Law firms, bank failures and loss of client funds

December 2009

The issue of bank failure has been taxing the minds of managing partners and finance directors for several months now. Even after the demise of the Northern Rock, the prospect of the failure of a major UK clearing bank seemed unimaginable. The sight of HBoS and the Bradford & Bingley teetering on the brink of collapse; and the administration of the Icelandic Banks, Kaupthing and Landsbanki has brought the prospect into sharp focus. London Scottish is now in administration, and may not be the last UK Bank to collapse.

Guidance for solicitors
Following the collapse of BCCI in 1991 the Law Society flagged up the duties of a solicitor when holding client money in trust, as well as contract and tort.¹

The SRA, in conjunction with the Law Society, has recently revisited their guidance in respect of insolvent banks and the impact of bank insolvency on solicitors’ client accounts. Solicitors must continue to comply with their undertakings, without which the conveyancing world would grind to a halt.

The Law Society Gazette recently advised that if a bank went bust, affecting a solicitor’s client account, that it was the client’s problem unless the solicitor’s choice of bank was negligent.²

However is it that simple? - Solicitors’ Accounts Rules
Some commentators have suggested that loss of client money due to bank failure represents a breach of the Solicitors Accounts Rules “SARS”.

Solicitors must invest money in a bank or building society. They have no choice. The bank or building society must be registered with the FSA. The regulations permit investment in foreign banks provided the client bank account is held at a branch in England and Wales.

How could loss due to a bank failure be a breach of SARS? - Rule 14
The notes to Rule 14 represent a potential trap. Solicitors should be alert to the notes at (vii), which provide that “money held in a client account must be immediately accessible, even at the sacrifice of interest, unless the client otherwise instructs or the circumstances clearly dictate otherwise”.

If client money is put in a fixed term account that cannot be immediately accessed, this is a breach of SARS. The loss of funds in those circumstances would represent money improperly withdrawn (Rule 22) which the solicitor would be obliged to remedy promptly (Rule 7).

Strict liability?
The loss of client money properly placed in a client account is unlikely to result in liability for the solicitors in the absence of other factors. The SARS were not drafted with bank failure in mind. Bank failure on its own will not render the solicitors liable. However, if client funds were lost through bank failure, then the solicitor’s decision to invest with a particular bank would come under close scrutiny.

Hindsight is a wonderful thing. The Icelandic banks had impressive ratings up until their collapse, and were FSA regulated. Solicitors choosing where to invest client money should be able to rely on the approval of the Regulator.

However, as we all know, matters are not that straightforward. Some financial commentators were raising question marks over their stability many months before their demise. There is a risk that criticism could be levelled against a firm for investing with such a bank. The reasons for investing have to be examined closely.

Investing to benefit the client or the firm?
Many firms spread client money over a number of banks. The motivation may be to spread risk; encourage a business relationship with the bank; to generate work; or to achieve a more attractive rate of interest for partners’ capital accounts.

If the decision to invest with a specific bank was to benefit the firm, rather than the clients – for example the higher rate of interest was not passed on to the clients, but rather benefited the partners - this may persuade a court that the solicitor was in breach of trust. If so, it becomes the solicitor’s problem and, by extension, that of their insurers.

Summary
The normal position is that a solicitor is not liable for loss of client money following the collapse of a bank, in the absence of negligence or breach of contract or trust.

However if the decision to invest in a particular bank was not taken with the client’s best interests in mind, there is a risk of a finding of breach of trust.

Placing client money in a fixed term deposit account may put solicitors in breach of SARS.

Solutions – risk awareness
Many firms would find it difficult to identify which clients were affected by the loss of client account money as its constitution changes on a daily basis. The cost of unravelling precisely whose money has been lost could be expensive. Solicitors should be urged to ensure that there is an accurate accounting paper trail.

Bank failure has implications for risk management in a number of areas, including undertakings. A solicitor can still be liable on an undertaking to pay money over, notwithstanding bank failure. Solicitors must take great care with the wording of their undertakings.

Steps should be taken to secure clients’ consent to the placing of money with a particular bank. This will be particularly important in the case of designated deposit accounts holding significant amounts of money.

It would be prudent for solicitors to review their retainer letters and make it clear to clients that they are not liable to repay money lost from client account through bank failure.

Even if there is no claim by the client, SARS require the solicitor to remedy a client account breach. Breaches of SARS are covered by the Minimum Terms.

Conclusions – the implications for solicitors and insurers
The apocalyptic prospect of bank failure may prove as unproblematic as the predicted Y2K meltdown, and leave the vast majority of law firms unscathed. However, there are implications for solicitors and their insurers.

Solicitors must be mindful of the minutiae of the Solicitors’ Accounts Rules and look closely at their motivation for placing client sums with a particular bank.

Solicitors and their insurers are not guarantors of client money. In most cases the failure of a bank will result in a problem for the client. However, where there has been a breach of the SARS, they may become liable to refund shortfalls in the event of a bank collapse.

Despite the lack of clarity in this area, we hope this advice give you some steerage in managing potential risk.

For further information, please see the most recent guidance issued by the Law Society.³

If you would like to discuss any issues raised in this update or have a specific query relating to this topic, please contact Sarah Grant, or your usual Hill Dickinson representative.