Residual balances – a silent danger?

If residual balances sitting in client accounts haven’t been promptly cleared as soon as there is no longer any proper reason to hold those funds, your law firm is breaching the SRA Accounts Rules 2019. They are something that comes up in almost every assignment reporting accountants carry out. The Solicitors Regulation Authority (SRA) have said previously that their main concern is where the amounts in residual balances are large and have been present for some time. However, all residual balances may indicate a more serious underlying issue for law firms.

The regulations

Rule 2.5 of the SRA Accounts Rules 2019 states “You ensure that client money is returned promptly to the client, or the third party for whom the money is held, as soon as there is no longer any proper reason to hold those funds”.

One question that we frequently get asked is: “What does ‘any proper reason’ mean?” There is no clear definition of this, but it may be where the legal work has ended and the monies remaining in client account are not earmarked in any other capacity to do with the completion of the matter.

Rule 2.5 can be closely linked to Rule 3.3 which states “You must not use a client account to provide banking facilities to clients or third parties. Payments into, and transfers or withdrawals from a client account must be in respect of the delivery by you of regulated services”.

It may be possible that a breach of Rule 2.5, may also be a breach of Rule 3.3, and firms must carefully consider why they continue to hold money in client account if there are no ongoing regulated services being carried out.

Further, under rule 8.3 of the SRA Accounts Rules, the compliance officer for finance and administration (COFA) or manager has to sign off a three-way client bank reconciliation at least once every five weeks which compares the bank statement balance, the cash book and matter listing. This rule also states that “You should promptly investigate and resolve any differences shown by the reconciliation”. Normally, on a matter listing, the last movement of monies or time posting will be shown.

Procedures

Residual balances may indicate a problem with the firm’s internal procedures and more widely their systems and controls. Firms should have processes when closing a file and dealing with any client monies at the end of a matter. A qualified accountants report may be the primary reason for the SRA beginning an investigation, but it could also result in them looking at other areas of compliance.

Monitoring work in progress (WIP) and irrecoverable time on a ledger that has been there for a while might indicate that a matter has substantially concluded. So, if compliance officers or managers sign off a bank reconciliation where there are non-moving balances on the matter listing month after month, questions could be asked as to whether they are satisfied with what they are checking.

Finally, the existence of residual balances creates the possibility of “teaming and lading”. This is where an individual residual amount may be small but lots of them collectively add up to a substantial amount. If there is shortfall in client account, these balances may be used to that shortfall even though the total amount held for an individual client may not be available. Hence monies from residual ledgers are used to pay out on a live matter.

Residual balances can stay dormant for months or years before the impact of the breach is felt, and therefore monitoring and reconciling them is something every law firm needs to do.

See also the Law Society Practice Note on Residual client balances