FinCEN Proposes More Extensive Customer Due Diligence Obligations

 by Keith R. Fisher

As part of the U.S. Treasury Department’s ongoing efforts to combat all forms of illicit financial activity, from terrorist financing and sanctions evasion to more traditional financial crimes (including money laundering, fraud, and tax evasion), the Financial Crimes Enforcement Network (FinCEN) has issued a notice of proposed rulemaking (NPR) to strengthen the customer due diligence (CDD) efforts of “covered financial institutions.” Such institutions include banks, broker-dealers, mutual funds, futures commission merchants, and introducing brokers in commodities.

The principal change is to enlarge upon the extent that an institution’s CDD efforts look beyond the juridical entity that is, formally, the customer and identify its principal shareholders or holders of comparable ownership interests. The NPR has been two years in the making, as the process began with an Advance Notice of Proposed Rulemaking (ANPR) issued on February 28, 2012. FinCEN issued this NPR after consideration of comments received and consultation with the federal functional regulators and the Department of Justice.

Major narcotics trafficking organizations use shell companies to launder drug proceeds. As noted by FinCEN, a 2011World Bank report “highlighted how corrupt actors consistently abuse legal entities to conceal the proceeds of corruption, which the report estimates to aggregate to at least $40 billion per year in illicit activity.” In announcing the NPR, the Treasury Department said separately that the proposed rule was related to U.S. commitments in the G-8 Action Plan for Transparency of Company Ownership and Control published in June 2013.

Another motivation for this regulatory action is the impending 2015-16 evaluation of U.S. compliance with international AML and countering the financing of terrorism (CFT) standards established under the aegis of the Financial Action Task Force (FATF). Surprisingly, given the breadth and proliferation of AML/CFT regulation in this country, the prior (2006) FATF evaluation of the United States was only “partially compliant” overall, with special criticism (and a “non-compliant” category rating) for the lack of a beneficial ownership regime.

As an absolute minimum standard, FinCEN has previously articulated the following pillars of an effective AML program:

  • Identifying and verifying the identity of customers
  • Identifying and verifying the identity of beneficial owners of customers that are juridical persons, i.e., meaning those natural persons who own or control corporations and other business entities (“legal entity customers”)
  • Understanding the nature and purpose of customer relationships
  • Conducting ongoing monitoring to maintain and update customer information and to identify and report suspicious transactions

FinCEN is proposing to amend its existing rules so that each of these CDD elements is explicitly linked to a corresponding requirement within FinCEN's program rules. Items 1, 3, and 4 are already part of the Customer Identification Program (CIP) process; FinCEN recognizes this, though it intends further to enhance compliance with those elements. Also, to "ensure alignment between existing AML requirements and minimum CDD standards," the proposed rule expands upon Item 2 by requiring “covered financial institutions” to maintain and collect records on beneficial ownership of legal entity customers, the better to understand the nature and purpose of their customer relationships and conduct ongoing monitoring. These expanded CDD requirements will become a fifth pillar.

In addition to banks, “covered financial institutions” include broker-dealers, mutual funds, futures commission merchants, and introducing brokers in commodities.

The beneficial ownership requirement, according to FinCEN, is the only new requirement imposed by the rulemaking, whereas the other CDD aspects of the proposed rule merely clarify existing requirements. In defining what constitutes a “beneficial owner,” the proposed rule adopts a bifurcated approach with an ownership prong and a control prong, somewhat similar to the first two prongs of the definition of “control” under the Bank Holding Company Act. Under this proposed approach, each covered financial institution would have to identify:

  • Each individual who owns 25 percent or more of the equity interests in the juridical entity that is the customer of the covered financial institution
  • One individual who exercises significant managerial control over that customer

If no individual owns 25 percent or more of the equity interests, the covered financial institution may identify a beneficial owner under the second prong only. The same individual (or more than one) may be identified under both prongs.

On the one hand, this definition is narrower than what was originally proposed in the ANPR, which would have required financial institutions to identify the single individual “with greater responsibility than any other individual for managing or directing the regular affairs” of the legal entity. On the other hand, the proposed definition is broader in that it contemplates looking for beneficial owners through multiple corporate entities and potentially complex organizational structures.

The proposed rule would require covered institutions to identify only beneficial owners of entities that are already under the CIP provisions; those that are exempt are outside the scope of the proposal. Furthermore, identification of beneficial owners of certain other entities whose beneficial ownership is generally available from other credible sources is not required. Examples of customers falling within this category include certain charities and nonprofit organizations, majority-owned U.S. subsidiaries of publicly traded companies, the majority of trusts, and investment advisers. In addition, the proposed rule is not intended to supplant or supplement the existing requirements for foreign correspondent accounts under Section 312 of the USA PATRIOT Act.

Responding to industry concerns with the ANPR’s burdensomeness, the NPR abjures any requirement to verify that an individual identified by a customer as a beneficial owner is, in fact, a beneficial owner; covered entities may rely on the information furnished by the customer. Moreover, reliance by one financial institution on information from another, which already exists with respect to conducting CIP on shared customers, will be extended to the beneficial owner context if the same conditions to such reliance are met—namely, that (1) such reliance is reasonable; (2) the other financial institution is subject to an AML program rule and is regulated by a federal functional regulator; and (3) the other financial institution enters into a contract and provides annual certifications regarding its AML program and CIP requirements.  

Comments on the proposal are due by October 3, 2014. FinCEN specifically requests comment on (A) the definitions of “beneficial owner” and “legal entity customer,” (B) the proposed exemptions from the beneficial ownership rule, and (C) the treatment of existing accounts, intermediated accounts, pooled investment vehicles, and trusts.

Some potential implications of the proposed rule are worth noting. First, will covered institutions be expected to use beneficial ownership information as part of aggregating transactions for the purposes of filing Currency Transaction Reports, and, if so, how? Second, will covered institutions be expected to take beneficial owners into account when monitoring for activity suggestive of structuring, or when applying other ongoing monitoring rules on accounts?

Upcoming Webinar

Ballard Spahr will host a webinar, "FinCEN's Notice of Proposed Rulemaking on Consumer Due Diligence: What You Need To Know," at 12:00 p.m. ET on October 2, 2014, to discuss the NPR and its implications. Registration information is now available.

Ballard Spahr's Bank Regulation and Supervision Group and Consumer Financial Services Group regularly counsel bank and nonbank clients on AML compliance, represent them in connection with enforcement actions, and assist them in preparing and submitting comments in pending rulemakings. In addition, the Bank Regulation and Supervision Group, Consumer Financial Services Group, and White Collar Defense/Internal Investigations Group include experienced lawyers who regularly assist clients in corporate investigations, responses to subpoenas, and civil investigative demands.

Copyright © 2014 by Ballard Spahr LLP  (No claim to original U.S. government material.)

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