So what is it with residual balances and why do I keep returning to this thorny subject? I often ask myself the same question. Surely it can’t be as bad as all that. And if it is that bad, why hasn’t the regulator done something to fix the problem? I mean, what harm can they actually do? After all, it’s just a small amount of money, sitting in a client account that can at some point be returned to the client - if the client was ever to ask for it. Put like that, you can understand why this issue is never a top priority. And every firm has them. Well, that’s not quite true. When we asked ILFM members at one of their conferences the question “who does not have residual balances” only one hand in the whole room went up. I subsequently discovered that the firm in question was a new start up so hadn’t been operating a client account long enough to generate their own residual balances!
So how big is this problem? Well given that there are approximately 9,300 active law firms and based on our experience of working in this sector for over ten years, I would guess that the number is close to £1billion. Wow I hear you say. And this is not an exaggeration. So how has this happened? It’s a very good question and it certainly didn’t happen overnight. But the root of the problem probably goes all the way back to the days of prescriptive rule-based legislation. Back then, firms were able to hold client balances provided they wrote to the client every 12 months to advise them that they still held monies on their behalf. As a result, the balances began to build. And then one day, the fee earner responsible for the balances leaves the firm and nobody else is in a hurry to pick up the file. So the problem is never addressed until it’s too late.
That’s just one example. In our experience, acquisitions and mergers have a much bigger part to play in this £1billion problem. Financial Eye has worked with a number of acquiring firms and so have first-hand experience in seeing these issues come to light. For example, we have seen the SRA take a very active interest in any balances transferred to the acquiring firm. So much so that the firm was expected to report to the regulator every two weeks with an update. Those of you who may have been involved in a merger will know how terribly busy everyone is bedding into their new world. Residual balances are the last thing on their mind. As we dug a little deeper into one such balance, we discovered that the client was an offshore company with no actual bank account. The balance was in excess of £20K and the client was in no hurry to have the money returned. In fact, they were happy for the law firm to hold the money on their behalf indefinitely! Try telling that to the SRA.
We are constantly amazed by what we come across. What about the firm who did have a problem with residual balances and which we were in the process of tackling on their behalf? They received a random visit from the SRA to conduct an AML audit to ensure that they had all the appropriate policies and procedures in place. As part of that process, they asked each fee earner for a file for review. One of the files handed to them had a residual balance on it! This was enough for the SRA to carry out a full-blown investigation into their residual balances. Fortunately, we had made considerable progress in clearing them up and so they avoided a fine, but only just. But it did mean that the entire management team who were all fee-earners, were forced to focus on this issue instead of fee-earning.
We were once contacted by a firm who needed assistance in tackling some really old balances. These balances, and there were a lot of them, totalled in excess of £100K had been picked up by the firm’s reporting accountant. The same auditor that had been carrying out the AR1 for the past 10 years had now decided to qualify their report. The SRA’s response was instantaneous, and they found themselves on a watchlist that saw them having to report to the regulator every month with an update.
In another instance, we were contacted by a firm that had just been contacted by the SRA and had been warned that they faced an investigation into their conduct. Unlike the previous firm I mentioned, this firm had recently appointed a new reporting accountant, and they had noticed that the firm’s residual balances referred to in a prior year’s report had mysteriously disappeared. After further digging, they discovered that the firm had raised invoices totalling some £10k and by some weird coincidence, this matched exactly the total of the disappearing residual balances! Needless to say, the SRA took a dim view of this behaviour, and the firm were fined and had to repay the missing money into the client account and then deal with residual balances in accordance with the Accounts Rules.
These are just some examples of some of things we have come across. There are many, many more such stories and you may have some of your own. So, what have we learned from all of this? Well the most important thing is that just doing nothing is not an answer. Nor is playing fast and loose with the rules. In future articles, I will be addressing ways in which COFA’s and finance teams can deal effectively with historic balances as well as focussing on ways to prevent new ones arising in the future. The more these matters are discussed, the more likely it is that we can all arrive at workable solutions to a £1billion problem.
David Thorpe
Director – Financial Eye
First published - ILFM -Legal Abacus August/September 2025
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