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10/19/2018

Anti Money Laundering and Hedge Funds in 2018

The continued advance of the hedge fund market, increase of the corresponding investor base, and heavy reliance placed on third parties to perform many compliance tasks highlight the importance of identifying and managing vulnerabilities related to money-laundering risk.  While there is not a great deal of data on the amount of money laundering through hedge funds, these vehicles can be exploited via money laundering schemes. They offer varying degrees of secrecy, offshore accounts and the ability to place large sums of money.

Specifically, as inflows from institutional investors continued to follow a steady upward trend, contributions from private wealth sources, including high-net-worth individuals. Capital from these private investors surpassed that of institutional investors back in 2014, marking an unprecedented development in the alternative investment world. Given the money laundering risks associated with these private wealth sources, this evolution of inflows may suggest an increase in the overall money-laundering risk to hedge funds surrounding operations in which they invest as well as fund service providers. Therefore, efforts to Know Your Customer (“KYC”) and monitor for suspicious activity are key components for fund managers to help mitigate money-laundering risk.

Further, hedge funds are reliant on third-party providers — such as broker-dealers, wealth managers, and depository institutions and transfer agents —for a suite of services and transactions that facilitate a fund’s investment activities. These services may include custody and valuation of assets, marketing, securities lending, regulatory advisory, legal documentation, and assisting fundraising and investor subscription efforts.  In discharging their responsibilities, these third parties may be at a disadvantage because they often do not have direct interaction with the customers or access to KYC information.  This may hinder their ability to identify suspicious activity. Investment advisors of hedge funds, however, are ultimately responsible for overseeing and supervising the third parties.

As a result, it would be prudent to re-review the proposed rule (“Proposal”) that Financial Crimes Enforcement Network (“FinCEN”) issued for public comment on August 25, 2015, requiring investment advisers registered with the SEC (“RIAs”) to establish Anti-Money Laundering (“AML”) Programs and report suspicious activity.

RIAs should consider that if the Proposal is implemented, hedge funds and their Registered Investment Advisers (“RIAs”) would become a target of the regulators. Further, although hedge funds are currently not subject to Bank Secrecy Act (“BSA”) requirements, they are still subject to federal criminal money laundering statutes and the sanctions imposed for violations.  If an RIA should violate the criminal money laundering statutes, the Department of Justice would review the AML Compliance Program in connection with indicting the RIA.  Further if found guilty, the U.S. Federal Sentencing Guidelines require prosecutors to consider the effectiveness of the AML Compliance Program in determining sentences.

Background

The BSA requires “financial institutions” to have effective AML Compliance Programs. “Financial institutions” currently include banks, broker-dealers, any entity required to register under the Commodity Exchange Act (“CEA”) (including futures commission merchants (“FCMs”)), introducing brokers in commodities (“IB-Cs”), commodity trading advisors (“CTAs”), and commodity pool operators (“CPOs”)), mutual funds, operators of credit card systems, money services businesses, insurance companies, casinos, loan or finance companies, and dealers of precious metals, stones and jewels. The AML Compliance Program rules instituted under the USA PATRIOT Act currently do not apply to private funds and investment advisers.

Under the Proposal, FinCEN would add “investment adviser” to the list of entities within the general definition of “financial institution”. “Investment adviser” would be defined as any person registered, or required to be registered, with the SEC under section 203 of the Investment Advisers Act of 1940, including both primary advisers and subadvisers.

Generally, large advisers with US$100 million or more in assets under management are required to register with the SEC unless an exemption from registration is available. Mid-sized advisers with US$25 million or more but less than US$100 million, and small advisers with less than US$25 million in regulatory assets under management are generally prohibited from registering with the SEC and are instead subject to state regulations. Of course, FinCEN may consider future rulemakings that expand the application of the BSA to state-regulated investment advisers or investment advisers that are exempt from SEC registration.

Proposal Requirements

To adequately fulfill the AML Program requirements in the Proposal, RIAs must:

1. Develop and Implement Policies, Procedures and Internal Controls to Help Ensure Ongoing Compliance

The RIA is to establish and implement written AML policies, procedures and internal controls. The AML program must be “reasonably designed to prevent the investment adviser from being used for money laundering or the financing of terrorist activities and to achieve and monitor compliance with” the BSA. Regulators want to see a “risk-based” approach in the design of the program.

2. Designate a Qualified Person or Persons Responsible for Implementing and Monitoring the Operation and Internal Controls of the Program (the “AML Compliance Officer”)

The RIA must designate an individual or committee responsible for implementing and monitoring the operations and internal controls of the program. The AML Compliance Officer(s) must be “knowledgeable and competent” regarding the regulatory requirements and the RIA’s money laundering risks. Depending on the size and type of services, the AML officer need not be dedicated full time to BSA compliance, but “should be an officer of the investment adviser.”  The Proposal does not appear to allow the RIA to delegate the role of AML Compliance Officer to a third party administrator implying that this role would most likely be filled by the fund’s current CCO.

3. Provide Ongoing Training for Appropriate Personnel

The nature, scope and frequency of training is to be determined by the employees’ responsibilities and the extent to which their functions bring them into contact with the BSA’s requirements and possible money laundering. In addition to ensuring that such ongoing training complies with the Proposed Rule (e.g., tailoring training to the audience), the RIA should document its practices and approach related to training.

4. Conduct Independent Compliance Testing

The Proposal requires testing on a “periodic basis,” explaining that the frequency of testing will depend upon the RIA or Compliance Officer’s assessment of the risks posed. Such testing, that is designed to ensure that the program is functioning as intended, may be conducted by a qualified outside party. Alternatively, testing may be conducted by employees of the RIA, provided those employees are not involved in the operation or oversight of the AML program.

Other AML Compliance Program Requirements

Because the Proposal subjects RIAs to the BSA, they would also be required to:

  • File Currency Transaction Reports (CTRs) with FinCEN for transactions of more than $10,000;
  • Electronically file Suspicious Activity Reports (“SARS”) with FinCEN;
  • Comply with Recordkeeping and Travel Rules and keep a record of ‘transmittal of funds’ in an amount equal to or greater than US$3,000 and cross-border transfers and extensions of credit for amounts greater than US$10,000; and,
  • Reply to government requests for information under Section 314(a) of the USA PATRIOT Act;

Note, however, that the Proposal does not require the RIA to implement a Customer Identification Program.

Finally, the Proposal will allow RIAs to delegate the implementation and operational aspects of the AML Program to third parties.  The RIA and not the third parties, however, remains responsible for the effectiveness of the AML Program and ensuring access by Regulators to requested documents. The RIA, therefore, is responsible for ensuring that the third party is effectively carrying out the requirements of the AML Program.

Items for the RIA to Consider

In addition to building or strengthening an effective AML Program, RIAs should consider the following:

Administration Agreements

If the RIA delegates AML responsibilities to a third party, the RIA should ensure this is covered in the administration agreement or the contractual agreements with service providers.  The RIA should ensure the agreement covers not only the fund but also the RIA. 

Also, the RIA should ensure that the agreement permits the RIA to inspect and review the operations of the administrator with respect to the AML functions.  Perhaps periodic reporting metrics can be built for the fund and RIA.

Offering Memorandums

The offering memorandum should reflect the AML laws and regulations to which the RIA is subject.  It should also be updated to reflect SAR reporting requirements, which is a new requirement under the Proposal.

Also, RIAs will need to disclose any additional expenses required for the maintenance of the AML Program.

Subscription Agreements

The RIA may need to revise the subscription agreement if an AML Program is implemented and requires additional or different information from the investors.

Conclusion

Last year, financial regulators imposed more than $2 billion in fines related to AML compliance failures1. With AML enforcement shifting into higher gear, hedge funds would be well advised to ascertain a comprehensive picture of their AML priorities so they can effectively enhance their compliance functions.  Regulators often view hedge funds as a potential outlier or loophole with respect to AML. Therefore, Hedge Funds need to be on the alert for potential enforcement actions should the Proposal be adopted.

Sources

2017 Anti-Money Laundering Year in Review and 2018 Outlook: https://www.debevoise.com/insights/publications/2018/02/2017-anti-money-...

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