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.

NY Fed President Calls for “Aggressive Action” for LIBOR Transition

Federal Reserve Bank of New York President William C. Dudley argued that “aggressive action” is needed across the financial industry to address market-wide issues concerning the global market transition away from LIBOR.

In his remarks at Bank of England’s Markets Forum, Mr. Dudley expressed concern over “the great uncertainty over LIBOR’s future and the risks to financial stability that would likely accompany a disorderly transition to alternative reference rates.” He stated, “we need aggressive action to move to a more durable and resilient benchmark regime.”

Mr. Dudley recounted the history and other factors that led to the need for the global markets to transition away from LIBOR. He emphasized that this transition represents a significant risk for firms “of all sizes,” which should actively manage the risks in a way that is commensurate with their exposures.

Mr. Dudley emphasized the important role of the official sector, including the Federal Reserve and the Financial Stability Board, in the development of reference rate principles, convening private sector participation and supplying robust alternative reference rates. He recognized the progress made by market participants acting through the Alternative Reference Rates Committee to identify a more robust U.S. dollar reference rate and to develop a plan for an orderly transition, including best practices in contract design. Mr. Dudley opined that “LIBOR is likely to go away – and it should,” but noted that there are those with a direct interest in LIBOR, “such as its administrator,” who support the “status quo.”

President Trump Imposes Additional Sanctions on Venezuela

President Donald J. Trump issued an Executive Order (“E.O”) prohibiting certain financial transactions with the government of Venezuela. President Trump cited the Maduro regime’s recent activities, which include “attempts to undermine democratic order by holding snap elections that are neither free nor fair” – a reference to the presidential elections held on May 20.

The transactions prohibited by the E.O. include, among others, any dealings in the United States or by U.S. persons related to:

  • the purchase of debt owed to the Government of Venezuela, including accounts receivable;
  • debt owed to the Government of Venezuela that, after the effective date of the E.O., is pledged as collateral, including accounts receivable; and
  • the sale, transfer, assignment or pledging as collateral by the Government of Venezuela of any equity interest in which the Government of Venezuela has 50 percent or greater ownership interest.

As with previous Venezuela-related Orders, including E.O. 13692, E.O. 13808 and E.O. 13827, the “Government of Venezuela” is defined broadly to cover not only political subdivisions and agencies, but also companies and other entities – including the state-owned oil company Petroleos de Venezuela S.A. (“PdVSA”) – that are owned or controlled by, or acting for or on behalf of, the Government of Venezuela.

CFTC and UK Financial Conduct Authority Sign FinTech Collaboration Arrangement

The CFTC and the UK Financial Conduct Authority (“FCA”) signed an agreement to facilitate collaboration, share information and support each other’s FinTech initiatives. This is the first FinTech arrangement for the CFTC with a non-U.S. counterpart.

The “Cooperation Arrangement” is primarily focused on the agencies’ respective FinTech initiatives, specifically the CFTC’s “LabCFTC” and the FCA’s “Innovate” programs. The regulators agreed to a framework for the exchange of information on businesses who participate in the programs, trends and developments in FinTech, regulatory issues surrounding FinTech development, best practices for engaging with innovators, and the activities of organizations that promote innovation. The regulators further committed to referring FinTech businesses to each other when such businesses are interested in operating in the other regulator’s jurisdiction. They also agreed to a variety of other measures intended to foster their mutual understanding of technology. The FCA and CFTC will host a joint event in London to facilitate FinTech firms’ engagement with both regulators.

CFTC Chair J. Christopher Giancarlo spoke of the groundbreaking nature of the arrangement: “This is the first FinTech innovation arrangement for the CFTC with a non-U.S. counterpart. We believe that by collaborating with the best-in-class FCA FinTech team, the CFTC can contribute to the growing awareness of the critical role of regulators in 21st century digital markets.” FCA Chief Executive Andrew Bailey agreed, saying, “As our first agreement of this kind with a U.S. regulator, we look forward to working with LabCFTC in assisting firms, both here in the UK and in the U.S., who want to scale and expand internationally in our respective markets.”

Lofchie Comment: Regulators cooperating with each other to better understand markets and products and to prepare for change is a far better approach than fighting over jurisdiction or shutting down change.

U.S. Banking Agencies Support Finalization of International Capital Standards Reforms

The Basel Committee’s oversight body, the Group of Central Bank Governors and Heads of Supervision, finalized reforms to the Basel III international capital standards. The reforms’ key elements include revisions to (i) the standardized approach for credit risk, (ii) the standardized approach for operational risk, (iii) the internal ratings-based approach for credit risk, (iv) the credit valuation system framework, and (v) the measurement of the leverage ratio and a leverage ratio buffer for global systemically important institutions. In addition, the reforms will modify the floor for calculating banks’ risk-weighted assets that are generated by their internal models. The final standards text detailing the reforms and a summary document containing short descriptions were made available by the Basel Committee.

In an interagency release, U.S. banking agencies (the Board of Governors of the Federal Reserve Board, the FDIC, and the Office of the Comptroller of the Currency) expressed support for the final reforms. The agencies explained that the reforms “are intended to improve risk sensitivity, reduce regulatory capital variability, and level the playing field among internationally active banks.” The agencies will assess how to appropriately apply the reforms in the United States and propose any changes through the standard rulemaking process.

European Commission Recognizes U.S. DCMs and SEFs as “Equivalent”

The European Commission (“EC”) announced a decision recognizing certain CFTC-regulated DCMs and SEFs as “eligible for compliance” with EU trading obligations for certain derivatives. CFTC staff recommended that the CFTC adopt a similar order exempting EU-authorized trading facilities from U.S. registration requirements. The decisions follow the recent agreement between the CFTC and EC to adopt a “common approach” to derivatives trading on certain platforms.

According to the EC, this recognition will allow for EU counterparties to trade derivatives on CFTC-authorized designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) based in the United States. In accordance with the decision, traders will be able to use U.S. trading platforms for such transactions even as MiFID II (and its derivatives trading obligation) becomes applicable on January 3, 2018. The trading obligation will require certain derivatives transactions to be executed on EU venues or venues designated as equivalent by the EC. The European Commission noted that its decision does not affect the ability of EU counterparties to trade on CFTC-regulated DCMs and SEFs with respect to derivatives that are not subject to the EU trading obligation.

CFTC Chair J. Christopher Giancarlo urged his fellow commissioners to “act expeditiously in approving” an exemptive order for EU trading facilities. CFTC Director of the Division of Market Oversight Amir Zaidi added that the CFTC is “close behind” with its own order.

Lofchie Comment: This is a significant success. CFTC Chair Giancarlo had, at once, both reached out to the Europeans in regard to the mutual acceptance of “comparable regulations” and cautioned the Europeans against imposing regulatory requirements that would disadvantage U.S. financial intermediaries.  See CFTC Chair J. Christopher Giancarlo Criticizes “EU Plan to Invade U.S. Markets.”

OFAC Updates FAQs on Venezuelan Economic Sanctions

The U.S. Treasury Department (“Treasury”) Office of Foreign Assets Control (“OFAC”) published two Frequently Asked Questions (“FAQs”) related to economic sanctions against Venezuela.

The first FAQ (No. 547) discusses U.S. person participation in meetings concerning the restructuring of Venezuelan and Petroleos de Venezuela, S.A. (“PdVSA”) debt that existed prior to the effective date of Executive Order 13808 (“E.O. 13808”). The second FAQ (No. 548) addresses the treatment of PdVSA subsidiaries under E.O. 13808.

As previously reported, E.O. 13808 – issued on August 24, 2017 – levied restrictions to prevent U.S. persons from contributing to the Government of Venezuela’s “shortsighted financing schemes.” With certain exceptions reflected in four General Licenses issued by OFAC on the same date, E.O. 13808 generally restricted transactions with respect to the following:

  • new debt with a maturity of longer than 90 days of PdVSA (Venezuela’s state-owned oil and natural gas company);
  • new debt with a maturity of longer than 30 days, or new equity, of the Government of Venezuela;
  • bonds issued by the Government of Venezuela before the effective date of the Executive Order;
  • dividend payments or other distributions of profits to the Government of Venezuela from any entity owned or controlled, directly or indirectly, by the Government of Venezuela; and
  • purchasing securities, directly or indirectly, from the Government of Venezuela, other than new debt with a maturity of less than or equal to 90 days (for PdVSA) or 30 days (for other Government of Venezuela debt).

CFTC Chair J. Christopher Giancarlo Criticizes “EU Plan to Invade U.S. Markets”

CFTC Chair J. Christopher Giancarlo warned of the potential negative effects of European regulatory changes on U.S. financial markets.

In an Opinion/Commentary in The Wall Street Journal, Chair Giancarlo argued that as a result of Brexit pushing London financial markets outside of the European “regulatory umbrella,” the European Commission is proposing to delegate regulation of non-European Union entities to the European Central Bank (“ECB”) and the European Securities and Markets Authority (“ESMA”). Chair Giancarlo is concerned that U.S. financial institutions would now be subject to European regulatory oversight. In particular, he is concerned about potential European Commission regulations that might allow ESMA to conduct on-site inspections of U.S. businesses, like the Chicago Mercantile Exchange, without informing the CFTC.

Chair Giancarlo asserted that such regulatory measures would negatively affect U.S. markets, and potentially “dry up the capital necessary for growth and job creation.” Chair Giancarlo argued that “overlapping” regulation inhibits growth, and said that U.S. acceptance of European regulation would represent a “dangerous precedent.” The “rules-based” European approach contrasts with the “principles-based” U.S. approach, he said, and so any imposition of additional burdens is the “last thing” that the American economy needs.

Lofchie Comment: Not so long ago, CFTC Commissioners were imagining the adoption of U.S. regulations that would have required the rest of the world to acquiesce. CFTC Commissioner Chilton Delivers Speech before International Regulators Conference (with Lofchie Comment). The current Chair is now left to see if peace can be made.

OCC Provides Guidance for Federal Branches and Agencies of Foreign Banks

The Office of the Comptroller of the Currency (“OCC”) updated two documents providing guidance for OCC-supervised branches of foreign banking organizations (“FBOs”): (i) a paper titled The OCC’s Approach to Federal Branch and Agency Supervision (the “paper”), and (ii) the “Federal Branches and Agencies” booklet of the Comptroller’s Licensing Manual. The paper replaces a document from October 8, 2014, while the booklet is an update of a document previously issued in July 2015.

With the passage of the International Banking Act (“IBA”) of 1978, FBOs could opt to conduct banking operations through a branch or agency licensed by the OCC. Such licensed entities are known as “federal branches and agencies.” FBOs acting through federal branches and agencies generally have the same rights and responsibilities as national banks operating at the same locations and are subject to the same laws, regulations, policies and procedures that apply to national banks. There are important differences, however, between an FBO and a full-service bank with respect to OCC supervision.

The paper gives an overview of OCC regulatory practices with regard to FBOs. The OCC International Bank Supervision group of the Large Bank Supervision Department is responsible for the supervision program for these entities. The paper explains the supervisory approach for federal branches and agencies, including a “multifaceted” risk assessment process that takes into account the impact of the parent bank on each supervised entity. Supervision also includes onsite and offsite monitoring, cross-border coordination with home country regulators, and clear communication of examination results. The paper also includes a discussion of resolution and recovery planning, as well as of licensing processes.

The booklet includes all OCC policies and procedures for establishment, operations, and other activities for the federal branches and agencies of FBOs. It provides information regarding establishing branches or agencies, acquisitions, the conversion or contraction of operations, relocations, fiduciary powers, voluntary liquidation, and other relevant topics.

SEC Provides Relief Related to MiFID II Research Payment Provisions

The SEC issued three no-action letters to enable market participants to comply with the research provisions of MiFID II while complying with the applicable requirements of U.S. securities laws. MiFID II is due to come into effect on January 3, 2018. The issues addressed by each letter arose because investment advisers subject to MiFID II (“MiFID Managers“) will be required to separate out payments for research from commissions they pay broker-dealers for execution services.

1. Relief for Broker-Dealers from Regulation as Investment Advisers. The Division of Investment Management issued a letter permitting broker-dealers to receive cash payments for research services from MiFID Managers without being subject to regulation as “investment advisers” under the Investment Advisers Act of 1940 (the “Advisers Act“). The relief is required, as such cash payments may constitute “special compensation” for advisory services that may cause a broker-dealer to fall outside the scope of the broker-dealer exclusion from the definition of “investment adviser” in Section 202(a)(11)(C) of the Advisers Act.

The relief applies both where a MiFID Manager pays for research from its own account, and from a separate MiFID-qualifying “research payment account” (an “RPA“), which is an account funded with client money for the purpose of paying for research. Further, the relief extends to payments by non-EU managers that are contractually required to comply with the research payment provisions of MiFID II (e.g., a non-EU sub-adviser appointed by a MiFID Manager). The Division granted the relief for 30 months from the implementation of MiFID II.

2. Aggregation of Orders by Investment Advisers. The Division of Investment Management issued a second letter permitting investment advisers to aggregate client orders if clients pay the same pro rata share of execution costs, even if they pay different amounts for research. Under prior guidance, the SEC permitted investment advisers to aggregate client orders where clients shared all transaction costs (which could include research costs) on a pro rata basis. As MiFID II will result in different clients paying different sums for research, the SEC relief limits the cost-sharing requirement to execution costs. The letter requires investment advisers to implement specified policies and procedures to ensure that they otherwise aggregate (and subsequently allocate) client orders fairly.

3. Reliance on Section 28(e) Safe Harbor by Advisers Making Cash Payments for Research with Client Funds. Section 28(e) of the Exchange Act establishes a safe harbor that permits investment advisers to use client funds to purchase “brokerage and research services” for their managed accounts without breaching their fiduciary duties to clients. The Division of Trading and Markets issued a letter to permit a MiFID Manager to use client funds to make payments for research through a client-funded RPA in reliance on Section 28(e). The relief was requested because Section 28(e) arrangements typically contemplate that an investment adviser will make a single “bundled” commission payment to a broker-dealer to cover both execution and research services. Under MiFID II, a MiFID Manager will be required to make separate payments for execution and research services, and retain control of any RPA account used to make payments for research services with client money. The letter acknowledges that, notwithstanding these different payment mechanics, a MiFID Manager should be permitted to rely on Section 28(e) provided the executing broker-dealer is contractually obligated to pay for research through use of an RPA, and the arrangement otherwise meets the requirements of Section 28(e).

While SEC Chair Jay Clayton said that the relief represents a “measured approach” that allows U.S. market participants to comply with MiFID II without significantly changing the U.S. regulatory approach, Commissioner Kara Stein argued that the relief merely “kicks the can down the road” without addressing key policy questions regarding the U.S. approach to the transparency of fees relating to research and trading.

Lofchie Comment: Notwithstanding Commissioner Stein’s comment as to kicking the can down the road, kudos to Chair Clayton for adopting a fairly long-term no-action letter that gives both regulators and market participants an opportunity to see what the effects of the MIFID rule changes might be, whether the U.S. rules should be changed, and, if so, what those rule changes should be. It is a waste of Commission and industry resources to adopt short-term no-action letters that must be continually renewed. While thirty months may seem a long time, the reality is that the SEC still has significant Dodd-Frank rulemaking on its plate, as well as numerous other issues that are also pressing, such as market structure and corporate disclosure.

Further, it should be pointed out that the SEC issued the no-action letters because the Europeans have adopted regulations that are inconsistent with the U.S. Securities Exchange Act. While Commissioner Stein is right in asserting that Section 28(e) of the Securities Exchange Act may not be good public policy, there are very good arguments to be made that it is; i.e., that the Section encourages the production of investment research. This is the determination that Congress made when it adopted the statutory provision. If the determination seems no longer correct, then, at least insofar as U.S. market participants are concerned, it is the U.S. Congress that should reverse the determination, not the Europeans.