Handling Client’s Funds — Guidelines from Texas Judge

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By Joseph S. Genova
[Originally published in NYPRR July 2000]


[Editor’s note: This is Part II of a two-part article. Part I was published in NYPRR April 2000.]

After trial, following remand from the Supreme Court, Judge James R. Nowlin performed an important service for both the legal profession and the indigent. In a comprehensive Memorandum Opinion and Order, he confirmed that IOLTA programs (New York’s program is called IOLA) did not constitute an unconstitutional “taking” of private property for public purposes. [Washington Legal Foundation, et al. v. Texas Equal Access to Justice Foundation, et al., 86 F. Supp. 624 (W.D. Tex. 2000).] In so doing, he preserved this important device for funding legal services for the indigent. IOLTA programs permit a lawyer to pool, in an IOLTA account, all client funds that cannot reasonably be expected to earn net interest for an individual client; the resulting interest provides funding for legal services for the poor.

At trial, the Washington Legal Foundation (WLF) pressed alternate ways of handling such client funds, which they said would be more beneficial to clients. The first alternative, discussed in Part I, was the “net benefits theory,” in which a lawyer deposits into his own account client funds which are not likely to earn net interest for the client. The theory is that the interest resulting from pooling these client funds would benefit the lawyer and therefore ultimately the client. Judge Nowlin quickly rejected the “net benefits theory.”

Court Criticizes In-Firm Pooling

The second device recommended by the WLF was “in-firm pooling,” a technique in which the lawyer makes no initial determination whether a client’s money is capable of earning net interest on its own, but places all client funds in a pooled money market account in the lawyer’s name and makes an entry for each client in a spreadsheet. When the bank notifies the lawyer of interest, the lawyer uses the spreadsheet to apportion it among clients. The lawyer charges an administrative fee “which is about one half of the interest earned,” or in one characterization, “one percent of the client’s interest plus principal.”

Judge Nowlin made several observations criticizing, if not condemning, in-firm pooling. Referring to testimony by New York attorney Robert I. Randell, Judge Nowlin observed that:

(1) “[T]he funds described in Mr. Randell’s in-firm pooling scenario are funds that in most cases would earn a net benefit for the client without in-firm pooling” and therefore would not be placed in IOLTA accounts anyway.

(2) “Mr. Randell’s allocation of the administrative fee by percentage of the client’s money changes the ultimate determination of net interest [because] the administrative costs of allocating $2,000 should not be less than those for the allocation of $200,000.”

(3) “[T]he larger dollar amounts in [Randell’s] ‘pool’ in effect pay the costs for the smaller amounts and allow those smaller amounts to earn interest. There may be net interest on the smaller accounts but only at a loss to the larger.”

(4) “This system would only affect a small percentage of money that otherwise would be placed in IOLTA and fails to address small amounts of money held for short periods of time that could not earn interest at all.”

(5) “Mr. Randell’s system is not a demand account as mandated by the rules of ethics.” (citations omitted.)

Concluding, the court said:

Only in … cases [where the funds can earn net interest] would Mr. Randell’s in-firm pooling arrangement be feasible. Even in these cases, Mr. Randell is subsuming the bank’s role in an effort to generate an added administrative fee for his practice, albeit with the agreement of his clients. Added to this, Mr. Randell must prepare the 1099 forms for each client earning in excess of $10 in interest. (Emphasis added.)

New York lawyers should think long and hard before trying in-firm pooling. Although Judge Nowlin noted that Randell’s clients had agreed to the arrangement, it is difficult to understand why a rational client with a large deposit would ever agree after being told the simple facts. Imagine the disclosure. “Dear client: Have I got a deal for you! How would you like to earn less interest by subsidizing my other clients, who couldn’t earn net interest on their own, and by giving me one percent of your interest-plus-principal. OK?”

Court Rejects Sub-Accounting

The final “alternative” proffered by the WLF was “sub-accounting,” described by the court as “a banking product where an entity such as a law firm opens a master account in its name and a linked sub-account for each client for whom the firm is holding funds. These sub-accounts are interest bearing” at about the money market rate, and the bank does all the accounting and prepares the IRS 1099 forms. IOLTA’s detractors claimed that, with sub-accounting, even tiny client deposits could earn net interest for the client.

Evidence was to the contrary. Banks themselves said sub-accounting was “specifically suited to high balance, low activity funds management.” The evidence also showed that the banks did not permit certain transactions and charged a complex set of hefty fees for transactions that are permitted — often free — with IOLTA accounts, and also charged monthly fees starting at $21 per month. (Client funds of $4,000 will earn only $20.57 per month at the June 13, 2000 JP Morgan Prime Money Market Fund “7-day yield” of 6.17%.) The court also found that clients would forfeit their interest in some circumstances and that, despite the accounting by banks, it was still necessary for lawyers to expend administrative time reconciling statements, etc., and that those costs could legitimately, and probably would, be passed along to clients.

Summing up, the court found that sub-accounting was not, as a matter of fact, the marvel IOLTA’s detractors have been saying it is:

[T]he costs of sub-accounting in lawyer and staff hours and in addition to bank charges exceed the costs of IOLTA. These costs make net interest to clients infeasible except in cases where large sums of money are held or when client funds are held for long periods of time. In these cases, the client funds would not be placed in IOLTA. Therefore, the Court finds that Plaintiffs have failed to establish … that Mr. Summers’ funds could theoretically earn net interest in a sub-account.

A fundamental principle of IOLTA is that if there is a reasonable way to obtain interest for the client after deducting bank charges and reasonable costs of the lawyer’s own administrative effort, the lawyer should do so and should not use IOLTA. Available technology — whether a lawyer’s spreadsheet or a banking product like sub-accounting — is and has always been relevant to the lawyer’s consideration of the practical question whether or not the clients’ money can earn net interest, but the technology is not determinative.


Judge Nowlin flatly condemned the “net benefit theory” as a violation of legal ethics. In this writer’s view, he also found more than enough facts to condemn in-firm pooling on similar grounds. To me, it is simply a way for a lawyer to profit from being a fiduciary of client funds. It allows the lawyer to withhold from IOLTA client funds that, in reality, cannot earn net interest but are made to appear to do so by causing the larger funds of other clients (who could earn net interest on their own) to earn less interest because they are subsidizing both the small funds and the lawyer’s practice. And there may be more ethical problems, too.

Sub-accounting is complex. That complexity makes it very difficult to determine whether clients will gain or lose from the use of a sub-account in marginal cases. Even if the interest rate, times the amount, times the projected holding period exceed the cost of opening the account, there is more to consider. What will the transaction costs be? Will the rate change? Exactly when will the money be withdrawn? Is interest forfeiture a possibility? What about the lawyer’s administrative time and expense? And, of course, the banks can change the rules; what is free or inexpensive or permitted today, may not be so tomorrow.

New York lawyers confronted with uncertainty in a particular case can take comfort from the fact that, if they choose IOLA in good faith, they are protected by statute from a client’s claim that they should have used, e.g., a sub-account. On the other hand, a New York lawyer who chooses a sub-account that loses his client even a little money is absolutely exposed unless the client has agreed, in advance, to hold the lawyer harmless.

What about that original decision to use a sub-account system? Is it completely free of ethical taint? I’ll bet the bank salesman stresses the benefits to you of handling your clients’ money in this way, but doesn’t (and probably couldn’t) explain why it is better for your client. When you choose sub-accounting, are you being a good fiduciary, or just a shrewd businessman acting in self-interest?

There are other issues. For example, many sub-account products risk inadvertent ethical violation. A common bank restriction is that the lawyer may not write checks directly from the interest-bearing sub account, but must first transfer the funds to a “master” account. Unless the master account is an IOLA account, disciplinary authorities may take the position that, when the funds of two or more clients pass through the master account, the lawyer has engaged in prohibited co-mingling. (The co-mingling potential is even worse if the firm’s account is also a sub-account or is the master account.) For another example, assume that one of the linked accounts is your firm account, on which the bank waives transaction fees as long as the aggregate balance in all the accounts, including the ones containing your clients’ money, meets a certain minimum (another common provision). Are you sure you are not benefiting from your role as a fiduciary? Assume the balance is very close when your client asks to move up a title closing, which will cause the aggregate balance to go below the minimum and incur significant transaction costs for you. Will you have an incentive to delay that closing just a little? More to the ethical point, will you appear to have such an incentive?

Mr. Genova is a former member of the ABA Commission on IOLTA, a litigation partner at Milbank, Tweed, Hadley & McCloy, LLP, where he also supervises the pro bono program, and a frequent contributor to NYPRR.

DISCLAIMER: This article provides general coverage of its subject area and is presented to the reader for informational purposes only with the understanding that the laws governing legal ethics and professional responsibility are always changing. The information in this article is not a substitute for legal advice and may not be suitable in a particular situation. Consult your attorney for legal advice. New York Legal Ethics Reporter provides this article with the understanding that neither New York Legal Ethics Reporter LLC, nor Frankfurt Kurnit Klein & Selz, nor Hofstra University, nor their representatives, nor any of the authors are engaged herein in rendering legal advice. New York Legal Ethics Reporter LLC, Frankfurt Kurnit Klein & Selz, Hofstra University, their representatives, and the authors shall not be liable for any damages resulting from any error, inaccuracy, or omission.

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