John O'Donovan, head of banking and finance at Harold Benjamin, highlights the need for CFOs and financial directors to be tight on due diligence when raising funds for a transaction, and avoid pitfalls that could potentially result in disagreements and/or litigation
The recent controversy that UK Chancellor Nadhim Zahawi found himself embroiled in led to some awkward questions being raised by officials in relation to his financial affairs. He has been under pressure to explain the source of unsecured loans reported by his family business in 2018. This has also led to additional questions over his tax affairs and what, if any, offshore structures he may or may not have benefited from.
Clarity and transparency as to where a customer or client has obtained the funds they are using to carry out a transaction or investment are integral to effective anti-money laundering (AML) compliance. This, along with a robust Know Your Customer (KYC) process incorporating adequate customer due diligence and transaction monitoring measures, will help firms protect both their assets and customers. Whilst these requirements and obligations are nothing new to businesses and individuals, the scrutiny of the Chancellor provides a timely reminder of the importance of getting it right.
The most common funding sources are personal savings (particularly for small businesses), friends and family, business loans, angel investors or venture capital. It is of course a fundamental element of client due diligence to understand the nature, background and circumstances of a client or customer. This includes their financial position and an assessment as to whether the transaction or investment contemplated accords with the understanding and analysis of that background and circumstance. The financial circumstances of a client can generally be split into Source of Funds (SOF) and Source of Wealth (SOW).
Once the SOF has been provided it is also important to consider the bank accounts they came from, how long they were held in said account as well as the activity that generated the funds. Where the risks assessed are thought to be higher, it may be prudent to conduct further investigation to confirm the source as well as any further documentary evidence deemed necessary.
When evaluating the SOF it is not just about collecting documents. Consideration needs to be given as to whether the documents support the client’s explanation and if it sounds sensible and feasible. Once a decision is reached it is also important to document the rationale and decision-making process. This way should there be any questions in future from a regulatory body you will be able to show how the SOF was verified and the steps taken to satisfy the requirements.
In higher risk situations or where Politically exposed people are involved it is prudent to evaluate whether the SOW is aligned with the client’s business interests. For example, it is reasonable that the client’s wider wealth has been acquired in the way they have advised? The SOW information provided will give an indication of this. Depending on the client, this evidence may include audited accounts, share registers, property portfolios and other suitable documents of this nature. It should be noted that it is not essential to account and understand all of the client’s assets. The key is to be able to build a rationale and be comfortable as to why they have accrued such wealth and that it was obtained through legal means.
For firms to effectively discharge their obligations in relation to SOF and SOW they should develop and implement suitable KYC measures. Under the risk-based approach to AML compliance recommended by the Financial Action Task Force, the measures should be proportionate to the risk different customers present. But there are certain key components:
Customer due diligence: Firms should establish and verify their customers’ identities requesting a range of identifying information. Firms should also establish the beneficial ownership of customer entities.
Transaction monitoring: Firms should monitor their customers’ transactions for activity that isn’t consistent with their established SOF. In particular, firms should be vigilant for unusual volumes or frequencies of transactions, or transactions with high risk jurisdictions. This should be on-going through the relationship with a customer.
Sanctions screening: Firms must ensure they do not do business with customers that are subject to international sanctions. Accordingly, firms should be prepared to check customer names against the relevant sanctions and appropriate watch lists.
Politically exposed persons: Elected and government officials present a heightened money laundering risk and firms should review their SOF carefully. With that in mind, firms should screen customers as well as their family and close associates to establish their status.
Adverse media: News stories can also be good indicators that a customer’s SOF may warrant AML scrutiny. Firms should monitor for adverse media that involves their customers, this should include traditional screen and print media and online news sources.
AML compliance is an ongoing requirement that requires adequate measures and processes to be in place. Whilst a risk-based approach is advised it is imperative to strike the right balance and be able to demonstrate the steps taken and decisions reached. Failure to do this and not complying with the regulation will cause firms to have more than just awkward questions to answer like the Chancellor.
