Negative interest rates?

Subscribe

In December 2020 the Bank of England MPC voted unanimously to maintain the bank interest rate at 0.1% and noted that the future of the UK’s economy is unusually uncertain.  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. 

A number of central banks around the world are starting to experiment with negative interest rates, including Japan, Denmark, Sweden and Switzerland, and so there is a precedent which the Bank of England will no doubt be closely monitoring.

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

Long 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 have now got 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.

Now minds are turning to a different picture entirely though – what would happen if there were direct costs to a law firm of holding client money, in the form of interest payments to the financial institutions?  At present, there is no definitive answer from the SRA or guidance from the Law Society, and of course, even if the central bank rate was negative the banks may not actually charge interest on law firms, but would what happen if they did is not clear.

Although the SRA Accounts Rules are flexible, do allow bespoke arrangements to be agreed with individual clients and do 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. Rule 7.1 of the SRA Accounts Rules notes that – “You account to clients or third parties for a fair sum of interest on any client money held by you on their behalf”
2. Rule 7.2 of the SRA Accounts Rules notes that – “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 above provides flexibility but is written assuming that the 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.

On the basis of the above, and in accordance with Rule 7.1, it would appear that law firms will struggle to apply blanket charges for holding client money.  However, 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 the law firm incurs 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.

It is 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 have mind for market rates and perceived value for money, but I would never encourage the crowd to be followed, instead, 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.

A further alternative may be the use of Third Party Managed Accounts (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 third-party managed account 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.  If negative interest rates are introduced, perhaps TPMAs will become more attractive – although there is a cost that needs to be paid to the TPMA , and firms will then 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 turn to 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.