Banking Facilities for the Politically Correct
September 29, 05Antwerp’s Dexia bank has informed its diamond clients that it is withdrawing from the diamond financing business. In a letter to its clients, Dexia states that its decision "is based on several elements related to the financing of the diamond sector." These elements on which their decision is based have a lot to do with the high administrative costs associated with the anti-money laundering and anti-terrorist financing compliance rules, which are placing an ever growing financial burden on a bank’s administrative overhead. The nature of the diamond industry – in which much of the rough diamonds are sourced in so-called weak governance countries – has significantly heightened the risks of diamond financing as compared to other sectors. This doesn’t refer to financial or commercial risks, but rather compliance and reputational issues.
A major diamond industry financing institution in New York has advised many of its smaller industry customers that they should be looking for a different bank. This is no reflection on these customers (who are probably all very good) but rather on the lack of profitability that now characterizes the maintenance of relative small accounts.
It must be stressed again that, in this compliance context, banks are not concerned about commercial risks – they know their clients and have plenty of collateral. No, their concern centers on the reputational risks – the due diligence requirements on transactions and the legal risks of failure. I am writing these lines from Barcelona where I am attending the Second Annual European Money Laundering Conference which has drawn hundreds of participants from around the world. Quite a few banks with exposure to the diamond business are in attendance: ABN-AMRO, Dexia, Fortis, ING, including moderate size banks such as the Union Bank of Israel, the First International Bank of Israel, Israel Bank Discount and others. These bankers have joined governmental law enforcement officials, central bankers (even from the Congo, South Africa, Dubai, U.S. and elsewhere) in trying to come to better grips with ever increasingly complex and sometimes ill-defined compliance requirements.
"Make no mistakes,” warned a German banker at the meeting, who then was politely asked “whether he could define what constitutes a mistake."
"We’ll tell you after you have made it,” was the answer. If you are fined $200 million or indicted and drawn into the court room, you know that a mistake has been made…"
One subject that dominated one of the larger conference sessions was the uncertainty surrounding “politically exposed persons (PEPs).” There are diamond companies who trade, or are in partnership, with so-called politically exposed persons, which I would define as someone who is particularly vulnerable because he/she holds prominent public office or has been entrusted with public functions. The clients of a bank may not necessarily have a formal association with PEPs, but they may have business dealings with them – or with companies in which PEPs have a declared or hidden equity or profit-sharing interest. These companies may be at risks – and so may their bankers. And even if banks have it totally wrong – it is they who make the judgment call.
From my own experience I can state that there are many assumptions made by law enforcement officials and by banks which are not necessarily true – and misread the situation. Banks and governments reason that persons in high places in African diamond source countries, in Russia and other places, are expected to “face temptations to abuse their positions” – and that would imply the receipt of kickbacks, bribes, etc. Often such allegations are not proven – and certainly not provable.
The counter-argument – or the difficulty of the judgment call -- is maybe best illustrated by the following anecdote: an elderly gentleman is seen going into his hotel room late in the evening, accompanied by a super mini-dressed provocative, sexy young lady who had just arrived at the hotel. The lady leaves the room a little after midnight. The next morning law enforcement officials conduct separate interviews with both the man and the woman to find out what has taken place in the room, whether sex had been performed and whether it was legal. The “suspects” had synchronized their answer: “We have a keen interest in literature and discussed William Shakespeare.” To prove their point they actually quoted the famous author: “Our bodies are our gardens - our wills are our gardeners.” Would a reasonable compliance officer in a bank be satisfied with such kind of explanation? Or with the level of Shakespeare proficiency?
The answer is discomforting: a bank’s compliance officer doesn’t need proof – if he suspects an improper relationship this is enough for him to act – or not to act. Most diamond traders may not be aware that many (and in some instances all) diamond business transactions are subject to a bank’s compliance review – also post-facto. And this compliance comes with a high price tag. According to a recent survey among global financial institutions (covering over 40 countries), conducted by KPMG, anti-money laundering (AML) and countering the financing of terrorism (CFT) compliance costs have skyrocketed by 61% in the past three years. In the United States, these costs have increased by over 100% since the passage of the Patriot Act. The majority of the AML/CFT spending increases – in order of priority – will go toward transaction monitoring, staff training, external reporting requirements and account opening procedures. The annual costs associated with financial service compliance in the United States are estimated at $10.9 billion in 2005.
And these costs are excluding the fines imposed on banks when they “make a mistake”; they also exclude reputational damage or quantify the legal liability risks – so it quite understandable that there will be no banking compliance officer who will be satisfied with the explanation on the midnight Shakespeare literature session. His will is his garden, to paraphrase Shakespeare.
Earlier this month – without much publicity – did the EC Council pass the so-called EC’s Third Directive on Money Laundering and Terrorist Financing. No need to stress that this is also a piece of legislation that specifically includes the diamond industry as a designated non-financial business which is subject to the rules of the Directive.
Don’t look at the Directive for guidance – as it doesn’t know exactly how to define PEPs. Though one runs the risk that a bank account can be frozen (or even confiscated) when there are suspicions of customer’s involvement with PEPs, the lack of clarity is extremely worrisome. [Indeed, the EC itself has now invited interested parties to present their opinions on the best definition.]
The directive defines PEPs as “natural persons who are or have been entrusted with prominent public functions and close family members or close associates of such persons.” (Article 3(8)) The question of who exactly constitute PEPs may well be different in various jurisdictions – and may be different in Belgium or in the United Kingdom then in other diamond countries.
An internal EC working paper, discussed at the Barcelona conference, which aims at avoiding distortions and different interpretations of the various PEP provisions, breaks down the definition of PEPs into three parts – prominent public functions, immediate family members, and persons known to be associates of PEPs.
As it is most likely that banks that have clients who conduct business with many of the diamond source countries will “look” for political involvement, it is useful to understand the criteria which may well be used by banks to define people who are engaged in “public functions” of which are of “prominence.”
The EC (and thus the banks) hold the view that “public functions” include:
Positions in the public administration and bodies (including military authorities),
Legislative organs and judicial/semi-judicial bodies;
Positions in State Owned Enterprises charged with the exploitation of natural resources or which obtain monopoly revenues; and
Positions in the ruling political party when there is only a single or largely dominant political party and the identification between the administration and the ruling political party is high.
Concerning the “prominence” of the public functions:
In respect of the State administration (and bodies), the public functions should be sufficiently important to be in a position to have a dominant influence in the decision making process (e.g. heads of State and of government, ministries, high ranking officials) or to a dominant/decisive influence in major public expenditure (high ranking officials);
In respect of the judiciary (including semi-judicial authorities such as courts of auditors), prominent positions should be those which are more likely to be abused (e.g. members of judicial bodies controlling State conduct etc) and those which are more relevant to prosecution of money laundering or terrorist financing (e.g. members of judicial bodies applying criminal justice). Key officials (other than judges) in judicial bodies should be covered only to the extent they could materially influence the process;
In respect of State Owned Enterprises, prominent positions should be those allowing to exert managerial responsibilities (e.g. members of the board, persons holding executive powers);
In respect of the legislative bodies, given their nature, all their members should be covered by the definition of prominence;
In respect of the positions in ruling parties, only the high ranking positions could be considered as prominent.
The definition followed by the EC is not intended to cover middle ranking or more junior individuals in the aforementioned categories. However, and that is extremely problematic, one remains a Politically Exposed Person also after one has left the relevant position. The longer one served in a high position, the longer the framework in the time thereafter that one remains in that category. The EC paper doesn’t say “how long.” It does mean, for example, that heads of governmental natural resource organizations remain PEPs well after they left such positions.
In many countries (Russia and others) there are high officials at national levels, regional levels and local levels. The EC takes the position that there is no evidence at this stage that the risk of money laundering or terrorist financing is lower with respect to persons exercising public functions at local or regional level as opposed to national/federal level. Hence, banks and others do not need to make a distinction in this regard.
I fear that these new rules are so broad – and so ignorant of the realities in some of the diamond source countries – that basically anyone with any decision-making authority on natural resource exploitation may become suspect. That may well be ridiculous – but it will not change the fact.
The EC’s internal working paper says that the phrase “immediate family members” also encompasses the spouse, children (including in-laws), and parents of the person considered a PEP. This therefore also includes any legal entity or arrangement whose beneficial owner is one of the family members mentioned. In regards to close PEP associates (the rough buyer, the concession holder, etc.), the paper defines this as “persons who are known to have close business relationships with the PEP.”
Except for those diamond companies (in Antwerp, mostly) who already have seen their bank accounts frozen, funds confiscated, or – if they are lucky – been given to understand that they should consider banking elsewhere, most companies in the diamond business aren’t convinced yet that having good contacts with a producer country's president or members of the political elite may become more of a liability than it is an advantage.
The tremendous pre-occupation of government officials, enforcement community and banking executives with the issue of PEPs is enough reason for the diamond industry to take note. It is certainly important enough to be raised in this column. In a non-perfect world, don’t expect justice always to prevail. In the post 9/11 world, in compliance issues, banks will hang over backwards to play it safe. It is often easier to assume that one is associated with a PEP than accepting the Shakespeare counter arguments. It is useful to reflect on one’s situation – and wonder whether the shoe will fit.
Have a nice weekend.