The Financial Crimes Enforcement Network (FinCEN) recently issued new guidance to financial institutions regarding certain customer relationships, which was co-signed by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Securities and Exchange Commission.  The guidance’s purpose was to clarify “regulatory expectations for obtaining beneficial ownership information for certain accounts and customer relationships.”  The following is intended to be a “plain English” summary of the guidance. It is not a substitute for the guidance and you should refer to the guidance to answer any question about what its expectations are.

Generally speaking, the guidance encourages institutions to adopt procedures that identify customers who pose a high risk for money laundering and terrorist financing.  Heightened risk can arise from persons or entities that actually control and manage the assets in the account.  Because of the potential for abuse by these beneficial owners, FinCEN offered the following examples of customers who might pose a higher risk:

•  customers who act as agents for others;
• legal entities not publicly traded in the United States; and
• customers who are trustees.

 The guidance summarizes some of the due diligence requirements that financial institutions must follow to help identify and monitor these higher risk customers.

Customer Due Diligence

 The first line of defense against possible illicit activities by customers is a comprehensive customer due diligence program consisting of policies and staff to implement the policies.  The guidance states that these policies “should be developed to identify customers who pose heightened money laundering or terrorist financing risks.” 

• For customers who are agents of others, the policy should allow the institution to find out on whose behalf the customer is acting.
•  For foreign entities, the policy should allow the institution to obtain information about the entity’s structure and ownership. 
•  For trustees, the institution should gather information about the trust structure and find out who has control over the funds and the trustee.

Financial institutions should implement this program across all their business lines.  The institution’s staff that is responsible for implementing these policies should ensure that all information is cross-checked with other business areas within the institution. 

Enhanced Due Diligence

 Once an account has been identified as posing a heightened risk, the account should undergo the institution’s enhanced due diligence procedures.  These procedures allow the institution to take steps to “reasonably”: 

• verify the identity of beneficial owners;
•  understand the source and use of funds in the account;
• understand the relationship between the customer and beneficial owner; and
• institutions should also monitor these accounts on an ongoing basis to ensure that the information initially received regarding the intended purpose of the account matches the sources of the funds and the uses of the account.

Other Types of Due Diligence

 Financial institutions should take reasonable steps to determine the source of any private banking customers’ wealth and the activity of those accounts.  Institutions should also take steps to detect any suspected money laundering activity in “correspondent accounts” established for foreign financial institutions.  Failure to establish proper due diligence in these areas could result in a violation of the anti-money laundering regulations.

Bottom Line:  Know Your Customer

 Most of the information contained in the guidance was previously issued in the Bank Secrecy Act and the anti-money laundering statutes.  The major theme of the guidance is merely that financial institutions should make every reasonable effort to know their customers.  Extra precautions should be taken to know customers who pose a higher risk of money laundering or terrorist financing.  Simply knowing the customers who do not pose a risk is not enough.  But identifying which customers may be potential terrorist sympathizers or money launderers can be difficult if not impossible.  Staff members of financial institutions should work to identify accounts that are named for agents, trustees or foreign entities, but which are beneficially owned by other persons or entities who actually manage and control the account’s assets.  Institutions have the responsibility to delve deeply enough into the structure and financing of these higher risk customers to try to detect and report any illicit activity.  The bottom line is each financial institution should know its customers (especially the ones that it does not know).

Changes to the SEC’s proxy rules that will require publicly registered TARP recipients to permit an advisory shareholder vote on executive compensation are set to take effect on February 18, 2010.  The rule changes, which were adopted by the SEC last month, help implement and clarify how recipients should comply with the requirements of Section 111(e) of the Emergency Economic Stabilization Act of 2008.

            In addition to the vote itself, the amended proxy rules require TARP companies to disclose in their proxy statements that they are providing the separate shareholder vote on executive compensation, as disclosed pursuant to the compensation disclosure rules, and to briefly explain the general effect of the vote, such as, for example, whether the vote is non-binding.  The rules do not require the use of any specific language or form of resolution.  The SEC has also clarified that smaller reporting companies will not be required to provide a compensation discussion and analysis in order to comply with these requirements.

            For companies who received TARP funds prior to their last annual meeting, the new requirements are likely to be similar to what these companies prepared in connection with their proxy materials for last year’s meeting.  TARP companies may be pleased to know that the new SEC rules provide that TARP recipients will not have to file a preliminary proxy statement in advance of the definitive proxy statement due to the required “say-on-pay” vote. 

            To view the SEC release of the final rule, click here.

            http://www.sec.gov/rules/final/2010/34-61335.pdf

Last week, President Obama announced a proposed rule aimed at separating banks from certain securities activities.  He dubbed the proposal the “Volcker Rule” after Paul Volcker, the Economic Recovery Advisory Board Chairman and former Federal Reserve Chairman who endorses the rule.  The proposal would prevent commercial banks from owning or investing in hedge funds and private equity funds.  The rule would also limit banks from trading for their own accounts, a practice referred to as “proprietary trading.”  Basically, the proposal would restrict a bank’s ability to engage in speculative investing for its own personal gain.

Here’s the full quote from Obama’s announcement:

It’s for these reasons that I’m proposing a simple and common-sense reform, which we’re calling the “Volcker Rule” — after this tall guy behind me.  Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.  If financial firms want to trade for profit, that’s something they’re free to do.  Indeed, doing so – responsibly – is a good thing for the markets and the economy.  But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people.

The Volcker Rule presents President Obama an opportunity to show Main Street that he is toughening his stance on Wall Street.  He argues that risky investing by investment banks such as Goldman Sachs and Morgan Stanley played a significant role in the recent financial crisis.  The rule attempts to punish these institutions by eliminating revenues derived from speculative investing.  Austan Goolsbee, a White House economist, put it more succinctly in a Wall Street Journal article when he stated, “the key issue is that institutions that are getting a backstop from the taxpayer shouldn’t be able to make a profit off their own investing.”

Clearly, some action needs to be taken to ensure that we do not face another financial meltdown.  But the problem with the Volcker Rule is its unintended consequences.  In his address to the Senate Banking Committee on February 2, 2010, Mr. Volcker argued for complete separation of commercial banks from financial markets.  A rule like this that would not allow a commercial bank to speculate in capital markets would immediately affect bank profits, at least in the short run.  Recently, investment banks have tended to make less money at banking and more money at investing.  Suddenly illegalizing investing at institutions that also own banks would eliminate this main source of revenue, which could have a domino effect on the rest of the economy.  Once revenues in this area are lost, banks would actually take less risk on the banking side by tightening lending practices.  If companies can’t borrow, they don’t spend.  If companies don’t spend, then they don’t hire.  If people don’t get hired, then they don’t spend either.  Of course, less spending halts the economy, which leads directly to worldwide chaos.

Now maybe that’s an exaggeration.

But not really.

So what should the Volcker Rule actually do to achieve the President’s goals?  First, I agree with the part of the proposal that would separate hedge funds from banks.  As a former hedge fund manager, I can tell you that combining a hedge fund and a bank is a bad idea.  Hedge fund managers are paid to take risks.  The more risks they take, the more fees they generate.  Taking risks is not necessarily a bad thing.  However, in this context, it could lead to an unfortunate outcome. 

For example, consider a stand-alone hedge fund, completely detached from a bank or other large institution.  That manager would be more reluctant to take extraordinary risks because once the money is gone, both the manager and the fund itself soon follow. 

Now consider the hedge fund bankrolled (literally) by a large bank, such as Wells Fargo or Bank of America.  This manager has an incentive to take extraordinary risks and may even be encouraged to do so.  If these extraordinary risks do not pay off, the fund has an entire bank’s assets at its disposal to replace the blown investment.  In normal economic times, this would not necessarily be a problem either.  Except these are not normal economic times and our hypothetical bank’s assets in this case have been subsidized by taxpayer dollars.  (See any one of the eight million articles written about the “Bank Bailout” on Google.)  Separating hedge funds from banks ensures that the entire risk of any speculative investing is borne solely by the hedge fund itself and not by banks and, subsequently, by taxpayers.  Mr. Volcker agreed with this sentiment in his Senate testimony stating:  “Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depositary institutions.”

Once the hedge funds are removed, the question becomes how far should proprietary trading be curbed in banks.  Again, this type of investing, if profitable, may give banks more cash to lend to customers, which reverses the domino effect discussed above.  However, if the speculation that can occur by proprietary traders is not checked in some meaningful way, then we are right back to where we started.  But cutting off this entire revenue stream would go too far.  Instead of wholly eliminating this practice in banks, the President would be better served by merely regulating the activity.  One solution would be to limit the amount of assets that a bank can invest.  This solution would allow banks to maintain this stream of revenue while ensuring that their speculation does not get out of hand.  Treasury Secretary Timothy Geithner backs this solution despite his vocal support for the Volcker Rule.  In his testimony before Congress, Mr. Geithner stated that banks “should be subjected to a set of constraints on capital, on leverage and how you are funded that limit the amount of risks you take.” 

A second solution would be to require banks investing in speculative assets to increase their capital reserve to cover any potential losses.  This solution would also effectively lower the total assets that the bank has to invest in speculative ventures.  A bank that has a limited amount of assets to invest will invest those assets more wisely. 

With these solutions, everyone wins.  The President gets to appear tough on Wall Street.  Banks get to continue receiving this revenue stream.  And bank customers are free to borrow and spend, resurrecting the economy, which leads directly to worldwide harmony.

Now maybe that’s an exaggeration. 

But not really.