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02 October 2018
In The Matter of an Intervened Law Firm,(1) the High Court recently considered the proper basis for the distribution of money in the client account of a closed law firm. The money is held by the relevant regulator on trust for the persons beneficially entitled to it – namely, the former clients. Where there is a shortfall between the verified claims of former clients and the balance in the client account, the court may need to direct how the money should be distributed. The fairest and most convenient basis for distribution is often a pro rata basis.
In Hong Kong, law firms (both Hong Kong and foreign) and their members are regulated by the Law Society of Hong Kong ('the regulator'). The governing statute is the Legal Practitioners Ordinance (Cap 159). The ordinance provides for the different grounds on which the regulator can rely to intervene in the practice of a firm or sole proprietor.
The regulator can intervene as a result of exercising its own powers and, on doing so, can resolve to take control of (among other things) all money held in the client and office bank account(s) of the firm in the course of its practice. Such money vests in the regulator as trustee for the persons beneficially entitled. The regulator can also apply for court guidance to administer aspects of the intervention – for example, and importantly, the distribution of money held in the client account of the intervened firm.(2)
An intervention is, in effect, a closure. A decision to intervene in the practice of a law firm is not taken lightly and is a serious matter. What underpins a decision to intervene, and the intervention itself, is the public interest. In order to assist with the intervention, the regulator appoints an intervention agent (ie, another law firm).
While interventions are relatively rare, in the past few years there appears to have been an increase(3) – possibly reflecting (in part) difficult trading conditions for some firms in certain practice areas, or as a result of practitioners that have (in effect) abandoned their practice.
An intervention could be due to the unfortunate death or mental incapacity of a sole proprietor. Other interventions might be based on credible grounds that the practice of a law firm is (in effect) not fit for purpose – for example, dishonest behaviour on the part of one or more of the legal practitioners or their staff.
The trend with some interventions might suggest that the regulator is becoming more proactive.
In The Matter of an Intervened Law Firm(4) the council of the regulator intervened in the practice of the firm on or about 2 September 2016. The firm apparently had two partners who were the two respondents in the subsequent court proceedings commenced by the regulator. Both former partners were later adjudged to be bankrupt.
The intervention proceeded on the basis that there was reason to suspect dishonesty on the part of an employee at the firm.(5) As a result, that employee appears due to spend some considerable time in prison.
On the exercise of the regulator's statutory power to intervene, all money held by the law firm in connection with its former practice – including money held in the firm's client account – vested in the council of the Law Society (as representative of the regulator). The money was held on trust for the firm's former clients, subject to the verification of their claims through a process overseen by an intervention agent and to be approved by the court.(6)
In this case, it appears that approximately 50 claims were made by former clients to money held in the firm's client account. The total amount claimed was approximately HK$11 million, while the balance on the client account was approximately HK$2.5 million. The firm also appears to have held stakeholder money in the amount of approximately HK$800,000 with respect to a number of conveyancing transactions.
In light of the shortfall, the regulator applied to the court for directions as to (among other things) the proper basis for the return of client money to claimants whose claims had been verified.
There are a number of different approaches that the court could adopt – including 'first in, first out', a pari passu or pro rata basis or such other basis as the court sees fit in the circumstances.
In addition, the regulator requested the court to grant directions as to whether (among other things):
The court noted that a traditional starting point for distribution where there was a shortfall in client money was the 'first in, first out' rule. However, the court accepted that this was just a starting point and it did not take much to displace this rule – particularly given the circumstances of an intervention into the practice of a law firm and the nature of a solicitor's general client account, in which client money could be commingled (albeit subject to a firm's reconciliation statements).(7)
The court also noted that any basis of distribution other than pro rata gave rise to practical difficulties. While these difficulties are not described in detail in the court's decision, it is probably fair to surmise that the law firm's files and accounts may not have permitted a tracing exercise to be conducted that was proportionate in the circumstances. It is one thing for an intervention agent to verify claimants' claims, but quite another to have to trace specific payments in and out of a firm's client account over a long period of time.
In a further exercise of pragmatism, the court granted directions that:
Given that both former partners in the intervened firm had been adjudged bankrupt, there appears to have been little prospect that the regulator would recover its costs from them. Therefore, the court directed that the money in the office account of the firm be applied towards payment of the regulator's costs. These costs are likely to far exceed this amount.
The court's decision is interesting, particularly regarding the directions normally required to distribute money held in the client account of an intervened law firm in circumstances where (for example) verified claims far outweigh the amount available for distribution.
While such interventions are relatively rare (and fact-specific), when they occur it is not unheard of for former clients to lose money. While an intervention is not an insolvency or rescue procedure, just like those procedures, unfortunately, losses must fall somewhere. The reality is (as the court appears to accept in this case) that a pro rata distribution is often the least unfair basis for distribution. It is difficult to envisage another viable method of distribution in this case, given the shortfall in the firm's client account and the overall circumstances alluded to in the court's decision.
It is worth noting from the court record that the directions appear to have been obtained within approximately five weeks of the regulator's application for directions and well under two years after the commencement of the intervention. This appears to be relatively quick, as befits an intervention in circumstances where money is alleged to have been misappropriated.
It should also not be lost on relevant stakeholders that an increase in regulatory activity by a regulator may give rise to an increase in the number of anti-money laundering suspicious transaction reports made to relevant law enforcement agencies. Lawyers and their staff should be reviewing their compliance with the solicitors' accounts rules, internal anti-money laundering protocols and attending relevant training.(8)
For further information on this topic please contact Samuel Hung, Michael Maguiness or Antony Sassi at RPC by telephone (+852 2216 7000) or email (email@example.com, firstname.lastname@example.org or email@example.com). The RPC website can be accessed at www.rpc.co.uk.
(7) In an era of low interest rates in Hong Kong, client or transaction-specific bank accounts tend to be unusual in practice. Practice Direction J (Interest on Client's Account) is, at the time of writing, suspended – although a solicitor and client can agree for payment of interest on money held in a client account.
(8) www.jfiu.gov.hk/en/statistics_str.html. Also see:
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