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Are Banks Reporting State Governments to Uncle Sam for Suspicious Activity?

By Aaron Klein, Kristofer Readling

Thursday, March 10, 2016

The Bank Secrecy Act (BSA) requires banks to file reports when they suspect their customers of making transactions using money derived from illegal activities. But what if the customer is a state government? That might seem impossible, but consider what happens when a state government deposits tax revenue obtained from marijuana businesses operating legally under state law, but illegally under federal law.

While the law is unclear, it seems banks might need to file suspicious activity reports (SARs) to the federal government on states depositing revenue that contains taxes paid by marijuana sellers. This raises key questions about the functioning of the current BSA framework: is it successfully targeting the sorts of criminal activity it was designed for, or is it starting to not make sense? As a policy matter, we don’t think the federal government needs a bank to file a suspicious activity report on a state government to know that states are taxing marijuana sales.

BSA Reporting

Congress passed the BSA in 1970 to provide a comprehensive framework for the prevention of tax evasion and money laundering. Since then it has been expanded to combat drug trafficking and terrorism. As we’ve written previously, the BSA deputizes financial institutions to police the financial system because Congress found that they were best placed to understand their customers, identify bad actors, and report suspicious activity to law enforcement. In general, there are two types of reports banks must file: those triggered by transacting in large sums of cash (CTRs) and those filed when a bank suspects a transaction conducted through them involves funds derived from illegal activity. In this way, the BSA utilizes the central role of financial intermediaries to keep illegal funds out of the financial system and prevents legal funds from being used for illicit purposes.

States as Suspicious Actors?

The recent legalization of marijuana in a number of states presents a unique challenge for the BSA framework because financial institutions serving states as their customers may now be required to view state activities as suspicious. This is because marijuana continues to be illegal under federal law regardless of legalization measures taken by the states. Since marijuana remains illegal, any transaction involving funds derived from the purchase, sale, distribution, or manufacture of recreational or medical marijuana results in funds derived from illegal activity.

Unlike the federal government, which keeps its money at the Federal Reserve, states must contract with private banks who are subject to the BSA. After legalization of medical marijuana in the late 1990s, states like California began to receive tax revenue derived from their dispensaries. Since full legalization in Colorado, Washington, Oregon, and Alaska, the issue has come to a head as those states have begun to take in tens of millions of dollars in marijuana derived tax revenue. Colorado for example reported receiving over $135 million in revenue from marijuana taxes, licenses, and fees in 2015 alone.

The question then is whether the bank for Colorado should be filing a SAR on the state. The law exempts states from being considered customers for the purposes of banks’ filing CTRs. However, it’s not clear whether state governments are also exempted from the requirement for banks to file SARs. So when states like Colorado take marijuana tax revenue and deposit it in their bank it’s not clear whether banks are required to report them to the federal government.

If the banks read the law to mean they are required to file reports, it raises the bizarre scenario where banks report state governments as suspicious actors. Are federal government officials looking through the banking records of Colorado, Washington, Oregon, Alaska and other states that tax the sale or distribution of marijuana? Did Congress really intend the BSA to require enhanced monitoring of state government bank accounts?

Banks should not be filing suspicious activity reports on state governments. The federal government does not need a SAR to tell them that Colorado or Oregon has legalized and is taxing marijuana. Law enforcement and private sector resources would be better spent tracking down terrorists or drug gangs. In light of this, federal regulators should make clear that banks are not required to file SARs on state governments.

KEYWORDS: BANK SECRECY ACT, FEDERAL RESERVE, SUSPICIOUS ACTIVITY REPORTS