Risk Management Legal Aspects of Capital Markets and Pensions

Introduction

Good governance and good management require careful attention to internal and external risks. This session will provide an overview of risks arising from money laundering, terrorism and bribery in capital markets and pension schemes.
Capital market development is an important component of financial sector development and supplements the role of the banking system in economic development. Specifically, capital markets assists in price discovery, liquidity provision, reduction in transactions costs, and risk transfer.
Pension funds should provide proper risk management to ensure that the retirement income of their members is safeguarded. To do this, pension funds should have appropriate risk management policies that safeguard the replacement rate, investment safety and time-based risks such as inflation.

Definition of Terms

Definition of Money Laundering  
In general terms, money laundering is the process of hiding or disguising the origin, receipt, existence, movement, destination, use and acquisition of capital or movable or immovable property, as a result of an illegal activity, to make them appear legitimate.  The current principal methods of money laundering are cash carriers, the international payments or financial system and the international trade system (purchase of goods and services or trade based money laundering).
Stages which define the activity are placement, layering and integration.  There have been attempts to simplify these stages to include:

1. a) Collection of money: Physical receipt of the money in cash, coming from illicit activities.  
2. b) Placement: Introduction in financial or non-financial institutions of cash coming from criminal activities.  
3. c) Mix with funds of legal money origin: Making of successive financial transactions with illegal money by mixing it with legal money, to eliminate or to hinder monitoring of its track.  Otherwise called layering!
4. d) Investment: Conversion of illicit money in various kinds of assets: movable and immovable properties, securities and other financial assets or business transactions, through the transfer of the laundered funds to legal organizations without apparent links with the organized crime. The level of complexity in an Assets Laundering scheme is virtually endless and only limited by the creative imagination and the delinquent ability.

Definition of terrorist financing  
This is covered in the Kenya Proceeds of Crime and Anti Money Laundering Act. It is generally accepted that terrorist financing is the crime that is committed by any way, directly or indirectly, illegally and by choice, it provides and collects funds with the purpose of being used, or knowing that they will be used, wholly or partly to cause death or serious injuries to civilians, or any other person who is not participating actively in a war situation, when the purpose of such act is to intimidate a  population or compel a good government or an international organization to perform or abstain from doing any act.

PART I

Money Laundering, Terrorist Financing and Bribery in Capital Markets
The securities industry, capital markets, banking and insurance, are among the core industries through which persons and entities may access the financial system. This access provides opportunities for criminals to misuse the financial system to engage in money laundering (ML) and terrorist financing (TF). The securities sector is perhaps unique among these industries in that it may be used both to launder illicit funds obtained elsewhere, and to generate illicit funds within the industry itself through fraudulent activities. The securities industry is not only a vehicle through which illicit assets may be laundered; it is also an ideal vehicle for generating illicit assets that would eventually have to be laundered.
According to the report by Asia/Pacific Group (APG) member countries, the following were the most common suspicious indicators and methods related to money laundering and predicate offences involving the securities industry:

1. Changing share ownership in order to transfer wealth across borders;
2. Redeeming a long-term investment within a short period;
3. Opening multiple accounts or nominee accounts;
4. Using brokerage accounts as long term depository accounts for funds;
5. Effecting transactions involving nominees or third parties;
6. Engaging in market manipulation, e.g. “pump & dump” schemes.

Some Modes of ML/TF in Capital Markets

• Low Priced Securities Risks

Low priced securities, also known as penny stocks, refer to low-value equity interests in companies that are publicly traded or are about to become so. The issuers of these shares generally have legitimate business operations and revenue streams.
The ML/TF vulnerabilities posed by these securities are two-fold.
First, these types of securities are often used to generate illicit assets through market manipulation, insider trading, and fraud. Illicit actors may either use existing shares that are already publicly traded, or start a shell company for the express purpose of engaging in those illicit activities. In addition, criminal organisations have also been known to use illicit assets generated outside the securities industry to engage in market manipulation and fraud.
Second, these securities may be acquired by investing illicit assets into a company that is about to become public. Once the company goes public, the money launderer sells his or her stake, thereby giving funds the appearance of having been derived from a legitimate securities transaction. Moreover, criminal organisations mayalso initially invest in a private company that they then use as a front company for mixing up illicit with legitimate assets. They will then convert the company to a public company through an offering in the public securities markets, thus creating what appear to be legitimate offering revenues. Alternatively, criminal organisations acquire a publicly traded company and use it to launder illicit assets.
 

• Broker Risks

A broker-dealer might assume that, because another financial institution has opened an account for a customer, the customer is not exposed to ML/TF. The vulnerability is most problematic in relation to the funding of a securities account. If illicit assets are successfully placed at a depository institution, the broker-dealer may assume that, because the funds are from an institution which is subject to Anti Money Laundering and Combating the Financing of Terrorism (AML/CFT) under the Proceeds of Crime and Anti Money Laundering Act, the customer does not pose a ML/TF risk and will, therefore, accept cheques or wire transfers from that institution to fund a securities account. Once a securities account is funded, a customer may engage in a number of transactions that further conceal the source of his or her illicit funds, thereby successfully layering and integrating illicit assets that were placed through a depository institution.

• Depository Institutions Risks

The most common vulnerability associated with depository institutions involves the placement of illicit assets into the financial system. Once these illicit assets are placed they may be wire transferred out of a jurisdiction or used to purchase different assets, such as securities products. The risk that illicit assets will be used to purchase securities products is increased in jurisdictions where customers may purchase securities directly through the depository institution or through an affiliated securities intermediary. Moreover, if illicit assets are successfully placed at a depository institution, a securities intermediary whether affiliated or not, may unjustifiably rely on the depository institution’s investigation and assume that the customer poses no ML/TF risk.

• Use or Creation of a Financial Institution for ML/TF Purposes

Criminal elements may either create or gain direct control of such an entity or seek to exert influence over the management or staff in furtherance of their aims.
It is possible for a securities broker-dealer, for example, to be created or used for the specific purpose of laundering funds/financing terrorism. It is important that there be measures to prevent criminals or their associates from “holding or being the beneficial owner of a significant controlling interest or holding a management function.” Clearly, the risk of criminal penetration of the securities market is heightened by opaque corporate structures, but also increases when dealing with other financial institutions from countries with lax AML/CFT measures.
There are suspicious indicators associated with criminal influence in a financial institution which include corporate structures where beneficial ownership is difficult to determine; and Companies incorporated in countries without adequate AML/CFT controls.

• Trust, Nominee, and Omnibus Accounts

Trust and nominee accounts present ML/TF vulnerabilities in the layering and integration stages. A particular risk involves jurisdictions where the formation of a trust or nominee account does not require the collection of beneficial ownership information for individuals.
Moreover, while some jurisdictions may require beneficial ownership information, the information required may be limited to information regarding non-natural persons. As with shell companies, a lack of beneficial ownership information regarding the individuals who benefit from the account may mask an individual’s identity such that he or she would gain access to a financial system when such access would otherwise be restricted or forbidden.
An omnibus account is an account established for an entity that is acting as an intermediary on behalf of multiple individuals or entities. For example, a bank in jurisdiction X could open an omnibus account with a securities intermediary in jurisdiction Y through which the bank in jurisdiction X manages a portfolio for its clients. In this scenario, the ML/TF vulnerability is that the securities intermediary may not know who the beneficial owners of the investment portfolio are.

• Charitable and Other Non-Profit Organisations’ Risks

Whilst most charitable and non-profit organisations are reputable and provide legitimate services or funding for their causes, some organisations have been and may be used for ML/TF. Although not unique to the securities industry, a particular vulnerability involves organisations that may be used as a front for transferring funds to suspect beneficiaries located in high-risk areas/jurisdictions or conflict zones deemed to harbour or support terrorists. For example, legitimate funds may be used to purchase securities that are donated to a charitable organisation. The charity, in turn, could liquidate the securities or use the income generated by the securities to transfer funds to, or to purchase material for, individuals who further terrorists’ activities.

• Shell Companies

The term “shell company” often refers to a non-publicly traded corporation or limited liability company that might have no physical presence and generates little or no independent economic value. These companies are commonly organised in a way that makes their ownership and transaction information easier to conceal. Thus, transactions involving shell companies present a high ML/TF vulnerability.
Shell companies may also be used to introduce illicit funds into a financial system and/or generate illicit funds through manipulative or fraudulent securities activities. For example, a brokerage account may be opened in the name of shell companies and used to engage in fraudulent conduct with regard to low priced, illiquid, low volume or privately placed securities. In addition, a shell company may be established to accept payments from criminal organisations for non-existent services. These payments, which appear legitimate, could be deposited into depository or brokerage accounts and either wire transferred out of a jurisdiction or used to purchase securities products that are easily transferable or redeemable.

• Unregulated Investment Funds and Pools (i.e. Hedge Funds)

Generally, hedge funds are vehicles established to hold and manage investment assets. Because of the way they are structured, they may not be subject to regulatory oversight. Hedge funds may receive funds domestically or internationally, and some (feeder funds) are established to invest into other hedge funds.
A hedge fund will often utilise the services of a regulated securities intermediary. Hedge funds present ML/TF vulnerability because the regulated entity that the hedge fund is using to effect transactions (e.g. a broker-dealer) may not know the identity of the underlying hedge fund investors. Typically, hedge fund investors are of higher net worth than other retail investors. This anonymity of ownership may also result from the opacity associated with some feeder funds. In addition, some hedge funds may be used to perpetuate a securities fraud.
Suspicious Indicators Associated with Trust, Nominee, and Omnibus Accounts, Charitable Organisations, Shell Companies and Hedge Funds

1. During the account opening process, the person opening the account refuses to provide information to complete the relevant forms (e.g. occupation, prior financial relationships, etc.), in particular with respect to beneficial ownership;
2. The person opening the account is reluctant to provide complete information about the nature and purpose of the customer’s business, prior financial relationships, anticipated account activity, the entities’ officers and directors or business location; and
3. The trust or beneficial owner of a nominee account is located in a high-risk area/jurisdiction or conflict zone.

Terrorism Financing Risks in Capital Markets
There is relatively little evidence of the securities industry being used to finance terrorism. However, this lack of evidence specific to the securities industry does not rule out the potential for terrorist financing in this sector.
For example, following the 9/11 attacks in the United States, various agencies worldwide engaged in studies to ascertain which sectors of the financial services industry had been used to finance the attacks. No empirical evidence was revealed to suggest that securities had been used either to finance the attacks or to generate funding from them (for example, through short selling of airline or hotel stocks).
Bribery in Capital Markets
Bribery in its simplest definition aids money laundering and terrorism financing in securities exchange and capital markets. This will take the form of giving financial advances to individuals to gain advantage or cause them to act improperly. In securities, the person advancing financial benefit will make the receiver not to collect adequate information required thus concealing their identities.

PART II

Money Laundering, Terrorism Financing and Bribery in Pension Schemes
Pension schemes have been at some point abused and criminals use them to launder money, finance terrorism and bribe officers. In simple terms, bribery will be a forerunner to money laundering and terrorism financing.
The following are indicators of bribery in pension schemes. It should, however, be noted that many of the indicators set out above may also apply to pension schemes:

1. Large cash sums deposited in Pension schemes by members of the scheme.
2. Deposit of securities or other assets whose possession is not justified by the contractor’s or policyholder’s income-earning capacity and/or type of business payment into a capitalisation scheme.
3. Transfer of assets from an unrelated third party into a capitalisation scheme.
4. Insistence on depositing securities or other assets into a capitalisation scheme that would not normally be allowed by the scheme rules.
5. Unrelated third party paying contributions cash on behalf of a member of a pension scheme.
6. Unemployed persons paying contributions into an employee pension scheme.
7. Funds or other assets deposited into a pension scheme which are inconsistent with the profile of the policyholder.
8. The type or volume of the transaction, which is untypical of the economic activity of the client and explanatory notes to transactions conducted by the client arise reasonable suspicion.
9. The client performs a large number of identical transactions involving amounts immediately below or close to the threshold for reporting large transactions.
10. The transaction is related to another transaction, which has already been reported to the relevant law enforcement agency by a credit institution, credit union, investment brokerage company, investment management company, depository, organiser of a regulated market or pension fund.

Steps taken to address money laundering and terrorism financing in Kenya
According to the Financial Action Task Force (FATF) Public Statement, 18 October 2013 Kenya has taken steps towards improving its AML/CFT regime, including by parliamentary approval of the Finance Bill, which amends the financing terrorism offence. Despite Kenya’s high-level political commitment to work with the FATF to address its strategic AML/CFT deficiencies, Kenya has not made sufficient progress in implementing its action plan within the agreed timelines, and certain strategic AML/CFT deficiencies remain. Kenya should continue to work on implementing its action plan to address these deficiencies, including by:

1. Adequately criminalising terrorist financing;
2. Ensuring a fully operational and effectively functioning Financial Intelligence Unit (this is the Financial Reporting Centre(FRC));
3. Establishing and implementing an adequate legal framework for the identification and freezing of terrorist assets (Assets Recovery Agency now established by administrative decree in the office of the Attorney-General); and
4. Implementing an adequate and effective AML/CFT supervisory programme for all financial sectors. The FATF encourages Kenya to address its remaining deficiencies and continue the process of implementing its action plan.

In accordance with the report of FATF on 27th June 2014, the FATF welcomes Kenya’s significant progress in improving its AML/CFT regime and notes that Kenya has established the legal and regulatory framework to meet its commitments in its action plan regarding the strategic deficiencies that the FATF had identified in February 2010. Kenya is, therefore, no longer subject to FATF’s monitoring process under its on-going global AML/CFT compliance process. Kenya will work with the Eastern and Southern Africa Anti Money Laundering Group (ESAAMLG) as it continues to address the full range of AML/CFT issues identified in its mutual evaluation report.
Kenya has taken significant steps towards improving its anti-money-laundering and combating the financing of terrorism (AML/CFT) regime. These include the enactment of the Proceeds of Crime and Anti-Money Laundering (Amendment) Act—which strengthened provisions on the criminalization of money laundering and freezing / seizing / confiscation of assets—and the issue of revised AML Guidelines by the CBK. The Financial Action Task Force (FATF) found that Kenya should continue to work on implementing its action plan to address remaining deficiencies, including by:

1. adequately criminalizing terrorist financing;
2. ensuring a fully operational and effectively functioning Financial Intelligence Unit (FRC);
3. establishing and implementing an adequate legal framework for the identification and freezing of terrorist assets;
4. implementing effective, proportionate and dissuasive sanctions in order to deal with natural or legal persons that do not comply with the national AML/CFT requirements;
5. implementing an adequate and effective AML/CFT supervisory program for all financial sectors; and
6. further improving and broadening customer due diligence measures.

Money laundering and terrorism financing are closely related and the two vices pose a serious threat to the integrity and stability of the international as well as our country’s financial and security systems. For this reason, the international community has over the last several years, put in place measures and mechanisms aimed at addressing and possibly eliminating these iniquities.  
The Financial Action Task Force (FATF) is a global body that is universally recognized as the international standard setter for anti- money laundering and combating the financing of terrorism policies and standards. The international standards are referred to as the 40 Recommendations on Anti-Money Laundering, Combating the Financing of Terrorism and Proliferation. These Recommendations have been revised from time to time to take into account emerging dynamics.
FATF Recommendation 29 requires countries to establish a Financial Intelligence Unit (FIU) which shall be a central, national agency responsible for receiving, analysing and disseminating disclosures of financial information. There are different types of FIUs ranging from Administrative, Law Enforcement, Judicial or a Hybrid type of FIU comprising a mixture of all of the foregoing. The type of FIU established by a country will depend on the country’s criminal policy considerations as well as its supervisory, legal and administrative framework and systems. In Kenya, we have adopted the Administrative model type of FIU as this is best suited to our circumstances.  
Kenya’s Anti-Money Laundering regime is largely contained in The Proceeds of Crime and Anti-Money Laundering Act, 2009 (POCAMLA) which came into effect on 28th June 2010. In summary, POCAMLA criminalizes money laundering and provides for a comprehensive framework of criminal and civil seizure and forfeiture of illicit proceeds. It also establishes the Anti-Money Laundering Advisory Board, the Financial Reporting Centre (FRC), the Asset Recovery Agency and the Criminal Assets Recovery Fund. The Act places an obligation on Reporting Institutions to file suspicious transaction reports and cash transaction reports to the FRC and also provides for international cooperation on matters relating to the investigation and prosecution of money laundering cases.  
The Anti-Money Laundering Advisory Board (AMLAB) is established under section 49 of POCAMLA. The Board’s mandate is to advise the Director of the Financial Reporting Centre (FRC) generally on the performance of his functions and the exercise of his powers under the Act. It brings together Government departments/agencies, the representative bodies of Reporting Institutions and individuals from the private sector with particular expertise in AML. International best practice requires the Financial Reporting Centre to be autonomous and operationally independent. For this reason, the role of the AML Board is to provide strategic guidance to Financial Reporting Centre (FRC).  
The Financial Reporting Centre (FRC), Kenya’s Financial Intelligence Unit is established under Section 21 of POCAMLA.  The FRC is an independent body whose principal objective is to assist in the identification of the proceeds of crime and combating money laundering.  The other objectives of the FRC are to:

1. Make information collected by it available to investigating authorities and supervisory bodies to facilitate the administration and enforcement of the laws of Kenya;
2. Ensure compliance with international standards and best practice in anti-money laundering measures. In this regard the FRC has oversight over Reporting Institutions for AML purposes. It will however closely work with Supervisory bodies to implement and enforce compliance with POCAMLA;
3. Exchange information on money laundering activities and related offences with similar bodies in other countries.  

To enable it undertake its duties effectively, the FRC is empowered to amongst others:

1. Receive and analyse reports of unusual or suspicious transactions and cash transaction reports made by Reporting Institutions. Reporting institutions under POCAMLA comprise entities in the financial sector such as banks, insurance companies, money transfer companies as well as players in the non-financial sector such as casinos, accountants, real estate & motor vehicle dealers to name but a few.   
2. Receive reports on cash declaration forms received from border points. What this means is that anyone leaving or entering the country will be required to disclose to the Customs Officer, any monetary instrument in excess of USD 10, 000.00 in whatever currency. The law does not prevent people from leaving or coming into the country with monetary instruments above USD. 10,000, rather it is required is to report the particulars of the monetary instruments to the designated Authority.  
3. Facilitate information sharing and exchange of financial information between appropriate law enforcement authorities or other supervisory bodies. The FRC will be the link between law enforcement and the financial sector. This linkage is important because in most crimes, particularly organized crime, there is a financial element or benefit to it. It is therefore important for all parties involved in investigation to understand and see the full picture.  
4. Undertake inspection and supervision of reporting institutions so as to ensure compliance with AML/CFT reporting obligations as prescribed in POCAMLA. The FRC will work closely with the regulators to see how best to harmonise and coordinate AML oversight of reporting institutions.   
5. Because of the transnational nature of money laundering activities, it is important for agencies involved in combating money laundering to be able to exchange information with their counterparts across the borders. For this reason, the FRC will facilitate the exchange of information on money laundering activities with other financial intelligence units in other countries.  
6. The FRC will also be responsible for formulation of AML Policy in the country.  
7. Create and maintain a database of all reports of suspicious transactions and related Government information.  
8. To design AML training requirements for reporting institutions. The FRC will in this regard work with specialized training institutions and bodies to deliver on this mandate.  
9. Develop AML Regulations to provide guidance to support implementation of the Act. The Centre in furtherance of this mandate, on 28th September 2012, released draft Anti-Money Regulations to the public and key stakeholders for review and comments. The Centre has reviewed the comments provided and is currently finalizing the draft Regulations for issuance. The Regulations provide guidance on a number of areas such as: Registration by Reporting Institutions with the FRC; Cross border conveyance of monetary instruments; Anti-Money Laundering obligations of Reporting Institutions including internal control obligations; Customer Due Diligence

The FRC has adopted measures for AML including Enhanced Due Diligence Measures. The FRC is already receiving suspicious transaction reports from commercial banks and mortgage finance institutions. Other Reporting Institutions will be brought on board starting with forex bureaus. An AML National Risk Assessment is currently underway. The outcome of this exercise will guide on the sequencing of other sectors to be brought on board  
The immediate priority is to ensure the full operationalization of the FRC in line with international standards. It is recommended to undertake AML sensitization & awareness programs so as to raise the level of AML awareness amongst the public and specific sectors. This seeks to entrench AML/CFT implementation so as to ensure that there is an effective AML/CFT framework.
Perceived Risks in Capital Markets and Pension Schemes
Kenya remains vulnerable to money laundering and financial fraud. It is the financial hub of East Africa, and its banking and financial sectors are growing in sophistication. Money laundering and terrorism financing activity occurs in both the formal and informal sectors, and derives from both domestic and foreign criminal activity. Such activity includes transnational organized crime, corruption, smuggling, illicit trade in drugs and counterfeit goods, and wildlife trafficking.
Although banks, wire services, and mobile payment and banking systems are available to increasingly large numbers of Kenyans, there are also thriving, informal, and unregulated networks and remittance systems that facilitate cash-based, unreported transfers that the Government of Kenya cannot track. Mobile payment and banking systems are increasingly important and make tracking and investigating suspicious transactions difficult, although they have the potential to facilitate investigations and tracking, especially compared to transactions executed in cash.
Kenya is a transit point for international drug traffickers. Trade-based money laundering is a problem in Kenya, though the Kenya Revenue Authority has made recent strides in improving internal monitoring and collection procedures. There is a black market for smuggled goods in Kenya, which serves as a major transit country for Uganda, Somalia, Tanzania, Rwanda, Burundi, eastern Democratic Republic of Congo, and South Sudan. Goods marked for transit to these northern corridor countries are not subject to Kenyan customs duties, but Kenyan authorities acknowledge that many such goods are often sold in Kenya.
Kenya’s proximity to Somalia makes it an obvious and attractive location for the laundering of certain piracy-related proceeds and a financial facilitation hub for Al-Shabaab, a UN- and U.S.-designated group. The 2013 Westgate Mall attack, which resulted in the first cases being charged under Kenya’s Prevention of Terrorism Act (POTA), demonstrates the critical importance of first responders, regulators, law enforcement, and prosecutors understanding legislative developments and continuing to develop their expertise to investigate and charge high impact cases, including terrorism financing and money laundering.
The FATF first included Kenya in its Public Statement in February 2010. Since that time, Kenya has made a number of substantive improvements to its AML/CFT regime; however, Kenya is still included in the October 18, 2013 FATF Public Statement because it has not made sufficient progress in implementing its action plan within the agreed timelines and continues to have certain strategic AML/CFT deficiencies.

Conclusion

Terrorist Financing

Although there is no adequate evidence to suggest that the securities industry lends itself to terrorist financing, it remains a serious risk. In particular, the possibility that the use of opaque corporate structures and/or charities combined with the transfer of value via securities and transactions at securities firms is a potential vulnerability. This is also the same case for pension schemes

Money Laundering

The use of the securities industry to launder money constitutes an actual threat. The industry itself may be uniquely used to generate illicit proceeds from proceeds which might have had a legitimate origin. These illicit proceeds lead to almost “automatic” laundering when they are realised. This phenomenon may be contrasted with the more traditional use of the securities sector to disguise the origin of illicit funds derived from outside the sector.
As defences in areas more traditionally associated with ML/TF, such as banking, are tightened, the use of the securities industry may become a greater temptation to those seeking to disguise illicit proceeds, or indeed to generate them.

Bibliography and References

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