Andy Poole, Legal Sector Partner at Armstrong Watson LLP, considers the implications of negative interest rates for law firms.

In December 2020 the Bank of England Monetary Policy Committee (MPC) voted unanimously to maintain the bank interest rate at 0.1% but given the fragile nature of the economy, there is the possibility that at some point in the future the MPC may vote for negative interest rates in order to stimulate economic activity.

If interest rates do become negative, what are the implications for law firms, particularly in relation to client money held?

Holding client money

Gone are the days when the high interest rates earned on client money meant such interest was the source of the greatest profits for some law firms! Firms are now used to not profiting from holding client money, and have accepted that there is in fact a cost of doing so, given the need to employ cashiers and ensure compliance with the SRA Accounts Rules and the requirements of the COFA’s role.

So, what would happen if there were direct costs to a law firm for holding client money, in the form of interest payments to the financial institutions? At present there is no definitive answer or guidance from the SRA, although they are monitoring the situation. Even if the central bank rate was negative the banks may not actually charge interest on law firms. If some banks do apply negative interest rates, others may not. Firms will therefore need to continue to monitor rates being offered by banks and where it is best to place client money – such considerations will also need to include continue client money protection.

If banks do apply negative interest rates to client money, what law firms would do is not clear. Some may not pass the charges on, others may seek to do so.

The SRA Accounts Rules

Although the SRA Accounts Rules are flexible—they do allow bespoke arrangements to be agreed with individual clients and they also permit interest policies to be applied for a ‘fair amount’—the SRA has cast doubt on whether law firms could pass on the cost to clients.

Let’s look at the detail:

  1. Under rule 7.1– “You account to clients or third parties for a fair sum of interest on any client money held by you on their behalf”.
  2. Under rule 7.2– “You may by a written agreement come to a different arrangement with the client or the third party for whom the money is held as to the payment of interest, but you must provide sufficient information to enable them to give informed consent”.

Rule 7.1 provides flexibility, but assumes that payments are to be made from the law firm to the client. This is most probably why, during a recent Institute of Chartered Accountants in England & Wales Solicitors Group virtual conference, an SRA policy officer cast doubt on whether law firms will be able to charge clients for holding client money.

While it would appear that law firms will struggle to apply blanket charges for holding client money rule 7.2 does provide more flexibility and will permit a law firm to agree, on a case by case basis, how interest rates should be applied in the particular circumstances of the matter and the client.

The law firm would need to provide sufficient information for the client to make an informed decision on whether to agree to reimburse the law firm for interest costs for holding their money on their behalf, and any agreement would need to be in writing. This will create additional work for law firms, who will need to consider commercially and strategically whether they want to take such steps.

Value Added Tax (VAT)

It’s not absolutely clear how such charges would work from a VAT perspective. Interest is exempt from VAT and so one may assume that there would be no additional VAT to pay for the client, but if the law firm is viewed as charging interest to the client then it may conceivably be subject to the partial exemption rules.

If the law firm is not viewed as charging interest to the client, but merely passing the cost on, then consideration may need to be given as to whether that meets HMRC’s criteria to class as a VAT disbursement. If it does then no VAT would be charged, but if it does not then the law firm may need to add VAT to the charge it is passing on to the client. If the client is VAT registered, they will be able to reclaim it, but if they are not VAT registered, this will increase the costs they need to meet still further.

This is not a clear-cut area and HMRCs manuals do not cover such eventualities. If negative interest rates do become a reality, it is likely that HMRC will publish further guidance at the time.

An alternative may be to reflect the cost of holding the client money as part of the cost of doing business and so in the headline costs of the service the law firm is providing. There is nothing that prevents a law firm from charging what they feel is the right amount for the particular service, and although they are required to publish prices, they do not need to break down the prices in the detail of how they are reached. Generally for any increase in the costs of running a business, that business needs to determine whether they will pass on those costs to their customers or absorb them – there is no difference to a law firm.

Of course firms will need to consider market rates and perceived value for money, but I would never encourage following the crowd—it is far better to make pricing decisions based on the firm’s strategy, the type of work and clients they want to be involved with and the service levels that are provided. Under this option VAT would need to be charged to the client as it is part of the supply of services from the law firm.

Third Party Managed Accounts (TPMAs)

A further alternative may be the use of TPMAs, which are now permitted under the SRA Accounts Rules. Care is needed here as rule 11.2 of the SRA Accounts Rules states that: “You obtain regular statements from the provider of the TPMA and ensure that these accurately reflect all transactions on the account”.

There is further guidance on the SRA website on the use of TPMAs, which downplays the fears of some law firms over compliance with rule 11.2, but still the take-up of TPMAs has been low, and there are not many TPMA providers in the market.

If negative interest rates are introduced, these might become more attractive – although there is a cost that needs to be paid to the TPMA , and firms will still have the same dilemma as to whether to pass on such costs to clients. In this case, rules 7.1 and 7.2 would not apply and firms would only be left with the headline rates for the particular service to amend should they wish to.

Whether to introduce negative interest rates will be a difficult decision for the Bank of England, as is what law firms will do as a result. There are steps that can be taken, but firms should take care in making changes to their standard terms and conditions that apply blanket charges for holding client money.

This article is a general guide to the issues that we see in practice not a substitute for professional advice which takes account of your personal circumstances. No responsibility can be accepted for any loss occasioned by any person acting or refraining from action on the basis of this article.

Armstrong Watson LLP is exclusively working in partnership with the Law Society for the provision of accountancy services to law firms.