Formal Opinion 1986-5
Committee Report
Formal Opinion 1986-5
July 14, 1986
ACTION: Formal Opinion
OPINION:
LAWYER AS ESCROW AGENT
Introduction
This opinion addresses certain ethical questions that arise when lawyers hold funds in escrow. Although the issues are, in many cases, similar to those involving trust funds or other funds held for clients or third parties, only escrow accounts are covered here.
We first discuss the general duties of escrow agents and the need for fully informed consent by all parties before the lawyer for one of them can act as escrow agent. We stress the importance of having a carefully drafted escrow agreement that covers, among other things, possible disputes over the escrowed funds. Our opinion then speaks to the possibility that the escrow agreement may involve a client confidence or secret and discusses the conflicts that may arise between the interests of the client and the interests of the other party to the escrow. We then turn to the conflicts that may arise between the interests of the lawyer and the interests of his own client with respect to the escrowed funds. Finally, our opinion discusses the permissible modes of investing the funds, the lawyer’s entitlement to any income that may be earned thereon, participation in the New York IOLA (Interest on Lawyer Accounts) program, problems of commingling and recordkeeping requirements.
I. Escrow Accounts and Escrow Agents
An escrow agent is a custodian or stakeholder of funds designated for a special purpose, usually pursuant to a written agreement. The escrow agent has contractual and fiduciary duties to all parties to the escrow arrangement and may dispose of the escrowed funds only in accordance with the terms of the escrow agreement or with the consent of all parties. The duties of an escrow agent are thus principally matters of contract and fiduciary law, rather than of ethics, and to that extent are beyond the jurisdiction of this Committee.
A lawyer serving as escrow agent has fiduciary duties and obligations, not only to his client, but to all parties to the escrow agreement. In addition, a lawyer’s conduct with respect to escrow arrangements is governed by the Code of Professional Responsibility. As discussed more fully below, the requirements of Canon 9 pertaining to the preservation, safekeeping and use of client funds and trust property are applicable to escrowed funds held by a lawyer, although such funds are not literally “”funds of clients.”” N.Y. City 82-8; N.Y. City 79-48 (1980); N.Y. State 532 (1981); In Re Hollendonner, No. D-1 (N.J. Sup. Ct., Oct. 17, 1985).
II. Consent and Escrow Agreements
As a general rule, it is ethically permissible for a lawyer to represent a client and to act as escrow agent in the same transaction if all interested parties have consented after full disclosure by the lawyer of the possible effect of his dual role on the interests of each party, and if it is obvious that the lawyer can adequately represent the interests of all parties. See DR 5-105(C); N.Y. County 573 (1969). Such consent must be fully informed. A consent based upon the contemplated discharge of routine escrow instructions, without taking into account potential disputes among the parties, is not sufficient to override a conflict of interest in the event of a dispute. N.Y. City 80-56.
It is advisable, therefore, to include in the escrow agreement carefully drafted provisions making clear that the non-client party agrees that, in the event of a dispute between the parties with respect to the escrow or the underlying transaction, the lawyer may represent his client in the dispute. Such a provision clarifies the scope of the non-client’s consent and therefore lessens the likelihood of confusion and delay that might be caused by the lawyer’s attempting to obtain such consent after a dispute occurs, or having to resign as escrow agent or being disqualified from representing his client.
In order to give the lawyer-escrow agent an agreed-upon means of resolving any conflict of interest, the escrow agreement should also provide that the escrow agent may at his option pay the escrowed funds into court or submit the matter to arbitration in the event of a dispute over the funds. Such a provision should expedite the ability of the escrow agent to resign as such, but to continue to represent his client, in the event that he deems it necessary or desirable. If the escrow agent were to bring an interpleader action, however, the court might decide that, notwithstanding the fully informed consent of all interested parties, the lawyer-escrow agent cannot represent one of the claimants to the escrowed funds while at the same time he is seeking to be discharged by the court from any further liability with respect to the funds. It is also possible that the lawyer would be required to testify in such an action, thereby disqualifying him from representing his client. See DRs 5-101 and 5-102.
III. Escrow Agreement as Confidence or Secret
Whether the existence of an escrow account, or information pertaining to that account, is a confidence or secret of a client within the meaning of Canon 4 is a question that frequently arises, usually in the context of a request for such information by the Internal Revenue Service or other governmental authority. Under Canon 4, a lawyer is prohibited from knowingly revealing a confidence or secret of his client. A “”confidence”” refers to information protected by the attorney-client privilege under applicable law. DR 4-101(A). Whether information pertaining to an escrow account constitutes a confidence is thus a question of law beyond the jurisdiction of this Committee. A “”secret”” refers to other information gained in the professional relationship that the client has requested be held inviolate or the disclosure of which would be embarrassing or would likely be detrimental to the client. Id. Whether the existence of, or information with respect to, an escrow account fits this definition requires a factual determination on a case-by-case basis.
A lawyer may reveal confidences or secrets with the consent of the clients affected, but only after full disclosure to them. A lawyer may also reveal confidences or secrets when permitted under the Disciplinary Rules or required by law or court order. DR 4-101(C). Thus, if presented with a request by a governmental authority for production of information pertaining to escrow accounts when a client is a target of an investigation, a lawyer must, unless the client has consented to disclosure, decline to furnish such information on the ground either that it is protected by the attorney-client privilege or that it has been gained in the course of a confidential relationship. Taking such a position (as in support of a motion to quash a subpoena) will usually result in a court order deciding the issue. If disclosure is compelled, it will not breach a lawyer’s ethical obligation with respect to his client’s confidences or secrets. If the records of the lawyer, rather than of the client, are the subject of the inquiry, the lawyer’s response should be the same, unless he is certain that the requested information does not constitute a client confidence or secret. See N.Y. County 413 (1953); ABA 393 (1961); N.Y. County 377 (1975); N.Y. City 312 (1934); Connecticut 81-3 (1980); Oregon 440 (1980); Michigan CI-1088 (1985); Michigan CI-925 (1983); Michigan CI-389 (1979); Tennessee 81-F-20 (1981). Depending upon his client’s interests, however, the lawyer may have a further duty under Canon 7 (a lawyer should represent his client zealously within the bounds of the law) to appeal a court order adverse to his client. See Michigan CI-925 (1983); Michigan CI-1088 (1985).
IV. Conflicts of Interest — Client versus Third Party
Canon 5, which requires a lawyer to exercise independent professional judgment on behalf of his client, and in particular to avoid a stake in interests that might conflict with those of his client, is applicable to the conduct of a lawyer who represents one party to a transaction and at the same time acts as escrow agent for both parties. See N.Y. City 80-56; N.Y. County 573 (1969); N.Y. County 477 (1959); ABA 923 (1966). The role of the escrow agent as a neutral stakeholder may conflict with the obligation of the lawyer to assert his client’s position with respect to the transaction. See N.Y. City 82-8; N.Y. City 80-56; N.Y. County 357 (1940); Nassau County 80-7. In the event of a dispute over the disposition of the escrowed funds, the escrow agent, as a fiduciary for both sides, would be obligated to assume a neutral position, while, as the lawyer for one party, he would be ethically bound to represent his client zealously. See N.Y. County 357 (1940); Canon 7.
Another source of conflict between the simultaneous roles of lawyer and escrow agent may arise when the lawyer is put in a position of having to assert a lien on the escrowed funds on behalf of his client. On the one hand, the escrow agent has a duty to treat the escrowed funds neutrally and in accordance with the terms of the escrow agreement. See Nassau County 80-8. On the other hand, the lawyer has an ethical obligation to assert any claims his client may have in a dispute. This Committee has noted in the past that although the issue involves questions of law relating to the duties of an escrow agent, such a lien would nonetheless appear to be an encumbrance on escrowed funds, the imposition of which would seem incompatible with the stakeholder’s role. N.Y. City 80-56. In the absence of knowing consent by the non-client to the lawyer’s continuing to act in both capacities, the lawyer should either resign as escrow agent or decline to represent his client in the dispute. In any case, Canon 9 requires a lawyer to avoid even the appearance of impropriety. Depending upon the circumstances, it might appear improper for a lawyer to participate in the attachment of funds he is holding as escrow agent. Id.
Even in the absence of a dispute between the parties to the escrow agreement, the lawyer-escrow agent may face conflicts of interest. For example, in the course of the attorney-client relationship, the lawyer may acquire information material to the escrow arrangement which should be disclosed to the parties in interest. If such information does not constitute a client confidence or secret, the lawyer should, if circumstances warrant, advise his client to take action to eliminate the need for disclosure. If the client is unwilling or unable to do so, the lawyer should disclose such information to the other parties to the escrow agreement. See N.Y. County 477 (1959). If the information does constitute a confidence or secret, the lawyer should probably resign as escrow agent to avoid even the appearance of conflict of interest or divided loyalty to his client.
V. Conflicts of Interest — Lawyer versus Client
Lawyers sometimes wish to assert their own claims against funds they are holding in escrow, usually to recover unpaid legal fees. Such claims may arise in one of three situations: (1) funds which are payable in full to the parties to the escrow and the client is entitled to receive at least part; (2) funds which are immediately payable only in part; and (3) funds which are only potentially payable to the client. The question whether the lawyer-escrow agent may claim the funds in any of these situations principally involves legal issues. For example, the existence of an attorney’s retaining or charging lien on the escrowed funds as well as the lawyer-escrow agent’s contractual and fiduciary duties are all legal matters and, as previously noted, are thus beyond the jurisdiction of this Committee.
The ethical considerations come into play only to the extent the lawyer has legal rights to the escrowed funds. There are two provisions of the Code of Professional Responsibility with which a lawyer in this position should primarily be concerned. The first is DR 9-102(A)(2), which provides as follows:
Funds belonging in part to a client and in part presently or potentially to the lawyer or law firm must be deposited [in a separate account], but the portion belonging to the lawyer or law firm may be withdrawn when due unless the right of the lawyer or law firm to receive it is disputed by the client, in which event the disputed portion shall not be withdrawn until the dispute is finally resolved.
The second is DR 9-102(B)(4), which states that a lawyer shall:
Promptly pay or deliver to the client as requested by a client the funds, securities, or other properties in the possession of the lawyer which the client is entitled to receive.
See N.Y. City 82-22; N.Y. City 82-61; N.Y. City 82-65; N.Y. City 590 (1941); N.Y. City 229 (1932); ABA 859 (1965); Maryland 84-60 (1983); Kentucky E-292 (1984); Michigan CI-636 (1981).
When the entire amount in escrow is payable and at least a part is to be paid to the client against whom the lawyer has a claim, the lawyer must first determine whether the funds to be paid the client “”presently”” or “”potentially”” belong to the lawyer. This is a legal and not an ethical question. For example, the escrow agreement may provide that a portion of the escrowed funds is to be paid to the lawyer as legal fees. (In such cases, because of the potential conflict the lawyer may have, all parties to the escrow agreement should have the conflict explained to them at the outset and their consent should be obtained.) In such situations, as a matter of contract law, part of the funds would presently or potentially belong to the lawyer. The client would not be “”entitled to receive”” the funds and thus DR 9-102(B)(4) would not require that the funds be paid to the client. However, if the funds do not presently or potentially belong to the lawyer, they must be “”promptly”” turned over to the client.
Assuming the funds may legally belong to the lawyer, he should then notify the client of his claim to see if the client agrees or disagrees. If the claim is disputed, then, under DR 9-102(A)(2), the lawyer may not pay out the disputed portion to himself until the dispute is resolved, but may retain the funds until such time. n1 Again, this is because the client would not be “”entitled to receive”” the funds and thus DR 9-102(B)(4) would not be applicable. Of course, if there is no dispute, the funds may be taken by the lawyer. If the lawyer has a claim to only part of the funds, the undisputed portion should promptly be paid to the client.
n1 One committee has said that the only instance in which a lawyer may ethically withhold escrowed funds from a client is when the escrow agreement specifically so permits. Nassau County 80-7; Nassau County 85-7. We do not agree.
If the escrow agreement calls for only a portion of the escrowed funds to be paid out, or if the funds are only potentially payable to the client, a similar analysis to that described above should be followed. There may, however, be additional ethical considerations. The lawyer as escrow agent may be presented with a conflict of interest. To the extent that his disputed claim may only partially be satisfied by the funds payable, or is only to be satisfied from potentially payable funds, the lawyer will have a self-interest in interpreting the escrow agreement, if susceptible to interpretation, in such a manner that the funds not yet payable become so as soon as possible. This conflict would be greater if the escrow agent is, in certain circumstances, required to pay the funds to a third party. In such an instance, the lawyer-escrow agent will have an interest in interpreting the agreement so that the funds go to his client and thus may be obtained by the lawyer. If the funds payable would fully satisfy the disputed claim, the lawyer may have an interest in delaying further distributions to the client, if possible, as a means of forcing a settlement of the dispute. Because of the conflict, the lawyer should resign as escrow agent in these cases.
VI. Permissible Modes of Investing Escrowed Funds
All escrowed funds received by a lawyer must be deposited in one or more identifiable accounts, in which (with limited exceptions) no funds belonging to the lawyer may be deposited. DR 9-102(A). We have previously opined that, although the rule by its terms refers only to “”bank accounts,”” it allows the lawyer to deposit escrowed funds in other types of accounts which bear characteristics of safety and security similar to a bank account. We express no opinion on the merits of any such alternative investment account. See N.Y. City 82-8; N.Y. City 81-15; N.Y. City 79-48 (1980); N.Y. City 79-22.
The propriety of using a particular investment mode is primarily a matter of the lawyer-escrow agent’s authority under the escrow agreement and his obligations under applicable law. We urge that the lawyer obtain the consent of the parties to the escrow agreement before depositing escrowed funds in an account other than a bank account. N.Y. City 82-8; N.Y. City 79-22. Further, the lawyer should ensure that any pre-withdrawal notice and waiting periods that may apply are understood and approved. N.Y. State 90 (1968). If knowing consent of all parties is obtained, the limitation of DR 9-102(A) to bank accounts (or their equivalent) should not be applicable to escrow accounts.
VII. Commingling of Escrowed Funds
It is impermissible for a lawyer to commingle a client’s funds with his own funds; however, since it is generally impractical to deposit each escrowed fund in a separate account (DR 9-102(A) and EC 9-5), lawyer-escrow agents often commingle several funds in one escrow account. This is permissible as long as proper records are maintained and other ethical requirements are fulfilled.
VIII. Interest-Bearing Accounts; Distribution of Interest
The typical escrow account — containing several escrowed funds — is often not an interest-bearing account because of the difficulty in calculating the interest attributable to each party. ABA 348 (1982); N.Y. State 554 (1983). Nonetheless, Canon 9 has been repeatedly interpreted to permit, but not require, n2 the placement of escrowed funds in one or more interest-bearing accounts, as long as the requirements of DR 9-102 and other ethical rules are met. N.Y. City 81-15; N.Y. State 554 (1983); ABA 348 (1982); cf. N.Y. City 79-22.
n2 Although there is generally no ethical obligation to place funds in an interest-bearing account, there may be a fiduciary obligation to do so under the law of trusts where the funds are sufficient to earn interest. See N.Y. State 554, citing 2 Scott, Law of Trusts, �� 180.3, 181 (3d ed. 1967); N.Y. State 575 (1986); Judiciary Law � 497(4). Further, in ABA 348, it was indicated that where the amount and the holding period of particular funds make it obvious that the interest to be earned would exceed the cost of placing the funds in an interest-bearing account, the failure to seek the client’s instructions as to how to invest the funds could be an “”extreme violation”” of the lawyer’s fiduciary obligation, and thus violative of DR 6-101(A) and DR 7-101(A)(1). We agree with the ABA position.
Lawyers may not retain as compensation for their escrow services or otherwise any of the interest earned in interest-bearing escrow accounts unless they have obtained the prior knowing consent of their clients and the other parties to the escrow, and even with such consent, there are still serious risks of ethical impropriety.
In light of the fiduciary nature of the attorney-client relationship and the fact that the lawyer may be in a superior bargaining position, agreements purporting to grant consent to such arrangements present a clear danger of overreaching and could lead to a breach of Canon 5, which requires a lawyer to exercise independent professional judgment on the client’s behalf. This is so because the lawyer would have a financial interest in delaying the event that terminates the escrow which might conflict with his duty to his client and other parties relating to the funds. See N.Y. City 81-68 (1982).
There is also the danger of violating DR 2-106(A), which prohibits a lawyer from collecting a clearly excessive fee. Since the expenses involved in an escrow account are generally nominal, the interest accrued would often substantially exceed any actual administrative costs. See N.Y. City 79-48 (1980). See also N.Y. City 181 (1931) (professionally improper for an attorney, “”arbitrarily,”” to retain interest as compensation for his services as escrow agent where the escrow agreement is silent on the subject); N.Y. City 81-15 (“”In the absence of an explicit agreement, any income realized on the client’s funds by an attorney-escrow agent belongs to the client.””); ABA 348 (1982) (reaffirming ABA 545 (1962) and ABA 991 (1967), and stating that under present-day Canon 9, although depositing funds in statutory “”IOLTA”” or “”IOLA”” accounts is proper, it is unethical to use interest earned on client funds “”to defray the lawyer’s own operating expenses without the specific and informed consent of the client.””); N.Y. State 554 (1983) (interest earned on “”trust accounts,”” absent the client’s consent, belongs to the client).
Some bar association ethics committees have gone farther and concluded that agreements permitting payments to lawyers from the interest earned on escrow accounts for the purpose of defraying their administrative costs are per se improper. See N.Y. State 532 (1981) (expressly rejecting N.Y. City 79-48 (1980)); N.Y. State 575 (1986); Nassau County 85-9; Nassau County 84-2. Our Committee does not agree with this view. We adhere to the position of our earlier opinions that it is not per se improper for a lawyer to pay himself interest earned on escrowed funds if he has obtained the prior knowing consent of the client and the other interested parties; however, we again caution that even with such consent, there are grave risks of ethical impropriety. These risks include overreaching, a conflict of financial interest between the lawyer and client in violation of Canon 5, overcharging the client in violation of DR 2-106(A), and commingling client funds with the lawyer’s funds in violation of DR 9-102(A). Any agreement purporting to give such consent, if challenged, would be subject to strict scrutiny.
IX. IOLA
The New York IOLA (Interest on Lawyer Accounts) program, authorized by the legislature in Section 497 of the Judiciary Law, n3 is a nonmandatory, state-supervised program under which lawyers may deposit and commingle in an interest-bearing account clients’ funds (including escrowed funds) that are too small, or to be held for too short a period of time, to be worth investing in a separate interest-bearing account. The interest on the funds is automatically paid to legislatively approved organizations. The main purpose of the program is to help provide civil legal assistance to the poor.
n3 Subdivision (5) of � 497 provides that “”No attorney shall be liable in damages nor held to answer for a charge of professional misconduct because of a deposit of moneys to an IOLA account pursuant to a judgment in good faith that such moneys were qualified funds.”” The term “”qualified funds”” is defined in subdivision (2) as “”moneys received by an attorney in a fiduciary capacity from a client or beneficial owner and which, in the judgment of the attorney, are too small in amount or are reasonably expected to be held for too short a time to generate sufficient interest income to justify the expense of administering a segregated account for the benefit of the client or beneficial owner.””
It is ethically proper for lawyers to participate in IOLA. N.Y. State 554 (1983); see also ABA 348 Since the funds used in IOLA are not reasonably expected by the client to earn interest (because the sum is so small or to be held for so short a time), the client is not “”entitled”” to the interest earned by virtue of the program DR 9-102(B)(4); hence, there is no violation if that interest is paid out under the program rather than to the client.
X. Recordkeeping
Pursuant to DR 9-102(B)(3), a lawyer must maintain complete records of all escrowed funds coming into his possession and render appropriate accounts to his client and the other interested parties regarding them. Lawyers in New York should also refer to the Uniform Rule for the Preservation of Client Funds, applicable in all four Departments of the Appellate Division (22 NYCRR �� 603.15, 691.12, 806.18 and 1022.5), which sets forth detailed requirements regarding client-fund recordkeeping, including a seven-year retention rule.
