Money laundering is like chaos in motion. Gain insights on emerging trends to stay in front of evolving risks.

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1 White Paper Money laundering is like chaos in motion. Gain insights on emerging trends to stay in front of evolving risks. February 2010 Risk Solutions Financial Services

2 Every financial institution is charged with the responsibility of developing policies and procedures to combat money laundering, which includes the duty to be aware of trends and adaptations in the methods by which money laundering is carried out. The most difficult aspect of this responsibility is a financial organization s ability to anticipate new criminal behavior and to proactively implement protocols before the criminal behavior occurs. It s like trying to guess what previously unknown disease will be the greatest threat to life next week or next year. In truth, much as the emergence of a new disease frequently determines the direction of medical science, it is often the money launderer who determines the course the industry takes to restrict criminal money laundering activity. With this in mind, this white paper will briefly describe the principal organizations involved in determining money laundering policy and procedures and will focus on emerging money laundering risks facing the financial services industry. Policy-making organizations There are a variety of industry and/or regulatory organizations which keep an unwavering eye on money laundering processes on national, international and global scales. These organizations assist financial institutions by tracking developments in money laundering and reacting with recommendations and regulations to limit the capacity in which criminals may operate. Much of the below discussion is the result of their findings and conclusions. They include: U.S. Departments of Treasury, Justice and Homeland Security: The 2007 National Money Laundering Strategy, released May 3, 2007, specifies the channels of greatest risk for money laundering. They include traditional financial institutions such as banks, as well as money services businesses, online payment systems, informal value transfer systems, commercial enterprises, insurance companies and casinos. Other means of money laundering with increasing risks include shell companies and trusts and bulk cash smuggling. 1 Financial Crimes Enforcement Network (FinCEN): This bureau within the U.S. Department of Treasury, and the administrator of the Federal Bank Secrecy Act, expresses its mission, in part, as safeguarding the financial system from the abuses of financial crime, including terrorist financing, money laundering and other illicit activity. One way in which it attempts to achieve this is by enhancing communications between the government and the financial industry to facilitate prompt notification to law enforcement of possible terrorist or other illegal activity. 2 Since 1998, FinCEN has published the SAR Activity Review to provide information to the industry relating to SAR (Suspicious Activity Report) filings that may alert the industry to trends in money laundering methods and other criminal activity. Every financial institution is charged with the responsibility of developing policies and procedures to combat money laundering, which includes the duty to be aware of trends and adaptations in the methods by which money laundering is carried out. The most difficult aspect of this responsibility is a financial organization s ability to anticipate new criminal behavior and to proactively implement protocols before the criminal behavior occurs. 2

3 Financial Action Task Force (FATF). A multi-national body created in response to growing concern over international money laundering activities, FATF has grown to include 33 member countries and a number of associate members and observer bodies. It has issued 40 Recommendations addressing money laundering; updated with nine Special Recommendations on Terrorist Financing. 3 Federal Financial Institutions Examination Council (FFIEC). This formal interagency body is comprised of the highest officials of each of the Federal Regulatory Organizations (FROs), including the Federal Reserve, the OTS, the OCC, the NCUA and the FDIC. It has the authority to create uniform principles, standards and report forms for the federal examination of financial institutions by the FROs and make recommendations for standardizing the supervision of financial institutions. 4 The FFIEC is responsible for the development of the Bank Secrecy Act/Anti-Money Laundering (BSA/AML) examination manual utilized by the FROs to audit the effectiveness of financial institutions in limiting money laundering activity. Emerging anti-money laundering risks The financial industry s responsibility to identify and stop money laundering affects its entire business process and failure to do so is loaded with risk. Such risks include operational, reputational and financial risks as a result of regulatory penalties, forced operational and policy changes, lost revenue streams or frozen assets and lost customer base because of negative publicity. A financial institution need only look to its FROs enforcement actions 5 to understand its degree of risk, but money laundering in the post-9/11 world also makes big headlines outside of the industry. The risks we see emerging today are identified by bodies such as FATF and FFIEC, as well as the industry s observations, self-reported in SARs and Currency Transaction Reports (CTRs) and compiled through the efforts of FinCEN. The most significant emerging money laundering risks are identified in funds transfers, including stored value cards, mobile payments and Internet payments. Other money laundering risks are identified in shell corporations, and contractual transactions including real estate, exchange trades and insurance transactions. The financial industry s responsibility to identify and stop money laundering affects its entire business process and failure to do so is loaded with risk. Such risks include operational, reputational and financial risks as a result of regulatory penalties, forced operational and policy changes, lost revenue streams or frozen assets and lost customer base because of negative publicity. Funds transfers Stored value cards: Stored value cards, also known as prepaid cards, come in many forms and are available for various uses. They may be in the form of gift certificate alternatives for retail use in one store or multiple stores. They may be offered for specific purchases such as gasoline or auto services, phone services or mass transit. In as much as their use is widely diverse, stored value cards are typically categorized as either open system or closed system cards. 3

4 Open system stored value cards are connected to the global funds networks such as Cirrus or Plus. They allow for access to worldwide ATM funds and purchases with nearly any merchant. They are often cobranded by financial institutions and may carry the VISA or MasterCard logo with their associated benefits. They may be geographically restricted, but are frequently available for use internationally and are marketed as a safer alternative to carrying cash. They may be used by anyone, including a non-purchaser and are typically reloadable 6 with varying restrictions. The usual means of obtaining such a card begins with an individual registering for, prepaying funds into and receiving a card. This part of the process may occur at a financial institution, a retailer, the postal service, money service business or similar companies. They may also be obtained over the Internet. Closed system cards are limited by the issuer and usually only available to purchase goods or services from the issuer. Their use may be as limited as to a single merchant, or as broad as to a family of businesses under the umbrella of a parent company, and they also may be reloadable, but usually only up to a certain dollar amount. Stored value cards are vulnerable to money laundering for a number of reasons. Unlike debit cards, stored value cards may be issued without the obligation of a depository account. Because the issuers and sellers of stored value cards are defined within the regulations under money services businesses, they currently are not required to register with FinCEN or to file Suspicious Activity Reports. 7 Frequently, a financial institution will have little direct contact with a purchaser and is not required to perform customer identification procedures on individual purchasers when a pooled account is utilized to process payments on the cards. There also appears to be some ambiguity of where the responsibility lies for AML and Customer Identification Program (CIP) provisions between banks, processors and other entities involved in the issuance and redemption process. Moreover, although cards issued within the United States are subject to the Bank Secrecy Act, this is not true for cards issued outside the U.S., although they may still be used within its borders. For example; transferring value across borders, as in a case where two $5,000 prepaid cards are used within the U.S., does not trigger the related currency reporting requirements. Mobile payments: The cellular phone industry is developing new technologies to facilitate funds transfers such as bill pay, cross border money transfers and point-of-sale (POS) payments and is partnering with other service providers to achieve this in the U.S. Mobile payments are already widespread in many European and Asian countries. If not performed through a financial institution with an underlying account through an ACH debit or credit card transaction, payments are conducted with the wireless company acting as a financial intermediary that makes the payments and charges the user s service account (Bill to Phone). Such transactions may be made by charging a transaction to Stored value cards are vulnerable to money laundering for a number of reasons. Unlike debit cards, stored value cards may be issued without the obligation of a depository account. Because the issuers and sellers of stored value cards are defined within the regulations under money services businesses, they currently are not required to register with FinCEN or to file Suspicious Activity Reports. 7 Frequently, a financial institution will have little direct contact with a purchaser and is not required to perform customer identification procedures on individual purchasers when a pooled account is utilized to process payments on the cards. 4

5 the account, or by prepaying an account for future services or purchases. Money transmission may be made to, or received from, any mobile phone number or bank account. Purchases can include travel tickets, and depending on the service provider, cash may be obtained at ATMs or over the counter at participating businesses. Mobile payments, or m-commerce, is not yet recognized as a potential money laundering threat by most Federal regulatory and oversight bodies. The 2007 National Money Laundering Strategy and Threat Assessment makes no mention of m-commerce. The FATF Report on New Payment Methods discusses mobile payments as mostly relying on the banking industry to facilitate transactions, but neglects to discuss money laundering risks associated with the growth of transactions that do not rely on financial institutions. 8 This field of commerce is largely unregulated directly and it is uncertain whether or how the regulations which apply to the financial institutions that facilitate these transactions would also affect mobile payments. Meanwhile, at least the same level of risk, and perhaps even greater risk, associated with transfer methods such as stored value cards, for example, would be found with m-commerce. This is in part, due to the fact that many emerging service providers do not fall within the definitions of institutions subject to the Bank Secrecy Act or USA PATRIOT Act. Internet payments: The rapidly growing number and variety of services and goods available through the Internet has created a proportional demand for methods of financing their purchase. Vendors and merchants are interested in payment methods that do not carry the same fee burdens as credit cards. Consumers, still wary of using credit cards over the Internet in spite of assurances of digital encryption security, or who do not have credit cards, prefer payment methods that do not require their use. In response, numerous service providers, such as well-known PayPal, offer individuals the ability to make online purchases, funding accounts with wire transfers, money orders and even cash. These providers have tapped into a huge, still unsaturated market for Internet financial services. In 2004, Paypal did million transactions totaling $18.9 billion dollars. 9 In the last quarter of 2005 alone, it conducted million transactions for a total of $8.1 billion dollars. 10 In most cases, the provider of this service will not have a face-to-face relationship with its customers and may even allow anonymous accounts. The ability to engage in transactions across international borders enhances the potential for money laundering as payments may be directed to off-shore Internet payment service providers that thereafter facilitate transactions unregulated by anti-money laundering laws of the United States. The potential for maneuvering around OFAC restrictions is also enhanced using similar means. 11 Business entities Shell corporations: Shell corporations are legal entities that are not publicly traded and have no assets, no employees, no operations and no physical address. They are frequently created for the legitimate purposes of easing corporate mergers and the transfer of currency and assets between companies as well as to hold the stock or tangible assets of other businesses. They have also been used for less than legitimate purposes such as tax evasion and, more recently, money laundering. Because they are not publicly traded, they are not subject to many of the ownership disclosure requirements of other companies listed on the stock exchanges. Additionally, many states incorporation laws do not require owners to be named at all and will allow other companies to own shell corporations, further clouding the ability to trace accountable parties. The formation of shell companies within the U.S. is often promoted abroad for the privacy protections they offer. Shell companies create a risk for money laundering because they allow for access to the nation s financial institutions without the transparency required of the AML regulations. 12 FinCEN notes there are 47 state jurisdictions within the U.S. that do not require the reporting of owners of an LLC. 13 Aside from foreign shell banks, a subset of shell corporations, they are not defined within the Bank Secrecy Act so as to fall within the regulatory reporting provisions, and may be subject to the BSA s catch-all definitions 14 only under certain conditions. Nevertheless, transactions with shell companies pose such a growing concern that, despite the need for substantially more rigorous due diligence to expose potential money laundering activity, it is well within a financial institution s best interests to develop policies and procedures to identify owners and monitor their business activities. 5

6 Contracts Real estate: In November and December, 2006, FinCEN released two important assessments of the money laundering risks associated with real estate transactions, both commercial and consumer 15, 16. In the 10 years through August 2006, of nearly 10,000 SARs filed involving commercial real estate transactions, more than 96 percent were filed by banks and other depository institutions. 17 Of a sample analysis, 66 percent involved suspected money laundering, structuring and related activities. 18 These activities included frequent transfers of funds between accounts for no apparent business purpose, multiple cash deposits and wire transfers, deposits of large numbers of traveler s checks and withdrawals of cash to purchase monetary instruments that were later re-deposited. By contrast, whereas suspicious activity reporting of mortgage loan fraud has nearly quadrupled since 2002, the percentage of reports that also indicated structuring or money laundering activity was less than one percent of the total. 19 Nevertheless, the numbers represent a significant increase in such activity, roughly coinciding with the boom in the housing market. Mortgage lending activities that have been identified as increasing risk include automated loan processing and the use of document couriers and mortgage brokers. Automated loan processing, via the telephone or the Internet, as well as the use of couriers, diminishthe ability of financial institutions to obtain positive, verifiable identification of the parties to a transaction. Mortgage brokers are still largely unregulated in the current AML environment 20, face disparate licensing requirements state to state and are frequently not subject to background checks. Persons Involved in Real Estate Closings and Settlements are not required to have an AML program, file SARs or CTRs, or to have a CIP program in place. Trade based money laundering: Trade based money laundering is not the newest means of hiding the illicit sources of money. The Black Market Peso Exchange, recognized in the period surrounding the terrorist attacks of 2001, is one example of this method of laundering money. Additional means of trade based laundering are becoming more common, as terrorist financiers and launderers seek less obvious ways of infiltrating the financial industry. These methods frequently include the exchange of legitimate goods and even services. The difference between trade based money laundering and legal business transactions, however, is in the price obtained or paid. An over-valuation of merchandise results in an importer paying a higher-than-market price which facilitates the transfer of additional funds offshore. An under-valuation results in the opposite with funds moving into the country. Other methods of conducting trade based money laundering include double invoicing, misrepresenting the quantity of goods shipped and misclassifying shipped merchandise as different products of higher or lower value. 21 Additional means of trade based laundering are becoming more common, as terrorist financiers and launderers seek less obvious ways of infiltrating the financial industry. These methods frequently include the exchange of legitimate goods and even services. The difference between trade based money laundering and legal business transactions, however, is in the price obtained or paid. An over-valuation of merchandise results in an importer paying a higher-thanmarket price which facilitates the transfer of additional funds offshore. An undervaluation results in the opposite with funds moving into the country. Other methods of conducting trade based money laundering include double invoicing, misrepresenting the quantity of goods shipped and misclassifying shipped merchandise as different products of higher or lower value. 21 6

7 Trade based money laundering is often the most difficult to detect because of the potential complexity of the transactions and the number of individuals or merchants involved. The financial services industry has little regulation when it comes to trade based money laundering, but it should be noted that it is very involved in providing information to financial intelligence units. This is likely because financial institutions often already have in place the means by which they can evaluate the business practices and inventory of their customers. They may increase their ability to spot potential money launderers with the use of red flag indicators available through FATF. 22 Insurance: Insurance companies have gained the attention of money laundering observers as a result of the availability of certain products that lend themselves to greater risks. 23 The penetration of traditional financial institutions into the insurance market makes it particularly important that these risks be understood. Financial institutions must be aware that the risks are apparent at every stage in the insurance cycle, from underwriting to termination and redemption. Scenarios include third-party payment of premiums with illicitly obtained funds, borrowing against policies purchased with illegal money, one-off payments for policies that are subsequently terminated within the contract cancellation period, and fraudulent loss claims involving high value goods purchased with illegal funds. 24 One difficulty in tracking illegal activity through the insurance industry is the lack of anti-money laundering program and suspicious activity reporting requirements for one of the largest segments of the industry, agents and brokers. These obligations are left to the insurance companies and made more difficult to enforce in a competitive market when the agents and brokers are not their official employees. Action steps and best practices Review policies and procedures Determine whether your policies address emerging forms of payment methods, higher risk commercial transactions and new lines of business or products. Determine whether your current or projected product lines warrant implementation of new policies. Compare and strengthen Reinforce your current policies using directives and guidances by your Federal Regulatory Organization to fill in the gaps or shore up weak spots. Review new AML examination procedures to determine deficits within your own policies. Determine breadth Assess your current CIP procedures to verify its application across the spectrum of your product lines. Understand that new product lines, while not yet formally or fully regulated, may still fall within catch-all provisions of the regulations. Monitor Continually review processes such as Internet identity verification to assure that non-traditional application procedures meet minimum requirements. Review the actions of unofficial employees, such as agents that may carry the burden of implementing policy without the risk of failure to implement. Document and retain Maintain records of executive and procedural decisions determining risk and applicability of program implementation, particularly when a decision to not implement new policies or change existing procedures is made. 7

8 Conclusion The risks associated with emerging trends are not all new to financial institutions, some resulting from previously known activities, but growing in frequency and scope. Whether new or increasing, these risks require financial institutions to adapt and adopt new policies and procedures to mitigate their effects on their business and the financial industry, as a whole. The most obvious means of combating these trends relies heavily on already implemented procedures, particularly customer identification and effectively managing high-risk customers. This may be difficult when dealing with customers who present with minimal information, as with shell corporations. Due diligence procedures should be well crafted and applied in all cases unless their relaxation is justifiable and documented. Policies should be put in place to restrict account opening in situations where the risk to the institution outweighs the benefits of doing business. In all situations, reputational and operational risk should weigh heavily in the minds of policy makers and institutions. The best sources of policy making guidelines and information come from the advisory groups and governmental bodies noted above, as well as a financial institution s Federal Regulatory Organization. Time and again, they have proven in audits and disciplinary actions that one of the best mitigating factors for isolated mistakes is communication. Communication is key, not only to compiling the data used to analyze the effectiveness of policy, but also to determining the best approaches to the emerging trends in money laundering. Sources National Money Laundering Strategy, Appendix A, Money Laundering Threat Assessment. 2 FinCEN Strategic Plan, FY , Safeguarding the Financial System from the Abuse of Financial Crime, February, MANDATE FOR THE FUTURE OF THE FATF, September December, Authorized under title X of the Financial Institutions Regulatory and Interest Rate Control Act of 1978 (FIRA), Public Law , March 10, A reloadable card allows the purchaser to add value at a later date and reuse the card many times, whereas a nonreloadable card may be used only for the initial value at the time of issuance, after which it is discarded or relinquished to the issuer. Common examples of either are a Starbucks card and a Borders Books store gift card C.F.R (uu); 31 C.F.R (a)(5); 31 C.F.R (a)(1). 8 Such transactions may be facilitated through the use of RFID chips or phone SIM cards (electronic wallets) that act much like a stored value card or debit card and may be reloaded throughout the life of the device. Other transaction types include callback payments or text message payments. Speech: Towards a European Payment and Information Space: m-payments, Viviane Reding, Before the Roundtable Conference on m-payments, Brussels, June 29, Statement of Kevin Delli-Colli, Deputy Assistant Director, Financial & Trade Investigations Division, Office of Investigations, U.S. Immigration and Customs Enforcement, Department of Homeland Security, Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, April 4, 2006, Washington, D.C. 10 F.N. 1, at Report on New Payment Methods, Financial Action Task Force, October 13, Company Formations: Minimal Ownership Information is Collected and Available, Testimony Before the Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, U.S. Senate, Yvonne D. Jones, Director, Financial Markets and Community Investment, November 14, FinCEN Advises Financial Industry on Potential Risks of Shell Companies, Press Release, November 9, [A]ny business or agency which engages in any activity which the Secretary of the Treasury determines, by regulation, to be an activity which is similar to, related to, or a substitute for any activity in which any business described in this paragraph is authorized to engage: or any other business designated by the Secretary whose cash transactions have a high degree of usefulness in criminal, tax, or regulatory matters. 31 USCS 5312(a)(2)(y) and (z). 15 Mortgage Loan Fraud: An Industry Assessment based upon Suspicious Activity Report Analysis, FinCEN, November, Money Laundering In The Commercial Real Estate Industry: An Assessment based upon Suspicious Activity Report Analysis, FinCEN, December,

9 17 Ibi d at Ibi d at F.N. 14, at Although an Advance Notice of Proposed Rulemaking for Persons Involved in Real Estate Closings and Settlements was issued in April, 2003, no rules have yet been made. 21 U.S. Money Laundering Threat Assessment, December, Trade Based Money Laundering, Financial Action Task Force, June 23, Permanent life insurance products besides group life, annuity contracts, except for group contracts, and any other insurance product with cash value or investment features. 31 C.F.R Money Laundering and Terrorist Financing Typologies , Financial Action Task Force, June 10, Electronic bibliography and additional references Departments Of Treasury, Justice and Homeland Security 2007 National Money Laundering Strategy <www.treas.gov/press/releases/docs/nmls.pdf> U.S. Money Laundering Threat Assessment, December, 2005 <www.treas.gov/offices/enforcement/pdf/mlta.pdf> FFIEC <www.ffiec.gov/> Bank Secrecy Act Anti-Money Laundering Examination Manual <www.ffiec.gov/bsa_aml_infobase/pages_manual/manual_online.htm> FinCEN <www.fincen.gov> Strategic Plan, FY , Safeguarding the Financial System from the Abuse of Financial Crime, February, 2005 <www.fincen.gov/strategicplan2006_2008.pdf Potential Risks of Shell Companies <www.fincen.gov/advisoryonshells_final.pdf> The Role of Domestic Shell Companies in Financial Crime and Money Laundering: Limited Liability Companies <www.fincen.gov/llcassessment_final.pdf> Mortgage Loan Fraud: An Industry Assessment based upon Suspicious Activity Report Analysis <www.fincen.gov/strategicplan2006_2008.pdf> Money Laundering In The Commercial Real Estate Industry: An Assessment based upon Suspicious Activity Report Analysis <www.fincen.gov/commercial_real_estate assessment_final.pdf> Statutes and Regulations Financial Institutions Regulatory and Interest Rate Control Act of 1978, P. L <www.access.gpo.gov/uscode/title12/chapter34_.html> 31 C.F.R. 103 <ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&tpl=/ecfrbrowse/title31/31cfr103_main_02.tpl> 31 USCS 5312 <www.law.cornell.edu/uscode/html/uscode31/usc sec_31_ html> Speeches and Testimony Speech: Towards a European Payment and Information Space: m-payments, Viviane Reding <ec.europa.eu/commission_barroso/reding/docs/speeches/mpayments_ pdf> Statement of Kevin Delli-Colli, U.S. Immigration and Customs Enforcement, Before the Committee on Banking, Housing and Urban Affairs <banking.senate.gov/_files dellicolli.pdf> Testimony of Yvonne D. Jones Before the Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, U.S. Senate <www gao.gov/new.items/d07196t.pdf> Financial Action Task Force <www.fatf-gafi.org> Mandate for the future of the FATF <www.fatf-gafi.org/document/49/0,2340,en_ _ _ _1_1_1_1,00.html> Trade Based Money Laundering <www.fatf-gafi.org/dataoecd/60/25/ pdf> Money Laundering and Terrorist Financing Typologies <www.fatf-gafi.org/dataoecd/16/8/ pdf> Report on New Payment Methods <www.fatf-gafi.org/dataoecd/30/47/ pdf> 9

10 For more information: Call lexisnexis.com/risk/financial-services About LexisNexis Risk Solutions LexisNexis Risk Solutions (www.lexisnexis.com/risk) is a leader in providing essential information that helps customers across all industries and government predict, assess and manage risk. Combining cutting-edge technology, unique data and advanced scoring analytics, we provide products and services that address evolving client needs in the risk sector while upholding the highest standards of security and privacy. LexisNexis Risk Solutions is part of Reed Elsevier, a leading publisher and information provider that serves customers in more than 100 countries with more than 30,000 employees worldwide. Our financial services solutions assist organizations with preventing financial crime, achieving regulatory compliance, mitigating business risk, improving operational efficiencies and enhancing profitability. LexisNexis provides authoritative information concerning risk management and related subjects. In distributing these works neither the authors nor LexisNexis, or its affiliated companies, is engaged in rendering legal or other professional services. Competent professional persons should be considered and consulted if such assistance is required. This information is not intended to and does not constitute legal advice. The accuracy, completeness, adequacy or currency of the information is not warranted or guaranteed. LexisNexis and the Knowledge Burst logo are registered trademarks of Reed Elsevier Properties Inc., used under license. Other products or services may be trademarks or registered trademarks of their respective companies. Copyright 2011 LexisNexis. All rights reserved. NXR

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