CHANGES TO GOVERNMENT POLICY OF PROLIFERATION FINANCING

Why should I read this?

Proposed changes to UK money laundering rules, in particular new Financial Action Task Force ("FATF") proliferation financing requirements, will place new obligations on regulated firms. When this new obligation is viewed alongside the recent "Dear CEO" letter relating to trade finance activities, those regulated will need to implement new procedures for reviewing relevant transactions.

Key takeaways are:

• In response to the amendments of policy and the "Dear CEO letter", regulated firms must have in place detailed risk assessments that consider financial crime risk factors

• Proliferation financing is an added threat that UK policy now considers as important to control. Firms must examine proliferation financing independent from other risk factors and implement counter-proliferation policy meet new international standards.

Introduction

The new FATF Recommendations relate to the risk of breaches of relevant UN Security Council Resolutions that apply targeted financial sanctions related to the proliferation of weapons of mass destruction, applying specifically to Financial Institutions, Designated Non-Financial Businesses and Professions and Virtual Assets Service Providers. In light of this, updates are going to be made to the Money Laundering, Terrorist Financing and Transfer of Funds Regulations 2017 ("MLR") in order to assure that the UKs measures implement international standards set by the FATF. As part of this process, HM Treasury has published a national risk assessment (NRA) of proliferation financing

Proliferation financing (PF) as defined by the FATF and the proposed amendments to the MLR, is "the act of providing funds or financial services which are used, in whole or in part, for the manufacture, acquisition, possession, development, export, trans-shipment, brokering, transport, transfer, stockpiling or use of chemical, biological, radiological or nuclear (CBRN) weapons and their means of delivery and related materials (including both technologies and dual use goods used for non-legitimate purposes), in contravention of national laws or, where applicable, international obligations.”

It is important to note the breadth of the definition, that it applies to financing all elements of the supply chain including financing of:

• a supplier of air-condition or HVAC to nuclear plants or research facilities;

• the manufacture of dosimeters;

• a logistics provider certified to transport radioactive or biological materials or

• the production of high specification storage tanksThese changes to the MLR come at a time when UK authorities are asking certain parts of the financing supply chain to review and then demonstrate how they assess existing financing risks (via the "Dear CEO" letter immediately below). Adding in a new PF process will make this review more complex, both now and in the future.

"Dear CEO" Letter

The "Dear CEO" letter co-published by the PRA and FCA was written in response to failures of commodity and trade finance firms resulting in financial loss in the past 18 months. The letter reiterates their expectations for an assessment of risk in relation to trade finance activity having seen significant issues relating credit risk analysis and financial crime controls in regulated firms. The letter reinforces the need to create a robust risk management framework. These expectations, placed on undertakings regulated by the PRA and FCA, are often different to and in some cases go beyond the strict letter of UK law.

The PRA and FCA attribute issues relating to credit risk analysis and financial crime control risks to insufficient focus on the identification and assessment of financial crime risk factors.

Having found firms failing to meet their current obligations to enforce functional risk assessment policies, the letter establishes the need for firms to have a clear methodology that sufficiently evidences the assessment of mitigating controls and records the rationale used to support conclusions drawn on the level of residual risk. In regulated businesses, the Money Laundering Reporting Officer is responsible for ensuring that this assessment is subject to appropriate governance, oversight and challenge within businesses. Firms may be asked to provide evidence of risk assessments and follow up action in future engagements with the FCA/ PRA. Such requests may require waiver of any legal privilege in those assessments.

The letter highlights the importance of having a clearly documented risk sensitive approach to transactions that holistically considers the different types of risk exposures that might exist in trade finance relationships. This should dictate the scope of due diligence undertaken to assess all aspects of risk to prevent exposure to suspicious activity.The "Dear CEO" letter is likely to result in heightened scrutiny by the FCA of trade finance activities (for example, through more intrusive supervisory work or by appointing a Skilled Person pursuant to the FCA's powers under section 166 of FSMA) which, in turn, may precipitate enforcement action. Firms should therefore take steps to assess gaps in their existing financial crime frameworks for mitigating risks in their trade finance businesses.

Consultation for amendments to the MLR

In October 2020 the FATF incorporated amendments to its international standards that require countries and the private sector to identify and assess the risks of potential breaches, non-implementation or evasion of the targeted financial sanctions relating to PF. The proposed updates to the MLR reflect the threshold of action required in response to new standards set out by the FATF

Regulations 16, 18 and 19, as amended, will include these provisions.

The MLR place very simple obligations on regulated entities to comply: Regulators do not need to prove an actual breach of underlying substantive rules, but merely the maintenance of systems and controls to prevent violations that are overlain on regulated entities.

In response the amendments made to the MLR, relevant persons are expected to take appropriate steps to identify and assess risks of PF within their businesses. It is expected that policies, controls and procedures to mitigate and manage PF risks will be established and maintained within regulated firms. The government have published a national risk assessment of proliferation financing to outline where the threats and vulnerabilities relating to PF lie.

National Risk Assessment of Proliferation Financing

The NRA has been published to compliment the updates to the MLR. Risk assessments are a central feature of the UK's national response to the threats posed by money laundering and terrorist financing. The NRA is necessary to provide a thorough understanding of PF risk . In respect to regulated businesses, the NRA is vital for an accurate implementation of counter PF measures as it sets out where businesses may be exposed to PF.

The NRA states that it is crucial that businesses consider PF as an independent risk, separate from other illicit financial activity. The NRA covers risks both direct and indirect that businesses may face that contribute to the financing of the procurement of CBRN technology by an actor.

Historically, the supply of CBRN technology has always been problematic but based on the FATF recommendation and the MLR updates, an equal emphasis is being placed on the need to be aware of the avenues that lead to the financing of such technologies to disrupt to the flow of financing available to proliferators.

Businesses must be aware of threats which include but are not limited to:

• Having operations that reach countries that are exposed to PF activities, particularly in Asia where there are active PF networks or when trade is carried out between countries and proliferating states;

• Facilitating access to financial services for proliferation actors operating in said countries – directly or indirectly through links to local national bank with insufficient compliance controls; and

• Clearing transactions for trade through the UK and auxiliary services for out of country shipments of proliferation-sensitive items

Within these transactions, firms must be diligent to observe PF risks which could be triggered by the use of front and shell companies, foreign intermediaries, indirect payment methods or activity that involves proliferating states and shipping companies related in non-proliferating states.

The NRA divides PF threats facing the UK into the three subcategories of:

• Direct PF activity;

• Indirect PF activity; and

• PF activity undertaken by state actors.

The NRA concludes that involvement in PF activity can be averted within businesses with increased attention on:

• Due diligence policies – sufficient levels of customer due diligence must be carried out to ensure that end users are legitimate and are not linked to illicit actors , the importance of obtaining accurate beneficial ownership information must be considered as well; and

• Any changes to designations under UK sanction regimes. – Legitimate business activity with an entity that later becomes a designated states needs to result in the termination of the activity prohibited under the sanctions regime (unless certain provisions apply.)

Conclusion

In summary, as set out in the "Dear CEO" letter, and the amendments to the MLR, regulated firms undertaking trade finance will be expected to put in place rigorous risk assessments and procedures to prevent PF within their businesses. These will be subject to review by the FCA and PRA.

Assessments must be undertaken prior to the approval of individual transactions, considering the financial and non-financial risk on the end buyer and the rationale of the transaction in particular. Due diligence must be undertaken where 'red flags' are revealed in risk assessments.

Firms should ensure there is capacity to oversee the work being undertaken, to confirm that their policies and controls are operating effectively.