Collaborative Gatekeepers

Stavros Gadinis is an Assistant Professor of Law at the University of California, Berkeley Law School. This post is based on a recent article by Professor Gadinis and Colby Mangels.

In his annual letter to shareholders for 2014, Jamie Dimon, J.P. Morgan’s CEO, made an astonishing revelation. That year alone, his firm hired 8,000 new employees just to improve its compliance with anti-money laundering laws. J.P. Morgan’s recruitment zeal stemmed from a $2.6 billion penalty for anti-money laundering violations, due to its failure to spot Madoff’s ponzi scheme. This was hardly an isolated case: anti-money laundering laws have played a central part in four out of the eight biggest fines in the wake of the financial crisis, becoming a key legal basis in the quest to hold banks accountable. The newfound prominence of the anti-money laundering framework is striking. These laws target drug cartels and terrorists, the criminal periphery of the financial system rather than its core weaknesses. But since 2007, the anti-money laundering framework has evolved into a critical detection and enforcement mechanism for regulators, and a key priority for private industry compliance. So far, there is little in the legal literature that could explain this puzzling shift towards the anti-money laundering toolkit.

Our article, Collaborative Gatekeepers, argues that regulators have turned to anti-money laundering because of distinct features that set it apart from other common bases of financial misconduct, such as the anti-fraud provisions of the federal securities laws. Most financial laws require financial institutions to identify misbehaving clients, imposing heavy liability when they knowingly or negligently fail to shut them out of the financial system. We argue that this liability threshold produces a perverse effect: market players are very careful to ensure that they never reach such knowledge or negligence. Instead of looking for signals of underlying fraud and investigating indications, our laws incentivize market players to turn a blind eye.

In contrast, anti-money laundering laws require private industry to share with authorities suspicions of misconduct, even when these pieces of information fall far short of proving illegality. This reporting obligation, we argue, can help financial intermediaries overcome conflicts of interest and motivates them to organize more effective compliance operations. In this Article, we explore this approach as a template for other areas of financial regulation. We develop a theoretical framework that explains the advantages of our proposed model, explore its history and application in anti-money laundering law, and discuss how it could operate in other fields.

Imagine requiring gatekeepers to report not positive knowledge, but suspicions of illegality. In their dealings with clients, gatekeepers may come to realize that there are gaps in a client’s rationale for pursuing a transaction, or that the information the client provides does not add up. Alternatively, a client’s conduct might be very unusual, or have much in common with past instances of client fraud. Such indications of potential illegality are information that gatekeepers can collect and pass on to authorities. In return, regulators could guarantee the anonymity of the report, so as not to disrupt the gatekeeper-client relationship should the transaction turn out to be legitimate.

Setting the reporting threshold at the level of suspicions, rather than knowledge, can radically change gatekeepers’ incentives and improve the effectiveness of regulatory interventions. Suspicions are bound to arise at a much earlier stage in the gatekeeper-client relationship, when the resources invested in building this relationship are lower, and the bond of loyalty between the two parties is not as strong. Some client proposals may trigger suspicions even before gatekeepers actually start offering any services. Consequently, the conflicts of interest that gatekeepers are likely to face will be weaker. Moreover, regulators may be able to combine multiple reports on a single client or transaction and take preventive actions even if each gatekeeper has come to know only part of the client’s activities or dealings. Because of the close interactions between gatekeepers and regulators, we term this approach “collaborative gatekeeping.”

While these arguments underscore the theoretical appeal of the model, there might be doubts as to its workability. One set of worries might focus on the political economy of financial regulation. Private industry might choose to oppose the expansion of its regulatory obligations and the additional effort and resources it entails. Another set of questions might concern the promised informational upside. The financial industry might choose to stick with client loyalty and refuse to embrace suspicious activity reporting. Or, in the exact opposite scenario, finance professionals might flood regulators with reports about clients’ activities, providing incomplete information about countless cases that authorities could not possibly analyze or pursue any further.

We can shed some light on these concerns by looking at anti-money laundering law, which, due to a historical happenstance, follows closely the theoretical model outlined above. While the conventional gatekeeper model is deeply embedded in U.S. law, the anti-money laundering regime has its origins in 1970’s Switzerland, from where it spread around the world, including to the U.S. Taking advantage of archival materials released publicly from the Swiss central bank for the first time after 40 years, the Article brings to light the motivations of the regime’s inspirers and the contributions of key players, such as financial institutions and industry associations.

A unique constellation of enforcement bodies and market players have seen the value of intelligence gathered through the anti-money laundering regime and launched large-scale collaborations aided by cutting-edge technology. In the last few years, over 1.5 million suspicious activity reports have reached the Treasury Department annually. Institutions across the financial industry have espoused suspicious activity reporting, from banks to brokerages to wire services, from big financial powerhouses to small community ventures, from urban centers to rural areas. To fulfill their obligations, private firms have revolutionized their compliance operations and introduced digitalized systems using “bid data” approaches. All this private industry activity shows how the collaborative model can effectively change market-wide attitudes. In turn, these reports have helped regulators pursue a wide range of financial and criminal misconduct beyond money laundering, including tax evasion, mortgage fraud, and insider trading. Financial regulators such as the Federal Reserve and the SEC, as well as government agencies such as the IRS and the Department of Justice, have expanded their oversight operations to better take advantage of gathered intelligence. Over one hundred review teams from these agencies pore over the reports in weekly or monthly meetings, while the Treasury also operates a central database that is open to hundreds of local and state authorities.

The full article is available here.

Both comments and trackbacks are currently closed.