As there are different perspectives on the area of “Anti-Financial Crime Compliance”, I would like to start by outlining what is meant by this, without going into too many details. This is followed by an assessment of 2022 and an outlook for the near future. At msg Rethink Compliance, we summarize the following areas under the term “Anti-Financial Crime” (AFC). Each of these areas is to be regarded individually even if there are overlaps between them. For this, see our Glossary.

• AML/CFT Compliance. The acronym stands for anti-money laundering (AML) and identification of terrorism financing (Combating the Financing of Terrorism), sometimes abbreviated as CTF (Counter-Terrorist Financing).
• KYC Compliance. This acronym stands for Know Your Customer (KYC), although we define it a bit broader and interpret “C” it as “Counter party”, commonly meaning the business partner, whether the business partner is a supplier, a development partner, sponsoring partner, sales agent or customer.
• ABC Compliance. In our context, this is a common acronym for fighting corruption and bribery (Anti-Bribery & Corruption).
• Fraud Prevention. Interestingly, there seems to be no comprehensive acronym for the English term fraud prevention. However, only could derive FPD from Fraud Prevention & Detection.
• ESG Compliance. Implicitly, ESG compliance consists of KYC, ABC and fraud prevention. As this is not clear to everyone, I list this topic, which also includes the block Corporate Social Responsibility (CSR), individually here.
• Sanctions. The area of finance embargo monitoring, which itself is already covered by the areas AML/CFT and KYC, will also be listed here individually.

Explicitly excluded from this consideration are the areas of tax evasion, which overlaps with AML and KYC, and the area of anti-cybercrime, which in a broader sense is part of fraud prevention but which is an individual topic in the area of industrial espionage, for example. We take this into account in the msg group and offer specialist expertise in the form of msg security advisors.

For 2022, the Financial Crimes News platform provides what I consider to be a very good and structured overview and analysis of events, including interesting questions (Fighting Financial Crime in 2022 – Dashboard by FCN). Since almost every software vendor in the field never tires of commenting on the events of the year, sometimes more, sometimes less, I don't want to join the ranks.

We are continuously and systematically investigating the market. For this, we have developed our AFC Radar, in which we take a closer look at all stakeholders, collect observations, identify trends, and then examine the extent to which these have significant impact on AFC compliance. This includes politicians, regulators, watchdog organizations or the affected industries such as banking, insurance and others. But we also consider changes in the type of work, availability of technologies, system suppliers and software providers as well as the possible uses of the applications. We attempt to corroborate these observations using four consideration perspectives. The following illustration gives a rough impression of the multitude of drivers considered.

Basically, we can assume that these drivers are motivated by a general desire to improve the fight against white-collar crime. Following a recent discussion about artificial Intelligence (AI), I recently tried ChatGPT, an advanced chatbot prototype from the US-based OpenAI. I asked “Got any ideas to improve combating financial crime?” and received the following answer from the AI-driven bot^[i]:

1. Improved recognition and monitoring systems: Using advanced analytics and machine learning, financial institutions can more effectively detect and monitor suspicious activities.
2. Improved collaboration and information sharing: Financial institutions can collaborate and share information about potential finance crimes, which will help better detect and prevent these crimes.
3. Increased regulatory oversight: A stronger regulation framework and a stricter enforcement of regulations can help deter financial crimes by increasing the risk of detection and punishment.
4. Better education and awareness: Educating the public about financial crimes and how to protect themselves may reduce the number of victims of these crimes.
5. Improved international cooperation: Financial crime often crosses national borders, making international cooperation essential to effectively combat it. This can include sharing information and coordinating enforcement efforts.
6. Using technologies: The use of blockchain and other distributed ledger technologies can help increase transparency and traceability of financial transactions, making it harder for criminals to operate.

The underlying transformer-based machine learning model^[ii] has been trained using a large dataset of conversations. Mainstream dominates here, not necessarily facts. Thus, these six points mentioned by ChatGPT hardly come as a surprise. This remains the case if one further questions each individual aspect of the above answers. Even on the question of how this can be implemented, the model provides clues. We have already pointed out the particular importance of transformer models, including the newer feedback transformer architectures^[iii], for regulatory compliance at various conferences, as well as the problems, especially with respect to perception bias of AI/ML. ChatGPT has attracted a great deal of attention and received much acclaim. However, there are wholly different questions critical to this specific artificial intelligence that we will not pursue here now. Nevertheless, one can predict that in the area of AFC compliance, the use of technology - which ultimately includes AI/ML - will continue to grow to increase effectiveness and efficiency.

For the near future of AFC compliance, we also see the following additional topics, signals and trends, among others:

Regulation & Supervision. Under this heading I have tried to present our main observations on the requirements and behaviors of regulators and supervisory authorities, without going into new laws or adaptations of existing laws (AMLA (Anti-Money Laundering Act), LkSG (Lieferkettensorgfaltspflichtengesetz), EU Supply Chain Directive, EU AI Act and many more). I have also left out specific industry topics such as Target2 in payment transactions, which is to be successfully implemented in the EU this year, the real estate sector, which is facing tighter regulation and supervision, DNFBPs (“Designated Non-Financial Businesses & Professions”) which will see similar challenges or the challenges in payments and eCommerce. Instead, I will deal with the generally applicable topics below.

• Policy & Control Management. Preventing ethical misconduct of employees without having to introduce additional rules and controls and taking into account that human beings do not necessarily act rationally in all situations, demands a risk management approach that works on a behavior basis (“Behavioral Risk Management”). This can be used to trigger so-called "nudges", i.e., thought-provoking and reminder devices, to help employees behave within the framework of the rules and specifications. This is another approach to prevention that can prevent problems from arising in the first place. There is already initial experience of implementation in this area, although there are as yet no best practices.
• Compliance Resilience. Resilience in this context follows Markus Brunnermeier's concept of resilient societies.^[iv] This states that it is not only about resilience but about flexible adaptability to new conditions in such a way that societies are not permanently damaged in the long term. We are seeing an increased focus among international regulators, but also increasingly within the EU, to demand such resilience and also to review it. This goes hand in hand with a significantly reduced response time for obligated parties. Backtesting, stress testing and ad-hoc simulations of the monitoring and screening solutions used, as well as the adequacy of the risk analyses, represent the major challenges here.
• Risk Assessment & Analysis. The aforementioned regulatory requirements for companies to become more resilient and agile, also with regard to compliance, leads to a clear emphasis on the regulatory risk model and thus the areas of risk assessment and risk analysis. Let me put it this way: While an annual look at compliance risk assessment has been sufficient in the past, this will no longer be the case in the foreseeable future. While we don't see an indication to address the topic on a weekly basis, we do see an indication to address it on a quarterly, if not monthly basis, not to mention ad-hoc requests. This will force compliance departments into a different form of implementation planning and control, which has long been standard in other areas and is very closely linked to the area of “Enterprise Performance Management”. In the near future, however, this will be more of a free skate. However, backtesting, which in some countries and regions has so far been treated more as a marginal issue in regulatory compliance, will become mandatory. What justifies exactly those thresholds, exactly those ratios, and exactly those chosen exclusion criteria? Officers have better answers to these questions and can point to a systematic approach. Also part of this topic block are ownership analyses of legal entities in order to identify the beneficial owner(s) in compliance with the law. Here, we participated in the FATF consultations on Recommendation 24 in 2022. The uncoordinated and patchy implementation of transparency registers within the EU and the lack of governance on the part of the authorities mean that this topic will continue to be a focus and challenge for officers in 2023 and the near future. There is currently no improvement in sight. Please see our blog post for more information. [👉 Selina Trotno & Natalie Hürler: From a Backup Register to a Full Register – Are the Alterations by the German Act TraFinG Enough?] However, there are more and more market intermediaries offering solutions usually with a regional focus (for example, Russia and Ukraine or Africa) for qualitative automation. This is also an area where the use of technology will continue to grow rapidly in line with the tightened sanctions regimes. New challenges are also emerging from the field of ESG ("Environment, Social, Governance"), which are spilling over into institution or company-specific risk models and risk analyses from various regulations.
• Public-Private Partnerships & Private-Private Partnerships. In our opinion, both will receive attention in the future and will be necessary to improve the situation in the fight against incriminated funds. However, it needs to start with the public-public partnerships. One would think that the Financial Intelligence Units (FIUs) of this world would find it easy to share data in such a way that concrete starting points for law enforcement and prevention can be efficiently derived from it. There are many reasons why this can only be agreed to a limited extent. One major reason is different data protection regulations and, of course, different politically motivated systems. Since the latter will be difficult to influence, in the area of data protection, reference should be made to technological progress that simplifies exchange using so-called "privacy enhancing technologies," or PET for short. I would also like to refer you to our blog post on this topic. [👉Natalie Hürler: Privacy-Enhancing Technologies (PETs) in the Fight Against Financial Crime]. This is also an approach for the other form of partnerships. Purely private-sector partnerships are seldom seen as an effective means of improving the fight against white-collar crime. The fear of rejection by the supervisory authority and the fear of data protection problems are too great here. But how is KYC compliance to be ensured and made more effective in the future without exorbitantly increasing costs and/or the associated risks? In our opinion, this is only possible through cross-company exchange and cooperation.

In the area of industry drivers, I would like to mention the following from the sum of the identified observations:

• Metaverse & Web3. The first steps into metaverse for bank and financial services providers and even more so for consumer brands have been taken. Not much else has happened so far, despite billions in investment, although the gamer metaverse is clearly on the rise with Roblox and Fortnite. The sober balance of the metaverse may also be due to the swelling dispute over how identities can be established and protected, who owns what data, and what regulation can/will be used and how. Web3 is based on the idea that ownership of data is shared between creators and users, thus avoiding domination by large corporations. It is supposed to be the decentralized continuation of Web2, i.e., the Internet as we know and experience it today. That’s the theory. In fact, a complete digital economy is to be created. The first ATMs in the metaverse already exist, and the payment service providers are getting ready. Nevertheless, we still see the coming months here as more of a playground for advertising and marketing. Considering that it took 15-20 years for the Internet to hit the banking world, but only 5-6 years for app-based mobile banking, we may assume that it will at least not take longer with the metaverse, especially considering that most areas of smart cities will also need Web3 as a basis. The closer you are already to cryptocurrencies, NFTs and smart contracts with your business model, the faster the metaverse and Web3 will gain relevance, also in the AFC environment.
• Smart Contracts & NFTs. Let’s start with the simpler one, Non-Fungible Tokens (NFTs). These unique proofs of ownership are a core component of the Web3 but are already well advanced in their broad adaptation. Apart from their existence in digital art, trading and tokenization represent interesting features that suggest NFTs will continue to grow in the near future. Similar to the metaverse, the consumer goods industry is leading the way here. We should therefore not just reduce NFTs to an asset class but perceive them as an interesting technology. This is even more true for smart contracts. These are digital contracts in the form of an application based on blockchain technology. These smart contracts can act through their own application when certain conditions are met and do not require human supervision. The parties to the contract are defined by tokens. The first financial products based on smart contracts are emerging to facilitate trade finance. Smart contracts are also increasingly being used in the supply chains of commercial and industrial companies. In the future, we expect to see more complex trading constructs that are subject to volatility and therefore also require smart adjustments to these self-executing contracts. But the extent to which this helps combat trade-related money laundering depends on the acceptance and increasing adaptation of the technology.
• Crypto Currencies. Away from being viewed as a speculative asset rather than a substitute for fiat currencies, this asset class will continue to endure. Whether you call the crypto winter a structural collapse or a controlled crash, it will not change the fact that crypto currencies are here to stay. From the perspective of AFC compliance, they are a risky asset. It is imperative that this be reflected in the risk model and risk analysis, and it will leave many anti-money laundering officers with question marks. After the collapse of the trading platform FTX and now alleged transparency issues at Binance, crypto exchanges are facing an increased regulatory attention. In these cases, however, it is more in terms of unraveling potential fraud scenarios, specifically in the area of financial reporting. Either way, crypto exchanges are in for at least one more frosty spring in the coming months after the crypto winter.

Effectiveness & Efficiency. We are inclined to always think of this point as technologically motivated. But that’s not true. Although the topics of automation and AI/ML play a major role in the discussion in this area, it would be fatal to assume that technology alone can bring about an improvement in the situation. Technology – whether new or changed – should always entail an adaptation of processes and, if necessary, of the organizational structure, or this should even precede the technology.

• Compliance Resilience addresses the effectiveness perspective and represents an increasing challenge for obligated parties. To manage this efficiently, concepts are needed. Technologies and techniques are available. We will present such a concept in the scope of our AFC Governance initiative soon. We see this as a long-term focus for obligated parties, system providers and integrators in the coming years.
• Technology Use. In the same corner, I would see the increasing use of automation techniques as well as AI adoption. In addition to the further use of robotic process automation (RPA), the topic of entity resolution (ER) should also be mentioned, which will increasingly contribute to an improvement in quality and thus to an automation of decisions in the area of KYC processes. With regard to AI, reference should be made to the bunq ruling^[v], which will certainly result in further AI adaptation in regulatory compliance. In our opinion, little will change in the use cases. These are known and should be implemented in a well-considered manner – taking into account the application guidelines of the regulators, but also the specific regulation (keywords here are EU AI Act or New York AI Bias Act, among other things). AI is a supplement and not necessarily a replacement of existing rule-based systems. Again, our research into the vendor landscape (AML/KYC application providers) shows increasing openness, ranging from existing interfaces to AI models to embedding these models. Cooperation and coexistence instead of competition and substitution, in other words. However, the area of explainable AI would have to be mentioned here as a key technology in the case of a (partial) replacement of rule-based systems. Due to the fact that there is hardly reliable training data − not to mention fuzzy FIU reports and their underlying data − it is all the more important to recognize model biases and understand how results are found. In addition, mention should be made of "digital twins" for handling peaks in case processing as well as the area of "Natural Language Processing" (see the above mentioned ChatGPT) for case disposition and/or pre-assessment of raised cases. As AI/ML become more prevalent in the AFC space, the issues of operations and reliable and efficient deployment ("Machine Learning Operations" (MLOps)) will become more important.
• Data Integration, Data Quality & Data Protection. Data quality is an idle topic that is at least as old as my professional career to date. On the one hand, some regulators, including Bafin, have called for measures to be taken to improve data quality where necessary. On the other hand, the quality of the data is of much higher importance when working with AI/ML methods. In this respect, there are two motivations in AFC compliance for taking action, however unwelcome the topic may be. An evaluation of the corresponding application notes of Bafin on this point can be found here: 👉Mirko Janyga: Item 6 of the AuA BT - BaFin Concretizations on Monitoring Systems helpful, 👉Uwe Weber: Impact of Poor Data Quality on Compliance. Data integration is part of data quality, but it poses its own challenges in digital transformation, especially in the traditional banking environment, including AFC. This is less true for neo banks due to the lack of IT system history. That the topic is strategically relevant has been known for some time. Whether it will be addressed in the current economic environment remains questionable. The issue of data protection is also not a new one. But in the context of the public-public, public-private and private-private partnerships mentioned above, it will inevitably be a pressing issue for FIUs, officers, and also industrial companies in compliance in 2023 and subsequent years. I would also like to mention synthesization of data related to the AI/ML technologies mentioned above, which is very beneficial for backtesting. Especially the latter will be of great importance this year, as described above in the area of regulation, for model governance, the monitoring of risk models.
• Total Cost of Ownership. With all the IT initiatives, the multitude of systems, system components and high integration points in the area of AFC, the costs of AFC compliance are also becoming a focus of attention in the current economic situation. Besides the standardization of systems, the homogenization of the system landscape and the improved integration of data, the question is increasingly being asked whether a simple reduction to a one-vendor strategy is not just as problematic as the other extreme, the best-in-class strategy. The discussion is rounded off by outsourcing on the one hand and insourcing on the other. Both are also driven by one or the other regulation, for example AMLA. In addition to the actual software systems, the operating models are also put to the test in AFC compliance.

One could write a lot more, but in my opinion the points listed above represent a good mix of currently discussed challenges and those to be expected in the near future. Unsurprisingly, AFC compliance remains a challenging topic in 2023, both in terms of effectiveness and the need to improve efficiency and proportionality of resources.

^[i] ChatGPT Dec 15 Version in a Free Research Preview; Original Question: “Got any ideas to improve combating financial crime?”

^[ii] Transformer refers to a deep learning model based on sequential data input, but which can be parallelized, helping to significantly reduce training time.

^[iii] The term “Feedback Transformer” originates from a research paper dated January 25, 2021 by the authors Angela Fan, Thibaut Lavril, Edouard Grave, Armand Joulin and Sainbayar Sukhbaatar, all from Facebook AI Research, in which the limitations of traditional transformer models were identified as well as the possible elimination of these restrictions. We tend to find the term misleading and usually use the term “recursive transformer”. Here, all layers in a vector are fed into the model memory per time step, not just the representations of the lower levels.. This results in much more powerful models.

^[iv] Compare Brunnermeier, M. K. (2021), The Resilient Society, 2^nd Edition.

^[v] On October 18, 2022, the competent court in Amsterdam ruled that Neobank bunq could very well use artificial intelligence methods to combat money laundering. Among other things, this has so far been rejected by the Dutch central bank. However, the ruling also confirms shortcomings of the bank in the effectiveness of monitoring, especially in the area of customer risk classification. Both DNB and bunq see their opinions confirmed in the ruling. With regard to the use of modern technology to combat money laundering, DNB has announced on the basis of the ruling that it will enter into a dialog with the financial sector

Much is being written about and reported on the topic of supply chain compliance, whether this be the German Lieferkettensorgfaltspflichtengesetz (LkSG/Supply Chain Act), the corresponding EU directive that is in preparation, or the extraterritorial laws that have been valid internationally for some time and also affect the supply chain such as the UK Bribery Act (UKBA) or the US Foreign Corrupt Practices Act (FCPA). My colleagues have already addressed the content of the individual guidelines as well as the broader context on bribery, corruption and ESG and have published this in other blog posts. [👉Pinar Karacinar-Gehweiler: Compliance Requirements Due to the German Supply Chain Due Diligence Act; 👉Lea Ilina: ESG in the Tension Field of Corruption]. This blog post now outlines a corresponding IT system to support supply chain compliance and shows which components should be part of such a system, how and why.

Even if the above-mentioned regulations seem to have little in common at first glance, they all have at least the following points in common:

• Risk Analysis: The basis for compliance with the regulations is the creation of a company-specific risk analysis covering, among other things, vendors, their relationship to your own company, regions, products and services, contract types and other risk objects. It seems beneficial to initially create this risk analysis for all regulations, if this has not already been done, or to expand the existing risk analysis accordingly.
• Vendor Screening: The most obvious part of a supply chain compliance system is the "Know Your Customer" (KYC) screening of vendors. This part is referred to differently on the market: KYV (“Know Your Vendor“), KYBP (“Know Your Business Partner“), etc. We like to translate the "C" as Counterpart and can get by with the KYC principle without any problems. Apart from the confusion of terms, the point here is to know the business partner per se and the relevant actors of the partner, if any, and to check against relevant lists. In addition to sanctions lists, PEP lists (PEP = Politically Exposed Persons) and other information such as negative news ("Adverse Media") must also be used. Here, three levels need to be considered: Identity screening, integrity screening, and specific risk screening against the risks identified in the risk analysis. This screening takes place initially when the request/decision is made as to whether a business relationship can/may/should be entered into, as well as on an ongoing and risk-based basis.

This results in the following process view on the topic:

Fig. 1: Process view business partner screening

Combining the topics outlined above enables efficiency and productivity benefits to be leveraged. This makes it possible to create a uniform system for business partner compliance that covers and presents the relevant company-specific risks in a holistic manner. In addition to transparency benefits, this results above all in the avoidance of redundancy in processing both within the company and on the part of the business partner, i.e. the vendor. The support provided by a flexible IT system, called a supply chain compliance solution for simplicity’s sake, further contributes to cost reduction by avoiding IT silos, redundant data preparation and storage, and reducing other direct and indirect costs of such a software solution compared to multiple stand-alone solutions.

Based on the above considerations in connection with the process-related view of a business partner lifecycle, the following schematic structure results for the construction of such a flexible software solution, starting with the core processes:

• Identity Check (Check of business partner master data): In addition to the legal name and address, for example members of the governing bodies (managing directors, advisory boards, executive boards, etc.) and ownership structure (keyword: beneficial owner) need to be recorded. This information plays an important role in the automatic further processing for various reasons. This check needs to be conducted during the on-boarding process but also for continuous monitoring. As the process name suggests, this involves establishing the identity of the business partner in all its aspects. Connections to credit agencies and intermediaries, such as Dun & Bradstreet or similar, can increase the level of automation. The use of flexible, dynamic, digital questionnaires can also have a positive impact on efficiency. They help reduce redundancies and can be used as a self-service component in the bidding process, for example.
• Integrity Check (Check of identified master data of business partners against a number of lists (direct as well as indirect/sectoral sanctions, PEP, companies with bad press/unfriendly media, etc.)): This list set is different from the one used for identity check. Typically, compliance-specific lists are used here. Of course, in the area of sanctions management, it is also possible to work with the publicly provided lists of the EU, USA, UK and, for example, the World Bank. However, in the context of a make-or-buy consideration, both the expense and the risks of data management must be taken into account. In addition to the check during onboarding of a business partner, integrity must also be checked continuously, as the associated risk can change constantly.
• Specific Risk Check: To check the extended data of business partners for relationship risks with regard to regulatory aspects (non-operational risks), rules derived from the risk analysis are defined, which can then give rise to so-called "red flags", i.e. risk-relevant facts that need to be assessed and processed. It is advisable to perform this check during the onboarding of the business partner and to review it periodically on the basis of the risk rating after the decision to enter into a business relationship has been made. It is also advisable to be able to design the risk model flexibly. On the one hand, this means the possibility of defining additional checking rules as required - preferably by the relevant department - and, on the other hand, of making changes to the risk scoring model. A risk scoring model with dominant risks has proven to be both effective and efficient here. The digital questionnaire component already mentioned has also proven advantageous in the past, as long as it can be flexible in its structure and dynamically interactive in its responses.
• Event & Transaction Check: The event and transaction check can be implemented at different levels of complexity. In addition to some standard checks for high-risk transactions, it is also possible, for example, to work here on the basis of a fraud prevention system already in use. Even though this is not recommended, this area is often given lower priority in a software-based solution. This has not least to do with the complexity of the matter in connection with the implemented process reality in companies and in their ERP systems. This check is therefore often outsourced transaction-specifically per company directive to the so-called "first line of defense" (operational controls) and "third line of defense" (internal audit) as well as whistleblower systems and supported secondarily by means of IT. However, artificial intelligence and process mining functionalities offer new, highly efficient IT support and automation options that can significantly reduce the risk of bribery and corruption in this area.
• Case Management: All alerts and generated cases from identity, integrity and risk checks must be analyzed and decided, if necessary only after an extended check, also called "enhanced due diligence" (EDD). A case management system makes all of this transparent, enables the necessary processing quality to be ensured, and enables the complexity-controlled distribution or delegation of leads, cases or partial aspects thereof. Typically, the software solution generates a proposal for the initial risk to be confirmed or rejected based on the previous testing steps. This, in turn, defines that the risk should ideally be subdivided as follows:
  • Initial risk, which is initially identified and confirmed during onboarding.
  • Ongoing risk that continuously arises and changes as a result of collaboration (primarily through risk-relevant master data changes or corresponding events and transactions).
  • Manual risk, which is manually controlled by an appropriately authorized employee.
  • Inherited risk, which exists, for example, due to company affiliation or beneficial owners. In contrast to the aforementioned three, this type of risk is optional in connection with business partner compliance.
• Approval Management: The acceptance of a specific risk position of a specific business partner must be approved by the company's decision-makers in close cooperation with Compliance. In most cases, Compliance acts only as an advisor; in other cases, it should demand a right of decision or veto. This is done as part of the approval management process. In connection with the risk model mentioned above, an identified gross risk resulting from the risk analysis can thus be mitigated by measures related to the business relationship and the associated contract administration - if this is allowed. In such a case, the result is then the net risk on which a decision would have to be made. It goes without saying that all measures must be logged as part of the approval process in order to ensure auditability. The process-related illustration above shows that this does not only apply to approval management, but runs through the entire process.
• Reporting: In addition to audit reports, this includes the regulatory requirements for management reports, which should be supported from within the application on a template basis so as to save time and effort. Reporting for management on the risk situation along the supply chain and governance across the entire business partner process should also be mentioned in this context.

After the core processes have been roughly described, the question arises of the actors who must work on or with such a system, in other words, the question of interfaces and user roles. Here, too, the list is shown schematically.

Interfaces:

• ERP System(s): This primarily refers to the system in which the master data is managed. This can be an ERP system, or it can be a CRM, SCM, MDM, bidding portal, or similar system that manages business partner master data, events, and transactions (e.g., Microsoft, Salesforce, SAP, and others). It is not uncommon to have multiple systems. The type of integration determines the degree of automation and the acceptance of the system in the overall process.
• Credit Agencies/Research Providers: These are public or licensed providers of relevant content on business partners that can/should be used for master data maintenance as well as for risk assessment (e.g., Dow Jones, Dun & Bradstreet, Moody's, but also public lists of the EU, UK, USA, etc.). Here, from a risk perspective, it is necessary to define which providers and data sources should be worked with. For example, there are special providers who specialize in business partners from certain regions, e.g., the former CIS states or the Arabic-speaking world, as well as generalists. Depending on the risk appetite, one provider can be chosen for the simple risk check, and another for the extended risk check or quality assurance
• Internet: For a deeper online research on a specific business partner, an Internet search that can be logged should be provided.
• Whistleblower/Complaint Management: The possibility to lodge a complaint about direct/indirect business partners must be set up and covered, e.g. according to LkSG. An investigation and risk reassessment must then be performed. This can be implemented as an interface to an existing system or by means of a company directive and manual recording of a corresponding note as part of the core process for case management.

With regard to the interfaces, it should be noted that this does not address specific, country- or industry-specific reporting requirements to regulators, which may be another interface requirement.

User roles:

• BP Requestor: This role requests a new business partner/vendor and/or a new business partner relationship.
• BP Owner: This role "owns" and is responsible for a specific business partner and/or business partner relationship.
• Compliance: This role is only intended as an example of Compliance as a user role. This role can be sub-divided as required.
• Approver: This role exemplifies the business decision makers who can review and approve/deny the addition of a specific business partner and/or change the risk potential of an existing business partner.
• Business Partner: The business partner or vendor can be directly involved in the process as part of a self-service.

With regard to the roles, it should be noted that these must always be set up on a company-specific basis and that these, as well as the role designations, may well be different.

This roughly results in the following use case diagram for an IT-supported supply chain compliance system:

Fig. 2: Use case diagram of an IT-based system for supply chain compliance (without event/transaction monitoring).

The outlined IT-supported implementation of a business partner compliance system is generic and, in this form, can support the regulatory compliance requirements for cooperation with business partners in general (sales partners, joint ventures, research initiatives, HR partners, etc.) and vendors in particular. Regulatory specifics have been omitted for clarity, as have industry-specific requirements. As part of this blog series, we will soon also provide insights and examples on risk model, audit strategy and reporting. So it's worth following the #rethinkcompliance blog and staying tuned.

Six months after the disaster, there was an agreement called the "Rana Plaza Arrangement", whereby relatives received compensation. The companies initially refused, and it was not until October 2015 that the compensation was paid to those affected. Another change triggered by this event was the “Accord on Fire and Building Safety in Bangladesh”. This stands for better protection and more safety in the textile factories in order to eliminate violations there. At the end of 2013, the minimum wage for textile workers was finally raised.^[i]

What is covered by the Supply Chain Act?

In general, companies are aware of the risks of their operations in an international context. Nevertheless, they are often accused of producing cheaply abroad, for example, without taking care of the risks that arise for people and the environment. This is precisely where the LkSG comes into the picture. In the future, companies will bear responsibility for the violation of human and environmental rights along the supply chain.

The Supply Chain Act, which was passed on 11 June 2021, is intended to ensure that companies pay attention to human rights and the environment from the extraction of raw materials to the end customer. This applies both at home and abroad and is intended to prevent child labour, forced labour, discrimination and inadequate safety standards in the supply chain. Better working conditions should minimise the risk of occupational accidents and other health risks.

The term supply chain is broadly defined. According to section 2 V of the LkSG, this covers all products and services, in particular all steps at home and abroad that are necessary to manufacture the products and provide the services. In addition to its direct applicability, the indirect spillover effect of the LkSG should also be taken into account.

When must the contents of the new Supply Chain Act be implemented?

The LkSG will come into force on 1 January 2023. However, companies already have to adapt their risk management in accordance with the new legal requirement now. The Supply Chain Act obliges all companies to comply with a clear proportionate and reasonable legal framework to fulfil human rights due diligence obligations. The requirements are based on the due diligence standard.

Is my company affected by the LkSG?

The LkSG applies to all companies under German or foreign law, regardless of their legal form, if they have their main administrative or statutory seat or their headquarter in Germany.

In addition, companies that have a branch office in Germany pursuant to section 13 d of the HGB (German Trade Law) are also covered. German subsidiaries can also fall within the scope of the LkSG.

A further prerequisite is that the companies must have at least 3,000 employees, which also includes any employees sent abroad. In the case of parent companies, the number of employees of all companies belonging to the group must be included. The number of employees must also include temporary workers who have been working for the company for at least six months.

As of 1 January 2024, this threshold will drop from 3,000 to 1,000 employees.

Furthermore, in the summer of 2024, it is to be decided whether the scope of the LkSG will be extended even further, so that companies with less than 1,000 employees will also be obliged by the LkSG.

Experts suspect that companies that are not obliged parties under the LkSG will be at least indirectly affected. Companies working with them could contractually oblige them so that they too must comply with the due diligence requirements of the Supply Chain Act. Furthermore, supplying companies are indirectly affected by the LkSG.

What happens if I do not comply or comply too late with the new legal requirements?

If the LkSG is violated, fines of up to € 800,000 may be imposed for intentional and negligent violations. For companies with a turnover of more than € 400 million, the fine can be increased to up to two percent of the global turnover. Under section 22 of the LkSG, companies can even be excluded from public procurement for a period of up to three years if a fine of € 175,000 or more is imposed. A damaged image associated with a violation of the law could indirectly lead to further financial damage.

However, according to section 3 III of the LkSG, a civil liability of the company due to violations of due diligence obligations regarding the protection of human rights as well as the protection of the environment is excluded. Consequently, there is also no personal liability of the managing directors in the case of violations of the LkSG.

What are my obligations as a company?

The due diligence resulting from the LkSG can be divided as follows:

• own actions in one's own business area according to section 2 V no. 1, VI of the LkSG,
• the actions of a contractual partner,
• the actions of a direct supplier according to section 2 V no. 2, VII of the LkSG and
• the actions of an indirect supplier according to section 2 V no. 3, VIII of the LkSG.

This means that responsibility no longer ends exclusively within the company itself, but - as the name of the law suggests - extends beyond it: along the supply chain.

The Supply Chain Act contains a final catalogue of eleven internationally recognised human rights conventions. From the legal rights protected there, behavioural requirements or prohibitions for corporate action are derived in order to prevent a violation of protected legal positions. These include the prohibition of child labour, slavery and forced labour, the disregard of occupational health and safety, the withholding of an adequate wage, the disregard of the right to form trade unions or employee representatives, the denial of access to food and water as well as the unlawful deprivation of land and livelihoods.

In section 3 of the LkSG, the law only mentions the companies' obligation to make efforts. Therefore, there is neither a duty to succeed nor a warranty liability. Furthermore, all due diligence obligations are subject to an appropriateness proviso, which gives companies discretion and room for manoeuvre. A gradation of the duty results from the company’s existing possibilities of influence. As a result, according to section 3 III of the LkSG, companies cannot be held liable under civil law for a violation of the due diligence imposed on them. Thus, there is also no personal liability of the managing directors.

Even if companies have to observe human rights and environmental concerns, nothing impossible can be demanded of them. Due diligence obligations can be fulfilled even if the entire supply chain cannot be traced, or preventive or remedial measures cannot be taken in case these actions are practically or legally impossible.

Even though the LkSG has been criticised particularly by business associations because, according to them, it would harm competitiveness, for example, the topic of sustainability is not entirely new in the legal landscape. Since 2017, there has been an obligation under the CSR RUG (CSR Directive Implementation Act) to disclose certain sustainability aspects such as environmental and social concerns, employee concerns, respect for human rights and the fight against corruption.

What compliance measures must be taken?

Based on the LkSG, companies and business managers are obliged to set up a compliance system to observe human rights and environmental due diligence obligations:

• Establishment of a corresponding risk management system
• Establishment of an internal responsible person or a representative
• Issuing a corresponding policy statement
• Implementation of a (direct/indirect event-based) supplier due diligence process
• Conducting regular/continuous risk analyses
• Focusing on risk-based and corrective actions
• Definition of preventive measures within the own business unit(s) and direct suppliers
• Establishment of a complaints procedure ("whistleblowing system")
• Documentation and reporting

The law stipulates in section 4 I of the LkSG that risk management must be established to identify, prevent, end or at least minimise risks and violations of human and environmental rights along their supply chains. The law indicates which preventive measures, obligations for complaint procedures and reporting are required for this. In addition, clear responsibilities must be established within the company to monitor the risk management system. A person responsible for risk management must be appointed within the company. According to section 5 of the LkSG, an appropriate risk analysis must be carried out to determine human rights and environmental risks.

At least once a year as well as on an ad hoc basis in the event of a significantly changed or expanded risk situation, the company must check its own business area and its direct suppliers whether there is a violation of human rights or environmental concerns. In the case of indirect suppliers, the obligation to conduct a risk analysis only exists if the company has sound knowledge of possible violations.

According to section 6 I and V of the LkSG, if companies identify a risk, they must immediately take appropriate preventive measures and review them annually and on an ad hoc basis. If the company then detects violations, it must take corrective measures. The last resort may also be the termination of the business relationship with the supplier.^[ii]

Section 8 of the LkSG obliges companies to set up an appropriate internal complaints procedure. This is intended to enable individual persons to point out possible human rights or environmental risks and violations in the company's own business sector or at a direct supplier.

Pursuant to section 10 I of the LkSG, compliance with due diligence obligations shall be documented accordingly and kept for seven years. In addition, according to section 10 II to IV of the LkSG, there is an obligation to prepare an annual report on the fulfilment of due diligence obligations in the previous business year and to publish it on the company website no later than four months after the end of the business year. Furthermore, the management levels shall issue a policy statement for the human rights strategy of the company.

Environmental, Social, Governance (ESG)

The examination of ESG aspects plays a central role in the discussion of how companies position themselves in a way that is compliant with the LkSG. Against the background of a sustainable supply chain, the topics of environment, social (includes aspects such as safety, health of employees, labour rights, etc.) as well as corporate governance (includes topics such as corruption, etc.) must be taken into account. A rating of business partners for the entire spectrum of ESG areas should be included in the risk analysis in order to meet the requirements of legal due diligence.

Other regulations besides the LkSG

In addition to the German LkSG, there are other regulations that are to be taken into account in the international context:

EU Supply Chain Act: Since February 2020, there has been a draft for an EU Supply Chain Act. This goes much further than the German LkSG. The draft law is aimed at EU companies and companies operating in the EU with 500 or more employees and a turnover of more than € 150 million. According to the draft directive, the threshold is already 250 employees and € 40 million turnover in sectors that pose a risk to people and the environment.

The new EU regulation includes civil liability for companies. Affected parties can sue for damages in European courts. However, companies can be exempted from liability if they have set up a compliance management system that defends them. Even though it is only a draft at the moment, it makes sense to also orientate oneself on the EU regulations in the context of the implementation of the German LkSG in order to avoid having to make further costly improvements later on.

Bribery and corruption prevention: Within supply chain compliance, aspects of bribery and corruption prevention, which fall under governance in the ESG check, should also be taken into account. The fact that a large number of companies operate globally, foreign laws with extraterritorial application may also have to be taken into account.

US Foreign Corrupt Practice Act (FCPA): Originally, the FCPA only applied in the United States. It is considered the mother of all anti-corruption laws. In 1998, the FCPA was expanded to the effect that foreign companies and individuals could also be covered by the FCPA. A de facto effect has only been recorded since 2004 through increased implementation. This development has led to an enormous sensitivity to compliance issues worldwide and has set standards for the establishment of compliance management systems.

It consists of two parts:

• Anti-bribery rules: These prohibit giving or promising benefits to non-US public officials with corrupt intent to gain a business advantage.
• Accounting and internal control rules: These require proper accounting and data custody as well as internal control systems to ensure the proper use of company funds.

The FCPA has also encouraged other countries, such as Canada and the UK, to enact similar laws with extraterritorial application.

UK Bribery Act (UKBA): The law applies to all companies doing business in Great Britain and Northern Ireland. Neither the act of corruption nor the act intended by the bribery have to take place in the UK. As a result, any business with a foreign connection to the UK can be covered by this law.

German companies can be held accountable for corrupt behaviour anywhere in the world, even if the act of corruption is not related to an activity in the UK. It is sufficient that affected companies carry out business activities in the UK. However, the fact that shares of the company are traded on the London Stock Exchange or that subsidiaries are registered in the UK is not sufficient.

United Nations Global Compact (UNGC): The United Nations Global Compact has developed ten principles^[iii] in the areas of human rights, labour standards, environmental protection and anti-corruption, which can be applied not only within one's own company but to the entire value chain. The UN Global Compact and the UN Global Compact Network Germany (UN GCD) call on companies to align their strategies with these ten principles. Even though it is a non-binding recommendation, the UNGC is the world's largest initiative for corporate sustainability (also known as corporate social responsibility) with 13,000 company participants and other stakeholders in over 170 countries. The guide "Sustainability in the Supply Chain^[iv]" can be consulted by companies to help them establish and develop sustainable supply chain management. However, the UNGC looks at the relationship with upstream suppliers and does not focus on relationships with distributors, end customers or product disposal. The United Nations Global Compact Office will look more closely at actors downstream in the value chain in the future.^[v]

United Nations Office on Drugs and Crime (UNODC): The United Nations Office on Drugs and Crime offers a web-based anti-corruption portal called TRACK^[vi] (Tools and Resources for Anti-Corruption Knowledge). “The UNCAC Legal Library is a comprehensive database of anti-corruption and asset recovery legislation and jurisprudence from over 175 States, systematized in accordance with the requirements of the Convention. The legal library, which will be regularly updated, identifies laws that have been successfully used to recover assets as well as barriers to asset recovery caused by inadequate or incompatible legal frameworks. This practical and user-friendly resource will aid countries as they design and improve their legal frameworks so that they are more conducive to the recovery of stolen assets.”^[vii]

The database provides a unique overview of UNCAC articles and the corresponding provisions of national law. Searches can be limited to a specific country, UNCAC chapter and UNCAC article. Clicking on a country name opens a page with links to detailed information on domestic anti-corruption authorities and the full text of UNCAC-related laws. Here, too, companies can seek out targeted assistance and relevant information for their compliance.

Who checks compliance with the LkSG?

The Federal Office of Economics and Export Control checks compliance with the Act. It checks company reports and investigates complaints submitted.

An authority is provided with effective enforcement tools to monitor companies' supply chain management. The responsible authority, the Federal Office of Economics and Export Control, has far-reaching control powers. It can, for example, enter business premises, demand information and inspect documents, as well as request companies to take concrete action to fulfil their obligations and enforce this by imposing penalty payments.

Conclusion

The entry into force of the Supply Chain Due Diligence Act entails numerous legal obligations for companies. Not to be disregarded are the legal regulations from other countries, which must also be taken into account due to their extraterritorial effect. In addition, an ESG check is recommended.

Companies obliged under the LkSG must comply with a clear, proportionate and reasonable legal framework for due diligence. The requirements are based on the due diligence standard.

In addition to effective risk management, compliance with these legal obligations also requires more extensive duties and the implementation of various mechanisms that require a certain lead time. These cannot be named in general terms but must be clearly identified individually for each company.

In the download provided, you can make your own initial assessment of the type and scope of the legal obligations imposed by the LkSG that may affect your company. The following overview shows you which steps have to be taken to comply with the Supply Chain Act. If you have any further questions, please do not hesitate to contact us.

^[i] Die Lebens- und Arbeitsbedingungen der Textilarbeiter in Indonesien. Welche Organisationen setzen sich für bessere Umstände ein?

^[ii] Lieferkettensorgfaltspflichtengesetz; NJW-Spezial 2021, 399

^[iii] The Ten Principles of the UN Global Compact 

^[iv] UN Global Compact Office: NACHHALTIGKEIT IN DER LIEFERKETTE - Ein praktischer Leitfaden zur kontinuierlichen Verbesserung 

^[v] UN Global Compact Office: NACHHALTIGKEIT IN DER LIEFERKETTE - Ein praktischer Leitfaden zur kontinuierlichen Verbesserung 

^[vi] TRACK — UNODC's central platform of tools and resources for anti-corruption knowledge 

^[vii] UNCAC Legal Library Launched: New Database of Anti-Corruption Legislation from 178 States  

On August 25, 2022 the Financial Action Task Force (FATF) published the final report ("Mutual Evaluation Report (MER)") on the audit of Germany. As a result, it should be noted that Germany has implemented considerable reforms over the past five years to better detect and combat money laundering activities and terrorism financing. These reforms are bearing fruits. However, further efforts are needed to optimize the effectiveness of prevention measures.

Poor domestic agency coordination and use of financial intelligence

The problems are not new but have long been known and discussed across agencies for many years. They include national coordination between the law enforcement agencies of the individual federal German states. While in the past the respective state criminal investigation offices sometimes conducted parallel investigations in an uncoordinated manner due to a lack of information flows, the creation of the financial intelligence unit (FIU) has already improved effectiveness in recent years. Nevertheless, the FATF has detected optimization potential here in the scope of its audits. It expects proactive risk prevention and improved availability and use of financial intelligence by the FIU. This includes, for example, access to bulk data and analytical tools to increase the effectiveness and efficiency of the FIU analyses and to enable more intensive coordination and collaboration of FIU and law enforcement agencies. These findings need to be analyzed, not as a theoretical exercise but in cooperation with specialists and practitioners. Thereafter, implementation should take place as soon as possible, ideally with the involvement of the planned new German federal anti-money laundering authority.

Germany's cash intensity as a risk

In principle, the FATF has addressed cash intensity and unlicensed money transfer service providers as a particular risk. The fact that Germany is considered a cash-intensive country and that organized crime has taken advantage of this in the past to place incriminated money is not a new finding. Economic developments, especially the European interest rate policy, have led to a flight into tangible assets in recent years. The real estate sector is a case in point. One of the FATF's main criticisms is that real estate transactions in Germany can still be conducted in cash. For the banking industry, this means that there must be an even stronger focus on cash transactions than in the past. However, as a result of cost pressure and falling margins, institutions have increasingly switched to processing their services in connection with cash transactions via ATMs. Certainly, the regulation of the proof of origin for cash deposits above €10,000 has led to a sensitivity among obligated parties. However, the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin - Federal Supervisory Authority for Financial Services) communicated in its journal of August 2021 that the institutions can take into account the specifics of their respective business relationship in order to achieve a risk-oriented and practical procedure. This naturally leaves plenty of scope for design and interpretation for the banking industry. This leaves the obligated parties free to decide by which customers and in which form the proof of origin needs to be provided. Countries such as Spain, with an upper limit of €2,500, and Italy, with a maximum amount of €1,000, have already shown that such problems can also be addressed differently. Cash deposits above this amount are rejected in principle.

Problem area money value transfer services

Informal money value transfer services (see also MVTS in the #AML glossary) represent a particular problem area. While registered and established MVTS providers observe the legal requirements and are sensitized by the FIU to conspicuous facts or indicators, the informal MVTS are the focus of the FATF. Cases such as the large-scale raid by the North Rhine-Westphalian State Criminal Police Office (LKA NRW) on November 12, 2019, in which large amounts of cash and gold bars were seized from a jeweler’s in the Duisburg area, are seemingly just the tip of the iceberg. In total, more than 200 million euros were smuggled abroad without any name or sanction check. This way, the FATF addresses one of Germany's main problems: The prevention and control of Designated Non-Financial Business and Professions (see also DNFBPs in the #AML glossary) (FATF recommendations 18 and 23). The result of the audit of this group of obligated parties was one of the main points of criticism. It attested that Germany needs to make considerable efforts in a timely manner to meet the requirements of the FATF.

With this finding, Germany is in good company because countries such as Great Britain, Switzerland or the United States of America were attested as having the same deficit level. Even The Netherlands, which was highly praised on the day of the publication of the German report, is facing the same challenge. A first beneficial step would be to centralize the more than 300 supervisory authorities in Germany for this area. This should be accompanied by the establishment of uniform standards and appropriate, risk-oriented audits − similar to those which are known from the banking sector. Coordination with the above-stated countries would also be beneficial to achieve synergy effects and to define objectives and measures jointly, ideally in coordination with FATF.

Implementing asset recovery effectively

The topic of asset recovery was also addressed. The objective is to confiscate the illegally acquired asset values from the offenders. Germany evidences massive progress here. However, Germany still has a long way to go before it can match the effectiveness of other countries in this area. While in Germany the burden of proof still lies with the state, other countries have long since demonstrated how asset recovery can be implemented effectively. Even if there are initial moves in Germany to abolish the system of shifting the burden of proof, it remains to be seen to what extent such cases will be decided positively by the courts.

In Italy, defendants must prove that they are not involved in illegal business. There, a villa can be confiscated unless the owner can prove that it was purchased with legal funds. The situation is similar in Great Britain. British courts can force suspects to disclose the origin of their assets. They have the option of confiscating assets until the beneficial owner explains where the funds came from.

FIU problems

There has been considerable criticism of the effectiveness of the FIU, the anti-money laundering unit based at customs. This also comes as no real surprise because the media have already repeatedly and emphatically pointed out in recent years that there are obviously problems with the processing or follow-up of cases. Issues such as the pending suspicious activity reports (SAR) in the Wirecard scandal, the search of the FIU's premises due to investigations by the Osnabrück public prosecutor's office, and the large number of generally unprocessed cases at the FIU in the past have not been explicitly addressed. However, they lead to a negative perception among the population, the obligated parties and ultimately by the FATF. Despite all the scolding, the FIU must also be credited for its dependence on the information provided by the reporters and its quality. If the FIU receives SARs that are incomplete or contain incorrect data, the FIU's possibilities are limited, also in terms of international cooperation. You can find out which impact poor data quality can have on compliance in the #rethinkcompliance blog. 

Challenges

That Germany is willing to meet the FATF's requirements is demonstrated by the paradigm shift anti-money laundering announced by Finance Minister Christian Lindner, including the creation of a new federal authority. However, this alone will not solve existing problems. It will require enormous efforts and cooperation with the different public authorities and sectors to make the work effective. This applies not only to the financial sector, but to a large extent also to the non-financial sector and DNFBPs already mentioned above.

Germany must report to the FATF within one year on the measures taken and progress made. Therefore, there is no time to wait for things to come. The BaFin, other obligated parties and the financial sector are facing major challenges in order to even begin to meet the FATF's expectations.