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Marijuana $475,000,000 in Tax Revenue? IRS Says “No Thanks, We Have Other Priorities”

On March 30, 2020 the Treasury Inspector General released a OIG Report titled  “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance”. It is, in large part, a stinging rebuke of the way the IRS has handled – or has avoided handling – federal income tax payments made, and tax returns filed, by marijuana related businesses, or MRBs.

To the extent that Government laws and regulations discourage banking for marijuana businesses (and to the extent they encourage cash only transactions), they also may be indirectly and unintentionally encouraging tax noncompliance. – Report, page 5

From a federal tax perspective, MRBs face a number of hurdles.

Limited Access to Banking and the Impact on Paying Taxes

“Marijuana businesses have limited access to banking because marijuana is classified as a Schedule I controlled substance, and banks and credit unions who service marijuana businesses can potentially be charged with money laundering. Many financial institutions are not willing to risk potential civil or criminal liability associated with their obligations under the Bank Secrecy Act (BSA).” – Report, page 4.

And the entirety of page 5 of the Report is important:

“One of the main barriers for banks and credit unions is the information reporting requirements when providing banking services to marijuana businesses. For example, BSA regulations require the filing of a Suspicious Activity Report (SAR) when a financial institution knows, suspects, or has reason to suspect that a transaction of $5,000 or more involves funds derived from an illegal activity or is an attempt to disguise funds derived from an illegal activity.

The SAR filing requirement is both costly and risky as the reporting of all transactions the financial institution has with the respective marijuana business can be extensive, and if the activity is incorrectly reported, fines to the financial institution could result. Banks and credit unions that service marijuana businesses may charge large fees to compensate for the extensive reporting requirements and risk for providing services to these businesses. One credit union in California stated it was charging banking fees to marijuana businesses of up to $10,000 as an upfront fee and $5,000 a month for producers and $7,500 a month for dispensaries. Another small credit union in Oregon that serves marijuana businesses stated the credit union filed more than 13,500 individual reports over the past two years (2017 and 2018) for approximately 500 cannabis clients.

We have also identified recent trends with banks and credit unions providing banking services to marijuana businesses. According to the U.S. Treasury Financial Crimes Enforcement Network, the number of financial institutions actively banking marijuana-related businesses increased from 401 in October 2017 to 715 in June 2019. However, the lack of banking access continues to be an issue in the marijuana industry with most banks or credit unions across the United States not willing to accept marijuana business customers. Marijuana businesses without bank account access are also unable to set up merchant accounts for accepting credit or debit cards. This results in most marijuana businesses conducting business transactions in cash only. Marijuana businesses may have automated teller machines on the premises for customers to facilitate cash only transactions.

The main tax-related concern about cash intensive businesses is that cash transactions are more difficult to track and are therefore more likely to go unreported to the IRS. Unlike checks and credit card receipts, cash transactions do not generally result in third-party information capable of being reported to the IRS. To the extent that Government laws and regulations discourage banking for marijuana businesses (and to the extent they encourage cash only transactions), they also may be indirectly and unintentionally encouraging tax noncompliance.”

(citations omitted)

There are at least three issues stemming from the difficulties that cash intensive businesses, such as MRBs, have in obtaining and keeping banking relationships. First is that they may not file tax returns at all: the OIG observed a filing rate of active MRBs to be between 60% to 70%. Second, they may under report income that is not flowing through a bank relationship or is not otherwise being tracked and monitored: the OIG observed an under-reporting rate of about 25%. And third is the penalty that filers must pay for not paying federal taxes electronically. Known as the Failure To Deposit, or FTD penalties for not making tax payments by ACH, the OIG found that almost half the MRBs that were potentially unbanked, based on FTD data, paid penalties. The OIG recommended, at page 22 of the Report:

“Taxpayers including marijuana businesses should not be penalized because they cannot satisfy their respective employment tax obligations via the required electronic transmission process. The current conflict between Federal and State law regarding marijuana business activity is well established regarding banking access. The IRS needs to increase awareness of the current FTD penalty relief policies for unbanked taxpayers such as marijuana businesses.”

This was one of the few (of six) recommendations that the IRS agreed to.

I.R.C. §280E from 1982

In 1982, section 280E was added to the Internal Revenue Code to prohibit businesses engaged in illegal activity from deducting business expenses such as payroll, employee benefits, and rent from gross income for purposes of determining federal income tax. Section 280E was the legislative response to a number of court decisions that allowed illegal businesses to deduct certain expenses incurred in operating those illegal businesses. Since the Controlled Substances Act makes it federally illegal to manufacture or distribute marijuana, §280E then prohibits the deduction of expenses incurred in trafficking controlled substances. The only expenses allowed by §280E  is cost of goods sold, so businesses that sell marijuana can reduce gross receipts by the cost of goods sold but cannot deduct other business expenses.

 

The Report included a hypothetical example of the impact of §280E to a marijuana related business. As seen from Figure 2, the effective tax rate is about 80% – $80,750 on net income of $100,000.

The OIG found that about 60% of the MRBs in their sample that filed federal tax returns improperly applied §280E adjustments, yet “the IRS lacks guidance to taxpayers and tax professional in the marijuana industry” and that “no references to marijuana businesses can be found in IRS publications.” The OIG estimated the 5-year impact on federal tax collected in the three states (California, Oregon, and Washington) was almost $250 million.

 

I.R.C. §471(c) from 2017

The Tax Cuts and Jobs Act of 2017 added section 471(c) to the Internal Revenue Code to provide some relief to small businesses in whether and how they could track and account for their cost of goods sold. The OIG noted:

“Under this new provision, marijuana businesses could argue they are entitled to use a method of accounting that includes all expenses in cost of goods sold to potentially avoid the impact of I.R.C. § 280E. According to IRS Chief Counsel, at least two practitioners have identified this issue and have questioned IRS personnel on how the IRS plans to handle I.R.C. § 471(c) as applied to marijuana industry taxpayers. These practitioners have identified the potential unintended consequence of I.R.C. § 471(c) that appears to allow small marijuana businesses to include non-cost of goods sold expenses in their cost of goods sold and potentially avoid the application of I.R.C. § 280E. IRS Chief Counsel noted that practitioners assert that the new law may provide small business taxpayers wide latitude to characterize all expenditures as cost of goods sold. The effect of the law is still uncertain.” – Report, page 15.

The OIG’s fourth recommendation was that the IRS should publish guidance on the impact of § 471(c) on § 280E. The IRs response was, essentially, that it was too busy:

Recommendation: that the IRS “develop and distribute, internally and externally, specific guidance on the application of I.R.C. § 471(c) in conjunction with I.R.C. § 280E for taxpayers that report Schedule I related activities on Federal tax returns.”

IRS Response: “IRS Chief Counsel disagreed with this recommendation because the Department of the Treasury and Chief Counsel resources at present are focused on priority guidance in response to the Tax Cuts and Jobs Act and identifying and reducing regulatory burdens in response to Executive Order 13789.” – Report, page 22.

Marijuana Businesses – “High Impact” for IRS Attention

The IRS has acknowledged that the marijuana industry is a “high impact compliance area” because of its unique tax compliance risks due to I.R.C. § 280E, cash intensive sales, and potential lost tax revenue. In fact, the OIG report estimated a five-year impact of approximately $475 million. The OIG had two recommendations for the IRS: that the IRS develop a comprehensive compliance approach for the marijuana industry (recommendation 1 on page 13); and that the IRS use more state information (which it was reluctant to use) to identify non-filers (recommendation 5 at page 20). The IRS response to both recommendations was the same:

Recommendation 1 –  IRS should develop a comprehensive compliance approach for the marijuana industry and leverage state marijuana business lists to identify non-compliant taxpayers. IRS Response: “whether it pursues taxpayers in the marijuana industry depends on priorities and available resources … it will use data analytics to identify the size and scope of non-compliant taxpayers and prioritize the compliance activities based on resources available.” – Report, page 13

Recommendation 5 – IRS should leverage publicly available state tax information and expand use of Fed/State agreements to identify non-filers and unreported income in the marijuana industry. IRS Response: “whether it pursues taxpayers in the marijuana industry depends on priorities and available resources … it will review the publicly available State tax information and Fed/State agreements to determine whether and how they could be legally, systemically, effectively, and efficiently used in compliance activities.” – Report, page 20

Conclusion

It’s unfortunate that this report was published in the midst of the Great Pandemic of 2020: but for the pandemic, it would have garnered more attention from the public and Congress. Tax compliance should be encouraged and tax enforcement should be consistently and fairly applied. The Treasury Inspector General has reported that neither is happening with respect to the marijuana industry, and the IRS response to its Inspector General seems to be “we’ll think about, but we’ve got other things to worry about”.  The IRS doesn’t seem too interested in an industry made up of thousands of marijuana related businesses employing hundreds of thousands of people that is apparently under-reporting hundreds of millions of dollars – perhaps billions of dollars – of federal taxes. After the coronavirus pandemic eases, perhaps somebody in Congress can ask the Commissioner of the IRS what would get his attention.

“Descriptive & Memorable” – The Fed’s soon-to-be-published Pandemic Response Accountability Committee Website

The CARES Act, section 15010(g) (1) (A) requires that: “Not later than 30 days after the date of enactment of this Act, the [Pandemic Response Accountability] Committee shall establish and maintain a user-friendly, public-facing website to foster greater accountability and transparency in the use of covered funds and the Coronavirus response, which shall have a uniform resource locator that is descriptive and memorable.”

Subsection (3) provides that the Committee shall ensure that the website provides “materials and information explaining the Coronavirus response and how covered funds are being used. The materials shall be easy to understand and regularly updated”.

There follows thirteen explicit requirements, including … any progress reports, audits, inspections, or other reports … user-friendly visual presentations to enhance public awareness of the use of covered funds and the Coronavirus response … detailed data on any Federal Government awards over $150,000 … by month to each State and congressional district, where applicable … a means for the public to give feedback on the performance of any covered funds and of the Coronavirus response, including confidential feedback … a link to estimates of the jobs sustained or created by this Act to the extent practicable … a plan from each Federal agency for using covered funds.

Stay tuned – April 26th is the due date for this new descriptive, memorable, and critically important website. Congress and, more importantly, the public, need to keep a watchful eye over how the hundreds of billions of dollars are being allocated and spent. Bookmark your calendar … and stay safe.

The CARES Act of 2020: “Tall, Dark, or Handsome” and “Tall, Dark, and Handsome” in one bill

There is a big difference between someone who is tall, dark, and handsome – he is all three of those things – and a guy who is tall, dark, or handsome – he is one of those things. Unfortunately, the new Special Inspector General for Pandemic Recovery is the Congressional version of tall, dark, or handsome, and their peers – the Executive Director and Deputy Executive Director of the Pandemic Response Accountability Committee – are the Congressional versions of tall, dark, and handsome. Although Congress didn’t take my pre-passage advice to spruce up the SIGPR (there wasn’t time, apparently), we can still hope that they are as polished as their PRAC peers.

In an article I wrote in August 2019 titled  “Lessons Learned as a BSA Officer – 1998 to 2018” I covered nine topics:

  1. All the Cooks in the AML Kitchen aka Stakeholders
  2. All the Resources Available to You
  3. The 5 Dimensions of Risk – Up, Down, Across, Out, and Within
  4. FinTech versus Humans
  5. The 7 Cs – What Makes a Good Analyst/Investigator
  6. Tall, Dark and Handsome – Words and Punctuation Matter!
  7. SMEs v SMEs – Subject Matter Experts vs Subject Matter Enthusiasts
  8. Is Transaction Monitoring a Thing of the Past?
  9. The Importance of Courage

I thought of topic 6 – Tall, Dark and Handsome – the morning I read the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) bill that the Senate and House were then negotiating. Back in 2019 I wrote the following:

Tall, Dark, and Handsome – Words (especially adjectives and adverbs) and punctuation matter!

    1. Write simply and clearly

“We know all too well that drugs are killing record numbers of Americans – and almost all of them come from overseas.”  Former AG Jeff Sessions, August 2018 speech

This is a good example of a poorly written sentence that is begging for clarity. The phrase “almost all” means very little: at least 51% and less than 100%. Second, do “almost all” drugs come from overseas, or do almost all Americans come from overseas? And finally, Mexico is the source country for 90% – 94% of heroin entering the US, and the final transit country for 90% of the cocaine entering the US. Mexico isn’t actually overseas from the US.

    1. Use Adjectives and Adverbs Sparingly, if at all

Most modifiers are unnecessary. Whether necessary or not, as a risk professional you should be very aware of both your use of adjectives and adverbs, and when reading others’ use of adjectives and adverbs. When confronted with any modifier, ask yourself (i) why is that modifier being used? (ii) is it being used correctly? (iii) does it change the meaning of the sentence in a way that is unintended? (iv) is it being used consistently with other modifiers? And (v) could it limit or prevent us in the future?

    1. Watch out for Red Flag Words and Phrases

Intended, Primarily, Pilot, Agile Development, shall versus may, Artificial Intelligence, Machine Learning

Special Inspector General for Pandemic Recovery

Section 4018 of the CARES Act calls for the appointment of a new Special Inspector General for Pandemic Recovery. This appears to be a position similar to the TARP (Troubled Assets Relief Program) Inspector General position created after the 2007-2009 economic crisis to manage the TARP monies distributed to banks, the auto companies, and other businesses.

(I’ll point out that, just as the DMV’s vanity license department checks that proposed vanity license plates aren’t offensive, I’m sure someone in the Congressional Research Acronym Program Office checked the title for possible embarrassments. In this case, SIGPaR is much preferable to, say, Pandemic Inspector General.)

What is the federal government looking for in its new Special Inspector General for Pandemic Recovery? As seen from the screen shot of the section in the bill, “the nomination of the Special Inspector General  shall be made on the basis of integrity and demonstrated ability in accounting, auditing, financial analysis, law, management analysis, public administration, or investigations.”

To put it another way, the nomination shall be made on the basis of two things: (i) integrity, and (ii) demonstrated ability in either accounting or auditing or financial analysis or law or management analysis or public administration or investigations.

Prior to the passage of the Act, I suggested that Congress change “or” to “and” on line 8 of section 4018(b). As I wrote in my original article (published March 26th, the day vefore the bill was signed into law), “It would be great if we had a Special Inspector General for Pandemic Recovery who exhibited integrity and demonstrated ability in accounting, auditing, financial analysis, law, management analysis, public administration, and investigations. She’ll need all of those attributes to do her job, I expect.”

Unfortunately, Congress didn’t take up my suggestion.

And oddly enough, pursuant to section 15010(c)(3)(B)(ii) of the CARES Act, two other critical oversight positions created by the Act – the Executive Director and Deputy Executive Director of the Pandemic Response Accountability Committee – shall:

“(I) have demonstrated ability in accounting, auditing, and financial analysis;

(II) have experience managing oversight of large organizations and expenditures; and

(III) be full-time employees of the Committee.”

 There you have it: the legislative equivalent of “tall, dark, or handsome” (the Special Inspector General) and “tall, dark, and handsome” (the Executive Director and Deputy Executive Director of the Pandemic Response Accountability Committee) in one Bill. Yikes!

The Perfect Storm: More Alerts, Fewer Investigators, & More False Positives

The Focus Has Always Been On the Increase in Fraud

Natural disasters bring out the best in some people and the worst in others. Almost fifteen years ago, in the wake of Hurricane Katrina, the Department of Justice formed the National Center for Disaster Fraud[1] to coordinate the investigations and prosecutions of benefits, charities, and cyber-related frauds that sprang up when billions of dollars in federal disaster relief poured into the Gulf Coast region. In October 2017, after a series of hurricanes in the southeast US and Caribbean (Harvey, Irma, and Maria), and California wildfires, the Financial Crimes Enforcement Network (FinCEN) issued an “Advisory to Financial Institutions Regarding Disaster-Related Fraud” that described some of the same fraud scams and instructed firms how to identify and report that activity.

FinCEN Recognizes The Strain on Resources

On March 16, 2020, three days after the President declared a National Emergency in response to COVID-19, FinCEN issued a press release (not an Advisory) encouraging financial institutions to (1) communicate concerns related to the “coronavirus disease 2019 (COVID-19)”, and (2) to remain alert to related illicit financial activity.[2]

Specifically, FinCEN requested that financial institutions contact FinCEN and their functional regulator as soon as practicable if it “has concern about any potential delays in its ability to file required Bank Secrecy Act (BSA) reports.”

This is an important acknowledgment by FinCEN. The previous Advisory focused on the increase in fraud as a result of natural disasters. This press release adds another element: at the same time fraud is increasing, the ability of financial institutions to manage that increase is impacted because of the “shelter in place” or work from home requirements. To put it in simple terms, where a bank may have had 1,000 fraud alerts handled by 50 investigators prior to the pandemic, it may now have 2,000 alerts being handled by only 20 investigators.

The Third Issue – Your Existing Fraud Alerting Logic May Produce More False Positives

Not only will the alerting “numerator” be going up (that is the transactions that a financial institution’s rules find are anomalous) but the denominator, or the volume of and types of transactions, is also changing. Very simply, people transact differently because of the pandemic. There will be more cash withdrawals (both numbers and amounts), and more activity (transactions and interactions) will shift from in-person to mobile, online, and telephone.

Elder fraud is a good example of the impact of the pandemic. The older population is most at risk from COVID-19, and most at risk of various fraud schemes. The alerting logic a bank had programmed was based on historical data relating to, say, changes in elderly customers’ use of online and mobile channels. With the pandemic, elderly customers are using those channels more often, and those alerts will now be hitting on anomalous but now-expected activity. This new current activity will be different than the historical activity on which the bank based its alerting logic.

And all of this at a time when banks have fewer investigators able to handle the output: they’re at home and either unable to access bank systems or less efficient in doing so.

Communication is the Key

As FinCEN points out, financial institutions need to communicate with their regulators if they’re finding that their investigations teams cannot keep up with the increase in fraud cases. One aspect a bank needs to consider is whether it should – and can – move analysts and investigators from AML over to fraud and sanctions screening. Sanctions screening and fraud monitoring requires real- and near-time screening and monitoring to prevent transactions from occurring – whether those are transactions with sanctioned entities, possible Business E-mail Compromise (BEC) frauds, or other frauds. Sanctions and fraud analysts and investigators need to be able to prevent certain transactions and investigate others in real- or near-time. AML analysts and investigators do not operate in the same time-sensitive environment: as a general rule, an AML alert generated in March will involve activity that occurred in February, it will be investigated in April in order to determine whether it was “suspicious”, then a SAR will be filed in May. So part of the external and internal communications a bank will need to have will involve shifting its AML resources over to sanctions and fraud monitoring and investigations.

But more important are the communications banks need to have with their clients and customers to warn them about common disaster-related frauds, and the communications within the bank to adapt to the changes in overall customer activity. How will the changes in customer activity impact the sanctions and fraud monitoring, detection, and alerting systems?

It’s the perfect storm: more alerts, more false positives, fewer investigators.

[1] https://www.justice.gov/disaster-fraud

[2] https://www.fincen.gov/news/news-releases/financial-crimes-enforcement-network-fincen-encourages-financial-institutions

When it comes to BSA/AML compliance programs, success has a hundred fathers, but failure is, apparently, an orphan

“FinCEN Penalizes U.S. Bank Official for Corporate Anti-Money Laundering Failures”

In 1961 President John F. Kennedy commented on the failed Bay of Pigs invasion: “victory has a hundred fathers and defeat is an orphan”. This statement came to mind as I read the Treasury Department’s March 4, 2020 assessment of a $450,000 penalty against the former Chief Operational Risk Officer of US Bank for the bank’s failures to implement and maintain an effective anti-money laundering (AML) program. And although the bank itself, and its holding company US Bancorp, were sanctioned and paid hundreds of millions of dollars in penalties, it appears that no other officers or directors of US Bank were personally sanctioned.

I have previously written that running an AML program in an American financial institution is like Winston Churchill’s description of Russia in 1939: a riddle, wrapped in a mystery, inside an enigma. The riddle is how to meet your obligations to provide law enforcement with actionable, effective intelligence (the stated purpose of the US AML laws set out in Title 31 of the US Code). That riddle is wrapped in the mystery of how to satisfy the multiple regulatory agencies’ “safety and soundness” requirements set out in Title 12 of the US Code. And the enigma is the personal liability you face for failing to satisfy either or both of those things.

And that enigma of personal liability was recently brought front and center with the March 4, 2020, announcement from FinCEN that the former Chief Operational Risk Officer of US Bank, Michael LaFontaine, was hit with a $450,000 penalty for his failure to prevent BSA/AML violations during his seven to ten year tenure.

Before going further, keep this in mind: it is inconceivable that a single person could run an AML program in one of the largest banks in the United States. They would need hundreds if not thousands of others to help design, implement, modify, test, audit, oversee, and examine that program. Everyone from a first-year analyst to the Board of Directors. But it is equally inconceivable – with all the checks and balances built into the US financial sector regulatory regime, with the three lines of defense, and all the auditors, examiners, and directors – that a single person could single-handedly screw up that same AML program over a period of five years. Yet that is the conclusion that seems to have been made: no matter how many people were responsible for US Bank’s AML program over a five year period, only one was held accountable for it.

“FinCEN Penalizes U.S. Bank Official for Corporate Anti-Money Laundering Failures” – FinCEN Press Release

March 04, 2020

WASHINGTON—The Financial Crimes Enforcement Network (FinCEN) has assessed a $450,000 civil money penalty against Michael LaFontaine, former Chief Operational Risk Officer at U.S. Bank National Association (U.S. Bank), for his failure to prevent violations of the Bank Secrecy Act (BSA) during his tenure.  U.S. Bank used automated transaction monitoring software to spot potentially suspicious activity, but it improperly capped the number of alerts generated, limiting the ability of law enforcement to target criminal activity.  In addition, the bank failed to staff the BSA compliance function with enough people to review even the reduced number of alerts enabling criminals to escape detection.

“Mr. LaFontaine was warned by his subordinates and by regulators that capping the number of alerts was dangerous and ill-advised.  His actions prevented the proper filing of many, many SARs, which hindered law enforcement’s ability to fully combat crimes and protect people,” said FinCEN Director Kenneth A. Blanco.  “FinCEN encourages technological innovations to help fight money laundering, but technology must be used properly.”

In February 2018, FinCEN, in coordination with the Office of the Comptroller of the Currency (OCC) and the U.S. Department of Justice, issued a $185 million civil money penalty against U.S. Bank for, among other things, willfully violating the BSA’s requirements to implement and maintain an effective anti-money laundering (AML) program and to file Suspicious Activity Reports (SARs) in a timely manner.

Mr. LaFontaine was advised by two subordinates that they believed the existing automated system was inadequate because caps were set to limit the number of alerts.  The OCC warned U.S. Bank on several occasions that using numerical caps to limit the Bank’s monitoring programs based on the size of its staff and available resources could result in a potential enforcement action, and FinCEN had taken previous public actions against banks for the same activity.

Mr. LaFontaine received internal memos from staff claiming that significant increases in SAR volumes, law enforcement inquiries, and closure recommendations, created a situation where the AML staff “is stretched dangerously thin.”  Mr. LaFontaine failed to take sufficient action when presented with significant AML program deficiencies in the Bank’s SAR-monitoring system and the number of staff to fulfill the AML compliance role.  The Bank had maintained inappropriate alert caps for at least five years.

FinCEN has coordinated this action with the OCC and appreciates the assistance it provided.

FinCEN’s March 2020 action against Mr. LaFontaine was the third of a series of actions in the last five years against US Bank, its parent US Bancorp, and now, one of its former officers.

The US Bank Cases – 2015, 2018, and 2020

In October 2015 the OCC and US Bank entered into a Cease & Desist Order (on consent) for longstanding and extensive BSA/AML program failures and failures relating to suspicious activity monitoring and reporting. US Bank was compelled to perform a lengthy list of remedial actions, including a “look-back” of activity. Apparently, US Bank eventually satisfied the OCC, and in November 2018 that Order was lifted or terminated. But no individuals were singled out.

In February 2018 US Bank was hit with a series of orders and actions relating to (1) those aforementioned BSA/AML program and SAR failures, and (2) a multi-billion dollar, multi-year payday lending fraud that was effectuated, in part, through the fraudster’s accounts at US Bank (the so-called “Scott Tucker” fraud). Among other orders and penalties, US Bank and/or its parent US Bancorp paid a $75 million fine to the OCC, a $70 million fine to FinCEN, a $15 million fine to the Federal Reserve, and forfeited $453 million to the Department of Justice (and those forfeited funds were later distributed to the victims of the Scott Tucker fraud) in a federal civil case filed in the Southern District of New York (civil case no. 18CV01357). US Bank also consented to a one-count criminal charge and entered into a two-year Deferred Prosecution Agreement (DPA) with the US Attorney for the Southern District of New York. Finally, the Treasury Department brought a civil case against US Bank, also in the Southern District, to “reduce” the FinCEN $70 million penalty to a civil judgment: that was civil case no. 18CV01358. Again, no individuals were singled out.

The (former) Chief Operational Risk Officer was held personally accountable: but who is actually responsible for a bank’s BSA/AML compliance program?

US Bank – the 5th Largest Bank in the United States

Based on all the orders and civil and criminal complaints, it appears that the core period of time the government was concerned about were the years 2010 through 2014. Based on the Annual Reports of US Bank, during that period the bank had:

  • Between thirteen and fifteen directors each year. Eleven of those directors served from at least 2009 through 2014
  • A Managing Committee made up of:
    • 1 Chairman and CEO (the same person for the entire period);
    • Eight to ten Vice-Chairmen each year, one of which was the Chief Risk Officer in 2014; and
    • Four to six Executive Vice-Presidents each year, one of which was the Chief Risk Officer from 2005 through 2013, and one of which was Michael LaFontaine as Chief Operational Risk Officer in the 2012 and 2013 annual report

It’s fair to say that since US Bank listed these people – the Board of Directors and the Managing Committee – in its Annual Reports, these people were seen as being collectively responsible for overseeing and managing the affairs of US Bank.

OCC’s Regulations for BSA/AML Compliance – Title 12 of the Code of Federal Regulations

US Bank’s primary regulator is the OCC. The OCC’s regulations for a BSA/AML compliance program are set out at 12 CFR § 21.21. Subsection (a) describes the “purpose” for the section: “to assure that all national banks and savings associations establish and maintain procedures reasonably designed to assure and monitor their compliance with the requirements of subchapter II of chapter 53 of title 31, United States Code, and the implementing regulations promulgated thereunder by the Department of the Treasury at 31 CFR Chapter X.” So the purpose of the OCC’s BSA/AML program requirement is to assure that banks meet their requirements under FinCEN’s legislation and regulations.

12 CFR § 21.21 continues. Subsection (c) goes beyond mere procedures and compels banks to “develop and provide for the continued administration of a program reasonably designed to assure and monitor compliance with the recordkeeping and reporting requirements set forth in subchapter II of chapter 53 of title 31, United States Code and the implementing regulations issued by the Department of the Treasury at 31 CFR Chapter X. The compliance program must be written, approved by the national bank’s or savings association’s board of directors, and reflected in the minutes of the national bank or savings association.”

And then subsection (d) sets out the minimum contents that the program shall have. It shall:

(1) Provide for a system of internal controls to assure ongoing compliance;

(2) Provide for independent testing for compliance to be conducted by national bank or savings association personnel or by an outside party;

(3) Designate an individual or individuals responsible for coordinating and monitoring day-to-day compliance; and

(4) Provide training for appropriate personnel.

So the OCC’s regulations tell us how a bank’s program is documented, who approves it (the board of directors), and what it must contain (at a minimum, the four “pillars” from subsection (d) – internal controls, independent testing, a BSA compliance officer, and training). Those OCC regulations don’t specifically set out who is responsible for the program. But they do refer to subchapter II of chapter 53 of title 31, United States Code and the implementing regulations issued by the Department of the Treasury at 31 CFR Chapter X. What do those provide? Do those laws and regulations set out who is responsible for a bank’s BSA/AML program?

FinCEN’s Regulations for BSA/AML Compliance – Title 31 of the Code of Federal Regulations

31 CFR Part X, specifically § 1010.210, provides that “each financial institution (as defined in 31 U.S.C. 5312(a)(2) or (c)(1)) should refer to subpart B of its chapter X part for any additional anti-money laundering program requirements.” The subpart B for national banks, like US Bank, provides as follows:

31 CFR § 1020.210

Anti-money laundering program requirements for financial institutions regulated only by a Federal functional regulator, including banks, savings associations, and credit unions. A financial institution regulated by a Federal functional regulator that is not subject to the regulations of a self-regulatory organization shall be deemed to satisfy the requirements of 31 U.S.C. 5318(h)(1) if the financial institution implements and maintains an anti-money laundering program that:

(a) Complies with the requirements of §§1010.610 and 1010.620 of this chapter;

(b) Includes, at a minimum:

(1) A system of internal controls to assure ongoing compliance;

(2) Independent testing for compliance to be conducted by bank personnel or by an outside party;

(3) Designation of an individual or individuals responsible for coordinating and monitoring day-to-day compliance;

(4) Training for appropriate personnel; and

(5) Appropriate risk-based procedures for conducting ongoing customer due diligence, to include, but not be limited to:

(i) Understanding the nature and purpose of customer relationships for the purpose of developing a customer risk profile; and

(ii) Conducting ongoing monitoring to identify and report suspicious transactions and, on a risk basis, to maintain and update customer information. For purposes of this paragraph (b)(5)(ii), customer information shall include information regarding the beneficial owners of legal entity customers (as defined in §1010.230 of this chapter); and

(c) Complies with the regulation of its Federal functional regulator governing such programs.

So, other than the OCC regulation having only four pillars while the FinCEN regulation has five, neither the OCC nor the FinCEN BSA/AML program regulations specifically describe who, if anyone, in a bank, is actually responsible for the BSA/AML program. But we know from the Michael LaFontaine case that the Chief Operational Risk Officer was found personally accountable for the failures of the program.

Regulatory Guidance – the FFIEC BSA/AML Examination Manual

So if the answer isn’t in the regulation, perhaps it can be found in regulatory guidance. For BSA/AML purposes, the golden source for regulatory guidance is set out in the Federal Financial Institutions Examination Council (FFIEC) BSA/AML Examination Manual. All five editions of the Manual (from 2005 through 2014) provide: “The board of directors, acting through senior management, is ultimately responsible for ensuring that the bank maintains an effective BSA/AML internal control structure, including suspicious activity monitoring and reporting.” (At page 29 of the most recent (2014) edition).

Hmmm … that appears to indicate that the board of directors is ultimately responsible, but the “acting through senior management” interjection is confusing. But the details that follow (again, the same language since 2005) provide clarity:

BSA Compliance Officer

The bank’s board of directors must designate a qualified individual to serve as the BSA compliance officer.[1] The BSA compliance officer is responsible for coordinating and monitoring day-to-day BSA/AML compliance. The BSA compliance officer is also charged with managing all aspects of the BSA/AML compliance program and with managing the bank’s adherence to the BSA and its implementing regulations; however, the board of directors is ultimately responsible for the bank’s BSA/AML compliance.

While the title of the individual responsible for overall BSA/AML compliance is not important, his or her level of authority and responsibility within the bank is critical. The BSA compliance officer may delegate BSA/AML duties to other employees, but the officer should be responsible for overall BSA/AML compliance.  The board of directors is responsible for ensuring that the BSA compliance officer has sufficient authority and resources (monetary, physical, and personnel) to administer an effective BSA/AML compliance program based on the bank’s risk profile.

This seems pretty clear: the board of directors is ultimately responsible for the bank’s BSA/AML compliance program, and for ensuring that the BSA compliance officer has the tools to do their job.

In addition, the Manual makes it clear that the BSA Officer cannot be “layered”: the BSA Officer must directly report to and take direction from the Board. The Manual provides:

“The line of communication should allow the BSA compliance officer to regularly apprise the board of directors and senior management of ongoing compliance with the BSA.  Pertinent BSA-related information, including the reporting of SARs filed with FinCEN, should be reported to the board of directors or an appropriate board committee so that these individuals can make informed decisions about overall BSA/AML compliance.  The BSA compliance officer is responsible for carrying out the direction of the board and ensuring that employees adhere to the bank’s BSA/AML policies, procedures, and processes.”

Although banking and financial crimes regulations don’t specifically spell out who is responsible for a bank’s BSA/AML program, written guidance makes it clear that the Board of Directors is responsible for ensuring that a bank implements and maintains an effective BSA/AML program.

But that isn’t what has happened in this case. The former Chief Operational Risk Officer – not the Board of Directors, nor the BSA compliance officer(s) that should have reported directly to the Board, nor anyone on the Managing Committee of the bank – was held accountable. Why was that? The answer may lie in FinCEN’s assessment against Mr. LaFontaine.

The March 4, 2020 FinCEN Assessment of Civil Money Penalty

What were the allegations against Mr. LaFontaine?

Page 2 – “Mr. LaFontaine at various times had responsibility for overseeing U.S. Bank’s compliance program and therefore shares responsibility for the Bank’s violations of the requirements to implement and maintain an effective AML program and file SARs in a timely manner.”

So it appears from this that Mr. LaFontaine shared responsibility for the program violations. Who did he share that responsibility with? Some detail is provided on page 3:

Page 3 – “Beginning in or about January 2005, and continuing through his separation from U.S. Bank in or about June 2014, Mr. LaFontaine held senior positions within the Bank’s AML hierarchy, involving oversight of the Bank’s AML compliance functions, from approximately 2008 through April 2011, and then from October 2012 through June 2014. He was the Chief Compliance Officer (CCO) of the Bank from 2005 through 2010, at which time he was promoted to Senior Vice President and Deputy Risk Officer. Thereafter, in October 2012, Mr. LaFontaine was promoted again to Executive Vice President and Chief Operational Risk Officer. In this latter position, which Mr. LaFontaine held throughout the remainder of his employment at the Bank, he reported directly to the Bank’s Chief Executive Officer (CEO) [Footnote: From early 2014 to the end of his tenure, Mr. LaFontaine reported to the Bank’s new Chief Risk Officer and had direct communications with the Bank’s Board of Directors.] As Chief Operational Risk Officer, Mr. LaFontaine oversaw the Bank’s AML compliance department (which was referred to internally as Corporate AML), and he supervised the Bank’s CCO, AML Officer (AMLO), [Footnote: The AMLO did not report directly to Mr. LaFontaine following the hiring of new Chief AML and BSA officers in the spring and summer of 2012. After these hirings, the AMLO reported to the Bank’s CCO, who reported to Mr. LaFontaine] and AML staff.”

We don’t know why the Board of Directors, any one or more of the directors (and there were at least eleven of them that were directors during the entire period in question), or any other senior officers of US Bank (and there were about a dozen of them every year), weren’t held accountable. And in this case, in at least six (6) regulatory, civil, and criminal orders running to hundreds of pages filed over a five (5) year period, we didn’t find out who the government felt was responsible for this bank’s BSA/AML compliance program. Other than Mr. LaFontaine, who was held accountable.

But one of those documents had an interesting take on responsibility. Paragraph 18 of the Treasury Department’s civil complaint against US Bank (Case No 18CV01357, filed February 15, 2018) referenced the FFIEC BSA/AML Manual. The paragraph provided:

“18. Under the BSA/AML Manual, a bank’s risk profile informs the steps it must take to comply with each of the BSA’s requirements. To develop appropriate policies and controls, banks must identify “banking operations . . . more vulnerable to abuse by money launderers and criminals . . . and provide for a BSA/AML compliance program tailored to manage risks. Similarly, while banks must designate an individual officer responsible for ensuring compliance with the BSA, such designation is not alone sufficient. Instead, the BSA/AML Manual notes that banks are responsible for ensuring that their compliance functions have ‘resources (monetary, physical, and personnel) [necessary] to administer an effective BSA/AML compliance program based on the bank’s risk profile.’”

In fact, as set out above, that is not what the Manual provides: according to the Manual, published by the OCC and FinCEN, among many other FFIEC agencies, the board of directors is responsible for ensuring that the bank implements and maintains an effective AML program. Not the “bank”, nor, in this case, the Chief Operational Risk Officer.

Paragraph 31 of the February 15, 2018 civil complaint provided that “US Bank delegated the responsibility for ensuring that it met its obligations under the BSA to its AML compliance department, which it referred to internally as Corporate AML.”

It would have been more accurate to write “US Bank attempted to delegate the responsibility for ensuring that it met its obligations under the BSA to its AML compliance department, which it referred to internally as Corporate AML; but the Board of Directors retained ultimate responsibility.” As the Manual provides, the board of directors maintains ultimate responsibility for the bank’s BSA/AML compliance, with their board-appointed BSA compliance officer “charged with managing all aspects of the BSA/AML compliance program and with managing the bank’s adherence to the BSA and its implementing regulations.”

Based on everything that is in the various pleadings, orders, and press releases, it appears that Mr. LaFontaine didn’t do that part of his job that involved managing Corporate AML. As one of the senior officers in the chain of command of US Bank’s risk organization, and as a member of the Managing Committee in 2012 and 2013, he had some responsibility and accountability: he appears to have organizationally been positioned somewhere between the BSA officers and the Board, and apparently thwarted or ignored the warnings of the AML Officer and/or BSA Officer(s) – who should have been reporting to the Board.

There is much we don’t know about this case. No one person – not even a CEO or Chairman of the Board – has the ability to run an AML program, let alone screw up that program. But apparently the Government has concluded that one person alone can be found accountable for the failures of a mega-bank’s AML program. Which begs a few questions …

Question 1 – Did the OCC inform the Board of Directors that BSA/AML risks weren’t being managed?

Paragraph 58 of the February 2018 civil complaint provided that “… despite recommendations and warnings from the OCC dating back to 2008, the Bank failed to have [the transaction monitoring system] independently validated.”

The phrase “warnings from the OCC dating back to 2008” could be explored. In the section in the Manual titled “Examiner Determination of the Bank’s BSA/AML Aggregate Risk Profile” is the following: “when the risks are not appropriately controlled, examiners must communicate to management and the board of directors the need to mitigate BSA/AML risk.” At this point, we don’t know what the OCC told the board, or when. We do know that the OCC issued a public Cease & Desist Order (on consent) in 2015.

Question 2 – Where was Internal Audit?

Independent testing, or internal audit, is one of the four (Title 12) or five (Title 31) required (minimum) pillars of a BSA/AML compliance program. And the Exam Manual provides that “the persons conducting the BSA/AML testing should report directly to the board of directors or to a designated board committee comprised primarily or completely of outside directors.” (see page 30 of the 2006 Manual, page 12 of the 2014 Manual). Which begs the question: where was US Bank’s audit team during the six+ years that there was capping of alerts and staffing issues? Shouldn’t the audit function have reported to the Board that there were long-standing issues with the transaction monitoring system and AML staffing, and that the OCC had made recommendations and warnings that went unheeded?

Question 3 – Where were the BSA Officers?

As a former BSA Officer, this was the question that was most on my mind as I read the March 4, 2020 FinCEN Assessment, and re-read the 2015 OCC order and the orders and complaints from February 2018. Indeed, I was relieved when the March Assessment came out and it was not against any of the former BSA Officers. The 2015 and 2018 documents showed an organization that appeared to organizationally bury its BSA officers, didn’t empower them, didn’t give them the required access to the Board, and certainly didn’t provide sufficient resources to allow for an effective program (all of which has been corrected with US Bank’s current BSA Officer and organization). And the March 2020 FinCEN Assessment describes two AML Officers and one Chief Compliance Officer, all reporting directly or indirectly into Mr. LaFontaine, who raised serious concerns over a number of years. At page 10 of the Assessment is this:

“In or about November 2013, a meeting was scheduled, at the request of the Bank’s CEO, so that the AMLO and CCO could update the CEO on the Bank’s AML program. In advance of that meeting, the AMLO and CCO prepared a PowerPoint presentation that began with an “Overview of Significant AML Issues,” the first of which was “Alert volumes capped for both [Security Blanket] and [Q]uery detection methods.” The AMLO and CCO put the alert caps issue first because, from their perspective, it was the most pressing of the Bank’s AML issues.  The PowerPoint identified the alert caps as a “[c]overage gap” that “could potentially result in missed Suspicious Activity Reports.” It also said that the “[s]ystem configuration and use could be deemed a program weakness, with potential formal actions including fines, orders, and historical review of transactions.” Prior to the meeting with the CEO, Mr. LaFontaine reviewed the PowerPoint, yet failed to raise the issue of the alert caps with the CEO during the meeting, choosing instead to prioritize other compliance-related issues.”

This suggests that the CEO wanted to meet with the AMLO and CCO, yet eventually met only with their boss, Mr. LaFontaine. Who took the opportunity to bury the primary message that his BSA Officer wanted the CEO to hear: that they were capping the number of alerts coming from the transaction monitoring system.

A financial institution must not organizationally “bury” its BSA Officer (AML officer): their organizational reporting line must be no more than “two-down” from the CEO and within an independent risk organization (e.g., the BSA Officer reports to the Chief Risk Officer, who reports to the CEO) and – critically – the BSA Officer must personally and directly report to the Board.[2]

It appears from the US Bank documents that neither the organizational structure nor the lines of communication allowed the BSA Officer(s) to “apprise the board of directors and senior management of ongoing compliance with the BSA … so that these individuals can make informed decisions about overall BSA/AML compliance”, as the Exam Manual requires. And it wasn’t the Chief Operational Risk Officer that was “responsible for carrying out the direction of the board and ensuring that employees adhere to the bank’s BSA/AML policies, procedures, and processes” … it was the BSA Officer(s). But it appears those BSA Officer(s) were organizationally and/or culturally stymied from directly communicating to the Board. In fact, the paragraph immediately after the description of the CEO meeting provides that “[t]he above-described conduct by Mr. LaFontaine continued until May 2014 when the AMLO bypassed Mr. LaFontaine and sent an email to the Bank’s then-Chief Risk Officer referencing the alert caps issue.”] A BSA officer must not be forced to bypass or do end-runs around a blocking boss in order to raise issues.

But whose responsibility is it to ensure that the BSA officer has the organizational stature and resources to do their job, and to ensure that the BSA officer has direct access to senior management and the board? It is the responsibility of the Board of Directors. The Manual is clear: “The board of directors is responsible for ensuring that the BSA compliance officer has sufficient authority and resources (monetary, physical, and personnel) to administer an effective BSA/AML compliance program based on the bank’s risk profile.” It shouldn’t take the regulators and, perhaps, a whistle blower to get the bank to act (page 11 of the 2020 Assessment includes: “The Bank did not begin to address its deficient policies and procedures for monitoring transactions and generating alerts until June 2014, when questions from the OCC and reports from an internal complainant caused the Bank’s Chief Risk Officer to retain outside counsel to investigate the Bank’s practices.”).

But maybe the directors weren’t aware that they were responsible for ensuring that the bank implemented and maintained an effective AML program. Which then begs the question …

Question 4 – Where was the Law Department?

Boards rely heavily on in-house counsel. Among other duties, in-house counsel must ensure that the directors understand their legal and regulatory obligations. In the case of BSA/AML, as the Exam Manual clearly sets out, the BSA program must be in writing and approved by the Board. The Board must designate a qualified individual to serve as the BSA compliance officer. The Board is responsible for ensuring that the BSA compliance officer has sufficient authority and resources (monetary, physical, and personnel) to administer an effective BSA/AML compliance program.

The first and last thing in-house counsel should leave the Board with when they are conducting their annual board training and awareness is this: “folks, if you remember one thing, remember this: as directors, you are ultimately responsible for the bank’s BSA/AML compliance.”

Question 5 – Where were the other senior managers of the bank?

The most vexing thing about this is not what is written in the FinCEN assessment or accompanying press release, but what is not written. Anyone who has spent any time in AML compliance in a mid-size to large financial institution knows that there are hundreds to thousands of people involved in designing, implementing, testing, maintaining, auditing, overseeing, and examining an AML program. Nothing happens – or doesn’t happen – without the involvement of modelers, testers, auditors, examiners, and committees; without endless finance meetings, HR meetings, “credible challenge” meetings; without senior management buy-in and support; and without the monthly or quarterly meetings with the board of directors (or a committee of the board) and the annual review and approval of the program and appointment, or re-appointment, of the BSA compliance officer.

The Government has singled out one senior manager in the 5th largest bank in the country for failures in a critical risk program that occurred over a five or six year period: where were the other senior managers?

Which takes us back full circle to the Board of Directors …

Question 6 – If the Board of Directors is responsible for a BSA compliance program, how come the Directors were not held accountable for its failures?

We simply don’t know what the US Bank board of directors knew or didn’t know when it came to the five or six years that the bank’s AML program was, apparently, not meeting regulatory requirements. We don’t know what they approved (or didn’t approve) annually. We don’t know what management, or audit, was reporting (or not reporting) to them. We don’t know whether they understood their responsibilities under the BSA regulations and regulatory guidance. We don’t know whether their annual approval of the AML program and appointment of the BSA Officer was a rubber-stamp or a fair and credible challenge of the program, the BSA Officer, and whether the BSA Officer had the monetary, physical, and personnel resources necessary to administer an effective BSA/AML compliance program based on the bank’s risk profile (paraphrasing the Manual). But it’s fair to assume that the Government found it difficult to find anyone liable where they simply failed to do their appointed task well. “We didn’t know the AML transaction monitoring system had been capped”, or “no one told us that the AML investigations team was grossly under-staffed”, or “none of the audit reports that came to the board indicated there were any problems with the AML program” become reasonably solid defenses when someone is looking to assign blame. It is much easier to find someone liable when they were presented with a problem and failed to address it, or even worse, took actions to hide it.  That said, it may simply go back to this:

“Success has many fathers; failure is an orphan”

Michael LaFontaine was considered a rising star in the banking world. The Minneapolis/St. Paul Business Journal included him in its “40 under 40 – 2014” class. In a March 21 2014 Video Clip for the “40 Under 40” program he said “success doesn’t happen alone”. Unfortunately, it appears that the opposite is true: he appears to have been singled out and left alone when it comes to finding one person responsible for something that many were accountable for. As President Kennedy said, “victory has a hundred fathers and defeat is an orphan”. More than a dozen directors had responsibility for US Bank’s AML program; eleven served from 2009-2014; and four of those are still directors. But none were held accountable.

Conclusion

The point of this article is not to encourage the Government to impose fines on all the directors, senior management, auditors, and BSA Officers involved in a program that has failures and regulatory violations. Rather, it is to point out to all the Boards of Directors out there that they are responsible for their bank’s AML program, and with that responsibility comes accountability. Knowing that, those Boards will push the management of those banks to implement and maintain effective AML programs … and hopefully prevent another individual from the horrors of personal liability.

[1] Footnote 34 in 2014 Manual: “The bank must designate one or more persons to coordinate and monitor day-to-day compliance.  This requirement is detailed in the federal banking agencies’ BSA compliance program regulations: 12 CFR 208.63, 12 CFR 211.5(m), and 12 CFR 211.24(j) (Federal Reserve); 12 CFR 326.8 (FDIC); 12 CFR 748.2 (NCUA); 12 CFR 21.21 (OCC).”

[2] There is a third question. It doesn’t involve responsibility and accountability for a BSA program, but is important nonetheless. And that is … how do you get SAR filing rates of 30% to 80% from below-the-Line testing? Both the 2018 civil complaint and March 2020 FinCEN Assessment describe the results of a look-back conducted in 2011. Paragraph 41 of the February 2018 civil complaint provides, in part: “… in November 2011, the Bank’s AML staff concluded that, during the past year, the SAR filing rates for below threshold testing averaged between 30% and 80%. In other words, between 30% and 80% of the transactions that were reviewed during the below-threshold testing resulted in the filing of a SAR.” The most efficient transaction monitoring systems have alert-to-SAR rates of 20% – 30%. In fact, the industry laments that the “false positive” rate for most transaction monitoring systems is 95% or more, for a true positive rate of 5% or less. So having a false negative rate (which is a below-the-line testing rate) of 30% to 80% makes no sense at all. Particularly since paragraph 64 of the complaint provides that 2,121 SARs were filed as a result of a six-month look back of 24,179 alerts: an alert-to-SAR rate of about 9%. [NOTE: the average value of these “look-back” SARs was over $339,000].

The Roger Stone Case – The Shenanigans Continue

Federal Court concludes that Roger Stone’s lawyers’ motion to disqualify Judge Amy Berman-Jackson is “nothing more than an attempt to use the Court’s docket to disseminate a statement for public consumption that has the words ‘judge’ and ‘biased’ in it”


www.merriam-webster.com › shenanigan 1 : a devious trick used especially for an underhand purpose. 2a : tricky or questionable practices or conduct —usually used in plural. b : high-spirited or mischievous activity —usually used in plural.

This is the second article I’ve written on the Roger Stone case. The first from February 12th, “The Roger Stone Case: Whether Outraged or Relieved, At Least Be Informed”, can be found here.

Roger Stone’s five lawyers are continuing their high-spirited activity. They filed a motion seeking to disqualify Federal District Court Judge Amy Berman-Jackson. The factual underpinning of their argument was that they had filed a motion for a new trial, alleging that one of the twelve jurors lied on their juror questionnaire and during their questioning by the Court, and that those lies related to their bias against Roger Stone and Donald Trump. That motion was pending during the sentencing hearing on February 20, 2020. Stone’s lawyers argue that during that hearing, Judge Berman-Jackson made statements that give rise to a reason to question her impartiality in connection with that pending motion for new trial based on alleged juror misconduct. They relied on section 455(a) of title 28 of the United States Code (title 28 governs the federal judiciary and judicial procedure). Section 455(a) states: “any justice, judge, or magistrate judge of the United States shall disqualify himself in any proceeding in which his impartiality might reasonably be questioned.” The purpose of section 455(a) is to promote public confidence in the judiciary by avoiding even the appearance of impropriety whenever possible, and in the District of Columbia, where this court sits, recusal is required when “a reasonable and informed observer would question the judge’s impartiality.”

What did Roger Stone’s lawyers argue? They point to this section of Judge Berman-Jackson’s sentencing:

“Sure, the defense is free to say: So what? Who cares? But, I’ll say this: Congress cared. The United States Department of Justice and the United States Attorney’s Office for the District of Columbia that prosecuted the case and is still prosecuting the case cared. The jurors who served with integrity under difficult circumstances cared. The American people cared. And I care.”

Stone’s lawyers argued that the Judge’s use of the words “jurors” and “with integrity” (which Judge Berman-Jackson noted were “three words on the 88th page of the 96-page transcript of a two-and-a-half-hour hearing”) are disqualifying because there is a pending motion for new trial with respect to a single juror, and the hearing has not yet taken place. They wrote:

“The Court’s ardent conclusion of ‘integrity’ indicates an inability to reserve judgment on an issue which has not yet been heard. Moreover, the categorical finding of integrity made before hearing the facts is likely to lead a reasonably informed observer to question the District Judge’s impartiality … The premature statement blessing ‘the integrity of the jury’ undermines the appearance of impartiality and presents a strong bias for recusal.”

How did Judge Berman-Jackson rule? Writing in the third person (“the Court, “it”, and “its”), the Judge wrote the following:

“Its characterization of the jurors’ service was voiced on the record, and it was entirely and fairly based on the Court’s observations of the jurors in the courthouse; through the nine days of voir dire and trial, when they were uniformly punctual and attentive, and through their thoughtful communications with the Court during deliberation … and the delivery of the verdict … Moreover, the record dating back to January of 2019 reflects that the Court took each issue raised by this defendant seriously; that on each occasion, it ruled with care and impartiality, laying out its reasoning in detail; and that it was scrupulous about ensuring his right to a fair trial. It granted important evidentiary motions in his favor; it proposed utilizing a written questionnaire to ensure that the parties could receive more information than is usually available for jury selection; it struck 58 potential jurors for cause based on the defendant’s motions or on its own motion; and it repeatedly resolved bond issues in his favor, even after he took to social media to intimidate the Court, after he violated conditions imposed by the Court, after he was convicted at trial, and after he was sentenced to a term of incarceration. Moreover, at the sentencing hearing that forms the sole basis for the defendant’s motion, the Court concluded, based in part on many considerations put forth by the defendant, that it was appropriate to vary from the applicable Advisory Sentencing Guideline Range.”

And finally the conclusion:

“At bottom, given the absence of any factual or legal support for the motion for disqualification, the pleading appears to be nothing more than an attempt to use the Court’s docket to disseminate a statement for public consumption that has the words “judge” and “biased” in it. For these reasons, defendant’s motion is hereby DENIED. SO ORDERED. AMY BERMAN JACKSON United States District Judge DATE: February 23, 2020”

The five lawyers that filed the motion to disqualify Judge Berman-Jackson are, no doubt, fine attorneys. This has been, and continues to be a grueling legal case (indeed, with 343 documents having been docketed, that is more than 1 each business day since the indictment was filed on January 24, 2019). I trust they’re sleeping well at night … high-spirited activity can be tiring.

Lack of Beneficial Ownership Information: a “Glaring Hole in our System” Says Treasury Secretary

On February 12, 2020, Treasury Secretary Mnuchin testified before the Senate Finance Committee on the President’s Fiscal Year 2021 budget. At the 75:22 mark of the hearing, Senator Mark Warner (D. VA) began a series of statements and questions about the lack of beneficial ownership information. Senator Warner observed that the just-submitted (February 6th) 2020 National Strategy for Combating Terrorist and Other Illicit Financing – National Strategy  – indicated that the number one vulnerability facing the U.S. efforts to combat terrorism, money laundering, and proliferation financing was the lack of beneficial ownership requirements at the time of company formation.

Senator Warren noted that “one of the key vulnerabilities identified in the report is the lack of a legally binding requirement to collect beneficial ownership at the time of company formation.” At the 76:50 mark, the Senator posed the following question:

Mr. Secretary, do you agree that one of our most urgent national security and regulatory problems is that the US Government still has no idea who really controls shell companies?

At the 77:25 mark Secretary Mnuchin replied:

“This is a glaring hole in our own system.”

What did the National Strategy have to say about lack of beneficial ownership information?

2020 National Strategy for Combating Terrorist and Other Illicit Financing – Key Vulnerability is Lack of Beneficial Ownership Information

The National Strategy listed 10 vulnerabilities. In the “Vulnerabilities Overview” section (page 12), the first of the “most significant vulnerabilities in the United States exploited by illicit actors” was “the lack of a requirement to collect beneficial ownership information at the time of company formation and after changes in ownership.” The Strategy goes on:

“Misuse of legal entities to hide a criminal beneficial owner or illegal source of funds continues to be a common, if not the dominant, feature of illicit finance schemes, especially those involving money laundering, predicate offences, tax evasion, and proliferation financing.

*****

More than two million corporations and limited liability companies (LLCs) are formed in the United States every year. Domestic shell companies continue to present criminals with the opportunity to conceal assets and activities through the establishment of a seemingly legitimate U.S. businesses. The administrative ease and low-cost of company formation in the United States provide important advantages and should be preserved for legitimate investors and businesses. However, the current lack of disclosure requirements gives both U.S. and foreign criminals a method of obfuscation that they can and have repeatedly used, here and abroad, to carry out financial crimes. There are numerous challenges for federal law enforcement when the true beneficiaries of illicit proceeds are concealed through shell or front companies. Money launderers and others involved in commercial activity intentionally conduct transactions through corporate structures in order to evade detection, and may layer such structures, much like Matryoshka dolls, across various secretive jurisdictions. In many instances, each time an investigator obtains ownership records for a domestic or foreign entity, the newly identified entity is yet another corporate entity, necessitating a repeat of the same process. While some federal law enforcement agencies may have the resources required to undertake complex (and costly) investigations, the same is often not true for state, local, and tribal law enforcement.

*****

To address a major aspect of this recognized vulnerability, FinCEN issued a Customer Due Diligence (CDD) Rule, which became fully enforceable for covered financial institutions on May 11, 2018. This rule requires, among other things, more than 23,000 covered financial institutions to identify and verify the identities of beneficial owners of legal entity customers at the time of account opening and defined points thereafter.

*****

While the CDD Rule addressed the gap of collecting beneficial ownership information at the time of account opening, there remains no categorical obligation at either the state or federal level that requires the disclosure of beneficial ownership information at the time of company formation. Treasury currently does not have the authority to require the disclosure of beneficial ownership information at the time of company formation without legislative action. The CDD
Rule is an important risk-mitigating measure for financial institutions and an equally important resource for law enforcement, but it is not a comprehensive solution to the problem and a crucial gap remains.

The United Sates is traditionally the global leader on AML/CFT. But the lack of a legally-binding requirement to collect beneficial ownership information at the time of company formation hinders the ability of all regulated sectors to mitigate risks and law enforcement’s ability to swiftly investigate those entities created to hide ownership. Crucially, this deficiency drives significant costs and delays for both the public and private sectors. The 2016 Financial Action Task Force (FATF) Mutual Evaluation Report (MER) underscored the seriousness of this deficiency. Indeed, this gap is one of the principal reasons for the United States’ failing grade regarding the efficacy of its mechanisms for beneficial ownership transparency.” (citations omitted)

Key Priorities of the US Government in Combating Terrorism, Money Laundering, and Proliferation Financing

After setting out the threats and vulnerabilities, the 2020 National Strategy turned to the US Government’s three key priorities in fighting terrorist and other illicit financial activity:

“To make this 21st century AML/CFT regime a practical reality, the U.S. government will continue to review and pursue the following key priorities: (1) modernize our legal framework to increase transparency and close regulatory gaps; (2) continue to improve the efficiency and effectiveness of our regulatory framework for financial institutions; and (3) enhance our current AML/CFT operational framework. This will include the supporting actions discussed below.” (page 39)

Priority 1: Increase Transparency and Close Legal Framework Gaps

This first priority has four supporting actions: (i) require collection of beneficial ownership information by the government at time of company formation and after ownership changes; (ii) minimize the risks of the laundering of illicit proceeds through real estate purchases; (iii) extend AML program obligations to certain financial institutions and intermediaries currently outside the scope of the BSA; and (iv) clarify or update our regulatory framework to expand coverage of digital assets.

Supporting Action: Require the Collection of Beneficial Ownership Information by the Government at Time of Company Formation and After Ownership Changes

Currently, there is no categorical obligation at the state or federal level that requires the disclosure of beneficial ownership information at the time of company formation. Also, Treasury does not have the authority to require the disclosure of beneficial ownership information at the time of company formation without legislative action. Having immediate access to accurate information about the natural person behind a company or legal entity is essential for law enforcement and other authorities to disrupt complex money laundering and proliferation financing networks. However, this must be balanced with individual privacy concerns and not be unduly burdensome for small businesses.

The Administration believes that congressional proposals to require the collection of beneficial ownership information of legal entities by FinCEN, including the Corporate Transparency Act represents important progress in strengthening national security, supporting law enforcement, and clarifying regulatory requirements. The Administration is working with Congress. The aim—pass beneficial ownership legislation in 2020. It is important that any law enacted should closely align the definition of “beneficial owner” to that in FinCEN’s CDD Rule, protect small businesses from unduly burdensome disclosure requirements, and provide for adequate access controls with respect to the information gathered under this bill’s new disclosure regime.

The ILLICIT CASH Act – A Solution to the Beneficial Ownership Vulnerability

The 2020 National Strategy refers to congressional proposals. One of those was mentioned by Senator Warren, who referred to the bipartisan support that exists in Congress for addressing this vulnerability through a Senate bill, the ILLICIT CASH Act, S.2563 before the Senate Banking Committee. Senator Warren noted that the ILLICIT CASH Act, or Improving Laundering Laws & Increasing Comprehensive Information Tracking of Criminal Activity in Shell Holdings Act (clearly one of the great “backronyms” of all time!) had the support of 4 Democrats and 4 Republicans. Title IV of that bill set out “Beneficial Ownership Disclosure Requirements”, and included provisions to establish beneficial ownership reporting requirements. Although there is bipartisan and Administration support for the bill, not everyone is as supportive: the American Bar Association, for one, opposes the bill.

The American Bar Association – Supportive of Reasonable Measures to Combat Money Laundering, But Not the ILLICIT CASH Act

The American Bar Association – ABA Position on Combating Financial Crime  – “supports reasonable and necessary domestic and international measures designed to combat money laundering and terrorist financing. However, the Association opposes legislation and regulations that would impose burdensome and intrusive gatekeeper requirements on small businesses or their attorneys or undermine the attorney-client privilege, the confidential attorney-client relationship, or the right to effective counsel.” With respect to the ILLICIT CASH Act, the ABA opposes key provisions, and expressed that opposition in a June 19, 2019 letter to the Chairman and Ranking Member of the Senate Banking Committee. ABA Letter Opposing the ILLICIT CASH Act. And on their webpage:

“The ILLICIT CASH Act would require anyone involved in a real estate purchase or sale to file a detailed report with the Treasury Department containing the name of the natural person purchasing the real estate, the amount and source of the funds received, the date and nature of the transaction, and other data. Because attorneys often represent clients in real estate transactions, the ILLICIT CASH Act would compel many attorneys to disclose confidential client information to the government, a result plainly inconsistent with state court ethics rules.”

Conclusion – Courage to Compromise Is Needed if We Are to Make Inroads in the Fight Against Terrorism, Money Laundering, and Proliferation Financing

The ABA’s concerns about burdensome and intrusive requirements and undermining the attorney-client privilege are understandable. The Treasury Department’s concerns about the vulnerabilities of, and need to amend, the broken beneficial ownership regime are understandable. Democrats and Republicans in the House and Senate, and Republicans in the White House, will need to come together to draft, pass, and enact laws to fix the broken beneficial ownership regime. All of these groups, and more, will need the courage to compromise if we are to fill the most glaring hole in our AML system.

The Roger Stone Case – Whether Outraged or Relieved, At Least Be Informed

“A good deal of hysteria, some of it reflexive, much of it recreational”

The media, social media, politicians, and pundits are reacting loudly and passionately about the President’s decision to weigh in on the sentencing of Roger Stone, the resignations of four Assistant United States Attorneys involved in the case, and the decision of the Department of Justice to submit a revised sentencing recommendation. And the hysteria should continue for the foreseeable future, with the sentencing of Mr. Stone now set for February 20th.

Whether you are outraged or relieved about what is happening in this case, your outrage or relief should at least be informed.

In an essay published on May 10, 2004 in the Wall Street Journal’s Opinion section titled “The Spirit of Liberty: Before Attacking the Patriot Act, Try Reading It”, then chief judge of the U. S. District Court, Southern District of New York Michael Mukasey reminded us that if we were to express opinions on something, those opinions should at least be informed. Judge Mukasey was writing about the USA PATRIOT Act, passed in October 2001 in the wake of the 9/11 terrorist attacks, a statute which had “become the focus of a good deal of hysteria, some of it reflexive, much of it recreational.” Judge Mukasey wrote that “[l]ike any other act of Congress, the Patriot Act should be scrutinized, criticized and, if necessary, amended. But in order to scrutinize and criticize it, it helps to read what is actually in it.”

The Roger Stone case isn’t an act of Congress, but the facts of the case – set out in the 288 documents on the docket – should be read and understood before one expresses an opinion. But 288 documents is a lot of reading. Three of those documents should, in my opinion, be enough to provide enough of a balanced background to allow someone to have and express an informed opinion: the Government’s original Sentencing Memorandum, Roger Stone’s Sentencing Memorandum, and the Government’s Revised Sentencing Memorandum.  These are all publicly available documents. I’ll summarize them here. But first, a stop to explain the Sentencing Guidelines that are used in all federal criminal cases and which have been the subject of much of the rational, irrational, reflexive, or recreational hysteria around the Roger Stone case.

Federal Sentencing Guidelines – a Primer

The following is an excerpt from my April 2019 article on the College Admissions Scandal – College Admissions Scandal – RegTech Consulting Article April 16, 2019.

The Federal Sentencing Guidelines are intended to provide “guideline ranges that specify an appropriate sentence for each class of convicted persons determined by coordinating the offense behavior categories with the offender characteristic categories.” US Sentencing Commission Link

So there are two things to be considered: the defendant’s own criminal histories, if any, and the “offense level” of their crime, adjusted for various aggravating factors, and adjusted down for “acceptance of responsibility”. This gives an offense level of between 1 and 43, organized into four “zones”. The defendant’s criminal history is then considered, resulting in being placed into one of six criminal history categories. The result is a Sentencing Table with the seriousness of the crime on the Y axis and the seriousness of the criminal on the X axis. The court refers to, and can depart from, the ranges set out in the Table. A (partial) sentencing table (showing only the first 30 of the 43 offence levels) is seen below.

United States v. Roger J. Stone, U.S. District Court, District of Columbia Case 19CR00018 – Sentencing Scheduled for February 20, 2020

Government’s Original Sentencing Memorandum – Seeking imprisonment consistent with Sentencing Guidelines of 87-108 months

The Government’s original Sentencing Memorandum went through the history of the case. In January 2019 a federal grand jury indicted Roger Stone on seven criminal counts: one count of obstruction of a Congressional investigation (relating to his sworn testimony before the House Intelligence Committee), five counts of making false statements to Congress (“in his testimony before the House Intelligence Committee, Stone told the Committee five categories of lies”), and one count of witness tampering. In November 2019, after a lengthy trial, a jury convicted Roger Stone of all seven counts. The Memorandum also included a number of issues relating to the pre-trial conduct of Mr. Stone, and the court’s response to that conduct. An episode relating to an image Mr. Stone posted to Instagram of the judge with cross-hairs next to her head was included in the Memorandum.

The Government asked that “a sentence consistent with the applicable advisory Guidelines would accurately reflect the seriousness of his crimes and promote respect for the law.” At page 16 of its Memorandum, the Government set out the Guidelines Range based on an offense level of 29 and a Criminal History category of I (no criminal record), resulting in a range of imprisonment of 87 months to 108 months. That offense level of 29 was determined as follows:

14 for the base offense(s) level

+8 for threatening a witness

+3 for interference with the administration of justice

+2 for an offense that was extensive in scope, planning, or preparation

+2 for obstruction of justice

Roger Stone’s Sentencing Memorandum – Seeking probation below the Sentencing Guidelines of 15-21 months

Roger Stone’s attorneys’ Memorandum included a number of character references (letters) and focused on his exemplary personal life, a life they pointed out was very different than his public persona. They laid out a position that the sentencing guidelines should be based only on the base offense level of 14, without any enhancements, leaving a guideline range of 15 to 21 months, and that the Court should go below that range and sentence the defendant to a period of probation. They concluded ” the Court should impose a non-Guidelines sentence of probation with any conditions that the Court deems reasonable under the
circumstances.”

Government’s Amended Sentencing Memorandum (February 11) – Seeking imprisonment “far less than” Sentencing Guidelines of 87-108 months, but leaving it up to the Judge to decide how much less than

After the four Assistant US Attorneys withdrew from the case, new counsel from the Department of Justice filed an amended Sentencing Memorandum, setting out the Government’s position that:

“The prior filing submitted by the United States on February 10, 2020 (Gov. Sent. Memo. ECF No. 279) does not accurately reflect the Department of Justice’s position on what would be a reasonable sentence in this matter. While it remains the position of the United States that a sentence of incarceration is warranted here, the government respectfully submits that the range of 87 to 108 months presented as the applicable advisory Guidelines range would not be appropriate or serve the interests of justice in this case.”

And the Government concluded:

“The defendant committed serious offenses and deserves a sentence of incarceration that is “sufficient, but not greater than necessary” to satisfy the factors set forth in Section 3553(a). Based on the facts known to the government, a sentence of between 87 to 108 months’ imprisonment, however, could be considered excessive and unwarranted under the circumstances. Ultimately, the government defers to the Court as to what specific sentence is appropriate under the facts and circumstances of this case.”

Conclusion

You’ve read, or will read, the three sentencing memoranda. You have or will have a rudimentary understanding of the Federal Sentencing Guidelines and how they were applied in this case. From there, you can join the debate and express a reasonably learned opinion, backed by some knowledge of the facts. It is my opinion that everyone has a right to their opinion and to express that opinion, but it is their duty to express that opinion only after informing themselves of the facts and, to paraphrase Judge Mukasey, without resorting to reflexive, recreational hysteria.

Chinese Money Brokers – The First US Case Involving An Identified Threat to the US Financial System?

February 6, 2020 – US Warns of Chinese Money Brokers Integrating Illicit Cash Proceeds through Trade Based Money Laundering, or TBML

On February 6, 2020, the Treasury Department released its 2020 National Strategy for Combating Terrorist and Other Illicit Financing. 2020 National Strategy. Among other threats to the US financial system were Chinese money laundering networks, or money brokers, described at pages 24 and 25 of the Strategy …

U.S. law enforcement has seen an increase in complex schemes to launder proceeds from the sale of illegal narcotics in the United States by facilitating the exchange of cash proceeds from Mexican drug trafficking organizations to Chinese citizens residing in the United States. These money laundering schemes, run by Professional Money Laundering Networks, or PMLNs, are designed to sidestep two separate obstacles: Drug Trafficking Organizations’ (DTOs’) inability to repatriate drug proceeds into the Mexican banking system due to dollar deposit restrictions imposed by Mexico in 2010 [of $4,000 a month per individual and $1,500 a month for U.S. currency exchanges by non-accountholders] and Chinese capital flight law restrictions on Chinese citizens located in the United States that prevent them from transferring the equivalent of US$50,000 held in Chinese bank accounts for use abroad. Chinese money laundering networks facilitate the transfer of cash between these two groups.

As described in the graphic from the Strategy [below], a variety of Chinese money brokers, processors and money couriers facilitate these PMLNs. Brokers in Mexico coordinate with DTOs in order for the DTOs to receive pesos in exchange for drug profits earned in the United States. The DTO instructs a courier in the United States to provide U.S. currency to the broker’s U.S. processor. The processor then launders the cash and identifies U.S.-based buyers. In exchange for U.S. currency, the buyer will transfer renminbi (RMB) through their Chinese bank account to a Chinese account controlled by the money broker. The broker then uses the RMB to buy commodities from a Chinese manufacturer for export to Mexico. Once the goods arrive in Mexico, the broker or the DTO completes the cycle by selling the goods locally for pesos.”

 

February 3, 2020 – Owners of Underground, International Financial Institutions Plead Guilty to Operating Unlicensed Money Transmitting Business

The First Chinese Money Broker Prosecution? On February 3, 2020 – three days before the 2020 National Strategy was released, the US Attorney for the Southern District of California issued a press release that announced that Bing Han and Lei Zhang pleaded guilty in federal court for operating unlicensed money transmitting businesses. The US Attorney noted that the guilty pleas “are believed to be the first in the United States for a developing form of unlawful underground financial institution that transfers money between the United States and China, thereby circumventing domestic and foreign laws regarding monetary transfers and reporting, including United States anti-money laundering scrutiny and Chinese capital flight controls.”

The press release described the scheme as admitted in the plea agreements (which are not available online) as follows:

“Han and Zhang would collect U.S. dollars (in cash) from various third-parties in the United States and deliver that cash to a customer, typically a gambler from China who could not readily access cash in the United States due to capital controls that limit the amount of Chinese yuan an individual can convert to foreign currency at $50,000 per year. Upon receipt of the U.S. dollars, the customer (i.e., the gambler) would transfer the equivalent value of yuan (using banking apps on their cell phones in the United States) from the customer’s Chinese bank account to a Chinese bank account designated by defendant Han or Zhang. For facilitating these transactions, Zhang and Han were paid a commission based on the monetary value illegally transferred … Han and Zhang further admitted that they were regularly introduced to customers by casino hosts, who sought to increase the gambling play of the casino’s customers. By connecting cash-starved gamblers in the United States with illicit money transmitting businesses, like those operated by Han and Zhang, the casinos increased the domestic cash play of their China-based customers. All a gambler needed was a mobile device that had remote access a China-based bank account. As a result, Han and Zhang managed to transmit and convert electronic funds in China into hard currency in the United States; all while circumventing the obstacles imposed both by China’s capital controls, and the anti-money laundering scrutiny imposed on all United States financial institutions. For their efforts, the casino hosts often received a cut of Han’s or Zhang’s commission.”

This sounds very similar to what was described in the 2020 National Strategy document. AML professionals should put a reminder in their calendars for the sentencing hearings of Han and Zhang in order to learn more about these “Chinese Money Broker” crimes that pose a threat to the US financial system.

US v. Bing Han, SD CA Case 20CR00369 is scheduled for sentencing on May 1, 2020.

US v. Lei Zhang, SD CA Case 20CR00370 is scheduled for sentencing on May 4, 2020.

OCC Comptroller Talks About AML “False Negatives” and Technology

Whether “False Negatives” or “False Positives”, the Answer May Not Lie Just in New or Improved Technologies, but in an Improved Mix of New Technologies and More Forgiving Regulatory Requirements


On January 24, 2020, Jo Ann Barefoot had Thomas Otting, Comptroller of the Currency, as her guest on her podcast. The link is available at Barefoot Otting Podcast. Among other things, the Comptroller talked about BSA/AML, or as he put it “AML/BSA”.

Approximately 12:00 minutes into the podcast, the Comptroller had this to say about BSA/AML:

“Are we doing it the most effective way? … what we’re doing, is it helping us catch the bad guys as they’re coming into the banking industry and taking advantage of it?”

In a discussion on technology trends, the Comptroller spoke about how banks are using new technologies to learn about their customers and for risk management. Beginning at the 20:45 mark, he stated:

“Today our AML/BSA relies upon a lot of systems to kick out a lot of data that often has an enormous amount of false negatives associated with it that requires a lot of resources to go through that false negative, and I think if we can get to the point where we have better fine-tuned data with artificial intelligence about tracking information is and the type of activities that are occurring, I think ultimately we’ll have better risk management practices within the institutions as well.”

Having been a guest on Jo Ann’s podcast myself (see Richards Podcast), I know how unforgiving the literal transcript of a podcast can be, so it is fair to write that the Comptroller’s point was that the current systems kick out a lot of false negatives that require a lot of manual investigations; and better data and artificial intelligence could reduce those false negatives, resulting in greater efficiencies and better risk management.

But it is curious that he refers to “false negatives” – which are transactions that do not alert but should have alerted – rather than “false positives” – which are transactions that did alert and, after being investigated, prove not to be suspicious and therefore falsely alerted.  The Comptroller has many issues to deal with, and it’s easy to confuse false negatives with false positives. In fairness, his ultimate point was well made: the current regulatory requirements and expectations around AML monitoring, alerting, investigations, and reporting have resulted in a regime that is not efficient (he didn’t addressed the effectiveness of the SAR regime).

At the 21:30 mark, Jo Ann Barefoot commented on the recent FinTech Hackathon she hosted that looked at using new technology to make suspicious activity  monitoring and reporting more efficient and effective, and stated that “we need to get rid of the false flags in the system” (I got the sense that she was uncomfortable with using the Comptroller’s phrase of “false negatives” – Jo Ann is well-versed in BSA and AML and familiar with the issue of high rates of false positives). Comptroller Otting replied:

“If you think just in the SARs space, that 7 percent of transactions kind of hit the tripwire, and then ultimately about 2 percent generally have SARs filed against them, that 5 percent is an enormous amount of resources that organizations are dedicating towards that compliance function that I’m convinced that with new technology we can improve that process.”

Again, podcast transcripts can be unforgiving, and I believe the point that the Comptroller was making was that a small percentage of transactions are alerted on by AML monitoring systems, and an even smaller percentage of those alerts are eventually reported in SARs. His percentages, and math, may not foot back to any verifiable data, but his point is sound: the current AML monitoring, alerting, investigations, and reporting system isn’t as efficient as it should be and could be (again, he didn’t address its effectiveness).

I don’t believe that the inefficiencies in the current AML system are wholly caused by outdated or poorly deployed technology. Rather, financial institutions are (rightfully) deathly afraid of a regulatory sanction for missing a potentially suspicious transaction, and will err on the side of alerting and filing on much more than is truly suspicious. For larger institutions, it will cost them a few million dollars more to run at a 95% false positive rate rather than an 85% rate, or 75% rate (I address the question of what is a good false positive rate in one of the articles, below), but those institutions know that by doing so, they avoid the hundreds of millions of dollars in potential fines for missing that one big case, or series of cases, that their regulator, with hindsight, determines should have been caught.

Running an AML monitoring and surveillance program that produces 95% false positives is not “helping us catch the bad guys that are taking advantage of the banking industry” as the Comptroller noted at the beginning of the podcast. Perhaps a renewed and coordinated, cooperative effort between technologists, bankers, BSA/AML professionals, law enforcement, and the Office of the Comptroller of the Currency can lead us to a monitoring/surveillance regime enhanced with more effective technologies and better feedback on what is providing tactical and strategic value to law enforcement … and, hopefully, tempered by a more forgiving regulatory approach.

Below are two articles I’ve written on monitoring, false positive rates, the use of artificial intelligence, among other things. Let’s work together to get to a more effective and efficient AML regime.

Rules-Based Monitoring, Alert to SAR Ratios, and False Positive Rates – Are We Having The Right Conversations?

This article was published on December 20, 2018. It is available at RegTech Article – Are We Having the Right Conversations?

There is a lot of conversation in the industry about the inefficiencies of “traditional” rules-based monitoring systems, Alert-to-SAR ratios, and the problem of high false positive rates. Let me add to that conversation by throwing out what could be some controversial observations and suggestions …

Current Rules-Based Transaction Monitoring Systems – are they really that inefficient?

For the last few years AML experts have been stating that rules-based or typology-driven transaction monitoring strategies that have been deployed for the last 20 years are not effective, with high false positive rates (95% false positives!) and enormous staffing costs to review and disposition all of the alerts.  Should these statements be challenged? Is it the fact the transaction monitoring strategies are rules-based or typology-driven that drives inefficiencies, or is it the fear of missing something driving the tuning of those strategies? Put another way, if we tuned those strategies so that they only produced SARs that law enforcement was interested in, we wouldn’t have high false positive rates and high staffing costs.  Graham Bailey, Global Head of Financial Crimes Analytics at Wells Fargo, believes it is a combination of basic rules-based strategies coupled with the fear of missing a case. He writes that some banks have created their staffing and cost problems by failing to tune their strategies, and by “throwing orders of magnitude higher resources at their alerting.”  He notes that this has a “double negative impact” because “you then have so many bad alerts in some banks that they then run into investigators’ ‘repetition bias’, where an investigator has had so many bad alerts that they assume the next one is already bad” and they don’t file a SAR. So not only are the SAR/alert rates so low, you run the risk of missing the good cases.

After 20+ years in the AML/CTF field – designing, building, running, tuning, and revising programs in multiple global banks – I am convinced that rules-based interaction monitoring and customer surveillance systems, running against all of the data and information available to a financial institution, managed and tuned by innovative, creative, courageous financial crimes subject matter experts, can result in an effective, efficient, proactive program that both provides timely, actionable intelligence to law enforcement and meets and exceeds all regulatory obligations. Can cloud-based, cross-institutional, machine learning-based technologies assist in those efforts? Yes! If properly deployed and if running against all of the data and information available to a financial institution, managed and tuned by innovative, creative, courageous financial crimes subject matter experts.

Alert to SAR Ratios – is that a ratio that we should be focused on?

A recent Mid-Size Bank Coalition of America (MBCA) survey found the average MBCA bank had: 9,648,000 transactions/month being monitored, resulting in 3,908 alerts/month (0.04% of transactions alerted), resulting in 348 cases being opened (8.9% of alerts became a case), resulting in 108 SARs being filed (31% of cases or 2.8% of alerts). Note that the survey didn’t ask whether any of those SARs were of interest or useful to law enforcement. Some of the mega banks indicate that law enforcement shows interest in (through requests for supporting documentation or grand jury subpoenas) 6% – 8% of SARs.

So I argue that the Alert/SAR and even Case/SAR (in the case of Wells, Package/Case and Package/SAR) ratios are all of interest, but tracking to SARs filed is a little bit like a car manufacturer tracking how many cars it builds but not how many cars it sells, or how well those cars perform, how well they last, and how popular they are.  The better measure for AML programs is “SARs purchased”, or SARs that provide value to law enforcement.

How do you determine whether a SAR provides value to Law Enforcement? One way would be to ask Law Enforcement, and hope you get an answer. That could prove to be difficult.  Can you somehow measure Law Enforcement interest in a SAR?  Many banks do that by tracking grand jury subpoenas received to prior SAR suspects, Law Enforcement requests for supporting documentation, and other formal and informal requests for SARs and SAR-related information. As I write above, an Alert-to-SAR rate may not be a good measure of whether an alert is, in fact, “positive”. What may be relevant is an Alert-to-TSV SAR rate (see my previous article for more detail on TSV SARs).  What is a “TSV SAR”? A SAR that has Tactical or Strategic Value to Law Enforcement, where the value is determined by Law Enforcement providing a response or feedback to the filing financial institution within five years of the filing of the SAR that the SAR provided tactical (it led to or supported a particular case) or strategic (it contributed to or confirmed a typology) value. If the filing financial institution does not receive a TSV SAR response or feedback from law enforcement or FinCEN within five years of filing a SAR, it can conclude that the SAR had no tactical or strategic value to law enforcement or FinCEN, and may factor that into decisions whether to change or maintain the underlying alerting methodology. Over time, the financial institution could eliminate those alerts that were not providing timely, actionable intelligence to law enforcement, and when that information is shared across the industry, others could also reduce their false positive rates.

Which leads to …

False Positive Rates – if 95% is bad … what’s good?

There is a lot of lamenting, and a lot of axiomatic statements, about high false positive rates for AML alerts: 95% or even 98% false positive rates.  I’d make three points.

First, vendors selling their latest products, touting machine learning and artificial intelligence as the solution to high false positive rates, are doing what they should be doing: convincing consumers that their current product is out-dated and ill-equipped for its purpose by touting the next, new product. I argue that high false positive rates are not caused by the current rules-based technologies; rather, they’re caused by inexperienced AML enthusiasts or overwhelmed AML experts applying rules that are too simple against data that is mis-labeled, incomplete, or simply wrong, and erring on the side of over-alerting and over-filing for fear of regulatory criticism and sanctions.

If the regulatory problems with AML transaction monitoring were truly technology problems, then the technology providers would be sanctioned by the regulators and prosecutors.  But an AML technology provider has never been publicly sanctioned by regulators or prosecutors … for the simple reason that any issues with AML technology aren’t technology issues: they are operator issues.

Second, are these actually “false” alerts? Rather, they are alerts that, at the present time, based on the information currently available, do not rise to the level of either (i) requiring a complete investigation, or (ii) if completely investigated, do not meet the definition of “suspicious”. Regardless, they are now valuable data points that go back into your monitoring and case systems and are “hibernated” and possibly come back if that account or customer alerts at a later time, or there is another internally- or externally-generated reason to investigate that account or customer.

Third, if 95% or 98% false positive rates are bad … what is good? What should the target rate be? I’ll provide some guidance, taken from a Treasury Office of Inspector General (OIG) Report: OIG-17-055 issued September 18, 2017 titled “FinCEN’s information sharing programs are useful but need FinCEN’s attention.” The OIG looked at 314(a) statistics for three years (fiscal years 2010-2012) and found that there were 711 314(a) requests naming 8,500 subjects of interest sent out by FinCEN to 22,000 financial institutions. Those requests came from 43 Law Enforcement Agencies (LEAs), with 79% of them coming from just six LEAs (DEA, FBI, ICE, IRS-CI, USSS, and US Attorneys’ offices). Those 711 requests resulted in 50,000 “hits” against customer or transaction records by 2,400 financial institutions.

To analogize those 314(a) requests and responses to monitoring alerts, there were 2,400 “alerts” (financial institutions with positive matches) out of 22,000 “transactions” (total financial institutions receiving the 314(a) requests). That is an 11% hit rate or, arguably, a 89% false positive rate. And keep in mind that in order to be included in a 314(a) request, the Law Enforcement Agency must certify to FinCEN that the target “is engaged in, or is reasonably suspected based on credible evidence of engaging in, terrorist activity or money laundering.” So Law Enforcement considered that all 8,500 of the targets in the 711 requests were active terrorists or money launderers, and 11% of the financial institutions positively responded.

With that, one could argue that a “hit rate” of 10% to 15% could be optimal for any reasonably designed, reasonably effective AML monitoring application.

But a better target rate for machine-generated alerts is the rate generated by humans. Bank employees – whether bank tellers, relationship managers, or back-office personnel – all have the regulatory obligation of reporting unusual activity or transactions to the internal bank team that is responsible for managing the AML program and filing SARs. For the twenty plus years I was a BSA Officer or head of investigations at large multi-national US financial institutions, I found that those human-generated referrals resulted in a SAR roughly 40% to 50% of the time.

An alert to SAR ratio goal of machine-based alert generation systems should be to get to the 40% to 50% referral-to-SAR ratio of human-based referral generation programs.

Flipping the Three AML Ratios with Machine Learning and Artificial Intelligence (why Bartenders and AML Analysts will survive the AI Apocalypse)

This article was posted on December 14, 2018. It remains the most viewed article on my website. It is available at RegTech Article – Flipping the Ratios

Machine Learning and Artificial Intelligence proponents are convinced – and spend a lot of time trying to convince others – that they will disrupt and revolutionize the current “broken” AML regime. Among other targets within this broken regime is AML alert generation and disposition and reducing the false positive rate (more on false positives in another article!). The result, if we believe the ML/AI community, is a massive reduction in the number of AML analysts that are churning through the hundreds and thousands of alerts, looking for the very few that are “true positives” worthy of being labelled “suspicious” and reported to the government.

But is it that simple? Can the job of AML Analyst be eliminated or dramatically changed – in scope and number of positions – by machine learning and AI? Much has been and continues to be written about the impact of artificial intelligence on jobs.  Those writers have categorized jobs along two axes – a Repetitive-to-Creative axis, and an Asocial-to-Social axis – resulting in four “buckets” of jobs, with each bucket of jobs being more or less likely to be disrupted or even eliminated:

A good example is the “Social & Repetitive” job of Bartender: Bartenders spend much of their time doing very routine, repetitive tasks: after taking a drink order, they assemble the correct ingredients in the correct amounts, and put those ingredients in the correct glass, then present the drink to the customer. All of that could be more efficiently and effectively done with an AI-driven machine, with no spillage, no waste, and perfectly poured drinks. So why haven’t we replaced bartenders? Because a good bartender has empathy, compassion, and instinct, and with experience can make sound judgments on what to pour a little differently, when to cut-off a customer, when to take more time or less with a customer. A good bartender adds value that a machine simply can’t.

Another example could be the “Asocial & Creative” (or is it “Social & Repetitive”?) job of an AML Analyst: much of an AML Analyst’s time is spent doing very routine, repetitive tasks: reviewing the alert, assembling the data and information needed to determine whether the activity is suspicious, writing the narrative. So why haven’t we replaced AML Analysts? Because a good Analyst, like a good bartender, has empathy, compassion, and instinct, and with experience can make sound judgments on what to investigate a little differently, when to cut-off an investigation, when to take more time or less on an investigation. A good Analyst adds value that a machine simply can’t.

Where AI and Machine Learning, and Robot Process Automation, can really help is by flipping the three currently inefficient AML ratios:

  1. The False Positive Ratio– the currently accepted, but highly axiomatic and anecdotal, ratio is that 95% to 98% of alerts do not result in SARs, or are “false positives” … although no one has ever boldly stated what an effective or acceptable false positive rate is (even with ROC curves providing some empirical assistance), perhaps the ML/AI/RPA communities can flip this ratio so that 95% of alerts result in SARs. If they can do this, they can also convince the regulatory community that this new ratio meets regulatory expectations (because as I’ll explain in an upcoming article, the  false positive ratio problem may be more of a regulatory problem than a technology problem).
  2. The Forgotten SAR Ratio– like false positive rates, there are anecdotes and some evidence that very few SARs provide tactical or strategic value to law enforcement. Recent Congressional testimony suggests that ~20% of SARs provide TSV (tactical or strategic value) to law enforcement … perhaps the ML/AI/RPA communities can help to flip this ratio so that 80% of SARs are TSV SARs. This also will take some effort from the regulatory and law enforcement communities.
  3. The Analysts’ Time Ratio– 90% of an AML Analyst’s time can be spent simply assembling the data, information, and documents needed to investigate a case, and only 10% of their time thinking and using their empathy, compassion, instinct, judgment, and experience to make good decisions and file TSV SARs … perhaps the ML/AI/RPA communities can help to flip this ratio so that Analysts spend 10% of their time assembling and 90% of their time thinking.

We’ve seen great strides in the AML world in the last 5-10 years when it comes to applying machine learning and creative analytics to the problems of AML monitoring, alerting, triaging, packaging, investigations, and reporting. My good friend and former colleague Graham Bailey at Wells Fargo designed and deployed ML and AI systems for AML as far back as 2008-2009, and the folks at Verafin have deployed cloud-based machine learning tools and techniques to over 1,600 banks and credit unions.

I’ve outlined three rather audacious goals for the machine learning/artificial intelligence/robotic process automation communities:

  1. The False Positive Ratio – flip it from 95% false positives to 5% false positives
  2. The Forgotten SAR Ratio – flip it from 20% TSV SARs to 80% TSV SARs
  3. The Analysts’ Time Ratio – flip it from 90% gathering data to 10% gathering data

Although many new AML-related jobs are being added – data scientist, model validator, etc. – and many existing AML-related jobs are changing, I am convinced that the job of AML Analyst will always be required. Hopefully, it will shift over time from being predominantly that of a gatherer of information and more of a hunter of criminals and terrorists. But it will always exist. If not, I can always fall back on being a Bartender. Maybe …