The front lines of the war on terror, it turns out, are the cramped offices of compliance officers across the country.
The USA Patriot Act has made this so, mainly through its much-debated Section 326, which essentially pumps up traditional know-your-customer rules in hopes of heading off terrorist-related money laundering. The Act, which took effect October 1, has sent the brokerage industry into a compliance frenzy, one that is expected to result in $700 million in technology costs through 2005, according to consultancy TowerGroup.
Unfortunately, many firms — particularly smaller broker/dealers — lack the resources to properly deal with the implications of the Act. As a result, some are just “kind of winging it,” in the words of one compliance officer at a small firm. “We're just dealing with it day by day.”
Don't Get Burned
That's playing with fire. With penalties ranging to $500,000, plus twice the amount of money laundered, broker/dealers have all the motivation they need to get compliant. And the larger firms are doing just that: by deploying legions of lawyers, compliance officers and anti-money laundering experts to update procedures and to analyze suspect transactions. Even with these resources, the large firms are groping a bit. A rep at a large regional firm says she had more than two dozen foreign accounts summarily closed, without notice, because of the Patriot Act.
At smaller firms, though, the trouble is much more pronounced. For starters, there's an interpretation problem. Compliance officers say the Patriot Act has some terms that are so broad that defining the minimum requirements is a chore in itself. Patriot Act compliance “revolves around developing your plan to put the requirements in place,” says Marianne Czernin, director of b/d client services for National Regulatory Services, a compliance consulting firm in Lakeville, Conn. “If a small broker/dealer doesn't have a mountain of attorneys to put that together, that's a serious problem.”
The most obvious requirement of Section 326 involves positively identifying people opening new accounts by checking their photo IDs, social security numbers, home addresses and dates of birth. Seems straightforward enough, but it gets more complicated in the Act's dealings with non-resident aliens and natives of “red flag” countries. These higher-risk people require more extensive scrutiny, and smaller firms quickly hit a resource wall when vetting them.
Even some of those who might be able to add compliance staff are holding off until they can determine what exactly is called for. Waltham, Mass.-based Commonwealth Financial Network, an independent with 850 reps, fulfilled the Act's requirement of a special Anti-Money Laundering Compliance Officer by appointing their current compliance officer to the job — without relieving him of his old duties. “It hasn't been easy… The SEC says it's coming out with interpretive guidelines, but of course they're doing that after the fact,” says Michael Mahoney, Commonwealth's assistant director of compliance and the firm's Patriot Act designee. “We mainly just subscribe to relevant publications and try to get a barometer for what other people are doing.”
Mahoney says Commonwealth will spend a few months trying to handle the Act's restrictions in-house. He is hesitant to name an exact Act-related cost, but he notes his firm pays “considerable dollars” to its third-party compliance vendor for each new account added.
Non-compliance is a non-option, so many smaller firms are left with a hard choice: pony up money for the compliance resources, or scale back your business dealings to a level the current compliance resources can handle.
“There's a lot of pressure being put on smaller firms,” says Alan Sorcher, associate general counsel for the Securities Industry Association.
The Trickle-Down Effect
Much of Patriot Act compliance, of course, resides in paperwork. Montauk Financial Group in Red Bank, N.J., an independent broker/dealer with about 500 producing reps, has redesigned its new account information form and instituted a foreign account daily activity report. Commonwealth put language in its contracts informing clients that they could be subject to background checks.
Meanwhile, Cambridge — and many others — have adopted an “all hands on deck” attitude towards compliance, meaning that reps are often deputized in this war — a job they're not necessarily qualified for.
Ideally, Czernin says, the regulators would love for brokers to turn down potentially “high-risk” accounts, but she doesn't see that happening. “You have to have a feel for, On this one, we'll go a little further,” Czernin says.
The problem with this is that brokers are poorly trained for this sort of judgment call. “We're playing security guard, which really has nothing to do with the business of being a broker/dealer,” says Nancy Lininger, a compliance consultant in Camarillo, Calif.
Because of their inherent compliance limitations, smaller firms are considered more susceptible to the very kind of terrorism support systems that the Patriot Act is trying to prevent. “The people who would commit those acts are, frankly, probably going to go to a small broker/dealer to launder their money,” Czernin says. “It'll be easier to hide there.”
If that happens, meeting the minimum requirements of the Patriot Act will be the least of a broker/dealer's problems.