Meaningful Overlap or Superficial Similarities?
On October 3, the release of the Pandora Papers flooded the global media, as millions of documents detailed incidents of wealthy and powerful people allegedly using so-called offshore accounts and other structures to shield wealth from taxation and other asset reporting. Data gathered by the International Consortium of Investigative Journalists, the architect of the Pandora Papers release, suggests that governments collectively lose $427 billion each year to tax evasion and tax avoidance. These figures and the identification of high-profile politicians and oligarchs involved in the scandal (Tony Blair, Vladimir Putin, and King Abdullah II of Jordan, to name a few) have grabbed headlines and spurred conversations about fairness in the international financial system – particularly as COVID-19 has highlighted and exacerbated economic disparities.
Much of the conduct revealed by the Pandora Papers appears to involve entirely legal structures used by the wealthy to – not surprisingly – maintain or enhance wealth. Thus, the core debate implicated by the Pandora Papers is arguably one of social equity and related reputational risk for financial institutions (“FIs”), rather than “just” crime and anti-money laundering (“AML”). Media treatment of the Pandora Papers often blurs the distinction between AML and social concerns – and traditionally, there has been a distinction.
This focus on social concerns made us consider the current interest by the U.S. government, corporations and investors in ESG, and how ESG might begin to inform – perhaps only implicitly – aspects of AML compliance and examination. ESG, which stands for Environmental, Social, and Governance, are criteria that set the foundation for socially-conscious investing that attempts to identify related business risks. At first blush, the two are separate fields. But as we discuss, there are ESG-related issues that link concretely to discrete AML issues: for example, transaction monitoring by FIs of potential environmental crime by customers for the purposes of filing a Suspicious Activity Report, or SAR, under the Bank Secrecy Act (“BSA”). Moreover, there is a bigger picture consideration regarding BSA/AML relating to ESG: will regulators and examiners of FIs covered by the BSA now consider – consciously or unconsciously – whether FIs are providing financial services to customers that are not necessarily breaking the law or engaging in suspicious activity, but whose conduct is inconsistent with ESG principles?
If so, then ESG concerns may fuel the phenomenon of de-risking, which is when FIs limit, restrict or close the accounts of clients perceived as being a high risk for money laundering or terrorist financing. Arguably, and as we discuss, there also would be a historical and controversial analog – Operation Chokepoint, which involved a push by the government (not investors) for FIs to de-risk certain types of customers. Regardless, interest in ESG means that FIs have to be even more aware of potential reputational risk with certain clients. Even if the money in the accounts is perfectly legal, the next data breach can mean unwanted publicity for servicing certain clients.
These concepts are slippery, involve emerging trends that have yet to play out fully, and the similarities between AML and ESG can be overstated. Nonetheless, it is possible that these two fields, both of which are subject to increasing global interest, may converge in important respects. A preliminary discussion seems merited, however caveated or subject to debate.
ESG and AML
According to recent pronouncements by the Securities and Exchange Commission, and pending the issuance of formal rules, disclosures by public companies now can include material information on everything from climate change to diversity and civil rights. ESG has allowed investors to hone in on the social and sustainability issues that might matter to them, in the hope that attention to those issues will enhance a company’s financial and operational metrics. Demand for ESG investment has soared in recent years, with companies devoting more and more resources to it. ESG is largely driven by market forces rather than laws and regulations. While ESG first gained momentum among socially conscious investors, it has now become so mainstream that any company that chooses not to report on its environmental and social impact risks reputational harm and loss of stock value. In this way, ESG serves as an indirect mechanism for potential social change: companies must be able to stand by their decisions with respect to their role in such issues like climate change, civil rights, and other culturally significant issues.
In contrast to ESG, AML exists within a defined statutory and regulatory framework that has existed for decades, and which focuses on rooting out “dirty money” flowing from specific crimes and combatting terrorism. Nonetheless, there are some high-level parallels between AML and ESG. First, transparency – a recurring issue in the Pandora Papers discussion – is at the heart of AML, which requires FIs to know their customers. Likewise, ESG attempts to use market forces to increase corporate transparency. By making climate change and other socially-conscious disclosures part of the calculus for companies to garner financial support, investors and the general public have incentivized those companies to reckon with their actions in order to compete. Second, the “requirements” of both AML and ESG can be opaque in operation. The maxim that AML compliance should be “risk based” can be vague and allow for post-hac critiques by regulators; the goals of ESG sometimes can be poorly defined and subjective. Third, even AML can implicate social issues. According to the AML priorities recently identified by FinCEN, on which we have blogged, the most significant AML threats that FIs should address include corruption and human trafficking. Focusing on this third point, we will discuss the more concrete overlaps between AML and ESG.
Environmental concerns offer the most concrete example of the overlap between AML and ESG. On the ESG side, sustainability reporting has become a critical component for companies across industries. Investor demand for disclosures related to climate change is at an all-time high, with the SEC even creating its own enforcement task force focused on scrutinizing and identifying gaps in climate disclosures.
On the AML side, and as we recently blogged, environmental crimes are attracting increasing regulatory attention. Such crimes globally generate up to $281 billion per year in ill-gotten gains, and consist of illegal logging, land clearing, forestry crime, illegal mining, illegal waste trafficking, the illegal wildlife trade, and other crimes. However, environmental crimes are notoriously difficult to track and prosecute, largely due to the perpetrators’ practice of comingling (mixing legally and illegally-obtained materials throughout the supply chain) and difficulties associated with cross-border enforcement. The Financial Action Task Force (FATF) issued a report identifying clear regulatory gaps when it comes to environmental crimes, and finding interagency collaboration to be lacking. Further, the punishments for environmental crimes are weak in relation to their cost – both economic and environmental – unless they are labelled instead as money laundering offenses, when the proceeds of the underlying environmental offenses are transacted.
Although environmental concerns have driven the growth of ESG, environmental concerns have tended to take a back seat in AML compliance and enforcement, which necessarily must focus limited resources on a very broad spectrum of illicit activity. But the possibility remains that ESG could impact AML compliance and regulatory examinations. If comingling is at the root of environmental crimes, then transparency is a likely solution. It therefore will not be surprising if companies that transact in logging, land clearing, forestry, mining, waste trafficking and related activities will be subject to enhanced due diligence and increased scrutiny by financial institutions.
“Social” is perhaps the broadest and most nebulous category to tackle under ESG, as social issues span everything from community engagement, to consumer protection, to human rights and more.
One area of definite overlap between AML and ESG under the “social” umbrella is human trafficking. It is one of the most profitable forms of international crime, generating up to $150 billion worldwide per year and affecting nearly every country in the world. In regards to filing Suspicious Activity Reports, or SARs, FinCEN has provided red flags for financial institutions to consider when determining whether a transaction may be associated with human trafficking. Through the AML Act of 2020, Congress also recently tasked the Government Accountability Office to conduct a studies on identifying and stopping human trafficking.
But ESG’s “social” umbrella is potentially very broad, and can include wealth distribution. Accordingly, a more slippery but potentially more interesting AML issue relating to ESG “social” concerns is the sometimes very thin line between tax avoidance – which is legal – and tax evasion – which is illegal – and how tax issues fit into larger public debates regarding fairness and economic disparities. As exemplified by the Pandora Papers and related scandals, discussions of tax avoidance and wealth protection issues can bleed into discussions of tax evasion issues, which can bleed into discussions of money laundering issues. Although tax evasion and money laundering are separate legal concepts – money laundering requires “dirty” money from an underlying crime, whereas tax evasion can and often does involve only “clean” money – the two types of conduct are often regarded as almost interchangeable in many public discussions. Accordingly, tax compliance may become an increasingly critical issue for financial institutions executing their AML compliance plans. It is incredibly hard for financial institutions to detect potential tax crimes by their clients, due to lack of relevant information. But as the Pandora Papers reflect, servicing a client who takes legal but unsavory steps towards tax avoidance can produce reputational risk.
The most concrete connection between AML and ESG in the “governance” space is the fight against corruption in the U.S. and across the globe. As noted, the AML priorities recently identified by FinCEN begin with fighting corruption. This stated AML priority is consistent with the fact that President Biden unveiled a National Security Study Memorandum in June 2021 entitled Memorandum on Establishing the Fight Against Corruption as a Core United States National Security Interest, which asserts that the Biden administration views “countering corruption as a core United States national security interest.”
Otherwise, ESG governance issues typically take the form of Board composition, structure and diversity—which do not have a clear analog in the AML compliance space. However, according to the FFIEC BSA/AML Examination Manual, it is the Board that maintains ultimate responsibility for a bank’s compliance with BSA/AML regulations. In a time of crisis—whether an environmental scandal or an AML-related investigation—the Board will be under immense scrutiny. When a regulator questions whether a bank’s Board adopted the proper controls to fully inform itself of the institution’s execution of its BSA/AML policies and procedures, it is really asking whether the Board follows good governance practices. Under ESG, good governance practices must take into account the Board’s composition and structure. As we discuss below, it will be interesting to see if and when the AML regulatory scheme borrows from ESG in its evaluation of the Board’s oversight function or other corporate practices.
In addition to these specific areas of overlap, there may be a broader convergence between AML and ESG. As ESG expectations grow, AML regulatory expectations may change accordingly and become more informed by social issues – consciously or unconsciously. That is, regulators and examiners of FIs covered by the BSA may start asking whether client relationships held by FIs are problematic – not necessarily because of specific transactions that might be suspicious, but rather because of the very identity of the customer. In certain respects, this concept is nothing new to AML: enhanced due diligence is routinely applied to certain types of customers, such as those operating in “high risk” foreign jurisdictions or those regarded as higher-risk industries, such as money services businesses. Any change may involve barely perceptible degrees, as examiners tend to ask harder questions of FIs about clients with perceived ESG issues.
Historically, the frequent response by FIs when regulators express concern regarding certain types of clients or industries has been to “de-risk” them – that is, reflexively close the accounts of implicated customers, rather than deal with the related compliance costs on a case-by-case basis. Ironically, de-risking has been criticized as frequently impacting smaller and poorer countries with limited financial markets, as well as non-profit entities. If ESG issues contribute to a form of FI de-risking, this scenario may be turned on its head, as FIs respond to ESG concerns by dropping U.S. corporate or high-end individual clients. It is conceivable that a FI may respond to ESG investor pressures by “de-risking” customers that could cause reputational risk or otherwise devalue the FI’s “brand,” impair the FI’s employee recruitment or retention, or undermine the FI’s stated ESG positions on voting rights, supporting diversity, or responsiveness to climate change.
Such a scenario echoes, roughly, a historical and controversial analog – Operation Chokepoint, a now-abandoned DOJ initiative in which banks were pressured to stop dealing with certain identified industries, regardless of whether particular transactions were regarded as suspicious or criminal. Some industries identified by Operation Chokepoint likely made sense from an AML perspective – for example, “pyramid-type sales,” which could involve Ponzi-type schemes. Others did not – for example, “ammunition sales.” Regardless of one’s personal position on firearms, that target appears to be more of a value judgement rather than a data-driven decision regarding AML risks. Operation Chokepoint eventually was abandoned, and was criticized by some as “asking banks to identify customers” who were “simply doing something government officials don’t like. Banks then ‘choke off’ those customers’ access to financial services, shutting down their accounts.” The perceived problem with Operation Chokepoint was that it was subjective and untethered to any basic due process or regulatory rule making – even if the targets were unsavory.
Further, ESG has been driven not just by public investors, but also by regulators – in particular, the SEC. Of course, political administrations can change, and one administration’s perception of a social good obviously can be quite different than its predecessor. Even if the inexorable and brutal pressures of climate change make environmental concerns more “mainstream,” other topics – such as civil rights – can be subject to wildly different approaches by different administrations, and sometimes immune to investor opinion or corporate initiatives.
The real-world nexus between AML and ESG may turn out to be exceedingly thin. But as the Pandora Papers scandal reflects, issues of social justice and equity can have real-world consequences for financial institutions and companies that are “outed” as servicing clients who may not necessarily be breaking the law but nonetheless are engaging in debatable conduct.
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