Residual client balances – where do law firms go wrong?

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Karen Garthwaite is the head of professional development at Legal Futures Associate ILFM

Garthwaite: Don’t let client balances linger

Residual balance issues just don’t seem to go away. Despite years of guidance and multiple regulatory warnings, many firms still trip up on these sums of money, forgotten or left unresolved long after a matter concludes.

Why do they matter? Lingering residual balances can create regulatory exposure, reputational damage and, in the worst cases, substantial fines.

A case involving Law and Lawyers Ltd in East London earlier this year illustrates this risk. The firm and its director were each fined £25,000 for multiple compliance failures. Among them was a failure to deal with residual balances across 1,786 matters amounting to £287,800, some of which had lain dormant for over a year.

If firms of all sizes can get this wrong, often repeatedly, the ILFM wondered: what causes these residual balance failures and how can they be prevented?

Common pitfalls

Residual balances can easily arise through no fault of a firm, for example following an acquisition. There are a number of other reasons why they occur and. in the majority of cases, it may be because the firm cannot trace the client, as they have moved on without notifying the firm, or the firm simply doesn’t hear back from them, particularly where the amounts are small.

Other common reasons include:

• Lack of/poor file-closing procedures. Unless the file is formally closed, account ledgers may remain open, allowing small overpayments or money on account of un-incurred disbursements to linger. Sometimes balances are ‘static’ simply because no one has taken responsibility for closing the matter or reconciling the client ledger;
• Mis-categorisation and understanding exactly when a balance becomes residual; and
• Inadequate internal procedures. Monitoring of balances tends to be passive, with lack of follow-up actions. Fee-earners, support staff and the COFA or equivalent are not always clear who must chase up, who must approve, who must log client contact and how often.

Why these mistakes matter

Rule 2.5 of the SRA Accounts Rules requires that any client money be returned “promptly… as soon as there is no longer any proper reason to hold those funds”.

As mentioned, law firms have been fined tens of thousands of pounds for breaching this rule. Another recent example is another East London firm, Christofi Wells & Co, which was rebuked after holding nearly £289,000 across 369 matters with no movement for 12 months or more; many of the balances dated back over a decade.

These failures not only expose firms to financial penalties but also to investigations, qualified accountant’s reports, damage to client trust, potential reputational harm and the cost of remedial work (staff time, auditing, tracing clients etc).

How to avoid the problem

The simple answer is to be as proactive as possible, as dealing with residual balances can be a time-consuming and expensive issue to deal with. Here are some example controls that could be put in place.

File closing: timely completion of file closure processes ensures that client ledgers are reviewed upon completion of the work and any residual balances are therefore investigated as part of that process.

Matter balance/exception reporting: arranging for the finance team (or use of IT systems where your practice management system allows) to extract and distribute matter balances or exception reports to the relevant people, which detail amounts held on each client ledger that have not moved for a certain period, with an obligation to review and take appropriate action on any balances no longer required.

Client communication: maintaining communication with the client throughout the course of the matter, including regular notifications of any balance that remains held on their behalf, will help ensure that firms have up-to-date contact details should any balance need to be returned.

Wherever possible, the client’s own bank account details should be obtained at the outset of the matter so that any balances can be repaid directly to that account. This will also avoid the problem of repaying balances by way of cheque, where there is a possibility that those cheques may not be presented.

Policies and procedures: having clear policies and processes in place to detail your firm’s procedures for the prevention and management of residual balances is key to ensure consistency and control.

This, along with training, will clarify the firm’s expectations for the management of residual balances and will make sure that those expectations are met. Firms should ensure everyone understands the SRA Accounts Rules (especially rule 2.5), the absence of de minimis, and why residual balances generate regulatory risk.

Keep appropriate accounting records: maintain a residual client balance register, noting the amount held, date of matter conclusion, nature of the balance being held, the steps taken to trace to return the funds, name of the recipient charity (if applicable), and the date of the payment, along with the required SRA authority (if required). Ensure that this register is reviewed regularly.

Moving forward

Residual balances are a recurring source of regulatory intervention. Sometimes firms do more than “get it wrong briefly” – they fall into patterns: balances accumulating, years going by without resolution, accountant’s reports being qualified, and fines being imposed.

If your firm has residual balances you’ve been putting off, treat them as urgent. For COFAs, finance leads or practice managers, this is not the kind of problem to let linger. Once you have established a strong control environment for dealing with them you will be in a much stronger position going forward. Prevention is better than the cure.