria Street
London SW1E 6QW

Dear Sir David
Report on our work for the Review of the Regulatory Framework for Legal Services in England and Wales
We are delighted to present this report which summarises our work for the Review.

You were appointed to undertake an independent review of the regulation of legal services in England and Wales.

In order to assess the various options, you needed to assess not only the qualitative advantages and disadvantages of each but also the financial implications of each.

You appointed us to help you assess the costs of the current regulatory framework; as well as the possible costs under each alternative model. We performed this assignment in accordance with the detailed scope of work we agreed with you. Our report is set out as follows:-

Section
1   Scope of our work
2   Limitations of our work
3   Summary of our findings

Yours sincerely

Ernst & Young LLP

Section 1: Scope of our work

We were engaged by the Review Team to undertake financial data collection and analysis to aid the Team in their assessment of the various model options put forward in the Review's Consultation Paper dated March 2004. Our aim was to enable the Team to have a clearer view on the financial implications of each model.

Our work was organised into two phases, as discussed below. We agreed our approach, methodology and key assumptions for each of the phases with the Review Team.

Phase 1 - Cost of current regulatory framework

The objective of Phase 1 was to collect financial information from each of the regulatory bodies on their costs of conducting regulatory activities.

In order to do this we agreed a template with the Review Team to analyse costs by regulatory function (regulatory rule-making, setting entry standards, monitoring, enforcement, complaints and discipline), by cost category (direct and indirect) and by cost type (such as employment, property). We also included key cost drivers (for example, numbers of employees, enquiries and complaints).

We sent the template to 20 institutions, identified by the Review Team as currently carrying out regulation, to complete. We asked for information from each institution for their last two financial years. We, typically with a member of the Review Team, then met with representatives of each of these institutions to obtain further understanding of the costs incurred by them in regulation, and the basis on which they completed the template.

We also asked the institutions for information on the time given voluntarily by their members to discharge regulatory functions. This gives rise to an opportunity cost that is not captured within the historic cost data which therefore understate the total cost of regulation.

The historic cost data do not fully capture senior judicial and ministerial time, and therefore understate the total cost of regulation in this respect, too.

We have relied upon the information provided to us by the institutions in the meetings and through the completed templates. We have not sought to audit or otherwise externally verify the data. Consequently, we express no opinion thereon.

Phase 2 Cost of alternative models of regulation

The objective of Phase 2 was to estimate, using the data obtained in Phase 1, the ongoing cash costs (excluding opportunity or set-up costs) of each of the Review Team's possible alternative regulatory models.

We initially developed a high level estimate of the costs of the theoretical models and constructs, including those described in the Review's Consultation Paper as an initial costing, based directly on the data available from the Phase 1 templates. This was a “top-down” approach, re-allocating existing costs to the bodies proposed under each model according to their function.

At the request of the Review Team, we excluded from our assessment the impact of the models on the costs of the front-line bodies' representative functions, which are outside the regulatory framework.

As work progressed we focused, at the request of the Review Team, on two particular models - Model A and Model B+. Within each model we separated the costs of the regulatory functions dealt with in Chapter B (entry standards and training, rule making, monitoring and enforcement) from those dealt with in Chapter C (complaints and discipline). The issue we were asked to consider within Chapter B was the costs of Model A and Model B+. The issue we were asked to consider within Chapter C was the cost of a single consumer complaints body against the current system. Our cost estimates for these models underwent a series of iterations following discussions with the Review Team as to how these options might work in practice.

We supplemented our top-down approach with a (still high level) bottom-up costing for a Legal Services Board (LSB) and an Office for Legal Complaints (OLC), based on the Review Team's estimation of the LSB's and the OLC's structure and number of staff. However, we recognise that the actual costs of either a Legal Services Authority (LSA) as part of Model A or LSB as part of Model B+ would be substantially dependent on decisions taken by its Board as to how it discharges its regulatory functions.

Section 2: Limitations of our work

Reliability of financial information collated from regulatory institutions

The level of financial management information held by the institutions as a basis for completing the Phase 1 template varied widely. The institutions have not previously been required separately to identify the costs of regulation along the lines of the regulatory functions set by the Review Team. The institutions, therefore, developed methodologies of substantially varying degrees of sophistication, according to the information they had available. Generally, each of the methodologies involved allocating costs on the basis of estimates of the proportion of time spent by the institution or its employees on regulatory activities.

During Phase 1 we encountered a number of definitional issues:

the classification of certain activities as regulatory or non-regulatory; and
the allocation of costs to the specific categories of regulatory activity.

We sought to manage these issues by issuing guidance notes with the template, and through the meetings held with the bodies. However, it is possible that there is nonetheless still some inconsistency in the manner in which institutions categorised their costs.

Reliability of the cost estimates of alternative regulatory models

The Review Team's work has been high level and accordingly we have not developed detailed budgets for the regulatory bodies under the proposed alternative operating models.

We have developed our cost estimates on the basis of an understanding of the current costs of conducting various regulatory activities. As such the reliability of our estimates is dependent upon the reliability of the direct and indirect costings provided by the regulatory institutions and upon a number of assumptions set out below.

Working assumptions

The underlying nature and volume of activities performed under the new model would not be substantially different from those performed under the current regulatory framework, i.e. we assume steady state operation.
Under Model A, the direct costs currently incurred by the regulatory bodies represent a reasonable basis for estimating the costs of the regulatory functions consolidated together within a Legal Services Authority, but that there will be a 10% saving of indirect costs achieved through economies of scale in managing the infrastructure.
Under Model B+, the costs of the front-line bodies will remain at their present level, except that additional costs have been included arising from the requirement to separate regulatory and representative functions.
Where front-line bodies do lose regulatory functions, as well as losing the direct costs associated with those functions, over time they will also be able to eliminate allocated indirect costs. Where they are unable to do so, these costs would have to be borne by the representational functions of the front-line bodies.

By way of illustration, if, as is proposed in Chapter C, complaints were to be moved from the front-line bodies to a single Office for Legal Complaints, the failure to eliminate 15% of the allocated indirect costs would add £2 million to the costs of the front-line bodies' representational functions.

For the Legal Services Board and Office of Legal Complaints, for which we have conducted bottom-up costing, our work was informed by some benchmarking, based on the operating assumptions made by the Review Team and set out in the footnotes to tables 2 and 3 in the next section.
In respect of voluntary time:
- Analysis of the historic costs of the current regulatory system excludes the cost of the significant time given on a voluntary basis by members of the professional bodies. This assumption is also made in respect of the alternative models considered in the tables in the Summary.
- In costing the alternative models, we have to consider whether there will be a financial cost associated with the activity currently being performed voluntarily. The professional bodies provided us with estimates of the time involved, and two provided us with an estimate of the charge-out rate at which this time might be costed. The majority of the cost relates to governing bodies and committees.
- In respect of Chapter B costs, under Model A, we assume that whilst there would be less practitioner involvement in different levels of governance than under the previous model, there would be some ongoing involvement through advisory panels, the members of which are paid an annual fee. Some of the voluntary time would be replaced by senior management of the Legal Services Authority and this time is costed. Under Model B+, we assume that, as the majority of activity remains with the front-line regulators, there will be no significant change from current arrangements. In either alternative model, we have not included time which continues to be given voluntarily within our cost estimates.
- In respect of Chapter C costs relating to complaints and discipline, assuming Model B+ is adopted for other regulatory functions, we assume that within a single complaints body complaints would be dealt with by full time employees of the Office of Legal Complaints (OLC). Therefore the element of voluntary time given by professionals in respect of complaints would be significantly reduced.

Analysis of the historic costs also excludes senior judicial (other than the Master of the Rolls) and ministerial time, which cannot be reasonably costed. Under Model B+, we assume that this expertise would be delivered by senior staff and the board members of the LSB, who are included in the bottom-up costing.

Section 3: Summary of our findings

Costs of the current regulatory system

The aggregate of the costs reported to us by the institutions was £81m for 2003/4 and £69m for 2002/3 (an increase of 17% year-on-year). An analysis of costs by regulatory function is set out in figure 1 below. Of the £81m in 2003/4, £46m represents Chapter B costs and £35m represents Chapter C costs. Five bodies carrying out regulatory functions account for 90% of the costs. These are the Law Society, the Bar Council, the Office of the Immigration Services Commissioner, the Council for Licensed Conveyancers and the Legal Services Ombudsman. 56% of total costs are direct and 44% are indirect overhead costs.

Figure 1: Current regulatory costs

We noted that complaints handling is the largest regulatory function accounting for c.35% (£29m) of total costs. The Law Society's complaints functions account for £23m of this cost (including £11m allocated overhead costs) and over 90% of complaints volume.

In addition to these historic costs, our work identified a significant amount of time given by legal professionals at zero cost or on an expenses only basis. The opportunity cost of this time is estimated to be in the range £7.5m - £9.5m (assuming rates of £125 per hour to £250 per hour for that time for which we were not provided with an estimate of cost). The majority is accounted for by the Bar Council and the Law Society.

Estimated costs of alternative regulatory models

We were asked by the Review Team to focus our work on the decisions to be taken in Chapter B and Chapter C. These are set out in the tables 2, 3 and 4 on the following pages. These high-level costings are in 2003/4 prices and are subject to the limitations stated in section 2.

Given the conclusions of the Review, summarised in the Foreword, the cost of the proposed complete regulatory system, comprising front-line bodies, an oversight Board (LSB) and an Office for Legal Complaints (OLC) would amount to approximately £79.5 million. This compares with the cost of the current system of approximately £81m. The key drivers of the difference are:

The additional cost of a Legal Services Board, which is offset by:
Savings from the rationalisation of existing oversight functions; and
Savings from a single complaints body, compared to the current system. These are suggested by the bottom up costing of the OLC as arising through the rationalisation of numerous complaints functions into one body, and savings in indirect costs.

Table 1: Complete regulatory system

Chapter B costs

Table 2: Chapter B functions

Chapter C costs

Table 3: Complaints

Table 4: Discipline

This report has been prepared on the instructions of, and solely for the purposes and use of the Review Team. It is issued subject to the limitations outlined above and in our agreed terms and conditions. The contents of the report should not be depended upon by third parties. We shall have no responsibility to any third party in respect of the contents of this report which may not have considered issues relevant to such third parties. Any third party use of this work is entirely at their own risk.

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