ENABLERS in the Legal Profession: Balancing Client Confidentiality Against Preventing Money Laundering

The anticorruption world is abuzz with discussion of the Pandora Papers, a major leak of financial documents that exposed how wealthy elites, including various political leaders and shady businesspeople, conceal their assets. But alongside revelations about the illicit expenditures of the rich and powerful, reporting based on the Pandora Papers also highlighted the role that lawyers and law firms have played in facilitating these arrangements—many of which are technically legal, but at least some of which suggest possible money laundering or other illicit activities.

This is hardly the first time that concerns have been raised about attorneys’ involvement in money laundering. Indeed, such concerns have existed for years, and have been repeatedly emphasized by groups like the Financial Action Task Force, and a 2010 study found that lawyers played a facilitating role in 25% of surveyed money laundering cases in an American appeals court. But perhaps because of the Pandora Papers revelations, U.S. legislators finally appear to be taking the problem seriously. Within days of the Pandora Papers leak, Members of Congress introduced a bill called the ENABLERS Act, which would expand the scope of the Bank Secrecy Act (BSA) so that many of the BSA’s requirements, including the duty to file suspicious activity reports (SARs) with the Treasury Department and to implement anti-money laundering (AML) controls, would apply to a broader set of actors—including attorneys and law firms.

The American Bar Association (ABA), which has consistently resisted pretty much every effort to impose even modest AML requirements on the legal profession, has strenuously opposed this aspect of the ENABLERS Act. The ABA’s principal objection is that many BSA requirements—especially the requirement that covered entities file SARs with the government—conflict with the lawyer’s ethical duty of client confidentiality—the attorney’s obligation not to reveal information gained in the course of representing a client to outside parties, including the government, save in a very narrow set of circumstances. (The duty of confidentiality is related to, but distinct from, the attorney-client privilege, which prevents a lawyer from testifying against her client in court regarding private communications that the attorney had with the client in the course of the legal representation, or providing such communications in response to a discovery request. Some critics have also raised attorney-client privilege concerns about SAR filings.) The ABA and other commentators have argued that extending the BSA’s mandatory reporting requirement to attorneys, as the ENABLERS Act would do, compromises attorneys’ ability to guarantee confidentiality, and thereby discourages the full, frank communications between attorney and client that are essential for effective legal representation.

The ABA has a valid concern, but only to a point. A broad and unqualified extension of BSA reporting requirements to attorneys could indeed impinge on traditional and important principles of lawyer-client confidentiality. But this is not a reason to leave things as they are. Rather, the ENABLERS Act and its implementing regulations can and should draw more nuanced distinctions, imposing SAR and other AML requirements on lawyers when those lawyers are acting principally as financial advisors, but enabling lawyers to preserve client confidentiality—including with respect to suspicious transactions—when lawyers are providing more traditional legal representation, for instance in the context of litigation.

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Little Trust on the Prairie

Offshore finance has always been glamorous. The world’s tax dodgers and kleptocrats seem to favor the same jurisdictions as James Bond, places with soring vistas, crystalline waters, and plenty of five-star resorts. Yet as the recent release of the Pandora Papers makes clear, the geography of offshore finance has shifted in recent years. For those seeking to obscure the origins of their wealth, South Dakota now eclipses Grand Cayman. Customer assets in South Dakota trusts have more than quadrupled over the past decade to $360 billion. And while there are of course legitimate reasons to set up a trust, trusts offer an ideal mechanism—even better than shell companies—for concealing ownership and preserving anonymity.

South Dakota is an especially attractive jurisdiction for setting up such trusts because it offers not only low costs and flexibility, but also a combination of privacy and control that those seeking to hide their wealth find attractive. Notably, South Dakota automatically seals trust records, preventing outsiders from identifying settlors and beneficiaries, and does not require publicly filing trust documents. (Although South Dakota’s privacy laws do not shield settlors and beneficiaries from federal law enforcement, they do conceal the trust from journalists and the private parties, making it less likely that those involved in the trust come to the attention of government authorities.) South Dakota also allows the creation of “dynasty trusts,” which exist in perpetuity, as well as “directed trusts,” which give families and their advisors maximum control in managing the trust’s affairs. Unusually, South Dakota also allows trusts whose settlor and beneficiary are the same person.

These rules make South Dakota trusts particularly appealing to business and political elites whose assets may be the target of civil as well as criminal litigation. Indeed, the Pandora Papers identified, among those who used South Dakota trusts to conceal their assets, a Colombian textile baron who had sought to launder international drug proceeds, a Brazilian orange juice mogul who allegedly underpaid local farmers, and the former president of a Dominican sugar producer who was accused of exploiting workers. With banks and even real estate agents wary of taking large sums from officials in corrupt regions, a U.S. domiciled trust offers a veneer of legitimacy.

Allowing states like South Dakota to join the archipelago of secrecy jurisdictions where bankers and trustees ask few questions undermines the United States’ fight against global corruption. Indeed, attacking those who abet foreign corruption while welcoming dirty money as an investment strategy is not just hypocritical but self-defeating. The rise of anonymous domestic trusts in the United States demands and an aggressive response from federal regulators. That response can and should include the following measures:

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Beneficial Ownership Disclosure Mandates and the Legitimate Privacy Interest in Anonymously-Owned Real Estate

In a forthcoming article in the Notre Dame Law Review, Professors Reid Weisbord of Rutgers Law School and Stewart Sterk of the Cardozo Law School examine the trade-offs posed by requiring the public disclosure of the beneficial owners of real estate. While promoting real estate ownership transparency and curbing criminals’ ability to use anonymously-owned real estate, there are clear disadvantages to making the home addresses of all citizens public, the recent murder of a federal judge’s son at the family home by a disgruntled litigant who found their address online the most patent.

As Professors Weisbord and Sterk explain, a common law trust is one way citizens can keep their home address private, but as they also say, the Pandora Papers shows how easy it is for corrupt officials and criminals of all kinds to use a trust to thwart law enforcement. As Congress considers legislation to end trust abuses, the two urge lawmakers not to lose sight of the downsides of requiring the unrestricted public disclosure of the home addresses of all citizens.  At GAB’s request, Professor Weisbord summarized the relevant portion of their article for GAB readers. The Notre Dame article and an earlier article by Professor Weisbord prompted by publication of the Panama Papers should be required reading for those struggling with how to ensure criminals cannot hide from law enforcement through the use of anonymous corporations, trusts, and other “offshore vehicles,” while protecting judges, victims of domestic or sexual abuse, or others with a legitimate need to keep their home address private.

On October 3, 2021, the International Consortium of Investigative Journalists (“ICIJ”) published the findings of a massive worldwide investigation that painstakingly reviewed nearly 12 million confidential financial documents, a collection now known as the Pandora Papers. In keeping with its prior bombshell investigations, including the Panama and Paradise Papers, the ICIJ has once again exposed a trove of secret financial transactions by a global cohort of world leaders, politicians, and billionaires who have offshored assets by covertly acquiring or storing property in foreign countries. There can be legitimate reasons for individuals to secretly acquire property abroad, but such transactions are also notoriously used to launder money and defraud creditors or tax collectors by evading the jurisdictional reach of the individual’s domestic legal system.

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A Dearth of Data in the De-Risking Debate

As readers of this blog are likely well aware, the fight against grand corruption is closely linked to the fight against money laundering. After all, kleptocrats and others involved in grand corruption need to hide the origins of their ill-gotten wealth. While the criminals who seek to launder their illicit cash are sometimes prosecuted for money laundering, much of the burden of the anti-money laundering (AML) regime falls on banks and other financial institutions. These institutions have obligations to perform due diligence on prospective clients—especially those clients with attributes suggesting high risk—and to report suspicious transaction to the government. Financial institutions can be held liable for failing to fulfill these obligations, and in some cases for their complicity in money laundering schemes. Yet many advocates believe that the current AML framework is not stringent enough, and have called for reforms that would impose additional obligations, and potential liabilities, on the financial institutions that handle clients and transactions that pose a high money laundering risk.

Banks and other skeptics often resist these reforms, arguing not only that the various proposals will do little to reduce money laundering, but also that more stringent AML regulations will lead to a phenomenon known as “de-risking.” This piece of industry jargon refers to the practice of ending or avoiding relationships with individuals or businesses perceived as “high risk” for money laundering. Of course, we want banks to eschew an individual client or transaction with characteristics that suggest a high probability of money laundering. But when banks and others warn about de-risking, they are referring to a phenomenon in which banks refuse to do business with broad categories of clients – for instance, those from particular countries or regions, or in specific lines of business – despite the fact that most of the individuals or firms in that category do not actually present a serious money laundering risk. If the monitoring costs and legal risks associated with certain kinds of accounts are too high relative to the value of those accounts, the argument goes, it’s easier for banks to simply close all of the accounts in the “de-risked” category. But this indiscriminate closure of allegedly risky accounts cuts off many deserving people, firms, and organizations from much-needed financial services.

Is de-risking really a significant problem? Skeptics might observe that the financial industry has incentives to resist more stringent AML regulation, and their warnings of de-risking may be, if not deliberately pretextual, then at least self-serving. That said, other actors, including non-profit groups, have alleged that they have experienced account closures due to de-risking. So the concern is likely a real one. Still, to set rational AML policy, we would want to know not just whether de-risking is a potential problem (it is) or whether it occurs sometimes (it probably does); we would want to know whether it is a systematic and serious problem, one that would likely be exacerbated by a significant enhancement of banks’ AML obligations.

So, what do we know about the extent and magnitude of de-risking in response to AML regulations? The short answer is: not much.

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The Case Against High-Denomination Bank Notes

Although the use of cash continues to decline in both the legitimate and illicit economies, lots of criminal transactions, including bribe payments, still use cash—slipped into pockets or envelopes, or carried in briefcases and suitcases. The anonymity, untraceability, and universal acceptance of cash make it useful for many types of criminal activity, including not only corruption, but also drug trafficking, human trafficking, and terrorism. Cash is also indispensable to money laundering, because it both obscures the source of funds and enables money to flow undetected across borders. (As a Europol report observed, “[a]lthough not all use of cash is criminal, all criminals use cash at some stage in the money-laundering process.”) Indeed, as governments and banks increasingly scrutinize electronic transactions, parts of the illicit economy will embrace cash all the more.

Nobody seriously argues for eliminating cash entirely. But there is a simple step that monetary authorities can and should take to make cash-based criminal transactions substantially harder, without substantially impinging on the legitimate cash-based economy: eliminate high-denomination notes.

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Improving Anti-Money Laundering Models with Synthetic Data

As readers of this blog are well aware, an effective anti-money laundering (AML) regime is crucial for fighting grand corruption, as well as other organized criminal activity. A key part of the AML system is the requirement that banks and other financial institutions identify suspicious transactions and file so-called suspicious activity reports (SARs) with the appropriate government agencies. This is an enormous task, given the volume of financial transactions that banks need to monitor and the challenge of identifying which of those transactions ought to be considered suspicious. Banks spend billions on AML compliance every year, and have developed complex automated systems to assist them in flagging suspect transactions, but existing systems’ ability to efficiently sort suspicious from innocent transactions is limited by the sheer complexity of the task. (False positive rates with current systems, for example, frequently top 90%.)

Many believe that artificial intelligence (AI) systems, such as those employing machine learning (ML), hold enormous promise for improving AML compliance and reducing cost. ML algorithms scrutinize vast datasets to identify patterns that can be used to fashion predictive models. In the AML context, ML algorithms identify those transaction characteristics (or complex combinations of transaction characteristics) that are associated with money laundering, and use these patterns to more efficiently and effectively identify suspicious transactions.  

But some commentators have suggested reasons for skepticism, or at least caution. For example, Mayze Teitler recently wrote on this blog about a number of challenges to operationalizing AI-derived algorithms in the AML context, primarily those arising from limitations in the data on which those algorithms are based. As Mayze correctly pointed out, ML algorithms require vast datasets from which to learn, and the data demands are compounded by the relatively rarity of known money laundering cases in the existing datasets.

Despite these concerns, I am more bullish than Mayze regarding the promise of AI-based AML systems. Many of the challenges and concerns regarding the development of effective AI systems in the AML context can be overcome through the use of synthetic data.

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ML for AML: Is Artificial Intelligence Up to the Task of Anti-Money Laundering Compliance?

Fighting corruption—especially grand corruption—requires effective anti-money laundering (AML) systems capable of efficiently and correctly flagging suspicious transactions. The financial institutions responsible for identifying and reporting suspicious transactions employ automated systems that identify transactions that involve certain red flags—characteristics like transaction amount, location, or deviation from a customer’s typical activity; when the automated system flags a transaction, this triggers further review. But—given the ever-increasing volume and complexity of financial transactions that occur each day, as well as the increasing sophistication of kleptocrats, criminal groups, and others in disguising their illicit activities to avoid the usual red flags—picking out the genuinely suspicious transactions can be extraordinarily difficult. Even the cleverest compliance system designer couldn’t hope to incorporate every potential red flag into the automated system.

The need to stay one step ahead of the bad actors has fueled greater interest in how new advances in data processing technology may help make automated suspicious transaction detection systems more effective. Techno-enthusiasts are particularly interested in deploying deep learning artificial intelligence (AI), as well as classic algorithms that fall under the machine learning (ML) umbrella, in the AML context. ML and AI systems extract patterns from training datasets, and “learn” (by induction) what data patterns are associated with particular identifiable categorizations. Email spam filters provide a simple example. A spam filter, which can be created to conduct a process known as classification, sorts input variables into two categories: “spam” and “not spam.” It makes its categorization based on individual characteristics of the emails (such as the sender, body text, etc.). In the AML context, the idea would be to train an algorithm with data on financial transactions, so that the system “learns” to identify suspicious transactions even in cases that might lack the usual red flags that a human designer would program into an automated system. Advocates hope that ML/AI systems could be used both to filter out the false positives (transactions which are flagged as suspicious but turn out, on review, not to raise any concerns—an estimated 99% of all flagged transactions), while also identifying unusual, potentially fraudulent behavior that may be overlooked by human regulators (false negatives). Indeed, industry experts are understandably enthusiastic about AI systems that will cut costs while improving accuracy, and proponents claim that “AI holds the keys to a more efficient and transparent AML stance[,]” urging that “[b]anks must take hold of this new [AML] weapon[.]”

To the extent that AI tools can improve upon the admittedly-clunky automated systems currently in use, it could be a step forward. But ML/AI systems have a less than stellar track record in other contexts, and a model targeted at AML compliance presents some unique challenges.

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New Paper: “A Proposal for a Global Database of Politically Exposed Persons”

My former student (and former GAB contributor) Ruta Mrazauskaite and I have a new paper, in the Stanford Journal of International Law, entitled “A Proposal for a Global Database of Politically Exposed Persons.” Here’s the abstract:

As part of the global effort to combat public corruption, anti-money laundering laws require financial institutions and other entities to conduct enhanced scrutiny on so-called “politically exposed persons” (PEPs)–mainly senior government officials, along with their family members and close associates. Unfortunately, the current system for identifying PEPs–which depends entirely on a combination of self-identification, in-house checks, and external private vendors that rely on searches of publicly available source material–is both inefficient and in some cases inaccurate. We therefore propose the creation of a global PEP database, organized and overseen by an inter-governmental body. This database would be populated with data compiled by national governments, drawing primarily on the data those governments already collect pursuant to existing.financial declaration systems for public officials. A global PEP database along the lines we propose has the potential to make PEP identification more accurate and more efficient, reducing overall compliance costs and allowing compliance resources to be used more productively.

I hope readers will find the paper and the proposal to be of interest, and we welcome comments, criticisms, and further ideas about how to address the problem that our proposal is meant to ameliorate.

It’s Not Just the Corporate Transparency Act: Other Reasons To Welcome the Passage of the U.S. NDAA

Last week I posted about the Corporate Transparency Act (CTA), the new law requiring companies to provide the government with information about their ultimate beneficial owners. The CTA, which was passed (over President Trump’s veto) as part of the National Defense Authorization Act (NDAA), has been getting a lot of attention in the anticorruption and anti-money laundering (AML) community, and rightly so. The product of decades of tireless and shrewd advocacy, the CTA—despite its limitations and imperfections—will make it substantially harder for kleptocrats, terrorists, organized crime groups, and others to abuse corporate structures to facilitate their crimes and hide their loot. But the CTA is not the only part of the NDAA that may have a substantial positive impact on the fight against corruption and money laundering. And while it’s entirely understandable that most of the attention (and celebration) in the anticorruption community has focused on the CTA, I wanted to use today’s post to highlight several other provisions in the NDAA that may also prove important in combating corruption and money laundering. Continue reading

It’s Time for the United States to Mandate Enhanced Scrutiny of Domestic Politically Exposed Persons

In February, former Baltimore mayor Catherine Pugh became the latest in the long line of Maryland politicians sentenced to prison for corruption-related crimes. According to the Department of Justice, Pugh sold copies of a self-published children’s book series to a variety of local organizations that already had or were attempting to win contracts with the city and state governments. Over eight years, Pugh and her longtime aide failed to deliver, re-sold, and double-counted the orders, squirrelling away nearly $800,000 into bank accounts belonging to two shell corporations registered to Pugh’s home address. Pugh, who did not maintain a personal bank account, used the funds to purchase and renovate a private home as well as fund her re-election campaign, among other activities.

These facts are classic red flags in the anti-money laundering (AML) world. Pugh would have had more difficulty executing this corrupt scheme, and might have been brought to justice much earlier, if the banks handling her illicit revenues had conducted the sort of enhanced customer due diligence and monitoring that financial institutions are required to perform on so-called “politically exposed persons” (PEPs), as well as their immediate family and close associates. While there is no uniform definition, PEPs are typically understood to be someone who holds a powerful government position, one that provides greater opportunities for engaging in embezzlement, bribe-taking, and other illicit activity. (Defining a PEP’s “close associates” is more challenging, but the category is generally thought to include someone like Pugh’s aide, who has the requisite status and access to carry out transactions on behalf of the PEP.) But U.S. financial institutions were not required to subject Pugh or her aide to enhanced scrutiny, because under the U.S. AML framework, such scrutiny is only obligatory for foreign PEPs, not domestic PEPs.

For many years, that was the standard approach internationally. But a new consensus is emerging that financial institutions should subject all PEPs, both domestic and foreign, to enhanced scrutiny. This position has been embraced by the Financial Action Task Force (FATF), the international body which sets standards for combating corruption in the international financial system, by the Wolfsberg Group, an association of the world’s largest banks, and by the European Union’s Fourth AML Directive. But far from joining the growing tide of domestic PEP screening, the United States seems to be swimming against it. The United States is one of the few OECD countries that does not require domestic PEP screening, and this past August, the Financial Crimes Enforcement Network (FinCEN), the primary U.S. agency tasked with investigating financial crimes, reiterated that it “do[es] not interpret the term ‘politically exposed persons’ to include U.S. public officials[.]”

This is a mistake. It’s time that the United States joined the international consensus by formally requiring enhanced scrutiny of domestic PEPs as well as foreign PEPs. Continue reading