Self-Reporting Suspicious Money Laundering Activity
Last December the U.S. Department of Justice announced a record-setting Anti-Money Laundering (AML) settlement with U.K. bank HSBC, claiming it allowed hundreds of millions of dollars from Mexican drug traffickers to flow through accounts in the United States. In total, HSBC paid more than $1.9 billion in penalties.
In light of the HSBC case and other high-profile enforcement actions, the U.S. Department of the Treasury's Financial Crimes Enforcement Network (FinCEN), the Securities and Exchange Commission (SEC), and the Financial Industry Regulatory Authority (FINRA) are each proposing new, significantly stricter AML measures.
With greater AML oversight clearly on the horizon, it's recommended that legal and compliance staff at broker dealers (and potentially investment advisers) begin reviewing and, if necessary, upgrading their AML policies.
A key part of that review will include what is perhaps the most sensitive compliance obligation under the existing AML rules: self-reporting.
Broker-dealers are required to report on Form SAR-SF (SAR) if a suspicious transaction is attempted by, at, or through the broker-dealer; and if it involves or aggregates funds or other assets of at least $5,000. More nebulous is the requirement to file a SAR if the broker-dealer knows, suspects, or has reason to suspect that the transaction involves funds derived from illegal activity, is intended to hide or disguise such funds, is designed to evade the AML regulations, has no business or apparent lawful purpose and the broker-dealer "knows of no reasonable explanation for the transaction after examining the available facts," or involves the use of the broker-dealer to facilitate criminal activity.
By its terms, the SAR requirement applies both to outsiders seeking to transact "at" or "through" the firm, as well as to transactions "by" the firm itself. Recent enforcement cases by the SEC have focused on the latter self-reporting aspect of the rule.
With regard to self-reporting, perhaps the most detailed and instructive example can be found in a settled administrative enforcement proceeding against investment firm Ferris, Baker Watts, Inc. A registered representative of the firm purchased 960,000 shares of a security over two days, allocated 20,000 to his personal account, and moved the remainder to client accounts.
The purchases caused the price to rise, and the representative then sold the personal shares for a profit. The broker-dealer's AML officer discovered the trades and asked a senior executive to request an explanation. The senior executive did not. A few weeks later the AML officer sent the senior executive a follow-up email asking whether the trades were suspicious. If they were, he said at the time, he would be obligated to file a SAR.
The senior executive again failed to respond. Then Ferris's compliance director sent an email, with the AML officer's two emails attached, and told the senior executive that they needed an explanation. Still, there was no response. Finally, the AML officer attempted several times to discuss the trades with the senior executive, until it reached the point where he stood in the executive's door and refused to leave until he received an answer. He was told the firm would not be filing a SAR. The SEC noted the AML officer's observation that the trades "could create an appearance of manipulative market practices" and sanctioned the firm for failing to file a SAR.
For compliance officials, the Ferris case highlights several important considerations. First, the trading was suspicious because it created an "appearance" of manipulation, which was enough to trigger the filing requirement. Second, the trading was identified internally, and both the AML officer and compliance director became involved in seeking a determination of the firm's filing obligation. Third, in describing the events surrounding the decision not to filerepeated emails, in-person follow-up, standing in the executive's doorthe SEC was evidently adding color to the internal process it found wanting.
While the order against Ferris may be one of the SEC's more dramatic narratives of an alleged failure to self-report in a SAR, this problem has been raised in several other recent cases. These cases have included an alleged failure to self-report suspicious wire transfers by a co-owner of a firm; trading by a registered representative in low-priced, little-known securities, which was suspiciously timed and corresponded with the issuance of spam email and international wire activity; and manipulative trading by foreign traders who, the SEC alleged, were under the broker-dealer's control and therefore associated persons of the firm.
Reporting a Third Party
A related area of risk involves the obligation to file a SAR on a third party. While this is presumably less sensitive than reporting oneself, it is nonetheless a serious matter to report one's customers or counter-parties to federal law enforcement.
The difficulties are highlighted in an SEC enforcement case, portions of which are still in litigation. The SEC staff alleged that several individuals associated with Leeb Brokerage Services, Inc., a now-defunct broker-dealer, caused the firm to fail to file SARs. In an initial decision that has become final for one of the respondents and is under review by the commission for others, an administrative law judge (ALJ) found that over a period of several months, a large percentage of the clearing requests that originated in one of Leeb's offices raised red flags at its clearing firm.
Specifically, the ALJ noted, the clearing firm raised concerns about suspicious transactions (mostly, apparently, transactions in which large blocks of penny stocks were transferred into client accounts and then sold). When Leeb did not respond, the clearing firm terminated the relationship. The red flags that alarmed the clearing firm, the ALJ concluded, showed multiple suspicious transactions that should have been reported.
The allegations in the Leeb case highlight the important role played by red flags in AML compliance. The key step in the process is in identifying that a transaction is suspicious, which often requires an awareness of the meaning of red flags. In the Leeb case, the red flags allegedly arose from the nature of the penny stock transactions. However, the SEC has identified additional red flags as well, such as a customer issuing trade orders to a broker-dealer for accounts in which he was not an authorized signatory.
With regulators placing greater emphasis on AML, broker-dealers and investment advisors would be well-advised to reassess their compliance programs and, if necessary, upgrade processes associated with key AML components, including customer identification, suspicious activity identification, and reporting and due diligence procedures.
Further, instead of viewing it as a separate area that poses unique risks, AML should be integrated into the firm's overall compliance system. Doing so will go a long way toward keeping a firm and its reputation out of harm's wayboth today, and well into the future.
John. H. Walsh is a partner at Sutherland Asbill & Brennan. He previously served for 23 years at the Securities and Exchange Commission, where he was instrumental in creating the Office of Compliance Inspections and Examinations.