March 2001 

IOLTA: Is It a Taking? 
Is That Really the Issue?

On January 10, 2001 the 9th Circuit issued an opinion in Washington Legal Foundation v. Legal Foundation of Washington. In what has been described as a case of national importance to the funding of legal services for the poor, a three-judge panel found a per se taking of property in the regulation of the investment of funds that clients entrust to Limited Practice Officers (LPOs). Court rules subject LPOs to the IOLTA rules. It is these rules that the 9th Circuit panel addressed. 

But don't plan on closing that IOLTA account anytime soon. While the decision is a blow to the IOLTA program, the program is not yet history.

In 1984, the Supreme Court of Washington created a program by which interest on lawyers' pooled trust accounts is paid to the Legal Foundation of Washington (LFW) (not to be confused with the Washington Legal Foundation, the plaintiff in the case in question). Fundamental to the IOLTA program is the obligation of all those who are subject to the Court's rules to determine whether funds received from a client can be invested for net positive return for the client. If they cannot, and only if they cannot, then the funds are deposited into an IOLTA account. Interest on the IOLTA account — a pooled account — is given to the LFW for granting to statewide programs that provide legal services to the poor.

In its original IOLTA Adoption Order, the Washington State Supreme Court rejected the argument that the operation of the IOLTA rules amounted to an unconstitutional taking of private property. Other state courts around the country reached similar conclusions, reasoning that because deposits could not earn a positive net return for a client, the client had no property interest in the fund.

Then came the Washington Legal Foundation (WLF). Headquartered in Washington, D.C., this group advocates free enterprise, limited government and property rights. The history of its many federal court challenges to IOLTA programs is chronicled in "Interest or Principles: The Legal Challenge to IOLTA in Washington State," by Jay Carlson, Wash. Law Rev. Vol. 74, No. 4 119, at 1132-1137.

In January 1997, WLF descended upon Washington, filing a challenge to the Washington IOLTA program. Attacking the recent expansion of the IOLTA program to include LPOs, the WLF asserted that the IOLTA program, as applied to the LPOs, violated both the First and Fifth Amendments to the U.S. Constitution.

The WLF lawsuit was filed in the Western District of Washington and assigned to Judge John C. Coughenour. Judge Coughenour granted Summary Judgment of Dismissal to the defendants, ruling that no cognizable interest existed and that plaintiffs had lost nothing as a result of the IOLTA program. The WLF appealed to the 9th Circuit.

Before the 9th Circuit could hear oral argument on the Washington case, the U.S. Supreme Court weighed in with a decision in a case called Phillips v. Washington Legal Foundation, 524 U.S. 156 (1998). In Phillips, the U.S. Supreme Court held that under Texas law the proceeds from the Texas program were "property" for purposes of Fifth Amendment analysis. The U.S. Supreme Court did not decide that there had been a taking. Instead, the Texas case was remanded for further proceedings related to whether there was in fact a taking.

The 9th Circuit argument in WLF v. LFW was held on February 9, 2000. Perkins Coie lawyers Katie O'Sullivan, Nick Gellert and Dave Burman did (and continue to do) a great job, pro bono, on behalf of the LFW. The justices also are well-represented by senior appellate lawyer Maureen Hart of the Attorney General's Office.

Nearly a year after the argument, Judges Trott, Kleinfeld and Silverman joined in a unanimous opinion reversing Judge Coughenour. The panel ruled that in light of Phillips, the interest generated by the IOLTA pooled trust accounts was indeed property, and that there was a per se taking which entitled clients to "just compensation." But, the panel went on to say that just compensation could be "nothing," depending on the circumstances. So, the panel remanded the case to Judge Coughenour for further proceedings.

The 9th Circuit opinion is anything but a model of clarity. Thus, a joint petition for rehearing en banc was filed by the LFW and the justices of our Supreme Court (with the exception of Justice Sanders). The petitioners point out three major flaws in the opinion of the 9th Circuit panel. 

• First, the decision contradicts precedent both from the Supreme Court and the 9th Circuit because it applies a per se takings analysis that is applicable only to real property taking. 
• Second, the panel erroneously focused on the interest, rather than the principal funds that are in fact regulated by our court rules. 
• Third, the panel ignored the state action requirement, instead ruling that a "taking" was likely caused by private individuals who violated IOLTA rules.

In the petition for rehearing en banc, petitioners argue that Washington's program is not subject to the per se takings analysis that the 9th Circuit employed in reaching its decision. The per se analysis is inapplicable because it applies only to regulation of real property, and "not to regulation of who will benefit from the use of money where it is not practical for the client to do so" (Petition, p.6). The petitioners point out to the 9th Circuit that "[t]he per se takings doctrine is rooted in evidentiary assumptions that apply only when physical property is at issue." (Petition, p. 7.) The 9th Circuit panel's attempt to distinguish cases that restrict per se analysis to real property simply is not supported by cases or the record, according to the petition.

Moreover, the 9th Circuit seems to have reached the conclusion that the U.S. Supreme Court, in Phillips, actually ruled that a taking had occurred by virtue of the operation of the Texas program. This is not the holding in Phillips; indeed, the Phillips Court never even reached the taking issue. Worse, the 9th Circuit panel labeled as "absurd" an argument that was never even made by defendants. The panel wrote:

Defendants seem to be arguing that the government can confiscate people's money without it being a taking compensable under the Fifth Amendment. Slip Op at 320.

No such argument appears in the LFW briefs, nor was this theory advanced in oral argument. One is left to wonder why the panel would need to conjure up an argument never made, and then label it as "absurd" if it had solid legal grounds for the opinion rendered.

The second major flaw in the 9th Circuit opinion is that the panel concluded that the "economic impact" test of Penn. Cent. Transp. Co. v. City of New York, 438 U.S. 104 (1978), was inapplicable because the IOLTA regulation "entirely appropriates" the interest. The panel pointed out that "[t]he economic impact test would have relevance if the IOLTA rule merely regulated how the client used his interest, or where the interest was kept, or for how long." Slip Op. at 322.

As the petition for rehearing correctly notes, by simply replacing the word interest with the word principal in this sentence, the panel would have reached the correct result in this case. Thus, had the panel said: "The economic impact test would have relevance if the IOLTA rule merely regulated how the client used his principal, or where the principal was kept, or for how long," then the panel would have been forced to face the relevance of the economic impact test, and also apply the test. Had it done so, the outcome of the case would have been different. The IOLTA rules regulate where the LPOs can place the clients' principal.¹ Regulatory measures such as Washington's IOLTA rules consistently have been analyzed under the balancing of public and private interests implicated by the regulation. The panel undertook no such balancing because it confused interest with the IOLTA regulated principal.

It is confusion such as this — confusion over the operation of the rule itself — that makes the opinion of the panel less than a model of clarity. In reading the opinion, it almost appears that the panel failed to recognize that IOLTA rules do not, in any case, appropriate principal.

The third flaw in the opinion is the fact that the panel's decision that a per se taking occurred rests on an unsupported assumption that private lawyers and LPOs operate in violation of the state IOLTA rules. Thus, the 9th Circuit panel muses that a transaction could be delayed, resulting in money being held longer than initially anticipated and presumably generating a net positive return which is collected by IOLTA rather than paid to the client. The panel ignores the fact that once the possibility of earning a net return becomes apparent, the attorney or LPO is required under the IOLTA rules to open a separate interest-bearing account for those funds so they can, in fact, be paid to the client. There was no evidence in the record before the court that this situation ever arose for the parties who filed this case.

The panel also suggested that lazy or perhaps unethical lawyers and LPOs do not comply with their obligation to invest their clients' principal funds when a net benefit is available because "lawyers and closing officers have a substantial incentive not to be bothered with crediting clients with their interest." Slip Op. at 324. Again, as the petition for rehearing makes clear this proves too much.

Indeed, it proves why a regulatory approach was necessary to protect clients in situations where the amount/time calculus results in net positive returns. Further, the IOLTA regulations eliminate the incentive for self-dealing by applying any interest resulting from mistakes or amounts truly too small to earn net positive returns individually to public uses rather than abandoning it to the LPOs and banks. And, as a constitutional matter, if lawyers or LPOs do not comply with their obligations under the rules, any resulting taking, if it can be called that, is not caused by the rules but by private parties. (Petition, p.15.)

This sort of "taking," one done by private parties and not by state action, does not implicate the Fifth Amendment.

So, where do we go from here? If rehearing is granted, as it should be, the parties will make further arguments to the 9th Circuit in an attempt to clarify matters and secure a ruling that the program meets constitutional muster. If there is no rehearing, the case will presumably return to District Court in Seattle for trial on the "just compensation" issue. What would that trial involve? If you follow the panel's guidance, every individual IOLTA transaction might have to be examined to determine whether there is net positive return. If so, and if this net positive return was taken by IOLTA, then some sort of compensation may be owed. It is difficult to imagine that the Federal District Court will want to examine thousands of IOLTA transactions to make this determination.

The obligation of the lawyer and LPO to maintain an IOLTA account is clear, and one who fails to establish such an account or fails to follow the rules does so at peril of his or her license. Until there are further court proceedings, it is business as usual. If there is no possibility of a net positive return on clients' funds, these funds belong, for now, in an IOLTA account.

NOTE

1. The IOLTA rules do not appropriate the principal. The principal is still available for the client to utilize for whatever purpose he or she deposited it with the LPO or attorney.

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