Jon Bray and Rachael Eyre consider the importance of ongoing and effective client due diligence

Jon Bray headshot

Rachael Eyre headshot

Source of funds and source of wealth checks are higher profile than ever, with compliance being taken more and more seriously by the Solicitors Regulation Authority (SRA). If firms did not realise before, Mishcon de Reya’s recent £232,500 fine should be an indicator that regulators are taking a hard line with anti-money laundering failures (see Gazette, 5 January 2022). 

Here we focus on a very specific part of client due diligence (CDD) – formerly ‘Know your client’. CDD does not begin and end with ID checks – understanding how a client proposes to fund a transaction and how they obtained their wealth are important pieces of the puzzle. It can be an awkward conversation to have with clients, but it is a necessary step that can’t be ignored.

Regulator approach

The SRA’s thematic reviews of 2018 and 2020 uncovered significant knowledge gaps with regard to anti-money laundering (AML) in the firms they visited. Approximately one in five files reviewed by the SRA had inadequate source-of-funds and wealth checks. Some firms waited until the last minute in a transaction to do their checks, and others used out-of-date information. As a result, the SRA has bolstered its AML supervision function and is proactively checking firms’ compliance. 

Note that for the purposes of this article, we are talking about those matters which are caught under the Money Laundering Regulations 2017. That does not automatically mean all legal work, but that which is caught under the definitions of ‘independent legal professional’, ‘tax adviser’ or ‘trust and company service provider’ – see regulations 11 and 12 of the Money Laundering Regulations.

Source of funds and source of wealth

Source of funds and source of wealth are not the same thing. They are closely related, and indeed for some clients the overlap will be significant, but there are clear differences. 

The latest Legal Sector Affinity Group (LSAG) guidance gives the following definitions:

“Source of funds refers to the funds that are being used to fund the specific transaction in hand – i.e. the origin of the funds used for the transactions or activities that occur within the business relationship or occasional transaction. The question you are seeking to answer should not simply be, ‘where did the money for the transaction come from,’ but also ‘how and from where did the client get the money for this transaction or business relationship.’ It is not enough to know the money came from a UK bank account.”

“The source of wealth refers to the origin of a client’s entire body of wealth (their total assets). SoW describes the economic, business and/or commercial activities that generated, or significantly contributed to, the client’s overall net worth/entire body of wealth. This should recognise that the composition of wealth generating activities may change over time, as new activities are identified, and additional wealth is accumulated. You should seek to answer the question: ‘why and how does the individual have the amount of overall assets they do – and how did they accumulate/generate these?’ (see para 6.17).

In summary, source of funds means understanding how the client is funding a particular transaction and source of wealth means having a broader understanding of how the client obtained their assets. 

Establishing source of funds and wealth

The latest Money Laundering Regulations (2017) are actually a little vague on detail here. They say that firms must do relevant checks in three specific circumstances:

  • as part of ongoing monitoring (such as where this is more than a one-off transaction for a particular client)
  • when acting for a politically exposed person, their family or close associates, and
  • where a high-risk jurisdiction is involved (in these cases you also have to establish a source of funds and wealth for the client’s beneficial owners).

More useful is the LSAG’s practical guidance, tailored to the legal profession, which says that it is good practice to establish source of funds and wealth even in a one-off transaction and that this should be regarded as a protective measure for your firm and a key part of your risk-based approach. The guidance also says that firms should always establish source of funds and wealth:

  • in property transactions, when acting for a buyer
  • in any high-risk case (sector or jurisdiction)
  • where the transaction is being funded by a third party, and
  • when you are forming or managing companies, charities or trusts. 

Good practice and procedure

Assess the risk

Your risk assessment is always the starting point for CDD and is in itself a requirement of the Money Laundering Regulations. Every new client and every new matter falling under the regulations should be risk-assessed and it’s the responsibility of the file handler to do so. Most firms have a standard process that team members must go through on file opening. The rationale is that a full risk assessment will inform how far you have to go in your CDD exercise, to include source of funds and wealth checks. This is not to be confused with the firm-wide risk assessment, which is the high-level document used to plan out the firm’s policies, procedures and controls.

Record your assessment

It is not enough to simply do your risk assessment in your head. There needs to be an audit trail, which should include your thought process. Why did you assess this client or matter as low risk? What steps do you intend to take to establish the client’s source of funds and wealth? Have you documented it? It’s important to write things down and keep records should you be audited.

Gather and evidence the relevant information

Where the AML risk is low (and we would always exclude property transactions as being low risk), you may legitimately rely on the client’s word about their source of funds and wealth. Where additional evidence is required, how far you go again depends on your risk assessment. Let’s say this is a property transaction with no reasons to elevate the risk to the higher categories or enhanced due diligence. You would probably look to establish the specific source of funds but be slightly more relaxed on the client’s source of wealth, so long as the transaction is in line with what you know about the client. A salaried associate buying a Mayfair apartment is going to prompt questions. It’s worth noting that establishing a source of wealth does not mean accounting for every single penny of your client’s assets. Remember, it is about building up a holistic understanding. We always come back to the mantra “does this make sense?”. 

Documenting evidence

One of the more frustrating elements of AML regulation is that there is no definitive list of documents to view in any given circumstance to show you have complied. One of the reasons we all loved the checklist approach to identifying clients was that it was easy – nice and prescriptive. Unfortunately, the old list A/list B approach does not work in a risk-based system – it encourages box-ticking and ‘unthinking’ compliance – not popular with the regulator.

It is not enough to simply do your risk assessment in your head. There needs to be an audit trail, which should include your thought process. Why did you assess this client or matter as low risk? What steps do you intend to take to establish the client’s source of funds and wealth? Have you documented it?

Firms can of course formulate their own frameworks for CDD checks to save reinventing the wheel for every new client. Indeed, if this exercise flows from the firm-wide risk assessment, then it would surely be evidence that the firm has strong policies, procedures and controls. But even such a framework should never be entirely prescriptive.

The LSAG guidance, for all its faults, does at least give some very strong clues about what solicitors should be looking at (see Chapter 6 of the guidance). You just need to know your way around the document in order to pull the detail out. Click here for an overview

Acting on suspicions

If your risk assessment of the client and matter indicates that you need to see the source of funds and/or wealth evidence and you are unable to do so (perhaps the client isn’t playing ball), you will have a difficult decision to make. You may have to cease acting. If the client’s reticence tips you over into suspicion then you will be obliged to make a suspicious activity report to the National Crime Agency.

This is why it’s crucial to get the source of funds and wealth checks done at the outset of a matter, rather than waiting until the last minute of a transaction. Nobody, especially the legal adviser, wants to be responsible for a transaction falling over at the final hurdle.

Key risk indicators

  • We could produce a dizzying list of factors that would cause concern or suspicion as part of your checks on the client’s financial position. The list would include:
  • secretive and obstructive clients
  • unexplained levels of wealth
  • an ability to fund a transaction seemingly beyond the client’s means
  • complex funding structures
  • use of offshore accounts without any clear reason
  • newly formed companies with access to pots of capital
  • funding through cash-intensive businesses
  • money coming from high-risk or secretive jurisdictions
  • last-minute changes to funding arrangements
  • loans which are not properly documented or not on commercial terms, and
  • documentation that looks faked.

Such a list, while useful, is never going to be exhaustive. As gatekeepers to the legal and financial system, the regulators require lawyers to use their professional judgement. Which brings us back to the fundamental questions that all CDD relies upon: “Does this make sense, given what I know about the client?”; “Does this feel off or uncomfortable?”; and “Have I taken appropriate steps, given the risk presented by this particular client and matter?”.

The implications for AML training are that lawyers should be encouraged to think critically about source of funds/wealth rather than being taught to blindly follow checklists. Some checklists, however, are worth bearing in mind:

  1. Source of funds and wealth checks are a fundamental part of CDD – as important as identification checks
  2. Firms should follow the LSAG guidance and develop their own internal processes, informed by their firm-wide risk assessment
  3. The evidence you need will depend on the risk profile of the client and matter in front of you
  4. There is no room in the current AML regime for box-ticking compliance, and
  5. Your AML training needs to encompass taking a risk-based approach.