The Significant Seven

The draft Fourth Anti-Money Laundering Directive released by the European Commission contains seven significant points in particular that will, if enacted, have the biggest regulatory or practical impact on Scottish legal practices.

As the draft largely follows the revised recommendations of the inter-governmental Financial Action Task Force (“FATF”), you can expect that the vast majority of its provisions will be implemented. It is worth noting that when the Third Anti-Money Laundering Directive was issued, the UK Government implemented stricter compliance levels than were proposed.

The finalised version of the Fourth Directive will become pan-European legislation, with EEA relevance, and will influence the approach to anti-money laundering (“AML”) regulation in countries throughout the world. As the UK Government has already implemented a strict AML regulatory environment, much of what is proposed in the Fourth Directive reflects our current reality. It is worth reading the Directive to refresh yourself on what we have to do and why we have to do it.

When selecting our “Significant Seven”, we have focused mainly on new proposals, but a number of topical points have been usefully restated or strengthened, and some of these have been charted.

At #7: Expansion of the regulated sector

Not all work undertaken by legal practices in Scotland is caught by the AML Regulations. Article 2 states the activities that require to be regulated. The volume of activities has increased, but the addition most likely to impact the work of the profession is the inclusion of “letting agents”.

Estate agents’ services were included in the Third Directive, but letting agents are a new inclusion. If you run either of these services as part of your legal practice, they will be subject to supervision by the Law Society of Scotland (LSS). Otherwise they are supervised by the Office of Fair Trading.

Many practices that provide a range of services (civil and criminal court, property, employment, company, wills, trusts and executries, estate agency and letting) have adopted a uniform policy to all clients. This is a sensible business practice that allows practices to streamline their procedures and avoids time being wasted by staff debating whether or not to apply customer due diligence (CDD) for certain business. But, depending on the mix of business you do, you may decide to apply CDD only to certain types of business and treat existing clients who have not accessed these services before as if they are new clients.

Article 2 also extends who is affected by the legislation in the gambling sector, to go beyond casinos, as is currently the case, to “providers of gambling services”. The suggested threshold where CDD will kick in is a cumulative total of €2,000. Exactly what businesses and types of gambling this extension will affect remains to be seen, but if you act for clients who run “gambling services”, you might want to alert them that they may be caught by this extension to the current AML Regulations.

Article 2 (and article 10) also reduce by half the threshold for when traders in high value goods have to apply CDD, from €15,000 to €7,500 (about £6,000). This will pull a lot more traders into the AML sphere. Traders will require to carry out CDD when they sell goods at a price of over €7,500.

Many practices will have clients who might be caught by this and will appreciate your assistance and guidance. Even if it turns out your clients will not be affected, they will be pleased that you were thinking of them.

At #6: Risk assessment

Early indications are that the identification of risk (article 8) should be slightly less subjective, as better guidance is to be made available on what constitutes high and low risk.

It would appear the Fourth Directive seeks to ensure that risk is to play an increasingly important role in the application of customer due diligence.

An AML policy statement is to be documented and regularly reviewed to ensure that it reflects the changing nature of the practice’s business. This is consistent with current LSS guidance.

However, the inclusion of “an independent audit function to test internal policies, procedures and controls” could have significant repercussions.

In the increasingly strict regulatory environment in which the profession operates, external audit is probably something from which some practices would draw comfort, but how this would be implemented is not yet clear, and the Society will be raising this issue to try to ensure that any measure implemented is proportionate to the size and nature of the businesses likely to be affected.

At #5: Restricting simplified due diligence

The existing rules on simplified due diligence are thought to be too permissive, with certain categories of clients (e.g. listed companies and local authorities) being given outright exemption from due diligence requirements.

Article 13 provides that decisions on when and how to undertake simplified due diligence must be justified on the basis of risk. Simplified due diligence, as we know it, will only be permitted where a transaction is deemed low risk. As beneficial ownership of pooled accounts (i.e. client accounts) has also been removed from the scope of simplified due diligence affected by this change, it may be that the legal profession could see a sharp rise in administration in relation to client accounts.

As well as highlighting any potential issues of client confidentiality that may be caused by this change, the Society will be making representations to try and ensure it does not result in further bureaucracy for the profession.

At #4: Politically exposed persons

The current definition of a PEP (a politically exposed person) is to be extended and subdivided, by articles 18 and 19. PEPs outwith the EU will be known as “foreign politically exposed persons” (“F-PEPs”). PEPs within the EU will be known as “domestic politically exposed persons” (“D-PEPs”).

D-PEPs will include PEPs entrusted with prominent public functions within a member state or working for international organisations. Included in the definition of PEPs are “family members” and “persons known to be close associates” of PEPs.

Currently, the chances of most Scottish legal practices acting for a PEP are small, but when this change comes into effect, the number of transactions you will have to flag as “enhanced”, because the client is a D-PEP, will rise dramatically.

At #3: Beneficial ownership

Under articles 29 and 30, entities (companies, partnerships, executors and other legal entities) will be required to hold information on their beneficial ownership. This will have implications not only for clients of legal practices but for the legal practice itself. The Society will be looking into this further but, provisionally, considers that the provision is disproportionate and that its goals may be achievable through other means.

Depending how it is implemented, this proposal, left unaltered, may impose an unnecessary burden on small, uncomplicated, UK-based entities (e.g. small companies or partnerships), by requiring that they maintain a CDD pack that few regulated practices affected by the directive will accept.

At #2: Record keeping

Articles 29 and 30 also seek to harmonise the AML requirements with other legislation such as that on data protection.

There are potential issues concerning the destruction of documents on which the Society will be seeking clarification in consultation.

At #1: Sanctions

The preamble to the Fourth Directive recognises that the Third Directive was not implemented uniformly or strongly enough across all member states or by all supervisory authorities within member states. Articles 55 to 58 seek to strengthen the overall standard of compliance and enforcement across the board.

Currently, supervisory authorities are empowered to take measures and sanctions that are “effective, proportionate and dissuasive” against firms who breach the national provisions.

Article 56 provides that member states must target systemic failure by regulated firms to carry out their obligations relating to:

• customer due diligence;
• suspicious transaction reporting;
• record keeping;
• internal controls;
• and that such failure is to be met with a range of sanctions including:
• striking off;
• suspension;
• fines: up to 10% of an entity’s turnover in the previous financial year; or for individuals, up to €5m;
• twice the amount of the profits gained or losses avoided because of the breach.

The supervisory authority is directed to take into account a number of mitigating factors, but the bottom line is that practices who ignore their AML obligations will not be allowed to continue to practise.

Practices that have robust systems in place and are trying their level best to comply need not be concerned, as supervisory authorities will not be targeting you. These provisions are targeted at practices who have no coherent policy and procedures in place to ensure that they comply with the key requirements set out in article 56.

Article 58 requires supervisory authorities to have a confidential line for whistleblowers. Firms are required to have an internal, independent channel where employees can report breaches anonymously.

The Society is still preparing its formal response to the draft Fourth Directive. If you have any comments that you would like the Society to take into consideration, please contact either author.

Check out these resources

The text of the draft Fourth Directive can be found at bit.ly/13zzoGq

As firms are required to check all clients against the FATF lists and HM Treasury’s consolidated list, the checker will save them having to spend time and money obtaining electronic searches, and it is certainly a great deal easier and less time consuming than manually searching the FATF and HM Treasury websites.