How-to guide: How to navigate challenges relating to Source of Wealth and Source of Funds (UK)

Introduction

In recent years, corporate compliance teams and high net worth individuals have spent an increasing amount of time grappling with issues surrounding source of wealth (SOW) and source of funds (SOF).

SOW and SOF issues take up a lot of time for regulated firms' compliance personnel – they have anti-money laundering (AML) processes to follow and need to ask targeted questions, review documents, assess risk and decide whether a given relationship can proceed. Private companies and high net worth individuals have to respond to these questions, often in detail and quickly, to meet their commercial or private objectives. Allegations in the media may be relevant or there may be a politically exposed person (PEP) involved. Where this is the case, the questions posed may be even more in-depth and may touch on sensitive issues. SOW and SOF issues can therefore be difficult for all involved.

This how-to guide is designed to assist those concerned with 'know your client' queries to identify the tensions that can arise in relation to SOW and SOF and how to manage them.

This guide covers the following:

1. What is meant by SOW and SOF
2. Why there is interest in SOW and SOF
3. Examples of SOW and SOF
4. Issues with PEPs
5. Tips for examining SOW

Section 1 - What is meant by SOW and SOF

There is not a universally accepted definition of SOW or SOF, and different approaches are taken as to how much information is required in order to establish SOW or SOF. Different definitions are provided by, for example, the Financial Action Task Force (FATF), the Financial Conduct Authority (FCA) and the Wolfsberg Group (a group of 12 global banks seeking to develop frameworks and guidance for the management of financial crime risks). Different definitions may be used by regulated firms in their policies. This means that counterparties can sometimes be talking at cross-purposes when requesting or providing relevant information. Broadly:

• SOW refers to the origin of a person or entity’s entire body of wealth; and
• SOF refers to the particular funds or other assets which are the subject of the relevant transaction or business relationships eg, the assets held by a trust, the shares held by a holding company or the funds in a bank account.

Section 2 - Why there is interest in SOW and SOF

The UK’s AML framework is multi-tiered. Policy recommendations are made at a supranational level, with the Recommendations of FATF being particularly influential. These global standards have traditionally been translated into legal requirements at an EU level, before being given effect in UK legislation (prior to Brexit).

At a national level, FATF’s recommendations require states to have appropriate money laundering laws; provisions to allow the confiscation or forfeiture of assets by a court; and more generally to investigate and regulate money laundering. FATF also created the concept that certain businesses act as 'financial gatekeepers' due to their ability to provide access to financial markets. Such firms include banks, accountants, real estate agents and tax advisors. These financial gatekeepers have obligations regarding AML policies and procedures, including the need to perform customer/client due diligence.

At the European level, the EU’s Fourth Money Laundering Directive (4MLD) came into force in 2015, and member states were required to implement it by June 2017. This was shortly followed by the Fifth Money Laundering Directive (5MLD), which essentially amended 4MLD and was required to be transposed by member states by 10 January 2020. Among the amendments made to 4MLD by 5MLD was an increased focus on SOW and SOF when enhanced due diligence measures are applied (ie, when the customer/client is considered higher-risk from an AML perspective). Prior to 5MLD being given effect by states, as a matter of law, the SOW and SOF obligations related to PEPs, and SOF obligations were relevant to ongoing monitoring. The EU subsequently issued the (6MLD), which member states were required to transpose by 3 December 2020. The UK opted out of transposing 6MLD, as many of its requirements were already covered by existing UK law. This did not make any changes to SOW and SOF obligations. 6MLD formed part of a wider AML package which also included a significant new AML Regulation which is intended to harmonise rules across the EU (directly applicable in EU Member States from 10 July 2027 but not relevant to the UK).

Some regulated entities, such as banks, had already adopted a wider focus on SOW and SOF prior to 5MLD as a matter of policy. Other types of financial gatekeepers have had to move quickly to roll out new policies and procedures dealing with the broader assessment of SOW and SOF now required.

Section 3 - Examples of SOW and SOF

SOW and SOF exercises can range from the simple to the complex.

Section 4 - Issues with PEPs

PEPs have been a growing focus for the AML framework, on the basis that they pose a higher risk of bribery and other economic crime due to their actual and potential political influence and connections, and thus should be required to undergo enhanced due diligence by a regulated firm before the firm conducts business with the PEP.

The FATF’s PEP definition covers senior public officials, their close associates and their immediate family members.  For example, unscrupulous PEPs may be in receipt of bribes and, if so, will often launder their money by acquiring assets via nominees; these may include immediate family members, childhood friends or business associates.   

The PEP requirements are intended to be preventative rather than punitive, and FATF is clear that these requirements should not be interpreted as stigmatising PEPs as automatically being involved in criminal activity. Rather, the definition is intended to assist in the management of money laundering risk and the application of enhanced KYC.

This focus on PEPs ties in with a similar focus of legislation targeting bribery of foreign public officials, which can be seen in the US Foreign Corrupt Practices Act, the UK Bribery Act and similar legislation. Investigation of bribery in emerging markets has become big business, leading to settlements with law enforcement agencies in the US and the UK totalling hundreds of millions, and sometimes billions, of dollars.

In the UK, the AML focus on PEPs is further demonstrated by the introduction in 2018 of Unexplained Wealth Orders (UWOs) in an attempt to tackle money laundering. A UWO is an investigative order which requires an individual to account for how they came to obtain certain property, and can lead to the forfeiture of such property where no compelling explanation is provided. Law enforcement can obtain a UWO in relation to two categories of persons: PEPs and those suspected of involvement in serious criminality. If a person is a PEP, there is no requirement for a suspicion of criminality, which further demonstrates the focus on PEPs from an AML perspective. In practice, the UWO has turned out to be a little-used investigative order with only a handful obtained to date.

4.1 PEP databases

There is no universally agreed list of PEPs. Instead, there are a number of subscription-model compliance databases which collate publicly available information on individuals and decide whether or not to designate these individuals as PEPs. When assessing whether an individual customer/client or beneficial owner is a PEP, regulated firms often rely on searches conducted using one of these databases. Whether an individual is required to undergo enhanced due diligence before establishing a business relationship, or becoming involved in a one-off transaction, is therefore often dependent on whether or not a database has designated them as a PEP.

PEP databases will usually adopt the 'once a PEP, always a PEP' approach as a matter of policy. Neither FATF Recommendations nor EU law require that an individual be considered a PEP for the rest of their lives. Rather, both state that the level of risk should continue to be the key consideration in whether an individual remains listed as a PEP. Designation decisions should look at, for example, the seniority of the position which the person held; any continuing influence they may have (whether formal or informal); and whether the individual’s current non-public role is linked in any way to their previous public role. Compliance databases do not always take such a nuanced approach, usually on the basis of their internal policies and approach to PEP designation.

PEP designation for an individual can be a frustrating experience. PEPs are subject to greater due diligence, which they can find invasive and time consuming. Sometimes individuals disagree with their PEP designation. Most databases have a process whereby an individual may challenge their PEP designation. Challenges based on errors in information should be accepted by the database. Those who are considered PEPs because of an alleged close association with a senior government official may be more likely to successfully challenge a designation. PEPs seeking to challenge a designation made on the basis of their seniority in a state-owned enterprise, or on the basis of state ownership in an entity, are likely to face greater challenges, particularly because different databases have different methodologies in relation to state-ownership and the relevant percentage owned by a state. In the UK, guidance issued by the FCA makes it clear that the FCA considers a state-owned enterprise to be a for-profit enterprise, where the state has ownership of greater than 50% or where information reasonably available points to the state having control over the activities of such enterprises. Some databases take a broader approach to state ownership or state investment.

Section 5 – Tips for examining SOW

Regulated firms conducting due diligence, where the risk is perceived as particularly high, may engage a corporate intelligence firm to produce a report regarding their potential customer or counterparty which outlines the person’s SOW. The report will allow the firm to cross-check the answers given by the potential customer or counterparty to the questions they have asked, allowing them to ask further enhanced due diligence questions if necessary. The regulated firm would also want to request and examine underlying documents, to verify the answers to questions. All of this requires an investment in compliance time and costs relating to the instruction of any third parties. Commercially, this may not be a worthwhile investment for certain relationships and, in such cases, the firm may turn the relationship down. For other relationships, it may be that an investment is made in terms of time and money, but ultimately the firm decides that the risk of the relationship is too high and the existing relationship is terminated.

Sometimes a private company or a high net worth individual has to take a proactive approach, because they are dealing with inquiries from banks, estate agents, law firms and perhaps art dealers. These enquiries may be due to PEP status, or negative media coverage. It is not uncommon for such a firm or person to not initially take queries from a counterparty (eg, a bank) seriously enough, giving off-the-cuff answers, which they must subsequently correct following further questions. In those circumstances, the counterparty is likely to lose confidence in the answers and trust in their customer. The relationship will be put at risk. In order to avoid that, such a person or company can proactively commission a law firm or other advisor to produce an independent report, backed by a data room, setting out their SOW. In the case of a corporate, such a report may deal with the legal and beneficial ownership of that entity. Law firms will have to satisfy their own regulatory obligations regarding onboarding, and it might be that the law firm is ultimately unable to assist in conducting the SOW exercise.

Another option is to have precedent answers to questions that have been prepared ahead of time, or for a previous process, which can be re-used. Any such precedent will require tailoring to the specific questions that have been asked. All of these options are expensive and/or time consuming, but they are a necessity for those in the high-risk bracket who want to maintain or establish important relationships.

Additional resources

Related Lexology Pro content

How-to guides:

How to conduct an organisation-wide assessment of money laundering and terrorist financing risk
Understanding the role and responsibilities of a Nominated Officer under the Money Laundering Regulations
How to file a Suspicious Activity Report under the Proceeds of Crime Act 2002

Checklists:

Customer Due Diligence (CDD) obligations under the Money Laundering Regulations 
Enhanced Due Diligence (EDD) obligations under the Money Laundering Regulations
Staff awareness and training to prevent money laundering and terrorist financing

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