The Solicitors Regulation Authority (SRA) has launched its anticipated consultation on client money in legal services to review whether it remains appropriate for law firms to continue to hold significant funds in their accounts. The regulator announced plans to launch its consultation last week with SRA Chair Anna Bradley saying the reforms would tighten the rules on client account interest and residual balances for firms who see them as a source of income after one in six firms said client account interest accounted for more than 10% of turnover.
Amongst proposals under discussion is a time limit on the return of funds from client accounts; preventing firms from retaining interest earned; limits on monies put on account in anticipation of legal work; alternatives to client accounts including third party managed accounts (TPMA) and escrow; and splitting compliance and ownership roles to reduce conflict.
The consultation will review three key areas of concern
- Part 1: The model of solicitors holding client money – should we be looking at ways to reduce the client money held by solicitors?
- Part 2: Protecting the client money that solicitors do hold – what controls, checks and balances are appropriate?
- Part 3: Delivering and paying for a sustainable Compensation Fund– how should payments from the profession be calculated and payments from the Fund to reimburse consumers be allocated?
The SRA says the consultation has been launched in part due to the ‘sharp’ rise in law firm interventions undertaken by the SRA, with the regulator heavily criticised for its handling of the intervention at Axiom Ince. It added a ‘substantial’ proportion of regulatory breaches were related to the handling of client money with consumer protection at the ‘heart’ of the review.
Part 1 of the consultation focuses on the current model of firms holding client monies in a separate ‘client account’ which at any time could hold hundreds of thousands of pounds in it. In the consultation briefing note on the SRA website, 75% of SRA regulated firms declared they held client monies in the twelve months to August 2023. Of those, just under half held more than £1m, with the largest firs holding anywhere between £100m and £1bn. Consumer sentiment is broadly positive, with nearly 4 in 5 consumers happy to trust law firms to hold monies. But the SRA have indicate they have seen the inherent risks of lost or misappropriated funds materialise in recent years, with this consultation going as far as suggesting firms may not hold client money in the future.
The SRA has also taken aim at firms who do not place enough emphasis on returning residual balances to clients; and firms who hold on to client monies longer than necessary in order to benefit from the interest. A recent benchmarking survey by The Law Society estimated that firms could have made as much as £27m (total net income) in interest on client money in 2022/2023. And for some small firms this money is relied upon to remain viable, especially, say the SRA in ‘price competitive areas such as conveyancing.’
The rise of cybercrime is also a major concern raised in the consultation when it comes to safeguarding client monies and if the SRA were to pursue the idea of doing away with client account, the consultation proposes further exploration of TPMA, centralised systems like CARPA in France, and the current work being done on synchronisation of funds directly from one lender to another, although it is acknowledged this is specific to conveyancing rather than the whole of legal services.
Part 2 of the consultation focuses on the role of firms and regulators in protecting monies firms hold; with the consultation suggesting firms have a responsibility to the regulator to report on material changes to organisations, whether through merger and acquisitions, or organic growth into new areas of law. Currently firms are required to notify the SRA when
- that firm is closing or being acquired
- that firm is in serious financial difficulty
- there are changes in the financial services they provide
- there are changes to managers, owners and approved role holders including compliance officers
- they are using a Third Party Managed Account
The SRA acknowledges it must look at ways to improve its oversight of firms and options around greater transparency of reporting, timeliness in reporting, and/or a better understanding of firm’s financial health in the form of ‘out of cycle’ accountants’ reports or potential pre-approval of certain changes, including acquisition.
Two potential solutions tabled in the consultation are to create clear lines of differentiation between compliance roles in the law firms, and ownership/management; the SRA say around 1/4 of all regulated firms are in a position where the COLP/COFA/MLRO and ownership/management functions are held concurrently, potentially creating multiple points of conflict and failure. Alternatively, the role of the compliance officers could be embodied by an external specialist consultant, or through an independent audit.
The final part of the consultation relates to the future of the Compensation Fund which has been hit hard by interventions at Metamorph and Axiom Ince in particular. The SRA say in 2022/23 the intervened 65 times, the largest for some years, and by the end of 2022/23 financial year, despite contributions totalling £10.3m, grants to the value of £41.1m were made. The average annual amount of payments from the Fund between 2010 and 2022/23 was £29m.
While the current system of contributions to the fund being split between individuals and firms at a flat rate provide a great deal of simplicity to the issue, a ‘polluter pays’ option, much like the current CLC-regulated contribution to the Legal Ombudsman, is one option proposed in the consultation. This could either be on the basis of incentivising certain ‘enhanced requirements; such as accreditations like cyber security infrastructure, or employing external auditors. The amount of client money held or annual turnover is another proposal mooted in the consultation; with the added benefit of potentially disincentivising holding client monies and encouraging the use of alternatives. Currently firms using TPMAs who do not hold client money in their accounts are exempt from making firm contributions to the Compensation Fund. .
SRA guidance on the use of TPMAs states ‘Money held in a TPMA does not fall under the definition of client money in the SRA Accounts Rules (the Accounts Rules) as it is not held or received by you. As such it does not have to be held in accordance with our rules relating to the holding of client money.’
Another route proposed is to assign firms with a risk profile against which a contribution could be benchmarked. Those deemed lower risk would pay less than those at higher risk; the risk indicators, say the SRA, might include
- regulatory history (previous breaches, complaints, past interventions)
- practice areas (we know that areas such as conveyancing or personal injury may pose higher risks)
- financial stability (firms in financial difficulties may be more likely to take risks)
- firms’ internal risk management systems (having policies and processes in place to mitigate risk)
- staff turnover and training.
The Compensation Fund is a challenging conundrum for the regulator who admit the majority of its interventions (72%) have been into small firms, sole practices or freelancers. Indeed, sole practice firms alone made up 42% of all interventions. Just 3% of intervention fell into the ‘large’ or ‘very large’ category. However larger interventions place disproportionately higher pressure on the fund; in 2019/2020, the top 1,000 SRA regulated firms by turnover accounted for just one intervention (3%), but this one intervention accounted for 71% of payments made by value. In 2022/23, there were 6 interventions into this cohort (9% of all interventions) but 74% of payments made by value related to these interventions.
The consultation can be reviewed in full on the SRA website, alongside extensive supporting information; it opened on 14th November and will remain open to respond to until 21st February 2025.
