Enhanced Due Diligence

Enhanced Due Diligence (EDD)

Enhanced Due Diligence (EDD) stands out as a cornerstone in the fight against money laundering and terrorist financing. The evolution of EDD, especially through the lenses of the 4th and 5th Anti-Money Laundering Directives (AMLD) of the European Union, the German Anti-Money Laundering Act (GwG), and the interpretative guidance from the Federal Financial Supervisory Authority (BaFin), offers a comprehensive understanding of its critical role.

The 4th AMLD (Directive (EU) 2015/849) introduced stringent requirements for obliged entities to apply EDD in higher-risk scenarios. This directive was a response to the growing complexity of financial crimes and aimed to strengthen the EU’s defenses against money laundering and terrorist financing.

The 5th AMLD (Directive (EU) 2018/843) further amplified these requirements. It expanded the scope of EDD, especially in relation to high-risk third countries, and introduced additional measures such as obtaining accurate information about the customer and beneficial owner, understanding the nature of the business relationship, and enhanced monitoring of business relationships.

In Germany, the GwG aligns with these directives, focusing on detailed EDD measures. Section 15 of the GwG mandates EDD in addition to general due diligence in higher risk situations, such as business relationships with PEPs (Politically Exposed Persons), high-risk third countries, and in cases of complex or unusual transactions.

BaFin’s Interpretation and Application Guidance provides practical insights into implementing these requirements. It emphasizes the importance of a risk-based approach, where the extent of EDD measures is proportional to the level of identified risk. BaFin’s guidance is instrumental in clarifying the requirements for German obliged entities, ensuring that they not only comply with the law but also effectively contribute to preventing financial crimes.

Key Takeaways for Practitioners

  1. Risk Assessment Focus: Both AMLDs and the GwG underscore the need for a thorough risk assessment as the basis for applying EDD measures.
  2. PEPs and High-Risk Countries: Special attention is required for business relationships involving PEPs and entities from high-risk third countries.
  3. Ongoing Monitoring: EDD is not a one-time process but requires continuous monitoring and reassessment of the business relationship.

Understanding and implementing EDD effectively is crucial for financial institutions and other obliged entities to ensure compliance and protect the integrity of the financial system.

4th AMLD

The Articles from Section 3 of the 4th Anti-Money Laundering Directive (Directive (EU) 2015/849) provide detailed guidelines on enhanced customer due diligence (CDD) measures. These measures are crucial for preventing money laundering and terrorist financing. Here’s an explanation of each Article:

High-Risk Cases

  • Enhanced CDD in High-Risk Cases: Obliged entities (like banks and financial institutions) must apply enhanced CDD measures in higher-risk scenarios, including dealing with entities from high-risk third countries (as identified by the Commission) and other situations deemed high-risk by Member States.
  • Risk-Based Approach: Not all cases require automatic enhanced CDD. For branches or subsidiaries in high-risk countries that comply with the group’s policies, a risk-based approach is applied.
  • Monitoring Transactions: Obliged entities must examine complex, large, or unusual transactions, especially those without a clear economic or lawful purpose, and intensify monitoring to identify any suspicious activities.
  • Risk Assessment Factors: The assessment of money laundering and terrorist financing risks must consider factors listed in Annex III.
  • Guideline Issuance by ESAs: By June 26, 2017, the European Supervisory Authorities (ESAs) were to issue guidelines on risk factors and appropriate measures for situations warranting enhanced CDD.

Cross-border Correspondent Relationships

Focuses on cross-border correspondent relationships with third-country respondent institutions:

  • Information Gathering: Institutions must fully understand the nature and reputation of the respondent institution.
  • AML/CFT Control Assessment: The AML (Anti-Money Laundering) and CFT (Counter Financing of Terrorism) controls of the respondent institution must be assessed.
  • Senior Management Approval: New correspondent relationships require approval from senior management.
  • Responsibility Documentation: The responsibilities of each institution in the relationship must be documented.
  • Due Diligence on Payable-Through Accounts: Institutions must ensure the respondent institution conducts due diligence on customers with direct access to correspondent accounts.

Politically Exposed Persons (PEPs)

Addresses transactions or business relationships with politically exposed persons (PEPs):

  • Risk Management Systems: Institutions must have systems to determine if a customer or beneficial owner is a PEP.
  • Measures for PEP Relationships: This includes obtaining senior management approval, establishing the source of wealth and funds involved, and conducting enhanced, ongoing monitoring of those relationships.

Refers to insurance policies involving PEPs:

  • Determining PEP Status: Institutions must determine if beneficiaries or beneficial owners of life or investment-related insurance policies are PEPs.
  • Measures for High-Risk Cases: This includes informing senior management before payout and conducting enhanced scrutiny of the relationship with the policyholder.
  • Continued Risk Assessment for Former PEPs: Institutions must consider the continued risk posed by individuals who were PEPs and apply risk-sensitive measures for at least 12 months after they cease being PEPs.
  • Extending Measures to Family and Associates of PEPs: The measures for PEPs also apply to their family members and known close associates.

Shell Banks

  • Prohibition Against Shell Banks: Institutions are prohibited from entering or continuing correspondent relationships with shell banks and must ensure they don’t engage with institutions that allow accounts to be used by shell banks.

5th AMLD

The 5th Anti-Money Laundering Directive (Directive (EU) 2018/843) introduces significant amendments and additions to the 4th AML Directive (Directive (EU) 2015/849), particularly in relation to enhanced customer due diligence (CDD). Here is an analysis and explanation of the key changes:

  • Scope of Enhanced CDD Expanded: The requirement for enhanced CDD now applies to cases referred to in Articles 18a to 24, broadening the scope beyond the original Articles 19 to 24.
  • Examination of Transactions: Obliged entities must examine all transactions that are complex, unusually large, conducted in an unusual pattern, or have no apparent economic or lawful purpose. This includes increasing the degree and nature of monitoring to determine if such transactions or activities appear suspicious.

High-Risk Third Countries

  • Enhanced CDD for High-Risk Third Countries: Specific enhanced CDD measures are required for business relationships or transactions involving high-risk third countries. These measures include obtaining additional information about the customer and beneficial owner(s), understanding the intended nature of the business relationship, the source of funds and wealth, the reasons for transactions, senior management approval, and enhanced monitoring.
  • Additional Mitigating Measures: Member States must require obliged entities to apply additional mitigating measures in transactions involving high-risk third countries, such as additional elements of enhanced due diligence, enhanced reporting mechanisms, or limiting business relationships with entities from high-risk countries.
  • Measures Against High-Risk Countries: Member States are required to take specific actions against high-risk third countries, like refusing or restricting the establishment of subsidiaries or branches of obliged entities from these countries, increasing supervisory or audit requirements, and reviewing or terminating correspondent relationships with institutions in these countries.
  • Consideration of International Evaluations: When applying these measures, Member States should take into account evaluations by international organizations regarding the risks posed by individual third countries.

Cross-Border Correspondent Relationships

  • The amendment specifies that the additional CDD measures apply to cross-border correspondent relationships involving the execution of payments with third-country respondent institutions.

Lists of Prominent Public Functions

  • Each Member State is required to maintain and update a list of functions that qualify as prominent public functions. This extends to international organizations on their territories. The Commission will compile these lists, including functions at the level of the Union institutions and bodies, and make them public. This aids in identifying politically exposed persons (PEPs).

German GwG

Section 15 of the German Anti-Money Laundering Act (Geldwäschegesetz – GwG) outlines the enhanced due diligence (EDD) requirements that obliged entities must follow in addition to general due diligence requirements. Here’s a breakdown and explanation of each subsection:

General Requirement

  • Enhanced due diligence is mandatory alongside general due diligence measures.

When EDD is required?

  • When EDD is Required: Obliged entities must perform EDD when, through risk analysis or considering risk factors in annexes 1 and 2, they identify a higher risk of money laundering or terrorist financing. The specific extent of these measures should be proportional to the identified risk.
  • Demonstration of Adequacy: The adequacy of these measures should align with section 10(2) sentence 4 of the GwG.

Situations Indicating Higher Risk

  • Higher risk arises especially in the following scenarios:
    1. Involvement of politically exposed persons (PEPs), their family members, or close associates.
    2. Business relationships or transactions involving high-risk third countries as identified by the European Commission.
    3. Transactions that are complex, unusually large, conducted in unusual patterns, or lack apparent economic or lawful purpose.
    4. Cross-border correspondent relationships with third-country respondents or heightened risk respondents from the European Economic Area.

Politically Exposed Persons (PEPs)

  • EDD Measures in Cases Involving PEPs: In scenarios involving PEPs, obliged entities must:
    1. Obtain senior management approval for new or continuing business relationships.
    2. Establish the source of funds involved in the relationship or transaction.
    3. Conduct enhanced ongoing monitoring of the business relationship.
    • Additional measures apply if the PEP status is discovered during or after establishing the relationship.

High-Risk Third Countries

  • EDD in High-Risk Third Country Cases: For business related to high-risk third countries, obliged entities must:
    1. Obtain additional information on the contracting party, beneficial owners, nature of the business relationship, source of assets and wealth, and reasons for transactions.
    2. Get senior management approval for new or ongoing business relationships.
    3. Enhance monitoring of the business relationship.
  • Additional Measures for High-Risk Third Country Cases: Competent authorities may require extra measures such as:
    1. Reporting financial transactions.
    2. Limiting or prohibiting business relationships with entities from high-risk third countries.
    3. Restrictions on establishing business entities in Germany or high-risk third countries.
    4. Increased examination of compliance for entities in high-risk third countries.

Complex or Suspicious Transactions

  • EDD for Complex or Suspicious Transactions: For transactions that are complex, unusually large, or lack a clear purpose, obliged entities must:
    1. Examine the transaction’s background and purpose.
    2. Enhance ongoing monitoring if the transaction is part of a business relationship.

Cross-Border Correspondent Relationships

  • EDD in Cross-Border Correspondent Relationships: This includes obtaining sufficient information about the respondent, senior management approval, documenting responsibilities, and ensuring non-involvement with shell banks.

External Information

  • Measures Based on External Information: If additional risks are identified based on reports or assessments from national or international agencies, the supervisory authority may order enhanced monitoring and additional due diligence.

Inability to Fulfill EDD Requirements

  • If obliged entities cannot fulfill EDD requirements, the provisions of Section 10(9) of the German gwG apply. Section 10(9) of the German GwG outlines the actions obliged entities must take if they are unable to fulfill general due diligence requirements.
    • Prohibition on Establishing or Continuing Business Relationships: If an obliged entity cannot meet the due diligence requirements, it is prohibited from establishing or continuing any business relationship. This includes not executing any transactions.
    • Termination of Existing Relationships: In cases where a business relationship already exists, the obliged entity must terminate or end it. This action is required regardless of other statutory provisions or contractual terms.

BaFin-Interpretation and Application Guidance on the German GwG

Section 7 of the BaFin Interpretation and Application Guidance on the German Money Laundering Act (October 2021) elaborates on the enhanced due diligence obligations as outlined in Section 15 of the German Anti-Money Laundering Act (GwG). Here’s an analysis and explanation of each part:

Principles

  • Implementation of Enhanced Due Diligence: Obliged entities must conduct enhanced due diligence (EDD) when their risk assessment, or an assessment in an individual case considering Annexes 1 and 2, indicates a higher risk of money laundering or terrorist financing.
  • Determination of Measures: The specific extent of EDD measures should be determined based on the level of identified risk.
  • Addition to General Obligations: EDD is in addition to general due diligence obligations under section 10 of the GwG. Obliged entities must demonstrate the appropriateness of their measures to BaFin.
  • General Clause: Section 15(2) of the GwG serves as a general clause, imposing EDD obligations even in scenarios not specified in Section 15(3) of the GwG, based on the entity’s risk assessment.
  • Guidelines on Risk Factors: Entities must also consider guidelines on risk factors, especially nos. 4.45 et seq.
  • Inability to Fulfill EDD: If an entity cannot fulfill necessary EDD obligations, section 10(9) of the GwG applies.

Politically Exposed Persons (PEPs)

  • High Risk with PEPs: The involvement of a PEP, their family members, or known close associates generally indicates a higher risk.
  • Minimum Level of EDD for PEPs: In cases involving PEPs, certain EDD measures are mandated, such as management approval for establishing or continuing a business relationship, establishing the source of wealth, and enhanced continuous monitoring.
  • Guidance on PEPs: Relevant guidelines on handling PEPs are included in nos. 4.48 et seq.

High-Risk Third Countries

  • EDD for High-Risk Third Countries: EDD applies to business relationships or transactions involving high-risk third countries.
  • Exemptions: Branches and subsidiaries in the EU or high-risk third countries that fully implement group-wide policies are exempt.
  • Measures Required: Specific information must be obtained, management consent is needed for new or ongoing business relationships, and enhanced continuous monitoring is required.

High-Risk Transactions

  • Transactions Requiring EDD: Transactions that are complex, unusually large, follow unusual patterns, or lack economic or legal purpose require EDD.
  • Obliged Entity’s Discretion: The obliged entity must decide if a transaction falls under these criteria.
  • Special Examination Process: Such transactions must undergo a special examination process for risk assessment and monitoring.

Cross-Border Correspondent Relationships

  • Definition and Principles: Correspondent relationships are defined as specific banking services provided by obliged entities. EDD obligations apply to relationships with third-country respondents.
  • EEA Country Respondents: Enhanced obligations also apply when dealing with respondents in EEA countries identified as high-risk.
  • Implementation Measures: Before establishing a business relationship, obliged entities must obtain sufficient information about the respondent, obtain management consent, and determine responsibilities for due diligence obligations.

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