Manchester City Council

Cheshire East Council

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You can never be too diligent - the issue of know your client

Paul Feild considers the risk to local authorities posed by money laundering and the importance of carrying out due diligence properly in their transactions.

Of late I have looked at Local Auditors Reports in the Public Interest (RPI) and Best Value reviews. Times are desperate and the prospect of the section 114 notice Local Government Act 1988 looms larger over finances. So, some authorities have tried to generate an income by themselves with the section 1 Localism Act general competency power and working with investors on joint ventures.

I was also struck by comments in a RPI by the accountancy firm KPMG (the external auditor for Northampton Borough Council) and that council’s loans to Northampton Town Football Club. Much criticism was levied in KPMG’s view at the lack of due diligence exercised by the council which was mentioned no less than 19 times!

With that thought in mind in local government finance no matter is more deserving of due diligence than the subject of Know Your Client (KYC) and money laundering.

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KYC is about ensuring that a person or organisation which you do business with is acting in a lawful manner and that its finances are not funded by the proceeds of crime or terrorism.

Essentially, the purpose of money laundering is to enable bad people to establish a pseudo-legitimacy to assets they have acquired through crime and terrorism. The traditional handlers of finance are regulated by law and international agreements, however in the world of near instantaneous electronic money transfer it is a challenging task to establish the true source of finance.

So what has this got to do with local government? The answer is that a council as an instrument of the UK state can add a significant sense of integrity to property transactions.

Furthermore, those in possession of questionable finances are not driven primarily by getting the best return on their investment, their key imperative is to acquire legitimacy for their funds so local government considerations such as whether there is best value and does it meet say the S.123 LGA 1972 best consideration are not a shield against bad money investors. This is because a deal may well on paper and subject to even robust modelling appear to deliver outstanding returns for the local authority investment in a venture. But that is not the point, the nefarious funds financier’s primary concern is to legitimate the money.

This paper identifies key legislation, how bad money and the laundering of it could come into contact with a local authority in its business activities, the steps of KYC and a conclusion.

Key legislation

The Terrorism Act 2000

This Act applies to all individuals and businesses in the UK and therefore all members of staff within a local authority have an obligation to report knowledge, reasonable grounds for belief or suspicion about the proceeds from, or finance likely to be used for terrorism or its laundering where it relates to information that comes to them in the course of their business or employment. The primary offence is governed by Section 18 and states that:

“a person commits an offence if he enters into or becomes concerned in an arrangement which facilitates the retention or control by or on behalf of another person of terrorist property by concealment, by removal from the jurisdiction, by transfer to nominees, or in any other way”.

The Proceeds of Crime Act (PoCA) 2002

This Act applies to all individuals and organisations and further defines the offences of money laundering. It also creates mechanisms for investigating and recovering the proceeds of crime. The primary offences are:

  • Section 327 - concealing, disguising, converting, transferring, or removing criminal property from the UK.
  • Section 328 - entering or becoming concerned in an arrangement which you know, or suspect facilitates the acquisition, retention, use or control of criminal property by or on behalf of another person.
  • Section 329 - acquiring, using, or possessing criminal property

Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (as amended 2020) (2017 Regs)

These Regulations (the MLR) do not directly apply to local authorities but guidance from the Chartered Institute of Public Finance and Accountancy (CIPFA), is that councils (and by inference) and their companies comply with the underlying spirit of this legislation and regulations. These regulations set out detailed requirements for organisations to establish procedures to prevent its services being utilised for the purposes of money laundering. So, the Regulations on due diligence are to be observed in practice. Actions to comply with the obligations would be

  • Appoint a Money Laundering Reporting Officer (MLRO).
  • Obtain sufficient knowledge to ascertain the true identity of customers in certain circumstances, by applying customer due diligence measures.
  • Maintain record keeping procedures.
  • Know the intended nature of business relationships and undertake ongoing monitoring of them (to identify unusual transactions).
  • Implement a procedure for reporting suspicions of money laundering.

The Sanctions and Anti-Money Laundering Act 2018

This Act provides the power for the UK to impose sanctions where appropriate for the purpose of compliance with United Nations obligations or other international obligations as well as for several other specific purposes, including furthering the prevention of terrorism in the UK or elsewhere and protection of UK national security interests.

There are 25 supervisors that oversee regulated firms’ compliance with the MLRs. This includes credit institutions, financial institutions, crypto asset businesses, auditors, insolvency practitioners, external accountants and tax advisers, independent legal professionals, money service businesses, trust and company service providers, estate and letting agents, high value dealers, casinos, and art market participants. There are 3 statutory supervisors (FCA, HMRC and the Gambling Commission) and 22 approved professional body supervisors for supervising the legal and accountancy sectors, overseen by the Office for Professional Body Anti-Money Laundering Supervision.

As can be seen there is no direct supervisor for local government.

The Process of Money Laundering

This can be seen as four parts.

The first is the Creation or Acquisition stage, through crime or terrorist activities funds are created either through criminal enterprise or money provided by a hostile agent to promote and support terror activities. The goal is to accumulate and secure funds.

The second part is called the Placement stage, here the goal is to get the criminal / terror funds into a finance system. Techniques would include movement of currency by means of large or series of cash deposits and changes from one currency to another.

The third part is called the Layering stage, here the goal is to conceal the origin and obfuscate the trail back to the fund’s origins. Here electronic transfer across various international jurisdictions and use of nominee and shell companies enables fragmentation and splits of money into many accounts.

The final stage is the Integration stage and at this point its purpose is to give the criminal funds the legitimacy of being untainted. Transactions will take place for no real purpose other than to acquire a legitimacy of the funds being treated as if they were created through legitimate business activities.

The local authority and its companies

As mentioned, CIPFA advises compliance and observation of anti-money laundering protocols by a local authority and for that matter its owned companies.

In the case of the local authority the KYC is not so much about a client as such but the entities/ person(s) it is doing business with. As many transactions are with corporate entities it can be very difficult to piece together and pierce what is called the ‘veil of incorporation’ to find out who really has the controlling interest and who is the true beneficiary of the financial transaction. This means that it is not just a question of solvency and creditworthiness of the potential business partner but also the question where did their funds come from? As observed, this may come from crime, terrorism or sanction busting activities from hostile / renegade states.

The National Risk Assessment of Money Laundering and Terrorist Financing 2020 (Home Office and Treasury December 2020) (NRAMLTF for short) is a comprehensive and up-to-date review of Money Laundering from a UK perspective. It comments (p.38):

In the UK this [laundered] money is often invested in high end UK real estate, private school fees, luxury vehicles, and sometimes as donations to cultural institutions. These investments not only represent the end destination for this money but can also act as a mechanism for individuals to launder their reputation, improving their standing and influence in UK society. This poses a significant reputational risk for the UK as a global financial centre.

NRAMLTF flags the Covid 19 crisis may lead to further money laundering:

6.12 Criminals may also exploit the current distressed business environment by seeking to invest their illicit funds in struggling businesses, obtaining real estate sold out of desperation or bankruptcy. OCGs may also look to invest liquidity in small and medium sized enterprises (SME) which cannot obtain funds elsewhere. Professional services sectors are encouraged to be vigilant of such instances.

And

6.14 Criminals may also look to increase property purchases as a method to launder and increase their wealth, particularly while bank interest rates are low, and sellers may be more willing to accept much lower offers.

Further about property, NRAMLTF comments (10.10) that they consider conveyancing services related to both residential and commercial properties at high risk of abuse for money laundering due to the high value and large volume of transactions:

10.3 Although further evidence is needed to ascertain geographical conveyancing risks, it is likely that criminals favour locations with high value residential properties such as London or university towns due to high demand and potential investment return opportunities. However, commercial properties are also attractive for money laundering purposes, as they often carry an equally high price.

10.4 Not all conveyancing poses the same level of risk of criminal exploitation. Red flags indicating a higher risk of money laundering may include (but are not limited to):

  • clients seeking anonymity buying property through complex corporate structures, such as companies based in secrecy jurisdictions which can mask the ultimate beneficial owner.
  • clients buying the property without a mortgage from a financial institution with no verifiable source of income justifying their wealth.
  • conveyancing transactions that involve multiple LSPs.
  • customers that are PEPs from high corruption- risk jurisdictions and those charged with or alleged to have committed corruption offences.

In terms of what activities NRAMLTF observes:

12.3 Criminals often purchase properties as long-term investments and to release their criminal funds. The high amounts of money that can be moved in one transaction and the appreciation in value, along with the enhanced lifestyle, makes them very attractive to criminals.

12.4 However, properties are also purchased and sold as a method to layer criminal funds. Criminals may abort transactions, manipulate values and turn-around purchase and resale in short timeframes. While the speed of money movement involved in property purchases is slow compared with other methods, the large volumes that can be moved, and the accessibility of the sector are likely to still make property an attractive laundering method.

12.5 Property is particularly attractive for high-end money launderers looking to conceal large sums of money in few transactions. In particular, super-prime property is high-risk due to its location in highly desirable areas as well as its significant economic value. Super-prime property commonly features in investigations into grand corruption and money laundering.

12.6 Corrupt foreign elites continue to be attracted to the UK property market, especially in London, to disguise their corruption proceeds. Property can be bought through complex systems of shell companies registered overseas in secrecy jurisdictions to obscure ownership, rendering the true purpose and origin of money transactions unclear. For example, research by Transparency International has found that 75% of properties linked to corruption are owned by companies registered in secrecy jurisdictions.

12.7 Further evidence is needed to ascertain geographical risks, but it is likely that criminals favour locations with high value properties such as London, Edinburgh, or university towns, with London considered highly desirable for overseas entities to operate a residential or commercial base in. Importantly, commercial properties located outside of these regions can facilitate money laundering due to their high value and the ability to conceal large sums of money as legitimate commercial transactions.

So, it does look like local authorities for the metropolitan and university towns are at higher risk of being compromised by questionable investors.

Know Your Client (KYC)

So KYC does not necessarily mean that the other parties are actually the client of the authority, it includes those whom the authority or via its companies it may do business with. There are three key principles to the KYC they are:

  1. Customer Identification
  2. Customer Due Diligence
  3. Enhanced Due Diligence

Before the local authority either directly or via its companies commences a transaction with a third party the situation is the same, it needs to know who it is really dealing with.

NRAMLF comments that companies registered office or nominee directorship via accountancy services are also at risk of exploitation for money laundering as those services can enable concealment of beneficial ownership or be used to facilitate the movement of money to offshore jurisdictions. Companies House acknowledge the issues surrounding beneficial ownership transparency in the UK and are taking steps to prevent the system being abused.

A special consideration in preventive measures is when dealing with ‘Politically Exposed Persons’ (PEP’s). The Law Society states:

A politically exposed person (PEP) is someone who's been appointed by a community institution, an international body or a state, including the UK, to a high-profile position within the last 12 months.

The full definition and list of potential PEP’s is set out in reg 35 of the 2017 Regs. To reiterate while a local authority is not a relevant person for the 2017 Regulations the CIPFA guidance is that local authorities should act as if they were.

Furthermore, encounters can be made with companies owned by foreign governments. We call them State Owned Enterprises (SOE). They may be agents of government policy one step removed and may not be purely motivated by shareholder returns. Care needs to be taken particularly with regard to issues such as confidentiality and data protection. Indeed, data subjects lives and well-being could be at risk if asylum seekers or under a witness protection scheme. Do not share or provide access to data networks to such organisations until proper authority is granted to do so. There may be national security issues to be considered. For example the United States has made it clear it has security concerns about the telecom industry, so the diligence work would need to take into account the possibility of the potential investor being subject to an embargo or sanctions.

So, the KYC is built on understanding first who you are dealing with and where does their funding come from? Immediately there is a risk, if rather than deal directly with the ultimate party, the council is in contact with a broker or agent.

The first step is identification verification. This will be to find out the true identity and may require further parties of integrity to act as confirmation guarantors such a professional or, government agencies generated documents such as passports and licences can assist. Indeed, if you cannot confirm the identity then it is not possible to move onto customer due diligence.

Customer due diligence. This will involve name screening reference checking, digital fingerprint etc. The 2017 Regulations at Reg 28 sets out the necessary due diligence, with Reg 29 further due diligence required if the organisation is a credit or finance institution. 

The same checks must be carried out where there are multiple corporate entities and special caution where there are interests located in countries known for light regulation.

Special care needs to be taken with officials of overseas countries and the source of their funding. The CIA World Factbook gives an indication as to the political freedom of a state and the degree of risks, the Foreign and Commonwealth Office should be checked with too.

Enhanced due diligence. Here deeper drilling to find more about the potential business is carried out of database vetting and lists of persons subject to government control such as sanctions and watch lists. Checks should be made regarding open offending records and media / newspaper reports. Checks should be made for credit and default, bankruptcy and director disbarment and any register of debt judgements.

There are software systems to carry out checks, but deeper probing is normally at premium fee. NRAMLF observes that they found examples in money laundering where the agency involved had run checks but not at a deeper level and so not picked up concerns.

It the process of delving into the other parties does reveal matters of concern than advice must be sought. The other parties should not be advised of the concerns as it may frustrate any law enforcement action particularly in the case of organised crime groups or terrorist organisations. Indeed, your staff may be subject to threats if it were to get out there are suspicions.

Practical steps to take

I set out as an appendix a starter checklist to assist in vetting potential business partners with special caution for PEP’s.

Conclusion

As local authorities through their entrepreneurial use of the power of competency and use of investment strategies together with their companies become economically active, they face a risk of being a target for money laundering and the potential of exposure to persons and organisations with unlawful funds and objectives contrary to the interests of the UK. Section 4 Localism Act 2011 won’t help the devastating reputational damage of getting entwined with a hostile state or OGC’s.

Local governments reputation must be guarded and guidance on money laundering and terrorist funds from the Government and law enforcement agencies must be followed together.

While the 2017 Regulations do not directly govern a council’s activities, CIPFA’s advice is that a council should act as if it did. To prevent this risk knowledge of good practice and awareness should be propagated through the organisation, review carried out of current practices and training organised to increase awareness.

The UK is fortunate to have a strong secure state that firmly adheres to the rule of law with a superior unimpeachable judiciary, with high integrity in its government both local and national. It is not surprising that in an unstable and increasingly polarised world, investors both good and bad will want to put their funds here. The mission is to sift out the bad.

Reading the RPI of the Northampton football club investment the auditors were scathing regarding the ‘due diligence’ applied. The risk of a local authority getting involved with bad money is likely to increase and acquiring superior specialism profession support to check out potential business partners is a wise investment and indeed part of being properly due diligent.

Dr Paul Feild is Senior Standards Solicitor working in the Barking & Dagenham Legal Practice Governance Team. He has been a deputy Monitoring Officer on and off for various public authorities for twenty years. His 2015 Doctor of Business Administration thesis was ‘How does Localism for Standards Work in Practice? The Practitioner’s View of Local Standards Post Localism Act 2011’.

He researches and writes on governance issues and can be contacted This email address is being protected from spambots. You need JavaScript enabled to view it..

References

CIA World Factbook

KPMG   Northampton Borough Council: Report in the public interest regarding the Council’s loans to Northampton Town Football Club (accounts for the year ended 31 March 2016) (January 2021)

Local Government Act 1999

Localism Act 2011

Local Audit and Accountability Act 2014

Money Laundering, Terrorist Financing and Transfer of Funds (Information on the

Payer) Regulations 2017

The National Risk Assessment of Money Laundering and Terrorist Financing 2020 (Home Office and Treasury December 2020)

The Sanctions and Anti-Money Laundering Act 2018

Terrorism Act 2000

Appendix

Suggested Starter Check List for Know Your Client

Risk

Consequences

Prevention

Identity of Party

May be difficult to run checks

The person is not who they say are

  • Seek proof from Government Agencies and verification such as passport or photo licence
  • Establish their place of residence
  • Get Professional people provide confirmation of credentials
  • Get references from other users
  • Experian Report
  • Check directors’ details at Companies House – have any been disqualified?
  • Check filing history at Companies House and peruse filed accounts say 3 years – poor history of late filing is a significant indicator

Dealing with a PEP (Reg 35)

Could include heads of state, heads of government, ministers, and deputy or assistant ministers, members of Parliament, members of courts of auditors or of the boards of central banks, ambassadors, chargés d’affaires and high-ranking officers in the armed forces members of the administrative, management or supervisory bodies of state-owned enterprises members of judicial bodies

Such persons may be well-connected with the ability to apply coercive influence.

State owned Enterprises can be an agent of governments in certain non-democratic countries and must be dealt with extreme caution

Family or closely connected persons to PEP should be treated as PEP too.

  • If a PEP is identified, then enhanced due diligence is necessary.
  • The professionals e.g., bankers, lawyers, accountants have guidance and checklists from their professional bodies
  • Due diligence means carrying all enquiries and following up data to ensure it is sound

Acting for an undisclosed third party

Maybe for undesirable person if do not know who are dealing with

  • Seek declaration that not acting
  • Establish that they are of sufficient means do not need third party
  • Get references from other users
  • Check directors’ details at Companies House
  • Check details of any other companies involved and with shareholders

Funds from crime for Money Laundering (ML) as party to co-financing

Criminal activity

Serious reputational damage

Funds could be seized

  • Carry out ML checks
  • If find anything odd or strange report it to the designated Money Laundering Officer
  • Suspicious Activity Report must be completed

Reputation

Serious reputational damage could have political repercussions

  • News search
  • Check for poor record of safety
  • Check any prosecutions
  • Look into any directors / shareholder’s interest
  • Products for checking background – eg Arcadis / Encopass

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