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INTRODUCTION
Combatting money laundering and illicit finance has long been a
matter of national security in the United States, as well as a
matter of increasing concern globally.1 Anti-money
laundering (AML) efforts date back to the Bank Secrecy
Act2 (BSA), passed in 1970 and considered the
cornerstone of AML legislation. The BSA takes a recordkeeping and
reporting approach to AML and requires persons regulated thereunder
to report suspicious financial activity, including cash
transactions exceeding $10,000.
The terrorist attack of 2001 brought new focus on the potential
use of opaque “shell” entities and complex ownership
structures for money laundering and terrorism financing. These
concerns gave rise to an amendment of the BSA known as the USA
PATRIOT Act of 20013 (Patriot Act) which includes
“know your client” (KYC) provisions to enlist the aid of
financial institutions in the fight against terrorism and financial
crime. KYC regulations require banks and certain other financial
institutions to develop and implement a Customer Identification
Program (CIP) with procedures to verify the identity of each
customer so that the financial institution can better understand
its customer’s business and form a reasonable belief that it
knows the true identity of each customer.
The real estate industry underwent even greater scrutiny when
the Financial Crimes Enforcement Network of the United States
Department of the Treasury (FinCEN) began to issue geographic
targeting orders (GTOs) to: (i) look through shell entities which
were extensively used to purchase luxury apartments in Manhattan
and Miami potentially using funds from illegal sources; and (ii)
identify the beneficial owners of the entities.4
Originally issued in 2016, GTOs have since expanded to cover
geographic areas beyond the initial targets of Manhattan and Miami.
In 2021, FinCEN issued an Advance Notice of Proposed Rulemaking
(Anti-Money Laundering Regulations for Real Estate
Transactions)5 which seeks to expand the requirements to
collect, report, and retain information to a wider range of
transactions, in effect potentially expanding the requirements of
the GTOs to all non-financed commercial real estate purchases
nationwide.6
This article will explore the origin of KYC processes and AML
regulatory regimes in real estate finance, the evolution of lender
KYC practices in commercial real estate loan transactions, and the
future of lender KYC practices in the digital age.
THE PATRIOT ACT AND REAL ESTATE TRANSACTIONS
Real estate transactions have risen to the forefront for US AML
regulators who have stated that such transactions are particularly
susceptible to money laundering and other financial crimes. FinCEN
outlined key risks and vulnerabilities in real estate
transactions:
Real estate transactions and the real estate market have certain
characteristics that make them vulnerable to abuse by illicit
actors seeking to launder criminal proceeds. For example, many real
estate transactions involve high-value assets, opaque entities, and
processes that can limit transparency because of their complexity
and diversity. In addition, the real estate market can be an
attractive vehicle for laundering illicit gains because of the
manner in which it appreciates in value, “cleans” large
sums of money in a single transaction, and shields ill-gotten gains
from market instability and exchange-rate
fluctuations.7
Sophisticated lenders in the syndicated loan market typically
perform extensive due diligence on elements of the credit
transaction and the borrower and related parties prior to closing
the transaction or disbursing funds. Such loans may thereafter be
sold or transferred, in whole or in part, in the secondary loan
market. As a result of such extensive due diligence, the syndicated
and secondary loan markets generally have a low risk of money
laundering or terrorist financing. Nonetheless, under the Patriot
Act, financial institutions are required to develop formal CIPs in
order to detect potential money laundering or other financial
misconduct. Such CIPs must address the vulnerabilities related to
the limited transparency that FinCEN noted to be prevalent in real
estate transactions. The Loan Syndication and Trading Association
(LSTA) has been instrumental in providing and updating lender
guidance for KYC and CIPs, issuing its original Guidelines for the
Implementation of Customer Identification Programs in
2004.8 LSTA has updated its guidance to reflect changes
in regulations as well as market practices.9 The
guidance aims to: (i) identify the types of transactions or
relationships in the primary and secondary loan market which do,
and those which do not, require CIP scrutiny; and (ii) highlight
potential AML or The Office of Foreign Assets Control (OFAC)
compliance risks arising from such transactions or relationships
including counterparty relationships.
In a loan transaction, customer identification and verification
are performed on the borrower, any guarantor and, pursuant to
FinCEN’s beneficial ownership rule of 2016 (discussed below),
any other person or entity that has a direct or indirect ownership
interest of at least 25 percent in the borrower or any guarantor. A
financial institution may wish to screen other parties to the
transaction as well, depending on the nature of the transaction,
including indirect owners of less than 25 percent in the borrower.
Customer due diligence information to be gathered as part of the
CIP process includes, at a minimum, the customer’s name,
address of principal place of business, and taxpayer identification
number as well as the names of the company’s directors and
their similar identification information. This information is then
required to be verified through the financial institution’s CIP
by documentary means (which may be the entity’s charter
documents or an individual’s driver’s license or passport)
or other means such as internet searches of publicly available
information or physical visits to the customer’s place of
business.
US banks must also comply with OFAC regulations which set out
prohibited types of transactions and persons with whom US persons
may not engage in transactions. Failure to comply with OFAC
regulations can have severe consequences including civil or
criminal liability as well as possible non-repayment of the loan
should a borrower become the target of sanctions.10 Once
customer information is obtained and verified, it is compared
against various lists (such as the US Department of State sanctions
lists, the Specially Designated Nationals and Blocked Persons
Lists, and Financial Action Task Force Lists) to determine whether
persons or entities are subject to sanctions administered by OFAC
or otherwise considered “blocked” by OFAC.
Using a risk-based approach, a financial institution may engage
in enhanced due diligence if information obtained in the CIP
process indicates that the customer or transaction poses a higher
risk of money laundering or terrorist financing. Primary lenders,
including every lender in a syndicate for a syndicated loan, will
give the greatest scrutiny. Lenders who acquire a loan in the
secondary market or by merger, asset purchase, or the like are not
required to perform CIP under a “transfer
exception.”11
In addition to CIP and risk assessment protocols, lenders will
typically include Patriot Act, OFAC, and other AML and
anti-corruption representations and covenants in the loan
agreement, which are designed for compliance with AML and anti
corruption regulations at the time of signing the loan agreement
and for the life of the loan. These provisions include, among
others, a required Patriot Act notice notifying the borrower that
the lender is subject to the Patriot Act, a covenant to provide KYC
information, and representations and covenants relating to
sanctions compliance. Loan agreements will also provide for
continued compliance with KYC regulations such that transferees of
interest in the borrower will be subject to CIP and compliance with
the KYC requirements of the loan agreement. These representations
or covenants may help the lender avoid severe penalties in the
event that a borrower misrepresents its status or compliance or if
a violation occurs after disbursement, as such provisions evidence
the lender’s intent to comply with the regulations.
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Footnotes
1. An earlier version of this article was published in
The ACREL Papers – Fall 2022.
2. 31 USC § 5311 et seq.
3. Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism (USA
PATRIOT) Act of 2001, Title III of Pub. L. 107-56 (signed into law
October 26, 2001).
4. FinCEN Press Release, Geographic Targeting Orders
Require Identification for High-End Cash Buyers, Jan. 13, 2016,
available at https://www.fincen.gov/news/news-releases/fincen-takes-aim-real-estate-secrecy-manhattan
and-miami. Geographic targeting orders require certain title
insurance companies to report the identity of beneficial owners of
shell companies purchasing residential real estate in all-cash
transactions.
5. Anti-Money Laundering Regulations for Real Estate
Transactions, 86 Fed. Reg. 69589 (Dec. 8, 2021), available at https://www.federalregister.gov/documents/2021/12/08/2021-26549/anti-money-laundering
regulations-for-real-estate-transactions.
6. While GTOs and the Proposed Rule are significant
developments in the movement toward more transparency in real
estate transactions, they relate to either all-cash residential
real estate transactions (GTOs) or non-financed residential and
commercial real estate acquisitions (ANPRM) and, as such, are not
within the scope of this paper which is limited to commercial
lending practices.
7. FinCEN, Advisory to Financial Institutions and Real
Estate Firms and Professionals, FIN-2017-A003, Aug. 22, 2017,
available at https://www.fincen.gov/sites/default/files/
advisory/2017-08-22/Risk%20in%20Real%20Estate%20
Advisory_FINAL%20508%20Tuesday%20%28002%29.pdf
8. LSTA Guidelines for the Implementation of Customer
Identification Programs for Syndicated Lending and Loan Trading,
September 2004.
9. LSTA Know Your Customer Considerations for Syndicated
Lending and Loans (LSTA KYC Guidelines), Oct. 22, 2018.
10. LSTA Regulatory Guidance: U.S. Sanctions Issues in
Lending Transactions (LSTA Sanctions Guidance), Apr. 25,
2022
11. LSTA KYC Guidelines, supra note 9. The LSTA KYC
Guidelines analyze an array of roles and relationships in
syndicated loans and provide guidance as to whether a relationship
gives rise to CIP requirement and whether CIP is required to be
performed by financial institutions in such roles.
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guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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