Disbursing without Collected Funds

Last night, I presented a CLE at the Windham County Bar Association’s meeting.  A question arose related to disbursing against uncollected funds.  My answer required a short history lesson.

In April 2004, the Vermont Bar Association’s Professional Responsibility Committee issued Advisory Opinion 2002-4.  The opinion addressed 11 questions related to handling client funds.  One question was:

• “What procedures are required in issuing checks from client trust accounts
  for real estate closings drawn on funds deposited via broker’s or lawyer’s trust account checks that have not yet cleared pursuant to applicable banking rules?”

The Committee opined that, as then written, the rules prohibited lawyers from disbursing against deposits that had yet to clear.   Per the Committee:

• “As written, relevant provisions of the Vermont Rules of Professional Conduct support the inference that client funds cannot be disbursed from the client trust account until the deposit upon which the withdrawal or check will be drawn has cleared and the client funds are available for disbursement under applicable banking rules.”

Why?  Because:

• “If a check is drawn or a withdrawal is made from the client trust account before the corresponding deposit has cleared, then the funds that are being withdrawn from the account actually are the property of another client.”

Thus,

• “Under these circumstances, the only available response is for the attorney expressly to warn a client who will be involved in a closing that, unless liquid funds are available on the date of the closing the closing will not be able to proceed.”

Let me be clear: as the rules existed at the time, the Committee was spot on.

Nevertheless, the opinion caused concern.  Real estate attorneys were among those most concerned.  They worried that the opinion effectively made it unethical to conduct residential closings as we always had.  Imagine:

• Mike sells his house and buys another.
• The closings are on the same day.
• At the first closing, Mike receives a check representing the proceeds of his sale.
• Minutes later, Mike closes on his purchase.
• In so doing, Mike’s lawyer disburses from trust in reliance upon the check that Mike received minutes earlier eventually clearing and becoming “good funds.”

Per the opinion, that’s a violation.

So, in 2005, we changed the rules.  They are: Rule 1.15(f) and Rule 1.15(g).

Rule 1.15(f) carries forth the prohibition against disbursing without “collected funds.”  It defines “collected funds” as “funds that a lawyer reasonably believes have been deposited, finally settled, and credited to the lawyer’s trust account.”

Unlike the old days, however, the new rule included exceptions.  Per Rule 1.15(g):

• “In the following circumstances, a lawyer may disburse trust account funds deposited for or on behalf of a client or third person in reliance on that deposit even though the deposit does not constitute collected funds if the lawyer reasonably believes that the instrument or instruments deposited will clear and will constitute collected funds in the lawyer’s trust account within a reasonable period of time . . .”

Then, the rule lists 5 types of instruments against which a lawyer may disburse upon deposit and before the funds clear and become “collected funds.”  Essentially:

• money orders and certified/cashier’s/official checks issued by or drawn on a federally insured bank;
• checks drawn on an IOLTA or IORTA account of a lawyer or real estate broker licensed in Vermont;
• checks issued by the State of Vermont or the federal government;
• personal checks that, in the aggregate, do not exceed $1,000 per transaction; and,
• checks issued by an insurance company, including title insurance companies, licensed to do business in Vermont.

Two important points on the 2005 Amendment:

1. While the rule permits disbursement upon the deposit of certain instruments, it does not require it.  If a lawyer wait for the big settlement check to clear, that’s fine. When it clears, prompt disbursement is required.
2. If a lawyer disburses and the deposit fails to clear, it’s not an ethics violation, but Rule 1.15(h) requires the lawyer to immediately act to protect funds that remain in the account.  Per the Reporter’s Note “presumably by immediately making or securing reimbursement of the trust account to the amount of the failed deposit.”

As always, be careful out there.

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Reporter’s Notes — 2005 Amendment 

Rules 1.15(d)-(f) are added to address a problem that has arisen as a result of a recent Advisory Ethics Opinion of the Vermont Bar Association’s Professional Responsibility Committee (VBA Ethics Opinion 2002-4, published April 2004). The opinion concluded that ‘‘Trust account checks can only be drawn on client funds after the deposit on which the check is drawn clears’’ based on the Committee’s reading of V.R.P.C. 1.15(b) and other provisions of the Rules of Professional Conduct. Id. While the opinion does not have binding legal effect, it is of sufficient persuasive force to put lawyers who ignore it at risk. The impact is thus significant in the many real estate closings, tort settlements, and other transactions in which funds for clients pass through lawyers’ hands. If the lawyer cannot disburse such funds until the checks with which they have been transmitted have cleared, clients will experience significant delays in receiving funds to which they are entitled, and sequential transactions, such as the simultaneous sale and purchase of real estate, will be hindered. See, generally, R. Kohn, ‘‘Trust Account Ethics Rules: Sensible, Bizarre, or a Combination?,’’ 30 Vt. Bar Jour., No. 2, pp. 20-26 (2004). The present rule is based on provisions adopted in other states to address this problem. See, e.g., Del. Lawyers’ Rules of Prof ’l. Conduct, R. 1.15(n); Rules Regulating the Fla. Bar, R. 5-1.1(i).

Rule 1.15(d) sets forth two basic principles that must be adhered to unless the exceptions set forth in Rule 1.15(e) apply:

• (1) A lawyer may not disburse funds unless the disbursement is drawn against ‘‘collected funds’’ — i.e., those that a lawyer reasonably believes have been deposited, finally settled, and credited to the lawyer’s trust account. (Under present banking practice, there is no way a lawyer can be certain that funds have been finally settled, because the bank into which the check has been deposited is only notified when a check is dishonored, not when it is honored. As of August 2004, in accordance with Federal Reserve Board Regulation CC, checks drawn on banks within the same Federal Reserve Board region are usually honored by the banks on which they are drawn within two or three business days, and checks drawn on banks in other regions are usually honored within seven business days, except in extremely unusual circumstances. Accordingly, as of August 2004, it will usually be reasonable for a lawyer to believe that a check has been finally settled three business days after deposit for checks drawn on banks within the same Federal Reserve Board region, and seven business days for checks drawn on other United States banks.)
• (2) A lawyer may not use the funds of one client or other person held in trust to serve the needs of another client or person without full disclosure and permission of the owner. VBA Ethics Opinion 2002-4 essentially stands on the ground that a check drawn against uncollected funds in a trust account is in fact drawn against the collected funds of other clients that are held in the account.

The exceptions to these basic principles set forth in Rule 1.15(e) are based on the premise that certain categories of trust account deposits carry a limited and acceptable risk of failure so that disbursements of trust account funds may be made in reliance on such deposits without disclosure to and permission of clients owning trust account funds subject to possibly being affected. Four of the five categories of deposits enumerated in paragraph (e) reflect instruments issued by or drawn on sources of assured financial stability so that the likelihood that the instrument will be dishonored or that the deposit will otherwise fail is so slight that it may be treated as presumptively ‘‘collected.’’ The fifth category, personal checks aggregating $1,000 or less, covers the need for last-minute funds to cover minor and unanticipated closing costs and is a de minimis amount that can be readily repaid in the event of failure. The five categories in effect create ‘‘safe harbors’’ that allow the lawyer to draw against these uncollected funds, provided that the further requirement of paragraph (e) is met — that the lawyer ‘‘reasonably believes’’ that the instrument or instruments in question will clear and become ‘‘collected funds’’ in a reasonable time. (See discussion of clearance times above.) The essence of the rule is that a lawyer who draws against uncollected funds other than those within the safe harbors of paragraph (e) is in violation of the basic prohibitions of paragraph (d) and is thus subject to disciplinary action.

Rule 1.15(f) adds the further requirement that if a deposit fails, even though it was within one of the categories set forth in paragraph (e) and the lawyer’s belief that it would clear was reasonable, the lawyer must take immediate steps to protect the funds of other clients that are thus drawn upon — presumably by immediately making or securing reimbursement of the trust account to the amount of the failed deposit.