Changes To Trust Accounting Rule Will Reduce Discipline Risk But May Create Traps

By Joel M. Pores

 

Despite the availability of MCLE, the State Bar’s Handbook on Client Traust Accounting for California Attorneys (the Handbook) and the Ethics Hotline, there continues to be a significant problem in the mismanagement of funds, amounting to 12% of all State Bar complaints. The Commission for the Revision of the Rules Of Professional Conduct has created and submitted for public comment Proposed Rule 1.15 in a bold attempt to provide detailed standards for client protection and guidance for lawyers in handling funds and property of clients and other persons. The proposed rule is designed to instruct the lawyer as to the minimum standards at every phase of handling funds and property.

 

I.          THE CURRENT RULES:

 

Current CRPC Rule 4-100 (A) mandates that all funds held for the benefit of a client by an attorney, including advances for costs and expenses, shall be deposited into a Trust Account. No funds belonging to the attorney shall be deposited or otherwise commingled, except funds reasonably sufficient to pay bank charges. In the case of funds belonging in part to the client and in part to the attorney, the portion belonging to the attorney MUST be withdrawn at the earliest reasonable time after the attorney’s interest becomes fixed. The attorney must promptly pay or deliver, as requested by the client, any funds, securities, or other properties which the client is entitled to receive. CRPC Rule 4-100(B)(4)

CRPC Rule 3-700 (D)(2) requires the prompt refund of any part of a fee paid in advance that has not been earned. This section is specifically made inapplicable to the “true retainer” paid solely for the purpose of ensuring the availability of the attorney for the matter.

 

Illegal and unconscionable fees may not be agreed upon, charged, or collected, and are proscribed by CRPC Rule 4-200 (A). Among the factors for determination of unconscionability enumerated under subsection (B) of that Rule is the amount of fee in proportion to the value of the services, the actual time and labor spent, and whether the fee is fixed or contingent. The mere use of such terms as non-refundable, paid on receipt, true retainer, or minimum fee, do not make fees which are paid in advance automatically fall into such a “protected” category.

 

II.        HISTORY:

 

In the legislative history of Rule 3-700 (D)(2) and Rule 4-100 (A), inclusion of “advances for fees” was considered, and then intentionally excluded. Matters have come before the State Bar Court in which attorneys have been disciplined for not refunding fees, without ever reaching the issue of failure to deposit in trust as a disciplinary offense. In the Matter of Fonte (Rev. Dept 1994) 2 Cal. State Bar Ct. Rptr 752.

 

The State Bar Association’s Committee On Professionalism and Conduct (COPRAC) also grappled with the apparent conflict between the need to have the use of such funds and the duty to refund unearned fees upon termination. Over the years proposed changes to Rule 3-700 and Rule 4-100 were struck down each time they were presented to the California Supreme Court for review. Three basic forms of fees paid in advance were recognized:

 

  • A “true retainer,” that is, funds paid solely to reserve the attorney’s availability, whether any are performed or not. These fees are earned upon receipt and therefore need not be deposited into trust nor refunded upon termination. Baranowski v State Bar (1979) 24Cal.3d 153, CRPC Rule 3-700 (D)(2). If the attorney accepts such a fee and then places it into his or her trust account, or then renders an hourly or other billing against the funds received, the funds are treated as an advance, rather than a true retainer. S.E.C. v Interlink Data Network of Los Angeles, Inc. (9th Cir 1996) 77 F.2d 1201.

 

  • A “security retainer”, that is, funds paid in order to secure the future payment of services to be performed. This type of payment constitutes funds held “for the benefit of the client”, not the attorney, and therefore must be placed in trust. In re Montgomery Drilling Co (1990) 121 B.R. 32.

 

  • An “advance payment retainer” that is, funds which constitute payment for services is made in advance of performance. In re Montgomery Drilling Co, infra. Whether this latter advance payment is for the benefit of the client as opposed to the attorney has been the subject of much debate. There is no California Supreme Court case or State Bar Court decision on point to date. In fact, in several matters the State Bar Court has modified its decisions to remove a finding of disciplinary offense for failure to place advance fees into the attorney-client trust account. Baker v State Bar (1989) 49 Cal.3d 804, op. mod. 50 Cal.3d 30, Read v. State Bar (1991) 53 Cal.3d 1009.

 

We do have an actual finding that Rule 4-110 requires the deposit of advance payment retainer fees into trust, but it was made in a matter involving alleged legal malpractice, not discipline. T & R Foods Inc. v. Rose (1996) 47 Cal.App.4th Supp 1. In T&R Foods, for the first time, a court actually decided whether or not CRPC Rule 4-100 requires advances for attorneys’ fees be kept in trust accounts, segregated from money belonging to an attorney.  In T & R Foods, $25,000 had been paid to an attorney, the sole shareholder in his law corporation, who subsequently died. The funds were not placed in a trust account. Fees were to be charged against the retainer so paid. The court held that since fees were to be charged against the funds paid, it was not a “true retainer.” It further held that failure to place the funds into trust constituted a breach of fiduciary duty and professional negligence.

 

The court went through a discussion of the Baranowski and Montgomery Drilling cases, and then favorably mentioned the San Francisco Bar’s Legal Ethics Opinion SF 1980-1 (Opin SF 1980-1), as supporting its views. The court analyzed the difference between the security retainer and advance payment retainer, stating that under the latter, the intent is to pass ownership to the attorney upon receipt. The court concluded, however, that the intent of the State Bar under the Rule was that “funds” retain their ownership identity with the client until earned. In considering whether the failure to segregate funs constituted negligence or breach of fiduciary duty, the Court recognized the purpose served by Rule 4-100, to safeguard the client’s money “to provide against the probability in some cases, the possibility in many cases, and the danger in all cases that such commingling will result in the loss of client’s money.” Hamilton v. State Bar (1979) 23 Cal.3d 868, 876.  Opinion SF 1980-1, was cited in support of the court’s position in T & R Foods, yet Opinion SF 1980-1 includes both majority and dissenting minority opinions on the issue. The majority concluded that the advance payment retainer was in fact “held for the benefit of” the attorney, and not the client, and should be deposited into the general account. This was the exact opposite of the holding in T & R Foods. The dissent came to a contrary conclusion.  COPRAC’s Formal Opin. 01-02, referring to T&R Foods , advised lawyers to be safe rather than sorry, and to place fees paid in advance in trust.

 

Regardless of the fact that no current or proposed rule requires placement of  funds into trust, the potential for disaster is great where funds are received, and not accounted for, nor available for refund upon termination of employment. The case in point is In the Matter of Fonte (Rev. Dept. 1994) 2 Cal. State Bar Ct Rptr. 752. Mr. Fonte, when confronted with several allegations of misconduct, including the failure to account for, and to refund unearned fees, alleged that the advance fees paid to him were earned upon receipt, and that they did not have to be refunded nor accounted for. He seized upon the lack of the word “fees” in Rule 4-100 (B)’s accounting requirement. The court held, that the word “funds” in the Rule includes all money received, whether they had to be placed into trust, or not and imposed a six month actual suspension

 

The Montgomery Drilling case involved bankruptcy debtor’s counsel’s application for fees, and the trustee’s opposition to same on various grounds, including duplicative and unnecessary work, and excessive charges. At issue was whether funds paid, one day pre-petition, by the debtor to it’s counsel, would be considered a “security retainer” to secure payment of future services and therefore property of the estate, and not a “classic retainer” (true retainer), paid to reserve the availability of the attorney’s time. Since payments were to be made against the funds received, it fell into the security retainer category. The court made it clear that where advance payments are security for future payments and not present payments for future services, the fees are held for the benefit of the client and not the attorney, and are not a classic retainer which is earned upon receipt.  The court reasoned that under former Rule 8-101 (Repealed), such fees remained the property of the client until applied to charges for services actually rendered, and that the language of the Rule was such as to indicate an intent on the part of the State Bar that funds received from the client retain an ownership identity with the client until earned.

The court never decided whether such fees must be deposited into trust. Montgomery Drilling was a federal bankruptcy matter, not a discipline case.

 

III.       THE PROPOSED CHANGES:

 

(1)        When may fees paid in advance be placed in a trust account?

 

Proposed Rule 1.15 draws a clear distinction between fees that are paid in advance and an advance for costs and expenses, mandating the deposit of costs and expenses into a trust account in proposed Rule 1.15(a).  As to advances for fees, Proposed Rule 1.15 gives the member the same choice as was afforded in the State Bar Handbook, at page 14. Advance fees may be placed in either the trust or general account. Proposed Rule 1.15(d).

(2)        When must fees paid in advance be placed into trust?

 

Proposed Rule 1.15(d)(2) provides that “if a client or other person disputes a lawyer’s entitlement to a fee, any disputed portion of an advance for fees not yet fixed must be deposited into a trust account.” Whether entitlement to fees has been fixed is usually determined by resort to the language of the contract and performance there under by the parties.  Proposed Rule 1.15 (g)(4), carries forward  COPRAC Formal Opin. 2006-171 and provides that funds properly withdrawn from trust need not be replaced when the client later disputes fees.  The Opinion pre-supposes a proper withdrawal only after the amount has been fixed.

 

One area of concern may still lie in the use of language in agreements that call for immediate withdrawal of funds on specified dates with no warning or consent by the client as that date approaches. The danger in such advance consents is that an attorney may withdraw funds based upon the sum being “fixed” by contract, but the client may not know about it until much later through an accounting, at a time the money is gone and spent, never to be retrieved and repaid.  Another potential issue that might be addressed is the fact Proposed Rule 1.15 does not require that funds must be placed in trust where the fee agreement so specifies. The attorney is bound to do so whether CRPC Rule 4-100(A) requires it or not. S.E.C. vs. Interlink Data Networking of Los Angeles Inc. (9th Cir. 1996) 77 F.3d 1201.

 

(3)        What are the client protections?

 

Proposed Rule 1.15 (d)(1) protects the client with an accounting: “subject to Business and Professions Code §6068(e) the lawyer must account to the client or other person who advanced the fees. (Third parties who pay the fees for a client share the same protections as the client.)

 

Proposed Rule 1.15 (e) confirms the lawyer’s duty to maintain inviolate all funds on account in a trust account and all property entrusted to the lawyer for the benefit of the client or other person until distributed according to the Rule.

 

Proposed Rule 1.15 (f) restates the prohibition on commingling lawyers funds with trust funds, except (1) for funds necessary to pay bank charges, (2) deposits for an exact amount of overdraft protection plus bank charges, (3) funds deposited to restore entrusted funds improperly withdrawn, (4) funds n which the lawyer claims an interest but which are disputed by the client or other person (5) funds belonging in part to a client and in part presently or potentially to the lawyer but which are claimed by a third party. This provision sanctions the commingling of funds to pay bank charges or overdraft protection. The restoration of funds as non-commingling is in accord with current case law.

 

Proposed Rule 1.15 (g) provides “Duties when lawyer’s entitlement to funds becomes fixed or the lawyer’s entitlement is disputed: In the case of funds held in a trust account that belong in part to a client or other person and in part to a lawyer, the lawyer shall withdraw the portion belonging to the lawyer at the earliest reasonable time after the lawyer’s interest in that portion becomes fixed, provided that:

 

Proposed Rule 1.15 (g)(1) states that ” the client or other person may still dispute that the lawyer has earned the funds,”  This is true regardless of whether the fees have become fixed and have by necessity been withdrawn from trust..

 

Proposed Rule 1.15 (g)(2) continues the lawyer’s obligation to distribute any undisputed portion of funds to the client or other person and the lawyer’s duty not to withdraw the disputed portion until the dispute is finally resolved or the withdrawal is authorized by law or court order. Under case law the lawyer may withdraw disputed fees only with the client’s consent and a lawyer’s “honest” but mistaken belief the client authorized application of funds to pay outstanding fees is not a defense. Dudgjian vs. State Bar (1991) 52 Cal.3d 1092.

 

Proposed Rule 1.15 (g)(3) is consistent with case law in Garlow vs. State Bar (1988) 44 Cal.3d 698, in that it requires ” a lawyer shall take reasonable steps promptly to resolve any dispute regarding entrusted funds in the circumstances of paragraph (g)(2).

 

Proposed Rule 1.15 (h) deals with situations where the entitlement to funds or property is disputed by one client or other person against another client or other person. The lawyer is required to keep the funds on deposit until the matter is resolved or distribution authorized by law or court order. Undisputed funds are excepted.

 

Proposed Rule 1.15 (i) similarly protects against premature distribution where a third party disputes the client or other person’s entitlement to funds or property where that third party has a security or ownership interest or where the property is subject to a court order.

Proposed Rule 1.15 (j) sets forth the rules in regard to the acceptance of credit cards for fees and costs. As credit card issuers may be able to invade a merchant account, the use of credit cards for advance fees or costs is limited to situations where ” the lawyer’s obligations for any charges, chargebacks and offsets be paid from a source that is not a trust account.”  This provision adopts the reasoning of COPRAC Formal Opinion 2007-172.

 

Proposed Rule 1.15 (k) requires the management recordkeeping and accounting of funds and property held in trust, not just in response to a request as is presently called for under Business and Professions Code § 6148 (b). The Proposed Rule Section (k)(4) specifies that ” a lawyer shall (4) account to the client or other person for whom the lawyer hold funds or property. An accounting shall include but is not limited to a statement of all funds and property received, by source, amount, date, distributions by date and amount and payee, and trust account check number and any balance remaining,

 

Proposed Rule 1.15 (l) limits the application of the Rule in regard to multijurisdictional lawyers. Non-California lawyers, with non-California clients, arising from non-California legal representation, who handle property or funds in accordance with another jurisdiction’s laws are exempt, as are funds entrusted to such multijurisdictional lawyers regarding matters being litigated outside of CA even though the firm maintains an office in California, and lawyers practicing under California Rules of Court 9.47.

 

Proposed Rule 1.15 (m) allows the Board of Governors to formulate and adopt standards for what “records” need to be maintained.

 

IV.       CONCLUSIONS AND CONCERNS:

 

All considered, the Proposed Rule 1.15 is a very well thought out procedural guide that will serve the legal profession and clients well.  However, several aspects of the Proposed Rule could create a trap for the unwary lawyer, in several areas.

 

  • There is no definition of the term “fixed” which might be provided to the membership. Whether a fee is “fixed” is determined by looking to the agreement of the parties and their performance there under.

 

  • The words “unless as otherwise provided by contract” need to be read alongside section (a) since an agreement calling for deposit of entrusted funds into trust requires that client funds be handled in that fashion under SEC v Interlink.

 

  • Compliance with the Proposed Rule does not change the law in regard to State Court civil liability towards clients for the mishandling of funds and property, per T&R Foods, despite the federal cases to the contrary.  Both Montgomery Drilling Co.  and T & R Foods v. Rose came to the opposite conclusion. The Proposed Rule may provide lawyers with a false sense of security.

 

 

 


* Joel M. Pores is a solo practitioner in Laguna Hills, and a member of the Orange County Bar Association’s Professionalism & Ethics Committee.  The views expressed are his own.