The Consumer Protection Review - exploring the fine line between legal and financial regulation

The conclusion of the SRA's Consumer Protection Review remains to be seen but it seems likely that the way law firms handle client funds will face changes. In this article for Law360, Claire Van der Zant looks at some of the detail of the CPR and asks how firms can prepare.

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The Solicitors Regulation Authority (SRA) launched its Consumer Protection Review (CPR) earlier this year ostensibly to mitigate the kind of risks exposed by recent high-profile cases such as SSB, Metamorph and Axiom Ince; a case where some £64 million of client funds being held by the firm disappeared. 

These cases undoubtedly contributed to the question of to what extent law firms should be holding client funds. The last six months have seen SRA interventions double, as the regulator has taken action against firms where breaches of regulations around fund handling and anti-money laundering rules have been found. 

The CPR aims to address the risks exposed by these cases and give consideration to the ways in which firms handle client funds. While the outcome of the CPR remains to be seen, many firms across the UK have expressed anxiety about the CPR which they feel could lead to a significant culture shift in the UK legal sector, as well the potential loss of revenue streams. 

Business model

Law firms in the UK have a long-standing culture of handling client funds in-house which, while not unique to the UK, is certainly not universal. 

There are a number of reasons that firms attribute value to handling client funds. Funds are used for example, for receiving payments on a client account. This gives firms assurance that payments will be on-time and as expected, thus improving cash flow and business financial planning. Funds have also been used to allow firms to facilitate payments. Whether a  conveyancing service as part of a house purchase or a significant corporate merger, firms hold funds in order to execute payments for legal matters and put themselves at the heart of a deal on behalf of their clients. 

Given this it’s unsurprising that many are concerned about where the CPR might lead and there’s a sense in the market that the CPR risks penalising the whole legal sector for the actions of a few. There is also a fear that, just as the law firm business model might be disrupted if restrictions were to be placed on the handling of client funds, so too would perceptions of law firms amongst customers. The sense is that a regulatory intervention here would send a signal to customers - whether individuals or corporates - that legal firms cannot be trusted with fund handling. Given the centrality of trust to the legal services, this could damage the ‘solicitor brand’. 

It’s also difficult to talk about the business model as it relates to client money without referencing the point about interest earned on client balances. Getting a preferential interest rate from the bank is often the defining factor for selecting a client account, and with interest rates still high, interest is a feature of the revenue mix for firms, large and small. Having quite rightly optimised for interest, the future business model for law firms needs careful consideration, as an unintended consequence of making changes too quickly could lead to considerable consolidation in the market. 

Administrative burdens

Alongside the perceived advantages of handling client money, there are also a range of well documented downsides that firms should also be considering as the CPR moves towards its recommendations. 

One of the primary downsides to handling client money is the significant administrative burden it brings. Handling client money requires firms to maintain a separate client account, undertake bank reconciliations between the client account and office account to ensure that the ledgers tally, and to deal with any unreconciled items promptly. Whether this work falls to legal cashiers in larger firms or fee-earners in smaller ones, the fact remains that it takes significant time and resource which inevitably challenges some of the perceived advantages that firms believe come with handling client monies. 

Alongside this, dealing with client money also brings a compliance burden. As many recent cases have shown, remaining compliant with the SRA’s Solicitors’ Accounts Rules can be challenging and onerous and inadvertent breaches are not uncommon, particularly of the ‘residual balances rule’ (rule 2.5) and the ‘banking facility rule’ (rule 3.3). The ‘banking facility rule’ can be especially problematic for more transactional practice areas, with most firms refusing to provide any kind of escrow facility for their clients. 

Risk 

In a world of increasingly sophisticated cyber criminals and fraudsters, handling large sums of money brings risk to any organisation and this is another potential downside to the current model of handling client funds in-house. 

A recent industry survey revealed that cybersecurity threats are second only to macroeconomic volatility when it comes to perceived threats to legal businesses. The uptake of hybrid working habits and the increasing sophistication of social engineering and ransomware attacks have increased risk in this area. While the largest firms can hire dedicated cybersecurity teams and spend millions on risk mitigation, most firms are striving to do the best they can with limited resources and may find themselves exposed to greater risk as a result.  

This risk, combined with the risk of financial crime and fraud, is reflected in further costs to law firms which must also be taken into account when considering the client money question through a purely economic lens. Handling client funds, for example, means firms need to pay into the SRA’s compensation fund, which is set to increase more than threefold next year. Likewise firms need to pay higher premiums for professional indemnity insurance when handling client funds, reflecting the greater level of risk. A recent survey conducted on behalf of the Legal Services Board indicated that firms holding higher peak amounts of money at any point during the year were likely to pay higher rates of PII, predicting that a law firm holding 5x its average amount will pay a 13% higher premium compared to a law firm holding 2x its average amount.

These risks and regulatory responsibilities are further compounded by the increasing complexity that comes with handling client money and fund flows in an increasingly globalised and 24/7 economy. Within the world of corporate transactions in particular, transacting parties are often spread across multiple jurisdictions and therefore multiple currencies. 

The road less travelled 

So, the regulatory landscape is shifting and for law firms this might mean a challenge to existing business models. This will no doubt be a source of anxiety as the CPR heads toward its conclusion in 2025 but, as demonstrated by colleagues in the US and France, alternative models exist.

Whether or not the SRA compels firms to work with third party managed accounts (TPMAs) to handle client funds remains to be seen but, regardless, many firms may opt for this route for a number of reasons. 

These include a reduced administrative burden due to payments being reconciled at matter level, making it easier for legal professionals to track all payments relating to a matter; a reduced compliance burden as the risk of breaching SRA Accounts Rules falls away; reduced costs on, for example, audits, SRA compensation fund contributions and reduced cybersecurity risk. 

While firms will always be required to undertake KYC on their clients and due diligence on any matters, the risk of fraud, money laundering, terrorist financing and other financial crime is also significantly reduced through using an FCA-regulated payments provider with expertise in identifying and mitigating such risks. 

Next steps

The switch to TPMAs as an alternative to handling client money in-house does come with a few challenges in the short-term. Alongside those outlined above, there have been discussions about capacity constraints as currently there are very few solution providers, and even fewer offering APIs, to serve the needs of almost 10,000 firms in the UK which could create a ‘concentration risk’. The regulator has, however, expressed confidence in the fast maturation of the market as demand surges in response to regulatory change and providers continue to collaborate to build solutions that meet the needs of the industry.

When it comes to handling client money and enhancing consumer protection therefore, the challenge for the UK’s legal sector is both a regulatory and a cultural one. Regulatory change is arguably easier to bring about than cultural change, however there is a question over how long consumers should have to wait for cultural norms within a profession to catch up with the pace of change in the complex environment within which they operate. When scandals such as Axiom Ince are the subject of a special feature on one of the UK’s most popular morning magazine programmes, with questions being asked about how £64 million of client money can go missing, it is clear that some soul-searching is needed and for regulatory change to drive the cultural change necessary to continuously evolve and improve consumer protection.

This article was first published in Law360 - read online here. 

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