Readers will be aware of the recently released findings of the independent review commissioned by the LSB into the SRA’s handling of the Axiom Ince scandal.
The findings highlighted multiple missed opportunities to limit the impact of the firm’s collapse and emphasised the need for the SRA to enhance its oversight procedures.
Soon after the release of the report, the SRA released their long anticipated consultation entitled ‘Client money in Legal Services – safeguarding consumers’, which looks set to address many of the criticisms raised in the Axiom report and considers the fundamental model of law firms holding client money.
The consultation provided few surprises – much of the groundwork had already been laid earlier this year during the SRA’s consumer protection review. Any changes following the consultation will likely be a long time coming, but there are a number of areas that firms should be aware of, and that should be the focus for COFAs and managers of law firms.
The SRA consultation in brief
The consultation is split into three parts:
- The model of holding client money – what can be done to ‘de-risk’ the mere act of holding client money for law firms?
- Protecting client money – what additional checks should be in place to preserve the safety of client money?
- Delivering a sustainable compensation fund – how should it be funded and under what circumstances should it pay out?
Let’s take a brief look at the highlights of the consultation from a Reporting Accountant’s perspective:
- Residual balances take centre stage, and the SRA is taking aim at firms that it feels may be deliberately holding onto residual balances in order to benefit from the interest earned on them. The SRA also asks whether there should be more prescription around the concept of returning client funds ‘promptly’ at the end of a matter. Firms may welcome more certainty around what and what isn’t acceptable; the SRA is suggesting a limit of 12 weeks for example, but only if prescription doesn’t become too restrictive.
- Interest on client money is considered, and the SRA asks whether firms should be prevented from benefitting from this interest and, crucially for many, what will the impact be on firms of any such prohibition. Conversely, are there any circumstances under which firms might be allowed to retain client interest and how might this benefit the legal profession generally?
- Prior to the Axiom scandal, some readers may recall a much smaller, and since dropped, consultation around when firms should transfer money from the client to the office account to pay for their fees and disbursements. The question has again been raised around whether ‘incurred’, ‘spent’ and ‘anticipated’ costs should be treated in the same way, though it is likely that this will be the more straightforward change for the SRA.
- The SRA has posed the fundamental question about whether client money has a future. What would the impact be on the profession of removing the ability of firms to hold client money? Should client money be restricted to certain types of work? The SRA has previously stated that any changes here will take a long time to implement, and the general feeling from firms we speak with is that this will prove to be one of the most controversial parts of the consultation.
- Linked to this, the SRA wants us all to consider the use of Third Party Managed Accounts (TPMAs) as an alternative to holding money in a client account, but acknowledges that there will need to be a significant increase in market capacity for this to be a consideration. Currently, fewer than 100 firms use TPMAs on a regular basis.
- It was nice to see that the SRA clearly feels that there is a benefit to the role of the Reporting Accountant as a deterrent to ‘bad actors’ and the protection of client money. Recognising the needlessly self-imposed limitation of only requiring qualified Accountants Report to be submitted to them, they are now asking whether we should return to the requirement for all reports being submitted. There is also the question of whether the mandatory rotation of the Reporting Accountant will help maintain independence and improve overall audit quality.
- Turning to the fundamental client money systems and controls within firms, the SRA wants to strengthen those controls and improve the effectiveness of the compliance officers. With that in mind, the SRA wants to see separation of the COLP, COFA and other statutory roles within firms. Clearly for larger firms, that will present no particular challenge, but how that will translate to smaller firms and sole practitioners is a key question.
- Linked to this, the SRA wants to ensure that COFA knowledge remains current and relevant to the role and is thinking about some sort of package of support for compliance officers.
As mentioned previously, this is a major consultation, and there is a lot more covered than we have mentioned. We recommend that you read the consultation in full at www.sra.org.uk.
The consultation is open for comment from all members of the public and closes on 21 February 2025. We would encourage as many of you as possible to take part.
What does this mean for law firms?
Taking both the findings of the Axiom review and the consultation into account, what should firms be looking at in the short term, and what differences can they expect when next year’s audit season kicks off?
Bank confirmation letters
A major part of the fraudulent removal of £64m of funds from the Axiom client account appears to have hinged on the falsification of bank statements that were provided to both the SRA and the firm’s Reporting Accountants. The report suggests that the SRA’s forensic investigation officer (FIO) should have confirmed client account balances directly with the bank during their review.
The requirement for Reporting Accountants to obtain direct confirmation of client account balances from banks was removed in the 2019 Rules, and it is up to the Reporting Accountants to design their own procedures to obtain comfort over client money processes.
Don’t be surprised therefore if direct bank confirmations become part of the annual audit process again in the future. You may find that accountants are unwilling to sign their annual Accountant’s Report (AR1) form until all confirmations are received, and so giving early authority for your banks to correspond with your auditors will be important.
The report was also critical of the FIO for not crosschecking the list of active bank accounts provided by the firm to the bank reconciliations. We always ask firms for a full list of bank accounts before we start, but firms must ensure that it is a complete list of all accounts that have been active during the year, including any that were opened or closed. This list should include all client accounts, office accounts, client’s own accounts, joint accounts and designated deposit accounts.
Reviewing roles and appointments in the organisation
Both the Axiom report and the SRA consultation point to the enhanced risk associated with individuals holding multiple compliance roles, such as COLP, COFA, and MLRO.
Clearly this is unavoidable for many smaller firms, but all firms should consider carefully who they are appointing for these important roles and ensure there is adequate oversight. It is likely that your Reporting Accountant will ask more questions about the processes that your roles holders (particularly the COFA) have in place to ensure compliance.
Addressing residual balances
The Axiom report notes that residual balances were used to mask certain financial activities, paving the way for the fraud. It’s no surprise then that the SRA consultation dedicates a fair amount of space to the problem. This is a reminder that all firms must ensure that their controls over the identification, review and disposal of residual balances is strictly observed, without exception. With residual balances, prevention is always better than the cure, so having ‘bullet proof’ file closure and archiving processes at the end of all matters is key.
It is worth noting again that the SRA is considering the possibility that some firms may be using residual balances as a source of income via the interest earned on those balances.
The SRA is again putting residual balances in the spotlight as an area of maximum concern, and that means Reporting Accountants will too. Where firms do not have adequate processes in place to deal with residuals, it is more likely to lead to a qualified Accountant’s Report.
Understanding the nature of client account payments
According to the Axiom report, the Axiom client account was being used to pay for office expenses such as payroll, VAT and PAYE.
There has always been a requirement that COFAs have adequate systems around the review and approval of all client account payments, but COFAs do need to step back and consider whether those controls really go far enough.
This type of fundamental breach of the SRA Accounts Rules and SRA Principles is a clear driver behind the SRA’s apparent desire to move away from firms holding client money.
Reporting Accountants will need to scrutinise these controls and test the detail of transactions, perhaps in even greater depth than before.
The SRA released a warning notice earlier this year that re-emphasised the need for all amounts incorrectly withdrawn from the client account to be replaced immediately. This is of course nothing new, but it is worth pointing out that, in the eyes of the Reporting Accountant, ‘immediately’ means the same working day, and anything beyond this may be viewed as a serious breach of the Accounts Rules. Procedures such as daily bank reconciliations and regular reviews of ledgers (by both accounts teams and fee earners) can help maintain compliance here.
Submission of all Accountant’s Reports
As mentioned previously, the SRA is considering moving towards mandatory submission of all Accountant’s Reports, whether qualified or not. This will not impact firms significantly, and is really just a return to requirements from around 10 years ago. However, firms that struggle to meet the six month submission deadline would, by default, become much more visible to the SRA.
Greater scrutiny around the provision of prohibited banking facilities
Looking again at the Axiom report, this highlights instances where transactions were posted through ledgers that were in the name of the main Axiom owner and which bore the hallmarks of prohibited banking facilities.
Whilst scrutiny of such ledgers should come as no surprise to firms, it is important to be able to understand the nature of all matters in the names of individuals closely associated with the firm, such as partners and directors.
There may in the past have been an emphasis on reviewing slow moving or dormant matters when trying to identify matters that might fall foul of the banking facilities rule. For example, old retentions and rent deposits have been a focus area, but this highlights the need to remember more current or active matters too.
Qualified Accountants Reports may lead to greater SRA scrutiny
Given the report’s criticism of the SRA’s light-touch approach when investigating firms, it is likely that qualified reports will lead to more intense scrutiny from the SRA.
Where firms are subject to qualified Accountants Reports, they should expect the worst and prepare for enquiries from the SRA. In these cases, ensuring all compliance processes are up to date and operating properly will be important.
Learning from international practices and client’s own accounts
The SRA consultation makes mention of how other countries handle the presence, or rather absence of, client money. The independent Axiom report draws comparisons with Australia and New Zealand in particular, where firms operating trust accounts are subject to tight controls and regular reporting.
These comparisons may put the challenges around operation, monitoring and reconciliation of client’s own accounts back into the spotlight.
As we know, planned updates to the Accounts Rules relating to client’s own accounts were shelved in the aftermath of the Axiom scandal and the requirement to regularly reconcile these accounts remains unchanged. It feels unlikely that rules will loosen any time soon, and firms must make sure that they are complying with the Accounts Rules and related guidance.
Renewed guidance for Reporting Accountants
There is a recommendation for the SRA to renew its guidance to Reporting Accountants, so watch this space for further updates.
