Suspicious Activity Reports: Should Absolute or Qualified Immunity Apply?

US anti-money laundering compliance managers may have to think twice before filing suspicious activity reports (SARs) depending on what the Supreme Court decides in a case involving Fidelity Brokerage Services.

The petition filed by AER Advisors and two of its clients William J. Deutsch, chairman of Deutsch Family Wine & Spirits in White Plains, New York and his son, the firm’s chief executive Peter Deutsch, seeks to overturn the April 2019 decision of the First Circuit Court of Appeals in Massachussetts. That ruling upheld Fidelity’s absolute immunity in filing a SAR in July 2012 claiming that AER and the Deutches could have been responsible for a short squeeze on the stock of China Medical Technologies, a Beijing-based maker of cancer treatment devices. The SAR triggered an SEC investigation into the Deutsches and AER resulting in no sanctions ever being issued.

In insisting there was no way they could have causd the short squeeze, the three Fidelity Brokerage clients lay the blame strictly on Fidelity. The trio want the Supreme Court to give them restitution and decide whether the policy of absolute immunity when filing a SAR with the US Treasury’s Financial Crimes Enforcement Network (FInCEN) should apply or whether the policy should be one of “good faith.” If the high court decides not to hear the case the first circuit’s ruling in favor of Fidelity will stand.

At the heart of the matter are two conflicting rights. “The Supreme Court will have to decide whether fighting crime to benefit society will trump the rights of the individual,” explains Ross Delston, an anti-money laundering (AML) attorney and expert witness in AML cases in Washington, DC.

Should the Supreme Court agree to review the case and amend the principle of absolute immunity even in the slightest way, financial firms worry they could be stuck with a higher expense before filing SARs. Some AML compliance managers at US brokerages tell FinOps Report they are concerned about either needing to add more analysts, having more senior level executives sign off on SARs, or attaching even more documentation to SARs. They might even decide to file fewer SARs fearing potential litigation from a distgruntled customer or a potential whistleblower scenario should an employee feel he or she was forced to sign off on a dubious SAR.

The Bank Secrecy Act of 1970 requires US financial firms, including fund managers, banks and broker-dealers, to file SARs when they have even the slightest inkling of a potential crime being committed so they can help regulatory agencies combat money laundering. Financial firms don’t have to prove any wrongdoing. It’s up to regulatory agencies, such as the US Securities and Exchange Commission, to investigate the details in the SAR and prove a crime occurred. Not all investigations lead to prosecution.

SARs aren’t filed lightly. AML departments at financial firms typically review red flags or alerts issued by transaction reporting and other systems that indicate there might be something amiss with a client’s business activity. More often than not, further investigation leads the financial firm to conclude that the alert was a false positive or false alarm. However, as some AML compliance managers tell FinOps Report, some financial firms might still opt to file more SARs than necessary to err on the side of caution. Regulators won’t penalize firms for filing too many, but they will if they file too few.

The case involving Fidelity has already polarized the compliance community. The majority stance, favored by AML directors and legal counsels for financial firms as well as the trade group Securities Industry and Financial Markets Association (SIFMA), is to keep the commonly accepted barometer of absolute immunity. Once a financial firm has filed a SAR, its hands are washed and it shouldn’t have to worry about being sued by an unhappy customer, because it fulfilled its legal obligation under the BSA. AML directors and legal counsels insist the legislation offers their firms full immunity, but the Deutsches and AER dispute that viewpoint.

On the minority side of the debate are some vocal attorneys who say that financial firms could easily abuse their obligation to file SARs by filing too many unnecessarily, or even worse by filing SARs they know are blatantly wrong. As a result, government agencies investigating the accused culprits as well as the accused themselves will spend countless time and big bucks unnecessarily.

So far, legal precedent has been muddled. Some federal courts, such as the First Circuit Court of Appeals have ruled in favor of absolute immunity while others, such as the Eleventh Circuit Court of Appeals, favor more restricted immunity. In his petition filed before the Supreme Court Howard Graff, an attorney with Arent Fox in New York representing AER and the Deutsches, argues that Fidelity filed the SAR against AER and the Deutsches to cover up its own wrongdoing, thereby needlessly subjecting his cliens to hundreds of thousands of dollars in expense defending themselves. Although the investigation into the Deutsches and AER didn’t lead to any prosecution, it was enough to put AER, a registered investment advisor, out of business and cost the Deutsches their business reputation. “Absolute immunity permits financial institutions, such as Fidelity, to act with impunity and wastes the resources of the government agencies involved in investigating SARs,” writes Graff in his petition to the Supreme Court.

In his filing with the Supreme Court, Shay Dvoretsky, a partner with the law firm of Jones Day in Washington, DC representing Fidelity, counters that two federal appellate courts have already held that a financial institution is immune from a private suit if it files a SAR. It ultimately doesn’t matter whether Fidelity’s SAR resulted in a regulatory sanction or not. Fidelity did its job under the requirements of the BSA, which Dvoretsky insists makes financial institutions  absolutely immune from private suits based on filing a SAR. “The history of the Bank Secrecy Act as well as policy considerations confirm that the court [First Circuit Court of Appeals] reached the right decision,” writes Dvoretsky in his brief to the Supreme Court.

What’s more, says Dvoretsky, the Deutsches and AER don’t even know what Fidelity wrote on the SAR and the BSA prevents Fidelity from revealing its contents. Therefore, they can’t even prove a SAR was even filed, much less that the filing was improper. Dvoretsky never addresses the fact that AER and the Deutsches must have figured out what Fidelity’s SAR said based on the SEC’s investigation or that only the SARs themselves are privileged, not the suporting documentation created in the ordinary course of business.

Legal experts specializing in AML hope the Supreme Court takes on the case involving Fidelity to resolve any confusion about the standard of care financial institutions must take in filing SARs. None of the attorneys contacted by FinOps Report to comment on the case involving Fidelity, were willing to predict what the high court would decide. However, each attorney, unrelated to the case, was eager to opine on the ideal outcome. “If it takes the case, the US Supreme Court should rule in favor of absolute immunity so that financial firms can feel free to file SARs without fear of litigation which would ultimately reduce the number of SARs filed,” says Betty Santangelo, an attorney with the law firm of Schulte Roth & Zabel in New York. “Any other standard would also be impractical.”

Santangelo’s reasoning: a financial institution does not have the ability to conduct a full-scale investigation to detemine all the facts in the same manner that law enforcement can. Moreover, a firm’s questions to a clients must be somewhat limited in nature, because any extensive questioning might tip it off to the possibility a SAR is being filed, she explains.

Aegis Frumento, a partner with the law firm of Stern Tannenbaum in New York, argues that in an ideal world, financial firms would always file SARs in good faith. However, he agrees with Santangelo that practically speaking it would be impossible to implement the new litmus test of good faith instead of absolute immunity. “While I’m sympathetic to clients who claim they were wrongly accused, the financial firm could only establish good faith by proving that it would have been impossible for the client to have done anything suspicious and the firm knew that,” says Frumento. “You can’t prove that without a full scale investigation, which can’t take place because SARs are secret. The purpose of the SAR, argues Frumento, is only to raise a suspicion, not prove wrongdoing. Changing the litmus test from absolute immunity to qualified immunity would require a revamping of the BSA, he believes.

However, there are some attorneys who insist it is time to change a glaring loophole in the BSA. “The financial firm is allowed to write just about anything it wants on the SAR without fear of liability,” says Bill Skinner, a New York-based attorney who defends securities industry clients in regulatory matters and represents whistleblowers. “In balancing the needs of society with individual rights, the Supreme Court could uphold the standard of absolute immunity, but carve out an exception of when the firm has reason to believe the information presented on the SAR may be erroneous and cannot be defended.”

Based on Graff and Skinner’s stance, one might conclude that Fidelity should never have filed a SAR against AER and the Deutsches because the facts in the case explained by Graff appear to point to Fidelity, not the Deutsches or AER Advisors creating the short squeeze in China Medical Technologies’ stock. AER was operating as a registered investment advisor in 2011 using Fidelity’s Wealth Central platform when AER introduced a “China Gold” strategy designed to take advantage of a widespread sell off of Chinese companies. William and Peter Deutsch were trying to gain a controlling interest in China Medical Technologies when in March 2012 they received an e-mail from Fidelity asking them to participate in a fully paid lending program to allow Fidelity to lend their hres to short sellers for a fee.

The Deutsches explicitly declined the offer, but Fidelity went ahead in March and June of 2012 lending nearly 1.8 million of the Deutsches shares in China Medical Technologies to short sellers. When the Deutsches tried to move shares between their accounts in June 2012 Fidelity had to start recalling shares from short sellers, because it lent more than it should have, says Graff in his court documenttion. When that effort failed, Fidelity had to buy 1.2 million shares on the open market. The buy-in drove up the price per share of China Medical Technologies by nearly 200 percent leading to a halt in trading by the SEC. In early July 2012 Fidelity filed the SAR accusing the Deutsches and AER of influencing the stock’s sudden spike.

Why would Fidelity lend a client’s shares without its consent? If it hadn’t done so, the resulting events would never have happened. Fidelity earned lots of money from lending fees, says Graff in his filing. Neither AER nor the Deutches received any compensation.

However, the facts of the case might not be so easy to decipher as one would think. Here is why: Brokerage operations experts unrelated to the case say that once shares are put into a margin account it is practically impossible to prevent them from being lent out unless they are taken out of Street name which standard margin agreements would not allow. Street name refers to the name of the financial intermediary.

The Deutsches also tried to transfer shares of China Medical Technologies between margin accounts, thereby requiring Fidelity to recall the shares it lent out. Fidelity had to put them back into the Deutsches first account so they could be transferred to the Deutsches second account, speculate brokerage operations experts unrelated to the case. Therefore, one could theoretically argue that the transfer of shares ordered by the Deutsches themselves triggered the recall that led to the short sale. What cannot be determined with any certainty based strictly on reading the facts of the case are two interrelated requirements to put any blame on the Deutsches. Those two requirements are whether the Deutsches actually knew with certainty that Fidelity had lent out their shares without their consent and that transferring shares between their margin accounts would ultimately trigger the short squeeze because Fidelity would have to recall lent shares. The fact that an investigation occurred indicates there must have been some concern about the Deutsches and AER’s possible role in creating the short squeeze. The fact that neither the SEC nor any other agency ever sanctioned the Deutsches or AER shows they could not prove the Deutsches intentionally intended to create a short squeeze.

The First Circuit Court of Appeals in Massachussetts, which accepted the case in April 2019 after Fidelity managed to sucessfully transfer it from a Florida federal district court to a Massachussetts federal district, didn’t appear to dispute Graff’s account of the facts of the case. However, the First Circuit Court of Appeals still ruled in favor of Fidelity on the grounds that the BSA immunizes financial firms from disclosures made on SARs even if the disclosures are unfounded, incomplete, careless or malicious. “The First Circuit Court’s ruling in favor of Fidelity already presents a well-founded argument which would be hard to overturn,” asserts Delston.

Did Congress intend to give financial firms carte blanche when it comes to their filing SARs? In its ruling in April 2019, the First Circuit Court of Appeals suggests it did to ensure that financial firms could file as many SARs as possible without fear of liabiliity. However, it could easily be argued that by not explicitly including a standard of good faith when filing SARs, Congress unintentionally set the stage for a potential abuse of power in rare instances. It is unclear whether using the standard of good faith, instead of absolute immunity, would actually protect the rights of clients or simply harm financial firms and society at large. At the very least, the Supreme Court needs to resolve the issue. AML compliance managers shouldn’t rush to change their policies for filing SARs now, but they should consider the possibility they might have to do so in the future.