California Lawyers Association
Ethics Spotlight: Client Trust Accounts and Bank Stability Concerns
By Neil J Wertlieb
This Ethics Spotlight highlights attorney obligations with respect to client trust accounts in light of recent concerns with respect to bank stability.
Background
Silicon Valley Bank (“SVB”), based in Santa Clara, California, was closed in March 2023 by the California Department of Financial Protection and Innovation, with no advance notice to the public, and was subsequently sold by the Federal Deposit Insurance Corporation (acting as receiver, “FDIC”) to First-Citizens Bank & Trust Company. SVB was quickly shut down following a significant drop in the value of its investments and a run on the bank. A day later, a similar fate happened to Signature Bank, based in New York. Although the news of these bank failures created a great deal of panic in the financial markets, bank failures are not new nor all that uncommon, with well over 500 bank failures in the past two decades (as reported by the FDIC). [1]
In accordance with Rule 1.15 of the California Rules of Professional Conduct, an attorney has certain obligations with respect to safekeeping of funds or property held on behalf of clients and other persons, including depositing such funds into a trust account at a bank. With the recent failures of certain banks, and lingering questions about bank stability generally, do attorneys have enhanced obligations in safekeeping client funds?
Bank Stability Concerns
The State Bar of California has acknowledged that attorneys might have concerns about their obligations under Rule 1.15 in light of questions about bank stability, and has encouraged such attorneys to contact the State Bar’s Ethics Hotline for assistance.[2] The State Bar cautions, however, that attorneys must continue to comply with Rule 1.15, including depositing funds held on behalf of clients and other persons in a bank account, notwithstanding the current concerns with bank stability.
Pursuant to the State Bar Act (California Business and Professions Code §§ 6000 et seq.), client funds for multiple clients can be deposited into a single trust account if the amounts handled are small, or are held for a short period of time, and the account is an Interest on Lawyers’ Trust Account, or IOLTA account, at a financial institution eligible to hold IOLTA accounts under Business and Professions Code Section 6212. While the State Bar publishes a current list of eligible financial institutions on its website,[3] it cautions that “the State Bar does not make any determination regarding the relative stability of the financial institutions on the list.”[4]
As stated in the Handbook on Client Trust Accounting for California Attorneys, which is available on the State Bar’s website,[5] “Client trust bank accounts … [s]hould be maintained in a financially stable bank.” Despite this admonition, the State Bar acknowledges that “Rule 1.15 and the IOLTA requirements … do not resolve potential concerns about a lawyer’s liability for client funds in the event of a bank failure … which is a legal and risk management issue beyond the scope of the State Bar’s regulatory function.”[6]
There appears to be no California case law on point, but the State Bar Ethics Hotline does cite to a New York appellate decision for guidance. In Bazinet v. Kluge, 14 A.D.3d 324, 788 N.Y.S.2d 77 (N.Y. App. Div. 2005), an attorney for one of the parties to a real estate transaction deposited an escrow payment in his IOLA account (an “Interest on Lawyer Account,” New York State’s equivalent of California’s IOLTA account). Prior to the closing of the transaction, the bank had failed and was placed into FDIC receivership, and the funds were presumed lost. The attorney was sued for malpractice, among other claims. The court, determining that there were no allegations that the attorney knew the bank was in danger of closing, found that the proximate cause of any lost funds was the bank’s unforeseen demise. In citing to this case, the California State Bar states that “foreseeability is a key element”—implicitly suggesting that, in California, an attorney might be liable for lost funds held in trust when the attorney is on notice that the bank is in danger of closing.
FDIC Insurance
Attorneys should also consider whether, and to what extent, deposits in their IOLTA account are covered by FDIC insurance.[7] The FDIC is an independent agency of the United States government that protects bank depositors against the loss of their insured deposits in the event that an FDIC-insured financial institution fails. FDIC insurance, backed by the full faith and credit of the United States government, protects bank customers in the event that an FDIC-insured depository institution fails.[8] According to the FDIC website,[9] “Deposit insurance is one of the significant benefits of having an account at an FDIC-insured bank—it’s how the FDIC protects your money in the unlikely event of a bank failure. The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category. And you don’t have to purchase deposit insurance. If you open a deposit account in an FDIC-insured bank, you are automatically covered.”
As stated in the Handbook on Client Trust Accounting for California Attorneys, an attorney should “[c]onsider selecting a bank that is regulated by a federal or state agency and that carries deposit insurance from an agency of the federal government. As your client’s fiduciary, you are responsible for protecting your client funds.”[10]
Although the standard insurance amount is $250,000 per depositor, the funds held by an attorney in an IOLTA account on behalf clients and third parties may be treated as deposits by such persons such that the $250,000 coverage applies to each such person. As stated in the Handbook on Client Trust Accounting for California Attorneys, “the funds deposited by you [in an FDIC-insured IOLTA account] on behalf of one or more principals are insured as the funds of the principal (the actual owner) to the same extent as if the funds were deposited directly by the principal, provided … [(a)] The fiduciary nature of the account must be disclosed in the account title [e.g., “Trust Account”; and (b)] The identities and the interests of the principals for whom the fiduciary is acting must be ascertainable from either the deposit account records of the bank, or records maintained in good faith and in the regular course of business by the depositor …..”[11]
The amount of FDIC insurance coverage may also differ depending on the type of trust account used to hold client funds. For example, if such funds are deposited into a non-IOLTA trust account at a bank, the funds so deposited may be subject to a $250,000 insurance coverage limit applicable to the client—meaning that the insurance coverage for all money that the client has on deposit at that bank (including the funds deposited by an attorney on behalf of the client) is limited to $250,000. As a result, if, for example, an attorney is holding $100,000 for a client in a non-IOLTA trust account at a particular bank, and the client separately has $200,000 on deposit at that same bank, only $250,000 of the client’s $300,000 may be covered. As the Handbook on Client Trust Accounting for California Attorneys cautions, “You should check with your bank or the FDIC to determine any applicable deposit insurance.”[12]
Further, even if all such trust funds are covered by FDIC insurance, in the event of a bank failure, the client’s access to such funds could be significantly delayed. Although, historically, “the FDIC pays insurance within a few days after a bank closing,” on occasion “the FDIC may need additional time to determine the amount of deposit insurance coverage and may request supplemental information from the depositor in order to complete the insurance determination.” In addition, “as the receiver of the failed bank, the FDIC assumes the task of selling/collecting the assets of the failed bank and settling its debts, including claims for deposits in excess of the insured limit. If a depositor has uninsured funds (i.e., funds above the insured limit), they may recover some portion of their uninsured funds from the proceeds from the sale of failed bank assets. However, it can take several years to sell off the assets of a failed bank. As assets are sold, depositors who had uninsured funds usually receive periodic payments (on a pro-rata “cents on the dollar” basis) on their remaining claim.”[13]
As the Handbook on Client Trust Accounting for California Attorneys cautions, “While the presence of FDIC insurance is important, a lawyer should note that even if all of a client’s funds are covered, by the time the FDIC pays a client their money, that client’s interests might be adversely impacted.”[14]
Conclusion
As a result of the fiduciary duties that we owe to our clients, especially when holding their funds, we as attorneys should be mindful of the risks associated with depositing such funds in certain accounts or with certain financial institutions, where the risk of bank failures, limited insurance coverage and/or delays in such coverage are foreseeable.
Neil J Wertlieb is an Inaugural Co-Chair and Founding Member of California Lawyers Association’s Ethics Committee, and a former Chair of the Business Law Section and its Corporations and Business Litigation Committees. He is the General Counsel of Milbank LLP. The views expressed herein are his own.
[1] See https://www.fdic.gov/bank/historical/bank/index.html. Ailing Swiss bank Credit Suisse also agreed in March 2023 to be acquired by Swiss bank UBS.
[5] https://www.calbar.ca.gov/Portals/0/documents/ethics/Publications/Portals0documentsethicsPublicationsCTA-Handbook.pdf (page 13).
[7] Credit unions, certain of which are eligible financial institutions, may have insurance offered by the National Credit Union Administration.
[8] See https://www.fdic.gov/resources/deposit-insurance/faq/.
[9] https://www.fdic.gov/resources/deposit-insurance/.
[10] https://www.calbar.ca.gov/Portals/0/documents/ethics/Publications/Portals0documentsethicsPublicationsCTA-Handbook.pdf (page 13).
[11] Id., page 18. See also https://www.fdic.gov/news/fact-sheets/final-rule-trust-mortgage-accounts-01-21-22.pdf, which discusses new FDIC rules for trust accounts that are expected to go into effect on April 1, 2024.
[12] https://www.calbar.ca.gov/Portals/0/documents/ethics/Publications/Portals0documentsethicsPublicationsCTA-Handbook.pdf (page 13).
[13] https://www.fdic.gov/resources/deposit-insurance/faq/.
[14] https://www.calbar.ca.gov/Portals/0/documents/ethics/Publications/Portals0documentsethicsPublicationsCTA-Handbook.pdf (page 19).