New security regime

Solicitors could be forgiven for feeling relieved that soon they may not have to pay for an annual examination to check their dealings with client money. They should be apprehensive.

The Solicitors Regulation Authority (SRA) has just finished a consultation which is expected to lead to the removal of a mandatory requirement for independent oversight, one in place for as long as anyone can remember and a strong safeguard against error and abuse.

Instead, the SRA is likely to simply require an annual declaration from each firm’s Compliance Officer for Finance and Administration (COFA) of confirmation that their firm is managing client money in accordance with SRA accounting rules.

This is not the same as putting a child in a sweet shop and asking them to self-certify to abstinence, but it does raise the spectres of risk, temptation and hazard for law firms, and of reputational damage to the profession as a whole if a scandal erupts.

One concerning indicator that such fears may not be far-fetched, and of what may lie ahead, comes with the latest annual Risk Outlook published by the SRA. This sets out key risks to regulatory objectives and, ominously, noted a continuing trend for increased cases of misuse of client money and assets. Both the Law Society and the City of London Law Society have expressed concerns about dispensing with the mandatory reporting requirement.

In particular, the Risk Outlook noted that there were a number of firms where their own financial difficulty had been a contributory factor leading to the misuse of client money.

Regulatory scrutiny

Against this uneasy backdrop it might seem counter-intuitive, particularly in an age of heightened public sensitivity and regulatory scrutiny about the way client money is handled by financial service sector professionals, that a group also holding substantial amounts routinely should be looking to apparently relax theirs.

But whether the anticipated change is good or bad news will depend essentially on how well each firm responds to three key questions: how well does it deal with the rules surrounding client money? How confident is the COFA that adequate systems are in place to identify breaches? Does the firm consider it gets value for money beyond the annual ‘commoditised’ report from accountants and the work they currently undertake?

Any doubts about the first two questions should be a cause for concern if the rules do alter. Of course, the proposals are not being presented in isolation, nor are they intended to lessen the responsibilities on practices to act with full probity. There is thought and logic behind them.

The background to the latest proposals is that in October 2011 the SRA implemented outcomes-focused regulation (OFR), which saw a move away from a rules-based approach to one that centred on self-reporting. A key element was the introduction of the COFA role within firms.

Every practice now has a COFA in place and has done since 2013. Their job is to ensure that everyone, from top to bottom, complies with obligations imposed by the SRA. They must also record any failure to do so.

The rules for compliance depend on the size of the practice, work undertaken and client base. But one principle is central: all firms now have an increased obligation to implement monitored systems in place to safeguard client money, identify breaches as they arise, and demonstrate compliance.

Neither has the SRA washed its hands of responsibilities. Each firm has been and continues to be assessed to determine what level of attention it needs from the SRA with the introduction of outcomes-focused regulation. There were two criteria used: The potential impact on the SRA meeting its regulatory requirements and the probability of issues with the firm.

Interestingly, reports by qualified accountants have been used by the SRA as one of the indicators of risk, which is perhaps eloquent testimony to the value of outside assessment.

Currently, regardless of whether a firm represents a low or high risk in terms of handling client money, it must engage an accountant to assess and test systems and controls over client accounts. Any discrepancies between operations and the rules are reported by the accountant directly to the SRA. There are also whistleblowing obligations if serious breakdowns in control occur.

Human error

Discrepancies can arise for all sorts of reasons that are nothing to do with improper use, but result from lack of time, understanding or human error. Under the existing rules, the SRA must sift through each report to understand the nature and consistency of such errors to consider the risk profile of each practice. While this is costly and time consuming, it does provide useful data to the regulator.

The new proposals are part of a programme to reform the regulatory regime by reducing unnecessary burdens, while also providing a flexibility of approach to deliver good financial management.

The SRA receives about 9,000 reports from accountants each year, and more than half require further attention. Still, in practical terms, the organisation expects to save around £200,000 a year in reduced processing costs if the changes go ahead. The immediate evidence would be for solicitors’ firms saving money in accountancy fees if the changes go through.

However, the scope for saving costs really depends upon the integrity and robustness of the reporting, not to mention attitudes. Firms may view some or all of any compliance saving as an opportunity, one to invest in better practice management so that the COFA can ensure that the client account is efficiently managed in accordance with the SRA Accounts Rules.

Systems testing

In many firms the COFA is a fee earner. While systems are recorded and breaches get notified to the COFA, many firms do not test their systems (either through lack of time of knowledge of what to look out for). But the glass is not always half full. Others may think exactly the reverse, and see just a chance to
cut costs.

Some firms argue that the accountant’s report on client funds has limited purpose when all it serves to do is report retrospectively on the same prescriptive points each year. It is also true that the report represents a service and income stream for accountants that my profession will not want to lose. But the counter-argument is that it offers reassurance to the firm and their regulator. The accountant can feed back on systems and procedures in place to comply with client money rules.

A firm may consider retaining some form of independent testing anyway for a range of reasons: supporting the COFA to put in place and review systems to ensure compliance with the rules; training managers and employees on compliance and reporting requirements; providing clients and stakeholders with additional comfort that the firm is fulfilling its requirements.

The other issue practices should consider is the impact on their professional indemnity insurance (PII). How will insurers react to an absence of independent reporting, particularly in an area involving other people’s money? Some may be faced with increased premiums that far outweigh the potential compliance savings if firms abandon an external review of their compliance.

It is worth noting that the proposals do not fully abolish the accountant’s report, just the requirement to prepare one. The SRA will still require, under the plans for firms, to have one prepared where:

• certain risk circumstances are present;
• there are problems identified with client money; and
• if the SRA identify that a firm is getting into difficulty in dealing with types of work where there is risk to client money (such as conveyancing or probate).

An obvious question to ask is whether, given the determination to shift the way client money handling is monitored, an alternative exists to the way money is held.

Unfortunately, the amount of money and volume of transactions that many solicitors have to deal with makes it hard to think of one that improves on the current system, whereby client monies are managed and controlled by individual firms.

Escrow accounts

The operation of escrow accounts by a third party is a system implemented by the Bar and others. Such a system could have the same effect as the proposals in reducing the administrative burden on the SRA and could also place less pressure on the COFA. But it would also represent an administrative nightmare for firms and the banks involved.

And let us not forget the interest that firms can earn on client accounts. While the economic climate and decline in interest rates has put a serious dent in that revenue stream, it is still a source of income that most firms value. The economic downturn has only seen the profession become more adept at managing such funds to their best advantage, rather than abandon efforts to maximise its value to them. The potential rise in interest rates on the horizon is a further incentive to hold the money.

My profession, of course, will undoubtedly lament the removal of the reporting requirement but can expect to benefit from the opportunity to provide more contemporaneous, consistent and pro-active advice and support to clients.

Consultation on the proposed changes to reporting accounting requirements ended on
18 June 2014, and at their meeting on 2 July 2014, the SRA Board deferred a decision to allow for further analysis of the consultation and consideration of the options.

The SRA consultation document notes that the proposals are planned for implementation in October 2014. It remains unclear whether that is still the case.

In the meantime, firms might take the opportunity to consider their procedures. In particular, the appointed COFA would be well advised to contemplate the potential additional future responsibilities they might need to take on, contacting their advisers to discuss support if their role changes.

One thing is clear, as the delay to implementation shows: this is about much more than shaving costs for solicitors and their regulatory body. It represents a profound and fundamental shift in responsibilities away from auditing how solicitors look after other people’s money from qualified, independent third parties, to self-reliance, and that needs preparing for carefully. SJ

Jennifer Williamson is a business services partner at accountancy firm Reeves

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