With greater enforcement focus on illicit funds in real estate, risks rise for investors, corporates

Businessman pressing an Real Estate concept button.

By Brian Monroe
September 1, 2016

As the U.S. Treasury increases its scrutiny of the real estate sector to uncover ties to criminals hiding illicit funds or political powerbrokers secreting away corruption proceeds, the risks are also rising for investors who may be held accountable for the actions of rogue third-parties.

In recent months, there have also been high-profile reports and undercover investigations revealing the ease with which criminals, tax evaders and politically-exposed persons (PEPs) can hide their identities behind anonymous shell companies, a move that obscures their ownership interests in new and existing real estate projects. This combination of factors is requiring more creative thinking from investors and investigators to uncover illicit intersections, such as by scouring bankruptcy proceedings.

Real estate investors backing overseas projects, especially those in higher-risk jurisdictions, face an even greater likelihood of finding themselves putting money into a project tainted by dirty money or graft-gilt funds, as they are sometimes forced to rely on at-times nebulous, far-flung third-parties.

These in-country finders, property managers and joint-venture partners may be creating a chain of liability by using monetary or other gifts to expedite the process of acquiring required permits, a move that could trip U.S. rules prohibiting the bribing of foreign government officials.

Also at issue broadly are unclear or non-existent  anti-money laundering (AML) due diligence standards for many parties in real estate transactions. In some jurisdictions, these parties, like the investors themselves, typically aren’t covered by specific anti-money laundering (AML) due diligence rules, though they are tacitly beholden to anti-corruption legislation and related penalties for failures.

These wide-ranging risks can be mitigated by mirroring many of the more formal financial crime compliance obligations already followed by a broad array of financial institutions, including banks and certain non-bank lenders.

“A strong compliance program can help an investor detect and avoid a high-risk transaction, or at a minimum ensure that the investor avoids liability for conduct of a rogue third party,” according to a client alert by international law firm Ropes & Gray. The alert also details key tenets of a compliance program and even examples where such forethought helped avert problems:

  • Managing managers: During the due diligence process, a global real estate investor learned that a proposed property manager in India expedited the environmental approval process for a different property by paying small amounts of cash to local government officials.  By identifying the situation prior to engagement, the investor was able to proceed with the acquisition but engaged a different property manager.
  • Goodwill hunters: An investor’s proactive audit into a property management company identified dozens of small gifts and gift cards given to government officials in several cities throughout China in order to generate goodwill.  The investor and the property manager then conducted a joint investigation into the conduct, took appropriate remedial steps against the employees giving the gifts, and enhanced the compliance program at the property management company to deter and detect such conduct going forward.

Much of the focus on real estate in recent months has been spearheaded by the U.S. Treasury’s Financial Crimes Enforcement Network (FinCEN).

In late July, FinCEN expanded its use of a powerful “geographic targeting order” to capture more information on the beneficial owners working with non-bank entities in the real estate sector involved in cash deals, widening orders from January in two major metropolitan areas in Florida and New York, and adding locales in Texas and California.

The orders focus on requiring title insurance companies to capture and report individuals behind high-end real estate purchases in all the boroughs of New York City, three counties in South Florida, five counties in California and a county in Texas.

To get a better sense of the financial crime and corruption risks for individuals, investors and companies in the real estate and investment sector, and garner some guidance on what a strong compliance program would look like, ACFCS Director of Content and Business Development, Brian Monroe, spoke with Ropes & Gray partner, Kim Nemirow, who is a registered foreign lawyer in Hong Kong and has devoted her practice to white collar matters in Asia, Latin America, and globally. Here is an edited transcript of that conversation.


Why do you think real estate has gotten so much attention from FinCEN?

U.S. regulators have been increasingly focused on building cases and rooting out corruption and money laundering issues across industries.  Real estate is one additional avenue.

The real estate sector has not been singled out in any specific way, but it is a recognized high risk industry for a few reasons. Investments in real estate often rely heavily on third parties for property development and management. Additionally, a global investor or investment firm based in the U.S. and London, invests in real estate assets around the world or in higher risk jurisdictions and would need to rely on a local third party to oversee and develop the asset.

How can real estate be used to hide assets tied to corruption?

Real estate investments require a lot of interactions with government officials, including construction building permits,  and any other kind of safety approvals, such as fire safety. For that reason, real estate investing involves a number of government contacts.

One of the biggest risks in the real estate industry is reliance on third parties. The lion’s share of corruption cases involve misconduct by third parties. Real estate investing involves property managers, asset managers and developers who are all essentially acting on behalf of an investor, therefore creating potential liability and risk. Historically, the use of real estate funds and real estate investments to move money around and essentially create AML risks, as well.

What could or should individuals, corporations and investors be doing to ferret out corruption or financial crime tied real estate?

There are several components of establishing a compliance program and culture of compliance that are important for any investor, whether an individual or company, involved in the real estate sector.

This includes conducting due diligence into the potential real estate asset or the potential third parties involved in the investment. It’s important to make sure you know your business partners and also to understand who is doing what. What will the third party be doing for you? It’s important to understand the roles and responsibilities of all the players in the investment.

If you have engaged a property manager to develop the property, the person may want work with environmental consultants, for example, to get approvals or work with a construction consultant on getting the right permit. All of these people along the chain of activity create liability and risk and an investor needs to have the right controls in place.

Aside from due diligence, in real estate investing, it’s important to look at the involvement of entities other than owners, such as the activities of the property manager and asset manager. It’s key to make sure you have a training program that makes clear your commitment to compliance. It’s also important to have the right to conduct an audit of the books of the third party, and if there are allegations of corruption and bribery or financial fraud, be prepared to take it seriously and investigate. The U.S. government will expect it.

What are the kinds of questions banks, non-banks and others involved in real estate, those subject to formal AML rules and those not, should be asked to uncover connections, or activities that could be suspicious or indicative of financial crime or corruption?

It’s important to understand where there could be potential payments to a government official, and what type of conduct is considered to be higher risk. It’s also critical to focus on the third parties and due diligence on that activity.  Key questions might include:

  • Have any of the entities involved had any historical allegations of bribery and corruption?
  • Do they have compliance programs in place?
  • Do they have any compliance provisions in their contracts with subcontractors and third parties?
  • What kind of oversight of third parties is in place?

In any kind of real estate investment, it’s also important to understand the genesis of the deal. Did the investor use a deal finder or promoter? It’s important to understand context, because the circumstances could have compliance implications.

Are there any red flags that are more readily apparent tied to real estate crime or corruption? Or are there certain documents or fields in documents that could give a more bright line clue that something questionable has taken place? 

There are certain signs that are always important to look for, including whether parties have audit reports and whether concerning payments or issues have arisen in a financial audit.  Does the party have a reputation for improper conduct?  It’s also important look at vendor payments and consultant payments, especially to determine if there are potential avenues or indicators that money is flowing out of the company. It’s key to understand that if money is paid to a particular consultant, what services have been rendered and, if so, whether there are payments that look concerning or stand out. Some typical indicators include round number payments that seem larger than others or are out of context, for example.

Should these due diligence steps be informed by regions, or regional risks of actual or perceived financial crime and corruption? 

Definitely, due diligence tied to real estate investing should be risk based, particularly because of the pace of real estate investing around the world.

For instance, if you are operating in India, we know investments might be considered higher risk because of the extensive permitting required, such as environmental approvals. The regulations also vary from state to state in India, creating a heightened risk profile for real estate transactions, although it’s not necessarily higher than certain other high risk countries.

Overall, though, there are countries that definitely have heightened corruption risks, so investors and companies should be more vigilant in those areas. But, the culture in many countries is moving away from a culture where bribes are essential to investing. As the world gets smaller, international investors around the globe are sending a message that bribery is forbidden.

What financial crime regulatory frameworks should be adopted by professionals in the real estate sector and how are other countries dealing with this issue?

I think many of the broader anti-corruption and AML requirements are being enhanced globally. For instance, Mexico just announced a massive anti-corruption legislative change, and numerous other countries are implementing their own changes, and those laws would apply to real estate investing, as well.

The same can be said for AML laws. There are changes in the EU money laundering regulatory environment that could be very significant. Expect more developments later this year.


Making discoveries in bankruptcy court

But in order to properly even find assets tied to certain individuals, who may be trying to obscure ownership interests, you need to be creative, said John Couriel, an attorney in Kobre & Kim’s Government Enforcement Defense team.

His practice frequently involves efforts to recover assets in the U.S. and other jurisdictions on behalf of bankruptcy trustees and judgment creditors, he said.

“We find that real estate in certain jurisdictions – among them South Florida and New York – is a frequent store of value for judgment debtors or former control persons of insolvent companies seeking to avoid judgment enforcement,” Couriel said.

So in order to gain insight on potential obfuscated assets, “title companies, bank employees, and others involved in U.S. real estate purchases by shell companies and foreign nationals should ask about, and search for, non-U.S. insolvency proceedings involving the control persons and agents of any entities investing here.”

Insolvency laws differ across countries, but “generally speaking, a representative of an estate has the power to initiate a case under Chapter 15 of the U.S. bankruptcy code to take discovery about, and potentially recover, investments made with funds belonging to the estate,” he said.

There’s also 28 U.S.C. § 1782, which gives non-U.S. litigants the “ability to take discovery here in the U.S. in aid of non-U.S. proceedings – even before such proceedings are filed,” Couriel said. “We serve a lot of subpoenas on banks and title companies under these auspices. To avoid receiving them, or to be ready to respond when they come, it’s important to know as much as you can about any non-U.S. insolvency proceedings or debts involving your buyer.”


Here are some additional key potential issues and the parameters of a strong compliance program, according to Ropes & Gray

  • Anti-Corruption: Across industries, entities are subject to a heightened corruption risk if they operate in high risk locations, have extensive interactions with government officials, give gifts and entertainment to potential business partners, and rely extensively on third parties. The real estate industry is considered to be particularly high risk because it hits on so many of these risk areas:
    • High-Risk Markets: Many real estate investors are rapidly expanding into emerging markets that are perceived to have high levels of corruption. In particular, we have seen growing asset portfolios across India, China, Africa, Latin America and the Middle East. This enhanced corruption risk is further complicated by the fact that asset owners typically are not located in the same geography as the asset, and thus rely heavily on local third-party property managers or local joint venture partners.
    • Extensive Government Interactions: Asset owners and developers may be required to interact with government officials for a variety of reasons, including negotiating contracts, obtaining construction permits or environmental approvals, overseeing inspections, and meeting the requirements for daily operation. Moreover, the government requirements necessary to acquire and develop property vary significantly by jurisdiction, which only compounds the need to rely on local partners to navigate the sometimes very technical approval and permitting processes.
    • Reliance on Third Parties: U.S., UK, and other regulators are keyed in on the use of third parties to funnel improper payments to prospective business partners and government officials. In China, too, there is increased focus on bribes through third parties. For instance, China has expanded penalties for bribery and corruption through its Ninth Amendment to the PRC Criminal Law (the “Amendment”), which became effective on November 1, 2015. The Amendment adds the crime of providing bribes to current and former state functionaries’ close relatives or other persons closely related to them; adds monetary penalties in addition to other punishments for corruption-related crimes for individuals; replaces specific monetary figures that trigger different levels of punishments with more general standards such as “relatively large,” “huge,” and “especially huge”; and restricts the circumstances in which bribe-givers will be exempted from punishment.
  • Money Laundering: Bad actors, including sanctioned individuals and entities, frequently attempt to launder ill-gotten gains, including the profits of corrupt activity, through disguised property investments. In many jurisdictions, it is easy to disguise the ultimate beneficial owners of a particular asset through intermediate entities. This exposes real estate investors to the risk of inadvertently facilitating illegal money laundering.
    • The UK’s first national AML risk assessment identified significant gaps with respect to real estate holdings. Soon, however, as is explained in more detail in our recent alert “An Englishman’s Home is His Castle – Just!,” corporate entities that own property will be required to disclose their ultimate beneficial owners as UK regulators seek to crack down on corruption in this space.
      • “Corrupt individuals and countries will no longer be able to move, launder and hide illicit funds through London’s property market.” – David Cameron

 An Effective Compliance Program

Establishing an effective compliance program starts with a strong tone at the top from management expressing the importance of ethical business conduct and requiring compliance with laws, including appropriate anti-corruption, anti-money laundering, and economic sanctions regimes.

It will also consist of tailored policies, procedures, and training addressing relevant risk areas, as well as monitoring procedures aimed at assessing the effectiveness of the compliance program. Policies, procedures, training, and monitoring should be proportionate and tailored to the company’s risks.

  • Enterprise-Level Compliance Program: A real estate investor’s compliance program should begin with appropriate policies and procedures for its own business and employees. Investment professionals should be trained on the risks of doing business internationally and, importantly, anyone serving as a board director should understand their heightened obligations and potential individual liability for conduct at the investment. For example, investments in emerging Asian markets will likely involve undeveloped property or property that needs significant repair or redevelopment. In these instances, anti-corruption risk is heightened because construction and development of properties require government permits, licenses, and approvals.
  • Pre-Acquisition Due Diligence – Assets: Prior to acquiring an asset or making an investment, diligence should be conducted on the seller and asset to determine whether there are any past issues with the property or corrupt conduct on behalf of the seller. For established, fully operational properties, this might include looking at prior investors and property managers to determine if they have been involved in any criminal conduct that might raise red flags, or how prior contracts or licenses with government officials were negotiated or renewed. In the case of developing properties, or the purchase of land to build a property, the investor will need to understand what permits and licenses will be required to construct the property and how those will be obtained (including whether they will be obtained prior to or as a condition to the closing of the acquisition). In all cases, investors will want to pay particular attention to any red flags indicating that the seller may not have proper and clear title to the property.
  • Pre-Acquisition Due Diligence – Property Managers: Similarly, a company’s compliance program should set out risk-based due diligence steps to be taken when engaging property managers. Heightened due diligence will often be required for these parties, particularly in high risk countries, given that they may be interacting with government officials to obtain approvals, permits and licenses, and will also be working with prospective business partners to lease the property and provide management oversight.For both assets and property managers, the due diligence steps to be conducted will largely depend on the risk presented, but may include a public media search on the relevant parties and key individuals, including checking individuals and entities against sanctioned party lists, review of relevant documents, policies and procedures, and a discussion with management or completion of a due diligence questionnaire. Appropriate representations, warranties and covenants in contractual agreements should also be considered.
  • Portfolio Risk Assessment: In order to have an efficient and effective compliance program, it is imperative that real estate developers and investors understand their risks. Conducting a risk assessment across all properties and property managers in an investor’s portfolio will allow the investor to tailor its compliance program and effectively allocate resources. The risk assessment should include an analysis of the location of the assets, the extensiveness of government contacts, the use of third parties, and any existing compliance program in place.
  • Monitoring Assets and Third-Party Property Managers: Just as companies must monitor compliance at an enterprise level, they should also monitor compliance at the asset and property manager level. Depending on ownership stake and risk level, the type of monitoring will vary, but might include conducting periodic audits and obtaining compliance certifications. Moreover, in addition to proactive monitoring, owners, developers, and investors should take appropriate steps to investigate any red flags that might arise in relation to the property, including via an allegation or other complaint. We have seen whistleblowers report concerns about a property or property manager directly to the investor, and it is imperative that the investor take appropriate steps to investigate all reasonably credible allegations.