Federalizing Real Estate Transactions

The BSA now requires every 'financial institution' to establish an anti-money laundering program that includes the following minimal elements: 1) the development of internal policies, procedures, and controls; 2) the designation of a compliance officer; 3) an ongoing employee training program; and 4) an independent audit function to test programs. USA Patriot Act ' 352(a), 115 Stat. at 322.

The BSA's broad definition of 'financial institution' includes 'persons involved in real estate closings and settlements.' On April 10, 2003, after almost a year of delay, the Treasury Department, through its Financial Crimes Enforcement Network (FinCEN), finally issued a notice of proposed rulemaking ('Notice') for 'persons involved in real estate closings and settlements' ' the last financial institution to be defined. 68 Fed. Reg. 17571, April 10, 2003.

In its April 10, 2003 Notice, FinCEN identifies four broad issues for public comment:

• What are the money laundering risks in real estate closings and settlements?
• How should persons involved in real estate closings and settlements be defined?
• Should any persons involved in real estate closings or settlements be exempted from coverage under Section 352 of the USA Patriot Act?
• How should the anti-money laundering program requirement for persons involved in real estate closings and settlements be structured?

Observations

The Notice contains conflicting discussions on what is meant by a 'closing and settlement.' In one portion of the Notice, FinCEN defines a closing and settlement as the 'process in which the purchase price is paid to the seller and title is transferred to the buyer.' By contrast, a later portion of the Notice speaks of closings and settlements as including a vast array of real estate transactions that go far beyond a conventional purchase and sale consummated by the delivery of a signed deed. For example, the Notice points to lease agreements as being the basis of an acquired property right. By referring to lease agreements, FinCEN may be signaling that the proposed regulations may encompass not only traditional purchase and sale transactions, but also every commercial lease transaction throughout the country.

It is unclear from the Notice whether FinCEN intends to regulate those transactions involving the transfer of interests in a title holding entity as a means to acquire ownership of the underlying asset. For example, rather than conveying ownership of real property by a deed, the parties may structure the transaction as the sale of member interests in a single asset limited liability company. There are legitimate reasons for structuring transactions in this manner, but it is unclear whether such a transaction would fall within the purview of a 'real estate closing and settlement.'

If the phrase 'persons involved in real estate closings and settlements' means anything, it means the actual purchasers and sellers of the underlying real estate. The Notice, however, dismisses this notion by remarking that 'FinCEN wishes to make clear that it does not intend to cover purchasers and sellers of their own real estate ' The question of exemption is specifically directed to real estate professionals, and those who trade in real estate on a commercial basis.' This statement apparently means that FinCEN does not desire to regulate every home sale in the nation. But what is meant to 'trade in real estate on a commercial basis'? Does it include the one-time sale of a second home, the periodic leasing of a duplex owned by retirees, or the consummation of a certain number of real estate transactions within a defined time period? Does this standard mean all real estate other than a personal residence? Must one analyze the investment purpose and goal of the seller or buyer? Does 'commercial basis' include the purchase and sale of residential real estate?

It is interesting to observe that the Notice does not contemplate a threshold dollar value that would trigger the imposition of anti-money laundering program requirements. For example, an investor who buys and sells $30,000 row homes may have the same regulatory compliance obligations as a multi-billion-dollar real estate investment trust.

Of particular interest to the real estate bar is the Notice's discussion of the 'key role' often played by attorneys in real estate closings and settlements. The Notice, however, adopts an exceedingly narrow view of the attorney-client privilege. The Notice takes the position that the application of anti-money laundering program requirements on attorneys 'in connection with activities relating to real estate closings and settlements [does not raise issues of, or pose] obligations inconsistent with, the attorney-client privilege.' FinCEN arrives at this surprising conclusion by drawing a parallel to the existing BSA requirement mandating the reporting of the receipt of cash or cash equivalents in an amount over $10,000 on a Currency Transaction Report (IRS Form 8300). FinCEN believes that attorneys 'should take the basic steps contemplated by section 352 to ensure that their services are not being abused by money launderers.'

FinCEN's desire to impose anti-money laundering program requirements on attorneys runs afoul of fundamental principles of the American legal system. As noted in the report of the ABA Task Force on Gatekeeper Regulation and the Profession dated February 2003, a requirement that attorneys report activities of their clients 'would undermine the independence of the bar from the government, erode the essential trust relationship between the attorney and the client which is a bedrock of the U.S. administration of justice and rule of law, and compromise the principle of confidentiality in communications between a lawyer and the client.'

In defining 'persons involved in real estate closings and settlements' the Notice indicates that 'involvement with the actual flow of funds used to purchase the property is a significant factor.' The flow of funds is certainly germane, and FinCEN should place particular emphasis on those persons involved in real estate closings and settlements who actually 'touch the money.' For example, an attorney who directs a third-party escrow agent to release funds held in escrow should not be subject to anti-money laundering requirements, but the escrow agent through whose account the funds flow should be subject to these requirements.

It is becoming increasingly customary to conduct closings and settlements by escrow, where physical attendance of the participants is not required. For example, the parties may send all of the closing documents to an escrow agent who will close the transaction without other participants in physical attendance. The Notice touches on this growing practice (which it refers to as a 'Western-style' closing), but it does not explain whether different standards or levels of due diligence should apply to these types of closings. From a practical standpoint, this means that the closing documents are signed out of the escrow agent's presence, thereby making identification of the transaction parties more difficult. Indeed, the signatories may not even be located within the United States or the local jurisdiction.

Commercial real estate transactions often involve the use of a single asset ownership entity to hold title to a real estate asset. The person involved in the real estate closing and settlement may not know the identity of all of the members of a limited liability company or the partners of a partnership, particularly 'lower-tier' members or partners. It may be impractical to impose a burden on such a person to ferret out the identity of all of the members or partners in such an entity. The Notice does not appear to address this issue.

Finally, the cost of imposing an anti-money laundering program on real estate professionals may outweigh the benefit of such a program. The cost, both in terms of money and time, of anti-money laundering training and the cost of hiring a 'compliance officer' to audit the efficacy of the anti-money laundering program may be significant. It may be unrealistic to expect real estate professionals to steep themselves in the expansive gamut of domestic and international money laundering schemes, nuanced accounting issues, and to incur the cost of expensive and sophisticated software designed to detect money laundering.

Conclusion

The 9/11 terrorist attacks may unfortunately take yet another toll on the American economy if the Notice is transformed into a set of regulations that impose onerous anti-money laundering requirements on the real estate industry. This issue is most acute with real estate attorneys, who run the risk of breaching ethical obligations to comply with a federalized real estate regulatory regime. The requirements would also chill the attorney-client relationship with marginal benefit to the fight against money laundering. Interested parties must make their voices heard on this important issue by submitting written comments to FinCEN no later than June 9, 2003.

Kevin L. Shepherd is co-chair of the real estate department at Venable LLP, Baltimore.

Most real estate transactions are governed by state law and local custom, not federal law. But a massive federal law enacted shortly after the 9/11 terrorist attacks raises the specter that the federal government may intrude into commercial real estate transactions in ways heretofore thought unimaginable. Known as the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism ('USA Patriot Act'), the legislation has led the federal government to propose rules designed to combat money laundering and terrorist financing in these types of transactions.

Background

Title III of the USA Patriot Act amended a number of provisions of the Bank Secrecy Act (BSA). 31 U.S.C. ” 5311-5355. The International Money Laundering and Abatement and Financial Anti-Terrorism Act of 2001, Title III sought to amend the BSA to facilitate the prevention, detection, and prosecution of international money laundering and the financing of terrorism.

The BSA now requires every 'financial institution' to establish an anti-money laundering program that includes the following minimal elements: 1) the development of internal policies, procedures, and controls; 2) the designation of a compliance officer; 3) an ongoing employee training program; and 4) an independent audit function to test programs. USA Patriot Act ' 352(a), 115 Stat. at 322.

The BSA's broad definition of 'financial institution' includes 'persons involved in real estate closings and settlements.' On April 10, 2003, after almost a year of delay, the Treasury Department, through its Financial Crimes Enforcement Network (FinCEN), finally issued a notice of proposed rulemaking ('Notice') for 'persons involved in real estate closings and settlements' ' the last financial institution to be defined. 68 Fed. Reg. 17571, April 10, 2003.

In its April 10, 2003 Notice, FinCEN identifies four broad issues for public comment:

• What are the money laundering risks in real estate closings and settlements?
• How should persons involved in real estate closings and settlements be defined?
• Should any persons involved in real estate closings or settlements be exempted from coverage under Section 352 of the USA Patriot Act?
• How should the anti-money laundering program requirement for persons involved in real estate closings and settlements be structured?

Observations

The Notice contains conflicting discussions on what is meant by a 'closing and settlement.' In one portion of the Notice, FinCEN defines a closing and settlement as the 'process in which the purchase price is paid to the seller and title is transferred to the buyer.' By contrast, a later portion of the Notice speaks of closings and settlements as including a vast array of real estate transactions that go far beyond a conventional purchase and sale consummated by the delivery of a signed deed. For example, the Notice points to lease agreements as being the basis of an acquired property right. By referring to lease agreements, FinCEN may be signaling that the proposed regulations may encompass not only traditional purchase and sale transactions, but also every commercial lease transaction throughout the country.

It is unclear from the Notice whether FinCEN intends to regulate those transactions involving the transfer of interests in a title holding entity as a means to acquire ownership of the underlying asset. For example, rather than conveying ownership of real property by a deed, the parties may structure the transaction as the sale of member interests in a single asset limited liability company. There are legitimate reasons for structuring transactions in this manner, but it is unclear whether such a transaction would fall within the purview of a 'real estate closing and settlement.'

If the phrase 'persons involved in real estate closings and settlements' means anything, it means the actual purchasers and sellers of the underlying real estate. The Notice, however, dismisses this notion by remarking that 'FinCEN wishes to make clear that it does not intend to cover purchasers and sellers of their own real estate ' The question of exemption is specifically directed to real estate professionals, and those who trade in real estate on a commercial basis.' This statement apparently means that FinCEN does not desire to regulate every home sale in the nation. But what is meant to 'trade in real estate on a commercial basis'? Does it include the one-time sale of a second home, the periodic leasing of a duplex owned by retirees, or the consummation of a certain number of real estate transactions within a defined time period? Does this standard mean all real estate other than a personal residence? Must one analyze the investment purpose and goal of the seller or buyer? Does 'commercial basis' include the purchase and sale of residential real estate?

It is interesting to observe that the Notice does not contemplate a threshold dollar value that would trigger the imposition of anti-money laundering program requirements. For example, an investor who buys and sells $30,000 row homes may have the same regulatory compliance obligations as a multi-billion-dollar real estate investment trust.

Of particular interest to the real estate bar is the Notice's discussion of the 'key role' often played by attorneys in real estate closings and settlements. The Notice, however, adopts an exceedingly narrow view of the attorney-client privilege. The Notice takes the position that the application of anti-money laundering program requirements on attorneys 'in connection with activities relating to real estate closings and settlements [does not raise issues of, or pose] obligations inconsistent with, the attorney-client privilege.' FinCEN arrives at this surprising conclusion by drawing a parallel to the existing BSA requirement mandating the reporting of the receipt of cash or cash equivalents in an amount over $10,000 on a Currency Transaction Report (IRS Form 8300). FinCEN believes that attorneys 'should take the basic steps contemplated by section 352 to ensure that their services are not being abused by money launderers.'

FinCEN's desire to impose anti-money laundering program requirements on attorneys runs afoul of fundamental principles of the American legal system. As noted in the report of the ABA Task Force on Gatekeeper Regulation and the Profession dated February 2003, a requirement that attorneys report activities of their clients 'would undermine the independence of the bar from the government, erode the essential trust relationship between the attorney and the client which is a bedrock of the U.S. administration of justice and rule of law, and compromise the principle of confidentiality in communications between a lawyer and the client.'

In defining 'persons involved in real estate closings and settlements' the Notice indicates that 'involvement with the actual flow of funds used to purchase the property is a significant factor.' The flow of funds is certainly germane, and FinCEN should place particular emphasis on those persons involved in real estate closings and settlements who actually 'touch the money.' For example, an attorney who directs a third-party escrow agent to release funds held in escrow should not be subject to anti-money laundering requirements, but the escrow agent through whose account the funds flow should be subject to these requirements.

It is becoming increasingly customary to conduct closings and settlements by escrow, where physical attendance of the participants is not required. For example, the parties may send all of the closing documents to an escrow agent who will close the transaction without other participants in physical attendance. The Notice touches on this growing practice (which it refers to as a 'Western-style' closing), but it does not explain whether different standards or levels of due diligence should apply to these types of closings. From a practical standpoint, this means that the closing documents are signed out of the escrow agent's presence, thereby making identification of the transaction parties more difficult. Indeed, the signatories may not even be located within the United States or the local jurisdiction.

Commercial real estate transactions often involve the use of a single asset ownership entity to hold title to a real estate asset. The person involved in the real estate closing and settlement may not know the identity of all of the members of a limited liability company or the partners of a partnership, particularly 'lower-tier' members or partners. It may be impractical to impose a burden on such a person to ferret out the identity of all of the members or partners in such an entity. The Notice does not appear to address this issue.

Finally, the cost of imposing an anti-money laundering program on real estate professionals may outweigh the benefit of such a program. The cost, both in terms of money and time, of anti-money laundering training and the cost of hiring a 'compliance officer' to audit the efficacy of the anti-money laundering program may be significant. It may be unrealistic to expect real estate professionals to steep themselves in the expansive gamut of domestic and international money laundering schemes, nuanced accounting issues, and to incur the cost of expensive and sophisticated software designed to detect money laundering.

Conclusion

The 9/11 terrorist attacks may unfortunately take yet another toll on the American economy if the Notice is transformed into a set of regulations that impose onerous anti-money laundering requirements on the real estate industry. This issue is most acute with real estate attorneys, who run the risk of breaching ethical obligations to comply with a federalized real estate regulatory regime. The requirements would also chill the attorney-client relationship with marginal benefit to the fight against money laundering. Interested parties must make their voices heard on this important issue by submitting written comments to FinCEN no later than June 9, 2003.

Kevin L. Shepherd is co-chair of the real estate department at Venable LLP, Baltimore.