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Federal Reserve Issues Proposed "Know Your Customer" Regulations

Fall 1998

On October 1, 1998, the Federal Reserve Board ("FRB") released a draft of its long awaited proposed Know Your Customer ("KYC") Regulations ("Regulations"). The Office of the Comptroller of the Currency ("OCC") is expected to release parallel regulations shortly. The FDIC and Office of Thrift Super-vision are also considering publishing parallel regulations. The FRB and the OCC expect to publish the Regulations for public comment in the Federal Register before the end of October.

The Regulations are the latest effort by federal banking regulators to reduce the incidence and risk of money laundering and other illicit activities through U.S. banks. The Regulations, if adopted, will clarify existing regulations under the Bank Secrecy Act of 1970, as amended ("BSA"). The BSA mandates that banks (and certain non-bank financial services providers) report certain transactions in currency which exceed $10,000, track certain activity by their customers and report "suspicious activities" to federal authorities.

What is KYC?
KYC is the sensitization of all bank personnel to a comprehensive understanding of what each cus-tomer's business is and what types of activities and transactions are "normal" for each customer. Summary of Proposal.
The Regulations will require banks to develop and implement a KYC program. Under the proposal, at a minimum, the program must provide a method for:

- determining the true identity of the bank's customers;
- determining the customer's source of funds for transactions involving the bank, including the types of instruments used and from where the funds were derived or generated;
- determining the particular customer's normal and expected transactions involving the bank;
- monitoring customer transactions to determine if such transactions are consistent with nor-mal and expected transactions for that particular customer or for customers in the same or similar categories or classes, as established by the bank;
- identifying customer transactions that do not appear to be consistent with normal and ex-pected transactions for that particular customer or for customers in the same or similar cate-gories or classes, as established by the bank; and
- determining if a transaction is suspicious or unusual, in accordance with existing suspicious activity reporting regulations, and reporting it accordingly.

No specific form of KYC program is mandated. The Regulations anticipate that banks of different sizes, with different customer populations and product mixes, may use different methodologies in creating and implementing their KYC programs. Many banks already have a comprehensive KYC program. Such a bank should review its program in light of the Regulations to determine what, if any, fine tuning may be necessary.

Other banks may already be engaged in many of the activities which will be required under the Regulations, but have not prepared a comprehensive KYC program. Such a bank should review its existing procedures in light of the Regulations and prepare a written KYC program. During this development proc-ess, plans such as this should be made to implement any parts of the program which will be required by the Regulations but are not in place at this time. FinCEN Publishes Phase II Exemption Procudures.
On September 21, 1998, the Financial Crimes Enforcement Network ("FinCEN") published the sec-ond stage ("Phase II") of its effort to update the procedures by which banks may exempt a currency transac-tion in excess of $10,000 from the Currency Transaction Report ("CTR") filing requirements. Phase II, ef-fective October 21, 1998, applies only to banks as defined in the Regulations (generally insured depository institutions). In September 1997, FinCEN published the first portion of its updated exemption procedures ("Phase I"). Under Phase I "exempt persons" are defined as banks operating in the U.S., government de-partments and agencies, and entities listed on a national stock exchange and certain subsidiaries of these entities.

Generally under Phases I and II, a bank seeking to exempt a transaction from the CTR filing re-quirement needs to make a one-time filing of a document which identifies the exempt person and the ex-empting bank.

Phase II adds two new categories to the definition of an exempt person. The additional categories are intended to cover all of a bank's existing customers not covered in Phase I which use large amounts of currency in the course of their U.S. business operations. The new categories are "non-listed businesses" and "payroll customers." Non-listed businesses are defined as a customer which:

- has maintained a transaction for at least 12 months,
- frequently engages in currency transactions in excess of $10,000, and
- does business in the U.S.

A "payroll customer" is one which meets criteria (a) and (c) above and regularly withdraws more than $10,000 in currency to pay its U.S. employees in currency.

Under Phase I, a bank may designate a customer as an exempt person by filing a CTR (IRS Form 4789) with items 2-14 and 37-49 completed and line 36 marked "Designation of Exempt Person." The des-ignation should be made within 30 days of the occurrence of the first reportable currency transaction

Under Phase II, for non-listed companies and payroll customers, banks must renew the designation of the customer as an exempt person every two years. This Financial Institutions Update is published to provide our friends and clients with current infor-mation that may affect their businesses. This information is not intended to serve as specific legal advice or as a solicitation for business.

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