United States: Attempted Judicial Review of The FSA Fails - Continued

Although implementation of the Second Money Laundering Directive of 2001 in the form of the 2003 Money Laundering Regulations has been delayed, the year to date has seen radical developments in anti-laundering laws and rules. The PROCEEDS OF CRIME ACT 2002 (PART 7) (POCA)

More than eight months after POCA came into force on 24 February 2003, it continues to have a significant impact on financial institutions, particularly as a result of the uncertainties which the legislation has caused. Furthermore, since everyone is now judged by an objective test of whether they ought to have known or suspected the existence of money laundering, facing criminal liability if they get it wrong, the pressure is intense.

Pending interpretation by the Court of certain sections of Part 7 of POCA, advice in respect of the provisions can be but cautious.

POCA is primarily a consolidation of existing legislation concerning money laundering, but creates three new specific offences in relation to criminal property, two offences of aiding and abetting the commission of these new offences and a specific offence of "failure to disclose" for anyone working in the regulated sector (i.e. carrying on a regulated activity under FSMA 2000 or by virtue of various European Directives). The principal offences are:

• concealing, disguising, converting, transferring or removing criminal property (see below) (section 327);

• arranging or becoming concerned in an arrangement which a person knows or suspects facilitates (by whatever means) the acquisition, retention, use or control of criminal property by or on behalf of another person (section 328);

• acquiring, using or coming into possession of criminal property (section 329).

In addition, any attempt, conspiracy or incitement to commit any of these offences and aiding, abetting, counselling or procuring the commission of these offences will constitute money laundering. A person committing a relevant offence may be fined, or imprisoned for up to 14 years.

Definitions of criminal conduct and criminal property under POCA are very wide.

Criminal conduct is conduct which:

1. constitutes an offence in any part of the UK; or
2. would constitute a criminal offence in any part of the UK if it occurred there (section 340(2)).

It is not clear how the second limb of the definition will be interpreted, and whether an act carried out lawfully in a foreign jurisdiction but which, if carried out in the UK, would constitute a criminal offence under English law, would be caught by the definition of criminal conduct. For the time being the provision must be interpreted to mean just that.

Criminal property. Property is criminal if:

1. it constitutes a person’s benefit from criminal conduct or it represents such a benefit (in whole or in part and whether directly or indirectly), and
2. the alleged offender (i.e. the person alleged to have committed an offence under POCA) knows or suspects that it constitutes or represents such a benefit (section 340(3)).

The focus is on the property itself. It is immaterial who carried out the conduct which yields the property and who benefited from it (section 340(4)).

Property is defined as all property wherever situated and includes money, all forms of property (including real and personal), all things in action and other intangible or incorporeal property (section 340(9)).

If a person obtains a pecuniary advantage as a result of or in connection with conduct, he will be deemed to have received property (namely, a sum of money) equal to the value of the pecuniary advantage (section 340(6)). The definition of pecuniary advantage is also drafted very widely and appears to be aimed at depriving an offender of any legitimately earned profits that originated from criminal conduct in addition to the proceeds obtained in connection with the conduct.

Prior to POCA, in the case of R v. Moran [2002] 1 WLR 253, a market trader had failed to declare the full extent of his profits earned in his tax return. The Court of Appeal held that the offender’s pecuniary advantage (as the term appeared in the Criminal Justice Act 1988) extended to his unpaid tax together with interest, but it did not extend to the balance of the undeclared profits which were the product of lawful trading. Section 340(7) appears to be drafted to counter the interpretation given to the term "pecuniary advantage" in the Moran case.

Section 340(7) provides that references to both property and pecuniary advantage obtained in connection with conduct (e.g. tax evasion) include references to property and to pecuniary advantage obtained in that connection (i.e. the tax evasion) and some others (e.g. the profits earned from a legitimate investment of the sum that would have otherwise been paid in tax but for the tax evasion).

It should be noted that in order for property to constitute criminal property, it must constitute the benefit from such conduct. However, a person need not realise profit from criminal conduct in order for the results thereof to constitute a benefit for the purposes of section 340(3)(a) and (b). A person benefits from conduct if he obtains property as a result of or in connection with the conduct (section 340(5)) and such person’s benefit is the value of the property obtained (section 340(8)) as a result of or in connection with the conduct. Therefore, if a person were to obtain shares in a company by virtue of some fraud or deception, the value of the benefit obtained thereby would be the value of the shares at the time he acquired them and it would not matter if the next day the shares plummeted in value on the open market or if the transfer was annulled. His benefit would still be the value of the shares at the time he acquired them and is not diminished by a diminution in the value of the property at some later stage or by the recovery of the property by the authorities or its rightful owner.

In the above example, the offender would be liable to imprisonment in respect of the crime and also susceptible to having certain of his assets confiscated which equal the value of the Criminal Property notwithstanding the fact that the actual property might have been recovered. Section 9 of POCA allows the ARA to confiscate the "available amount", meaning the total of the values of all the free property then held by the Defendant at the time the order for confiscation is made. It is clearly intended that legitimately acquired property to the value of the benefit will be capable of being confiscated and that the Court should not be restricted to acting against the criminal property itself.

POCA imposes a mandatory requirement on everyone working in regulated business to report known or suspected money laundering. Failure to report may result in a fine, or imprisonment up to five years. An offence is committed by:

• failing to disclose as soon as practicable, information or other matter which has come to the attention of a person, in the course of a business in the regulated sector or otherwise, and which gives rise to knowledge, suspicion or reasonable grounds for suspicion (see below) that another person is engaged in money laundering (sections 330, 331 and 332).

The main defence consists of a reasonable excuse for not making a disclosure, provided the person did not know or suspect, or have reasonable grounds for knowing or suspecting (see below), that there was money laundering and his/her employer did not provide the prescribed training under Regulation 5(1)(c) of the Money Laundering Regulations 1993 (to be replaced by the 2003 Regulations) as provided by the POCA (Failure to Disclose Money Laundering Specific Training) Order 2003.

The duty to disclose covers any attempt or conspiracy to carry out any of the substantive offences (or any aiding or abetting) as they fall within the definition of money laundering.

The required disclosure is to a nominated officer, usually the MLRO or NCIS. It may be necessary for an authorised disclosure to be made before a "prohibited act" occurs, i.e. before any concealing, arranging or acquiring takes place. In that case, it will be necessary to receive appropriate consent (usually from NCIS) before completing any transaction which would amount to a prohibited act. If appropriate consent is received or nothing is heard within seven days ("the notice period"), the transaction can proceed. If consent is refused within the notice period, the transaction cannot safely proceed unless consent is given within the "moratorium period" (31 days from refusal of consent) or the "moratorium period" has expired.

When a person knows or suspects that a formal disclosure has been made about a third party’s potential money laundering activities and then he or she notifies that third party or otherwise makes a disclosure which is likely to prejudice any investigation into potential money laundering activities, that person will be guilty of the tipping off offence.

A person will not commit an offence if he is a professional legal adviser and the disclosure is to a client in connection with legal advice or to any person in connection with legal proceedings or contemplated legal proceedings, but not if made with the intention of furthering a criminal purpose. In P v. P [2003] EWHC 2260 (8 October 2003), the Court stated that unless such a requisite improper intention is present, a solicitor should be free to communicate such information to his client as is necessary and appropriate in connection with the giving of legal advice in actual or contemplated legal proceedings.

As for the mental test or mens rea, knowledge and suspicion are not defined in POCA itself.

Under sections 328, 330-333 and 340, knowing whether another is engaged in criminal conduct and/or whether a transaction involves criminal property appears to mean actual knowledge and not some lesser form or constructive knowledge.

A suspicion as to whether another is engaged in criminal conduct and/or whether a transaction involves criminal property is a much less stringent test. Suspicion is to be found in sections 49 and 50 of the Drug Trafficking Act 1994 and section 93A and 93C of the Criminal Justice Act 1988. Certain commentators have suggested that it simply means "the act of suspecting" and should therefore be a question of fact.

Nevertheless, an alleged offender will need to know or suspect that the property with which he is dealing, or in respect of which he is arranging, or which he is using, is a benefit or represents a benefit obtained from criminal behaviour. Property cannot be criminal property without some form of knowledge or suspicion of its origin in criminal conduct. Furthermore, in sections 328 and 330- 333, it is anticipated that the alleged offender will be one step removed from the actual process of dealing in criminal property. Therefore, in relation to these offences, the alleged offender will also need to know or suspect that the arrangements he is making involve criminal property or that information he has received relates to money laundering or that he might be tipping off someone involved in any investigation.

A requirement for this additional mental element is absent from sections 327 and 329 and would seem to imply that once the requisite knowledge or suspicion arises such that property is criminal property, the offences of concealing and acquisition/use/possession of criminal property become strict ones. In other words, once criminal property exists as defined in POCA, an offence is committed in respect of sections 327 or 329 whether or not the alleged offender knew that at that time he was in fact concealing or acquiring/using/possessing the criminal property.

Finally, it should be noted that under sections 330(2)(b) and 331(2)(b), a reasonableness test is specifically introduced as regards the offence of failing to disclose a transaction which someone knows or suspects or has reasonable grounds to (i.e. ought to) know or suspect involves criminal property. Therefore, negligence may result in criminal liability, although it is not clear how someone could have a reasonable excuse for not making a disclosure about something which they neither knew nor suspected was money laundering.

There is no specific reference to a reasonableness test in respect of the other offences under POCA. Clearly, firms are having to place a greater emphasis on the context and background of/to their clients’ businesses and transactions and on documenting the steps they take, so as not to fall foul of the new law.

In February, the JMLSG published a supplement to the December 2001 edition of its Guidance Notes for the Financial Sector to cover the Proceeds of Crime Act 2002 (POCA) (see above).

A new provision within Part 7 of POCA requires the courts to take into account guidance approved by HM Treasury when considering whether a person within the Financial Sector has committed an offence of failing to report.

In a letter dated 17 July 2002, the Financial Secretary to the Treasury, confirmed that HM Treasury had approved the December 2001 edition of the JMLSG Guidance Notes for the purposes of POCA. Therefore, a court will be obliged to consider whether an individual has followed the Guidance when deciding whether he has committed a failure to disclose an offence.

The purpose of the Guidance Notes is essentially to outline the requirements of the UK Money Laundering Legislation, provide a practical interpretation of the Money Laundering Regulations, set out the requirements of the FSA Money Laundering Rules, Evidential Provisions and Guidance, provide an indication of good generic industry practice and provide a base upon which management can develop tailored policies and procedures appropriate to their business.

Key elements of the supplementary guidance include guidance on the meaning of suspicion and reasonable grounds to suspect, monitoring and reporting procedures, the role of the MLRO and staff training. The supplementary guidance is to be included in the 2003 edition.

The 1993 Money Laundering Regulations were to be replaced in June 2003 by the 2003 Money Laundering Regulations, implementing the Second Money Laundering Directive of 2001. However, at that time the Treasury announced that it was delaying the implementation of the draft 2003 Money Laundering Regulations, in response to requests from industry for more time to implement training programmes and anti-money laundering procedures. The 2003 Regulations will apply, subject to final wording, to those carrying out "relevant business", which is an expanded version of the definition given for "relevant financial business" under the 1993 Regulations.

In considering whether a person is guilty of an offence under the new Regulations, the Court must take into account any guidance issued by a supervisory or other appropriate body, which has been approved by HM Treasury. This brings the new Regulations into line with the provisions of POCA. Under the draft 2003 Regulations, money laundering is an act which falls within section 340 (11) of POCA, which defines money laundering as being an offence under sections 327-329, which create offences relating to criminal property (see above).

It is anticipated that when, in due course, the Regulations are laid before Parliament, there will be a three month implementation period.

In July, the FSA published a briefing note to explain its decision not to require the identification of existing customers by regulated firms.

Last July, certain major banks announced that they would be reconfirming the identity of their existing customers, using a risk-based approach. At that time, the FSA indicated that it would consider requiring regulated firms to review the identity of all their customers who pre-dated FSMA 2000.

However, the FSA has now confirmed that it will not introduce a customer review requirement for all firms to which the 1993 Money Laundering Regulations apply, for various reasons. For example, the existing requirements within the FSA’s Rules and Guidance, oblige firms to maintain adequate systems and controls in order to counter money laundering. Furthermore, the FSA wishes to avoid a disproportionate number of demands being made on customers to verify their identity and increase numbers of suspicious activity reports by way of defensive reporting, at a time when the system for dealing with such reports may be under pressure.

The Financial Action Task Force (FATF) on money laundering published, in June, its revised Forty Recommendations to combat money laundering and terrorist financing.

The original recommendations drawn up in 1990 and amended in 1996, have been endorsed by more than 130 countries and set minimum standards for action by countries to combat the misuse of financial systems by organised crime. The main changes include the expansion of the customer due diligence process for financial institutions, enhanced measures for high risk customers and transactions, the extension of anti-money laundering measures to designated non-financial businesses and professions and new key measures in respect of international co-operation.

FATF has also announced that South Africa and the Russian Federation have been admitted as full members of FATF, following a positive evaluation of their respective systems for combating money laundering and terrorist financing.

In April 2003, the Basel Committee on Banking Supervision issued its final consultation paper on the new Basel Capital Accord (Basel II).

Basel II (which provides for worldwide application) is designed to replace the current 1998 Accord which sought to protect investors and markets by establishing a minimum capital adequacy framework for banks. Whilst Basel II has not been universally well received, there is need for major reform. The current rules for the assessment of credit risk do not provide for different capital requirements based on risk levels, which has encouraged the banking community to pursue more profitable high risk loans at the expense of safer less profitable ones with obvious consequences for loan portfolios and stability in the banking sector. The proposed minimum capital requirements address this situation with some more sophisticated risk assessment techniques by matching the application of capital more closely to the risk level.

However, there remains a potential weakness in regulatory supervision, since it is not yet clear whether the supervisory bodies in different jurisdictions will apply different standards.

The Committee’s consultation paper supersedes its previous publications and sets out the three key pillars on which Basel II is based.

• Minimum capital adequacy requirements: including methods by which credit and operational risk are to be measured. The definition of regulatory capital will remain unchanged, together with the existing minimum capital ratio of 8%. The definition of risk-weighted assets will be modified by changes to the treatment of credit risk and the introduction of an explicit treatment of operational risk (ie the risk of losses resulting from inadequate or failed internal processes or external events).

• Regulatory supervision: a new system is proposed which will provide a process by which banks may assess their overall capital adequacy in relation to their risk profile. Supervisors must review and evaluate banks’ internal capital adequacy assessments and should expect banks to operate above the minimum regulatory capital ratios and require banks to hold capital in excess of the minimum. They will intervene at an early stage in order to prevent capital falling below minimum levels.
• Market discipline: the consultation papers set out a set of disclosure requirements, allowing public assessment of key information about a bank’s risk profile and level of capitalisation.

Meanwhile, the European Commission has published a third consultation paper on the proposed new EU capital framework for banks and investment firms. The Commission’s review forms part of the Financial Services Action Plan (see below) and is taking place in parallel with that of the Basel Committee.

The consultation exercise aims to ensure that the proposed EU Directive on capital requirements, due to come into effect simultaneously with Basel II on 31 December 2006, is of the highest quality. The paper, divided into six sections, deals with matters such as: minimum capital requirements in relation to credit; operational and market risks; the supervisory review process and risk identification measurement and management; disclosure requirements; powers of execution; and transitional provisions.

In July 2003, the FSA issued a consultation paper on the implementation of the new Basel Accord and the EU Adequacy requirements. It sets out the FSA’s proposed approach to the implementation of certain aspects of the revised Accord and the equivalent European Directive on capital requirements.

The new Accord and Directive both allow firms to use internal risk systems to measure their credit and operational risk (the internal ratings based approach for credit risk (IRB) and the advanced measurement approach for operational risk (AMA)).

The FSA’s proposals cover the qualifying criteria for the use of the IRB approach, validation of the IRB approach (ie a mechanism by which a firm ensures that an IRB or similar system is in place producing accurate and consistent results), and technical issues such as the definition of default and the FSA’s approach to "stress" tests.

The FSA will expect firms to apply the standards set out in the Senior Management Arrangements, Systems and Controls section of its Handbook of rules and guidance and to develop policies which allocate responsibility to appropriate officers in order to ensure that there is proper oversight of their respective approaches.

The FSA, the Treasury and Bank of England have published a joint guide to the EU’s Financial Services Action Plan (FSAP). FSAP consists of a series of measures intended to achieve the creation of a single European market in financial services by 2005 for both wholesale and retail markets.

The guide, which was published in July 2003, makes the following statements:

• Integration of the wholesale markets has progressed much faster than in retail financial services, where there are still considerable differences between national markets;

• 36 of the original 42 measures in FSAP have now been finalised;

• The four-level decision-making Lamfalussy process relating to the adoption of EU legislation affecting securities markets, has been applied to the Market Abuse Directive (see above), the Prospectus Directive, the revised Investment Services Directive (see below) and the proposed Transparency Obligations Directive. It is also being extended to legislation on banking, insurance and financial conglomerates;

• FSAP measures should be based on mutual recognition with common core standards and the EU Commission is to attempt to carry out an objective analysis of the costeffectiveness of FSAP measures;

• The FSA, the Treasury and the Bank of England, aim to play a key role in identifying, promoting and overseeing the UK’s interests in financial services in the EU.

Last November, the European Commission published a proposal for a new directive to replace the existing ISD. The timetable envisaged political agreement among the Council of Ministers on ISD II to be achieved by the end of 2003, and for it to be adopted in 2004. The European Parliament has now held its plenary session to debate amendments to ISD II which the Commission approved in July. The agreement of Council must be given by November at the latest if ISD II is to meet its target deadline of March 2004, before the admission of the new member states.

The Commission has spent a very considerable amount of time consulting with market practitioners and regulators on how best to revise the existing ISD. While there has been no change in the objectives, there is a recognition that care must be taken to ensure that the revised ISD does not become ineffective or obsolete as quickly as the original.

The existing legislation enacted in 1993 is considered to be ineffective in light of the far greater number of retail investors, increased cross-border activity, and the proliferation of multi-lateral and alternative trading systems which compete with regulated exchanges. In other words, ISD does not address issues arising from the growth of electronic trading platforms and the competition for trade execution that has arisen among regulated markets, alternative trading platforms and broker-dealers effecting off-market trades. In short, ISD no longer covers all types of investment activities which potentially impact on market integrity and investor protection. Other drivers for change include the fact that ISD does not achieve sufficient harmonisation for the effective conduct of pan-European investment business.

ISD set minimum harmonised standards for the regulation of investment activities by banks and investment firms, creating a Europe-wide "passport" for the conduct of investment activities throughout the EU. It allows banks and investment firms to have access to membership of regulated markets in all member states.

The Financial Services Action Plan (FSAP) (see above), was adopted by the Commission in May 1999 and subsequently endorsed by the European Council, for the purposes of promoting integrated financial markets in Europe. FSAP sets out a series of harmonising measures to be completed by the end of 2005 and in order to speed up progress on implementing the FSAP, the four-level approach set out in the Lamfalussy Report was adopted (see above).

Therefore, European directives in the securities market can take the form of framework legislation, with the Commission having power to make Level 2 measures setting out more detailed provisions on certain aspects of the directives. As described above, in adopting Level 2 measures, the Commission acts on the advice of CESR, composed of high-level representatives of the national securities regulators of each member state.

ISD II extends the list of core investment services requiring a licence, to include investment advice. In addition, operating a multi-lateral trading facility which covers electronic trading platforms has been added as a new core investment activity.

The types of financial instruments covered by ISD II will extend to dealings in commodity derivatives.

A person licensed to conduct the core investment services will also be "passported" to conduct various ancillary activities, including investment research and financial analysis.

In addition, a few changes are proposed to the exemptions from licensing set out in the existing ISD. For example, there will be a new exemption for dealing on own account in financial instruments as an ancillary activity to one’s main business. In addition, an exemption for specialised commodity derivative dealers is also proposed.

Other features include:

• best execution/quote disclosure: broker-dealers will be required to evaluate trading conditions on a variety of markets and employ "smart" routing techniques to execute client orders on the most favourable terms. To this end, large firms will be obliged to disclose prices at which they are prepared to buy and sell shares for their own account in transactions above a certain amount. Small dealers will be excluded, since they are not considered to be a significant influence. The relevant criteria for size of firms and trades are yet to be determined;

• investment advice/research: investment advice, and ancillary services such as financial analysis and research are specifically included in order to prevent conflicts of interest in firms which combine these areas with other activities such as investment banking. This will not apply to firms specialising in independent research and analysis, which are also exempt from capital adequacy limits and may instead rely on professional liability insurance. The conflict requirements are without prejudice to the corresponding measures in the Market Abuse Directive;

• off-market/trading: most controversial is the proposal relating to the practice by which banks and investment firms "internalise" client orders, namely execute client orders off-exchange by arranging transactions directly inhouse between separate parties or for their own account. ISD II proposes that express client consent will be required to execute client orders outside a regulated market or multi-lateral trading facility. Furthermore, where a bank or investment firm has received a client limit order which cannot be properly executed under prevailing market conditions, the terms of the order must be disclosed to other market participants, with a view to facilitating the earliest possible execution of that order. In practice, this means that the order would have to be placed with a regulated market or multi-lateral trading facility. This has been criticised by market participants, because clients who place limit orders are not necessarily looking for prompt execution of the order. The client may be averse to the order being made public at a time when it does not represent the current market practice and is thereby unlikely to be capable of execution onmarket in any event. This requirement is seen as restricting flexibility to handle client orders off-market rather than executing them on-market.

Furthermore, an investment firm dealing in shares traded on a regulated market and representing an important provider of liquidity for the shares in question will be required to make public a firm bid and offer price for a specified retail transaction size in respect of those shares. This will only apply where there is a liquid market for the shares on a regulated market. This equally controversial proposal is viewed by many as unduly constraining the ability of investment firms and banks to deal off-market.

Where banks and investment firms have effected offmarket transactions in shares which are admitted to trading on a regulated market, post-trade transparency requirements will apply whereby the bank or investment firm must make public the volume, price and time at which such transactions are concluded.