In a recent decision, the Commercial Court has upheld a financial institution’s decision to exercise its contractual right to close a customer’s accounts and terminate its relationship without notice, where the financial institution had a suspicion that its customer’s accounts were being used for money laundering purposes: N v The Royal Bank of Scotland plc [2019] EWHC 1770. The decision will be welcomed by financial institutions seeking to take action to prevent financial crime occurring through use of accounts provided to customers, under tight time pressure and notwithstanding that the consequences of the bank’s action for the business in question could be severe.

This is not the first case in which a financial institution has successfully defended a breach of contract claim brought by its customer in the context of a money laundering suspicion. In Shah & Anor v HSBC Private Bank (UK) Ltd [2012] EWHC 1283 (QB) (see our corporate crime e-briefing), the court firmly rejected the customers’ claim that the bank was in breach of contract by refusing to process payment instructions while awaiting consent from the Serious Organised Crime Agency (now the National Crime Agency, “NCA”) in respect of a Suspicious Activity Report (“SAR”). In that case (in the absence of an express term) the court implied a term into the contract. The implied term permitted the bank to refuse to execute payment instructions in the absence of “appropriate consent” under the Proceeds of Crime Act 2002 (“POCA”), where it suspected a transaction constituted money laundering. Pursuant to the POCA ‘consent regime’, once a bank makes a SAR, it will not be able to process payments in relation to the relevant account until “appropriate consent” (now known by the NCA as “DAML”) has been given by the NCA. In Shah, the defendant bank was then put to proof that it had the requisite suspicion of money laundering in order to rely upon the implied term (which the bank satisfied).

However, in the instant case, the bank was assisted by express contractual provisions giving the bank discretion to close the customer’s account and delay/refuse to process payments in certain circumstances. As such, the test applied by the court was different to previous authorities (including Shah), because it derived from the wording of the contract itself and the contractual discretion expressly provided for.

While the terms governing accounts will vary between institutions and account type, a number of the court’s findings may be of general assistance to banks considering AML compliance procedures and assessing the risk of exposure to account-holder claims. In particular:

  • Interestingly, the court did not find it necessary to grapple with the question of the standard which the bank was required to meet in the exercise of its contractual discretion to close the account, i.e. whether the bank’s discretion was required to be exercised in a way which was not arbitrary, capricious or irrational in the public law sense (the so-called Braganza duty); or if the bank was required to meet the higher standard of objective reasonableness. This was because, even applying the higher threshold, the court found that the standard had been met by the bank and the decision to close the account did not breach the bank’s contractual terms. The applicable standard is important because contractual discretions are subject to increased judicial scrutiny if the latter standard applies (see previous blog post: High Court applies public law standard to the exercise of discretion by a financial institution under a receivables finance agreement). It may be prudent for those drafting the bank’s account terms to consider expressly incorporating the lower threshold where appropriate.
  • The court reached its conclusion notwithstanding the absence of any suspicion that the customer (a money service business (MSB), whose accounts received funds from its underlying clients) was implicated in its clients’ suspected criminality. This was because the end result of the customer’s poor AML due diligence and regulatory compliance was similar to the result of deliberate action on its part.
  • The court expressly stated that the bank was entitled to consider the impact (on the bank itself) of not freezing and terminating the customer’s accounts – here the bank could not countenance a risk that it would be money laundering and this was a relevant factor to take into account in the exercise of the bank’s discretion.
  • The court specifically rejected the customer’s broad contention that unless complicity/fraud is proven, closing an account without notice “could never rationally be adopted by a bank” (emphasis added). The court confirmed this will depend upon the wording of the contractual terms governing the account. In this case, the contract provided that the bank could take action where it considered there to be exceptional circumstances, not just where there is established complicity or proven fraud.

Regrettably, the court chose not to grapple with a number of other areas of interest from an AML compliance perspective which are raised by the case. Foremost among these is the question of co-mingling and ring-fencing (and in particular the circumstances in which ring-fencing might be a permissible approach, within the framework of POCA, as an alternative to freezing an account). This is a perennial debate, and the recent Law Commission consultation on reform of the SARS regime included an interesting discussion on the question of ring-fencing and fungibility (that money is considered to be an asset capable of mutual substitution, i.e. one £5 note can be substituted for any other £5 note). The Law Commission’s final report recommended an amendment to POCA to create additional clarity in this area. In the meantime, while the position taken by the court in N v RBS was helpful to the bank, the correct legal analysis as to the nature of the criminal property in play when funds are mixed remains open to debate.

Background

The claimant (“N”) was an authorised payment institution providing foreign exchange and payment services to its customers. N held several main accounts and client sub-accounts with the defendant, The Royal Bank of Scotland plc (the “Bank”).

Pursuant to the terms which governed the operation of N’s accounts, the Bank:

  • was under a duty to give N written notice to close an account, unless it considered there were exceptional circumstances; and
  • could delay or refuse to proceed with processing a payment if, in its reasonable opinion, it would be prudent to do so in the interests of crime prevention or in compliance with laws.

In September 2015, the Bank suspected that several of N’s clients were involved in “boiler room” scams, and that victims had paid money into N’s accounts held with the Bank. The Bank froze several client sub-accounts, and identified there had been “co-mingling” (i.e. mixing) between sub-accounts and the main accounts. On 8 October 2015, after the sub-accounts had been frozen, an attempted payment was made from the main account (the “Attempted Payment”), arousing the Bank’s suspicion that some of N’s clients were attempting to circumvent the freeze on the sub-accounts.

On 9 October 2015, the Bank froze the main accounts and terminated its relationship with N immediately. N commenced proceedings challenging the lawfulness of the Bank’s actions, alleging breach of contract and negligence.

Decision

The High Court found the Bank was entitled to terminate its relationship without notice in the circumstances.

Standard of contractual discretion

The court undertook a detailed assessment of the factual evidence presented, and found that the decision to terminate the relationship was taken on 9 October 2015. It then considered whether the Bank exercised its discretion to close the accounts (and therefore refuse to process payments) in accordance with the contractual terms governing the account.

In the court’s view, the case did not turn on the differences between the parties’ rival contentions as to the meaning of the contractual terms and it did not consider those questions further. In this regard, N argued that the Bank was required to meet the standard of objective reasonableness in the exercise of its contractual discretion to close the accounts. The court held that, even applying this standard (which is higher than the rationality threshold), the standard was met by the Bank.

Alleged failure by the Bank to exercise discretion in reasonable manner

The court considered various challenges made by N to the exercise of the Bank’s discretion. The key challenges which are likely to be of broader interest are explored further below.

  1. N’s primary challenge to the exercise of the Bank’s discretion was that there was no suspicion that N was implicated in money laundering. However, the court found that N’s poor control environment meant, in effect, whether N was implicated in the fraud or not was irrelevant to the Bank’s exercise of its discretion. In this regard it is noteworthy that the experts on both sides agreed that there were numerous failures in N’s due diligence and regulatory compliance, which the court held were “serious”.
  2. N argued that because there was no suspicion that it was complicit/implicated in the underlying frauds of its clients, the co-mingling issue “was not insurmountable”. However, the court considered and rejected the various ways suggested by N (ex post) as to how freezing N’s sterling pooled client account (one of the accounts in question) could have been avoided. In particular:
    • The court rejected N’s contention that the Bank could have ring-fenced suspected funds as the Bank had tried this by initially freezing the suspect sub-accounts. The success of this option had already been compromised by the co-mingling of accounts and the Attempted Payment. The court said the position was the same in relation to N’s separate contention that the Bank could have broken the account (if necessary with NCA consent), and commented that the Bank also had (and was entitled) to consider its obligations as to the prevention of crime, separate to the view of the NCA.
    • The court rejected N’s proposal that the Bank could have manually operated the account or sought consent on a daily basis by way of an ‘omnibus’ SAR. These two proposals were impractical, in light of the volume of transactions and the challenges posed by investigating each one, and of engaging with the NCA.
    • The court rejected N’s assertion that the Bank could have prevented further credits to the account or could have adopted a cooperative approach to the exit of the relationship by working with N over the suspect accounts. The court commented that the Bank was entitled to conclude that things had gone too far for this suggestion to be workable, and the proposal as to further credits did not address the position as to existing balances in the accounts.
  3. The court rejected N’s contention that the absence of suspicion in relation to N’s involvement in evasion in relation to the Attempted Payment was relevant – it was the evasion itself which was the problem for the Bank.
  4. The court also concluded that as co-mingling had been identified in the accounts, this fact could be taken into account by the decision-maker at the Bank, even without further investigation.
  5. N argued that the decision to terminate the relationship without notice did not take account of the potentially significant consequences for N’s business. As a matter of fact, the court found this was incorrect. The court also helpfully commented that the impact on the Bank of not freezing and terminating must be part of the consideration – here the Bank could not countenance a risk that it would be money laundering and this was a relevant factor to take into account in the exercise of the Bank’s discretion.
  6. The court specifically rejected N’s broad contention that unless complicity/fraud is proved, closing an account without notice “could never rationally be adopted by a bank” (emphasis added). The court noted that the contract provided for a right to close an account without notice where the Bank considers there are “exceptional circumstances”, not “where there is established complicity or proven fraud”.

The court recognised there were a range of honest, rational and reasonable decisions which could have been taken. However, it did not mean that the decision-maker’s chosen course was incorrect; it was within the realm of reasonable decisions. Accordingly, the court held that the decision taken by the Bank on 9 October 2015 was not in breach of the Bank’s terms (nor a breach of any tortious duty, for the same reasons).

Section 338(4A) POCA

The court found it unnecessary to consider s.338(4A) POCA, the post-Shah provision which was introduced into POCA with a view to assisting firms who are alleged to have caused loss to customers or counterparties by making authorised disclosures (typically, if there is a delay in a transaction while consent/DAML is sought). The provision did not assist the Bank, since the basis of the customer’s claim was the decision to terminate the account relationship, rather than a loss arising from the seeking of consent.