Heraclitus, the Greek philosopher and pioneer of wisdom, is quoted as saying "change is the only constant in life”. Never has this been more true than when considering client money banking arrangements for legal practices.
A decade ago many legal practices operated their transactional client money payments through their general client account, with funds expected to be held for longer periods being placed in a designated deposit account in the name of the firm’s client.
At the time banking was simple. Reconciliations were straightforward and the differentiation between banks focussed on their ability to operate these accounts complying with the Solicitors Account Rules. As long as a bank avoided causing a breach of the rules, firms generally were loyal to their banking provider.
As a result, access to borrowing was relatively easy and firms with high levels of client deposits often found themselves rewarded with lower interest rates for overdrafts, commercial mortgages and other types of borrowing.
My own conservative estimate would suggest c. 80% of firms across the UK would have held funds in this way, mainly with the big four - Barclays, HSBC, RBS/NatWest and Lloyds Bank.
Legislation as an enabler to change
With the new-found freedom to develop their own processes. Many firms elected to reduce their reliance on traditional designated client accounts and instead opted to retain all their client funds within general client accounts. They utilised their practice management systems to calculate any credit interest due to clients in line with their own de-minimis rule.
In 2011, the introduction of Outcomes Focussed Regulation removed the distinction between designated and general client accounts (producing a trigger for firms to question why they held money in designated deposit in many cases). This gave law firms the power to develop their own policy to handle client funds and associated client interest. The combined deposit levels now meant firms had high client balance levels which afforded to opportunity to negotiate better interest rates. Ultimately, it allowed them to earn more from client money interest. The income from client interest often competed with the partners for the best contributor to bottom line income.
The rise of the challenger bank
Smaller banks with a need to improve their liquidity position viewed solicitors’ client money as easy pickings and a quick way to attract ‘sticky’ client deposits. This brought about the rise of the challenger banks with Metro, Santander and local building societies often paying between 10 and 15 times more than a traditional designated account. With hundreds of millions of pounds up for grabs the challengers dined out on the excess funds held in general client accounts, often referred to as the ’Top Slice’.
Firms were encouraged to place funds in a fixed-term deposit account usually for around 12 months. These accounts often carried a clause which meant, should the funds be required before the fixed term ended, they’d incur a significant loss of interest penalty.
The big four high street banks defended their positions by developing new virtual client account models which were ostensibly a hybrid client money proposition which allowed the sub allocation into virtual accounts able to apportion interest whilst funds remain within the structure of a general client account.
These accounts passed the test of benefitting client, customer and bank;
The bank retained client funds rather than losing them to challenger banks
Law firms made interest on client money held, and operated the accounts without the administrative burden of designated client accounts
Clients potentially received more interest than they otherwise would have from funds being retained within a traditional client account
The next ten years
The high level of losses brought about by cyber-fraud has caused the Solicitors Regulatory Authority and Insurers to consider new ways to protect client funds.
With tens of millions of pounds stolen or misappropriated from client accounts, the objective is to open the sector to Third Party Managed Account (TPMA) providers whose system not only promise to eradicate fraud, but also encourage operational efficiencies and associated cost savings.
The cost and barriers to entry are high but, when done well, it’s conceivable that within the next ten years law firms will cease to hold any client funds, instead outsourcing this risky aspect of dealing clients to an FCA Regulated Third Party Managed Account provider.
The promise of TPMA look set deliver impressive benefits
Compliance with SRA Regulations
Reduced risk of cyber-fraud and the associated pressure on legal practices to safeguard client funds
Attract operational and cost efficiencies associated with client money
At time of writing, a growing number of firms are turning to TPMA providers and the next ten years will be interesting to see how firms’ welcome new ways of working
About the author
Paul McCluskey is the Managing Director of Gemstone Legal, which provides three distinct services to legal practices:
Advice on banking and finance - helping firms to source improved client money interest arrangements and sourcing commercial finance deals
Management consultancy - proving COLP and COFA support from ABS application through to ongoing risk management guidance
Lexcel Assessor and consultant: guiding law firms develop a robust risk framework in line with the Lexcel Standard, and/or assesses a growing portfolio of law firms against the Lexcel standard.
This article first appeared in the ICAEW publication