SC Lawyer, May 2009, #4. Who Can You Trust? How the TLGP, FDIC, NCUSIF and CDARS Affect the Safekeeping of Client Funds.

• Author: By Michael J. Virzi

South Carolina Lawyer

2009.

SC Lawyer, May 2009, #4.

Who Can You Trust? How the TLGP, FDIC, NCUSIF and CDARS Affect the Safekeeping of Client Funds

South Carolina LawyerMay 2009Who Can You Trust? How the TLGP, FDIC, NCUSIF and CDARS Affect the Safekeeping of Client FundsBy Michael J. Virzi"Put not your trust in money, but put your money in trust." -Oliver Wendell Holmes (1809-1894)

In the current economic climate, which includes a heightened risk of bank failure, lawyers and state bar ethics committees nationwide have been grappling with questions about deposit insurance limits and excess client funds held in trust. The federal government has responded, but only temporarily and incompletely. Meanwhile, our own Bar and Supreme Court have addressed questions regarding the use of credit unions rather than banks for lawyer trust accounts, but those clarifications may too be inadequate.

The credit union question appeared to be settled, but recent federal activity involving deposit insurance has shed new light on the problem. At the end of the day, what must lawyers do to keep trust funds safe? And who can they trust with their trust accounts? The first answer is different in 2009 than it may be in 2010, and the second answer is not as simple as it seems.

"Safekeeping"

A lawyer's obligations regarding client funds stem from Rule 1.15 ("Safekeeping Property") of the Rules of Professional Conduct, 407 SCACR. That rule requires lawyers to place client funds and third-party funds in a trust account, separate from the lawyer's own funds. The Ethics Advisory Committee was recently asked whether lawyers have an obligation in these uncertain times to protect client funds that exceed federal insurance limits. The Committee advised that they do not. "There is no requirement in the rules for an attorney either to insure funds in excess of $100,000 or to place funds in numerous different banks. To impose such a requirement would be an unreasonable burden on the practicing attorney in most cases." Ethics Advisory Op. No. 08-10 (2008). A few days later, the FDIC temporarily raised its insurance limit to $250,000. On January 1, 2010, the limit will return to $100,000.

As a preliminary matter, lawyers and clients alike should be aware of two factors concerning FDIC insurance limits. First, when a client personally banks at the same institution where the lawyer's trust account is held, the federal insurance limit is a single cap for the client's combined funds. See 12 C.F.R. §§ 330.6(a), 330.7(a). Thus, after the FDIC limit returns to $100,000, a client with $125,000 on deposit in a personal account and $125,000 in a lawyer's trust account at the same bank will be insured only up to $100,000 total, not $100,000 for each account.

Second, as long as a trust account is identified as such in its title, and the lawyer maintains records of the individuals on whose behalf funds are held and the specific amounts attributable to each owner (i.e., if the lawyer is in compliance with Rule 417, SCACR), the FDIC insurance limit will apply separately to each client's funds. See 12 CFR § 330.5(b); FDIC Advisory Opinion Op. 98-2 (1998). Thus, after the FDIC limit returns to $100,000, if a lawyer's trust account contains $400,000 belonging in equal amounts to four clients, the entire balance will be fully insured, assuming none of the four clients also has funds in a personal account at the same bank.

The TLGP

The bad news about the temporary FDIC insurance limit increase is that it does not apply to all IOLTA accounts. The good news is found in the reason it does not apply to some. On November 21, 2008, the FDIC released its Final Rule implementing the Temporary Liquidity Guarantee Program. Under TLGP, the FDIC is insuring deposits in non-interest-bearing accounts without limit at participating institutions. Thanks to heavy lobbying by state bars and the National Association of IOLTA Programs, lawyer IOLTA accounts are included in the TLGP (under the preliminary rule released in October, they were not). So the short-term good news is that all IOLTA funds at most banks are insured without limit for the remainder of 2009. Lawyers concerned about obligations beyond FDIC limits are largely safe for the time being, but TLGP will expire on December 31, 2009, if it is not renewed. Furthermore, it does not apply to interest-bearing lawyer trust accounts, often used when funds are not "nominal or short term" under Rule 412(b)(1), SCACR. Those accounts are subject to the temporary $250,000 limit for the remainder of 2009.

Because institutions must pay a fee to participate in TLGP, they were given the choice to opt out of the program. No major national bank opted out, but some regional and local banks did, including 15 in South Carolina. A list of opted-out banks can be found at www.fdic.gov/regulations/resources/TLGP/optout.html. Therefore, by simply determining whether one's bank participates in TLGP (and switching banks if it does not), a lawyer can fully protect all client IOLTA deposits in the short term and put off the question of any further safekeeping duties. This fix is only temporary, but if financial markets remain unstable toward the end of 2009, the program is expected to be renewed. If it is not, or when it eventually expires, these questions will again arise.

Excess funds

Neither the TLGP nor the temporary insurance limit increase affects the analysis of 08-10. Rule 1.15 merely requires lawyers to place client funds into a trust account. It does not require lawyers (in a pre- or post-TLGP world) to further ensure that client funds are protected against bank failure.

Our Ethics Advisory Committee is not alone in this view. One court and several state bars have reached the same conclusion. In Bazinet v. Kluge, 788 N.Y.S.2d 77 (N.Y. App. Div. 2005), a bank holding a lawyer's trust account failed while one client had $2.5 million in the trust account. The court held that the lawyer had no duty to protect client funds above FDIC insurance limit. Likewise, Bar Counsel in Oregon and Virginia have recently advised lawyers in those states that no such obligation exists. See James M. McCaulty, Bar Counsel, If Your Bank Goes Under, Are Your Clients' Trust Account Deposits Fully Insured?, Virginia State Bar News, (July 30, 2008); Sylvia Stevens, Bar Counsel, Trust Accounts and the FDIC, Oregon State Bar Bulletin (October Oct. 2008). However, the North Carolina State Bar qualified its statement about lawyer immunity: "[I]n the absence of information tending to suggest the imminent failure of a bank, a lawyer is presumed to be acting ethically if the lawyer establishes his or her trust account at a financial institution insured by the FDIC." Bruno DeMolli, Bruno's Top Tips for Tip Top Trust Accounting, available at www.ncbar.gov/programs/trust_accounting.asp.

The Rules of Professional Conduct are rules of reason, see RPC Preamblepmbl, Rule 413, SCACR, and clients are not entitled to expect lawyers to be bankers or insurers of trust account deposits. However, "lawyers should hold property of others with the care required of a professional fiduciary." RPC 1.15, Cmt. 1. Therefore, as DeMolli noted, if a lawyer has reason to believe that a particular institution is at risk of failure, that lawyer may be negligent in not moving excess client funds to another institution.

Credit unions

Rule 412 requires lawyer IOLTA accounts to be maintained at a "bank, credit union or savings and loan association authorized by federal or state laws to do business in South Carolina and insured by the Federal Deposit Insurance Corporation, the National Credit Union Share Insurance Fund, or any successor insurance corporation(s) established by federal or state law." Rule 412(a)(4) & (c), SCACR. Prior to this year, the "good funds" rule found in 1.15(f) (governing the prerequisites to disbursement of funds from a trust account) referred only to "bank," prompting one lawyer to inquire of the Bar whether a lawyer could treat as collected an instrument from a credit union. The Ethics Advisory Committee replied, "Subject to future clarification from the Supreme Court, the Committee believes the term "bank" in Rule 1.15(f) should be read to include credit unions and other financial institutions as defined in IOLTA Rule 412(a)(4)." Ethics Advisory Opinion No. 07-10 (2007).

The Bar subsequently proposed a rule clarification, which the Court provided on February 12 of this year. The February order changed the word "bank" to "depository institution" in Rule 1.15(f), but also suggested a broader purpose than just the good funds rule:

The amendment takes into account the fact that a lawyer may receive funds from, or deposit funds into, a financial institution which does not meet the definition of a traditional bank. These institutions include a traditional bank, credit union, or savings and loan association. These institutions also must be insured by the Federal Deposit Insurance Commission in the case of a bank or savings and loan, or the National Credit Union Share Insurance Fund in the case of a credit union.In re: Amendments to the South Carolina Appellate Court Rules, Shearouse Adv. Sheet No. 9, at 35 (Feb. 12, 2009) (emphasis added). That order also amended Rule 1.0 to define "depository institution" as "any bank, credit union, or savings and loan association" that is both licensed in this state and insured by the FDIC or the NCUSIF. Rule 412 (the IOLTA rule) was likewise clarified to allow lawyers to use credit unions that are insured by the NCUSIF.

Like the FDIC, the NCUSIF considers lawyer trust funds to be the funds of the client and applies its $100,000 limit separately to each client, provided the lawyer maintains appropriate records. The NCUSIF also temporarily raised its insurance limit to $250,000 until December 31, 2009.

Unlike the FDIC, however, the NCUSIF separately insures only the funds of those clients who personally are also members of the credit union where the funds are held. See 12 C.F.R. § 745.0. Therefore, unless the clients are also personally members of the lawyer's credit union, client funds in a credit union IOLTA account are not insured. A careful reading of the IOLTA rule and Rule 1.0 of the RPC shows they require only that the credit union be insured by NCUSIF, not that client funds be insured. Surely, however, these rules were intended to protect client deposits, not merely to distinguish among insurance-qualifying and non-qualifying institutions; thus, the spirit of the rule is left unsatisfied.

Lastly, both of the FDIC's recent actions (the insurance limit increase and TLGP) apply only to FDIC-insured institutions, not NCUSIF-insured credit unions, so there is no temporary fix for credit union IOLTA accounts and no increased protection for non-IOLTA trust accounts at credit unions.

Communication

Lawyers should talk to their clients about these issues. The communication requirement of Rule 1.4 does not ordinarily reach to matters as ancillary to representation as evaluating the reliability of banks for trust account purposes. Nevertheless, in these uncertain times, a prudent lawyer holding client funds on deposit in excess of federal insurance limits should, at least as a matter of good business practice, reasonably communicate with clients about the risk of such deposits and the available alternatives. Certainly those lawyers with credit union trust accounts should inform their clients of the potential lack of insurance protection and work with clients to protect their deposits. A lawyer should not assume that clients understand whether and to what extent their funds are insured. In many cases, at least two alternatives to uninsured excess funds are available.

First, lawyers can seek excess fund insurance protection from their depositary banks whenever one client's funds exceed the insurance limit. Many banks will insure excess funds for a fee. Lawyers are not obligated to obtain this insurance in all cases, but appropriate communication will allow an informed client to decide whether reducing the risk of loss is worth the cost of the insurance.

Alternatively, excess funds could be divided into separate trust accounts at separate banks, with each account holding no more than the insurance limit from any one client. Generally, splitting a client's funds reduces exposure to individual bank failures. Specifically, splitting funds to keep them below federal insurance limits practically eliminates that risk, or at least reduces it to an insured risk. This practice may be expensive for some lawyers to administer, and the Ethics Advisory Committee specifically noted in 08-10 that it is not required. Nevertheless, with appropriate communication the expense could be passed on to those clients who make an informed decision to employ this procedure.

A third option often posited (CDARS) is not an appropriate solution. The Certificate of Deposit Account Registry Service allows the deposit of funds into a single account which is then divided by the primary depositary institution into Certificates of Deposit that are transferred to as many other institutions as necessary to keep the funds at each institution within insurance limits. Lawyers should not put client funds in CDARS accounts for three reasons.

First, the account holder has no contact with (or even knowledge of the identity of) the institutions ultimately holding the money. This prevents a lawyer from complying with Rule 1.15(h), which requires written directives to depositary institutions. Second, CDARS funds may not be immediately available and thus may prevent a lawyer from complying with Rule 412(c)(1) (requiring that funds "shall be subject to withdrawal upon request and without delay") and with Rule 1.15(d) (requiring prompt delivery of funds to parties entitled to them).

Lastly, CDARS are designed to prevent overlap of a single account holder's funds. They are not designed to prevent overlap of lawyers' clients' funds. Suppose a client has $100,000 of personal funds at Bank A and other funds in a lawyer's trust account at Bank B. Under CDARS, the lawyer's Bank B funds would be divided up into several banks, possibly including Bank A and thereby potentially leaving the client's trust funds uninsured. The lawyer would have no way of knowing the funds are uninsured, much less preventing it.

Whatever options may be available to a particular lawyer, the lawyer should consult with clients about the risks and alternatives. In many practice areas, such as commercial real estate, clients are typically experienced enough with large sums of money to implicitly understand these risks and may need little if any explanation. However, personal injury plaintiffs, for example, often have no experience with such large sums of money and are unaware of the risks and alternatives.

Where client consultation is appropriate, the specific risk factors should be discussed. Those factors include the extent to which the funds exceed the insurance limit, the anticipated time the funds will remain on deposit, and the speed with which bank failures typically occur (to the extent a lawyer has this information). Furthermore, the risk landscape may be very different after TLGP expires than it is today. Staying apprised of the landscape and keeping clients informed is just good business.

Mr. Virzi is a legal writing instructor at the USC School of Law. He is chair of the Bar's Ethics Advisory Committee.