Understanding Money Laundering

Introduction
The prevention of money laundering is a hot topic with Congress, the SEC, and self-regulatory organizations (SROs) such as the National Association of Securities Dealers (NASD) and New York Stock Exchange (NYSE). Originally the domain of organized crime, the so-called “war on drugs” brought the problem of money laundering to prominence in the US media. Subsequently, the so-called “war on terror” renewed the interest of the American media in money laundering. We are inundated with money laundering, but most people can’t even agree on the definition. Past the definition, the mechanics of money laundering remain mysterious. Do we really know anything about how to do it?
This case study will help you improve your knowledge of money laundering – by understanding how to do it. While this case is not intended to be a “how to” manual – though it may look that way – it will walk you through the steps of moving funds from a US individual to an offshore entity, and back to a US individual. The purpose of this study is to show just how easy money laundering can be.
About Money Laundering
Money laundering is the concealment of the source and destination of funds in order to use it for a criminal purpose. Hiding money, in itself, is not illegal. What makes the act of hiding money become the crime “money laundering” involves how the hidden funds are used. Essentially, the result must be a crime. Common money laundering crimes include tax evasion, financial statement fraud, and the smuggling of contraband (such as weapons or drugs).
While drug smuggling and terror get the most press in relation to money laundering, the most common crime involved in money laundering is tax evasion. Drugs and terror are only a small percentage of money laundering crimes compared to tax evasion. Quite simply, wealthy people just don’t like to pay taxes; money laundering helps them avoid this problem.
Money laundering consists of three steps :
• Placement
• Layering
• Integration
Placement involves the “process of placing, through deposits or other means, unlawful cash proceeds into traditional financial institutions.” By depositing funds into legitimate financial institutions, using existing financial products (such as mutual funds, equities, and travelers’ checks and maintaining an awareness of federally mandated thresholds for reporting cash transactions, terrorists can place illicit funds into the legitimate economy. Examples of “placement” include the purchase of travelers’ checks using cash and depositing funds into a bank account in small, irregular amounts.
Layering entails the “process of separating proceeds from illegal criminal activity from their origin through the use of complex financial transactions.” Money launderers use a variety of financial vehicles to “convert cash into traveler’s checks, money orders, wire transfers, letters of credit . . . or purchasing valuable assets, such as art or jewelry.” Through layering, terrorists infuse illicit cash into the legal economy by structuring (this term is defined below) the purchase of money orders, travelers’ checks, and other financial instruments in a variety of permutations. Individuals engaged in layering use these financial products through a number of transactions in order to conceal the source of the illicit funds.
Integration is the “process of using an apparently legitimate transaction to disguise the illicit proceeds, allowing the laundered funds to be disbursed back to the criminal.” Consider integration the “output” component of money laundering schemes. Placement and layering involve ways to insert illicit funds into the legitimate economy. Integration is a way for the recipient to get those funds back through a legitimate source. To affect a disbursement back to the criminal, commonly used tools include “sham loans” and “false import/export invoices”.
Money launderers use their knowledge of existing regulations, legislation, and reporting requirements to avoid the monitoring controls of regulatory bodies. One way is called “structuring”. Structuring involves inserting money into the legal economy in ways that do not trigger alerts within the existing regulatory framework. For example, federal regulations require reporting of cash transactions of $10,000 or more. To structure deposits, for example, one could use deposits of irregular amounts – each less than $10,000 – to deposit funds into a legitimate financial account.
Structuring brings a second problem, called “sequencing”. Sequencing involves using a number of transactions to or from the same source immediately following one another. These numerically sequential transactions typically indicate the structuring of transactions to bypass money laundering controls. To overcome traditional sequencing controls, money launderers can spread transactions over time and institutions to ensure that structured deposits are out of sequence. Bypassing structuring and sequencing controls makes customer identification and verification controls even more important.
One can use a variety of financial products to launder money. Depending on specific money laundering goals, the following products can be useful:
• Cash value insurance policies and annuities – to make funds available quickly with a check from a financial institution to facilitate a deposit at a new institution
• Diamonds and precious metals – purchase these products overseas, import them, and sell them in the US for cash
• Money orders – cash equivalent that is difficult to track, particularly useful for paying bills with cash that has been laundered
• Travelers’ checks – similar to money orders
In order to provide context for the process of money laundering – i.e. placement, layering, and integration, an actual case is essential. Otherwise, these concepts appear to be disjointed activities that can be considered in conjunction with discrete financial products. How does this process really work?
Case Background
Purpose and Goals
The purpose of this case is to demonstrate how new income and existing assets can be concealed in offshore accounts and repatriated on an as needed basis in a manner that does not attract the attention of the authorities. While held offshore, the concealed funds will be invested in a variety of ventures that are intended to generate returns.
Key Players
1. Company A: US-based hedge fund
2. Company B: Cyprus-based private equity fund
3. Fund Manager X: Investment manager of both funds
4. Investors: Invest in both Company A and Company B to generate returns
5. New Ventures (receiving investments): receive investments from Company B to initiate operations and facilitate growth
Company A
Company A is a US-based hedge fund that operates in a manner completely consistent with hedge funds based in the United States. Company A is managed by Fund Manager X for the purpose of generating returns for investors in the hedge fund. The hedge fund is structured as a limited partnership, in which a management company (that owns both Company A and Company B) is the general partner. Company has a consulting relationship with Company B. Company A engages Company B for research services, and Company A invests in the ventures identified by Company B.
Company B
Company B is a Cyprus-based private equity fund which exists for the purpose of infusing capital into startup ventures. Investments in these new ventures are intended to generate returns over a medium to long period of time (generally more than three years). Additionally, Company B is the mechanism that will be used to show a legitimate business purpose in moving funds to an offshore entity.
Mr. X
Mr. X is the investment manager of both Company A and Company B. Additionally, Mr. X is the individual that wants to launder money through Company B and repatriate it into the US.
Investors
Investors represent the legitimate business purpose for both Company A and Company B. Investors in the US and Europe participate in Company A as a US-based investment. For Company B, European investors participate in a Cypriot fund, and US investors participate in a Delaware-based fund.
New Ventures
New ventures receive investment from Company B, and these new ventures provide the justification for Cypriot operations.
Business and Cash Flow Relationships
The relationships among the entities described above constitute a web of payments between investors, investment entities, and investment managers. Within this web of payments, Company B represents the vehicle by which funds are repatriated into the United States. Between the Company B and the investment manager, the funds flow only from the private equity fund to the investment manager in the form of management fees and services fees (billed on an “as consumed” basis). Funds enter Company B from individual investors, new ventures (in the form of fees for raising funds and from Company A (in the form of fees for research services).
Mr. X invests personal funds in Company A, alongside funds from investors. Through Company A, Mr. X manages his own funds and client funds. For these services, the investment manager receives a fee. Personal funds and fees collected need to be repatriated. Company A can retain and invest Mr. X’s fees for investment manager or invest (or pay) these funds to Company B to facilitate repatriation.
Company A and Company B have a bi-directional cash flow relationship. Company B reserves the right to invest in the hedge fund or new ventures at the discretion of the investment manager. To facilitate the laundering of funds, Company A pays a research fee to Company B. To make this most effective, Company A and Company B must have a contract in place for research services. An actual exchange of funds for legitimate research services must exist. Further, materials must exist to show that this relationship occurs. Against the backdrop of this relationship, additional fees can be sent from the investment manager’s account in Company A to Company B, left in Company B as cash, and repatriated through the investment manager’s personal foreign account as needed.
To survive an auditor’s scrutiny (not an IRS audit the foreign fund in Company B must keep a cash position to represent the collection and retention of fees for the investment manager’s services segregated. These fees can then be transferred to the investment manager’s personal foreign account without disrupting the legitimate investments of Company B’s investors, as well as the operations of the new ventures in which Company B invests. Company B’s cash position policy must be liberal and allow for significant cash positions. Liquidity of part of the fund makes the transfer and integration of funds easier for Mr. X.
Repatriation of funds must be affected carefully. It starts with the liquidation of the investment manager’s personal stake in Company B. The liquidation of these units yields cash. This is why Mr. X need to keep a significant cash position in the fund. With cash available, Mr. X can liquidate units and begin the repatriation process without disrupting Company B’s legitimate investment activities. Cash from the liquidation of units is paid to a personal offshore account to facilitate repatriation. Repatriation through traditional means (especially wire) is tricky. Wires over $3,000 are reported, and anything that hits a US bank account is reported to the IRS.
Repatriation: Patterns and Structuring
The two most menacing concerns pertaining to the repatriation of funds from Cyprus to the United States are sequencing and structuring. Structuring is a money laundering technique by which funds are integrated into the legitimate economy through multiple deposits that are used to bypass federal reporting requirements. Sequencing is the process by which money launderers avoid detection by spreading deposits over multiple branches and days in order to avoid successive sequential transaction identifiers. To be successful, integration must occur using unequal, substantially different deposit amounts and multiple financial institution branches over a period of time (such as days or weeks).
The bank in the US is the risk point in the repatriation process – in fact in the entire concealment process. Banks, like all financial institutions report to the IRS. Such filings could indicate the existence of concealed funds in the event of an audit. If audited, Mr. X needs to show that he has earned these funds. To avoid IRS scrutiny, all funds deposited into a US bank account should be identified as income, and taxes should be paid on these funds. Even when paying taxes, there is a risk in introducing funds into legitimate US financial institutions, but this risk is mitigated significantly by paying taxes on all integrated funds.
Avoiding US banks is infinitely preferable to depositing these funds into the legitimate economy via financial institutions. By using the cash repatriated from Cyprus, the money launderer evades the US reporting system completely. To accomplish this, the most effective means to repatriation entails bringing hard US currency into the US from Cyprus. Bringing euros requires the conversion of euros to USD at a financial institution in the United States – which generates a paper trail. This approach requires an individual to travel overseas to access the Cypriot funds. The risk involves getting caught with a significant amount of cash. To avoid this problem, receiving funds from the Cypriot bank in cashiers checks of unequal small amounts (all under $3,000 the cashiers checks (money orders, travelers’ checks, or other cash equivalents) can be repatriated through check-cashing facilities in the United States in amounts small enough not to attract the attention of regulators.
An alternative to importing cash is to import tangible goods that can be liquidated for cash in the United States. These goods can be purchased overseas, imported, and sold. The result is cash that can be integrated into the legitimate economy. Paying the taxes on these transactions results in the appearance of proper business activity, which facilitates the deposit the funds into a legitimate financial institution. An example involves the importing of leather goods into the United States. Using Cypriot funds, and anything that hits a US bank account is reported to the IRS.
Repatriation: Patterns and Structuring
The two most menacing concerns pertaining to the repatriation of funds from Cyprus to the United States are sequencing and structuring. Structuring is a money laundering technique by which funds are integrated into the legitimate economy through multiple deposits that are used to bypass federal reporting requirements. Sequencing is the process by which money launderers avoid detection by spreading deposits over multiple branches and days in order to avoid successive sequential transaction identifiers. To be successful, integration must occur using unequal, substantially different deposit amounts and multiple financial institution branches over a period of time (such as days or weeks).
The bank in the US is the risk point in the repatriation process – in fact in the entire concealment process. Banks, like all financial institutions report to the IRS. Such filings could indicate the existence of concealed funds in the event of an audit. If audited, Mr. X needs to show that he has earned these funds. To avoid IRS scrutiny, all funds deposited into a US bank account should be identified as income, and taxes should be paid on these funds. Even when paying taxes, there is a risk in introducing funds into legitimate US financial institutions, but this risk is mitigated significantly by paying taxes on all integrated funds.
Avoiding US banks is infinitely preferable to depositing these funds into the legitimate economy via financial institutions. By using the cash repatriated from Cyprus, the money launderer evades the US reporting system completely. To accomplish this, the most effective means to repatriation entails bringing hard US currency into the US from Cyprus. Bringing euros requires the conversion of euros to USD at a financial institution in the United States – which generates a paper trail. This approach requires an individual to travel overseas to access the Cypriot funds. The risk involves getting caught with a significant amount of cash. To avoid this problem, receiving funds from the Cypriot bank in cashiers checks of unequal small amounts (all under $3,000 the cashiers checks (money orders, travelers’ checks, or other cash equivalents) can be repatriated through check-cashing facilities in the United States in amounts small enough not to attract the attention of regulators.
An alternative to importing cash is to import tangible goods that can be liquidated for cash in the United States. These goods can be purchased overseas, imported, and sold. The result is cash that can be integrated into the legitimate economy. Paying the taxes on these transactions results in the appearance of proper business activity, which facilitates the deposit the funds into a legitimate financial institution. An example involves the importing of leather goods into the United States. Using Cypriot funds, the money launderer can purchase leather in Italy and import it into the United States using an existing, authorized leather importer. Mr. X purchases the leather in Italy. When the leather importer has brought the leather to the United States, Mr. X reclaims the revenue generated by the leather (minus his contribution to the importer’s overhead). Then, Mr. X has use of the cash in the US economy.