The SEC and Treasury Jointly Issue Final Broker-Dealer Customer Identification Rules June 2003

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1 The SEC and Treasury Jointly Issue Final Broker-Dealer Customer Identification Rules June 2003 On May 9, 2003, the SEC and Treasury jointly published a final rule requiring securities brokerdealers to establish customer identification programs as a part of their overall anti-money laundering programs ( Final CIP Rule ). The Final CIP Rule implements Section 326 of the USA PATRIOT Act. According to the SEC and Treasury, the Final CIP Rule incorporates important changes from its proposed form, which increase the effectiveness of the rule while eliminating unnecessary burden on broker-dealers. This Law Flash will describe the key differences between the proposed and final versions of the rule. The substantive provisions of the Final CIP Rule will be codified in 31 CFR Part 103 of the Treasury s Bank Secrecy Act regulations ( BSA ). Broker-dealers will be required to comply with the rule through Rule 17a-8 under the Securities Exchange Act of 1934, which provides that broker-dealers must adhere to the reporting, recordkeeping and record retention requirements of the BSA. The effective date of the Final CIP Rule is June 10, 2003 but broker-dealers have until October 1, 2003 to implement their customer identification programs ( CIPS ). The Final Rule Definitions Narrow the Application of Broker-Dealer CIPs What is An Account? The Final CIP Rule includes a more narrow definition of account and an expands the number of exclusions from the definition, thereby reducing the burden on broker-dealers as to the number of accounts for which they have a CIP obligation. Account was defined in the proposed rule as any formal business relationship with a broker-dealer established to effect financial transactions in securities, including, but not limited to, the purchase or sale of securities, securities loan and borrowed activity or the holding of securities or other assets for safekeeping or as collateral. The Final CIP Rule removes the word business to clarify that the rule applies only to relationships established for the purpose of effecting securities transactions as opposed to general business dealings such as those established in connection with a broker-dealer s own operations or premises. The Final CIP Rule also excludes not only certain account transfers from the definition of account, but also excludes from the definition any account that a broker-dealer acquires through an acquisition, merger, purchase of assets, or assumption of liabilities. The definition does not exclude purchases of mutual funds and variable annuities on a subscription way basis

2 Who Is A Customer? Under the proposed rule, a customer was defined to include any person who opens a new account with a broker-dealer, and any person granted authority to effect transactions in an account. The Final CIP Rule defines customer as a person that opens a new account. That means persons with existing accounts are excluded from the definition, but only so long as the broker-dealer has a reasonable belief that it knows the true identity of the person. This more limited definition narrows the scope of individuals and entities that are subject to the requirements of broker-dealers CIPs. The Final CIP Rule eliminates from the definition of customer persons with authority over an account individuals who were included in the definition of customer in the proposed rule. The Treasury and the SEC point out in the release that as a result, broker-dealers are not required to consider as customers persons who fill out the account opening paperwork or provide information necessary to set up an account except for persons who undertake to open an account in the name of a minor or an informal group (i.e., non-legal entity). Although persons with trading authority are excluded from the definition of customer, the Final CIP Rule requires that broker-dealers describe in their CIPs the circumstances in which, based on the broker-dealer s risk assessment, it will take additional steps to verify the identity of a customer, who is not a natural person, by seeking information about individuals with authority or control over the account. The Final CIP Rule also excludes from the definition of customer certain readily identifiable entities, including: (1) financial institutions regulated by a federal functional regulator; (2) banks regulated by a state bank regulator; and (3) persons described in section (d)(2)(ii)-(iv) of the BSA regulations, including governmental agencies, municipalities and publicly traded companies to the extent of domestic operations. What about intermediary accounts? The proposed rule spurred much discussion in the industry about broker-dealers obligations to verify the identity of beneficial owners of accounts of intermediaries (e.g., trustees and investment advisers). The Final CIP Rule defines customer, as the person that opens a new account. And in the release to the Final CIP Rules, the Treasury and the SEC specifically indicate that broker-dealers are not required to look through an intermediary to ascertain or verify the identity of the underlying beneficial owners, if the intermediary is identified as the accountholder. Minimum Requirements for Broker-Dealer CIPs As set for the proposed rule, the Final CIP Rule requires broker-dealers to establish, document, and maintain written CIPs based on the type of identifying information available and on an assessment of relevant risk factors, including the broker-dealers size, location, methods of opening accounts, types of transactions executed for customers, and the broker-dealers reliance upon other financial institutions to perform certain CIP obligations. Further, the broker-dealers CIP procedures must enable the broker-dealer to form a reasonable belief that it knows the true identity of a customer. At a minimum, broker-dealer must incorporate four elements in their CIPs: collecting information, verifying identification, recordkeeping, and comparing customers to government lists of terrorists and terrorist organizations.

3 Obtaining Information. A broker-dealer s CIP is required to contain procedures for opening an account, which specify the identifying information that will be obtained with respect to each customer. A broker-dealer must obtain, at a minimum, the following information before the account is opened: name; date of birth for an individual; address (for an individual, a residential or business street address; and for an entity, an address for a principal place of business, local office, or other physical location), and identification number (for a US person, a taxpayer identification number; and for a non-us person, a taxpayer identification number or government issued document with a photograph or similar safeguard, evidencing nationality or residence). Verifying Identification. Under the Final CIP Rule, broker-dealer s CIPs must contain procedures for verifying, within a reasonable time after account is opened, the identity of the customer as ascertained by the required customer information described above. The procedures must describe when the broker-dealer will verify identity through the use of documents, non-documentary methods, or a combination of both methods as described below. Verification Through Documents. If a broker-dealer relies on documents to verify identity, the CIP must contain procedures that set forth the documents that the broker-dealer will use (e.g., the documents of identification described above). The adopting release suggests that, to prevent identity theft, brokerdealers obtain more than one type of documentary evidence and use non-documentary methods even when the customer has provided identification documents. Verification Through Non-Documentary Methods. Broker-dealers may also rely on non-documentary methods to verify identity. In such an event, the CIP must contain procedures that describe the nondocumentary methods the broker-dealer will use. These methods could include: contacting a customer; independently verifying the customer's identity by comparing information provided by the customer with information obtained from a consumer reporting agency, public database, or other source; checking references with other financial institutions; and obtaining a financial statement. The broker-dealer's non-documentary procedures must address situations where: an individual is unable to present an unexpired government-issued identification document that bears a photograph or similar safeguard; the broker-dealer is not familiar with the documents presented; the account is opened without obtaining documents; the customer opens the account without appearing in person; and the broker-dealer is otherwise presented with circumstances that increase the risk that the brokerdealer will be unable to verify the true identity of a customer through documents.

4 Additional Verification for Certain Non-Individual Customers. Under the Final CIP Rule, brokerdealers CIPs must address situations where, if the broker-dealer cannot verify a non-individual customer s true identity using documents or other verification methods, the broker-dealer will obtain information about individuals with authority or control over the non-individual account, including persons authorized to effect transactions in the customers account, in order to verify the customer's identity. Lack of Verification. Broker-dealer s CIPs also must include procedures for responding to circumstances in which the broker-dealer cannot form a reasonable belief that it knows the true identity of a customer. These procedures should describe: when the broker-dealer should not open an account; the terms under which a customer may use an account while the broker-dealer attempts to verify the customer's identity; when the broker-dealer should file a suspicious activity report in accordance with applicable law and regulation; and when the broker-dealer should close an account, after attempts to verify a customer's identity have failed. Recordkeeping. Under the Final CIP Rule, broker-dealers CIPs must include procedures for making and maintaining a record of all information obtained to verify customer identities. The Final CIP Rule is considerably less burdensome than the proposed rule in that it requires only a description of the documents and measures taken for verification purposes instead of copies of those documents or evidence of measures taken. At a minimum, broker-dealers must maintain: all identifying information about a customer obtained; a description of any document that was relied on to verify the customer s identity, noting the type of document, any identification number contained in the document, the place of issuance, and if any, the date of issuance and expiration date; a description of the methods and the results of any measures undertaken to verify the identity of the customer; and a description of the resolution of any substantive discrepancy discovered when verifying the identifying information obtained. Broker-dealers must retain identifying information for five years after the date the account is closed. The broker-dealer must retain the above descriptions for five years after the record is made. Checking Government Terrorist Lists. Under the Final CIP Rule, broker-dealers CIPs must include procedures for determining whether a customer appears on any government designated list of known or suspected terrorists or terrorist organizations within a reasonable period of time after the account is opened, or earlier if otherwise required by law. The Final CIP Rule requires regulators to provide separate guidance regarding the lists that must be checked. However, the Treasury and the SEC point out in a footnote to the release that broker-dealers should already have compliance programs in place to ensure they comply with Treasury s

5 Office of foreign Assets Control rules prohibiting transactions with certain foreign countries or their nationals (i.e., a mechanism in place to check account holders against the OFAC List). Notification To Customers Regarding CIPs? Like the proposed rule, the Final CIP Rule requires broker-dealers to provide customers with adequate notice that the broker-dealer is requesting information to verify its customers identities. Notice is adequate if the broker-dealer generally describes its identification requirements and provides the notice in a manner reasonably designed to ensure that a customer is able to view the notice, or is otherwise given notice, before opening an account. For example, depending on the manner in which the account is opened, a broker-dealer may post a notice on its website, include the notice on its account applications, or use any other form of written or oral notice. The Final CIP Rule provides sample notice language. Other Significant Aspects of the Final CIP Rule Can Broker-Dealers Rely on other Financial Institutions CIPs? Yes. Although the Final CIP Rule no longer requires a shared account (described in the proposed rule as being subject to a clearing or carrying agreement under NYSE Rule 382 or NASD Conduct Rule 3230) as the basis for reliance on another financial institution to perform any procedures in the brokerdealer's CIP, broker-dealers CIPs can include procedures specifying when a broker-dealer will rely on another financial institution (including an affiliate) to perform the same. However, such reliance must be with respect to customers of the broker-dealer that open, or have opened, an account or have established a similar formal business relationship with the other financial institution to provide or engage in services, dealings, or other financial transactions. To rely on another financial institution the broker-dealer must comply with the following requirements: the reliance must be reasonable under the circumstances; the other financial institution must be required to implement an AML program under the BSA and must be regulated by a federal functional regulator; and the other financial institution must enter into a contract requiring it to certify annually to the brokerdealer that it has implemented its AML program, and that it (or its agent) will perform the specific requirements of the broker-dealer's CIP. The effect of complying with the above requirements means that the broker-dealer will not be held responsible for the failure of the other financial institution to adequately fulfill the broker-dealer s CIP responsibilities. Can Broker-Dealers Delegate CIPs to Service Providers? Yes. Treasury and the SEC indicated that nothing in the Final CIP Rule affects the ability of brokerdealers to contractually delegate implementation and operation of their CIPs to service providers, which would not necessarily qualify under the reliance provisions of the Final CIP rule discussed above. In the release, however, Treasury and the SEC caution that in the event of such delegation, broker-dealers remain responsible for assuring compliance with the rule, and must actively monitor the operation of the CIP and assess its effectiveness.

6 If you have any questions about the final rule or other AML matters, please contact Denise Saxon at (213) or or Beth Kiesewetter at (202) or The final rule release is posted on the SEC s website at