Taking a risk-based approach to source of funds checks

Source of funds refers to the checks you’ll need to carry out to verify the origin of the funds being used in a particular matter or transaction, as opposed to source of wealth, which refers to finding out about how clients have acquired their wealth.

The level of detail with which you’ll look into the source of funds will depend on the risks presented by the client and the relevant transaction, with no one size fits all solution available. The following article explores how to take a risk-based approach to source of funds checks - using case studies to explore best practice in high, medium and low risk cases.

Low-risk cases and funds coming from banks

The Legal Sector Affinity Group Guidance (LSAG) states that funds coming from another law firm can be regarded as low risk. This doesn’t mean, however, that in every case there will be no risks of criminal property being involved.  Law firms carrying out regulated work are required to comply with UK Money Laundering Regulations and also codes of conduct imposed by the Solicitors Regulation Authority.

Accordingly, when handling transaction funds they are subject to strict rules of compliance and this is why the Guidance categorises funds from another law firm’s client account as low risk. Despite this it has been known for dirty money to find its way into a law firm’s client account and if you have concerns you should still ask questions and carry out proportionate due diligence.   

When considering risk it is fair to say that if funds are coming from a UK bank this is one factor that reduces the risk of money laundering. It shouldn’t be assumed, however, that  all monies coming from a UK bank are clean. We’ve seen that banks aren’t immune from money laundering activity with some heavy fines being dished out but it may also be that the bank is transferring the funds having requested and received “consent” from the National Crime Agency, so you will still need to carry out your own checks.

How to apply a risk-based approach to source of funds checks

Applying a risk-based approach means directing your resources where they are needed most, which seems like a sensible way to do things in terms of remaining compliant, but doing so efficiently. Because your approach will be different in each case, it will require you to make a judgement based upon  your client and matter risk assessment.

The best way to explain how to apply the risk-based approach is to run through a few case studies.

Low risk – The young married couple

In this scenario, you’re acting for a local, married couple in their mid-thirties, who are buying a property for £200,000. They have no children, both work full time in professional jobs and will be receiving a bank mortgage for 95% of the purchase price, with the remainder coming from joint savings. They are first time buyers currently living in rented accommodation and have both provided satisfactory ID evidence.

In a case like this you must ask yourself ‘’what are the risks of money laundering?”. The answer must be that the risks are very low and therefore due diligence measures can be kept to a minimum. If the clients provide a plausible explanation for the source of the deposit funds then that should be sufficient. Over burdening the clients in this case with extensive requests for proof of source of funds is not good for the client or the fee earner. Better to just make a note of the client’s explanation to justify the transaction as being classified a low-risk.   

Mid-high risk – The self-employed builder

In this scenario, we have a single, 28 year old, self-employed builder purchasing a commercial property for £500,000 to use for his business. He’s obtained funding from his bank for £300,000, paying the rest from his own cash funds. He doesn’t have any trading accounts as he’s only been in business for 12 months and has provided satisfactory ID evidence.

This situation appears to be more risky. First of all you would have to ask what is a 28 year old builder doing running a business where he’s accumulated £200,000 that he can use to purchase a property? If he has only been in business for 12 months are there any management accounts?

So you should start off being a little bit cautious with this one. The client may give you a perfectly reasonable explanation as to why he has £200,000, but you’ll need to ask the question and ask for supporting evidence.

If, for example, the client tells you that he has no trading account because he’s taken over his father’s business, who’s died and he’s converted the business into a limited company, which has only been trading for 12 months then this might change the risk factor.

He may also tell you that when his father died, he received a large inheritance in excess of £200,000, which accounts for the origin of funds being used as a deposit. You will need to obtain evidence of the inheritance to keep on file. One thing in this scenario which should also give you some comfort is that the client’s bankers have approved a bank loan of £300,000.

Very high risk – Complex corporate structure

This scenario is a much more complicated and is very high risk.

Your client is ABC Ltd, an offshore British Virgin Islands company acting under a power of attorney granted by DEF Ltd, a company registered in Panama.

ABC Ltd is acquiring a portfolio of commercial properties in the UK using substantial funds in excess of £50m from DEF Ltd, with your fees set to exceed £250,000.

From initial inquiries and the information you've been given, you're told that the Register of Members of ABC Ltd, shows that three other offshore companies each own 20% of ABC Ltd, and a Mr. Cheung owns 40%.

You’ll appreciate why this one is a lot more complex and will require a lot more digging. But the first thing to point out with a case like this is that unless you are an expert in dealing with offshore jurisdictions and offshore companies, you shouldn’t get involved.

Fraudsters often try to tempt smaller regional firms with large fees to entice them into taking on  dodgy transactions, but where the funds are coming  through very complex arrangements and corporate structures as is the case here you should decline the instructions at the outset if you don’t have the necessary expertise.

There are large sums of money involved in this case, so if you get involved and haven’t carried out sufficient source of funds checks and due diligence checks and something goes wrong, you will most likely end up in prison.

So, the attraction of the £250,000 fee, frankly, shouldn't be of any concern whatsoever. It should be completely and totally irrelevant. This sort of transaction needs to go to somebody very, very senior.

Some of the initial questions you’d need to be asking in a case like this are:

• What is the rationale behind the power of attorney?
• What is the relationship between ABC Limited and DEF limited?
• Why is the buying vehicle structured in the way proposed?
• Are there other solicitors involved?
• Are there any accountants involved?
• Why has your firm been instructed?
• You need chapter and verse on the source of funding

Be aware also that Panama is a country which currently is on the UK’s list of high-risk third countries.

The Money Laundering Regulations (Regulation 33(3A)) requires specific enhanced due diligence measures to be applied where a business relationship or transaction involves a party established in a high-risk third country. Senior management approval is required before proceeding with a transaction involving a high-risk third country.

Off shore companies can be used to avoid transparency of beneficial owners so you should insist on all company members/shareholders being identified and then make sure that the identities are verified. All parties involved should also be checked for adverse media.

You've also got Mr. Cheung who owns 40% of ABC limited, making him a beneficial owner. So, you need to verify his identity and carry out appropriate due diligence on him which should include checking his source of wealth.

In a case like this if, after carrying out your due diligence, you have concerns you should decline the instructions and also consider whether it is appropriate to report the circumstances to the National Crime Agency.

Top tip for source of funds checks: record everything

In each of these cases, whatever your decision and how you apply source of funds checks, you need to ensure that you are properly documenting everything. Keep a record of everything the client tells you, what checks you have carried out and the reasons why you’ve come to the relevant decision.

You’re not expected to be police officers and carry out a full forensic investigation, you just need to be satisfied that the monies being used for the transaction haven’t originated from criminal conduct. Should the prosecuting authorities come calling and asking about what inquiries were made you need to be in a position where you can demonstrate that you have complied with your regulatory and statutory obligations.

Download the Access Legal AML Guide for Law Firms for comprehensive, practical advice on your firm’s AML obligations and how you can meet them. Alternatively, get in touch with our specialist team to find out how Access Legal’s software can support your AML processes in-house. We also offer an AML elearning solution which is crucial for anyone handling company finances.