U.S. Broker-Dealers Revamp AML Programs Ahead of Customer Due-Diligence Rule

Pending requirements that U.S. financial institutions more thoroughly vet their accountholders may especially challenge broker dealers, some of which are designing new systems to scrutinize investment advisers and others who control omnibus accounts and pooled investment vehicles, say sources.

Set to take effect in May 2018, the U.S. Treasury Department’s customer due-diligence rule will explicitly require that covered financial institutions take reasonable steps to identify persons owning 25 percent or more of firms that open accounts and verify the accuracy of data they receive, particularly from companies and other legal entities considered high-risk for money laundering and other financial crimes.

The CDD rule represents perhaps the largest shift in anti-money laundering requirements for broker dealers in the past five years, superseding previous regulatory changes that really only amounted to new interpretations of existing rules, Bao Nguyen, a former AML examiner with the Financial Industry Regulatory Authority, or FINRA, said.

Some have already responded by putting policies in place to ask their customers, including certain high-risk investment advisers controlling omnibus accounts and other pooled investment vehicles, for beneficial ownership information down to the 10-percent threshold, rather than stopping at the required 25 percent, Nguyen, now principal of risk advisory services at Kaufman Rossin said.

Others have yet to establish even the most basic aspects of an AML program seen as standard for commercial and retail banks, such as robust transaction-monitoring systems and processes for assessing the particular compliance risks posed by each customer.

Broker dealers are already required to screen for potential violations of AML rules, but those expectations have not loomed as large with industry as anti-fraud efforts and attempts to counter market abuse, said Naji Osman, a New York-based financial crime consultant.

Anticipating the activity of their clients will present a unique challenge because, unlike banking customers, who tend to fall into identifiable patterns of financial behavior, a broker dealer’s customers may change their transactions dramatically as investors or fund managers respond to market conditions and change their trading strategies and portfolios accordingly.

“You’re going to see a lot of SARs coming from broker dealers that you didn’t see in the past,” said Osman.

Broker dealers are also taking steps to vet their customers’ customers, such as individual and corporate clients of certain investment advisers, even without an explicit requirement in the CDD rule.

They are instead doing so out of concern that even with procedures to vet their direct accountholder—an investment adviser, for example—in place, examiners will still ask them to explain their risk-based supervision of that investment adviser’s pooled accounts and their understanding of the source of funds within them.

Although omnibus accounts are excluded from heightened scrutiny, especially if they are controlled by investment advisers who are already being regulated themselves, many other types of investors can open omnibus accounts without being directly regulated, including individual investors, trust funds, LLCs and private equity firms.

In 2003 guidance still applicable today, the Securities and Exchange Commission exempted broker dealers from verifying the source of funds in omnibus accounts. The guidance states that because an investment adviser’s customers do not have their own accounts with a broker dealer, they are not considered customers requiring enhanced scrutiny by the latter institution.

Still, the securities industry’s preoccupation may spring from a key exception laid out by FINRA to a general exemption of omnibus accounts from enhanced due diligence.

FINRA states in the guidance that broker dealers are “generally not required” to peer past intermediaries who establish an omnibus account to the actual beneficial owners of the account, if the intermediary is identified as the accountholder.

“However, if an account, even an omnibus or a trust account, is determined to be higher risk, the firm may require additional information, including identification of the beneficial owners of the account to mitigate that risk,” FINRA states.

Some broker dealers historically have relied on investment advisers to identify and review their own customers, but the vast majority of those programs are deficient, said Ross Delston, a Washington, D.C.-based attorney and compliance consultant.

“The first question I ask every [registered investment advisor] is, ‘When was your last AML audit?’ The most often answer is, ‘We don’t have to do an audit, it’s a voluntary program,’” Delston said.

Investment advisers may prove reluctant to disclose many of the details that broker dealers will expect because the two types of institutions tend to be locked in fierce competition for the same, high net-worth clients, many of whom are routinely barraged with calls to switch firms.

According to Josh Horn, a securities attorney with Fox Rothschild LLP in Philadelphia, the pressure on investment advisers to share more know-your-customer data with broker dealers as a result of the CDD rule is expected to lead to new contracts that stipulate shared liability for legal fallout if the former institution’s client is later found to have engaged in illicit activity.

The contracts would likely place the lion’s share of liability on investment advisers since broker dealers occupy the more powerful bargaining position as a result of their critical role in clearing trades, Horn said.

With few exceptions, the structure of an omnibus account blocks broker dealers from identifying the individual clients and their source of funds, similar to the way that global banks often struggle with identifying the clients of their overseas correspondent banks.

Broker dealers can cite their lack of direct visibility into the individuals behind an omnibus account and the fact that investment advisers are responsible for directly onboarding those customers as further justification for such a contractual arrangement, Horn said.

FINRA already expects that certain transactions, especially those associated with microcap stocks or high-risk jurisdictions, will spur broker dealers to ask investment advisers for details associated with their customers.

Some broker dealers have stopped processing microcap stocks altogether and even ceased servicing omnibus accounts because they estimate they lack the necessary resources to monitor them sufficiently enough to avoid enforcement actions for penny stock frauds, which are often enabled by pooled investments, Nguyen said.

As a result of the additional scrutiny expected from broker dealers after the CDD rule takes effect, individual, high-risk customers may reroute their business through a pooled account operated by an investment adviser instead, he said.

Despite the pitfalls placed in the path of securities firms by the CDD rule, the first exam cycle following implementation most likely will not prove catastrophic for FINRA-regulated firms, as the agency’s chief executive has stressed a gradual enforcement approach before levying heavy penalties against offenders.

“I don’t know that [FINRA] will come out swinging, but they do expect people to have a plan in place, if not fully executing on that plan,” Alma Angotti, a former senior special counsel in the enforcement division of FINRA said. “Many will start from scratch.”