The Pandora Papers
Release of the Pandora Papers in 2021 (11.9 million documents published by the International Consortium of Investigative Journalists) revealed that the international financial system is awash in dirty money. Prime ministers, dictators, celebrities, arms dealers, oligarchs, and billionaires remain as determined as ever to move cash to places where the origin of funds is not questioned, taxes are low or non-existent, and one’s identity can be effectively concealed.
The Pandora Papers came five years after a previous and similar report, the Pulitzer-prize winning Panama Papers. These, however, exposed the files of just one law firm in Panama. The Pandora Papers were a much bigger story, encompassing 14 offshore providers, thousands of beneficial owners of shell companies and trusts, and span the period from 1996 through 2020. The finance ministers of Pakistan and Brazil were (and perhaps still are) siphoning money out of their countries and parking it offshore, often in the United States.
Acquiring American real estate, along with purchase of art and antiquities, are the preferred destinations for much of this international cash. Baker McKenzie, the largest law firm in the U.S., has been instrumental in creating vehicles (shell companies and trusts) to move this money.
Reverberations of the Pandora Papers and the Panama Papers will continue to be felt in legislation and government enforcement for years to come. The widening of FinCEN regulations (discussed below) is a direct result of this investigative journalism.
Financial Crimes Enforcement Network
The Financial Crimes Enforcement Network (FinCEN), an arm of the Treasury Department, is in the process of expanding its money-laundering regulations to encompass the entire U.S. real estate market. The legislative basis for this expansion is the Corporate Transparency Act of 2019 which authorized FinCEN to implement rules and regulations in this area.
FinCEN’s purpose is to crack down on anonymous or opaque shell companies used by money launderers, terrorists, and criminals to invest in real estate. In spite of this allegedly narrow focus, the new FinCEN rules will inevitably impact both investor transactions and entity formation, especially attempts by real estate investors to create a measure of anonymity by legal means. Going forward, it is easy to predict that anyone seeking to remain out of public view (i.e., not named in the real property records) will be culpable of suspicious behavior per se. Consider that for a moment. Seeking legitimate privacy in one’s business and real estate dealings by using entities that are entirely legal may soon be viewed as corruption, especially if transactions are handled in cash or by cashiers check.
FinCEN’s Rule-Making Power
FinCEN seeks to implement a “regulatory process for new real estate sector reporting requirements to curb illicit finance” (see its press release of December 6, 2021). FinCEN has proposed new rules that will restrict “the ability of illicit actors to launder criminal proceeds through the purchase of real estate [which] threatens U.S. national security and the integrity of the U.S. financial system.”
The scope and breadth of these new rules and their unprecedented intrusion into the realm of private real estate transactions previously regulated by the states is justified as a matter of national security and a way “to protect the U.S. real estate market from exploitation by criminals and corrupt officials.” The incidental (or perhaps not-so-incidental) effect, however, is to move us closer to the federalization of real estate transactions along with the near elimination of long-standing lawful means and methods for individual real estate investors to maintain privacy.
In its notice of proposed rule-making FinCEN asks “stakeholders to provide input to assist us in developing an approach that enhances transparency while minimizing the burden on business.” This begs a number of questions, but principally this one: since when is it the federal government’s role to achieve transparency in real estate transactions? And why is “transparency” now an absolute good? Are the legitimate privacy concerns of law-abiding citizens to be considered evil?
FinCEN invokes terms like corrupt and ill-gotten gains and exploitation to justify a crusade to cleanse the market of dirty money invested by bad people. Viewed objectively, however, the new FinCEN rules are a revolutionary expansion of federal power designed to enhance collection of tax revenue and further the criminalization of cash.
White House Strategy on Countering Corruption
In parallel with the proposed FinCEN regulations, the White House issued a “United States Strategy on Countering Corruption” (https://www.whitehouse.gov/wp-content/uploads/2021/12/United-States-Strategy-on-Countering-Corruption.pdf) which provides for a whole-of-government approach to opposing corruption both within the U.S. and abroad. Along with FinCEN in the Treasury Department, other anti-corruption task forces are established within the State Department, USAID, and the Commerce Department. The theme remains one of urgent national security. As the document states, “The U.S Government will continue to study the weaponization of corruption to understand its use and impacts on the United States, other democracies, and countries around the world, as well as how to thwart and build resilience against this evolving threat.” The Strategy also declares that the government will enhance enforcement of a related statute, the Foreign Corrupt Practices Act.
While corruption and money laundering are undoubtedly a social annoyance and detrimental to the economy, FinCEN’s declaration that these practices are weapons that threaten our national security is over the top. One has the impression that authors of both the White House Strategy and the new FinCEN regulations were aware that they have entered new territory in terms of the expansion of federal power. The extreme language used may be an attempt to encourage us all to accept the federalization of real estate transactions and erosion of personal privacy without a fight. Amidst the moralizing, it is worth remembering what all of this is really about: more money (tax revenue) and more power for the federal bureaucracy (FinCEN is set to receive a large funding increase which will undoubtedly feed the creation of yet more regulations). For those who have witnessed a comparable explosion of real estate-related regulation from the Consumer Financial Protection Bureau (created just a few years ago), this is alarming.
Geographic Targeting Orders (GTOs)
FinCEN’s initial foray into the real estate industry was more modest. For several years and continuing today, FinCEN has issued geographic targeting orders (authorized under the Bank Secrecy Act) in specific areas of the country where money laundering is common in the luxury residential real estate market. Current GTOs are in effect for the metropolitan areas of Boston; Chicago; Dallas-Fort Worth; Honolulu; Las Vegas; Los Angeles; Miami; New York City; San Antonio; San Diego; San Francisco; and Seattle. GTOs are supposed to be short-term in duration (up to 180 days) but as a practical matter may be extended by the agency at will. Overall, the results have been disappointing. GTOs have not had the hoped-for effect mostly because cash-laundering transactions have simply migrated to venues outside existing GTO parameters.
GTOs home in on transactions involving a corporation or LLC, especially companies formed offshore, that purchase residential properties for $300,000 or more using cash money or cashiers check. Oddly, GTOs do not currently include transactions accomplished solely by wire transfer even if the wire transfer originates from a bank in a tax haven.
A title company involved in a covered transaction must complete and submit a currency transaction report (CTR) on IRS/FinCEN form 401 along with IRS/FinCEN form 8300 if applicable (“Report of Cash Payments Over $10,000 Received in a Trade or Business”). The CTR requires disclosure of the identity of the purchaser and any beneficial owner controlling 25% or more of the entity involved. The title company must also obtain valid government-issued identification from the parties. Not surprisingly, about a third of transactions targeted by GTOs involve persons or entities that were previously the subject of suspicious activity reports.
The reality is that FinCEN’s efforts have fallen short of capturing all cash purchases of U.S. luxury properties by shell companies, particularly as offshore purchasers have begun to shift into commercial properties in smaller cities and towns. The local car wash or strip center could be owned (indirectly) by a genocidal African dictator and the locals would never know.
In its Notice of Proposed Rulemaking, FinCEN states its intention to expand enforcement beyond the limits of present GTOs:
Money laundering vulnerabilities exist throughout the United States real estate market. These vulnerabilities are not limited to any particular sector. Although in recent years FinCEN has focused its information collection efforts on non-financed purchases of residential real estate by shell companies, FinCEN believes that other areas of the real estate market, such as commercial real estate and certain real estate purchases by natural persons, may merit regulatory coverage. For this rulemaking process, FinCEN is considering how best to focus its regulatory attention on [both] residential and commercial real estate transactions.
As mentioned, wire transfer transactions are not subject to GTOs. There are other loopholes. For instance, what if a title company is not utilized as an escrow agent to close the transaction? There is no FinCEN form 8300 generated or filed. It is a matter of great frustration to FinCEN that the United States is still considered to be the land of opportunity when it comes to laundering cash using real estate.
Beneficial Ownership Rules and Entity Formation
Beginning in 2022, and without any geographical limits except the borders of the United States, FinCEN will require all new registered entities (LLCs and corporations, both domestic and foreign) to disclose personal information as to the “beneficial owners” of the entity, defined as any individual who directly or indirectly exercises substantial control over an entity or owns at least a 25% interest. Previously this was only a third-party reporting requirement for banks and title companies. The new rule requires self-reporting by everyone who forms a corporation or LLC in any American state, which is a huge change.
FinCEN’s customer due diligence (CDD) final rule states that covered financial institutions (e.g., banks and title companies) must: identify and verify the identity of customers; identify the beneficial owners of companies opening accounts; understand the nature and purpose of customer relationships to develop customer risk profiles; conduct ongoing monitoring to identify and report suspicious transactions; and, on a risk basis, to maintain and update customer information. With respect to the requirement to obtain beneficial ownership information, financial institutions will have to verify the identity of any individual who owns 25 percent or more of a legal entity or exercise substantial control over it.
The new reporting and enforcement regime significantly expands federal power into the area of state-chartered entities, giving the entity-formation process a distinct federal component. Everyone who forms a new LLC for real estate investment purposes will be affected by this federal crusade for transparency. This is unprecedented.
New Federal Database
Information collected pursuant to FinCEN reporting will be held in a (supposedly) non-public federal database available only to government agencies including law enforcement—which is to say that huge chunks of data will inevitably be leaked, hacked, or otherwise find their way into both the public domain and the hands of foreign intelligence services (think China).
Treasury Secretary Janet Yellen calls all of this a “dramatic step forward” in achieving beneficial ownership transparency in the case of “malign” actors and entities participating in real estate transactions. Such is the righteous tone and tenor of the new reporting and enforcement regime.
Persons Required to Investigate and Report
Part of the agency rule-making process is to invite public comment. FinCEN states that it “seeks comment on the approach that would most effectively address money laundering concerns and minimize burdens for persons involved in non-financed [cash] real estate transactions. FinCEN also solicits comments on whether and how to assign a reporting requirement to any or all of the following entities: title insurance companies, title or escrow companies, real estate agents or brokers, real estate attorneys or law firms, settlement or closing agents, as well as other entities . . . required to collect information, maintain records, and report information regarding non-financed purchases of real estate. . . . .” Expanding the list of persons required to report is an unwelcome trend. As any white-collar criminal attorney will tell you, charges of being a co-conspirator for failing to report will come next. Another likely effect of this trend will be the near criminalization of cash transactions in real estate, particularly if the cash originates abroad.
Banks and title companies already have compliance staff dedicated to meeting regulatory requirements, often referred to as BSA/AML (Bank Secrecy Act/Anti-Money Laundering) compliance officers. Since 2017, FinCEN has requested that these institutions file suspicious activity reports (SARS) in any transaction that lacks economic sense or has no apparent lawful business purpose; where a purchase or sale generates little to no revenue or is conducted without regard to high fees or penalties; involves the purchase of real estate without regard for the property’s condition, location, assessed value, or sale price; involves funding that far exceeds the purchaser’s wealth, comes from an unknown origin, or is derived from unconnected individuals or companies; is conducted in an irregular manner; or includes a request by the participants to alter records (pertaining to assessed value, for instance).
What FinCEN and the White House Strategy document now propose is a significant expansion of this compliance regime. The Strategy asserts that “various service providers, incorporators, and others [termed key ‘gatekeepers’] willing to be hired as registered agents or who act as nominees” as well as anyone who assists in creating “opaque corporate vehicles” should be compelled to perform pre-engagement due diligence on their clients. This would include investigating their incomes and the origin of any cash funds. The presence of “corrupt actors” would be need to be reported to the authorities by means of SARS.
FinCEN wants to require lawyers, real estate agents, and even small businesses to file reports of suspicious activity. Essentially, FinCEN’s goal is to deputize non-institutional gatekeepers who will now bear the burden of meeting due diligence and reporting requirements that were previously unheard of—all potentially on pain of being federally prosecuted as accomplices or co-conspirators.
For attorneys, this is particularly odious. Snitching on “suspicious” clients (meaning anyone buying real estate with cash or cashiers check) not only violates the attorney-client privilege but is contrary to historical norms and core ethics of the profession. In certain cases, it would also be a violation of the sixth amendment right to counsel. Anyone concerned with preservation of individual civil liberties should be justifiably worried and, going forward, extremely careful when buying and selling real property.
FinCEN Rules Applicable to LLCs and Corporations
There will now be a distinctly federal component to entity formation, an area that has long been the preserve of the states. FinCEN’s notice of proposed rule-making declares that companies formed both in the U.S. and abroad will be designated as “reporting companies,” meaning that they will now have reporting obligations. The “ultimate goal of this regulatory proposal is to combat, to the broadest extent possible, the proliferation of anonymous shell companies that facilitate the flow and sheltering of illicit money in the United States.”
In its NPRM of December of 2021, FinCEN claims that new reporting rules will “help stop bad actors from using legal entities to hide illicit funds behind anonymous shell companies or other opaque corporate structures.” What will inevitably occur, however, is that certain legal structures will become synonymous with bad actors. So . . . even if a structure is legal, if a bad actor uses it, does it then become illegal? Does the attorney who formed the legal structure for the client become a co-conspirator?
FinCEN’s new reporting rules are a significant step beyond existing reporting requirements now imposed on title companies and banks. Even small-business LLCs and single-member corporations will be expected to self-report key information including the names and addresses of persons who have substantial control or any beneficial owner who owns or controls 25% or more of a reporting company.
There is a window to file these Beneficial Owner Information Reports (“BOIs”). Reporting companies, domestic and foreign, created before the effective date of the final FinCEN regulation are also required to act. They will have a year to file their initial reports. Reporting companies formed afterwards will have 14 days to file. But it doesn’t end there—FinCEN will expect updates as time goes on and circumstances change, within 30 days of the change, all of which will go into its database.
The initial phase of FinCEN regulation will be finalized in 2022, so these requirements are indeed upon us. FinCEN states: “Once finalized, these proposed regulations will affect a large number of entities doing business in the United States,” an understatement if there ever was one.
FinCEN’s rules are likely to expand in number and scope over time. FinCEN has said as much. Needless to say, achieving and maintaining anonymity in entity structuring becomes a more challenging project in this environment. As for penalties for non-compliance, don’t ask. They are predictably awful for anyone who provides or attempts to provide false or fraudulent information. Failure to act is also a violation.
The practice of civil forfeiture by law enforcement, often accomplished without charges or suit ever being filed, is already out of control in the United States. Confiscating cash, vehicles, guns, and houses from “suspects” is the main financial lifeline for many police and sheriffs’ departments across the country. These practices clearly violate the 14th Amendment due-process clause, but to their shame, American courts have looked away.
Expect FinCEN to take civil forfeiture to the next level. 18 U.S.C. Section 981 allows the U.S. Treasury to seize any property, real or personal, involved in a transaction involving money-laundering. In its NPRM, FinCEN literally boasts of the prospects, declaring that previous forfeitures have yielded “luxury properties in New York City, Los Angeles, Beverly Hills, and London, mostly titled in the name of shell companies, as well as paintings by Van Gogh, Money, Picasso, a yacht, several items of extravagant jewelry, and numerous other items of personal property.” A theme is apparent. In your hands, these things are extravagant. By transferring them to the government, the result is justice—even if the (former) owner is never accused or convicted of a crime.
Impact of the New FinCEN Rules on Attorneys
This part of the new FinCEN rules is worrisome for lawyers who form LLCs and other state-chartered entities for their clients. FinCEN says that a “company applicant” is anyone who directs or controls the filing of entity-formation documents, whether for oneself or for another. This is true whether or not the company applicant has any control over or beneficial interest in the entity. So will business lawyers now be considered to be company applicants? A widespread current practice is for lawyers to sign LLC formation documents for their clients as “organizer,” a state-law term that is substantially identical to “company applicant” as used by FinCEN. There has previously been no downside for lawyers who do this. In fact, most clients expect their lawyers to sign these documents as a matter of routine. Going forward, however, lawyers may take a hard look at this practice and—in order to avoid liability as the company applicant—ask clients to sign their own certificates of formation.
Standards promulgated by the American Bar Association (ABA Opinion 491) require a lawyer to decline representation of a client “where facts known to the lawyer establish a high probability that a client seeks to use the lawyer’s services for criminal or fraudulent activity.” Most lawyers already know this and willingly comply. The risk is that a “should-have-known standard” will in the future be applied to attorneys with no direct knowledge of the source of their clients’ money. Will lawyers now have to implement the kind of know-your-customer rules that banks impose upon new depositors? Will law firms be required to have an anti-money-laundering compliance officer on staff? Will they be required to file SARS that could harm the interests of their clients? Will attorney offices fear raids by the feds to inspect their files for FinCEN compliance? Under the new FinCEN rules, the answer to all of these questions may be a disturbing yes.
The Proposed “Enablers Act”
Not yet law as of this writing, the Enablers Act is a bipartisan measure introduced in the House of Representatives as a response to the Pandora Papers. It would amend the Bank Secrecy Act’s definition of financial institutions to add: (1) investment advisors; (2) art and antiquities dealers; (3) attorneys and notaries involved in financial activity or related administrative activity on behalf of another person (e.g., a client); (4) a trust company or service provider including persons who assist in forming business entities or providing such entities with a registered office or address (this clearly includes business and corporate attorneys and anyone acting as a registered agent); (5) CPAs; (6) public relations firms; and (7) third-party payment services, including payment processors, check consolidators, and cash vault service providers.
The proposed law would impose due diligence “know your customer” obligations and other compliance requirements on “gatekeepers” which would include establishing BSA/AML compliance programs and filing of SARS in suspicious cases.
If passed, the Enablers Act will forever change the life of an individual real estate practitioner. Every professional involved in real estate transactions, likely including real estate investors, would be made unofficial agents of federal law enforcement. This profound shift would be carried out in the name of achieving transparent and open markets worldwide. Problem, in business (as in diplomacy) not everyone wants the details of their transactions to be public. Legitimate concerns as to confidentiality in real estate transactions (supported by centuries of legal precedent) would go by the wayside.
States Pushing Back Against Transparency
Certain U.S. states (Delaware, South Dakota, Wyoming, and Nevada among others), are resisting the trend toward increased regulation and transparency by re-writing their trust and judgment-execution laws. South Dakota is now probably the leader in the effort to solicit the importation of world cash regardless of origin, having brought billions in deposits to the state in recent years.
There are several reasons for South Dakota’s lead in asset protection: first, there are no income or death taxes, a prerequisite for a state to become an asset protection haven; second, there is only a two-year “lookback” (statute of limitations) for fraudulent conveyances rather than the usual four or more; third, the rule against perpetuities (a limitation on generational trusts) has been abolished and trusts established in South Dakota can now be perpetual; fourth, trusts in South Dakota can be self-settled, which means that one can be both a trustor/grantor/settlor and a beneficiary of the trust.
In South Dakota one can put your money into a trust and direct its management for one’s own benefit. In Texas, which adheres to the common law doctrine of merger when it comes to trusts, this arrangement would fail because it would not be considered a trust at all. It would be viewed as the equivalent of fee-simple ownership.
Most revolutionary of all, South Dakota declares that a trust beneficial interest is not personal property (S.D. Codified Laws Sec. 55-1-43). The result is an extraordinary level of protection for cash that is held in a South Dakota trust. The word “extraordinary” is justified here because cash is always the hardest item to protect in any asset protection regime. But in South Dakota, as long as funds were not transferred into the trust with the intent to hinder, delay, or defraud creditors (or even if they were but more than two years has elapsed), cash assets in a trust are unreachable by a judgment creditor. This is a departure from common law and prevailing statutory law across the U.S. No wonder this tiny state is a bright spot on the international map of asset protection havens.
FinCEN and Trusts
FinCEN’s beneficial ownership rules apply broadly to individuals and legal entities such as LLCs, corporations, limited partnerships, and the like. As FinCEN’s reach expands, what will be its attitude toward trusts? Will FinCEN require trusts engaged in real estate transactions to make public disclosure of the identity of their principals?
Trusts do not fall within the category of registered entities such as LLCs or corporations. A trust agreement is a private document that need not be filed or recorded anywhere. Trusts, including those that hold real estate, have traditionally enjoyed a high degree of confidentiality.
Law professors will tell you that a trust is not a legal entity at all, registered or otherwise, nor is it a person. A trust is a contractual arrangement between a trustor, a trustee, and a beneficiary. One must concede, however, that in practice trusts often act like legal entities. They buy and sell real estate; they have bank accounts; they sue and get sued. A trust can obtain an EIN number and file its own tax return. Trusts can also embed themselves within an LLC and act as member and manager, a common anonymity device.
Under present FinCEN rules, a trust must be reported as a beneficial owner if it exercises substantial control or own 25% or more of a registered entity such as an LLC. But what if FinCEN decides to take this a step further and require disclosure of the identity of the principals behind the trust? Applying transparency rules to trusts would be a logical extension of the regulation of legal entities. It is reasonable to expect that momentum behind expansion of FinCEN’s penetration of the real estate industry may eventually bring the hidden details behind trusts within its purview. When that happens, anonymity jurisdictions like South Dakota may lose some of their asset protection appeal.
Money Laundering with Crypto Currency
A discussion of money laundering would not be complete without mentioning the rising role of crypto currency. Chainalysis, a crypto consulting and compliance firm, estimates that nearly $9 billion dollars was laundered last year using crypto. In the case of the Spartan Protocol hack in 2021, hackers found a vulnerability in the sparta code (a flawed liquidity-share calculation in the smart contract code) and utilized it to steal $30 million in sparta tokens. These tokens were then moved into etherium and bitcoin and finally into Tornado Cash, a process known as “chain hopping.”
Funds that are laundered in this manner are then ready to invest in real estate, where no rules regulate how consideration is tendered. If a seller of property is willing to accept it, then crypto is as good as cash.
In the world of “DeFi” (decentralized, blockchain-based finance) there is no central institution (a bank or regulatory authority) to monitor transactions for fraud; and once money is moved, whether for legitimate or illegitimate purposes, there is no reversing the process even if the funds can be traced through a multi-layered laundering process that may involve international shell entities. In most such cases, as a practical matter, the money is simply gone.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.
Copyright © 2023 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.