Legal Advisory for New Jersey Bankers Association April 2003
IOLTA Case - Brown V. Legal Foundation of Washington
On March 26, 2003, the United States Supreme Court, in a 5-4 opinion, issued its opinion in the case of Brown v. Legal Foundation of Washington, ___ U.S. ___ (2003 WL 1523550 (U.S.). The Brown decision upheld the Interest on Lawyer's Trust Accounts ("IOLTA") program in Washington State. In 1980, Congress permitted federally insured banks to pay interest on certain demand deposit accounts, referred to as NOW accounts. The Congressional measure, however, did not permit for-profit corporations or partnerships, such as law firms, from retaining the interest on funds that are held in trust for clients unless the deposits were made pursuant to a program under which charitable organizations had the exclusive right to the interest. In 1981, Florida became the first state to establish an IOLTA program. Since then, every state, including New Jersey, has enacted an IOLTA program. Before 1980, banks retained the value of the use of the trust account money deposited in non-interest bearing trust accounts. With the advent of IOLTA programs, such funds - the interest gained on these IOLTA accounts - were transferred to charitable entities providing legal services for the poor. In 2001, IOLTA contributions were estimated to have exceeded $200 million in the United States. New Jersey's IOLTA program is administered by Court Rule. R. 1 :28A-1 et seq. The New Jersey Supreme Court, which has authority to regulate the profession and practice of law in the State, requires attorneys to maintain an IOLTA interest-bearing trust account for all client's funds that are "nominal in amount, are to be held for a short period of time, or otherwise are not likely to realize income for the clients." R. 1 :28A-2(a). Financial institutions where IOLTA funds are deposited must remit to the IOLTA Fund of the Bar of New Jersey, at least quarterly, interest and dividends, net of any service charges or fees. R. l:28A-2(e). 75% of the IOLTA funds are directed to go to Legal Services of New Jersey and 25% of the finds go to grants for legal aid purposes, "improvements of the administration of justice", "education of lay persons in legal and justice-related areas," and other programs for the benefit of the public approved by the Supreme Court. R. 1 :28A-4(b)-(c). In anticipation of a decision in Brown, the New Jersey Supreme Court amended its IOLTA rules effective January 1, 2003. The NJBA opposed the rule changes via written comment. The amended rules changed the name of the program to "Income On Non-Interest Bearing Lawyer-Trust Account program. R I :28A. The rules also clarified that under New Jersey law, the IOLTA interest is the property of the financial institution holding the account and that the financial institutions are directed to remit to the IOLTA Fund a "reasonable and comparable" portion of the interest income as a condition of being approved to accept attorney trust account deposits. R. 1:21-6(a).
The Brown Decision
In Brown, the U.S. Supreme Court reviewed the Washington State IOLTA program that is similar, but not identical to New Jersey's program. The Washington IOLTA program required (1) all client finds to be deposited in interest-bearing trust accounts, (2) finds that cannot earn net interest for the client to be deposited in an IOLTA account, (3) that lawyers direct banks to pay the net interest on the IOLTA account to the Legal Foundation of Washington, and (4) the Foundation must use all funds received from IOLTA accounts for tax-exempt law-related charitable and educational purposes. The plaintiffs in Brown argued that the state was unconstitutionally taking their property without just compensation in violation of the Fifth Amendment to Constitution of the United States. Although, the Fifth Amendment does not prohibit a "taking" by the government, it imposes two conditions on such a taking. Under the Constitution takings must be for a "public use" and "just compensation" must be paid to the owner. In Brown, the Court confirmed that IOLTA programs are a clear public use within the meaning of the Fifth Amendment. The Court then discussed the next condition "just compensation" by analyzing the two lines of case law that differentiate between the type of taking. The Court noted that they have distinguished between physical takings and regulatory takings. In cases where the government has physically taken possession of property, the Court has applied a straightforward per se rule requiring just compensation. In cases of regulatory takings, courts engage in "ad hoc, factual inquiries," which require assessments of the purposes and economic effects of government actions. Relying on a recent decision in an earlier case reviewing the Washington IOLTA program, Phillips v. Washington Legal Foundation, 524 U.S. 156 (1998), the Court determined that the interest earned on IOLTA accounts is the private property of the owner of the principal. In other words, there was a taking. The Brown Court, continued, however, that where there is a taking, just compensation is not necessarily required. The case law directs that â€˜just compensation" is "measured by the property owner's loss rather than the government gain." Under the facts before the Court, the majority of the Court determined that the plaintiffs were due no compensation because, by rule, the only finds to be deposited in IOLTA accounts, were those funds that would not have generated net interest income for them. The Court reasoned that there would be no loss because the interest earned would not have been enough, on an individual account basis, to pay for the administrative costs and fees associated with an interest-bearing account. As such, the net loss was zero. The Brown Court's summation is instructive:
To recapitulate: It is neither unethical nor illegal for lawyers to deposit their clients' funds in a single bank account. A state law that requires client finds that could not otherwise generate net earnings for the client to be deposited in an IOLTA account is not a "regulatory taking." A law that requires that the interest on those funds be transferred to a different owner for a legitimate public use, however, could be a per se taking requiring the payment of just compensation" to the client. Because that compensation is measured by the owner's pecuniary loss which is zero whenever the Washington law is obeyed -- there has been no violation of the Just Compensation Clause of the Fifth Amendment in this case. It is therefore unnecessary to discuss the remedial question presented in the certiorari petition. Accordingly, the judgment of the Court of Appeals is affirmed.
The Supreme Court, in the short time that has passed since the Brown decision was handed down, has not indicated that it will alter the current IOLTA rules. NJBA is exploring possible legislative and judicial remedies to address its concerns with the new IOLTA program. Differences between the Washington and New Jersey IOLTA programs, particularly in light of New Jersey's recent IOLTA rule changes, may leave the door open for legal challenges to New Jersey's IOLTA program. The Supreme Court found the Washington State IOLTA program was a taking, however, it also determined that just compensation was not necessary as only finds which were not likely to collect net interest were required to be put in the IOLTA finds. As such, the government's gain was not a loss of the interest income to the owners of the finds. First, procedurally, NIBA may have standing to argue that the NJ Court Rules on IOLTA overreach their authority and regulate the banking industry. New Jersey courts view standing generously and any problem with standing for the Association could be cured if one or more banks bring an action. Further, there may be procedural due process concerns in that the banking industry has had no recourse or other involvement in the Supreme Court's recent decision to alter the rules which now appear to regulate the banking industry. Second, under the decisions in Phillips and Brown, it appears clear that the U.S. Supreme Court has taken the position that interest earned in IOLTA accounts is the private property of the owner of the principal. Under the New Jersey IOLTA system changes, New Jersey has said that the interest is the property of the financial institution. Finally, now that New Jersey has determined that IOLTA interest is the property of the financial institutions holding such finds, NJ7BA could argue that just as the client property was "taken" in Brown, the banks' property is being taken in New Jersey, an action for which just compensation is required. The banks have property, which is a net gain for them, which the IOLTA program takes, resulting in a net loss for them. Such net losses require just compensation under the Fifth Amendment of the Constitution.