Effective Source of Funds and Wealth Checks: A Practical Guide for Hong Kong Law Firms

Introduction

Navigating anti-money laundering and counter-terrorist financing (AML/CFT) laws and regulations can be daunting for Hong Kong law firms, particularly when verifying the Source of Funds (SoF) and Source of Wealth (SoW) of clients. Under the Practice Direction P and the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615 of the laws of Hong Kong)(AMLO), SoF and SoW checks are mandatory for certain activities and high-risk clients.

This guide offers practical guidance for Hong Kong law firms on establishing a robust framework to verify SoF and SoW. Effective SoF and SoW checks require balancing between implementing a robust AML/CFT process to mitigate client risks, and adopting a flexible and risk-based approach tailored to each client’s profile and specific circumstances.

Do legal professionals have to verify source of funds for every transaction and source of wealth for every client?

There is no strict requirement under the AMLO and the Practice Direction P to verify the SoF for every transaction and SoW for every client. However, SoF and SoW checks are integral to the client due diligence (CDD) and enhanced client due Diligence (EDD) processes for law firms. These checks enable law firms to identify potential money laundering and terrorist financing (ML/TF) risks by assessing the client’s background and financial history.

Legal Framework for Hong Kong Law Firms 

In Hong Kong, the key requirements relating to SoF and SoW for legal professionals are found in the AMLO and the Practice Direction P. Legal professionals as designated non-financial businesses and professions (DNFBPs), must conduct SoF checks and/or SoW checks in the following situations:

1. “Applicable Circumstances” (Paragraph 120.3 and Annexure 3 of the Practice Direction P) – Legal professionals must obtain information on the SoF of the client when acting for a new or existing client in any of the following activities:
2. • financial transactions (e.g., buying and selling of real estate, business, company, securities and other assets and properties);
   • managing client money, securities, or assets;
   • managing of bank, savings, or securities accounts;
   • formation, re-organisation, operation, or management of companies, entities or legal arrangements;
   • insolvency cases or tax advice; or
   • other transactions involving custody of funds (e.g. as stakeholder or escrow agent or fund transfers through bank accounts.
2. High risk clients requiring EDD (Paragraph 122.2 and Annexure 3 of the Practice Direction P and Schedule 2 of Part 2 of the AMLO) - Law firms must verify the SoF and SoW of the client and its beneficial owners in the following high risk situations:
3. • transactions that are unusually large, complex, exhibit unusual patterns, or lack an apparent economic or lawful purpose;
   • the client and/or the beneficial owners who are considered “high risks” based on factors such as client risk, country risk, service risk, transaction and delivery channel risks as set out in paragraph 121 of the Practice Direction P; and
   • the client and/or the beneficial owners who are from or in non-cooperative countries identified by the Financial Action Task Force (FATF) or other jurisdictions known to have insufficiently complied with FATF Recommendations.
3. Client or beneficial owner of the client who is a non-Hong Kong and other high-risk politically exposed person (PEPs) (Paragraph 124 of the Practice Direction P and Schedule 2 of Part 2 of the AMLO)

For non-Hong Kong PEPs, legal professionals must conduct enhanced investigations into the client’s SoF and SoW.

For Hong Kong PEP or the international organisation PEP, legal professionals must conduct a risk assessment to determine whether they present a high ML/TF risk. Verification of SoF and SoW is required only if the Hong Kong PEP or international organisation PEP is assessed as high-risk for ML/TF.

Practical Guidance for establishing SoF and SoW of the clients

There is no standardised SoF and SoW procedure for every client in a law firm. Legal professionals should use a risk-based approach, implementing reasonable measures tailored to the client’s ML/TF risk profile. These measures should be proportionate and necessary, avoiding excessive demands such as requesting decades of financial records from every client. Legal professionals should also note that verifying SoW of the client is only one of the several possible EDD measures for “high risk” clients but it is not mandatory for every high-risk scenario.

Here are some practical guidance on how Hong Kong law firms may approach the verification of SoF and SoW of clients:

1. Implement a risk-based approach and set clear internal policies for high risk clients and transactions

Law firms should adopt a risk-based approach to design a robust procedure for their SoF and SoW checks tailored to the client’s risk profile and circumstances. In their AML policies, law firms should outline the acceptable proof for SoF and SoW for each category of high risk clients and transactions. Below are some examples which would require a higher level of CDD:

• Client Type: PEPs or clients from high risk jurisdictions;
• Transaction Nature: Conveyancing, corporate acquisitions or transactions involving large cash payments or funds from unknown sources; or
• Jurisdictional Risks: Transactions involving countries with weak AML controls.

2. Thorough Documentation and Record Keeping for Complete Audit Trial 

Effective SoF and SoW checks rely on thorough documentation during the CDD process. The type of document required for SoF and SoW checks can vary depending on the risk level of the transaction and the client. Typical acceptable documentation for establishing SoF and SoW of a client include bank statements, pay slips, employment contracts, recent tax returns, loan agreements and proof of sale for acquired assets. These documents help the law firms better understand the client’s financial situation and detect suspicious transactions or clients with high ML/TF risks.

Law firms should always document all supporting documents received for SoF and SoW checks. Detailed records of SoF and SoW checks help firms defend against potential regulatory scrutiny and demonstrate robust compliance practice in future regulatory reviews.

3. Tailored Enquiries and Corroboration

Typical CDD process enables law firms to determine whether the SoF and SoW are consistent with the client’s risk profile and the nature of the transaction. Subject to the risk assessment on the client, legal professionals should consider making tailored enquiries and collecting additional supporting documents for clients or transactions that pose a higher ML/TF risk. This may include obtaining further documentation to better understand  the client’s background, ownership and financial situation, as well as that of other parties to the transaction, to ensure the transaction is consistent with the purpose and intended nature of the business relationship.

As a matter of good practice, law firms should adopt a risk-based approach to determine whether to corroborate the information and documents provided by clients with data from other reliable sources. Legal professionals should verify whether the SoF and SoW information is consistent with reliable, independent third-party or publicly available information, such as the public records that can be found in official registries.

In certain situations, clients may be hesitant to share detailed financial information due to privacy concerns. It is important for law firms to educate their clients and explain why SoF and SoW checks are necessary to comply with the requirements under AML laws and regulations. Legal professionals should explain to their clients that law firms are legally required to obtain specific information, including but not limited to, information about their financial details, for certain types of legal instructions.

Lastly, thorough documentation of client enquiries and client responses is essential for compliance and audit purposes. Well-documented communications between the law firm and the client not only protect the firm but enable colleagues who access the file to quickly understand the background and financial information of the client, including SoF and SoW.

4. Provide training to staff and promote a culture of compliance

Every staff member in a law firm plays a critical role in ensuring compliance with the AML laws and regulations. Firm-wide training in the area of AML/CFT, particularly on identifying red flags when establishing SoF and SoW of the clients, is absolutely crucial. From receptionists to administrative staff and fee earners, each of them should undergo thorough AML/CFT training. Law firms should establish a systematic procedure for staff to report clients or transactions suspected of ML/TF. A robust CDD process should be implemented from the outset of client onboarding, with thorough checks and ongoing monitoring conducted throughout the transaction process. If uncertainty or suspicion arises, staff should be proactive and promptly escalate the matter to the law firm’s senior management.

Conclusion

Robust SoF and SoW checks are essential for Hong Kong law firms to comply with the regulatory framework in Hong Kong. There is no “one rule fits all” advice when it comes to SoF and SoW. Law firms are advised to adopt a risk-based approach and implement internal policies and systems for SoF and SoW tailored to their clients’ risk profiles and the nature of the transactions involved. 

It is never easy to initiate discussions or requests with your valued clients to establish their SoF and SoW. Nevertheless, legal professionals should aim to strike the right balance between thorough verification and maintaining a positive client experience. Legal professionals must remain vigilant against financial crimes and ensure compliance with the AML/CFT regulatory requirements to avoid the serious consequences of non-compliance, including reputational damage, fines, and criminal liabilities. Overcoming these challenges in the area of SoF and SOW requires a combination of legal expertise, a well-structured risk-based approach, and the right tools to streamline the CDD process.

Sources:

• Practice Direction P issued by the Law Society of Hong Kong
• Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO) (Cap. 615)

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