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Complex Risk: due diligence, conflict of interest, ultimate beneficial ownership

Recent headlines covered Brexit and Britain’s subsequent repeal of laws, Germany’s private bank Hauck & Aufhäuser, dissolved Welling & Partners in the British Virgin Islands (IcelandReview, ruv.is), and Fashion brand founder Karen Millen’s bankruptcy. Unrelated, at first glance, they also entailed various fraud-related issues and bring a pressing need for effective due diligence back into the focus of public attention.

National and international aspects:
The headlines and underlying cases are indicative of the complexity of cross-border transactions in a globalized world where legislation, regulation, and enforcement still remain largely a national matter.  Further significance has been added by the recent conflict of interest breach at the Bank of England, resulting in the Deputy Governor’s resignation.  The ongoing prolific debate around conflicts of interest in the current US White House (visualized web ) has additionally furthered public appetite for scrutiny and clarity byeond national confines and territories.

Spanning Britain, Germany, Iceland, the European Union (EU) and EEA (European Economic Area), as well as off-shore tax havens in the British overseas territories, taking a birdseye view helps to understand and illustrate the challenges resulting from a broad network of anti-money laundering regulatory provisions and policies.

Risk perspectives:

“EU legislation requires that institutions adequately manage and mitigate operational risk, which is defined as the risk of losses stemming from inadequate or failed internal processes, people and systems or from external events.

Operational risk includes legal risks but excludes reputational risk and is embedded in all banking products and activities. It has always existed in banking, and non-banking organizations but it has acquired a greater relevance given the increased complexity and globalization of the financial system and the recent materialization of unprecedented extremely large losses.”

Source: European Banking Authority (EBA)

Conducting required checks and ongoing monitoring and registry maintenance sufficiently, requires both, the buyer’s and seller’s concerted efforts in order to mitigate and manage risk emanating from improper or inadequate due diligence.

 

The complex landscape of regulations and guidelines:

  • Britain‘s exit from the EU will leave its leading role in anti-money laundering (AML), anti-corruption (and anti-bribery and sanctions compliance) mostly intact thanks to the UK Bribery Act which is independent of EU regulations.  Of greater concern is the stricter control of offshore territories, mainly in former colonies, as well as compliance regulation, applicable to financial firms, which is predominantly derived from EU legislation (OECD concern).
  • Iceland, as a member of the European Economic Area (EEA), has to comply with the EU regulations and its interpretations of the Financial Action Task Force (FATF) standards (Iceland in FATF). This scenario could also apply to Britain, depending on the outcome of future negotiations, for now, Britain remains a member of the FATF.
  • The European Union’s 4th Anti-Money Laundering Directive (4AMLD – summary) was adopted in May-2015, became effective in Jun-2015, and its national transposition is required by 26-Jun-2017.This will entail central registers of beneficial ownership as already set up in Ireland but currently not yet in place in Germany (see the Beneficial Ownership Transparency – Country report, 2015 – for in-depth analysis).

 

Knowing which rule, regulation, and watchlist apply:

Conducting checks is time-consuming, resource-intense and it may be costly.  However, failing to thoroughly substantiate the identity of a customer or UBO (buyer, seller, business or other transaction-partner alike) may be significantly more costly and damaging to the reputation and funds.

“Risk, I had learned, was a commodity itself. It could be canned and sold like tomatoes.  Different investors place different prices on risk. ”

(Michael Lewis, Liar’s Poker, 1989)

Outsourcing the checks may be one option but ultimate responsibility may remain with the outsourcing party – as the case of Karen Millen’s tax evasion scheme around-the-world (see EU Parliament Library note on corporate tax avoidance) demonstrated.  A list of significant failures of duty of care in this regard is available on the UK’s Financial Conduct Authority site (FCA).

Knowing when to conduct checks:
Certain types of risk cannot be insulated, transferred, or legally sold.  Due Diligence (and Enhanced DD: EDD), Know Your Customer (KYC), Conflict of Interest (COI), and Ultimate Beneficial Ownership (UBO) regulations and rules are neither effective nor meaningful past the event, which does not render them obsolete but makes their use all the more valuable as a set of preventive instruments throughout the interaction. Compliance programs and efforts have become increasingly sophisticated, however, human factors such as misplaced bias, trust, unquestioned routines, and practices may enhance the operational risk.

“Let me put it this way: I’m standing in front of a burning house, and I’m offering you fire insurance on it.”

(Jared Vennett explains Credit Default Swaps (CDS) in M. Lewis’ The Big Short: Inside the Doomsday Machine, 2010/2015)

Latent reputation risk and litigation risk may arise instantly, at a very early stage during negotiations.  This may apply irrespective of the nature of a transaction, whether an acquisition, a merger or a sale of a specific stake.

It requires due consideration and pro-active mitigation at a time when there is neither smoke nor fire, a long-term approach that may be deemed a challenge in environments where accounting for long-terms risk conflicts with short-term objectives. Adhering to ethics codes voluntarily may be one way to address the issue, voluntarily applying EDD can be yet another.

Overall, it can be argued that transparency of data, consolidation of watchlists, regulations, and enforcement efforts are increasing and increasingly streamlined, consolidated, and subject to public awareness and debate.