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Failing to comply with due diligence and know-your-client requirements

2018-06-29

Introduction

The recent decision handed down by the Hong Kong Court of First Instance, Arrow ECS Norway AS v M Yang Trading Ltd and Others [2018] HKCU 1479, illustrates situations where a financial institution may not rely on the change of position defence for breaches in anti-money laundering and know your client legislation.

Facts

The Plaintiff is a subsidiary of Arrow Electronics Inc (“Arrow Electronics”), and the 2nd Defendant is a company registered in Hong Kong and the holder of a bank account at Bank of Communications, Shanghai Branch (“D2 Account”). Between 18 and 22 January 2016, the Plaintiff was induced by unknown person(s) impersonating as the CEO of Arrow Electronics or a lawyer at a Wisconsin law firm over the telephone and in emails (“the Fraud”) to transfer sums totalling US$23,395,000 to the D2 Account.

Silver Fast Limited (“Silver Fast”), a licensed money service operator, used the bank accounts of the 10th, 13th and 14th Defendants for its money changing business; while the 5th, 11th and 15th Defendants carried on business as unlicensed money service operators in Hong Kong. Between 20 and 22 January 2016, portions of the aforesaid sum were transferred from the D2 Account to various bank accounts of the 5th, 10th, 11th, 13th, 14th and 15th Defendants (the “Second Level Recipients”) at HSBC in Hong Kong, totalling US$4,188,175, in view of the provision of money services for the conversion of approximately US$5 million into RMB (the “Funds”).

Judgment

The Second Level Recipients argued that Funds were transferred from the D2 Account to their respective accounts in the course of the money changing business operated by them and/or Silver Fast for legitimate commercial purpose, and the Funds were received in good faith, with consideration and without notice of the Fraud. Hence they changed their position in that they transferred the Funds out of their respective accounts afterwards and the defence of change of position applies. However, the court held that the defence of change of position could not be made out for the following reasons:

 

  • The effect of “illegality” on the defence of “change of position”

In the case of Barros Mattos Junior v MacDaniels Ltd [2005] 1 WLR 247, it was held that an innocent recipient of stolen money could not rely on the defence of change of position where that change was regarded by the court as wrongful, and that if the recipient’s actions of changing position were treated as illegal the court could not take them into account and had no discretion to do so, unless the illegality was so minor as to be ignored on the de minimis principle.

Illegality of a contract can be found in the following circumstances: (a) contracts the object of which involved committing a legal wrong or carrying out conduct other-wise contrary to public policy; (b) contracts entered into for the purposes of doing the above; or (c) contracts performed in such a way that the party(ies) commits a legal wrong or carries out such conduct.

The 5th, 11th and 15th Defendants were unlicenced money service operators, and is therefore illegal businesses. Whereas although Silver Fast was a licensed money service operator, it provided money changing service for US$5 million to an unidentified customer without making any inquiries about the identity of the “customer” or other details of the transaction. It is also noted that the directors of the 5th, 11th and 15th Defendants had no control over the respective accounts used by Silver Fast to operate its money changing business, and had no knowledge as to the identity of the 2nd Defendant. It is clear that they failed to comply with customer due diligence requirements stipulated in Schedule 2 of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap.615), which states certain due diligence/know-your-client requirements for remittance transactions. The breaches and/or failure to do any and/or sufficient due diligence work cannot be said to fall under the de minimis principle, noting that the ordinance set out measures designed to prevent online fraud situations and/or transfer of proceeds of a fraud by unknown/unidentified persons/entities through different bank accounts in multiple jurisdictions.

  • Absence of causal link between the receipt and change of position

Although the 5th, 11th and 15th Defendants alleged that they carried on business as unlicensed money service operators, they failed to produce any business records such as contracts, invoices, receipts and client instructions. Moreover, there was no documentary evidence to show that funds were transferred out to certain accounts as alleged. In respect of the 10th, 13th and 14th Defendants, they failed to produce evidence to establish a complete chain of the flow of funds. Therefore the Second Level Recipients were unable to demonstrate the causal link between the receipt and change of position.

 

  • Absence of good faith

Based on the facts and in view of the illegality abovementioned, it was held that the Second Level Recipients failed to act in a commercially acceptable way, and that it would be inequitable, unconscionable, or unjust to allow the Second Level Recipients to deny restitution to the Plaintiff.

Conclusion

To conclude, financial institutions and money service operators should strictly comply with due diligence/know-your-client requirements stipulated in Schedule 2 of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance in order to avoid being involved in money laundering activities and to ensure it is entitled to rely on the change of position defence, which in our experience is likely the only defence available to them in cases of online fraud.

For enquiries, please contact our Litigation & Dispute Resolution Department:

E: regcom@onc.hk

T: (852) 2810 1212

W: www.onc.hk

F: (852) 2804 6311

19th Floor, Three Exchange Square, 8 Connaught Place, Central, Hong Kong

Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.

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