Combatting money laundering and illicit finance has long been a matter of national security in the United States, as well as a matter of increasing concern globally.1 Anti-money laundering (AML) efforts date back to the Bank Secrecy Act2 (BSA), passed in 1970 and considered the cornerstone of AML legislation. The BSA takes a recordkeeping and reporting approach to AML and requires persons regulated thereunder to report suspicious financial activity, including cash transactions exceeding $10,000.
The terrorist attack of 2001 brought new focus on the potential use of opaque "shell" entities and complex ownership structures for money laundering and terrorism financing. These concerns gave rise to an amendment of the BSA known as the USA PATRIOT Act of 20013 (Patriot Act) which includes "know your client" (KYC) provisions to enlist the aid of financial institutions in the fight against terrorism and financial crime. KYC regulations require banks and certain other financial institutions to develop and implement a Customer Identification Program (CIP) with procedures to verify the identity of each customer so that the financial institution can better understand its customer's business and form a reasonable belief that it knows the true identity of each customer.
The real estate industry underwent even greater scrutiny when the Financial Crimes Enforcement Network of the United States Department of the Treasury (FinCEN) began to issue geographic targeting orders (GTOs) to: (i) look through shell entities which were extensively used to purchase luxury apartments in Manhattan and Miami potentially using funds from illegal sources; and (ii) identify the beneficial owners of the entities.4 Originally issued in 2016, GTOs have since expanded to cover geographic areas beyond the initial targets of Manhattan and Miami. In 2021, FinCEN issued an Advance Notice of Proposed Rulemaking (Anti-Money Laundering Regulations for Real Estate Transactions)5 which seeks to expand the requirements to collect, report, and retain information to a wider range of transactions, in effect potentially expanding the requirements of the GTOs to all non-financed commercial real estate purchases nationwide.6
This article will explore the origin of KYC processes and AML regulatory regimes in real estate finance, the evolution of lender KYC practices in commercial real estate loan transactions, and the future of lender KYC practices in the digital age.
THE PATRIOT ACT AND REAL ESTATE TRANSACTIONS
Real estate transactions have risen to the forefront for US AML regulators who have stated that such transactions are particularly susceptible to money laundering and other financial crimes. FinCEN outlined key risks and vulnerabilities in real estate transactions:
Real estate transactions and the real estate market have certain characteristics that make them vulnerable to abuse by illicit actors seeking to launder criminal proceeds. For example, many real estate transactions involve high-value assets, opaque entities, and processes that can limit transparency because of their complexity and diversity. In addition, the real estate market can be an attractive vehicle for laundering illicit gains because of the manner in which it appreciates in value, "cleans" large sums of money in a single transaction, and shields ill-gotten gains from market instability and exchange-rate fluctuations.7
Sophisticated lenders in the syndicated loan market typically perform extensive due diligence on elements of the credit transaction and the borrower and related parties prior to closing the transaction or disbursing funds. Such loans may thereafter be sold or transferred, in whole or in part, in the secondary loan market. As a result of such extensive due diligence, the syndicated and secondary loan markets generally have a low risk of money laundering or terrorist financing. Nonetheless, under the Patriot Act, financial institutions are required to develop formal CIPs in order to detect potential money laundering or other financial misconduct. Such CIPs must address the vulnerabilities related to the limited transparency that FinCEN noted to be prevalent in real estate transactions. The Loan Syndication and Trading Association (LSTA) has been instrumental in providing and updating lender guidance for KYC and CIPs, issuing its original Guidelines for the Implementation of Customer Identification Programs in 2004.8 LSTA has updated its guidance to reflect changes in regulations as well as market practices.9 The guidance aims to: (i) identify the types of transactions or relationships in the primary and secondary loan market which do, and those which do not, require CIP scrutiny; and (ii) highlight potential AML or The Office of Foreign Assets Control (OFAC) compliance risks arising from such transactions or relationships including counterparty relationships.
In a loan transaction, customer identification and verification are performed on the borrower, any guarantor and, pursuant to FinCEN's beneficial ownership rule of 2016 (discussed below), any other person or entity that has a direct or indirect ownership interest of at least 25 percent in the borrower or any guarantor. A financial institution may wish to screen other parties to the transaction as well, depending on the nature of the transaction, including indirect owners of less than 25 percent in the borrower. Customer due diligence information to be gathered as part of the CIP process includes, at a minimum, the customer's name, address of principal place of business, and taxpayer identification number as well as the names of the company's directors and their similar identification information. This information is then required to be verified through the financial institution's CIP by documentary means (which may be the entity's charter documents or an individual's driver's license or passport) or other means such as internet searches of publicly available information or physical visits to the customer's place of business.
US banks must also comply with OFAC regulations which set out prohibited types of transactions and persons with whom US persons may not engage in transactions. Failure to comply with OFAC regulations can have severe consequences including civil or criminal liability as well as possible non-repayment of the loan should a borrower become the target of sanctions.10 Once customer information is obtained and verified, it is compared against various lists (such as the US Department of State sanctions lists, the Specially Designated Nationals and Blocked Persons Lists, and Financial Action Task Force Lists) to determine whether persons or entities are subject to sanctions administered by OFAC or otherwise considered "blocked" by OFAC.
Using a risk-based approach, a financial institution may engage in enhanced due diligence if information obtained in the CIP process indicates that the customer or transaction poses a higher risk of money laundering or terrorist financing. Primary lenders, including every lender in a syndicate for a syndicated loan, will give the greatest scrutiny. Lenders who acquire a loan in the secondary market or by merger, asset purchase, or the like are not required to perform CIP under a "transfer exception."11
In addition to CIP and risk assessment protocols, lenders will typically include Patriot Act, OFAC, and other AML and anti-corruption representations and covenants in the loan agreement, which are designed for compliance with AML and anti corruption regulations at the time of signing the loan agreement and for the life of the loan. These provisions include, among others, a required Patriot Act notice notifying the borrower that the lender is subject to the Patriot Act, a covenant to provide KYC information, and representations and covenants relating to sanctions compliance. Loan agreements will also provide for continued compliance with KYC regulations such that transferees of interest in the borrower will be subject to CIP and compliance with the KYC requirements of the loan agreement. These representations or covenants may help the lender avoid severe penalties in the event that a borrower misrepresents its status or compliance or if a violation occurs after disbursement, as such provisions evidence the lender's intent to comply with the regulations.
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1. An earlier version of this article was published in The ACREL Papers – Fall 2022.
2. 31 USC § 5311 et seq.
3. Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act of 2001, Title III of Pub. L. 107-56 (signed into law October 26, 2001).
4. FinCEN Press Release, Geographic Targeting Orders Require Identification for High-End Cash Buyers, Jan. 13, 2016, available at https://www.fincen.gov/news/news-releases/fincen-takes-aim-real-estate-secrecy-manhattan and-miami. Geographic targeting orders require certain title insurance companies to report the identity of beneficial owners of shell companies purchasing residential real estate in all-cash transactions.
5. Anti-Money Laundering Regulations for Real Estate Transactions, 86 Fed. Reg. 69589 (Dec. 8, 2021), available at https://www.federalregister.gov/documents/2021/12/08/2021-26549/anti-money-laundering regulations-for-real-estate-transactions.
6. While GTOs and the Proposed Rule are significant developments in the movement toward more transparency in real estate transactions, they relate to either all-cash residential real estate transactions (GTOs) or non-financed residential and commercial real estate acquisitions (ANPRM) and, as such, are not within the scope of this paper which is limited to commercial lending practices.
7. FinCEN, Advisory to Financial Institutions and Real Estate Firms and Professionals, FIN-2017-A003, Aug. 22, 2017, available at https://www.fincen.gov/sites/default/files/ advisory/2017-08-22/Risk%20in%20Real%20Estate%20 Advisory_FINAL%20508%20Tuesday%20%28002%29.pdf
8. LSTA Guidelines for the Implementation of Customer Identification Programs for Syndicated Lending and Loan Trading, September 2004.
9. LSTA Know Your Customer Considerations for Syndicated Lending and Loans (LSTA KYC Guidelines), Oct. 22, 2018.
10. LSTA Regulatory Guidance: U.S. Sanctions Issues in Lending Transactions (LSTA Sanctions Guidance), Apr. 25, 2022
11. LSTA KYC Guidelines, supra note 9. The LSTA KYC Guidelines analyze an array of roles and relationships in syndicated loans and provide guidance as to whether a relationship gives rise to CIP requirement and whether CIP is required to be performed by financial institutions in such roles.
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