I. INTRODUCTION

11.1 Solicitors in New South Wales are commonly asked by clients to play some role in investing their money. Often the intended investment is a loan secured by a mortgage. In some instances, the money is received and invested by the solicitor through his or her trust account. In many other instances, however, it is received and invested by a nominee company, or a private finance company, in which the solicitor has an interest (often the controlling interest).

11.2 We have mentioned earlier in this Report the substantial number of irregularities and defalcations which have arisen from solicitors involvement in investing money for their clients.¹ In a number of these instances the investments have included loans to the solicitors themselves or to companies which they control. These defalcations have caused considerable loss and hardship for members of the public, who may be only partially compensated, if at all, by the Solicitors’ Fidelity Fund and, moreover, usually have to wait some months or even years before receiving any compensation from the Fund. This huge drain on the Fund’s resources has caused an increase in recent years of more than $1 million in the annual level of compulsory contributions from solicitors to the Fund.² Millions of dollars each year have been transferred to the Fund from the Statutory Interest Account instead of being allocated to legal aid and legal education.³ The Law Society and other authorities have had to devote very considerable amounts of time and money to investigating irregularities and defalcations, pursuing disciplinary and criminal proceedings, and attempting to prevent similar conduct in future.⁴ The reputation of the profession has also suffered significant harm. Between 1980 and 1984, more than $2 million was paid (or has been reserved for possible payment) under the professional indemnity insurance scheme as a result of claims relating to solicitors conduct of mortgage or lending transactions. In most cases the money being lent was passed through the solicitor s trust account.⁵

11.3 We begin this chapter by looking at three topics which are relevant to investment transactions whether they are made through the solicitor s trust account or through his or her nominee or private finance company. The topics are

• borrowing from clients;
• instructions for investments;
• registers and summaries of investments.

We then look at whether solicitors should be permitted to operate nominee companies or private finance companies and, if so, whether they should be subject to the same rules as apply to solicitors’ own trust accounts and/or to other rules.

II. BORROWING FROM CLIENTS

A. The Present Position

11.4 In 1975 the Court of Appeal in New South Wales made the following comments in Harvey’s Case about solicitors borrowing money from their clients:

“Where there is any conflict between the interest of the client and that of the solicitor, the duty of the solicitor is to act in perfect good faith and to make full disclosure of his interest. It must be a conscientious disclosure of all material circumstances, and everything known to him relating to the proposed transaction which might influence the conduct of the client.....

A solicitor, who deals with his client while remaining his solicitor, undertakes a heavy burden. Where a solicitor discovers that continuing to act for his client will, or may, bring the interests of his client and his own interests into conflict, it will be a rare case where he should not, at least, advise his client to take independent legal advice ...

A conflict of interest which is avoidable, and ought to be avoided, is that which arises from a deliberate proposal of the solicitor that his client deal with him ... Even the tender of advice to his client to have independent legal advice, although of importance, does not really overcome the objection to the solicitor having proposed, invited or encouraged the client to deal with him or his company ...

In the absence of very special circumstances, a solicitor who promotes himself as the dealer with his client misuses his position.... Therefore he ought neither to promote, suggest nor encourage a client to deal with him, but rather should take all reasonable steps positively to avoid dealing directly, or indirectly, with his client.”⁶

11.5 In 1975 the Law Society sent a circular to all solicitors summarising the views expressed by the Court in Harvey’s Case, including those to which we have referred above.⁷ In 1979 the Society published a ruling which, in effect, prohibited solicitors from borrowing money from their clients unless

• the client is represented by an independent solicitor for the transaction; or
• the solicitor makes full disclosure of his or her interests in the matter, and the client receives advice from an independent solicitor who then signs a prescribed Certificate of Independent Advice.⁸

The prohibition covers loans made to an “associated party”, which is defined as including

“any member of the immediate family of [the] solicitor or of his partner or of his employee and any corporation partnership, syndicate, joint venture or trust in which [the] solicitor or any member of his immediate family or of that of his partner or employee has or have any beneficial interest whether vested or contingent”.⁹

“Immediate family” is defined as including the solicitor s spouse, child, grandchild, sibling, parent or grandparent.¹⁰ The prohibition does not apply, however, where the client making the loan is a member of the solicitor’s immediate family or is a company falling within one of the categories specified in the ruling (for example, a bank, a registered life insurance company, or “listed company”.¹¹ There is also provision for the Law Society to approve loans in particular cases, whether prospectively or retrospectively.¹²

B. Discussion

11.6 The Law Society ruling to which we have referred was prefaced by a statement that the Society’s Council

“has been concerned for some time at the increasing number of trust account discrepancies attributable directly or indirectly to solicitors borrowing funds from clients or investor members of the general public where the purpose of such borrowing is that the funds raised may be used by the solicitor or members of his family for some on-lending or other personal investment by him or them.”¹³

The Society recognised that the ruling “is essentially, not innovative; rather it seeks to apply existing principles clearly and concisely to present-day transactions”.¹⁴ But, as the Society pointed out, “solicitors generally speaking, have experienced difficulty, in the current economic climate, in applying to commercial loan transactions in which they seek or are likely to become personally involved” the principles which had been enunciated by the Court of Appeal in Harvey’s Case and in earlier rulings by the Society.¹⁵

11.7 Since the Law Society’s ruling was made in 1979, there appears to have been a significant reduction in the incidence of borrowings from clients, and of defalcations or irregularities arising out of such borrowings as do occur. It seems, in particular, that there has been a substantial reduction in the number of solicitors who make a regular habit of borrowing from clients. We return to regular borrowings later in this chapter, when discussing private finance companies.¹⁶

11.8 On the other hand, there continue to be some instances of defalcations or irregularities arising from borrowing from clients.¹⁷ Moreover, there is a reasonable likelihood that a substantial up-turn in the real estate market might increase the incidence of borrowings made contrary to the Law Society’s ruling, and a subsequent sharp down-turn might cause serious defalcations. The effect of the economic climate on solicitors’ observance of ethical rules was acknowledged by the Law Society in the statement to which we referred above. It should be noted also that the requirement that a Certificate of Independent Advice be obtained is not necessarily an effective safeguard if the borrowing solicitor is unscrupulous, the certifying solicitor is careless or irresolute, or the client is naive.

11.9 In several other jurisdictions, specific rules about borrowing from clients have been imposed in recent years. In Queensland, for example, there is a general statutory prohibition on such borrowings unless the client has independent advice or falls within specified exceptions similar to those in the ruling of the Law Society of New South Wales.¹⁸ In Victoria, there is a broadly similar prohibition unless the solicitor

“is able to discharge the onus of proving that full written disclosure was made to the client and that the client s interests were fully protected in the circumstances of the case whether by independent legal representation or otherwise.”¹⁹

The prohibition covers loans to the solicitor s immediate family but that family is defined as including not only those relatives included in the New South Wales definition but also spouses (which includes de facto spouses) of those relatives.

C. Recommendation

11.10 It may become necessary at some future time to impose an absolute prohibition on solicitors acting for clients in relation to borrowing transactions between them, irrespective of whether the client obtains a certificate of Independent Advice. We do not, however, propose such a prohibition at this stage. First, the Law Society’s ruling is reasonably strict and has had beneficial effects, not all of which may have been manifested as yet in the incidence of irregularities or defalcations. Secondly, the risk of problems arising over borrowing transactions would be reduced by the adoption of recommendations which we have made in earlier chapters (for example, in relation to independent scrutiny of trust accounts) and later in this chapter (especially in relation to private finance companies).

11.11 However, we recommend that the substance of the Law Society ruling in 1979 about borrowing from clients should be embodied in statutory regulations. Also, the definition of the solicitor’s immediate family should be extended to include spouses of the relatives currently listed, and spouses should be defined as including de facto spouses.

III. INSTRUCTIONS FOR INVESTMENTS

A. The Present Position

11.12 At present, there is no requirement in New South Wales to the effect that, before investing trust moneys, solicitors must obtain their clients’ instructions in writing.

B. Discussion

11.13 We have referred earlier²⁰ to the disputes and difficulties which can arise, and have arisen over the nature of investments made by solicitors on their clients’ behalf. For example, clients have asserted that they directed that the investment be secured in a certain way, or be made at not less than a specified rate of interest, and that the direction has not been followed. Even where no dispute arises, the task of an examining accountant or Inspector may be made more difficult, time-consuming and expensive by the lack of adequate documentation to explain investment transactions and to establish their propriety.

11.14 In several jurisdictions there are specific requirements in relation to written authorisation for investments. In Queensland, for example, all withdrawals from the trust account “for the purpose of the investment howsoever”, or “the loan ... to any person”, of the money withdrawn must be authorised by the client in writing in advance.²¹ There is an exception where the withdrawal is “for the purposes of paying for any land chattels of livestock for the purchase in the name of the client of which the moneys in question were paid into the trust account”.²²

11.15 In Victoria, solicitors are required to obtain the “prior written authority of their clients before lending any money under a mortgage, or any other document purporting to secure or regulate the repayment of moneys, if “the principal or interest ... is to be collected by” the solicitor.²³ The authority must be in one of two prescribed forms. One form is a general authority for use where a “continuing instruction is to be given to ... advance monies on freehold first mortgage investments without the lender previously specifying any particular first mortgage security”.²⁴ The form provides, amongst other things, for the client to specify a maximum percentage of the property value which may be loaned under any such first mortgage. The other form is a specific authority which includes details of the amount and terms of the loan, the manner and amount of valuation of the security, a prominent indication if the security is secondary to other securities, and other matters.²⁵

11.16 In our Discussion Paper, one of us suggested that withdrawals of trust money for the purposes of investment should have to be authorised in writing in advance.²⁶ The Auditor-General for New South Wales specifically endorsed this suggestion.²⁷ The Law Society of New South Wales subsequently proposed a new statutory regulation broadly similar to the Victorian one to which we have referred above, and with similar prescribed forms.²⁸ The only significant difference is that the requirement to obtain written authorisation would extend also to any loans to a person who “is related to the solicitor, directly or indirectly”, whether or not secured or regulated by a mortgage or other document.²⁹

C. Recommendation

11.17 We recommend that solicitors should be subject to a general requirement to obtain the client’s written authorisation in a prescribed form before using trust money for the purposes of investment. The general and specific forms currently prescribed in Victoria have the support of the Law Society in this State and are appropriate for prescription here. It may be appropriate to prescribe one or more other forms to suit certain other types of investment transactions. It may also be appropriate to make certain limited exceptions to the general requirement which we have recommended; as is the case, for example, in Queensland.³⁰ We do not however, consider it necessary in this Report to make specific recommendations on these issues.

IV. REGISTERS AND SUMMARIES OF INVESTMENTS

A. The Present Position

11.18 We have described earlier in this Report the current obligations upon solicitors in New South Wales to make and retain records relating to trust money.³¹ There is no requirement to maintain anything in the nature of a separate register of trust money received or disbursed for the purpose of investment, nor is there any specific requirement to provide clients with summaries of such transactions. It is, however, a common practice for solicitors to provide an “epitome of mortgage” to the parties to a mortgage transaction. The epitome usually includes details of the lender and borrower, the amount of money lent, the date on which it was lent, the date on which it is repayable, the rate of interest and the dates on which instalments of interest are due, and particulars of the security sufficient to enable it to be identified.

B. Discussion

11.19 We have mentioned earlier the difficulties and disputes which can arise over the nature of investments arranged by solicitors for their clients.³² The maintenance by each solicitor of a register containing basic details of investment transactions, and the provision of similar details to the parties involved, would be of considerable assistance in reducing errors, uncertainties and arguments. The register would be of particular value to an examining accountant or Inspector. The Accounting Research Centre’s survey of New South Wales accountants in 1979 found that 79 per cent of respondents considered that solicitors should be required to maintain a “trust account investment register”.³³

11.20 Solicitors in most Australian States are now required to keep registers of securities and/or investments.³⁴ In Queensland, for example, solicitors must record in a Mortgage Register prescribed details relating to each “loan or security document” in relation to which they are authorised to collect principal or interest.³⁵ In Victoria, however, the corresponding requirements are more extensive. Broadly speaking, prescribed details of securities in relation to which solicitors are authorised to collect principal or interest must be recorded in a Mortgage Register,³⁶ prescribed details of negotiable securities for money and other securities and documents of title held on trust must be recorded in a Register of Securities,³⁷ and prescribed details of “every investment of trust monies for or on behalf of any person” must be entered in a Register of Investments unless it falls within the ambit of the Register of Securities.³⁸ Entries in the Register of Securities must be made “forthwith”³⁹ and those in the Mortgage Register “within one month”⁴⁰ after the occurrences to which they relate. We understand that consideration is being given to amalgamating the Securities and Investments Registers. In relation to each mortgage which is entered in the Mortgage Register, Victorian solicitors are also required to provide lenders with a Summary of Mortgage containing the same details as are recorded in the Register.⁴¹ The principal provisions in Victoria and Queensland are reproduced in Appendices IV and V respectively of this Report.

11.21 In our Discussion Paper we suggested that solicitors should be required to maintain a register of mortgage securities and mortgage investments, but not of other types of securities or investments.⁴² The register would be required to contain details of the kind which at present are usually included in epitomes of mortgages. The Law Society subsequently proposed a statutory regulation requiring maintenance of a Securities Register which, broadly speaking, would be required to include prescribed details of all securities, documents regulating repayment of money, or deposits of trust money, in relation to which the solicitor in question is authorised to collect principal and/or interest. This proposal is broader than the current requirement in Queensland but may not cover all investment transactions of the kind which in Victoria, must be recorded in a Register of Investments. We reproduce the proposal in Appendix III of this Report.⁴³

C. Recommendations

11.22 We welcome the general thrust of the Law Society’s proposals for a Securities Register, but we consider that there should also be a requirement to register unsecured investments, as is currently the case in Victoria⁴⁴ and South Australia.⁴⁵ The Society’s proposal would, in fact, cover many unsecured investments because of the extended meaning which it gives to the word “securities”. The definition includes not only mortgages, bills of sale and so on but any “ loan contract (whether evidenced in writing or not)”, “any document purporting to... regulate the repayment of moneys”, and any “deposit of money” held on trust “ by or under the control of the solicitor”.⁴⁶ In our view, this definition unduly stretches the normal concept of securities and accordingly risks causing considerable confusion and unwitting non-compliance on the part of solicitors.

11.23 We recommend that solicitors should be required to maintain a Securities and Investments Register containing prescribed details of

• all mortgages and other securities which are held in their name on trust or under which they are authorised to collect principal and/or interest;
• all investments of trust monies for or on behalf of any person and for which there is no such mortgage or security.

11.24 We have expressed this recommendation in general terms, but there may be a case for certain limited exceptions. For example, the Law Society has proposed an exception for securities handed to a solicitor in a sealed packet for safe custody only.⁴⁷ in relation to the details which ought to be prescribed, we agree with the substance of the proposals made by the Law Society.⁴⁸

11.25 Entries in this Register should have to be made within a prescribed time. The Register should form part of the trust account records and therefore, amongst other things, be subject to the same independent scrutiny as other parts of those records.

11.26 We recommend also that solicitors should be required to provide lenders within a prescribed time with a Summary containing the same details of transactions made on their behalf as are included in the Register.

V. NOMINEE COMPANIES

A. The Present Position

11.27 Many solicitors in New South Wales operate nominee companies. A common purpose of these companies is to act as trustee of those clients of a solicitor who wish to lend money on mortgage. The companies usually have no assets of their own (except a nominal amount of paid-up capital) and earn no income of their own. They are merely means for making investments on behalf of solicitors’ clients.

11.28 Nominee companies are of particular value where a solicitor has a client who wants to borrow, say, $30,000 on the security of a mortgage and also has, say, five other clients (not necessarily known to each other) who between them have $30,000 which they wish to lend on such security. if the five clients combine as mortgagees in a “contributory mortgage”, considerable legal and administrative difficulties may arise. These can be largely avoided, however, if the five clients pay their respective contributions to the solicitors nominee company which then becomes the lender on trust for them. The records of the company show that the particular mortgage is held on behalf of the clients and the company executes a declaration of trust in their favour. The company is managed and controlled by the solicitor and, subject to the terms of the declaration of trust, he or she, through the company, takes whatever action needs to be taken in relation to the mortgage. Another advantage which can be derived from the use of a nominee company is the provision of anonymity for lenders who do not wish their identity to be known to those borrowing from them.

11.29 Money received by solicitors’ nominee companies is not thereby money received by solicitors themselves. Accordingly, it is not subject to the statutory provisions relating to the handling and recording of trust moneys by solicitors, independent scrutiny of solicitors trust accounts, and reimbursement of defalcations through the Solicitors’ Fidelity Fund. The nominee company must, however, comply with the general law of trusts.

B. Discussion

11.30 We have mentioned certain benefits which can be obtained by solicitors and their clients through the use of nominee companies. Generally speaking, these benefits seem unobjectionable from the viewpoint of the public interest. However, it seems clear that most, if not all people who lend money through solicitors’ nominee companies do so because of their relationship with and confidence in, the solicitor as a solicitor. It is often only the professional status of the solicitor which gives the investor the confidence to invest his or her money through the solicitor. Also, it is often only that status which gives the investor confidence to allow the solicitor to choose the form of the investment. The investor usually pays little regard to whether the mortgage is taken in the name of the solicitor or the name of the solicitor s nominee company. Yet, under present law, the choice can have crucial effects on the degree of protection afforded to the investor. Clients are often aware in a general sense of the system of regulation applying to solicitors’ trust accounts, and the availability of compensation in the event of defalcations. They are much less likely to be aware that these protections do not apply to money invested through solicitors’ nominee companies. Indeed, they may not be aware that they are unlikely to have a right to claim against the solicitor personally in relation to any mishandling of such money.

11. 31 Moreover, solicitors’ nominee companies are not generally subject to the same degree of regulation as other financial intermediaries such as banks, building societies or finance companies. They are usually exempt proprietary companies, and thus not subject to the audit provisions of the Companies Code.⁵⁰ Also, it seems to be accepted, at least in New South Wales, that they are not subject to those provisions in the Companies Code⁵¹ and the Securities Industry Code⁵² which govern financial intermediaries dealing with the public.

11.32 Solicitors’ nominee companies are lawful throughout Australia, but in some States, notably Victoria and Tasmania, they are subject to specific statutory requirements. In Victoria, each of the members and directors of the company Must be a solicitor or other person approved by the Law Institute.⁵³ The company must not undertake any activity other than holding property as “a nominee or trustee for another person.”⁵⁴ Amounts paid by lenders or borrowers to the company are required to be passed through the solicitor s own trust account and the provisions relating to the Mortgage Register must be complied with in relation to mortgages in the name of the company.⁵⁵

11.33 In Tasmania each member and director must be a practitioner but sole practitioners are prohibited from being a member or director.⁵⁶ Each company must be formed with the approval of the Law Society.⁵⁷ The company’s books of account are deemed to be part of the practitioner s books of account, and its “books of account and affairs” are subject to the rules governing legal practitioners in the same way as if money held by the company is part of the practitioner s trust account.⁵⁸ The acts of the company are deemed to be those of each of its directors for the purposes of rules about professional conduct, and breach of the rules relating to the companies is deemed to be unprofessional conduct in the course of practice as a legal practitioner.⁵⁹ The directors are also required to guarantee jointly and severally the repayment of money deposited with the company, and the payment of interest to be earned on it.⁶⁰

11.34 In our Discussion Paper we suggested adoption of rules along the lines of those in Victoria and Tasmania to which we have referred above, save the Tasmanian rule against sole practitioners being members or directors of a nominee company.⁶¹ The Law Society subsequently proposed a draft regulation relating to nominee companies (see Appendix III).⁶² The proposed regulation restricts shareholding and directorship of such companies to solicitors, subject to special provisions relating to sole practitioners’ companies. Nominee companies would be restricted to the activity of holding and/or dealing with property as trustee for other persons. Certain details of transactions would have to be recorded in the companys records and provided in writing to the borrower “as soon as practicable after payment of”⁶³ the loan. Payments to and from nominee companies would have to be made through the solicitors trust account. In its original form, the Society’s draft regulation would have prohibited both the nominee companies and the solicitors involved from receiving any director indirect financial benefits “save for the professional costs of the solicitor of acting as the solicitor in the relevant transaction”.⁶⁴ Subsequently the Society proposed that this prohibition should apply only to the companies themselves, and that solicitors should be advised that they may “make a charge for the administration costs of the mortgage provided that the client has approved and is fully aware of the nature and amount of this charge.”⁶⁵

C. Recommendations

11.35 We agree with the general tenor of the Law Society’s proposed regulation, subject to certain additional rules derived from the Victorian and Tasmanian provisions. Accordingly, we recommend that solicitors should be entitled to operate nominee companies subject to the following conditions.

• All shareholders and directors of the company should have to be solicitors (subject to an exception in the case of sole practitioners, along the lines currently proposed by the Law Society).⁶⁶
• The company’s activities should have to be confined to holding or dealing with property on trust.
• The company and its directors should be prohibited from deriving any financial benefit from its activities, other than solicitors’ professional costs for acting as a solicitor.
• The directors should be required to guarantee jointly and severally the repayment of principal, and the payment of due interest, to lenders.
• The company should be required to execute appropriate declarations of trust, or otherwise to evidence the trust, in respect of each transaction.
• Money received by the company should be subject to the statutory provisions relating to solicitors’ trust money in the same way as if it is received by the solicitor as trust money (including, for example, the provisions relating to the keeping of Registers and the provision of Summaries to lenders).
• The company’s accounts should be deemed part of the solicitors’ trust accounts, and be subject to the statutory provisions relating to such accounts (including, for example, the provisions relating to inspections and accountants’ examinations).
• For the purposes of the rules of professional conduct, the acts of the company should be deemed to be also the acts of each of its directors, and the acts of solicitors as directors should be deemed to be acts in the course of their practice as solicitors.

As appears from these recommendations, we do not favour the Law Society’s recent proposal that solicitors should be entitled to charge “administration costs” on mortgage transactions handled by their nominee companies.⁶⁷ At least in its present form, the proposal leaves too much scope for solicitors’ nominee companies to become involved in entrepreneurial mortgage-broking replete with conflicts of interest and other dangers of the kind which as we point out later in this chapter, have arisen in relation to solicitors’ private finance companies.⁶⁸ The need to prevent nominee companies from developing in this manner would increase if, as we recommend later, solicitors are prohibited from operating private finance companies.⁶⁹

11.36 It is beyond the scope of this Report to make recommendations about the Solicitors’ Fidelity Fund. However, a logical corollary of the above recommendations is that money received by a nominee company should be taken into account in determining the statutory deposit which a solicitor must make of a prescribed portion of his or her trust funds⁷⁰ and that lenders should have the protection of the Fidelity Fund in the same way as if the money was received by the solicitor rather than by the company.

VI. PRIVATE FINANCE COMPANIES

A. The Present Position

11.37 Broadly speaking, solicitors’ private finance companies may be described as companies which are operated or controlled by solicitors or “associated parties”(such as close relatives, employees, or companies in which solicitors have an interest) and conduct the business of borrowing and lending money.⁷¹ The usual practice is for the companies to make loans, secured by mortgages, out of a pool of money deposited with the company by various people, most of whom are clients of the legal practice run by the solicitor or solicitors involved in the company.

11.38 Since money received by a solicitors private finance company is not money received by the solicitor, it is not subject to the statutory provisions relating to solicitors’ trust moneys and trust accounts. Moreover, the company’s relationship to the lender is that of debtor rather than of trustee. There are no statutory provisions in New South Wales relating specifically to solicitors’ private finance companies and there is considerable doubt whether they are subject to the provisions in the Companies Code or the Securities Industry Code relating to financial intermediaries dealing with the public.⁷²

11.39 A number of relevant comments were made, however, by the Court of Appeal in 1975 in Harvey’s Case,⁷³ which involved a solicitors private finance company. Some of the court's comments about solicitors borrowing from clients have been referred to earlier in this chapter.⁷⁴ The following extracts from the Court’s judgment are of special relevance to solicitors involvement in private finance companies.

“A conflict of interest which is avoidable, and ought to be avoided, is that which arises from a deliberate proposal of the solicitor that his client deal with him ... It can make no difference if he is not a party directly but the transaction is with a company in which he bas an interest. Even the tender of advice to his client to have independent legal advice, although of importance, does not really overcome [this] objection ....

In the absence of very special circumstances, a solicitor who promotes himself as the dealer with his client misuses his position. A solicitor who constantly promotes dealings with various clients clearly misuses his position and puts it beyond his capacity to observe his primary duty to his clients ....

[I]f a solicitor does occasionally act in the role of a loan- broker, he will need to take special care to ensure that the relationship of confidence engendered by the solicitor/client relationship does not cloud the client s judgment The client must not be encouraged to assume that the solicitor has necessarily any special expertise in the commercial, as distinct from the legal concomitants, of the transaction under consideration ....

... [A] solicitor who does act as a loan- broker ought to regard himself as precluded, by the very relationship between him and his client, from commending to his client a loan to a company, or for a venture, in which the solicitor has an interest. A solicitor ought not to intermingle his personal affairs, in a sense including the affairs of companies, ventures or others with whose financial position he has a personal connection with the affairs of his client.”⁷⁵

11.40 A few years later, in 1979, the Law Society of New South Wales issued two rulings of special relevance to private finance companies.⁷⁶ The first, relating to solicitors borrowing from their clients, has been outlined earlier in this chapter.⁷⁷ It relates to private finance companies because it covers borrowing from a solicitor s clients by an “associated party”, which is defined to include any company “in which [the] solicitor or any member of his immediate family or that of his partner or employee has or have any beneficial interest whether vested or contingent”.⁷⁸ As mentioned earlier,⁷⁹ the ruling requires that the lender either is given full disclosure of the solicitor s interests and receives advice from an independent solicitor or is represented by an independent solicitor in relation to the loan.

11.41 A few months after this ruling was issued, the Law Society published a ruling relating specifically to borrowings by solicitors’ private finance companies.⁸⁰ This second ruling, in effect, added certain restrictions to those specified in the first one. Broadly speaking, it prohibited loans from the company to the solicitor or an associated party unless all persons who have money on loan to the company have obtained advice from an independent solicitor about the company’s proposed loan to the solicitor.⁸¹ It also prohibited solicitors from making an express or implied representation that money lent to the company is “repayable at call or on a specified date if there is a possibility of a substantial delay in repaying ... on the due date,”⁸² and from representing that loans to the company are secured “unless there is a direct matching of those funds with a particular (and readily identified) security”.⁸³ Perhaps the most important aspect of the ruling however, is a requirement that the company must not pay “a lesser rate of interest to depositors than that which is received from borrowers.”⁸⁴

11.42 There are no accurate statistics about the prevalence of solicitors private finance companies in New South Wales in recent years, nor about the amounts of money which they have handled. There is no doubt, however, that during the latter part of the 1970s they were common and, in total, handled hundreds (and perhaps thousands) of millions of dollars. It is also clear that some of these companies were run without adequate regard for the interests of the solicitors clients involved.⁸⁷

11.43 Many of the irregularities and defalcations detected in recent years took place, or had their origins, prior to the Law Society’s rulings in 1979. Inquiries made of solicitors by the Law Society suggest that since those rulings were made there has been a substantial decline in the number of these companies.⁸⁸

B. Discussion

11.44 Solicitors’ private finance companies, like solicitors’ nominee companies, can serve useful purposes. In particular, they may enable borrowers to obtain finance more readily than might otherwise be the case, facilitate the pooling of small amounts from a number of would be lenders, and provide lenders with desired anonymity. On the other hand, under present arrangements they have a number of substantial disadvantages from the viewpoint of lenders, or borrowers, or both.

11.45 First, they have the disadvantages to which we referred earlier in relation to nominee companies.⁸⁹ For example, although it seems clear that many lenders and borrowers deal with companies because they believe they are run by solicitors, they need not be run solely or principally by solicitors, money paid to the company is not subject to statutory provisions governing solicitors trust moneys and trust accounts and, generally speaking, the solicitors involved are under no personal liability in relation to such money. Money received by the company may not be subject to the protection of the Solicitors’ Fidelity Fund.⁹⁰ Moreover, it is by no means clear whether the companies are subject to the provisions of the Companies Code and Securities Industries Code.⁹¹

11.46 Secondly, private finance companies can have a number of other disadvantages which do not apply to nominee companies. For example, since the money lent to the company is not held by it on trust, the lender has less protection than with a loan to a nominee company. Also, private finance companies have, in practice, been more likely than nominee companies to be involved in making loans to the solicitor or an associated party, to become involved in financial and commercial activities of a kind and scale which the solicitor is not competent to manage, and to give rise to defalcations.

11.47 A major potential danger of private finance companies is that, by contrast with nominee companies, they may be run as profit-making enterprises, which heightens the potential for conflict between the interests of solicitors and those of clients dealing with the solicitors’ companies. This danger, however, is reduced substantially if, as the Law Society has ruled,⁹² the companies are not allowed to pay lenders lesser rates of interest than they receive from borrowers. Indeed, this ruling removed much of the attraction for solicitors of handling investment transactions through private finance companies rather than through nominee companies, and together with the requirements relating to independent legal advice for clients lending to solicitors or associated parties,⁹³ may be the principal reasons for the apparently substantial decline in the number of private finance companies.

11.48 There seems no reason to doubt that such a decline has occurred, but it is by no means certain that the present number of private finance companies is as low as was reported recently to the Law Society. It is possible that some companies controlled by solicitors or associated parties were not reported, and that there are companies with which solicitors have a nexus which is very close but not of the kind about which the Law Society inquired. In any event, the recent decline may be reversed-if economic conditions change or the passage of time makes some solicitors less conscious of the disciplinary action and professional opprobrium which have been incurred in recent years by a number of solicitors who became involved in such companies. The advent of advertising, and increased competition both within the profession and with other professions or institutions, may heighten some solicitors interest in operating private finance companies.

11.49 Regulation in Other States: Solicitors’ private finance companies are the subject of specific statutory regulation in only two States, namely Tasmania and Victoria. We outlined earlier in this chapter the Tasmanian provisions relating to nominee companies.⁹⁴ These provisions, which were adopted in 1970, apply also to private finance companies.

11.50 In Victoria, a substantial number of private finance companies have existed for many years, especially in large country centres, and some have become very large operations. In 1976, a committee of the Law Institute recommended that solicitors should not be permitted to operate or control private finance companies.⁹⁵ It said that such arrangements “are fraught with peril for both client and Solicitor.⁹⁶ A Joint standing committee of the institute and the two principal associations of accountants said that” solicitors should not conduct investment companies due to the conflict of interests which may arise”.⁹⁷ It added that if such companies were allowed to continue they should be subject to regulation by statute.⁹⁸

11.51 The Attorney General of Victoria then established the Dawson Committee to inquire into these and other issues. The Committee said that solicitors private finance companies suffered from the following defects:

“(i) potential conflicts of interest;

(ii) inherent weaknesses in financial structure;

(iii) absence of public accountability and disclosure;

(iv) an altered legal relationship between solicitor and client;

(v) absence of personal liability;

(vi) unequal status of creditors concerned; and

(vii) public misapprehension as to the nature of the investment.”⁹⁹

11.52 The Committee concluded, however, that

“the fact that solicitors have been able to develop substantial mortgage banking businesses does indicate they are fulfilling a need in so doing. Any attempt now to prohibit solicitors from engaging in mortgage banking would involve the winding up of what have become substantial and, in most of the cases examined by the committee, well-run enterprises. It is for these reasons that the committee favours control rather than prohibition ....

Solicitor-controlled investment companies run the same risks as other financial intermediaries ... However, it is doubtful whether members of the public appreciate the risks involved, believing instead that the professional status of the solicitor affords sufficient protection. It is for this reason that the committee believes that, as far as possible, the protections which exist in respect of funds which a solicitor is required to deposit in a trust account should be extended to deposits with an investment company controlled by him.”¹⁰⁰

11.53 The Committee recommended that solicitors private finance companies should be required to obtain a licence from the Commissioner for Corporate Affairs, to have their accounts audited each year, and to comply with a number of other requirements relating, for example, to maintenance of a prescribed ratio of paid- up capital and reserves to deposits, maintenance of an investment register, restriction of securities to real estate mortgages, proper valuations of real estate, and restriction of loans to no more than a prescribed percentage of the value of the real estate in question.¹⁰¹

11.54 Considerable debate ensued after the Committee’s report was published. The Law Institute, for example, urged the Government to prohibit private finance companies and added that, if they were to be regulated rather than prohibited, the Institute should be the regulatory authority. Eventually, after discussions involving the Commonwealth Government and all State Governments, a system of licensing by the Victorian Commissioner for Corporate Affairs was established. Details of the licensing scheme, including the rules with which licensed companies must comply, are contained in Appendix IV of this Report. In essence, the scheme includes rules of the kinds recommended by the Dawson Committee, and certain other rules requiring, for example, that the company’s accounts be audited by the same auditor who audits the solicitor s trust accounts,¹⁰² that lenders be told that they “may have no recourse to the Guarantee Fund” (the Victorian equivalent of or Fidelity Fund),¹⁰³ that loans to the solicitor or an associated party be made only with prior written approval of the Commissioner,¹⁰⁴ and that the solicitor personally guarantees due payment of the company’s liabilities.¹⁰⁵ The licensing scheme came into operation in February 1984. By late in that year some seven companies had applied for licences but no applications had yet been determined.

11.55 Our Discussion Paper: In our Discussion Paper we said that private finance companies have “a dangerous potential for fraud, mismanagement and professional irresponsibility”.¹⁰⁷ But we suggested that “if they can be regulated in a way which so far as impracticable, ensures adequate protection for members of the public” they should be so regulated rather than being prohibited.¹⁰⁸ We suggested that regulation should be effected by the Law Society and be broadly along the same lines as in Tasmania, but that consideration should also be given to rules of the kind proposed by the Dawson Committee. We suggested also that this system of regulation should not exempt companies from complying with such other requirements, for example, under the Companies Code or Securities Industry Code, as may apply to them.¹⁰⁹

11.56 The Law Society responded that it “does not disagree” with our suggestion that the Tasmanian system should be adopted, in which event the Society’s draft regulation in relation to nominee companies “may well have to be amended to include corresponding references to private finance companies”.¹¹⁰ The Society said that it needed more time to consider our suggestions,¹¹¹ but it has not subsequently proposed any system for regulation of private finance companies.

C. Recommendations

11.57 The operations of some solicitors private finance companies have caused very serious problems, both in New South Wales and elsewhere.¹¹² A heavy cost, both financial and otherwise, has been paid by both the public and the profession as a result of the irregularities and defalcations which have occurred.

11. 58 Rulings made in 1979 by the Law Society of New South Wales¹¹³ appear to have reduced substantially the number of private finance companies and the incidence of problems arising from their activities. However, this decrease may be reversed, especially if economic conditions change or solicitors become subject to greater competitive pressures. Moreover, the current scarcity of private finance companies means that prohibition of them would cause less disruption than in previous years. By contrast, it seems reasonably clear that a major and perhaps determining factor in the decision to control rather than prohibit private finance companies in Victoria has been the continuing prevalence of such companies in that State.¹¹⁴

11.59 There is a substantial body of opinion amongst solicitors, including some leaders of the profession that private finance companies should be prohibited. The Court of Appeal in Harvey’s Case clearly considered their operation to be generally contrary to the proper role of a solicitor.¹¹⁵ Most if not all of the benefits which such companies can provide to members of the public can also be provided by nominee companies,¹¹⁶ and the latter type of companies provide greater protection for the public. Moreover, most of the benefits which private finance companies can provide for solicitors in New South Wales are also obtainable from the use of nominee companies. This applies, for example, to the role of the two types of company in attracting legal work and thus professional fees. Other possible financial benefits of private finance companies are already substantially curtailed by the Law Society’s prohibition on such companies paying lenders lower interest rates than are charged to borrowers.¹¹⁷

11.60 For these reasons, we recommend that solicitors’ private finance companies should be prohibited. Solicitors currently having an interest in such companies should be given a reasonable time (say, two years) within which to withdraw from them or wind them up. If, however, it is considered that such companies should not be prohibited, they should be required to be licensed by the Corporate Affairs Commission in accordance with a scheme of the kind currently administered by the Commissioner for Corporate Affairs in Victoria.¹¹⁸

11.61 We prefer the Victorian rather than the Tasmanian¹¹⁹ system for regulating private finance companies, principally because it is more detailed and stringent, more compatible with methods of regulating other financial intermediaries, and more capable of being adopted in a substantially uniform manner across Australia. Without limiting the generality of our agreement with the Victorian scheme, we regard the following specific aspects of it as being especially important:

• a requirement that the accounts be audited by the person who audits the solicitors trust accounts;¹²⁰
• rules relating to assets/liabilities ratios, and liquidity;¹²¹
• rules about the types of security permissible, the methods of valuation of securities, and the ratio between the amount of the loan and the value of the security;¹²²
• requirements concerning the maintenance of registers of transactions; and the provision of regular summaries to lenders;¹²³
• a rule that clients must be notified that they may have no recourse to the Fidelity Fund;¹²⁴
• a prohibition on loans to the solicitor or an associated party unless made with the written approval in advance of the licensing authority.¹²⁵

11.62 Although we believe that a licensing system, if established, should be under the control of the Corporate Affairs Commission, we consider that the Victorian approach gives insufficient recognition to the need for close integration with the Law Institute’s regulatory responsibilities in relation to other aspects of solicitors’ activities. Lack of an integrated and comprehensive understanding of a solicitors affairs may lead to deliberate or careless mishandling of moneys going undetected by the regulatory authorities. Accordingly, we recommend that if solicitors’ private finance companies are regulated rather than prohibited, the Law Society should be entitled to examine the accounts and other records of such companies. We consider that this recommendation provides sufficient scope for co-ordinated and comprehensive supervision of solicitors’ affairs, and that giving the Corporate Affairs Commission correspondingly broad rights of access is unlikely to be necessary and would raise major difficulties about the confidentiality of solicitor- client communications.

FOOTNOTES

1. See paras.2.23, 2.26 above.

2. See para.2.13 above.

3. Ibid.

4. See para.2.18 above.

5. Information supplied by Law Cover at the request of the Commission.

6. Law Society of N.S.W v. Harvey [1976] 2 N.S.W.L.R. 154, at 170-172.

7. Law Society of New South Wales, “Memorandum to All Members” (No.23 of 1975), 17th June 1975.

8. Law Society of New South Wales, “Special Bulletin to all Members: Borrowing Transactions” (No.2 of 1979), pp.3-5.

9. Id., p.4.

10. Ibid.

11. Id., p.3.

12. Id., p.4.

13. Id., p.1.

14. Ibid.

15. Ibid.

16 .See paras.11.37-11.62 below.

17. See, e.g., the Solicitors’ Statutory Committee decisions in Price (No.12 of 1982) and Howell (No.6 of 1982).

18. Queensland Law Society Rules, rr.68D, E. See also the decision of the Court of Appeal in England in Wills v. Wood (Law Society Gazette, 28th March 1984, p.867, and 2nd May 1984, p.1211).

19. Solicitors (Professional Conduct and Practice) Rules 1948, r.8

20. See paras.4.53-4.54 above.

21. Trust Accounts Act 1973, s.8(2).

22. Ibid.

23. Mortgage Register and Nominee Company Rules 1977, rr.2.4.7.

24. Id., Schedule 1, Part B.

25. Id., Schedule 1, Part A.

26. Discussion Paper, para.4.57.

27. Letter of Auditor General to the N.S.W. Law Reform Commission, dated 16th November 1983, p.2.

28. Draft Solicitors Trust Account Regulations, reg. 14 (see Appendix III of this Report).

29. Ibid.

30. See para.11.14 above.

31. See, in particular chapters 4,5 and 6.

32. See paras.4.53-4.54 above.

33. Accounting Research Centre Report, p.5.

34. See Legal Practitioners Regulations, 1982 (S.A.), regs.26-34; Rules of Practice 1977 (Tas), r.23; and notes 11.20 2, 3, and 4 below.

35. Queensland Law Society Rules, r.68G.

36. Mortgage Register and Nominee Company Rules 1977, r.4.

37. Solicitors (Audit and Practising Certificates) Rules 1965, r.28.

38. Id., r.30.

39. Id., r.29

40. Mortgage Register and Nominee Company Rules 1977, r.4

41. Id., r.10.

42. Discussion Paper, para.7.44

43. Draft Solicitors Trust Account Regulations, regs.2, 15 (see Appendix III of this Report).

44. See para.11.20 above.

45. See note 11.20.1 above.

46. Id., reg.2.

47. Id., reg.15(2)(m).

48. Id., reg.15(2)(a)-(k).

49. Solicitors (Audit and Practising Certificates) Rules 1965, r.30A(2), reprinted in Appendix IV of this Report.

50. Companies (New South Wales) Code, s.279.

51. See, esp., ss.5 and 164-177.

52. See, esp., ss4, 43, 48, 51, 56, 67: Securities Industry Regulations, reg.26.

53. Mortgage Register and Nominee Company Rules 1977, rr.2, 3.

54. Id., r.3.

55 .Id., rr.4, 9.

56. Rules of Practice 1977, rr.35, 36.

57. Id., r.36

58. Id., r.38(l)(c), (2)

59. Id., r.37.

60. Id., r.38(d)(ii).

61. Discussion Paper, paras.7.14, 7.16, 7.18.

62. Draft Solicitors Trust Account Regulations, reg.13.

63. Id., reg.13(8).

64. Id., reg.13(6).

65. The Society has proposed that advice in these terms should be included in a bulletin issued by it to all solicitors (Letter from the President of the Society to the Attorney General, 11th July 1984).

66. See Appendix III, reg.13(2).

67. See para.11.34 above.

68. See, e.g., paras.11.39-11.47, 11.50-11.52, and 11.55-11.60 below.

69. See para.11.60 below.

70. Legal Practitioners Act, 1898, s.42A.

71. See, e.g., the definition in Law Society of New South Wales, “Special Bulletin to All Members: Private Finance Companies” (No.3 of 1979), p.1.

72. See notes 11.31.2 and 11.31.3 above; see e.g., Australian Central Credit Union v. Consumer Affairs Commission, 28 September 1984, Supreme Court of South Australia, Olsson J.

73. Law Society of N.S.W. v. Harvey [1976] 2 N.S.W.L.R. 154.

74. See para. 11.4 above.

75. See note 11.39.1 above, at pp.171-172.

76. The Society had promulgated a ruling in 196i relevant to private finance companies (see R. Atkins, N.S.W Solicitor’s Manual (3rd ed., Law Book Co., Sydney, 1975), pp.245-246). The ruling placed substantial restrictions on solicitors involvement in such companies but clearly was not complied with by some solicitors in existing years.

77. See paras. 11.5-11.6 above.

78. Law Society of New South Wales, “ Special Bulletin to All Members: Borrowing Transactions” (No.2 of 1979), p.4.

79. See para.11.5 above.

80. Law Society of New South Wales, “Special Bulletin to All Members: Private Finance Companies” (No.3 of 1979).

81. Id., cl.2(i) and (ii).

82. Id., cl.2(c).

83. Id., cl.2(d).

84. Id., cl. 3.

85. See disciplinary proceedings against solicitors arising out of their conduct of private finance companies, such as Bolster v. Law Society of New South Wales, 20 August 1982, Supreme Court of New South Wiles, Court of Appeal; and the Solicitors’ Statutory Committee decisions in Sanders, Dickson, Gianacas and Kafer, (1981) 19 Law Society Journal 129; Nash, (1981) 19 Law Society Journal Supplement 20; and Crisp, (No.4 of 1982), 16 February 1984.

86. Information supplied by the Law Society at the request of the Commission.

87. See note 11.42.2 above.

88. See note 11.42.2 above.

89. See paras.11.29-11.31 above.

90. See Legal Practitioners Act, 1898, s.56.

91. See para.11.38 above.

92. See para. 11.41 above.

93. See para. 11.5 above.

94. See para. 11.33 above.

95 .Report of Conveyancing Committee, see Conflict of Interest and Investment of clients’ Monies’ Law Institute Journal, (1976), vol.50, p.277.

96. Id., p.280.

97. Standing Committee of the Law Institute of Victoria and the Institute of Chartered Accountants in Australia and the Australian Society of Accountants on the Accounting Provisions of the Legal Profession Practice Act and Solicitors (Audit and Practising Certificates Rules, Report (1976),

98. Ibid.

99. Dawson Committee Report, p.36. The Committee discussed these defects in detail at pp.36-43.

100. Id., pp.50, 51.

101. Id., pp.52-55.

102. See Appendix VI, Schedule B, cl.2(g).

103. Id., Schedule 1, Part 2, cl.5.

104. Id., Schedule B, cl.2(m).

105. Id., Schedule B, cl.2(q).

106. Information supplied by the Victorian Commissioner for Corporate Affairs at the request of the Commission.

107. Discussion Paper, para.7.31.

108. Ibid.

109. Id., paras.7.35-7.38.

110. Law Society’s Response, paras.6.5, 6.6.

111. Id., para.6.5.

112. See paras. 11.42, 11.46, 11.50 above.

113. See paras.11.40, 11.41 above.

114. See, e.g., the quotation from the Dawson Committee report in para. 11.52 above.

115. See para. 11.39 above.

116. See paras. 11.28, 11.30, 11.44 above.

117. See para. 11.41 above.

118. See paras. 11.53-11.54 above.

119. See paras.11.33, 11.49 above.

120. See Appendix V, Schedule B, cl.2(g).

121. Id., Licence Conditions, cls.5-7.

122. Id.. Schedule B, cl.1, 2(a) (1), (o).

123. Id., Schedule B, cl.2(i), (j), (k), (r), (s).

124. Id., Schedule 1, Part 2, cl.5.

125. Id., Schedule B, cl.2(m).