The right time to consider law firms holding client money

To sustain that trust it is vital that there are sufficient and effective protections in place when things go wrong and clients lose out. Our Consumer Protection Review is examining whether the current protections are sufficiently well-targeted at a time when the legal landscape is going through significant change.

The review covers two principal areas. Firstly, how we identify and manage risks to clients and their funds. This includes looking at identifying sector risks, approval and monitoring of firms, the rules and controls around client money and firms’ structures and ownership models. Secondly, we are considering the operation and efficacy of our compensation fund – the safety net that means clients can get their money back if money is taken or not accounted for by someone we regulate.

Shifting risks

Last year, we had to intervene to shut down more law firms than ever before. And there have been three much larger interventions which are far more costly for the fund.

Even though we think generally our consumer protection arrangements have worked well over the last decade, events change perspectives and new risks emerge. So, we are approaching this review with a wide lens. It is an opportunity to ask tough questions about some sacred cows of the profession, such as the continued viability of firms running a client account, and whether the current compensation fund remains an effective means of providing redress to consumers.

Client account

It is right we look at whether the compensation fund arrangements are appropriate, but there is a risk we end up addressing the symptom not the cause. A large proportion of our most serious cases relate to issues with firms’ client accounts – whether that’s money going missing, reckless disregard for our rules, or poor processes that open the door to money launderers.

We have lots of checks and balances in place in this area. We are considering tightening these up – for instance, through stricter rules on residual balances or whether it is ever appropriate for solicitor firms to benefit from interest on client money.

Yet every chain is only a good as its weakest link, and years of enforcement work shows there are too many weak links. Is now the time to take seriously the question of whether solicitors should continue to hold client money and whether the client account remains a necessary part of a firm’s working arrangements?

Solicitors holding client money is well established, but is it the right fit for twenty-first century ways of working? For instance, the advent of digital banking brings opportunities to introduce more sophisticated and robust systems, suitable for tackling increasingly complex challenges around issues such as cybercrime and money laundering.

It is not inevitable that firms need to hold client money. Other jurisdictions have other systems in place. For instance, in France client money is handled through an organisation called CARPA. Each local law society has its own account and oversees monies going in and out, supported by central regulation to ensure consistency. The possibility of an individual stealing money is limited and money laundering risk is reduced.

Interestingly in France the centralised pot of money enables the interest to be used to support wider access to justice. The latter could be particularly relevant given the Ministry of Justice has recently said it is looking at whether interest on client accounts could help fund legal services for people unable to afford advice.

Benefits of firms not running client accounts could include increased security, better anti-money laundering compliance, and less burdensome regulation, with its associated costs. It could help reduce PII premiums, or at least lessen the yearly contributions firms need to make to our compensation fund. Fewer issues with client account money would also bolster trust in legal services

Escrow accounts are a feature of financial transactions in different sectors and jurisdictions. Our rules explicitly allow the use of third party managed accounts, a type of escrow account, but to date the numbers of firms using them is low and the market limited. Any change would need time and a suitable glide path.

It would also not be without risk. Would a move away from firm’s holding client money result in more eggs sitting in one basket? Systems would likely be stronger, but a fraud, technical glitch or successful cyberattack, could risk causing widespread problems. Firms have told us they are worried about the costs, slowing transactions down and eroding its service to clients. In conveyancing, speed is of the essence with firms often completing multiple transactions every day.

However, to only focus on the downsides risks inertia. We need to explore ideas that could work in the public interest over the long term. Even if it is too soon to place a blanket ban on firms directly holding client money, exploring whether this is feasible in the short term is definitely on the agenda and, of course, we could still look to significantly increase checks and balances for firms involved in riskier areas of works while solicitors continue to hold client funds. Or we could mandate that firms can only hold client money if they provide greater reassurances around the robustness of their processes.

Other reforms

We have already spoken directly to well over a hundred stakeholders – consumer representatives, members of the public, and the profession about their views on our rules, identifying risk, and the compensation fund.

There are already clear themes coming through. For instance, on the compensation fund both the public and profession agree that it is a vital safety net that helps maintain confidence and trust in those we regulate. We have also heard some openness when it comes to whether we should consider risk-based contributions from firms to the Fund, so that riskier firms pay a higher proportion. Of course, the devil will be in the detail of how we would then define riskier firms.

Other themes include a recognition that the current process around firms commissioning an annual accountant’s report could work better. We also know we can improve how we manage and mine our data, so we can spot red flags, and emerging sector issues, as swiftly as possible.

We have also heard concerns about whether so called ‘accumulator firms’, that have expanded rapidly through acquisition, require closer attention, given Axiom was one such firm. We have put in place extra visits and checks to see whether such firms are presenting a greater risk to consumers. And we are also considering whether we need more checks around mergers and acquisitions, while being mindful that inserting ourselves more into the process could risk dampening such activity. M&A can be a part of healthy, well-functioning market, so we would need to be sure that any change in our approach is well-targeted and in the public interest.

Next steps

We are continuing with the discussion phase of our review until the start of July. Please let us know your ideas. Although we are already improving some of our internal processes, we will consult in the autumn on more significant reforms. What those proposals will look like is still to be decided, but they will be driven by the evidence of what is going to deliver in the public interest over the long term. That means making sure that our regulatory approach is well set up to continue to drive confidence and trust in legal services for the coming decade.