Reassessing Client Account Interest: Navigating Regulatory Changes for Financial Stability

Handling client money is a core responsibility for law firms, with an associated obligation to pay a fair sum of interest to clients. The Solicitors Regulation Authority (SRA) requires firms to account to clients for interest earned on funds held on their behalf, in line with the principle of fairness outlined in the SRA Accounts Rules (7.1).

In this article, we explore the current landscape, historical guidance, and the SRA’s ongoing concerns about firms’ reliance on client account interest. We also examine how firms can enhance their financial stability amidst potential regulatory changes.

The Emerging Issue

At the recent SRA COLP and COFA conference, SRA Chair Anna Bradley highlighted findings from the Crowe Law Firm Benchmarking Survey 2024, expressing concern about law firms potentially relying too heavily on client account interest to sustain their financial health. Such reliance may pose a risk of non-compliance with SRA guidance, which requires firms to monitor their financial stability and business viability (SRA Code of Conduct for Firms (2.4)).

While the survey covered less than 0.60% of the legal market, the SRA faces the challenge of assessing whether clients are being treated fairly across the sector. It’s crucial to provide context to this discussion to prevent any misunderstandings or implications that the sector is engaged in questionable practices.

Prior to the 2008 financial crisis, the average official bank rate was around 5%, with some banks even offering above-market rates to attract deposits. However, the economic downturn saw rates plummet, with the average official bank rate between 2008 and 2021 falling to c1.50%. In the aftermath, client accounts often paid little to no interest, making it less feasible for firms to pass on meaningful returns to clients.

Interest rates have recently climbed, reaching 5.25% in August 2023 and now fallen back to 4.75% in November 2024 but even with this increase, many banks continue to pay low rates—often 1.6% or lower—on designated and general client accounts.

A Look Back: The 1998 Law Society Client Account Rules

The 1998 Rules provided a clear structure for managing client money:

  • Rule 24: Offered prescriptive guidance as to when it was appropriate for interest to be paid.
  • Rule 25: Provided guidance on the calculation of interest.

The calculation of interest was intended to be transparent and fair, with firms expected to achieve at least a reasonable rate for clients. This principle ensured that clients were not disadvantaged by having their money held in general accounts.

The SRA’s own guidance outlined

“The sum in lieu of interest for money held in a general client account (or on money which should have been held in a client account but was not) must be calculated at a rate not less than the rate of interest payable on a separate designated client account.”

The Shift in 2011: Increased Flexibility and Outcome Focus

By 2011, the SRA had adopted a more flexible approach:

  • The Legal Services Act 2007 (Guidance note 22.3 (i)(d) eliminated the distinction between general and designated accounts. Interest was now to be paid on a “fair and reasonable” basis.
  • Firms were encouraged to develop clear interest policies and inform clients at the outset of their engagement.

Given the administrative burden of managing designated accounts, most firms opted to continue using general accounts, ensuring clients were paid interest rates aligned with those of designated accounts. However, with bank rates often at 0.01% or less during this period, the interest owed frequently fell below the de minimis threshold of £20, meaning clients received no interest.

The 2019 SRA Rules: Adapting to Technological Advances

The 2019 update to the SRA Accounts Rules coincided with advancements in Practice Management Systems (PMS), enabling firms to streamline interest calculations. However, despite these technological improvements, the reality remained that banks were still paying minimal interest on client funds. As a result, most firms continued their established practice of paying clients the same rate as the bank advertised for designated accounts. Yet, with the recent rise in interest rates, firms are facing renewed scrutiny over their approach to managing and distributing client interest.

The Core Issue: Fairness in Interest Payments

The central question is not necessarily about the interest rates themselves but rather about what is fair for clients. The variation in rates between banks, and even between different customers at the same bank, makes it difficult to standardise an approach.

Currently, banks incentivise firms to retain client balances by offering preferred rates to select customers. However, these rates are not consistent across the board, leading to a disparity in what firms can pay to clients. The rate paid will always be at least the advertised rates and therefore the sensible approach would seem to be to mirror previous guidance and require the firm to pay at least the advertised designated account rates by their primary bank.

In truth this approach is followed by most firms.

Future Considerations: Should Firms Be Reliant on Interest Income?

With the SRA expressing concerns over firms’ reliance on client account interest, the question arises: Is it appropriate to remove the ability to earn income from this source? For some firms, especially smaller ones, this income contributes significantly to their financial stability. However, with interest rates being unpredictable, firms should not rely on this source of income. Instead, the focus should shift towards enhancing financial resilience. The SRA could work with firms to develop strategies that improve overall financial health, rather than simply curbing the ability to earn interest on client funds.

Preparing for the Future: Strengthening Financial Stability

Given the potential regulatory changes, it is essential for firms to review their approach to managing client money and interest payments. A proactive step would be to improve transparency in interest policies and ensure clients are fully informed of how interest is calculated and paid.

With the SRA reviewing the framework for client interest, now is the time for firms to take action. The introduction of tools like the Gemstone Legal Financial Stability Scorecard, The Law Society Financial Stability Toolkit or the Law Society Financial Benchmarking Survey can help firms assess their financial management practices, identify areas of improvement, and strengthen their overall financial stability.

Conclusion: Taking Action to Protect Your Firm’s Future

The evolving regulatory landscape presents both challenges and opportunities for law firms. As interest rates fluctuate and the SRA increases its focus on financial stability, firms must be prepared to adapt.

To ensure compliance and maintain client trust, law firms could:

  • Review and update their interest policies to align with current best practices.
  • Implement transparency measures, clearly communicating how client interest is calculated and paid.
  • Leverage tools like the Gemstone Legal Financial Stability Scorecard to identify financial risks and optimise management strategies.

By proactively addressing these issues, firms can protect their financial health and continue to deliver value to their clients, even in a changing regulatory environment.

 

Paul McCluskey is the founder of Gemstone Legal

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