The United States District Court for the Southern District of New York (the “Court”) has issued a detailed and complicated Order in the case Banco San Juan Internacional, Inc. v. Fed. Reserve Bank of New York, denying a motion for preliminary injunction by Banco San Juan Internacional, Inc. (“BSJI”), a Puerto Rican bank entity, against the Federal Reserve Bank of New York (the “FRBNY”) and the Board of Governors of the Federal Reserve System (the “Board”).
The case arose out of the FRBNY’s decision to close BSJI’s master account for alleged deficiencies in its anti-money laundering (“AML”) system, which thereby posed systemic risk. The Court held, amongst other rulings, that there is no statutory right to a so-called “master account” with a federal reserve bank.
After the Court filed its Order on October 27, BSJI filed its appeal on October 30, and requested an emergency stay pending appeal and an expedited appeal. On November 9, 2023, the United States Court of Appeals for the Second Circuit referred BSJI’s motion for a stay pending appeal and to expedite to a three-judge motions panel and denied the request for a stay pending appeal.
As we have blogged, and generalizing greatly, having a master account allows financial institutions to operate in the normal course as a custodial bank in the U.S. Having a master account is therefore critical to any institution looking to operate in the U.S. financial system. Accordingly, the FRBNY’s decision, and the Court’s Order, in effect prevent BSJI from operating.
Although some of the background allegations are eye-catching, the Order makes broad legal pronouncements, many of which are not necessarily tied to the alleged facts. The Order therefore emphasizes the significant and unilateral powers of a federal reserve bank, and its discretion to provide or deny master accounts going forward. These powers apply to all financial institutions and require financial institutions to take a serious approach in meeting their AML obligations under the BSA as well as regulator remediation and recommendations regarding the same. This matter also illustrates how a financial institution can resolve an enforcement action with the Department of Justice, only to find itself still facing an existential threat posed by a regulator for the same underlying activity.
Background
This matter does not arise out of a vacuum. In 2020, BSJI and the Department of Justice (“DOJ”) reached an agreement that the DOJ would return approximately $53 million in seized funds to BSJI, and that BSJI would pay $1 million to the DOJ in order to settle an investigation into the adequacy of the bank’s Bank Secrecy Act (“BSA”)/AML compliance program, particularly in regards to the filing of Suspicious Activity Reports (“SARs”).
As the Order described, BSJI opened its master account in 2012. The bank’s customer base was “almost exclusively comprised of his close family members and offshore entities they control.” According to the pleadings, BSJI had 14 account holders in May 2023. BSJI is neither a federally insured institution nor subject to prudential federal supervision. Rather, it is an “International Banking Entity” (“IBE”) under Puerto Rican law. Based on BSJI’s status as IBE, it is subject to the strictest level of review and must demonstrate that it has implemented an effective compliance program through “the submission of independent consultants’ assessment reports of BSJI’s compliance program” to maintain a master account. BSJI engaged an outside consulting firm to assist with its AML program.
The Office of the Commissioner of Financial Institutions of Puerto Rico, or OCIF, supervises and regulates Puerto Rico’s financial sector for safety and soundness issues, as well as all other applicable laws and regulations. As the Order observed, the Department of the Treasury has stated that OCIF has “severe resource constraints” and that IBEs are “attractive money laundering vehicles, potentially allowing nefarious actors to misuse them to facilitate illicit financial activity.” Also, the Order found that IBEs pose heightened risk to the FRBNY, because their access to master accounts could cause the FRBNY to facilitate illicit activity. Not mentioned in the Order is the fact that the Financial Crimes Enforcement Network announced in September 2023 a $15 million penalty against another IBE, Bancrédito International Bank and Trust Corporation, for alleged willful violations of the BSA.
The Powers of a Federal Reserve Bank
The Order laid out several key principles and powers governing reserve banks. For one, reserve banks hold a special position and are not considered “agencies” but rather “instrumentalities” of the federal government. The Order underscored that under 12 U.S.C. § 342 Congress gave reserve banks “the authority to accept or reject deposits from depository institutions” – commonly called “master accounts.” That section provides that “[a]ny Federal reserve bank may receive from any of its member banks, or other depository institutions . . . deposits of current funds in lawful money[.]” Important for its holdings, the Order explained that master accounts are governed by 12 U.S.C. § 342. The Order further explained that master accounts are created when an account holder executes a Master Account Agreement (“MAA”) setting forth the terms under which a master account can be operating including, and crucial to BSJI’s motion disposition, “the Federal reserve bank’s right to terminate a Master Account ‘at any time.’” The wording strongly foreshadowed the Court’s emphasis on the role of contract law principles.
Furthermore, the Order found that BSJI belongs to a group of high-risk account holders who agree to enhanced risk-mitigation provisions. Specifically BSJI agreed “to limit the Risks the customer poses to the [FRBNY], the [FRBNY] may suspend or terminate the Customer’s access to one or more Financial Services [or] close the Customer’s Master Account at any time by giving written notice to the Customer.” (Emphasis added.)
The Powers of the Board
The Order explained that the Board, unlike the federal reserve banks, does not have the authority to provide services relevant to banking, and, instead, provides general oversight of the activities of the reserve banks, including guidance with respect to master accounts. The Board has no authority to open or terminate a master account. The Ordered mentioned the Board’s Guidelines for Evaluating Account and Service Requests (“Guidelines”) published in August 2022. As relevant to BSJI, the Court held that BSJI violated Principle 5 of the Guidelines: the “provision of an account and services to an institution should not create undue risk to the overall economy by facilitating activities such as money laundering, terrorism financing, fraud, cybercrimes, economic or trade sanctions violations, or other illicit activity.”
Warnings to BSJI
Based on the facts recited in the Order, BSJI’s troubles began in 2019 when, as previously noted, the DOJ seized a substantial amount of funds at BSJI. The FRBNY suspended BSJI’s master account at that time. In 2020, and as noted, BSJI agreed to pay a penalty to the DOJ and improve its AML policies. To that end, BSJI and the FRBNY entered in March 2020 into the “Supplemental Terms” which, in the Order’s words, “reconfirm[ed] the FRBNY’s right to close BSJI’s account.” The FRBNY restored BSJI’s master account in December 2020
In 2022, the FRBNY notified BSJI that it had breached the Supplemental Terms: BSJI had failed “to submit on time three mandated assessments attesting to the effectiveness of its compliance programs.” As a result, the FRBNY “concluded BSJI poses undue risk to the New York Fed due to, among other things, this noncompliance” and informed BSJI that its master account would be closed in September 2022. BSJI provided the missing reports and the FRBNY suspended the account closure.
In the following months BSJI continued to provide more information on its AML program. The FRBNY conducted an internal review of BSJI’s compliance programs and ultimately determined that “BSJI posed undue risk under Principle 5 of the Board’s Guidelines and that this risk could not be effectively mitigated with additional controls.” One notable deficiency was that BSJI did not file any SARs on any transaction activity reviewed by the outside consulting activity. This was “particularly concerning” for the Court given “large inflows from shell companies in high-risk jurisdictions, owned by related parties of BSJI’s owners.”
The FRBNY provided the Board its conclusion and received the Board’s concurrence to proceed with the account closure. BSJI was informed of the master account termination by a letter in April 2023; the letter included three pages of compliance deficiencies that led the FRBNY to conclude that “continuing to provide a master account and financial services to BSJI poses undue risk to the overall economy by facility activities such as money laundering, economic or trade sanctions violations, or other illicit activities.” The FRBNY also provided BSJI with a “detailed explanation” of its “significant” AML concerns in a telephone call:
BSJI’s transaction activity consists of the rapid movement of funds on behalf of high-risk entities located in high-risk jurisdictions that are controlled by close relatives of BSJI’s owner. . . . These transactions often lack a clear business purpose and in some instances are suggestive of layering.
BSJI unsuccessfully attempted to persuade the FRBNY otherwise. The FRBNY informed BSJI it would consider only extending the closure date so that BSJI could wind down the use of its master account and seek other banking opportunities.
Instead, BSJI commenced suit. BSJI filed a complaint against the FRBNY and the Board seeking, amongst other causes of action, (1) a preliminary injunction against the FRBNY; and (2) a declaratory judgment that its Fifth Amendment Due Process Rights were violated. In disposing of all of BSJI’s claims, the Court did not engage in a detailed discussion of the purported AML policy deficiencies and assumed those true as alleged in the pleadings.
BSJI Did Not Meet the Heightened Standard for a Preliminary Injunction Against the FRBNY
A moving party seeking to stay government action taken in the public interest must satisfy a heightened standard: irreparable injury plus a likelihood of success on the merits. The heightened standard applied in this case because the FRBNY, a federal instrumentality, determined to close BSJI’s master account to mitigate alleged risk to the overall economy.
With respect to the requirement to show irrespirable harm, BSJI contended that closing its master account and terminating access to the Federal Reserve System’s services would cause BSJI to lose customers and cease existing. The Court found BSJI’s reliance on a reduction in customers during the 22-month suspension period unavailing because it was BSJI’s strategic decision to reduce certain customer accounts. BSJI’s customer base was now closely allied with the bank’s owner, and BSJI’s argument of irreparable harm was, in the Court’s view, self-serving speculation.
The Order concluded that BSJI also failed to meet the second requirement because “12 U.S.C. § 342 makes clear that Federal reserve banks are authorized to maintain Master Accounts, but are not required to do so.” The Court found none of BSJI’s statutory arguments under 12 U.S.C. §§ 248 (a statute setting a fee schedule) and 342 convincing and further found that no statute provides the federal reserve banks lack power to terminate a master account. Furthermore, by executing the MMA and the Supplemental Terms BSJI “specifically agreed that the FRBNY had the right to terminate that account” and the FRBNY “specifically relied on its contractual rights when it terminated BSJI’s Master Account in 2023.”
The Court therefore denied BSJI’s motion for preliminary injunction against the FRBNY. The Court also agreed with the Board that BSJI did not have standing to seek a preliminary injunction against the Board. While the Board exercises supervision over federal reserve banks, it has no power to open, administer, or terminate master accounts – that is the purview of a federal reserve bank, and the FRBNY in this case. Consequently, the Order dismissed BSJI’s motion seeking relief from the Board as moot.
BSJI’s Due Process Rights were Not Violated
In its complaint, BSJI asserted that it had a property interest in the master account under the Fifth Amendment and that the FRBNY and the Board had not afforded BSJI the requisite procedures including a meaningful opportunity to be heard. The Order rejected the argument as an erroneous statutory interpretation. According to the Order, the relevant statutes provide the FRBNY with discretion to open and terminate master account, which meant that BSJI was not entitled to a master account and did not have a protectable property interest in the account. Consequently, BSJI it was not deprived of liberty or property without due process of law.
The Order further found that the FRBNY had given BSJI opportunities to be heard and, contrary to BSJI’s claim, it was not denied a full and fair opportunity to be heard on the FRBNY’s decision to close the master account. Even though the Court already held that there was no protectable interest, it went out of its way to make a finding as to the account closing process.
Additional Claims by BSJI
We briefly address BSJI’s other claims. BSJI claimed that the FRBNY and the Board violated the Administrative Procures Act, 5 U.S.C. § 706 (the “APA”) (Count I). The Order held that, even if the FRBNY was an “agency” under the APA, judicial review of its decision to close BSJI’s master account was foreclosed because the FRBNY had discretion to do so. The Order went on to explain that, in any event, the FRBNY’s decision was not arbitrary or capricious or contrary to law because its conclusions “were plainly reached after a thorough review of the evidence and pertinent factors and resulted in a decision that explained the FRBNY’s rationale.”
BSJI sought relief under the Mandamus Act (Count II) and a declaratory judgment asserting its right to a master account (Count III). Because BSJI raised these causes for the first time in its reply brief, and not in its opening brief, the Court deemed them abandoned. The Court noted, even though it did not have to, that these causes would not succeed on the merits because, as we discussed supra, the court held that BSJI did not have a clear right to a master account under 12 U.S.C. § 248(a).
Finally, the Order addresses BSJI’s claims that the FRBNY breached its contractual duty of good care and the implied covenant of good faith and fair dealing under New York law (Counts V and VI). The Order concluded that BSJI is unlikely to prevail on the contractual claims because there was no evidence that the FRBNY acted in bad faith and, additionally, the FRBNY had the contractual right to terminate BSJI’s master account and had notified BSJI of the insufficiencies in its AML program.
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