July 28th, 2016 By Virtual Paralegal Services

Making it difficult for terrorists to get funding was the mission of the United States Patriot Act of 2001. It paved the way for regulations requiring banks to know their customers. The Know Your Customer (KYC) regulations were also intended to help prevent money laundering by tying customers’ identities to their transactions.

One thing the KYC regulations did not account for was the use of shell companies to accomplish a variety of business goals. That loophole gained media attention when a Panamanian law firm had a massive leak of internal documents which is exposed the business dealings of a number of parties, including noteworthy political figures.

While the connection between offshore companies and politicians drew the most headlines, it didn’t escape notice that countless shell companies incorporated by the firm had dealings with international banks. The banks were allowed to do business with these shell companies without knowing the owners, and subsequently, their customers.

The Due Diligence Rule

The Treasury Department is pursuing methods of increasing financial transparency of legal entities. The goal is to bring the U.S. in line with a global trend against secrecy in financial dealings and financial institutions will soon be required to conform to a Customer Due Diligence (CDD) rule or face penalties.

The Treasury Department says there are six factors that show the importance of CDD:

  1. Assisting law enforcement in financial investigations
  2. Improved counterterrorism and general furtherance of national security
  3. Increased ability of financial institutions to assess and mitigate risk
  4. Improved tax compliance
  5. The establishment of clear and consistent expectations and practices
  6. Generally improved financial transparency of legal entities

The Bank Secrecy Act forces financial institutions to verify the identity of the beneficial owners of shell corporations, as well as any other legal entity customer. Effective July 11, 2016, the CDD rules explicitly apply to:

  • Banks
  • Brokers or dealers in securities
  • Mutual funds
  • Futures commission merchants and introducing brokers in commodities

Note: Institutions affected have until May 11, 2018 to comply with the CDD rules.

Who is a Beneficial Owner?

The concept of beneficial ownership is central to the impact of the new CDD rules. The final rule uses a two-prong system to define who is a beneficial owner. It’s anyone who:

  1. Directly or indirectly owns 25 percent of the equity interests of a legal entity customer
  2. Has significant responsibility to control, manage or direct a legal entity customer

All legal entities are required to identify at least one beneficial owner who exercises control over the entity, regardless of the ownership breakdown of the business. The ownership prong and control prong taken together define the total number of beneficial owners of a specific entity.

The final rule gives financial institutions the right to establish more restrictive thresholds regarding the identification of beneficial owners. Some entities may choose 10 percent ownership as the baseline for the ownership prong. It’s important to recognize that the CDD rules represent the minimum level of information that financial institutions must gather. Depending on the risk assessment policies of a specific company, more information may be required to open an account.

Legal Entity Customers

The CDD requirements apply specifically to legal entity customers. This legal term applies to specific forms of business, including:

  • Corporations
  • Limited liability companies
  • Limited partnerships
  • Any entity created by a filing with a state office
  • Any similar entity formed under the laws of other countries

The term does not apply to sole proprietorships or unincorporated associations.  Why? Those entities have no legal existence separate from the individuals owning them. Application of the legal entity owner designation is logically tied to entities that provide a shield for individual owners.

Reporting Requirements

In many cases, those doing business with a financial institution will be expected to complete a standard certification form. Some institutions will maintain their own forms, incorporating the baseline information required under the CDD rules with any other information deemed necessary by the business. The information provided on the form must be kept current. If a financial institution becomes aware of information that is not compatible with that provided in the form, it’s required to update its records. The banks are expected to maintain the information in a database and use it for compliance with other regulations, including those put forth by the Office of Foreign Assets Control and those necessary for currency transaction reporting.

Customer Due Diligence is about more than just identification. The CDD rule also contains an Anti-Money Laundering (AML) component. The rule requires financial institutions to take steps to understand the nature and purpose of the business relationship with a customer. They are also required to create a customer risk profile when opening an account, and to assess future transactions against that profile. The CDD rule requires banks to report any suspicious activity. Compliance with the rule forces banks and other financial institutions to gather and maintain sufficient information to identify when a client is engaging in transactions that fall outside the normal operating procedure of the business.

For attorneys looking to establish shell corporations for their clients, the CDD requirements pose new challenges in compliance and in achieving business goals. Opening an account with a financial institution will require more time, training and information than ever before. The more beneficial owners a legal entity has, the more time it will take to complete the verification process.

Perhaps more important is the reduced privacy rights of those that want to do business with financial institutions. The entity formation rules of various jurisdictions have not built in a CDD requirement. So, when forming a shell corporation or other business entity, it’s often possible to disclose minimal information. The beneficial owners of these entities may be unhappy to learn that the privacy they enjoyed in forming the business will not extend to transactions involving financial institutions. An attorney or law firm that wants to assist clients to create new business ventures should discuss CDD disclosure requirements early in the process.

The disclosure requirements are similar in form to those required for individual customers. Anyone familiar with the Customer Identification Programs (CIP) used by banks will find the CDD process familiar. The main impact of the new rule is to apply CIP rules to all the beneficial owners of an entity that wants to do business with a financial institution.

It’s fair to assume that the costs of doing business with some financial institutions will rise with the CDD. The costs of compliance attributed to financial institutions will likely be passed on to customers in the form of fees or higher minimum deposits. These costs will vary depending on the financial institution in question. Some already have established customer due diligence programs. The CDD rules are intended to unify these efforts and provide a baseline that all players must meet.

Retroactive Application

The final rule does not contain a categorical retroactive requirement. Banks and other financial institutions are not required to obtain beneficial ownership information for existing customers. They may choose to do so, but the law only applies to new accounts opened after the final rule is implemented.

The guidelines issued with the final rule do instruct financial institutions to obtain this information when, during the course of normal monitoring, they become aware of information relevant to assessing or reevaluating the risk posed by the customer.

Immediate Action

The CDD rules are of primary interest to financial institutions and these businesses must be ready to implement the new guidelines by May 11, 2018. For their customers, the impact is less concrete if no less important.

For years, the decision to incorporate a business in one jurisdiction or another has been based on the rules put forward by the state or nation in question. For example, there’s a reason many businesses are incorporated in Delaware. The new CDD rule may erode some of the benefits of choosing one jurisdiction over another. For companies looking to do business with financial institutions, there may be precious little advantage to choosing Delaware or another “friendly” jurisdiction over other alternatives.

The immediate impact of the CDD rule on new businesses is in choice of entity and jurisdiction. The CDD rule has the potential to alter both the ideal form and the ideal location of a new business. Anyone looking to do business with a financial institution must be prepared to provide information concerning beneficial ownership and control over the enterprise. Even existing customers need to consider the impact of this rule, as many financial institutions may choose to gather this information for existing as well as new customers.

In Conclusion

The comments attached to the final rule regarding the CDD indicate that the annual impact of the measure could reach $150 million or more. The Treasury Department hopes that a reduction in illegal business activity will recoup that cost.

Shell companies have a reputation as devices used for tax evasion and other unsavory ends, but there are perfectly legitimate reasons for using these entities. Shell companies are useful tools for:

  • Conducting foreign operations, including foreign capital investment
  • Tax avoidance, rather than tax evasion. While tax avoidance is legal, there are reasons why an individual or group of individuals would prefer to remain anonymous in seeking these benefits.

Despite the legal benefits of shell corporations, the Treasury Department has decided that anonymity for beneficial owners should not be maintained. The Bank Secrecy Act and its CDD rule lay out explicit rules that financial institutions must follow to pierce the veil of their legal entity customers. This may limit the utility of shell companies and cause some customers to shy away from otherwise beneficial transactions. It will also raise the costs of doing business with financial institutions by placing new burdens on them regarding the gathering and retention of customer information. Whether it will offset those costs with actual gains in the prevention of money laundering, tax evasion, and threats to national security remains to be seen.

For now, clients who want to establish legal entities with the expectation of privacy should know that the Treasury Department is not interested in secrecy and is actively working to further the financial transparency of legal entities.

Would you like to know more? Contact Virtual Paralegal Services.

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