Hong Kong: Dirty money and dubious structures: 7 practical insights into the revamped Hong Kong AML/CTF regime

Last Updated: 4 June 2012
Article by Richard Mazzochi and Urszula McCormack

The new anti-money laundering and counter-terrorist financing (AML/CTF) regime came into force on 1 April 2012. One month on, we answer 7 of our clients' most frequently asked questions about criminal liability, funds, SOEs and more in this alert.

A quick intro

Hong Kong has a new AML/CTF regime for Hong Kong-regulated financial institutions (FIs). The reforms respond to a 2007 "mutual evaluation" by the global standard-setter, which identified systemic weaknesses in Hong Kong's existing framework.

The new regime comprises two tiers of regulation:

  • legislation - the Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (Cap. 615) (AMLO); and
  • guidelines - supplementary guidance issued by each regulator, which includes guidelines that apply to all types of FIs, plus sector-specific guidelines (Guidelines).

While some aspects of the new Hong Kong regime stayed true to the old, there are some fairly substantial developments. The volume of the AMLO and Guidelines – more than double the previous industry guidelines - testifies to this.

King & Wood Mallesons was heavily involved in negotiating changes to both the AMLO and the banking industry Guidelines during 2010-2012. The following insights are drawn from that project and follow-up work with our clients.

1. Criminal liability - who it affects and how to avoid it

The most dramatic change to the Hong Kong AML/CTF rules is criminal liability.

Individual staff and managers can be criminally liable if they "knowingly cause" or "knowingly permit" a breach of customer due diligence (CDD, also known as "KYC") and other requirements.

The upshot is up to 7 years' imprisonment and a fine of up to HK$1 million, with the highest penalties applying where there is an "intent to defraud".

These penalty provisions are broad and severe. They potentially capture anyone associated with the breach, no matter how innocent the act itself. For example, they can penalise the banker facing the client, the business manager assisting with onboarding, the back-office employee processing an instruction, the compliance team approving it and the senior manager overseeing the relevant department as a whole.

However, there is a defence - complying with internal policies and procedures that were designed to ensure compliance with the relevant requirement.

The 6 takeaways for staff are as follows:

  1. Assume you are potentially on the hook, no matter what your role.
  2. Follow policies and procedures.
  3. Escalate the issue if the policies do not cover the situation or a deviation is needed.
  4. Keep a paper trail - the law expects the staff member to prove they complied.
  5. Anyone involved in designing policies and procedures must be extremely careful. The buck may ultimately stop with you. Include escalation procedures and when to obtain legal advice. Consider having policies reviewed by an external lawyer.
  6. Grey area? Don't risk it - speak to your legal advisors.

2. Who is a "customer"?

This depends on who is asking. The overarching principle is that "customer" has its "everyday meaning...in the context of industry practice".

Each sector then has its own flavour of that concept:

Banking sector Generally, each party with whom a business relationship is established or for whom a transaction is carried out, and excludes third parties.
Securities sector Each person who is a "client", as defined in Part 1 of Schedule 1 to the Securities and Futures Ordinance (SFO), unless the context requires otherwise. This is linked to regulated activities under the SFO.
Insurance sector The insurance policy holder.

As simple as this appears on paper, the question is more complex in practice. Offshore-booked accounts, the use of affiliated arrangers and prepaid cards are just three examples of tricky arrangements, where a small change in facts has material regulatory impacts.

Factual considerations include the following:

  • Is there any direct contact with the person?
  • If so, what is the nature of that contact – when, what and how?
  • What services are provided (directly or indirectly) to that person?
  • Who pays for those services?
  • Who receives the benefit?
  • In whose name are any accounts held?
  • Does any monitoring take place?

Substance is more important to regulators than form, and that assessment is not always easy. If in doubt, speak to us.

3. Investment vehicles - is DD required on underlying investors?

Investment vehicles can take a number of forms, including corporations, special purpose vehicles (or "SPVs"), trusts and other collective investment scheme structures (better known as funds).

What these have in common is the pooling of funds from groups of investors. Structures are often complex, with a fund manager, trust administrator or other person at the helm. Many refuse to disclose information about their investors given the sensitivities involved. This makes it difficult, if not impossible, for FIs to obtain information about those investors.

Under the AMLO, such underlying investors are "beneficial owners" of an investment vehicle and therefore subject to statutory due diligence (DD) requirements, if they hit the threshold ownership / control tests. This places FIs under considerable pressure when caught between an uncooperative client and potential criminal liability for a breach of those DD requirements.

However, there are exceptions available. The exceptions apply where:

If one of these exceptions apply, the FI need not look beyond the investment vehicle itself – it can effectively rely on DD having been performed on the underlying investors by someone else.

It is ultimately up to each FI to determine if non-FIs satisfy the compliance measures test in the boxes above. In some cases, a simple confirmation may be sufficient, but in others, more information may be warranted - for example, sighting actual AML/CTF program documents. Details of regulatory supervision are usually readily available from public sources or through local counsel.

If no exception applies, all investors that own or control 10%+ of the investment vehicle must be identified. If appropriate, FIs can rely on a written confirmation from the investment vehicle or a relevant appointed person (eg fund manager, trust administrator, agent etc) for that purpose, on a risk-sensitive basis. However, verification of any relevant interests identified (ie 10%+ or 25%+ depending on risk level) must still be undertaken by the FI itself.

4. Using signatory lists - when and how?

Gathering documents to identify and verify the signatories of a customer can be an overwhelming task. The Guidelines provide relief for large entities, by permitting the use of a "signatory list" provided by the customer itself.

When - The Guidelines allow FIs to use signatory lists to verify the signatories of:

  1. other FIs;
  2. listed corporations; and
  3. other customers with long signatory lists, on a risk-sensitive basis.

How - The signatory list should:

  1. record the name of each signatory;
  2. include a confirmation that each signatory is authorised to act on behalf of the customer; and
  3. be signed by a person / department within the customer that is independent to those identified in the signatory list (eg compliance, audit or human resources).

This streamlined approach means that other identity information (such as nationality, date of birth etc) and documents (eg passports / HKID cards) do not necessarily need to be collected, and makes DD substantially easier. However, if it is possible to include additional identity information in the signatory list, we suggest doing so - it may assist screening and reputational risk management.

5. State-owned enterprises - simplified or full CDD?

The short answer is - the closer the state and the simpler the structure, the simpler the CDD.

Simplified CDD can vastly reduce the amount of information needed about a particular customer, because it dispenses with the need to conduct DD on the customer's beneficial owner(s). For customers with a long and complicated ownership chain, this is good news.

There are some obvious candidates for simplified CDD, such as FIs, certain other financial institutions, listed corporations and governments (Special Category Persons).

But what about state-owned enterprises (SOEs)?

These are not Special Category Persons in their own right. However, the AMLO recognises that customers that have a Special Category Person somewhere in their ownership chain should be entitled to relief. That relief comes in the form of a permission to stop DD on beneficial owners beyond the Special Category Person.

The following diagram illustrates how this kind of 'modified simplified CDD' works for a basic corporate SOE that is wholly owned by a government or public body:1

Naturally, things become more complicated where there are multiple owners, numerous layers and other complexities such as trust structures.

For example, where there are multiple owners, the approach looks more like this:

Importantly, not all SOEs are considered equal. The "state" concerned must fall within one of the following categories:

  • the government of Hong Kong or an equivalent jurisdiction;
  • a "public body" in Hong Kong (broadly defined); or
  • a body in an equivalent jurisdiction that performs functions similar to a public body.

See item 6 in relation to what is an "equivalent jurisdiction".

6. What is an "equivalent jurisdiction"?

There are two types of equivalent jurisdictions:

  • members of the Financial Action Task Force (FATF); and
  • jurisdictions that impose requirements similar to those imposed under Schedule 2 of the AMLO, as assessed against the criteria in paragraph 4.15.2 and 4.20.3 of the Guidelines and, where necessary, the provisions of Schedule 2 itself.

There are a number of advantages for a jurisdiction to be considered "equivalent" under the AMLO. For example, FIs can:

  1. conduct simplified CDD - adopt simplified CDD measures for certain entities incorporated in, governments of, investment vehicles incorporated in and public bodies in, equivalent jurisdictions;
  2. use intermediaries - carry out their Hong Kong CDD responsibilities overseas by means of certain third parties incorporated, established or practising in equivalent jurisdictions; and
  3. use certifiers - rely on certification of documentation by lawyers, accountants and other persons in equivalent jurisdictions.

We are currently working closely with The Hong Kong Association of Banks (HKAB) on equivalence assessments for a number of non-FATF member jurisdictions, including the Cayman Islands, Bermuda, the British Virgin Islands, Taiwan and Malaysia.

For further information, please contact us.

7. Remediation of pre-existing customers - what to do

Many FIs are concerned about how the AMLO and Guidelines apply to their pre-existing customers - that is, those already on the books as at 1 April 2012.

Thankfully, remediation is not required automatically and the principles reflect (and require) common sense. Understanding customer behavioural norms is key.

When (trigger events) - The new CDD standards only kick in with respect to pre-existing customers if one of the following events occur:

  • an unusual, suspicious or inconsistent transaction takes place;
  • a material change occurs in the way in which an account is operated;
  • you suspect the customer or their account is involved in ML/TF;
  • you doubt the veracity or adequacy of information previously obtained for CDD purposes;
  • another trigger event specific to your business or customers occurs - examples include the re-activation of a dormant account or a change in the beneficial ownership or control of an account.

There is no set time limit for remediation, but it should be initiated immediately and completed as swiftly as possible. If not, the business relationship must be terminated as soon as reasonably practicable.

Some FIs have asked us whether customers of their affiliates can be treated as "pre-existing customers". Strictly speaking, no. Full CDD needs to be carried out when that person first becomes a customer of that FI - irrespective of their relationship with another entity in the same group - not only when a trigger event occurs.

What - Remediation means obtaining CDD information right up to the standard required under the AMLO and Guidelines. Remediation can therefore impact:

  • who you have information about;
  • what information you need to collect;
  • which types of documents you can use to verify that information;
  • how you verify their authenticity (eg certification); and
  • further steps you might need to take.

This emphasises the need for a detailed gap analysis between your current policies and procedures and the new AMLO and Guidelines. FIs should now have this well underway. If not, please contact us. We recently worked with HKAB on a 'new versus old regime' analysis.

How - There is no magic to remediation – the gap must simply be closed. FIs are free to adopt an approach that suits their business and customers best.

However, special care is required to avoid tipping off a customer - a serious offence under Hong Kong law. This is particularly risky where the trigger event for remediation is a suspicion that the customer is engaged in ML/TF. Tipping off has been the subject of much discussion in the last few months and there are no clear answers about how to manage that risk against the need to conduct CDD.

Given the very serious consequences of tipping off and of breaching the AMLO, speak to us if you are in any doubt about how to approach remediation.

Periodic reviews - Until remediation takes place, it is still necessary to conduct periodic reviews on pre-existing customers. However, only the documents, data and information currently held (ie under pre-1 April standards) need to be updated.

Practically speaking, this means that there is no need to obtain new kinds of materials that may be required under the AMLO or Guidelines until a trigger event actually occurs.

Questions?

We are working with a number of our clients on their transaction structures, onboarding procedures and AML/CTF policies. If you have any questions about the AMLO or Guidelines, please contact us.

Footnote

1 The diagrams in this alert apply the shareholding test of beneficial ownership. There may be other beneficial owners involved - see full definition of "beneficial owner" in section 1, Schedule 2, AMLO.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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