July 30, 2008
If Your Bank Goes Under, Are Your Clients’ Trust Account Deposits Fully Insured?
Bank Failures: If Your Bank Goes Under, Are Your Clients' Trust Account Deposits Fully Insured?
James M. McCauley, Ethics Counsel
Virginia State Bar
July 30, 2008
Here is a question that makes lawyers very nervous as the list of failed banks1 and banks on the "watch list" grows: Could a lawyer be liable if the bank that held a client's trust funds went under? After reading news articles about the recent collapse of Pasadena-based mortgage lender IndyMac Bank, lawyers are making inquiries on state bar ethics hotlines. With financial institutions recognizing losses on their sub prime loan portfolios, increasing mortgage foreclosures and steeply declining bank stock prices, concerned lawyers are making inquiries about the security of IOLTA/trust accounts in federal and state chartered banks.
On July 11, 2008, federal regulators seized IndyMac, marking the second largest bank failure since the demise of Continental Illinois Bank in 1984.2 One of the nation's largest independent mortgage lenders, IndyMac, ran into trouble after too many of its subprime loans defaulted. While the crash of IndyMac and other smaller banks recently came as a bit of surprise, the failure of a bank presents a problem attorneys should not ignore. Lawyers need to be thinking about ways to protect their clients' funds. A lawyer's failure to safeguard and protect client funds and property can be grounds for malpractice and discipline. But does this mean that a lawyer can be held accountable if the bank fails and client funds are not adequately insured? Not necessarily.
An Internet listserv for members of the Association of Professional Responsibility Lawyers has been buzzing with attorneys discussing whether a lawyer could be disciplined or found liable of malpractice as a result of future bank failures. At least 25 attorneys from across the nation had weighed in on this issue during the listserv discussion. No consensus was reached.
Virginia's Rules of Professional Conduct, specifically Rule 1.15 (a), requires lawyers to maintain a "clearly identified" trust account in a "financial institution" approved by the Virginia State Bar. These financial institutions must be regulated state or federally chartered banks, savings institutions or credit unions in which the deposits are insured by an agency of the federal government. Thus, the safety of bank deposits and the soundness of these financial institutions are the subject of federal and state regulation. In addition, private entities provide rankings and information about the financial safety of individual financial institutions.3
Generally, a depositor's account at a bank is insured by the Federal Deposit Insurance Corp. (FDIC) for up to $100,000.4 According to the FDIC, deposit account records of the banking institution must disclose the existence of a fiduciary relationship before insurance coverage based on fiduciary relationships will be recognized.5 If the deposit account records of the banking institution do disclose the existence of a fiduciary relationship, then FDIC insurance (up to applicable limits) will be available for each client or third person whose funds are held in the account. Under Rule 1.15 (a) a lawyer is required to "clearly identify" his or her trust account. Designation of the account as an IOLTA/trust account satisfies this requirement and discloses the existence of a fiduciary relationship for purposes of FDIC coverage. This designation means, for example, that if a lawyer's IOLTA is holding $100,000 for Client A, Client A's funds are insured up to $100,000 unless Client A has funds deposited in another account in the same financial institution as the lawyer's IOLTA account. A lawyer holding $1million in his or her clearly identified trust account on behalf of 10 clients would have FDIC insurance coverage up to $100, 000 for each of these 10 clients provided the lawyer's and /or bank's recordkeeping documents the identities and deposits of the client's on whose behalf the deposits were made.
In other words, for the purpose of FDIC insurance, IOLTA accounts are fiduciary accounts. As such, each client is insured as if the funds were deposited directly by the principal (the client), provided certain requirements are met. Generally, each client will be insured up to $100,000 if they have no other deposits held in the same name at that institution. Obviously, the vast majority of IOLTA accounts are sufficiently insured by the FDIC. However, there are still many IOLTA accounts that hold more than $100,000 for an individual client and, therefore, those accounts are underinsured. In these circumstances, legal ethics experts and bar officials recommend that such large accounts be spread over multiple FDIC-insured banks in order to increase FDIC insurance coverage.
To date, there are no reported disciplinary or malpractice cases in which a lawyer was held accountable to a client for lost trust funds caused by a bank failure. A 2005 New York appellate case may provide some reassurance from a civil liability standpoint. In Bazinet v. Kluge,6 a lawyer was not held liable for malpractice for putting a prospective purchaser's trust fund of more than $1 million into a bank that went under. The prospective purchaser accused the attorney, who was acting as an escrow agent in real estate transactions involving two co-op apartments in New York City, of malpractice for not depositing the funds in a manner that was FDIC-insured. The appellate court, however, found in favor of the attorney, noting there was no way he could have foreseen the bank's demise and that there was no rule, statute or regulation that an attorney-escrow agent must place funds in an account fully insured by the FDIC.
Lawyers should not take too much comfort in this decision. With the depth of current banking crisis, the failure of a major bank, and the improvements and availability of financial information on financial institutions, a malpractice claimant may convince a judge or jury that a particular bank failure was foreseeable. Moreover, regardless of possible malpractice or disciplinary exposure, good lawyers take reasonable measures to prevent or mitigate financial loss to clients.
In addition to opening multiple trust accounts at different banks, there are some other things to consider. Lawyers must also ensure that the trust account recordkeeping, as required by Rule 1.15, is properly maintained and accurate so that amount of every deposit designated to the client can be readily documented and proven to the FDIC. Lawyers should also identify for the client, at the outset of the engagement, the particular bank at which the client's trust funds will be deposited and ask the client if he or she holds any accounts at that same bank. If the client holds accounts in his or her name at the same bank where the lawyer has the trust account, the lawyer and client should consider opening a trust account at a different financial institution. Finally, lawyers should seek information or ratings regarding the stability of the financial institution where the trust account is maintained. The Virginia State Bar does not audit or certify the strength or stability of financial institutions. That work is performed by other governmental and private organizations. The Virginia State Bar also does not vouch for the entity's financial health or stability by placing a financial institution on its list of approved depositary banks for lawyer trust accounts.
1 For the list of failed banks maintained by the FDIC, point your Internet web browser to: http://www.fdic.gov/deposit/deposits/financial/fiduciary.html. Seven banks have been closed in 2008.
2 This bank was closed on July 11, 2008 by the Office of Thrift Supervision and the FDIC was named Conservator. All non-brokered insured deposit accounts and substantially all of the assets of IndyMac Bank, F.S.B. have been transferred to IndyMac Federal Bank, F.S.B. (IndyMac Federal Bank), Pasadena, CA a newly chartered full-service FDIC-insured institution. FDIC Press Release 56-2008 (7/11/08) found at: http://www.fdic.gov/news/news/press/2008/pr08056.html
3 For example, Veribanc rates every institution in the US on a quarterly basis using proven metrics with a solid track record over 25 years. For more information and to obtain a report on your bank, point your Internet web browser to: http://www.veribanc.com/Business%20Reports.html.
4 The FDIC oversees an industry-funded reserve of about $53 billion used to insure up to $100,000 per deposit and $250,000 per individual retirement account at insured banks. "Only 13 Percent of Banks on Watch List Fail," Reuters, July 28, 2008, last checked on July 30 at http://www.reuters.com/article/ousiv/idUSN2825428920080728. The so-called "Watch List" of 90 banks maintained by the FDIC is not published on the agency's website. One way to find out about the financial health of a particular bank is to read that bank's call report on the FDIC's website. Information about state chartered banks in Virginia can be obtained by calling the State Corporation Commission's Bureau of Financial Institutions at (804) 371-9657.
5 FDIC Advisory Opinions 92-30 and 98-2. Federal regulations regarding insured deposits can be found at 12 C.F.R. Part 330. For more information about FDIC insurance on fiduciary accounts, point your Internet web browser to http://www.fdic.gov/deposit/deposits/financial/fiduciary.html
6 Bazinet v. Kluge, Case No. 4647. N.Y, App. Div. 1st Dept. (1/6/2005) (found on FastCase on July 30, 2008)