House Subcommittee Considers AML De-Risking

The U.S. House Subcommittee on Financial Institutions and Consumer Credit considered testimony regarding the implications of “de-risking,” wherein financial institutions end relationships and close the accounts of “high-risk” clients to avoid legal liability and regulatory scrutiny. The subcommittee noted that de-risking (i) may affect “many legitimate businesses,” (ii) could reduce access by small businesses to financial products domestically, and (iii) could affect the flow of humanitarian aid globally.

Witnesses at the hearing included Michael E. Clements, Director of Financial Markets and Community Investment of the Government Accountability Office (“GAO”); Sue E. Eckert, Adjunct Senior Fellow at the Center for a New American Security; Gabrielle Haddad, Chief Operating Officer of Sigma Ratings Inc.; John Lewis, Senior Vice President of Corporate Affairs and General Counsel at the United Nations Federal Credit Union on behalf of the National Association of Federally-Insured Credit Unions; and Sally Yearwood, Executive Director of Caribbean-Central American Action.

GAO Reports

Mr. Clements based his testimony on GAO reports from February 2018 and March 2018. He stated that Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) regulations have been a factor for some banks in terminating or limiting accounts and closing branches. The February report found that certain geographic areas were more likely to lose bank branches if they were (i) urban and had higher per capita personal incomes and younger populations, or (ii) designated as High-Intensity Financial Crime Areas or High-Intensity Drug Trafficking Areas, or featured higher rates of banks filing suspicious activity reports. According to the February report, approximately 80% of U.S. Southwest border region banks, due to increased BSA/AML oversight, either limited or did not offer accounts to customers considered to be at high risk for money laundering. According to the March report, money transmitters in Haiti, Liberia, Nepal and Somalia (collectively, “fragile countries”) reported a significant loss of banking access and increased reliance on nonbanking channels as alternatives.

The February report urged the Financial Crimes Enforcement Network, the FDIC, the Federal Reserve and the Office of the Comptroller of the Currency to conduct a retrospective review of BSA/AML regulations and their implications for banks. The March report advised the U.S. Treasury Department (“Treasury”) to analyze how “shifts in remittance flows from banking to non-banking channels for fragile countries may affect the Treasury’s ability to monitor for money laundering and terrorist financing.”

Testimony and Recommendations

Mr. Lewis testified that financial institutions may de-risk themselves in response to examiners who go beyond what is required by guidance, or in response to broad law enforcement requests for information about particular types of customers. He said that additional pressure from examiners and the threat of overbroad investigatory demands are both factors in de-risking decisions. Mr. Lewis recommended (i) implementing a “safe-harbor” policy for financial institutions that provides services to high-risk accounts if the financial institutions conduct sufficient scrutiny of the accounts, (ii) educating financial institutions on risk-based review requirements and (iii) amending regulations so that a financial institution is not “the ‘de facto’ regulator of a business.”

Ms. Yearwood recommended that (i) the Treasury continue providing assistance to Caribbean nations (a high-risk region), (ii) regulations be harmonized to better enable small countries with limited capacities to remain compliant, (iii) investments in new technology be made to “level the playing field” and (iv) regulations be recalibrated when they are weighted against smaller economies.

Ms. Haddad recommended (i) improving the sharing of risk information between the private and public sectors to enhance overall transparency, (ii) using third-party providers to conduct assessments of respondent banks’ compliance with global standards, and (iii) using technology to lower AML and other related compliance costs without threatening financial institutions with regulatory backlash.

Ms. Eckert testified that the “de-risking phenomena” restricted financial access for non-profit organizations with “deleterious humanitarian consequences.” Ms. Eckert called for U.S. leadership to ensure the flow of humanitarian funds.

Lofchie Comment: Well-intended rules may have negative consequences. In this case, the potential fines — and the potential for public embarrassment for accepting an account that appears in any way AML-uncertain — far outweigh any ordinary business gain from accepting the account. It is not so clear how the regulators can be very tough on AML failures and at the same time motivate financial institutions to accept accounts that appear in any way AML-risky.

Federal Judge Determines that the CFPB Is “Unconstitutionally Structured”

The U.S. District Court for the Southern District of New York (“S.D.N.Y.”) dismissed Consumer Financial Protection Bureau (“CFPB”) claims based on the determination that the CFPB “lacks the authority to bring [these] claims” because it is “unconstitutionally structured.”

In the Opinion and Order, the S.D.N.Y. disagreed with the en banc holding of the D.C. Court of Appeals (the “Court of Appeals”) in PHH Corp. v. CFPB, which upheld the CFPB’s constitutionality under Title X of the Dodd-Frank Act. Judges Brett Kavanaugh and Karen LeCraft Henderson issued dissenting opinions in PHH Corp., which the S.D.N.Y. partially adopted in its decision. The S.D.N.Y. affirmed that, as stated in Judge Kavanaugh’s Opinion, the CFPB “is unconstitutionally structured because it is an independent agency that exercises substantial executive power and is headed by a single Director.” Furthermore, the S.D.N.Y. adopted Judge Henderson’s dissenting opinion, which argued that the entirety of Title X of Dodd-Frank should be stricken.

The S.D.N.Y. also rejected the argument within the Notice of Ratification (filed on May 11, 2018) that Acting Director Mick Mulvaney’s ratification dismisses any grounds upon which the CFPB’s constitutionality can be questioned. The Notice of Ratification debated that, because President Trump could remove Mr. Mulvaney at will, there are no longer grounds for an argument that the CFPB violates the Constitution’s separation of powers. The S.D.N.Y. stated that the Notice of Ratification failed to “render[] Defendants’ constitutional arguments moot.”

Lofchie Comment: Given the divide between the courts as to the constitutionality of the CFPB, one might ordinarily expect the government to appeal this decision. However, many members of the administration are likely in agreement with the S.D.N.Y. determination that the CFPB is not constitutionally established. It is not certain how the government will react.

That said, there is no justification for giving a single person – the head of the CFPB – such a tremendous amount of power, without subjecting the individual to any checks, whether that be the Presidential power to dismiss the individual, Congressional power to limit the CFPB’s budget, or the power of other Commissioners to dissent to actions taken by the CFPB. Hopefully, the Court’s decision will motivate Congress to improve the structure of the CFPB and to dampen the remarkable and unseemly authority granted to the agency’s head.

Fifth Circuit Strikes Down DOL Fiduciary Rule

On June 21, 2018, the Fifth Circuit issued a mandate finalizing its March 2018 decision vacating the DOL’s 2016 regulation that, among other things, expanded the scope of persons subject to fiduciary obligations (the “fiduciary rule”). The final decision relates to the definition of investment advice under ERISA, and certain related new prohibited transaction exemptions and amendments to existing prohibited transaction exemptions.

The appellants challenged the fiduciary rule on multiple grounds, claiming:

  • inconsistencies between the fiduciary rule and governing statutes;
  • the DOL overreached “to regulate services and providers beyond its authority”;
  • the DOL imposed “legally unauthorized contract terms to enforce the new regulations”;
  • First Amendment violations; and
  • “arbitrary and capricious treatment of variable and fixed indexed annuities.”

The Court’s majority found that (i) the fiduciary rule’s interpretation of “investment advice fiduciary . . . conflicts with the statutory text and contemporary understandings” and (ii) the fiduciary rule failed the “reasonableness test” of Chevron USA, Inc. v. NRDC, Inc. and the Administrative Procedure Act.

In striking down the rule, the Court observed that the fiduciary rule had already had significant negative consequences for both customers and service providers. The Court observed that:

“The Fiduciary Rule has already spawned significant market consequences, including the withdrawal of several major companies . . . from some segments of the brokerage and retirement investor market. . . . Confusion abounds — how, for instance, does a company wishing to comply with the BICE exemption document and prove that its salesman fostered the “best interests” of the individual retirement investor client? The technological costs and difficulty of compliance compound the inherent complexity of the new regulations. . . . It is likely that many financial service providers will exit the market for retirement investors rather than accept the new regulatory regime.”

The DOL did not seek a rehearing of the March 2018 Fifth Circuit decision and did not petition the Supreme Court for certiorari within the relevant time frame. The deadline to file a petition for a writ of certiorari was June 13, 2018.

Lofchie Comment: From the standpoint of securities regulatory policy, this is a good result. It simply makes no sense to have one set of rules apply to the relationship between a broker-dealer and an individual client and another set of rules that applies to the relationship with the individual client’s IRA.

Notably, the Court pointed out that the DOL Fiduciary Rule is a prime example of a well-intended act having negative consequences — in this case, the inability of certain investors to obtain commission-based transactional services because it is no longer worthwhile, given the legal risk, for broker-dealers to provide such services. It is to be hoped that the SEC will likewise consider these unintended consequences as it reviews comments on its Best Interest Requirements. See generally BD Best Interest Requirement; see also memorandum Choose One: Best Interest or Full Service.

SEC Chair Reviews Regulatory Priorities at House Financial Services Oversight Hearing

In testimony before the U.S. House Committee on Financial Services, SEC Chair Jay Clayton outlined priorities for the agency and reviewed recent accomplishments.

Mr. Clayton outlined three key priorities of the SEC: (i) aiding Main Street investors, (ii) being “innovative, responsive and resilient to developments and trends in the markets,” and (iii) improving the performance and management of internal resources and risks through “technology, data analytics and human capital.” These priorities are reflected in the SEC’s Draft Strategic Plan for FY 2018-2022.

Mr. Clayton highlighted notable accomplishments of the SEC since releasing the Fall 2017 Agenda, such as:

  • facilitating capital formation and investment opportunities by (i) simplifying the public capital-raising process, (ii) improving public company disclosure and (iii) monitoring exempt offerings and small-business initiatives;
  • working to correct the SEC’s cybersecurity deficiencies;
  • initiating rulemaking proceedings to enhance and clarify the standards of conduct for broker-dealers and investment advisers;
  • clarifying the application of federal securities laws to digital assets and initial coin offerings;
  • returning a record $1.07 billion to defrauded investors through enforcement actions;
  • monitoring areas that present increased risks for investors;
  • addressing equity market structure issues by (i) proposing a transaction fee pilot in National Market System stocks and (ii) conducting the first SEC roundtable on thinly-traded exchange-listed securities;
  • establishing the Fixed Income Market Structure Advisory Committee to analyze fixed-income markets;
  • progressing toward implementation of the Consolidated Audit Trail;
  • collaborating with the CFTC to harmonize rules governing security-based swaps;
  • improving investor experience by (i) issuing a request for comments on enhancing disclosure by mutual funds, exchange-traded funds and other investment companies, and (ii) adopting a rule to create an optional “notice and access” method for delivering fund shareholder reports;
  • modernizing asset management regulations by (i) working to replace the process of individually-issued exemptive relief for certain exchange-traded funds, (ii) issuing proposed rules, in furtherance of the mandate of the Fair Access to Investment Research Act of 2017, (iii) issuing proposed amendments to the liquidity reporting rules for open-end funds and (iv) revising certain securities-offering and proxy rules to allow business development companies to be treated like public corporate issuers;
  • completing rules mandated by the Dodd-Frank Act; and
  • educating Main Street investors and creating tools to assist them in making informed investment decisions.

President Trump Nominates OFR Director

President Trump nominated Dino Falaschetti to serve as the Director of the U.S. Treasury Department Office of Financial Research.

Mr. Falaschetti is currently the Chief Economist for the House Committee on Financial Services, and served previously as a senior economist on President George W. Bush’s Council of Economic Advisers. He was also a law, economics and finance professor and a corporate finance professional in the private sector.

Treasury Department Researchers Analyze Form PF Data

Researchers at the U.S. Treasury Department’s Office of Financial Research (“OFR”) analyzed information gathered from Form PF and described trends in the activities of private equity funds and their controlled portfolio companies (“CPCs”). As stated in a recent SEC comment request, “Form PF is designed to facilitate the Financial Stability Oversight Council’s (“FSOC”) monitoring of systemic risk in the private fund industry and to assist FSOC in determining whether and how to deploy its regulatory tools with respect to nonbank financial companies.” Investment advisers with greater than $150 million in private fund assets under management are required to provide information on Form PF, such as (i) the funds they advise, (ii) private fund assets under management, (iii) fund performance and (iv) the use of leverage.

The OFR researchers found:

  • borrowing and leverage increased among certain CPCs from 2013 to 2016, which could signal a greater likelihood of default;
  • some CPCs had significant short-term debt exposures, which “should continue to be monitored”; and
  • investment in financial CPCs has shifted toward non-bank entities.

The analysis, published in the OFR Brief Series, stated that the views and opinions of the authors do not necessarily represent the views of the OFR or the U.S. Department of the Treasury.

Lofchie Comment: The report concludes as follows:

“Form PF is not a perfect tool for monitoring trends in the private equity industry. The data collection lacks a long history, and reporting errors persist. Still, the analysis in this brief illustrates that Form PF data can be useful for monitoring basic fund characteristics. . . .”

There is only so much that analysts can do with data that is both limited and flawed. The report itself contains some moderately informative background as to the state of the private equity industry. However, observations such as “if a company borrows more money, then it is more likely to default” do not really add much to the government’s ability to understand financial markets or systemic risk.

The government would be better off scrapping Form PF and trying to understand why the process of creating it went so wrong. This is not intended as a criticism of the report’s authors. It is just the reality of so-so in, so-so out.

CFS Monetary Measures for May 2018

Today we release CFS monetary and financial measures for May 2018. CFS Divisia M4, which is the broadest and most important measure of money, grew by 4.5% in May 2018 on a year-over-year basis versus 4.6% in April.

For Monetary and Financial Data Release Report:

For more information about the CFS Divisia indices and the data in Excel:

Bloomberg terminal users can access our monetary and financial statistics by any of the four options:

3) {ECST} –> ‘Monetary Sector’ –> ‘Money Supply’ –> Change Source in top right to ‘Center for Financial Stability’
4) {ECST S US MONEY SUPPLY} –> From source list on left, select ‘Center for Financial Stability’

Bondi Testimony on SEC Seform

CFS senior fellow Bradley J. Bondi testified before the U.S. House of Representatives Subcommittee on Capital Markets, Securities, and Investment at a hearing entitled, “Ensuring Effectiveness, Fairness, and Transparency in Securities Law Enforcement” on June 13, 2018.

In his testimony and written statement, Brad advocated for transparency and reform from the SEC with respect to the imposition of issuer/shareholder penalties and disgorgement, advised against extending the statute of limitations for SEC enforcement actions, and discussed pending legislation to reform SEC administrative proceedings and to preempt enforcement of certain state securities laws.

Testimony and written statement

Bondi’s CFS Ten-Point Blueprint for SEC Reform

FinCEN Calls Attention to Transactional Red Flags Associated with International Corruption

The U.S. Treasury Department Financial Crimes Enforcement Network (“FinCEN”) issued an advisory describing how corrupt foreign “politically exposed persons” (“PEPs”) access the U.S. financial system. The advisory provides guidance on the (i) risks that U.S. financial institutions face when providing banking services to PEPs and their financial facilitators and (ii) types of suspicious transactions that may trigger reporting obligations under the Bank Secrecy Act.

The advisory includes the following non-exclusive list of red flags that may help identify methods used to hide the proceeds of human rights abuses and other illicit international activities:

  • using third parties when it is not normal business practice;
  • using third parties to shield the identity of a PEP;
  • using family members or close associates as legal owners;
  • using corporate vehicles such as limited liability companies (LLCs) to hide ownership, involved industries or countries;
  • receiving information from PEPs that is inconsistent with publicly available information;
  • transactions involving government contracts that (i) are awarded to companies in a seemingly unrelated line of business, or (ii) originate from or are going to shell companies that appear to lack a general business purpose;
  • documents supporting transactions regarding government contracts that include (i) charges that are higher than market rates, (ii) overly simplistic information or (iii) insufficient detail;
  • payments connected to government contracts that come from third parties that are not official government entities; and
  • transactions involving property or assets expropriated or otherwise taken over by corrupt regimes, including senior foreign officials or their cronies.

The advisory also provides examples of suspicious activities by PEPs and their financial facilitators, such as:

  • moving funds repeatedly to and from countries with which the PEP does not have ties;
  • requesting to use services of a financial institution or a designated non-financial business or profession (“DNFBP”) not normally associated with foreign or high-value clients;
  • holding substantial authority over or access to state assets and funds, policies and operations; and
  • controlling the financial institution or DNFBP that is a counterparty or correspondent in a transaction.

The advisory indicated that FinCEN would update these red flags and typologies in the future, and reminded financial institutions of their obligation to identify suspicious transactions and file suspicious activity reports (SARs) under the Bank Secrecy Act.

Banking Agencies Issue Statement on Enforcement Coordination

The Office of the Comptroller of the Currency, the FDIC and the Board of Governors of the Federal Reserve System (“Agencies”) issued an updated policy statement on coordination among the federal banking agencies during formal enforcement actions. The text of the statement was published in the Federal Register. The statement reflects the recent rescission of the Federal Financial Institutions Examination Council’s Revised Policy Statement on “Interagency Coordination of Formal Corrective Action by the Federal Bank Regulatory Agencies.”

The new statement outlines how a federal banking agency should proceed after deciding to take a formal enforcement action against any federally insured depository institution, depository institution holding company, non-bank affiliate or institution-affiliated party. According to the statement, each agency should first evaluate if the enforcement action relates to any areas that are regulated by other agencies. If it is determined that another agency has an interest in the enforcement action, then the agency proposing to take the action should notify the relevant agency (i) before notifying the party to the action or (ii) when the appropriate official determines that a formal action is expected to be taken. An agency should also share information with the other agency that will enable it to investigate the party.

Additionally, two or more agencies that plan to bring a complementary action are expected to coordinate on the preparation, processing, presentation, potential penalties, service and follow-up of the enforcement action.