October 30, 2008
Bank Failures and Lawyer Trust Accounts Redux
By James M. McCauley, Ethics Counsel
Virginia State Bar
Since I last wrote on the subject of what precautions lawyers should take to see that client funds in their trust account are fully insured by the FDIC,1 the financial crisis in this country has worsened — dramatically — and lawyers need to think proactively with regard to bank failures. One positive development, however, is that the FDIC raised the insurance limit to $250,000. If a depositor's accounts at one FDIC-insured bank or savings association total $250,000 or less, the deposits are fully insured. A depositor can have more than $250,000 at one insured bank or savings association and still be fully insured provided the accounts meet certain requirements.
Lawyer Trust or Escrow Accounts are Fiduciary Accounts
As stated in the July 30 article, IOLTA or lawyer trust accounts will be treated differently by the FDIC than a single depositor account. Provided the bank’s records for your trust account show the existence of a fiduciary relationship, then each client or third party whose funds are in that account are covered up to the $250,000 limit. Lawyers should make sure that the fiduciary nature of any account holding fiduciary funds is clearly reflected in the title of the account used by the bank.2 According to the FDIC, a clearly identified IOLTA or lawyer’s trust account meets this requirement and discloses a fiduciary relationship.3 In addition, the name and ownership interest of each owner must be ascertainable from the deposit account records of the insured bank or from records maintained by the agent (or by some person or entity that has agreed to maintain records for the agent).4 So, for example, assume a lawyer has $500,000 total in a pooled law firm trust account, holding trust funds for twenty clients. As long as the bank’s records show the fiduciary nature of that account, and the lawyer’s record keeping shows the name and amount held in trust on behalf of each client, each of these twenty clients is insured up to the $250,000 limit.
Lawyers should also ask clients where they do their personal banking because if the client has accounts at the same bank as the lawyer’s trust account, the FDIC will include the funds held in the client’s other accounts at that bank toward the $250,000 limit. For FDIC insurance purposes, funds in all accounts in that client’s name will be combined.
Bank Failures Not a Disciplinary Issue if Lawyers Use an FDIC Insured, Stable Bank
The consensus of the bar organizations that have considered this issue is that lawyers do need to be cautions about where they hold client trust funds, making sure they are FDIC-insured and financially stable institutions. Opinions vary on whether a client’s deposit should be divvied up among different banks to stay under the $250,000 limit. Whether such action is prudent depends on the practicality of the measure. Some lawyers hold client funds, in the millions of dollars, for as long as only one day to years. Opening multiple accounts for one client to make sure millions of dollars held for that client are FDIC insured may not be feasible. The most important thing is for the lawyer to exercise reasonable diligence in selecting a financially stable financial institution to hold client funds. Generally, however, lawyers should not worry about disciplinary action if a bank failure leads to the loss of client funds, provided the lawyer chooses an FDIC-insured, stable bank.
But if a Bank Fails, Is that a Basis for Malpractice Liability?
Bazinet v. Kluge,5 is one of the few reported cases involving a lawyer getting sued for legal malpractice, after a client lost money when a bank failed in 2003. In that case, a lawyer who represented a client selling two Manhattan apartments deposited the sales proceeds — $1.4 million — in the firm’s trust account, and an additional $1.3 million when the original deal fell through. The bank suddenly closed and the FDIC became the receiver. The buyer sued the client, who cross-claimed the lawyer for malpractice for depositing the funds in a small Connecticut bank. An expert for the plaintiff was supposed to opine that the lawyer should have kept the funds in treasury bills or by obtaining supplementary insurance. A New York appellate court concluded the lawyer was not responsible for knowing that the bank was financially unstable.6
However, a number of commentators believe that such a case may go the other way given the current banking and financial crisis. Lawyers should be checking the financial soundness of their bank using Veribanc or other rating companies.
Conflict: Lawyer Represents a Bank on the Verge of Failing and has Client Funds Deposited at that Bank.
The banking crisis presents unique situations for lawyers, especially those who represent a bank facing financial difficulty. Suppose a lawyer represents Bank X. The lawyer learns from discussions with Bank X’s management that Bank X’s solvency is doubtful and that its failure is a distinct possibility. May the lawyer alert his clients to this problem and move trust or fiduciary accounts to another bank? It does not appear that the lawyer can do this without breaching his duty of confidentiality to Bank X under Rule 1.6. More to the point is Rule 1.8 (b):
“A lawyer shall not use information relating to the representation of a client for advantage of the lawyer or of a third person or to the disadvantage of the client unless the client consents after consultation, except as permitted or required by Rule 1.6 or Rule 3.3.”
Neither Rule 1.6 nor Rule 3.3 permit disclosure unless the client, Bank X, intends to commit a future crime or has, in the course of the representation, perpetrated a fraud on a tribunal or third party. So it appears that there is a Hobson’s choice for the lawyer: either
the lawyer breaches his Rule 1.6 and Rule 1.8 (b) duties to his client, Bank X; or remains silent thereby breaching his/her fiduciary duties and Rule 1.15 duty to clients that have entrusted funds to the lawyers care to protect and safeguard.
Does the lawyer have a conflict of interest that requires him/her to withdraw from representing either? As it is not a conflict related to the substantive representation, the answer is probably “no.” However, this ethical dilemma may require a difficult choice of weighing one’s duty of confidentiality to the bank against one’s fiduciary duties when handling client’s funds. The lawyer would need to carefully scrutinize his/her jurisdictions version of Rule 1.6 to determine if moving the funds would be a breach of confidentiality. While not a perfect solution, the most prudent course would likely be to protect the client’s funds by moving the lawyer’s fiduciary accounts to another financial institution while disclosing as little as possible regarding the bank.
1 “If Your Bank Goes Under, Are Your Clients’ Trust Account Deposits Fully Insured?” (July 30, 2008) found at http://www.vsb.org/site/news/item/trust-account-deposits-insured/ last viewed on October 10, 2008.
2 The fiduciary nature of the account must be disclosed in the bank's deposit account records (e.g., "Jane Doe as Custodian for Susie Doe" or "First Real Estate Title Company, Client Escrow Account" or “Smith Law Firm IOLTA Account”).
3 “FAQs About FDIC Insurance, FAQ #17 found at http://www.fdic.gov/deposit/deposits/insured/faq3.html#fiduciary last viewed on October 10, 2008.