Protecting Client Trust Accounts When Banks Collapse

As if lawyers didn’t already have enough to worry about when it comes to protecting client trust accounts, add bank solvency to the list.  As the recent meltdowns of the Silicon Valley Bank and Signature Bank remind lawyers, even a bank may not always be a secure repository for client funds.

Lawyers Should Understand the Reason for 2023 Bank Collapses

For those unfamiliar, the Silicon Valley Bank (SVB) focused on serving tech startups and their VC backers, who have been struggling in the wake of rising interest rates.  As a result, for the past few months, many of these customers began drawing down on their deposits to keep their companies afloat.  But the actual tipping point came when the bank announced that it had sold a bunch of securities at a loss and needed to sell more shares to make up the gap.  Fearing insolvency, customers panicked and withdrew their money in large numbers – particularly the many larger depositors with accounts well in excess of the $250,000 FDIC-insured limit.  The SVP collapse spooked customers at Signature Bank – predominantly crypto-currency companies who similarly feared that their uninsured deposits were at risk and moved them to larger and more stable institutions.

What Are Lawyers Obligations to Protect Trust Accounts?

Notably, Signature Bank also served a significant number of law firms – which raises the question: what are lawyers’ obligations to protect client trust funds when a bank collapses? Fortunately, lawyers may not have to worry this time around in light of President Biden’s announcement that the FDIC will protect all deposits, even those in excess of the $250,000 insurance cap.  But going forward, here’s what lawyers need to know:

1.  Lawyers should choose a stable financial institution for trust accounts.

Foremost, lawyers should choose a stable institution for deposits that are eligible for FDIC protection.  If a bank isn’t eligible for FDIC protection, using it for client trust accounts is a non-starter.  Many state bars require lawyers to use certain designated banks to hold trust funds; choosing a bar-endorsed bank, if possible, is the safest bet.  

2. Lawyers Should Maximize FDIC Protection

The Federal Deposit Insurance Corporation (FDIC) insures these types of deposit accounts for up to $250,000.   Trust accounts are covered, with coverage for each individual client deposit per this  guidance: 

Funds in special trust accounts that lawyers establish for their clients — commonly known as “Interest on Lawyer Trust Accounts” or “IOLTAs” — also will be protected for at least $250,000. IOLTAs typically hold deposits for multiple clients, and under the rules the insurance coverage “passes through” to each individual client’s share of the account for up to $250,000. That means the total, fully insured amount in the IOLTA account can greatly exceed $250,000.  

Bear in mind, however, that the $250,000 coverage may apply to all of the client’s accounts at the same bank – both personal accounts and the funds in trust. For that reason, when a trust deposit is substantial, a lawyer might need to inquire if the client uses the same bank and consider opening up the trust account at a different institution to maximize coverage. 

3.  Lawyers Must Set Up Trust Accounts Properly to Qualify for Protection

Trust accounts are considered fiduciary accounts under 12 C.F.R.§330.5.  In order to qualify for FDIC protection under the regulations, lawyers must properly disclose and identify the account as a trust account and maintain records of funds associated with each client.  In general, if lawyers set up and operate their IOLTA accounts consistent with bar requirements, they’ll qualify for FDIC protection.  See also 2008 ethics guidance by New Jersey, Virginia, and Florida.

4. Lawyers Should Consider the Size of Deposits in Relation to Reputation of the Financial Institute

Does a lawyer need to divvy up trust funds between institutes to ensure adequate FDIC protection?  No, according to Florida Bar Ethics Opinion 72-37 – a practice that some experts regard as infeasible and overly complicated if only a few accounts are impacted. That said, Florida’s opinion states that a lawyer is expected to act prudently with respect to the trust account and consider the deposits’ size in relation to the size and reputation of the financial institutions concerned.

  5. Lawyers should monitor their banks’ financial health

At least one court held that a lawyer isn’t liable for malpractice when client funds are lost in a bank collapse because lawyers aren’t responsible for assessing the stability of a bank.  See Bazinet v. Kluge, 14 A.D.3d 324 (N.Y. App. Div. 2005) (finding no legal malpractice where firm deposited proceeds from client’s apartment sale in a small bank that failed shortly thereafter since no duty to assess bank stability).  Even so, who wants to be sued?  To maximize protection of client funds, lawyers can take these basic steps to monitor  bank stability;

1. Review financial reports: Banks are required to file financial reports with regulatory agencies on a regular basis. Customers can review these reports to get a sense of the bank’s financial health.
2. Check the bank’s rating: Several independent agencies, such as Moody’s and Standard & Poor’s, rate banks on their financial stability. Customers can check these ratings to get an idea of how stable the bank is.
3. Monitor news coverage: Financial news outlets often report on banks that are at risk of failure or experiencing financial difficulties. Customers can monitor news coverage to stay informed about the bank’s financial situation.
4. Check the bank’s website: Many banks have information about their financial health and stability on their websites. Customers can review this information to get a sense of the bank’s financial position.
5. Talk to bank employees: Customers can speak with employees at the bank to ask questions about the bank’s financial stability.

[Source; Chat GPT]

So long as lawyers must maintain client trust accounts, they need to ensure adequate protection

Of course, it goes without saying that if advance client payments were treated as earned on receipt and didn’t need to be put in trust – as I’ve urged previously – some of these problems would go away (trust accounts would still be needed for settlement and sales proceeds).  But so long as lawyers are required to deposit money in trust, they should understand the basics of FDIC insurance and take steps to monitor bank solvency to maximize protection of client trust accounts in an era of bank instability.