By Joseph S. Genova [Originally published in NYPRR December 1998]
In Phillips v. Washington Legal Foundation, decided in June 1998, a bare majority of the U.S. Supreme Court said that interest earned on client funds held in IOLTA accounts maintained by Texas lawyers is “private property” of the client for purposes of the takings clause of the Fifth Amendment. The majority did not reach the basic constitutional issue, which requires the Court to answer two more questions in the affirmative before there can be a violation of the takings clause. First, do IOLTA programs constitute unconstitutional “taking” of private property for a public purpose? Second; if they do, what is the economic value of what they take? The Court sent the case back to the district court to answer those questions. Resolution of these constitutional issues is still some time away. Plaintiff Washington Legal Foundation, a conservative action group which would like to end IOLTA, has moved for summary judgment, but the Texas IOLTA program will first take discovery of the plaintiffs.
In NYPRR Nov. 1998, I reviewed the basic purpose, structure and mechanics common to many IOLTA programs, and the reasoning of the ethical opinions endorsing lawyers’ participation in them. Here, I argue that Phillips may require closer reading of those ethical opinions, but that their conclusions are still sound. I also discuss the reaction to Phillips by state courts, IOLTA programs and bar associations, and explain why client consent to an IOLTA program is not a practical solution because of the tax problems which result. Finally, I offer a few of my own observations.
Does Phillips Rock IOLA Foundations?
At first blush, the Supreme Court appears to have undermined the ethical opinions blessing IOLTA. The opinions rely on the assumption, apparently no longer valid under Texas law applicable to trust funds, that interest which would not exist except for the IOLTA program is not the “property” of the client. For example, ABA Formal Opinion 348 (1982) concluded: “Assuming that either a court or a legislature … has made a determination that the interest earned is not the clients’ property, participation in the [IOLTA] program by lawyers is ethical.” Is the opposite proposition also true? That is, if a court has determined that the interest earned is the clients’ property, then is lawyer participation unethical? No.
The key factor cited in the opinions — that the interest was not the client’s property was shorthand for a more complex analysis — whether or not the client had any reasonable expectation of actually receiving net interest. Lawyer participation in IOLTA programs was ethical because the clients had no reasonable expectation of receiving net interest on the small or briefly-held sums to which IOLTA applied. In normal circumstances, the costs and charges would equal or exceed the gross interest. The view that participation was ethical did not depend on whether the interest was client property but on the practical question: would the client be losing anything of economic value.
No Economic Value to Clients
Neither IOLTA nor the lawyers who follow the applicable IOLTA rules take anything of economic value from their clients. For this reason, I believe — as do four members of the Court who dissented in Phillips — that when the Court decides the Fifth Amendment question, it will find that IOLTA programs pass constitutional muster. This is because IOLTA only applies to “qualified funds” (a term of art used in the New York statute, but a concept that applies to IOLTA funds generally.) Since qualified funds cannot, as defined, generate any net interest for the client, the Court should conclude that, even if there is a “taking” of this private property for a public purpose, the value of that property is zero, or less. Of course, if the value is zero or less, there should be no violation of the takings clause because “just compensation” is also $0.
I am not alone in my conclusion that, from every perspective, Phillips leaves IOLTA programs legally and ethically undisturbed. On Aug. 6, 1998, the Conference of Chief Justices (consisting of the highest judicial officer of each state, the District of Columbia, and various territories and protectorates) adopted Resolution IX, which concluded in part “the Conference … reiterates its strong support for the concept of IOLTA … [and] supports the continued operation of IOLTA programs in each jurisdiction.” In addition, the highest courts in several states in which IOLTA programs were established by court rule have specifically considered Phillips and issued opinions or orders directing the continued operation of the IOLTA program. A number of state Attorneys General have issued opinions to the effect that Phillips is no bar to continued operation of IOLTA, as have private counsel, bar leaders, and the programs themselves, including the major New York bar associations and the New York IOLTA program. Indeed, I have yet to encounter a credible source that disagrees with these conclusions, notwithstanding the initial speculation that Phillips spelled the end of IOLTA.
Should We Obtain Client Consent?
Some lawyers have suggested mooting the issue by obtaining the client’s consent to place funds in an IOLTA account. That impulse is wrong. Under applicable IRS rulings, if you seek the client’s consent, you create a tax problem for your client.
When the IOLTA concept arose, programs sought assurance that clients would not have to pay taxes on the interest created by and paid to IOLTA. Initially, some IOLTA programs permitted clients to choose between an IOLTA account and a non-interest bearing account. However, the IRS viewed the client’s ability to choose between accounts as the exercise of control over the interest. This meant the gross interest would be taxable to the client, even if the client chose to “give” it to IOLTA. The IRS would then expect the client to report the gross interest as income but allow the client to deduct the same amount as a charitable contribution. But funds in an IOLTA account generate no 1099 reporting and no charitable contribution receipt, so it would be difficult for the client to complete a tax return. Moreover, if the client is not in a position to take 100% advantage of a charitable deduction equal to the interest, the client could lose money.
In order to avoid this result, the IRS issued revenue rulings to the effect that a lawyer’s participation in IOLTA would have no tax consequence for the lawyer or the client as long as the client is not asked to consent. In the absence of choice, the IRS agreed to treat the interest earned on the client’s funds as income of IOLTA, and not income of the client. If a lawyer seeks the client’s consent, the lawyer deprives the client of the protection of the revenue rulings, creating tax burdens and potential tax law violations for the client.
Pundits have seized on Phillips to argue that, due to modern technology, “almost any money that can earn net interest in an IOLTA account could very likely be earning net interest for clients instead.” (Roger Parloff, “Other People’s Money,” American Lawyer, Sept. 1998.) Fortunately, Professor James Paulsen, of the South Texas College of Law, has exposed some of the many serious factual fallacies in that statement, so I need only point out that the entire technology issue is beside the point, ethically and constitutionally. If available technology, together with all other factors relevant to the time, place and circumstances of a lawyer’s receipt of client funds, tell the lawyer that the client can earn net interest consistently with other obligations to the client, the conclusion is simple. The lawyer has, and has always had, the obligation to enable the client to earn that interest both before and since the advent of IOLTA.
Some critics have also confused the IOLTA rule with its application. At issue in Phillips, for example, was a $1,000 deposit given by the client as security for the payment of legal bills to be rendered over a period of years. The lawyer was wrong to put that sum in an IOLTA account if, in his good faith judgment, he expected to hold the funds long enough to generate net interest for the client, after deducting all the costs and charges associated with opening, closing and administering the account. Under those circumstances, an interest-bearing account should have been used.
The fact that the lawyer in Phillips may have erred does not mean that IOLTA programs are unconstitutional or unethical. Prior to IOLTA, the same error would probably have resulted in the funds’ being placed in a non-interest bearing account, and the client would have been similarly deprived of the net interest. The beneficiary of the lawyer’s error would have been the bank (which would have had the use of the funds without paying interest). The client would have had no recourse, except against the lawyer. In contrast, under most IOLTA programs, a lawyer’s good faith error in putting a client’s funds in an IOLTA account can be corrected retroactively, and the client can be made whole, because the IOLTA program will return all interest on money erroneously deposited in an IOLTA account. Just try to get your bank to give you interest on funds you accidentally deposited in a non-interest bearing account!
New York IOLA Rule Protects Client
As I explained in Part I of this article, New York’s IOLA program has just such a rule to protect clients if a lawyer makes a good faith error by putting “non-qualified” client funds in an IOLA account. The IOLA statute also protects the lawyer against other claims arising from the error, as well as against claims based on the “failure” to place qualified funds in an IOLA account.
In my opinion, the statute does not protect a lawyer who erroneously places client funds in an interest bearing account which ends up generating more costs than interest (especially after taxes). Every New York lawyer should therefore make a good faith effort to determine whether or not the clients’ funds are “qualified funds” (i.e., funds expected to generate less than $150 in interest are presumptively “qualified”) and therefore eligible for IOLA treatment. When it is just too close to call, an IOLA account is the safest course.
Phillips requires no changes in New York, and IOLA is alive and well. Lawyers should go on using IOLA accounts for “qualified funds,” and should do so whenever the qualified/non-qualified analysis is “too close to call.” That is the safest course for the lawyer and the client. Lawyers have an obligation to support the provision of civil legal services to poor persons, and IOLA is absolutely critical.
Joseph S. Genova is a litigation partner at Milbank, Tweed, Haley & McCloy and directs the firm’s public service activity. As a member of the ABA Commission on IOLTA, he deals with lawyers’ obligations to the public and the courts, and their handling of client funds.
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