LEGAL
Insights & Trends
An expert Q&A with Bridget K. Marsh of the Loan Syndications and Trading Association (LSTA) on the LSTA’s Know Your Customer Considerations for Syndicated Lending and Loan Trading: Guidelines for the Application of Customer Identification Programs, Foreign Correspondent Account Due Diligence, and Other Considerations (KYC Guidelines). The KYC Guidelines are intended to help banks understand the applicability of U.S. anti-money laundering requirements in the context of their syndicated lending and loan trading activities.
The KYC Guidelines are the fourth publication in the LSTA’s Regulatory Guidance Series. The first three publications covered:
In particular, the publications addressed how each of the above areas of law applies to the U.S. loan market and lending transactions.
In early 2015, we turned our attention to drafting the KYC Guidelines, working with senior in-house counsel at our bank members and our external regulatory counsel, Davis Polk & Wardwell LLP, to develop AML and know your customer (KYC) guidance for the U.S. loan market.
It should be noted that the term “KYC,” when used outside the loan market, generally refers to the formal “know your customer” onboarding procedures followed by a bank when a customer opens a new account. In the loan market, it is a colloquialism used to describe any type of due diligence performed by a bank on another party in the loan market.
The target audience for this project includes business people, attorneys, and compliance personnel responsible for developing and implementing a bank’s KYC policies and procedures. As we roll out this project and inform LSTA members about the details of the KYC Guidelines, we are also engaging our buy-side members to ensure that they, who are often the parties being “KYCd,” are educated about KYC requirements in the loan market.
At the project’s outset, we recognized that there seemed to be a dearth of knowledge in the loan market about what type of KYC diligence was actually required under applicable U.S. law. Often KYC policies and procedures that were designed for other banking products and asset classes were being applied without modification to the loan asset class. As a result, we sought to create guidelines that were specifically tailored for:
Setting industry standards and best practices is one of the fundamental roles of any trade association. This is particularly the case for the LSTA, because industry practices in the loan market are often unintended by-products of legislation (and resultant internal bank policies) squarely aimed elsewhere.
The LSTA can play a pivotal role in these situations by pulling together industry experts and those responsible for overseeing a particular area within a financial institution and creating standards and best practices. Although improving loan market efficiency may not be a particular project’s primary goal, setting standards and best practices will inevitably help streamline loan market practices.
The AML and OFAC regimes are two separate programs. AML laws target covered financial institutions and require them to establish AML programs and/or CIPs, as appropriate, which will enable them to verify the identity of an accountholder when a formal account is opened with the bank. This verification may be by documentary or nondocumentary means. Although the AML laws do not offer a prescriptive list of the types of documents a bank should obtain to verify a customer’s identity, they provide a few examples, including certified articles of incorporation, government-issued business licenses, and other properly certified charter documents. Verification can also be done by nondocumentary means, such as an Internet search, checking references with another financial institution, and visiting the customer’s actual place of business. These different means must allow the bank to form a reasonable belief that it knows the true identity of its customer.
In addition to, and distinct from, the AML and CIP regimes, a bank must also comply with all OFAC-administered regulations, which generally prohibit all “U.S. persons” from engaging in transactions with persons, governments, and countries targeted by U.S. sanctions (unless those transactions are exempt or licensed by OFAC). U.S. persons are also generally prohibited from facilitating actions of non-U.S. persons that could not be directly performed by U.S. persons due to U.S. sanctions restrictions, although those actions may be entirely legal for a non-U.S. person. The LSTA, therefore, recommends in its KYC Guidelines that, in conjunction with any CIP or counterparty due diligence, a bank should screen a counterparty against government watch lists, including OFAC’s Specially Designated Nationals and Blocked Persons list (SDN list).
The KYC Guidelines can help shorten loan trading settlement times. There is a real possibility that, if this project is successful and financial institutions modify their KYC practices so that they adhere to the KYC Guidelines, we will see a reduction in loan trade settlement times.
The time spent “KYCing” a loan trade counterparty is often cited as a reason for settlement delays in the loan market. This is the case both in the primary loan market, where loans are originated and allocated to lenders, and in the secondary loan market, where portions of those loans are then traded. We have been told that KYCing a counterparty can add days to the settlement of a loan trade which, according to LSTA terms, should settle in seven business days.
Based on our working group discussions, it seemed that banks were KYCing counterparties in cases where it was not actually required under applicable U.S. law.
A goal this year is to educate our members about the KYC Guidelines and help ensure that they comply with U.S. law. We also plan to work with vendors that are developing KYC platforms to ensure that those systems are built to reflect the requirements of U.S. law and the U.S. loan market.
Market participants may be surprised to learn that ordinary loan trading relationships in the loan market do not create a formal “account” or banking relationship between the parties. Therefore, CIP procedures are not required.
As defined in the CIP regulations, an account means a formal banking relationship established to provide or engage in services, dealings, or other financial transactions, including:
When a bank trades a funded term loan in the ordinary course, no formal account is opened. Therefore, the bank does not need to verify the identity of its counterparty.
Verifying the identity of a customer under a bank’s CIP and performing counterparty due diligence (including satisfying OFAC regulations) are two distinct exercises. The verification process can be more time consuming and requires additional steps, including the collection of certified papers.
Fortunately, loans acquired through a loan trade in the secondary loan market are expressly carved out from the CIP regulations. The express exclusion of these loan assignments (where a buyer of a loan becomes a lender under the credit agreement) and participations (where a buyer is not eligible to become a lender and instead acquires a 100% participation interest in the loan while the seller retains bare legal title) from the CIP regulations is consistent with the purpose of the PATRIOT Act, which intends to capture primary transactions between borrowers and lenders and not ancillary transactions derived from those transactions.
Although there is no regulatory requirement for banks to perform CIP procedures on their counterparties in the primary or secondary loan market, the KYC Guidelines do recommend that banks consider the potential money laundering and OFAC compliance risks posed by counterparty relationships. The KYC Guidelines also note that it may be appropriate for a bank to perform risk-based due diligence on those counterparties.
As stated in the KYC Guidelines, KYCing a trade counterparty could include:
Yes. There is no need to repeat CIP procedures when a bank acquires a loan in the secondary market, since the original lenders would have conducted verification with respect to the borrower before initial funding under the credit agreement. However, purchasing a loan commitment under a revolving credit facility or a delayed draw term loan should trigger the need for CIP procedures on the borrower because those types of acquisitions legally obligate the purchasing bank to lend directly to the borrower at some future time.
The KYC Guidelines also remind members that, because of data privacy laws, the PATRIOT Act requires that a short customer notice should be included in every credit agreement notifying the borrower that each lender may be required to obtain, verify, and record information that will allow that lender to identify the borrower in accordance with the PATRIOT Act.
In the KYC Guidelines, the LSTA has identified every relationship that could arise in both the primary and secondary loan markets and explained what type of diligence is required under U.S. law and what type of KYC practices a bank may choose to perform in the light of its assessment of AML and other similar risks. Nonetheless, just as the regulators themselves have noted on different occasions, when assessing those risks, parties should recall that money laundering and terrorist financing risks in the loan market (which is a sophisticated market where only legal entities, and not individuals, are permitted to acquire loans) are low. The types of loan market participants and the trading patterns of secondary market loan trades directly contribute to this low-risk environment. Banks should bear this in mind when developing KYC practices for the loan asset class. As we saw during the global financial crisis, the risk of counterparty exposure arising as a result of loan trades that do not timely settle arguably poses a greater and costlier risk to the loan market and its participants.
This section was not covered in the LSTA’s 2004 CIP Guidance, but we thought it was an appropriate topic to address in this iteration. The PATRIOT Act generally requires banks to establish due diligence programs that include risk-based procedures and controls reasonably designed to enable them to detect and report known or suspected money laundering conduct relating to correspondent accounts maintained for foreign financial institutions (FFI). A bank should, therefore, consider whether its relationship with an FFI is a correspondent account requiring enhanced due diligence.
There has been overwhelming support for the KYC Guidelines. By distilling complex laws and applying them specifically to the loan market and the particular relationships that arise in it, we have created a practical, useful guide for our members. No one likes KYCing, and no one likes being KYCd, so the interests of all our members are aligned here. This makes adoption of the KYC Guidelines by the market more likely. There will, however, be challenges.
Certain members that operate globally may encounter internal obstacles as they seek to implement the KYC Guidelines. These global banks must determine if the local laws of a particular jurisdiction apply to them. Even where the laws are not applicable, certain banks are adopting internal KYC compliance policies which reflect the requirements of those local laws and applying them to their global operations, even those wholly operating within the U.S.
Where loan market participants establish policies that reflect the laws of foreign jurisdictions and not those of the U.S., it can create a significant challenge for the U.S. loan market, because those laws typically were not drafted to take into account:
The maintenance of our suite of documents is an ongoing process so we will continue to monitor the areas covered by the LSTA’s existing OFAC, FCPA, and KYC guidelines to ensure they reflect market practice and any additional regulatory insight that may be forthcoming.
Furthermore, we are currently considering how we can help standardize the KYC procedures followed, forms used, and data collected by banks’ operations teams for the loan market. We have also reconvened the Flood Standards Working Group to assess what more the LSTA should do to assist the loan market in that area in advance of the reauthorization of the National Flood Insurance Program in 2017.
This look at the major issues and regulations in AML and the finance industry comes from Practical Law – an online legal know-how service. To gain access to more related know-how resources, please visit us.practicallaw.com.
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