Nothing Lost, Nothing Owed: Supreme Court Upholds State Iolta Program in Brown v. Legal Foundation of Washington - Robert C. Hughes, Iii

• Citation: Vol. 55 No. 2
• Publication year: 2004

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Nothing Lost, Nothing Owed: Supreme Court Upholds State IOLTA Program in Brown v. Legal Foundation of Washington

In a 5-4 decision in Brown v. Legal Foundation of Washington,¹ the United States Supreme Court held that a state law that (1) requires lawyers and limited practitioner officers ("LPOs") to deposit client funds that cannot otherwise generate net-earning for their clients into an interest on lawyer's trust account ("IOLTA account") and (2) mandates that the interest produced on those funds be transferred to a different owner for a legitimate public use could constitute a per se taking of the clients' right to that interest, but no compensation is owed to such clients where they suffer no net loss.² The Court reasoned that any compensation must be measured by the owner's net pecuniary loss rather than by the value of the taker's gain.³ Conversely, the dissent argued that the appropriate measure of just compensation is the fair market value of the property at issue rather than the owner's net pecuniary loss, emphasizing that such fair market value should not be reduced by any administrative or transactional costs to the owner.⁴

I. Factual Background

In 1980 Congress passed legislation allowing federally insured banks to pay interest on negotiable-order-of-withdrawal accounts ("NOW accounts"). The federal law provides that interest can be paid on deposits made by individuals and charitable organizations, but not on deposits made by for-profit corporations or partnerships unless such deposits are made pursuant to a program under which charitable organizations are the sole recipients of the interest earned. This legislation prompted Florida to establish the first statewide IOLTA program in 1981, permitting the use of NOW accounts for the deposit of client funds when accumulated interest is used for charitable purposes. Other states quickly followed Florida's example, and now every state in the country uses an IOLTA program to help finance legal services for indigent clients.⁵

Like many states, Washington instituted its IOLTA program through the state supreme court.⁶ According to the Washington Supreme Court, Washington's IOLTA program imposes four basic requirements.⁷ First, all client funds that can earn net interest for the client—i.e., an amount greater than the costs associated with establishing and administering the account and disbursing the interest—must be deposited in interest-bearing trust accounts.⁸ Second, funds that cannot otherwise earn net interest for the client must be deposited in an IOLTA account.⁹ Third, lawyers must instruct the banks to pay the interest on the IOLTA accounts to the Legal Foundation of Washington ("Foundation").¹⁰

Fourth, the Foundation must use all funds received from IOLTA accounts for "tax-exempt law-related charitable and educational purposes."¹¹

In 1995 the Washington Supreme Court extended its IOLTA rules to reach LPOs¹² as well as attorneys.¹³ Thus, LPOs are bound by the aforementioned requirements with respect to their clients' funds. Soon after this 1995 amendment, plaintiffs Allen Brown and Greg Hayes sued the Foundation and other defendants to enjoin Washington state officials from continuing to require LPOs to deposit client funds into IOLTA accounts. Brown and Hayes were real estate investors who regularly purchased and sold real estate, and in the course of those transactions transferred funds to LPOs who were required to place them in IOLTA accounts. To establish standing, each plaintiff identified a specific transaction in which his money was held in an IOLTA account and interest earned on it was paid to the Foundation.¹⁴ Plaintiffs alleged that the state's requirement that the interest earned on their funds in IOLTA accounts be transferred to the Foundation effected a taking of that interest in violation of the Fifth Amendment. Plaintiffs asserted that the requirement that client funds be deposited in IOLTA accounts constituted a taking as well.¹⁵

The United States District Court for the Western District of Washington granted summary judgment in favor of defendants. The court observed that under the state's IOLTA rules, clients were not permitted to make any net returns on the interest earned in the IOLTA accounts; if the funds could earn net interest, they should not have been placed in IOLTA accounts in the first place.¹⁶ With that in mind, the court held that "the constitutional issue focused on what an owner has lost, not what the [government] has gained."¹⁷ The court concluded that Hayes and Brown suffered no loss as a result of the IOLTA program and accordingly found no constitutional violation.¹⁸

Reversing the lower court, a three-judge panel of the United States Court of Appeals for the Ninth Circuit held that the IOLTA program effected a taking. Significantly, the panel's holding came after the United States Supreme Court decided in Phillips v. Washington Legal Foundation¹⁹ that the interest earned in IOLTA accounts is the private property of the clients because the clients own the principal that produced that interest.²⁰ The panel took the Phillips holding into consideration and held that "'the interest generated by IOLTA pooled trust accounts is property of the clients and customers whose money is deposited into trust, and . . . a government appropriation of that interest for public purposes is a taking entitling them to just compensation.'"²¹ The panel explained that "'just compensation for the takings may be less than the amount of interest taken, or nothing, depending on the circumstances,'" and therefore remanded the case for determination of a remedy.²²

Subsequently, the Ninth Circuit reconsidered the case en banc. The en banc majority employed the factor-based approach set out in Penn

Central Transportation Co. v. City of New York²³ and affirmed the judgment of the district court.²⁴ In applying the Penn Central analysis, the majority concluded that plaintiffs suffered no actual loss because they would not have "earned net interest on their principal deposits" without the IOLTA program,²⁵ and plaintiffs failed to "show that the cost of their individual real estate transactions increased as a result of the IOLTA rules."²⁶ Moreover, the majority reasoned that the program could not have "interfered with [plaintiffs'] investment-backed expectations" because neither plaintiff "could have expected his principal to earn a net interest."²⁷ The majority also emphasized that "the IOLTA regulations are not out of character for either the commercial industry or the professions they affect."²⁸ Thus, the majority held that no taking occurred.²⁹ However, it observed that even if there was a taking, "there would be no Fifth Amendment violation because the value of their just compensation is nil."³⁰ The en banc dissent contended that it was improper for the majority to rely on the Penn Central factor-based approach because the IOLTA program involved a per se taking rather than a regulatory taking. Like the three-judge panel that heard the original appeal, the en banc dissent would have remanded the case for a determination of whether any compensation was owed.³¹

The United States Supreme Court granted Brown's and Hayes's petition for certiorari regarding the takings issue.³² A divided Court narrowly affirmed the Ninth Circuit's en banc holding by a margin of 5-4.³³

II. Legal Background

The Fifth Amendment to the United States Constitution states, "nor shall property be taken for public use, without just compensation."³⁴ In analyzing a takings claim, courts must consider: (1) whether the claimant owned the property at issue; (2) whether the government "took" that property; and (3) the amount of compensation owed to the claimant, if any.³⁵

A. Determining Ownership

The Supreme Court has addressed the ownership issue with respect to interest earned on principal. In Webb's Fabulous Pharmacies, Inc. v. Beckwith,³⁶ decided in 1980, the Supreme Court determined that interest follows the principal that produced it, and therefore interest belongs to the owner of the principal.³⁷ In that case, the plaintiff, Eckerd's of College Park, Inc. ("Eckerd's") filed an interpleader action in a Florida state court and tendered approximately $2 million into the court.³⁸ A Florida statute provided that interest earned on an interpleader fund deposited in the registry of the court " 'shall be deemed income of the office of the clerk of the circuit court.'"³⁹ Pursuant to that statute, the clerk of the circuit court retained over $100,000 in interest accumulated by the deposited interpleader funds.⁴⁰ Eckerd's objected to the clerk's retention of that interest.⁴¹ Upon a constitutional challenge to the Florida statute, the Court applied the Penn Central Transportation Co. v. City of New York⁴² factor-based approach and held that the statute effected a taking, emphasizing that "the earnings of a fund are incidents of ownership of the fund itself and are property just as the fund itself is property."⁴³

More pertinent here, the Supreme Court in 1998 held in Phillips v. Washington Legal Foundation⁴⁴ that interest earned on client funds held in an IOLTA account was the private property of the client for purposes of the Fifth Amendment Takings Clause.⁴⁵ The Court pointed out that "[w]hile the interest income at issue . . . may have no economically realizable value to its owner, possession, control, and disposition are nonetheless valuable rights that inhere in the property."⁴⁶ In reaching its conclusion, the Court dismissed the argument that the interest income constitutes " 'government created value.' "⁴⁷ The Court explained that the state does not create value; rather, the client's principal creates value.⁴⁸ The Court further noted that "'the [s]tate's having mandated the accrual of interest does not mean the [s]tate or its designate is entitled to assume ownership of the interest."⁴⁹ Thus, under the Court's holdings in Webb's and Phillips, it is clear that...