Practical considerations arising from the EU Fourth Money Laundering Directive

The fourth EU money laundering directive (MLD4) was approved by the European Parliament at its second reading on 20 May 2015.
EU member states will have two years to transpose the directive into national law. MLD4 encompasses a number of important changes, and regulated firms will need to consider how these changes will impact upon their operations.

An emphasis on the risk-based approach

MLD4 emphasises the need for a risk-based approach to anti-money laundering, a concept that is already well-understood, but not universally applied. Changes proposed under MLD4 recognise that, in certain situations – including the application of simplified due diligence procedures and reliance on third-country ‘equivalence’ – current approaches are too permissive and can lead to situations where money laundering risks are automatically deemed to be low. By classifying a larger number of customers as low risk, regulated firms can streamline operations and reduce costs relating to the Know Your Customer / Customer Due Diligence processes; however, this risks the creation of situations in which associated money laundering risks are not fully considered.

Under MLD4, regulated firms will no longer be able to apply simplified due diligence solely on the basis that a customer is regulated or listed on a recognised stock exchange. Instead, firms will need to consider other factors that might give rise to elevated money laundering risks, such as the nature of the underlying transaction or the location of the customer. These changes are likely to impact banks’ treatment of certain sectors, such as solicitors, as well as pooled accounts.

MLD4 also phases out the notion of third-country ‘equivalence’ – those countries deemed by the European Commission to have equivalent anti-money laundering standards to the EU. This change was considered necessary to reinforce a risk-based approach and to ensure that regulated firms do not place automatic reliance on ‘white-listed’ non-EU regulators without thoroughly considering the associated money laundering risks.

Extension of the definition of Politically Exposed Persons

Foreign PEPs, including senior political, military and judicial figures, and members of their close families, are already considered higher risk customers for anti-money laundering purposes. MLD4 extends the PEP definition to domestic PEPs. For higher risk customers, such as PEPs, MLD4 emphasises that regulated firms are expected to conduct enhanced due diligence – which will include reviewing source of wealth and source of funds.

An assessment of a customer’s source of wealth extends beyond the funds received by the regulated firm to consider the origins and totality of their wealth, including whether that wealth may be tainted by income from illegitimate sources. Under MLD4, the enhanced measures will need to be applied for at least 18 months (rather than the former 12 months) after a PEP leaves office.

Following reviews undertaken in 2011 and again in 2014, the UK Financial Conduct Authority has commented on the need for regulated firms to improve their handling of PEP relationships, including documenting source of wealth adequately, ensuring that the take-on of PEP customers is subject to senior management approval, and conducting regular ongoing reviews of PEP relationships. PEP risk will remain a key anti-money laundering consideration for the foreseeable future, and those regulated institutions with larger numbers of domestic PEPs will need to consider the adequacy of their current records.

Creation of centralised registers of beneficial owners

Following a number of global initiatives to increase corporate transparency to tackle financial crime and tax evasion (including the G8, G20 and FATF), MLD4 requires EU member states to implement registers of beneficial owners at a national level. These registers will be accessible to anyone who can demonstrate a ‘legitimate interest’, potentially including investigative journalists and NGOs. The recent communication from the European Commission to Parliament concerning the Council’s position on MLD4 presents an important clarification on the meaning of ‘legitimate interest’ with regards to the beneficial ownership registers. The Commission considers that the notion of ‘legitimate interest’ must be construed and understood in the light of the requirements flowing from Articles 7 and 8 of the Charter of Fundamental Rights, in full respect of the rules on protection of personal data and the right to privacy.

The UK government has already taken a lead, through its chairmanship of the G8 group, to promote availability of information on beneficial owners. The Small Business, Enterprise and Employment Act 2015 establishes provisions for a ‘register of people of significant control’, under which UK companies will be obliged to provide information on beneficial owners, via Companies House, by the beginning of 2016. This information will be publicly available from Companies House. Companies themselves will be obliged to obtain information on their beneficial owners; to achieve this objective, private companies will be accorded legal rights to compel shareholders to provide information similar to those currently available to public listed companies.

Following lobbying from the UK, trusts and foundations are excluded from the requirement to provide information on beneficiaries as part of a public register, although information will still be collected by trustees and may be accessed by national authorities. In addition to the provisions for a register of beneficial owners set out under the Small Business, Enterprise and Employment Act 2015, the Act also sets out provisions for the prohibition of bearer shares in the UK and the conversion of any existing bearer shares to registered shares. Furthermore, the Act curtails the use of corporate directors to a limited range of situations. Both of these measures are designed to restrict the opportunity for beneficial owners to hide behind a veil of secrecy.

The provisions for the creation of centralised registers of beneficial owners under MLD4 creates a precedent for non-EU states to follow, and advocates of greater transparency in the EU hope that, by taking a lead on the issue, other countries will in due course adopt similar measures, therefore restricting the opportunity for money launderers to hide behind shell companies, nominees and bearer instruments. Nevertheless, this will inevitably be a long process. Strong vested interests ensured that trusts and foundations were excluded from provisions for public registers, and a number of British Overseas Territories and British Protectorates, which are responsible for the creation of large volume of offshore companies with minimal disclosure requirements, have been reluctant to adopt greater transparency, despite intense pressure and threats at the highest political levels.

Furthermore, there remains the risk that determined money launderers will simply adapt to the new disclosure requirements – for example, by continuing to use ‘fronts’ as named beneficial owners or directors, acting either willingly or through coercion. This may lead to a degree of false comfort if a high level of trust is placed in corporate filings. Although sanctions for non-compliance with company filings requirements will be increased, including criminal penalties, and nominee directors will be held to a greater degree of accountability for their actions with a strengthening of the director disqualification regime, this may not deter such activity entirely – particularly criminal enterprises. Furthermore, currently Companies House does not have an extensive investigatory capacity to ensure accuracy of information provided and, without such capacity, it would be unable to verify whether information provided on beneficial owners was correct.

In the UK, rather than seeking to increase the capacity for Companies House to independently validate the information that has been provided, the approach taken has been to place the onus on companies to ensure the quality and timeliness of information provided, and to apply stricter penalties for non-compliance. For this reason and, unless this situation changes – which appears unlikely given the government is seeking to reduce ‘red tape’ – those firms obliged to undertake Know Your Customer checks should not rely at face value on beneficial ownership information held at Companies House without seeking to confirm or corroborate its validity.

Levels of administrative pecuniary sanctions

Specific minimum sanctions for breach of AML/CTF requirements have been outlined under MLD4. The directive sets out provisions related to the level of administrative pecuniary sanctions applicable to financial institutions and to non-financial institutions. In relation to financial institutions, as regards legal persons, the level of maximum pecuniary sanctions shall be at least EUR 5 million or 10% of the total annual turnover. As regards natural persons, the maximum of pecuniary sanctions is of a least EUR 5 million. MLD4 further states that, in the case of non-financial institutions, the maximum pecuniary sanctions is at least twice the amount of the benefit derived from the breach, or at least EUR 1 million.