Standards

K E Y P O I N TS The U.S. Financial Crimes Enforcement Network (FinCEN) collects and analyzes data to protect the integrity of the nancial system from criminal abuse. As the nancial intelligence unit of the United States, FinCEN works with counterparts in 100 countries in the ght against nancial crime in global markets. The rst two lines of defense against nancial crime are (1) vigilance by nancial rms and their employees and (2) cooperation (i.e., alignment of interests) between regulators and the nancial industry.

IN PRACTICE

Eagle Eye
As director of the U.S. governments financial intelligence unit, James H. Freis, Jr., CFA, is responsible for a network charged with detecting suspicious activities that can occur in a blink of an eye
BY JONATHAN BARNES

E
P RO F E S S I O N A L P R AC T I C E

very year, criminals launder billions of dollars through financial systems. One of the officials charged with trying to prevent lawbreakers from using financial networks to cover their tracks is James H. Freis, Jr., CFA, director of the Financial Crimes Enforcement Network (FinCEN). Established by the U.S. Department of the Treasury in 1990 to administer the suspiciousactivity reporting and recordkeeping requirements of the Bank Secrecy Act. FinCEN is the intelligence hub between financial institutions, law enforcement, and a global partnership of international financial intelligence units from more than 100 countries. In this interview, Director Freis speaks about the way criminals abuse the financial system, spotting the red flags of illegal activity, and aligning the anti-money laundering interests of government and industry.
Tell us about the work of FinCEN.

and it only takes a small number of bad apples to ruin the reputation of an institution or even an entire industry that is trying to serve their customers in a legitimate way.
How do criminals abuse the financial system?

FinCEN administers the Bank Secrecy Act (BSA), which authorizes the collection of certain currency transaction records and suspicious activity reports that have a high degree of usefulness in criminal, tax, or regulatory investigations. This includes collection of reports in the conduct of intelligence or counterintelligence activities. As such, the purpose of all FinCENs work is to protect the integrity of the financial system from criminal abuse. In that sense, it is very much in line with many of the fundamentals for which CFA Institute stands and which are consistently reiterated in the Code of Ethics and Standards of Professional Conduct. To put it in another way, if it werent for scammers and fraudsters interested in stealing other peoples money and not caring about their clients, you wouldnt need the Standards of Professional Conduct. Standard I(D) on misconduct states that members and candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit. If that standard were so obvious, CFA Institute wouldnt need to put it out there among members. There is a view that not everyone is using the financial industry ethically. We see unethical behavior and illicit activity day in and day out,

Fundamentally, the motive behind almost any criminal is profit. (It is the small exception when you are talking about violent crimes.) Almost any criminal actor is out there for profit, whether that is the embezzler from inside the institution, the insider trader that is misappropriating non-public information or frontrunning with respect to clients orders, or someone who is involved in any case of identity theft (whether at the retail level of a stolen PIN to the large-scale misappropriation of funds from client accounts). Once the criminal gets that money, they want to invest and enjoy the proceeds of their crime, the same way any person who legitimately earned money wants to invest those proceeds. Money that can be moved legitimately is vulnerable to abuse from the criminal side. Basically, any way that you can, intermediate value can be abused for criminal purposes. As a result, FinCENs regulation applies broadly. In fact, its the broadest measure by which you could define the financial industry, covering not just the asset management industry but banking institutions, credit unions, money transmitters, precious metals, or jewelry dealers and casinos.
So how does it happen in practice?

The way we look at money laundering is to describe it in three distinct stages. The first is placement, the second is layering, and the third is integration. In the placement stage, the criminal immediately takes the proceeds of the crime and brings them into a financial institution. For example, the proceeds of narcotic sales drugs are sold on the street; the seller gets cash and brings a bag of cash into the financial system in the form of a deposit or investment. Once its in the financial system in any type of account, the layering stage follows. An illicit actor will move the proceeds of the criminal act through multiple transactions to avoid being seen or having the source of funds discovered. The integration stage is spending and enjoying the assets of the proceeds. Criminals might purchase real

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assets, including real estate, cars, yachts, or make longterm investments.

What are some red flags for this type of activity?

Financial analysts must be aware of a number of red flags. Among them is churning. Its the responsibility of a broker/dealer, for instance, to ask why a client would order multiple and frequent trades when all thats really happening is that the client is racking up fees. From a commercial standpoint, churning makes no sense, and it may well be a case of layering proceeds from a criminal act so that, ultimately, the proceeds wont be tracked back to the initial source of the funds. Another red flag may be when a client approaches a financial institution to obtain the assistance as an intermediary in placing funds into custodial accounts. A financial institution might encounter a situation where a client places assets under management and shortly thereafter arranges for their immediate removal. There are a number of ways to spot possible illicit activity. The point, however, is that financial institutions are well advised to know their clients, even to the extent of knowing the source of funds.
What makes an effective anti-money-laundering (AML) program?

thought out and sufficiently implemented and followed. These are the four pillars of an effective AML program. Fundamentally, though, what will make or break a good AML program is having alert employees, people who understand what to look for and who are vigilant with respect to criminal abuse. Alert employees need to be supported with an electronic monitoring system and an institutions ability to look across multiple client accounts to gain a view of the whole picture as to what the client is doing. An effective BSA program comes back to having alert employees who make a real difference in preserving the reputation of an organization.
Where would an employee want to pay extra attention?

Customer identification programs in other words, customer due diligence is important. More generically, know your customer. Basically, you need to know who you are dealing for. Who are they really their name, date of birth, unique identifier, and information? One of the basic requirements of the CFA Institute Code and Standards is the suitability requirement. Basically, the suitability requirement says you need to do an inquiry into your clients investment experience, risk return objectives, and financial constraints prior to making investment recommendations. How can you do that without knowing who your customer is? It is impossible.
How do suspicious activity reports (SARs) factor in?

An effective AML program begins with what we refer to as the four pillars. First, there must be policies and procedures in place. Financial institutions must have written internal policies that all staff can understand and that are tailored to a specific business model and clients. Second, the institution must have a designated Bank Secrecy Act compliance officer. A compliance officer must be thoroughly versed in BSA rules of the road. Third, staff must be appropriately trained. Fourth, there has to be an independent audit that proves the AML program is well
James H. Freis, Jr., CFA, was appointed director of the Financial Crimes Enforcement Network (FinCEN) on 5 March 2007 by the secretary of the U.S. Treasury. Prior to his appointment, he served in the Treasury Department as deputy assistant general counsel for enforcement and intelligence, providing legal support to the Office of Terrorism and Financial Intelligence, FinCEN, and the Office of Foreign Assets Control. Freis also served as senior counsel in the legal service of the Bank for International Settlements (BIS) in Basel, Switzerland, and in the legal department of the Federal Reserve Bank of New York (FRBNY). He holds a JD from Harvard Law School and a bachelors degree from Georgetown University. In addition to being a CFA charterholder, he is a member of the American Bar Association and the International Law Associations Committee on International Monetary Law. Freis has received the U.S. Treasury secretarys Honor Award in recognition for outstanding service to the BIS, the FRBNY presidents Award for Excellence, and the 2009 Cressey Award from the Association of Certified Fraud Examiners for achievement in the detection and deterrence of fraud.

On an ongoing basis, one of the most useful requirements to fight the abuses of financial crime is to file suspicious activity reports (SARs). The kind of tip provided by a SAR is often the main source of information for law enforcement to follow up on a case of market manipulation or insider trading, for instance. Many professionals in the industry will have some requirement that they need to report their own trades. A great tip is when an individual who is a broker/dealer opens an account at another institution in his or her childs name to avoid those types of reporting requirements. You have other situations where investments might be coming from people who are hiding losses and trying to make off-the-book trades because they are worried about how that is going to tie into their annual bonus. These are a couple of examples of activities that get to the fundamental integrity of the financial markets.
Can you describe FinCENs outreach effort to financial institutions?

FinCEN is in a unique position as a financial regulator in that we dont directly go into and examine financial institutions for BSA compliance. With respect to the banking industry, Federal banking regulators in the course of their regular compliance examinations review a depository institutions BSA plan and procedures. In the securities industry, the SEC or (to a certain extent) self-regulatory organizations examine these organizations for compliance with FinCENs regulations. They refer to us evidence of

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Standards

IN PRACTICE
Has your involvement with the CFA Program helped you?

P RO F E S S I O N A L P R AC T I C E

potential noncompliance, and we make a decision as to potential enforcement action. In practice, we dont have the same day-to-day interaction with all of the financial institutions that most financial regulators do. What I launched a couple of years ago was what we refer to as our outreach initiative. FinCEN holds both one-on-one discussions and town hall-style meetings with some of the regulated financial institutions as a way to properly understand how the industry works in practice as well as to better understand how they see FinCEN regulations. Our goal is to align our regulatory requirements with their commercial incentives. Keep in mind, any aspect of regulatory compliance is something that, particularly in difficult economic times, the industry views as non-profitable. Compliance comes with cost, as opposed to the profit generating business, and they need to be careful about managing those costs. The more that we can work together with the industry and better align commercial incentives, the more it serves our joint goals. Knowledge of your customer should be gained, not in a vacuum of regulatory requirements, but as part of better service to that customer.

Being a CFA charterholder, along with my own experience working with a number of different financial institutions and particularly in asset management and at the wholesale level, I do think that helps me engage with the industry. Because I have been there, performing activities in the financial sector, working with regulators and complying with regulations, I know what financial institutions face from their perspective. Im able to talk with them on their terms, with an understanding of the commercial implications for regulations. I do think that helps me achieve what is critical to FinCEN, the partnership that is needed between the government and the financial industry to protect the integrity of the financial markets.
What is at the core of that partnership?

Its an appeal to the industry that our incentives are aligned. Criminals want to prey on the good name of an asset manager by getting funds into an institution and having those transferred from a well-known institution. That essentially gives a criminal a type of legitimacy. The thinking follows the logic that if ill-gotten gains come from

Suspicious Activity Reports by the Securities and Futures Industries: Filings by Type of Reporting Institution (1 January 2002 31 December 2009)
Type of Institution or Individual
Agriculture Trade Option Merchant Affiliate of Bank Holding Company Commodity Pool Operator Commodity Trading Advisor Direct Participation Program Futures Commission Merchant Futures Floor Broker Futures Floor Trader Introducing Broker Futures Investment Advisor Investment Company Mutual Fund Market Maker Municipal Securities Dealer National Futures Association Registered Equity Futures Other Registered Futures Associations Securities Brokers Clearing Securities Brokers Introducing Securities Dealer Securities Floor Broker Securities Options Broker Dealer Self-Regulatory Organization (SRO) Specialist Subsidiary of Bank U.S. Government Broker Dealer U.S. Government Interdealer Broker Other Unknown/Blank

2003
234 508 0 0 3 16 1 0 18 186 100 25 7 0 3 1,516 1,237 966 7 32 0 4 58 18 0 473 398

2004
115 757 1 5 10 54 2 4 18 329 485 300 62 7 4 4 2,265 1,858 1,159 27 69 0 1 99 51 3 676 698

2005
2 683 2 2 12 80 1 1 6 256 622 473 103 9 2 7 3,376 2,694 1,400 20 84 1 5 93 54 3 806 307

2006
62 1,196 2 2 7 172 3 3 14 698 646 384 78 15 2 10 2,976 3,016 1,673 28 165 4 3 79 54 3 1,490 393

2007
31 1,708 21 1 4 352 0 21 20 1,143 1,404 1,074 81 11 0 4 4,292 3,897 2,914 11 197 1 2 190 46 1 3,206 277

2008
33 1,853 3 3 25 786 3 1 36 1,430 1,874 906 86 12 2 2 5,391 4,626 3,469 219 164 1 3 359 46 2 3,260 421

2009
26 1,742 2 4 18 2,003 6 3 35 1,240 1,941 962 117 35 0 1 7,500 5,617 4,116 254 158 1 1 1,123 66 3 3,345 524

Note: Some Suspicious activity reports (SARs) may list multiple reporting institutions. Because SARs statistical data are continuously updated as additional reports are filed and processed, minor discrepancies may exist between statistical figures contained in various reports.

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an account at a recognized financial institution, who would question whether the money came from illegal activity? Criminals are indifferent to you as an asset manager, and that is an aspect of reputational risk. Asset managers and financial institutions dont want to put their reputation at risk and they dont want to be caught in a situation doing business with illicit actors. Again, alert employees are the single most critical element in a successful anti-money-laundering program. Dont be the one who turns a blind eye to suspicious activities. Its your job to figure out what is the nature of the criminal behavior and file a SAR. Its important to do more than say to yourself, That business looks a little bit too good to be true. I will just turn it down. Theres a good chance that when one asset manager turns business away because it looks suspicious, the illicit business will turn up elsewhere. The reason a financial institution may have for turning away funds that appear to have come from illicit sources is exactly the type of tip written up as a SAR that we need to put together the clues to track down and hold the criminals accountable.
Is there an accessible database for SARs?

of their colleagues or their counterparts with respect to the purposes underlying the transaction. Section 314(b) enables this type of cross-industry information sharing. Without this authority, financial institutions generally would be prohibited from sharing information because that is information with respect to ones own customer and is subject to confidentiality obligations. We actually have this statutory framework to promote the sharing of information because it encourages rooting out potential money laundering and other financial crime.
What about combating mortgage fraud and loan modification scams?

We do maintain a central database, but the database is accessible only to government personnel and to law enforcement organizations. When an individual broker/ dealer or an individual mutual fund reports suspicious activity to FinCEN, we take that information into our database. Because individual reports contain sensitive customer or commercial information, it is not something that we share with anyone outside of that reporting institution. FinCEN shares information with regulators who look into the potential illegal activity as well as with law enforcement if they need to follow up on a criminal investigation. FinCEN recently issued new rules that allow affiliates to share information centrally. For example, if a broker/ dealer processes a securities transaction but its affiliated bank actually processes the funds transfer obligation on the same transaction, we want those two different entities, which are often set up as separate companies, to share information with respect to what is essentially the same transaction for the same customer. This type of information sharing among affiliates can be an important tool that balances the needs of supporting law enforcement, managing costs at financial institutions, and promoting enterprisewide risk management.
Is there a benefit in greater cross-industry sharing?

This area has been among the most active for FinCEN in the past four years. The suspicious activity reports that we receive from banks are the most important source of lead information the government has in combating fraud and illegal activity in the residential mortgage markets. Mortgage lenders have a great deal of information related to specific transactions. The mortgage transaction is very different from a transaction involving processing of securities trades, where buying and selling securities can, relatively easily, move through multiple and different unaffiliated entities. Generally, when a bank is actually engaged in mortgage lending, it has a lot of information available, and if the mortgage loan goes bad (for instance, if a borrower stops paying on that loan), the bank can provide relatively quickly and easily information that is critically useful. With our ability to look at a large volume of data, FinCEN is able to distinguish between individual one-off cases and organized criminal rings, the crooked insider or the external appraiser. By examining this big picture, we are able to help law enforcement focus resources on the most egregious criminal conduct.
What kind of cooperation does FinCEN receive internationally?

FinCEN is what is known as the Financial Intelligence Unit of the United States and has counterparts that it works with in over 100 countries around the world. Criminals dont respect the law, and they certainly dont respect borders. In a blink of an eye, funds can move from one country to another, which makes it more difficult to follow the financial trail. FinCEN has the ability to share information with counterparts. I reach out to my counterparts who will help me track down stolen funds and hopefully help us repatriate them back to the victims. Jonathan Barnes is a journalist in the Pacific Northwest.

Theres a specific statutory program known as section 314(b) of the USA PATRIOT Act. This is a statutory safe harbor that I have been promoting from FinCEN to help financial institutions better share information when they see potential financial crime and money laundering. A specific example is when a transaction occurs between two institutions. If one of the institutions looks at the transaction and something just doesnt seem to make commercial sense, the institution is allowed to ask specific questions

RECOMMENDED RESOURCES
What New U.S. Anti-Money-Laundering Laws Mean for Broker-Dealers, Investment Companies, Banks, and Other Financial Institutions AIMR Advocate (March/April 2002) (www.cfapubs.org) Know Your Clients CFA Magazine (November/December 2003) (www.cfapubs.org)

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