It is no surprise to anyone that the cost of living and running businesses continues to increase. Law firms could therefore be exploring options to earn additional income and, with interest rates hitting 4.5% earlier this month, one option is to review the interest rates they are receiving on client funds.
Some law firm owners and partners may wonder if this is a legitimate source of income and whether looking around for better client rates could be non-compliant. Interest earned on client money belongs to the firm and is a legitimate source of additional income, as well as improving cash flow.
For example, you deposit £6m at a rate of 3.5%. That is additional revenue (and cash) to the firm of £210,000 per year, or £17,500 per month depending on the terms of the account. That is almost the monthly revenue of one fee-earner without the costs.
The Law Society’s guidance is that firms may earn profits from client interest, providing they are complying with the underlying requirements of the Solicitors Accounts Rules. Rule 7.1 states that firms need to account to clients or third parties for a fair sum of interest on any client money held by you on their behalf unless you have entered into a written agreement with the client or third party to come to a different arrangement (rule 7.2).
Of course, many firms operate a general client account and, therefore, the consideration and application of a fair sum of interest may appear more straightforward.
However, what is the position when it comes to client money held in a separate designated deposit account (SDDA)? There is no distinction in the rules between client money held in a general client account and client money held in an SDDA.
The Legal Services Act 2007 abolished that distinction and, therefore, interest earned on SDDAs can be managed in a consistent way with interest on any other client money on a ‘fair and reasonable’ basis.
The distinction that does exist here is that, in the case of general client accounts, the receipt of interest does not represent client money. Firms should therefore ensure they have arrangements in place with the bank to pay any interest due on that account into the business (office) account of the firm. This is to ensure rule 4 is complied with in keeping client and business money separate.
In the case of an SDDA, the position is different. The interest received on monies in the account belongs specifically to the client for whom the account is held. As such, interest on SDDAs must be paid by the bank into the SDDA itself.
As previously mentioned, although the 2007 Act abolished the distinction between interest earned on general client accounts and SDDAs, in the Law Society’s view, it would be difficult for a firm to show that the amount being received by the SDDA exceeded a fair sum for interest, and that it was therefore justified retaining any of the earned as income for the firm.
What is a fair sum? The rules contain no prescription as to how a firm should calculate the amount of interest a client should receive and simply state that it should be a ‘fair sum.’ This contrasts with the position before outcomes-focused regulation (OFR) was adopted; previous rules provided a prescriptive formula on the interest required to be paid.
The 2011 SRA rules explained that an OFR approach was being applied to client interest, allowing firms the flexibility to set their own interest policies to achieve a fair outcome for both the client and the firm. Therefore, under the current accounts rules, how a firm achieves compliance with rule 7 is largely a matter of their choice.
When looking at the market, be aware that many of higher rates will come with specific terms and conditions, such as fixing deposits for a certain period of time before that rate is achieved.
When considering these types of offerings, firms must bear in mind other requirements of the accounts rules regarding where client accounts are maintained, that client money is available on demand unless otherwise agreed with the client or third party, sufficient client accounting systems and controls are in place and maintained, and that, ultimately, the underlying principle of protecting client money is adhered to.
The ILFM’s Interest Rate Guide is up-to-date and its members have this guide and a plethora of others at their fingertips.