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Know Your Customer -- Or Be Liable to Third Parties?

by Mary Beth Guard

Financial institutions seek to "know their customers" in order to serve them better, to detect and prevent fraud losses, and guard against being victimized by lawbreakers who attempt to use the institution to launder money. Regulations promulgated pursuant to the Bank Secrecy Act require institutions to employ efforts to spot and deter money laundering, and penalties for violations of the BSA requirements can be steep. A new lawsuit, however, raises the spectre of much greater potential liability for financial institutions that fail to implement and maintain effective anti-money laundering procedures.

Insurance Commissioners from five states (Arkansas, Mississippi, Missouri, Oklahoma, and Tennessee) have joined together in a suit against two banks to recover money damages and compensation for losses the Commissioners allege were suffered due to inadequate anti-money laundering prevention procedures in the two financial institutions. The insurance commissioners are acting as receivers of seven insurance companies whose assets were looted by the notorious Martin Frankel and others acting in concert with him. The two banks held accounts belonging to the entities and processed transactions relating to them.

Martin Frankel and the entities he controlled were the worst kind of customers. They lied, they cheated, they stole money. Frankel was a twisted con artist who longed to show the world his brilliant insight into the stock market, but lacked the guts to even make trades. He duped prospective investors out of funds, surreptitiously purchased insurance companies with the money, and proceeded to loot the insurance companies' coffers to support a bizarre and lavish life>The Pretender: How Martin Frankel Fooled the Financial World and Led the Feds on One of the Most Publicized Manhunts in History.

The majority of funds stolen by Martin Frankel and his cohorts are long gone. So the Insurance Commissioners want to put their hands into different pockets -- the deep pockets of the two banks that held deposit accounts through which the money flowed. In order to do so, they've constructed a theory that the banks should be liable because the losses were caused by the negligence and breach of contract of the two banks, part of a course of illegal conduct that spanned nearly a decade. How? By virtue of the fact that the banks allegedly failed to "know their customers" and, as a result, according to the Complaint, in excess of $139 million of the insurance companies' assets were laundered through and looted from accounts at First American National Bank (now AmSouth Bank), and in excess of $228 million of the assets were laundered through and looted from accounts at First Tennessee Bank National Association. The Commissioners seek compensatory damages for the funds lost.

Here is a brief summary of the allegations:

  • Frankel had been barred from the securities industry. This meant he could not openly own or control insurance companies. He acquired insurance companies by concealing his involvement and control behind other individuals and entities.
  • Accounts were established for the companies in the two banks.
  • First American had a written policy "to comply with all applicable Federal and State banking laws and all implementing regulations." Its policy specified that each employee is accountable for compliance with the laws and regs that apply to the employee's position, violations and deficiencies are to be reported and investigated, and corrective action is to be taken.
  • First American's written policy required it to "make reasonable efforts to 'know our customers' prior to transacting business or accepting proceeds for deposit, exchange, or payment" and "not to transact business or accept proceeds for deposit, exchange, or payment with ...[persons] who may be involved in money laundering activities and from any other illegal activity, to the extent that these facts are known or probable."
  • First American's board of directors adopted a resolution under which it adopted the Basle Statement of Principles on money laundering and incorporated them into the bank's existing procedures.
  • First American's Compliance manual spells out what First American views as its role in the investigation, apprehension and prosecution of criminal activity using financial institutions as conduits and its responsibility "to help deter" money laundering.
  • First American's KYC policies and procedures required it to understand the nature of the business of a commercial customer and the types of transactions in which the commercial customer would be expected to engage.
  • The transactions the insurance companies engaged in were not consistent with what would have been the normal and expected business transactions of those particular entities, because they included $92 million in wire transfers in fifty-eight different transactions, many of which went directly or indirectly to Switzerland, a known banking secrecy haven, as well as a number of transfers into the account originating in Switzerland. There was also a series of large cashier's checks, and quick turnover of funds in the accounts, a high dollar volume circular transaction with no apparent business purpose, and other allegedly suspicious transactions.
  • Due to First American's actions and inaction, more than $139 million of the insurance companies' assets were laundered through and looted from accounts at First American.
  • First Tennessee had a write policy "to establish appropriate procedures for Know Your Customer and money laundering detection requirements." Its policy required it to take appropriate measures to identify and report "any suspected money laundering conducted through the bank."
  • First Tennessee had also adopted the Basle Statement of Principles on money laundering.
  • First Tennessee acknowledged its obligation to "take the utmost care and precaution to prevent [the bank] from being a party to [money laundering] as a willing partner or as an unwilling victim."
  • First Tennessee was aware that high risk entities, transactions, and geographic locations were specific areas to be monitored, and it failed to identify and take action to stop a variety of suspicious transactions engaged in by these insurance companies.
  • First Tennessee's KYC policies required it to "take reasonable steps to obtain knowledge of customers' normal and routine business activities" and to "take appropriate steps to be aware of any unusual transactions relative to the customer's known business."
  • The transactions the insurance companies engaged in at First Tennessee were not consistent with what would have been the normal and expected business transactions of these particular entities, because they included fifty different wire transfers totaling over $186 million which went, directly or indirectly, to Switzerland. The insurance company accounts also received over $81.5 million in wire transfers from Switzerland from 1997 to 1999 alone. Related accounts received almost $168 million in wire transfers from Switzerland during that period of time. There was also quick turnover of funds, a high dollar volume circular transaction and other allegedly suspicious transactions.
  • As a result of First Tennessee's actions and inaction, in excess of $228 million of the insurance companies' assets were laundered and looted from accounts at First Tennessee.
  • First American was negligent because it failed in its duty to recognize, detect, stop, and refrain from participating in fourteen specifically described types of transactions.
  • First American breached its deposit agreement with the insurance entities because it expressly, impliedly, or by operation of law agreed to handle the insurance company accounts consistent with applicable laws and regulations and its own internal policies, practices and procedures, and it failed to do so in fourteen specifically described respects.
  • First American also breached an implied contract with the insurance companies by failing to adhere to the laws, regulations, policies and procedures described.
  • First American negligently performed under its contract.
  • Virtually identical allegations are made as to First Tennessee.

The suit was filed July 31, 2002 in the Circuit Court of the First Judicial District, Hinds County, Mississippi. Every banker in this country needs to be aware of this suit and its grave implications. The potential liability here makes the aggregate amount of all regulatory penalties assessed against financial institutions for the last decade look paltry. Anti-money laundering efforts were important before, but in the wake of this lawsuit, they take on grave significance.

Related link:
Complaint filed by the State Insurance Commissioners

Related News Stories:
States Sue Banks to Recoup Stolen Funds
Mississippi joins four other states in lawsuit against bank used by rogue financier

First published on 07/31/2002

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