Spare change: Tips for tackling residual client balances

13 Jun 2014News

Sarah Mumford provides some pointers on how to tackle residual client balances in a cost effective and regulatory compliant manner

Four things you will learn from this Masterclass:

How to assess the extent and size of the problem
How to form an effective balances investigation team
How to trace the rightful recipients of residual balances
How to evidence your investigations for the client and regulator

Residual (or historic) client balances is an unglamorous subject and often involves an uphill struggle to return very small sums to former clients, but is something that management should support compliance officers in tackling.

Earlier this year, the Solicitors Regulation Authority (SRA) undertook a consultation (which closed on 26 May) to liberalise its rules on residual balances for law firms in England and Wales. It asked for comments on:

whether the financial limit for compliance officers’ oversight of payment of balances to charity could be raised from £50 to £500 per client or trust;
what type of charity should be the beneficiary; and
whether the proposed guidance is adequate or could be improved.

Your firm should tackle its balances right now (particularly those below £50 and above £500 as the result of the consultation is unlikely to affect either) and not wait for the amended rules/guidance that may result from the consultation. This is particularly important if your firm is thinking of merging, changing its legal status (such as to a limited company) or if the fee earner with the most balances is leaving.

Let’s assume that the reason your firm suddenly finds itself with residual client balances on its hands is because they were inherited from a recent merger.
In its July 2013 ‘Question of ethics’ note, the SRA made it clear that this is an issue that should be addressed pre-merger and
that the Rule 14.3 obligation to repay promptly commences at the point of transfer, i.e. the date of merger. This is not a problem that can wait.

Practical tips

Can you credit an existing client’s bill on other matters?
Don’t speak to your client contacts (the people who give the instructions). They may be embarrassed about the balance, busy or both. Some are frankly incredulous at the lengths lawyers go to over what is, to them, small change. Instead, phone up their finance department, which will always find a home for residual balances.
Don’t forget that there is still an inherent jurisdiction to pay money into court that is disputed.

Scope of problem

First, you will need to determine the extent of the problem. Are you sure that you have a complete list? Unless you are at a small firm with a domestic-level bank statement and ledger system, it is quite possible that you rely on reports generated by the practice management system (PMS) and that any regular report you run has restrictive parameters. You will certainly need to know your balances from all prior systems and closed files and to think carefully about the parameters for reports on apparently current matters (it has been known for files not
to be closed as promptly as they should be).

Most problems can, however, be tackled with a spreadsheet. Create a master sheet, colour code the columns and apply triage principles, dealing with the oldest and largest first. Ask yourself three questions:

Is there a legitimate reason for the balance staying (e.g. retention or regulatory-compliant escrow)? If there is, put it on another spreadsheet for interest certificate purposes. Make a very clear note on your PMS, make a diary note and create a system for interest certificates that is separate from any balances project.
If the balance belongs to a current client, make it clear to the client partner that he should deal with the balance and remind him of his obligation to do so promptly.
If the balance is venerable, keep it with the problem-solving team (whether outsourced or not) – do not rely on your lawyers to deal with them, particularly if the balance is left on a matter that they didn’t deal with.

If you knew where the client was or lives and why the balance had arisen, it is likely that the balance wouldn’t be an issue (see box: Closing every loophole). But, key issues such as the client’s full name are surprisingly rare on old files, let alone the person’s date of birth (DoB) or National Insurance number (NINO).

Files have often been destroyed or can’t be traced. Some very old balances may have been put in a long-term suspense account, which was apparently permitted in the 1990s.

Think very carefully about processing the client data in your spreadsheet in accordance with data protection best practice, particularly if it may leave the UK.

Regulatory position

Next, remind yourself of the regulatory position. Principles 2, 3, 4, 5 and 10 in the SRA Handbook are the most relevant. Also consider Outcome 1.1 (treat clients fairly) and Outcome 7.2 (effective systems and controls for compliance) in the Code
of Conduct.

The Code does not cover client balances in detail, probably because of the exhaustive treatment in the SRA Accounts Rules (SAR), but these two important outcomes are very relevant if the firm is investigated. Remember that the SAR makes all partners responsible on the firm’s client account.

The Law Society has published a practice note on holding client funds and the SRA has published guidance for lawyers and guidance for accountants on its website; all should be
read carefully.

There are two reasons for the hard line on returning balances: first, the SAR are rules and are not framed as outcomes; second, client money is trust money and solicitors are fiduciaries, required to account for all money with which they have been entrusted.

In summary, the rules are:

Rule 14.3 – Client money must be returned promptly;
Rule 20.1 – Client money can only be withdrawn in named circumstances unless you comply with 20.2 or get SRA consent; and
Rule 20.2 – The circumstances in which balances under
£50 can be paid to charity without the SRA’s involvement.

But, remember that solicitors should not serve as bankers for their clients. If you use your client account to act as banker
(i.e. with no underlying transaction), you may:

imperil your firm’s exempt status under the Financial Services and Markets Act 2000; and
run into anti-money laundering (AML) problems.

If the firm is acting as a banker for clients, your compliance officers should urgently reconsider this practice and consider self reporting. The only safe way to act as banker is to run a client’s own bank account, properly named, under a power of attorney.

Closing every loophole

Change the client inception procedureto capture useful identity information in a compliant way.
File closing procedure– how do you police that this happens promptly?
Partner remuneration policy– can you link drawings to clear financial housekeeping targets?
Fee-earner departure procedures– they will want to concentrate on current clients and current work; you will want them to hand outstanding client balances over. One way to achieve this is to get them to focus on financial housekeeping.
Management information – are you sending the right information to the right people? Overly long lists won’t be read by lawyers. How can you make communications manageable and encourage people to read them?
Do your policies, both internal (the firm’s clear expectations on financial housekeeping) and external (e.g. terms of business), make your expectations clear?

Size of problem

Next, it’s important to assess the size of the problem. You will not be considering every client account balance, just qualifying balances (i.e. balances that should, under the rules, be returned).

As soon as an element of judgement is introduced, there is room for doubt. It is therefore important that your compliance officer for finance and administration (COFA) agrees the parameters of the project and keeps a watchful eye on the process.

There are various reasons for balances to arise.

Client request. This should be scrutinised, with proper diary entries made for interest certificates; these should be sent out by the accounts team to ensure they are sent. However, think about where they are saved on the firm’s systems (see ‘Effort required’ below).
Client refusing the money. This balance type is hardly recognised in the guidance and practice note, but all practitioners recognise it. The client may be challenging
a settlement and so won’t take the money, or disagree
with a finding by the Legal Ombudsman or just be
misguided.
Post-transaction credits. Some account systems permit the accounts team to reopen an archived file, post credits and cheques and then close it. If your system permits this, change it. Most management information reports to the business don’t include archived files and, even if they do, the lawyers will be difficult to engage if the balances were at zero when they last handled the file.
No idea why. These are the orphaned balances with no explanation or, apparently, any evidence as to why they
exist. This is a particular problem when you change your accounts system (whether on merger or otherwise), which is why balances should be properly tackled before that happens.
Poor housekeeping. This is discussed in detail in the box ‘Closing every loophole’.

Balances project

When starting a balances project, you will need to put in place some measures to ensure that it is run effectively.

First, consider who will run the project. If the accounts team run the project, management backing is vital or the team will get very disillusioned by blocking behaviours by your lawyers.

Next, conduct a two-stage test to determine:

why the balances have arisen (the accounts team are usually best at establishing this); and
who is the best person to find the client (this may not be the accounts team).

A steady flow is likely to achieve the best results. One balance cleared is not fantastic but, if everyone clears one a week, the annual total will surprise the doubters. For the same reason, if you are sending balances to the lawyers to sort out, send them at a different time from other management information and certainly not as part of the billing cycle; a requirement to clear three a month might happen.

Also important to consider is who should be in the problem-solving team. If you firm is large enough to have a dedicated due diligence team with various databases at their disposal, perhaps make the detective work part of their day job (tackling a specific number of balances per day).

Alternatively, you may have a long-serving secretary who has the history of the firm at her fingertips. Or, you may have a consultant or retiring partner who is running down his work and may well take on the project as sponsor. Another option is that there may actually be someone in your organisation who would enjoy this task.

Tracing individuals

There are a range of resources that can be used to trace individuals to return client balances to them.

Document and case management systems. You may have relevant client information on some of your firm’s internal systems, such as your document management system (DMS) or case management system (CMS). However, the accounts team often do not have, or know how to, access the DMS
or CMS.
Client relationship management system. If you have one, it is worth mining it to check if you have more information that could help you to trace individuals via their relatives or partners, for example. But, be very careful about both client confidentiality and data protection.
AML subscriber services. These can be useful, but the
most useful ones may require the subject’s consent to
do the search, so ensure users know of any contractual limitations.
Department for Work and Pensions. This service is popular with the SRA, but it is often of limited help unless you have
a person’s DoB or NINO.
Ancestry tracing sites. As most work of these on a percentage basis, the risk of client criticism means they should be used as a last resort.
Private investigator. Be conscious of the Law Society’s guidance on using private investigators and remember that,
if you cannot trace the client, you may not deduct the cost from the balance without specific SRA approval, which is unlikely to be forthcoming.

What you cannot do

Bill the balance unless there is legitimate work in progress and the bill is delivered: a number of Solicitors Disciplinary Tribunal decisions confirm this.
Provide in your terms of business that small sums can be retained by the firm.
Bill or deduct the cost of tracing if you are not successful – this is a decision for the SRA, but it is unlikely to agree. If you do trace and the amount is over £50, you will still have to ask the SRA before you can deduct the cost.

Tracing organisations

Before the money laundering regulations came into effect, the client’s company number was rarely recorded – or if it was, it was by luck. A company that changes name a couple of times is not easy to track, although proprietary AML systems should be able
to assist.

Any money due to a dissolved company goes to the Crown (but, if the company was based in the Duchies of Cornwall or Lancaster, then slightly different rules apply). Be aware that the SRA still appears to say that it needs to clear such a payment.

It is worth writing to the bona vacantia (vacant goods or ownerless property) department at the Treasury Solicitor before sending the money. It can sometimes take quite a long time for a company to be dissolved, but keep using the Companies House’s online resource Webcheck until the dissolution notice
is published.

What reasonableness looks like for organisations is subtly different to the test for individuals. Typically, companies leave
a larger footprint than an individual and you don’t run into personal privacy issues in running searches, for example.

Effort required

How far should you go in tracing the rightful recipients of residual client balances? In the case of individuals, surprisingly far. This is a summary, based on a combination of the practice note and the SRA guidance:

below £4 – send stamps in a sensible combination;
below £50 – consent is not required if going to charity, but consent is required if going elsewhere (e.g. BV department); and
above £50 – consent is required whether going to charity
or not.

But, you must make some effort that is consistent with the size
of the balance; policing this is the responsibility of your COFA.
You can’t identify a balance under £50 and pay it straight to
a charity. There must be both:

reasonable attempts to trace; and
adequate attempts to pay.

Think carefully about how and where evidence of each investigation is recorded. Putting the information on a central spreadsheet has its uses, but you also need to keep a record for the client and your regulator of what has happened to the client’s money. This is best recorded against the client’s record on your DMS and/or CMS.

Before funds can be released, you must:

establish the owner, taking reasonable steps;
return the money, unless the cost of doing so is likely to be excessive in relation to the amount;
record the steps taken;
retain the records (including receipt/indemnity from charity); and
keep a central register that complies with Rule 29 (22) of
the SAR and is sufficient for reporting to the regulator and the client (your SAR accountant should be able to advise about systems).

If you record all investigation work for each balance on its own SRA Rule 20(1)(k) form, with dates where necessary, you will have a document that you can send once you have completed the investigation. The details that are required to be recorded include:

name of client and account (where held);
amount held, including interest accrued;
account of attempts made to trace owner;
length of time it has been due; and
independent accountant’s letter (may be required
but speak to the SRA first) confirming that:

o you have the proper recipient, or

o the proper recipient can’t be identified.

The level of detailed information required may be surprising until you remember that the SRA is representing the interests of the absent client, reminding you to behave as a fiduciary.

Sarah Mumford advises law firms on risk management and was previously best practice partner at two commercial law firms
(sjm@sarah-mumford.com)