Feature

posted 24 Jun 2005 in Volume 10 Issue 4

The EC’s Draft Third Money Laundering Directive: An attack on trusts and trustees?

Rushed legislation, regulations and bad law appear likely to make current ID regulations the least of readers’ problems. It will also be an expensive headache for clients. Martyn Frost, deputy chair of STEP and consultant in the trusts and estates department of Halliwells LLP, provides a welcome comprehensive analysis.

The draft Third Money Laundering Directive (3MLD)1, currently being considered in Brussels, represents a very major shift in:

Money-laundering regulation for third parties2 dealing with trustees;
Money-laundering regulation for ‘trustee service’ providers;
Money-laundering regulation of ‘politically exposed persons’;
State regulation of trustee service providers.

Implementation

Before considering these points in a little more detail, however, it is worth summarising the five-step process by which 3MLD will be implemented:

1. European Commission;

2. European Parliament;

3. National Parliament;

4. National Licensing Authorities rulebook;

5. EC review process.

(i) The draft 3MLD has completed its process of consultation, review and adoption by the Commission and, as part of this process, has received the approval of all of the member-states governments;

(ii) The draft 3MLD is now being considered by several committees of the European Parliament. There was, at the outset of this process, acknowledged to be a high level of political agreement on the terms of 3MLD on the part of the Commission, member states governments and the European Parliament, and a substantial political will between all of them to see 3MLD implemented without amendment or delay. Having said that, there are now some signs that there might be a willingness on the part of the European Parliament to seek some minor changes to the text (although it is believed that HM Treasury does not support any changes). It would not be realistic in this political climate to expect any substantial changes to the last published draft;

(iii) Once issued, 3MLD (at least as currently drafted) will require member states to implement its terms through national enabling legislation within 183 months of the issue of the Directive. Note that this is not to pass the legislation with some future effective date, but implement the terms of 3MLD within 18 months4;

(iv) Various national regulatory bodies are required by 3MLD and, if past experience of financial regulation is relevant, the regulators’ rule books will contain surprises5;

(v) The EC will create a committee that will review the implementation and operation of 3MLD and report accordingly6. Part of this process will be to ensure that the national processes have consistency and adhere to the requirements of 3MLD. There will be little chance of any government departing from the requirements of 3MLD.

This committee will also take into account trends and developments in money laundering and recommend changes to the Directive. From all the above it can be seen that:

The scope for amendment in Brussels is very limited;
National legislation is not likely to deviate to any significant degree from the aim, or terms, of the directive, as to do so risks a fine being imposed on the member state for failure to implement a Directive satisfactorily. Further deviation from the terms of the Directive would in all probability be caught by the comitology process;
The detailed operation of this regulation that is vital to practitioners will not become apparent until after national legislation has been passed and the regulatory environment (especially the rule book) has been established;
Periodic alteration to this directive is to be expected as the EC review process operates.

My personal view is that the proposed implementation period is a very short period indeed and that rushed legislation and regulation is likely to lead to mistakes and difficulties. I must also add an observation; will it really happen this fast? The Second Money Laundering Directive from 2001 has not yet been implemented in all member states.

Why a third Directive?

It is also pertinent to ask why 3MLD was necessary and if the Commission had evidence that the money-laundering problem was bigger and more pervasive than previously thought. The Commission cannot satisfactorily answer either question. No research has yet been undertaken on the part of the Commission to identify:

1. The scale of money laundering in Europe;

2. The geographical and financial areas most commonly involved;

3. The types of transaction presenting the greatest risk;

4. The institutions or individuals most commonly involved7.

Readers might be reassured to know that it is intended to commence research into these issues fairly soon, but none of this research will be available before this Directive will be implemented.

Although this directive specifically targets trustee service providers for additional regulation, a representative of the Commission has admitted (at a seminar in Brussels last December) that it has undertaken no research into the use of the trust in Europe. Although I have not had express confirmation of the point, it is my belief that the UK Government has also not carried out any research into the use of trusts within the UK before agreeing to the proposals affecting trusts. It would be interesting to know if any member-state governments did such research.

When discussing trusts with those who are not professionally involved with them, there seems to be an almost universal assumption that there is something inherently unsavoury about them. This assumption most often seems to be driven by a further assumption that trusts are vague disreputable matters used offshore to hide ill-gotten funds. Such assumptions are very wide of the mark. In so far as England and Wales are concerned, trusts run throughout the fabric of everyday financial life. However, the ubiquity of trusts in these jurisdictions seems to be lost on present-day law makers, and trusts now have the real risk of regulation imposed on them out of ignorance and prejudice.

Who does 3MLD apply to?

Article 2

“1. This Directive shall apply to the following institutions and persons:

(1) Credit institutions;
(2) Financial institutions;
(3) The following legal or natural persons acting in the exercise of their professional activities:

(a) Auditors, external accountants and tax advisors;
(b) Notaries and other independent legal professionals, when they participate, whether by acting on behalf of and for their client in any financial or real-estate transaction, or by assisting in the planning or execution of transactions for their client concerning the:

(i) Buying and selling of real property or business entities;

(ii) Managing of client money, securities or other assets;

(iii) Opening or management of bank, savings or securities accounts;

(iv) Organisation of contributions necessary for the creation, operation or management of companies;

(v) Creation, operation or management of trusts, companies or similar structures;

(d) Deleted;

(e) Real-estate agents;

(f) Other natural or legal persons trading in goods, only to the extent that payments are made in cash in an amount of EUR15,000 or more, whether the transaction is carried out in a single operation or in several operations which appear to be linked;
(g) Casinos.

2. Member states may decide that legal and natural persons who engage in a financial activity on an occasional or very limited basis and where there is little risk of money laundering or terrorist financing occurring do not fall within the scope of Article 3(1) or (2).”

(My emphasis added)

An interesting issue from the Article 2 definition (see above) is that there is not any restriction to apply 3MLD only to practitioners within the member states.

It will almost certainly apply to any one meeting this definition, wherever they are based, if they deliver a regulated activity within the member states. Naturally, much is going to depend upon the detailed regulation, but there are clear implications that providing trustee services to those within the member states from outside the member states will be subject to new more restrictive controls. No sensible law-making body would of course contemplate regulated services being delivered in an unregulated manner in its jurisdiction from a provider based outside that jurisdiction.

The intention of Article 27 is quite clear in looking to give this Directive an extra-jurisdictional reach:

Article 27

Member states shall require the credit and financial institutions covered by this Directive to apply, where applicable, in their branches and majority owned subsidiaries located in third countries measures at least equivalent to those set out in this Directive with regard to customer due diligence and record keeping. Where the legislation of the third country does not permit application of such equivalent measures, the member states shall require the institutions concerned to inform the competent authorities of the relevant home member state accordingly.
The member states and the Commission shall inform each other of cases where the legislation of the third country does not permit application of the measures required under the first subparagraph of paragraph 1 and co-ordinated action could be taken to pursue a solution.
Member states shall require that in cases where the legislation of the third country does not permit application of the measures required under the first subparagraph of paragraph 1, institutions will take additional measures to effectively handle the risk of money laundering or terrorist financing.

Dealings by third parties with trustees

Article 7

“Customer due-diligence procedures shall comprise the following activities:

(a) Identifying the customer and verifying the customer’s identity on the basis of reliable independent-source documents, data or information;

(b) Identifying, where applicable, the beneficial owner and taking reasonable measures to verify the identity of the beneficial owner such that the institution or person is satisfied that it knows who the beneficial owner is, including, as regards legal persons, trusts and similar legal arrangements, taking reasonable measures to understand the ownership and control structure of the customer;

(d) Conducting ongoing due diligence on the business relationship including scrutiny of transactions undertaken throughout the course of that relationship to ensure that the transactions being conducted are consistent with the institution’s or person’s knowledge of the customer, the business and risk profile, including, where necessary, the source of funds and ensuring that the documents, data or information held are kept up-to-date.”

(My emphasis added)

Article 7(b) (see box three) seems to me to contain a real problem for both trustees and any other person or institution, regulated by 3MLD, which they need to deal with. 3MLD will apply to the most commonly used financial counterparties of trustees: bankers; estate agents; investment advisers; stockbrokers; insurance providers; lawyers etc.

But, the Directive expressly requires that the third party who supplies services to a trustee (or, do not overlook it, companies as well) undertake:

Identification and verification on the trustee;
Identification of the purpose and intended nature of the business;
Identification and verification of the beneficial owner of the trust;
Identification of the ownership and control structure of the trust;
Checks on the transaction to make sure that it is consistent with the above knowledge;
Checks on the source of funds;
To have processes that will keep all of the above information up to date.

I will return a little later to who the beneficial owner is, but I would first of all draw attention to the above bullet points in the context of the current relationships of trustees with banks, brokers etc.

What skills are the third parties likely to have to undertake this work8?
What time will be necessary for them to undertake that work?
What costs will be added to the transaction by these checks?
What will be added to the trustees’ costs by providing documentation etc. to permit the checks?

The directive does (in parts) encourage a risk-based approach to due-diligence work, but my problems with the practicalities of this are:

To what extent will people apply a lighter risk-based approach to trusts that are in other respects singled out for special treatment?
How can you apply a risk-based approach without researching the matter first to establish what it is?

It becomes pertinent to ask what exactly is the problem with trusts that they require this type of financial quarantine? I am sure that we will all have our own views, but probably one has to go back to the Financial Action Task Force (FATF) for some of the current issues about trusts.

The 2003 FATF 40 Recommendations provide the backbone for 3MLD. FATF is an inter-governmental body originally created by the G-7 and since expanded to embrace 28 states. The 40 recommendations contain no detail regarding what types of trusts they believe should be regulated, but being an international body dealing with international issues, it seems unlikely that they were looking at trusts and money laundering in a domestic context. What they may have viewed as international issues translates uneasily into a domestic context, as will happen if there is no refinement to 3MLD.

Relying on third-party due diligence9

Anyone subject to 3MLD can rely on due diligence carried out by a third party, but the responsibility for compliance remains with the principal. This will probably be a limiting factor on accepting third-party due diligence.

Additional limiting factors are that third-party due diligence is only permitted from:

Persons or institutions subject to 3MLD in one of the member states;
Persons or institutions outside of the EC who are of equivalent status to those subject to 3MLD.

But for the second bullet point above the person or institution must also be:

Subject to mandatory professional registration by law;
Subject to due-diligence requirements equivalent to those imposed by 3MLD. However, it appears from 3MLD that judging equivalence is a matter for member-states governments who are obliged to advise the EC and other member states of those jurisdictions that are considered to have equivalent procedures.

Reporting obligations

Article 17 requires that: “Member states shall require that the institutions and persons covered by this Directive pay special attention to any activity which they regard as particularly likely, by its nature, to be related to money laundering or terrorist financing and in particular complex, unusual large transactions and all unusual patterns of transactions which have no apparent economic or visible lawful purpose.”

While the general aim of this particular provision might be reasonably clear, it seems to me that there is potential for disagreement over just what transactions fall within this definition and what constitutes the ‘special attention’ that must be paid to them.

Recording requirements10

There are some fairly extensive provisions for record-keeping. One provision that could cause some difficulty is that regarding institutions with subsidiaries in jurisdictions outside the EC. Such institutions are required to operate in those countries with due diligence and record-keeping that match the standards of those imposed by 3MLD. It will be interesting if those standards clash with the standards required in the jurisdiction where the subsidiary operates.

Beneficial ownership

Article 3 (8)

(8) ‘Beneficial owner’ means the natural person(s) who ultimately owns or controls the customer and/or the natural person on whose behalf a transaction or activity is being conducted. The beneficial owner shall at least include:1

(a) For corporate entities:

(i) The natural person(s) who ultimately owns or controls a legal entity through direct or indirect ownership or control over a sufficient percentage of the shares or voting rights in that legal person, including through bearer share holdings, other than a company listed on a regulated market that is subject to disclosure requirements consistent with Community legislation or subject to equivalent international standards; a percentage of 25 per cent plus one share shall be deemed sufficient to meet this criterion;

(ii) The natural person(s) who otherwise exercises control over the management of a legal entity.

(b) In the case of legal entities, such as foundations, and legal arrangements, such as trusts, which administer and distribute funds:

(i) Where the future beneficiaries have already been determined, the natural person(s) who is the beneficiary of 25 per cent or more of the property of a legal arrangement or entity;

(ii) Where the individuals that benefit from the entity or arrangement have yet to be determined, the class of persons in whose main interest the entity or arrangement is set up or operates;

(iii) The natural person(s) who exercises significant control over 25 per cent or more of the property of a legal arrangement or entity.

Article 3(8) provides the definition of beneficial ownership. Primarily this is going to be a matter for third parties dealing with trustees.

As far as trustees are concerned, the identification of beneficial interests is a fundamental part of their general duties inherent in trusteeship (as is ensuring that the funds are paid to the correct person).

It is fair to say that nothing within 3MLD appears to have attracted as much attention as this definition. It is perhaps a measure of the misunderstanding of trusts by the legislators that they have an almost obsessive belief that trusts have a shadowy presence behind them, ultimately owning them and operating the trustee as though a puppet.

Unfortunately, the beneficial-owner definition has had too much attention paid to it. Those drafting 3MLD have not really understood the mechanics of trusts and therefore have found it hard to understand that if the ‘beneficial owner’ really is an issue, for whatever reason, the draftsman could conceal this (power to add beneficiaries etc.). Nor have the draftsmen of 3MLD really thought through the implications of what happens when an interest was below 25 per cent and then becomes greater than 25 per cent.

Identification of beneficial interests becomes near farcical when applied to classes. This issue has been much debated, because of the potential expense if a trustee (or anyone else) was to be forced into identification and verification of a class at its inception. The solution of the legislators is that the class itself should be ‘understood’, that is, that if the deed specifies that those interested in remainder are ‘the children of John Smith’ then it is enough to understand that the beneficial owner is ‘the child of John Smith’. I am sure that we all understand the value implicit in that check.

Trust services

Article 32

“1. Member states shall provide that currency exchange offices, trust and company service providers must be licensed or registered and casinos be licensed in order to operate their business legally. Without prejudice to future Community legislation, member states shall provide that money transmission or remittance offices shall be licensed or registered in order to operate their business legally;

2. Member states shall require competent authorities to refuse licensing or registration of the entities referred to in paragraph 1 if they are not satisfied that the persons who effectively direct or will direct the business of such entities or the beneficial owners of such entities are fit and proper persons11.”

There is in addition a new draft recital to introduce this article: “When registering or licensing a currency exchange office, a trust and company service provider or a casino nationally, competent authorities should ensure that the persons who effectively direct or will direct the business of such entities and the beneficial owners of such entities are fit and proper persons. The criteria for determining whether or not a person is fit and proper should be established nationally, in conformity with national law. At a minimum, such criteria should reflect the need to protect such institutions and persons from being misused by their managers or beneficial owners for criminal purposes.”

(My emphasis added)

I am not aware if any of the member states have yet indicated the nature of their intended licensing or registration authority. However, from Article 32 (see box five), we can see that for trust services:

A licence to do business will be essential;
Fit and proper status will be tested, presumably, on an ongoing basis.
In seems to me to be inescapable that both points will have considerable costs implications for a trust service provider. Any licensing process is going to involve the applicant in expenditure:

To go through the process;
To establish the ongoing training and recording systems;
Dealing with licensing authority reviews and changed requirements.

It is also clear from contact with both Brussels and the UK Government that any licensing authority to monitor trust service providers will need a more significant understanding of trustees than has so far been shown by the legislators. It is of great importance that there is an early engagement between the government and practitioners’ professional bodies in order that the licensing authorities’ rule book can be as informed and realistic as possible.

Who will be trust service providers?

Article 3

“(9) ‘Trust and company service providers’ means any natural or legal person which by way of business provides any of the following services to third parties:

(a) Forming companies or other legal persons;

(b) Acting as or arranging for another person to act as a director or secretary of a company, a partner of a partnership, or a similar position in relation to other legal persons;

(c) Providing a registered office; business address, correspondence or administrative address and other related services for a company, a partnership or any other legal person or arrangement;

(d) Acting as or arranging for another person to act as a trustee of an express trust or a similar legal arrangement;

(e) Acting as or arranging for another person to act as a nominee shareholder for another person other than a company listed on a regulated market that is subject to disclosure requirements in conformity with Community legislation or subject to equivalent international standards.”

Article 3 provides the definition, but it is a rather vague definition that must be treated with some caution at this stage. I fully expect the definition to be refined in national legislation in order to clarify the scope.

I was puzzled by exactly what the EC were after with this definition, until it was revealed that they were not aware of what trusts were actually used for within member states. Is the definition meant to include providing services in respect of:

1. Trusts of ownership of joint property?
2. International corporate-bond issues?
3. Charities?
4. Pension funds?
5. Testamentary trusts?
6. Trusts of commercial ventures?
7. Employee-benefit trusts?
8. Insurance schemes?
9. Mutual funds?

Where any of these matters are dealt with within member states on a legal basis that does not involve trusts, it would seem that the Commission is content that they do not require additional regulation (over and above that already enacted after the previous two MLDs). Thus:

A notary dealing with succession issues not involving trusts would not need the additional licensing that apparently is needed for trust-service providers;
The same comment for those dealing with joint property or charities etc.

When I first started looking at these issues I made the assumption that many of the areas listed above would be omitted from regulation as they were patently not intended to be within 3MLD. However, the more questions that have been asked, the more certain I have become that all trusts will be left in. From the list above:

Trusts of ownership of joint property? When questioned in Brussels last December, two representatives of the Commission maintained that a trust of joint property was included12;
International corporate-bond issues? Initially, no-one approached in Brussels seemed to be particularly aware of the significance of this market (in which the City of London is the dominant global market). So far, there has not been any agreed amendment to take this area out of scope of the Directive;
Charities? Nothing known yet that would take them out of scope;
Pension funds? Confirmed by presentation slides used in a Commission presentation last December as being considered to be within scope;
Trust of wills? This has been an area on which STEP has focused its lobbying, but to date no change to the draft has resulted. This is, in my opinion, an area that will attract adverse press comment. Are there really votes for politicians in regulating the trusts of auntie’s will?

Politically exposed persons (PEPs)

It is difficult to find anything remotely complimentary to say about these provisions. PEPs are defined in Article 3(10) as: “…natural persons who are or have been entrusted with prominent public functions and close family members or close associates of such persons13.”

The Directive requires14 that those subject to it have risk-management systems in place to deal with PEPs in terms of identification and establishing business relations. I think that it is quite beyond the resources of any person or institution subject to 3MLD to:

Determine what is a PEP;
Decide who is a PEP;
Identify which relatives or associates of a PEP are to fall within this category.

Personally, I doubt that the CIA has the resources to do this, let alone the local estate agent. To add a little context to the problem I have received different answers from MEPs as to whether or not MEPs are PEPs.

Quite clearly, what was a specific FATF-40 recommendation and one of the key areas of 3MLD is going to either be watered down at a national level or widely ignored at a practitioner level simply because of the impossibility of compliance15.

There is some consultation currently under way in Brussels that could lead to this Article being restricted in its application. It is very welcome that such a consultation is taking place, but it probably also highlights the lack of thought that has been applied so far.

References:

This is an amended version of a paper given at a seminar for the Society of Trust and Estate Practitioners in Dublin in January 2005
‘Third parties’ in this context, and in the rest of the article refers to those businesses and individuals who are subject to the provisions of 3MLD and therefore have express duties imposed on them when dealing with trustees
This period was 12 months in early drafts and some European Parliamentary amendments favour 24 months
But note that Article 4 expressly permits a member state to adopt legislation that is more rigorous than 3MLD. There is therefore the possibility that a government could decide to go further than is required by the 3MLD (a repeat of the Proceeds of Crime Act 2002?)
It is commonly said that the devil is the detail; today it is just as often said of regulators that the devil is in the rulebook
The provisions are Chapter IV of the draft Directive. In Brusselspeak this is a process known as ‘comitology’. There are concerns that in the past this process has been less than transparent and lacking in democratic accountability. Considerable efforts are being made to ensure that in case of 3MLD the process will involve genuine consultation and representation from industry
In case this is thought strange, I do not believe that FATF (The Financial Action Task Force) carried out any such research when they
incorporated a reference to trusts into their forty points
I am not questioning their competence in dealing generally with money-laundering issues, but specifically whether they have the knowledge to apply this to trusts
See Articles 10-16 generally on due diligence
See Articles 26-29 generally
In UK legislation, this is probably the first time that trust and company service providers find themselves expressly in the company of currency-exchange offices and casinos
If conveyancers are to be treated as delivering a trust service, it is difficult to see how their additional costs of licensing are going to reduce in any way the overall costs of property transactions
Despite the best efforts of the draftsman, I don’t think that this is limited to politicians who have been entrusted with both public functions and close relatives
Article 11 “Enhanced Due Diligence”
If any one is tempted to think that compliance with this article is feasible, consider a randomly chosen state, such as Burkina Fasso, and then consider how one establishes who are PEPs in that country and how one would then identify their close relatives and business associates. Then consider the billable time that would be taken in that exercise if a way to do it could be found!

Martyn Frost is a deputy chair of STEP and consultant in the trusts and estates department of Halliwells LLP. He can be contacted at martyn.frost@halliwells.com