Due diligence requirements

Introduction

Money laundering is the process by which individuals or entities conceal the origins of illegally obtained funds, making them appear legitimate. Anti-money laundering (AML) regulations are established legal frameworks designed to prevent, detect, and report money laundering activities. Due diligence requirements are key components of these regulations, mandating that legal professionals and financial institutions verify the identity of their clients, assess potential risks, and monitor transactions to ensure compliance with the law.

The Process of Money Laundering

Money laundering typically occurs in three distinct stages: placement, layering, and assimilation.

1. Placement involves introducing illicit funds into the financial system, often through cash deposits, purchases of monetary instruments, or other means.

2. Layering entails conducting complex transactions to obscure the origin of the funds, such as transferring money through multiple accounts, investing in financial instruments, or moving funds internationally.

3. Assimilation is the final stage, where laundered funds are reintroduced into the legitimate economy, appearing as lawful assets or income through investments, property purchases, or business ventures.

A thorough understanding of these stages is fundamental for legal professionals to identify suspicious activities and apply appropriate due diligence measures.

Due Diligence Requirements: Core to AML Compliance

Due diligence is a basic element of AML compliance, requiring entities subject to AML regulations to verify the identity of their clients, understand the nature and purpose of the business relationship, and conduct ongoing monitoring to identify and report suspicious activities. Under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLR 2017), legal professionals have specific obligations to implement customer due diligence measures proportionate to the risks identified.

Customer Due Diligence (CDD)

Customer Due Diligence is the process of identifying and verifying the identity of a client, understanding the ownership and control structure of the client, and assessing the purpose and intended nature of the business relationship. According to the MLR 2017, CDD must be conducted in the following circumstances:

• When establishing a business relationship.
• When carrying out an occasional transaction amounting to €10,000 or more.
• When there is a suspicion of money laundering or terrorist financing.
• When there are doubts about the veracity or adequacy of previously obtained client identification data.

Primary CDD measures include:

1. Verifying the client's identity using reliable, independent source documents, data, or information, such as passports, driving licenses, or utility bills.

2. Identifying beneficial owners, which involves understanding the ownership and control structure of a client that is a legal person, trust, or similar legal arrangement, and taking reasonable measures to verify their identity. A beneficial owner is an individual who ultimately owns or controls more than 25% of a company's shares or voting rights or who otherwise exercises control over the company or its management.

3. Assessing the purpose and intended nature of the business relationship, aiding in understanding the client's activities and the expected pattern of transactions.

4. Ongoing monitoring of the business relationship, including scrutiny of transactions to ensure they are consistent with the firm's knowledge of the client and the client's risk profile.

Risk Assessment

A risk-based approach is mandated under the MLR 2017, requiring due diligence measures to be proportionate to the assessed risk of money laundering or terrorist financing. Legal professionals must evaluate risks related to:

• Client risk factors, including the type of client, their business activities, and their reputation.
• Geographical risk factors, considering countries where the client is based or operates, especially those lacking effective AML controls or known for corruption.
• Service risk factors, such as the complexity and potential for anonymity in services provided.
• Transaction or delivery channel risk factors, like non-face-to-face transactions or payments from unknown sources.

Firms must document their risk assessments and implement appropriate measures to mitigate identified risks.

Types of Due Diligence: A Tiered Approach

Recognizing that clients and transactions present varying levels of risk, AML regulations provide for different levels of due diligence.

Standard Due Diligence

Standard Due Diligence applies in normal risk scenarios and involves the core CDD measures described above. It requires:

• Verification of the client's identity through reliable documents.
• Identification and verification of beneficial owners.
• Understanding the purpose and intended nature of the business relationship.
• Ongoing monitoring of the relationship and transactions.

Simplified Due Diligence (SDD)

Simplified Due Diligence may be applied when the risk of money laundering or terrorist financing is low. Under Regulation 37 of the MLR 2017, SDD is permissible when:

• The customer is a public authority or a publicly listed company subject to disclosure requirements.
• The product or service poses a low risk due to its nature, such as life insurance policies with a low premium.

When applying SDD, firms may adjust the amount of information obtained and the extent of verification but must have sufficient information to assess that the customer qualifies for SDD.

Enhanced Due Diligence (EDD)

Enhanced Due Diligence is required in higher-risk situations. Under Regulation 33 of the MLR 2017, EDD must be applied when:

• The customer is not physically present for identification purposes.
• The customer or beneficial owner is a politically exposed person (PEP), their family member, or a known close associate.
• The transaction involves a high-risk third country identified for inadequate AML controls.

EDD measures include:

• Obtaining additional information on the customer and beneficial owners.
• Obtaining senior management approval to establish or continue the business relationship.
• Conducting enhanced monitoring of the relationship by increasing the number and timing of controls and examining transaction patterns.

Legal Framework and Regulatory Environment

The UK's AML regulatory framework is governed by key legislation:

1. Proceeds of Crime Act 2002 (POCA 2002): Establishes money laundering offences and provides for the recovery of criminal proceeds.
2. Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLR 2017): Implement the EU's Fourth Money Laundering Directive, detailing obligations on relevant persons, including legal professionals.
3. Terrorism Act 2000: Addresses offences related to terrorist financing.
4. Criminal Finances Act 2017: Enhances law enforcement powers to tackle money laundering and terrorist financing.

Guidance is provided by:

• The Financial Action Task Force (FATF): Sets international AML and counter-terrorism financing standards.
• The Joint Money Laundering Steering Group (JMLSG): Offers industry-specific guidance for AML compliance.
• The Solicitors Regulation Authority (SRA): Regulates solicitors in England and Wales, providing AML compliance guidance.

Legal professionals must ensure adherence to these regulations and guidelines to maintain compliance and uphold the integrity of the financial system.

Implementing Due Diligence Requirements

An effective AML compliance program requires robust due diligence procedures:

1. Risk Assessment: Conducting a written risk assessment evaluating exposure to money laundering and terrorist financing risks, considering clients, services, transactions, and delivery channels.

2. Client Onboarding: Establishing protocols for verifying identities, including obtaining necessary identification documents and information before entering into a business relationship.

3. Ongoing Monitoring: Implementing systems to monitor client transactions continuously, ensuring they align with the firm's knowledge of the client and their risk profile, and detecting unusual or suspicious activities.

4. Reporting Suspicious Activities: Establishing procedures for staff to report suspicious activities internally to the firm's nominated officer (Money Laundering Reporting Officer), who determines whether to file a Suspicious Activity Report (SAR) with the National Crime Agency (NCA).

5. Record Keeping: Maintaining records of client identification documents, transaction records, and evidence of AML policies and procedures for at least five years, as required by the MLR 2017.

Scenario: Handling a High-Risk Client

A law firm in London is approached by an individual seeking to purchase a high-value property. During the onboarding process, the firm discovers:

• The client utilizes a complex corporate structure with entities in offshore jurisdictions known for secrecy.
• The ultimate beneficial owner is a foreign national from a high-risk third country identified for inadequate AML controls.
• The source of funds is unclear, with indications that the funds may originate from industries prone to corruption.

In this situation, the firm is required to:

• Apply Enhanced Due Diligence measures, including obtaining additional information on the client and beneficial owners, understanding the ownership and control structure, and verifying the source of wealth and funds.
• Obtain senior management approval before establishing the business relationship.
• Conduct enhanced ongoing monitoring, scrutinizing transactions to ensure consistency with the client's profile and risk assessment.
• Consider filing a Suspicious Activity Report (SAR) with the NCA if there is suspicion of money laundering.
• Evaluate the engagement carefully, considering legal obligations and the firm's risk appetite.

This example illustrates the practical application of EDD measures in compliance with AML regulations.

Trends and Challenges in AML Compliance

The field of AML compliance is continuously adapting, presenting new challenges:

1. Virtual Assets and Cryptocurrencies

   The rise of virtual assets introduces complexities due to their potential for anonymity and rapid cross-border transfers. Regulatory bodies are developing guidelines to address risks associated with virtual assets, including the EU's Fifth Money Laundering Directive (5MLD), which brings certain cryptocurrency service providers within AML regulations.

2. Transparency of Beneficial Ownership

   There's an increasing emphasis on transparency to prevent misuse of corporate structures. The UK's Register of People with Significant Control requires disclosure of individuals holding significant control over companies. The Register of Overseas Entities mandates overseas entities owning UK property to disclose their beneficial owners.

3. Technological Advances in AML

   Advancements in technology provide tools for improved transaction monitoring and risk assessment. Implementing RegTech solutions can aid in the detection of suspicious activities, though firms must remain vigilant against new methods criminals may use.

4. De-risking Practices

   Financial institutions may limit or terminate relationships with high-risk clients or sectors to reduce exposure. While mitigating immediate risks, this can have broader impacts, including financial exclusion and movement of activities to less regulated channels.

5. Sanctions Compliance

   Managing sanctions regimes is complex, with overlapping national and international sanctions targeting specific individuals, entities, and countries. Firms must ensure up-to-date screening processes to comply with the UK Sanctions and Anti-Money Laundering Act 2018 and relevant international sanctions.

Conclusion

The complexities of money laundering methods and the evolving nature of financial crimes necessitate rigorous due diligence mechanisms under AML regulations. Legal professionals must comprehend and apply complex regulations, such as the MLR 2017 and POCA 2002, to implement effective risk assessments, customer due diligence measures, and ongoing monitoring. Enhanced Due Diligence is necessary when dealing with high-risk clients, including politically exposed persons and transactions involving high-risk jurisdictions. The interplay between due diligence obligations, risk-based approaches, and the legal frameworks supporting AML compliance requires a detailed understanding of each component and their practical applications.

Implementing robust due diligence procedures ensures compliance with statutory obligations, aids in the detection and prevention of money laundering activities, and contributes to the integrity of the financial system. Legal practitioners preparing for the SQE1 FLK1 exam should focus on the specific requirements outlined in AML regulations and understand how due diligence processes interact with broader legal obligations under UK law.