Picture anti-money laundering regulations as a wall around the U.S. financial system. Despite the increased focus in recent years on these controls, two major gaps remain: the poor job institutions do assessing beneficial ownership, and the quiet fact that investment advisers for hedge, private equity, and other funds have no AML obligations at all.
That latter gap in AML defenses may soon be plugged. On Aug, 25, the Treasury Department’s Financial Crimes Enforcement Network issued a notice of proposed rulemaking that would clarify the regulatory definition of “financial institutions” to include investment advisers with more than $100 million in assets under control and that are registered with the Securities and Exchange Commission.
For the first time, investment advisers would be required to establish a comprehensive anti-money laundering program and comply with reporting and recordkeeping requirements under the Bank Secrecy Act. These programs will be subject to SEC oversight and examinations.
If all this sounds familiar, it should. This is FinCEN’s second attempt to bring AML requirements to investment advisers. It proposed similar rules in 2003 that were seemingly abandoned. The proposed rule was published on Sept. 1, triggering a public comment period that ends on Nov. 2. The new requirements would go into effect six months after the release of the final rule.
“It is certainly déjà vu,” says Duane Thompson, a policy adviser for fi360. “This has always been on the back burner, but a lot of people forgot about it because it has been a dozen years since FinCEN looked at it seriously. A lot of times when you see an agency come in and revise or impose new rules it means that somewhere there has been a problem.” And yet, he adds, there is no record of any recent AML-related enforcement action against an investment adviser.
So why now?
“With the recent expansion of regulations into the non-bank financial institution space, coupled with the boon of money in hedge, venture capital, and other investment vehicles, the investment advisers area became a hole too big to ignore,” says Micah Willbrand, ?director of global AML product marketing for NICE Actimize.
“I think regulators take the view that this is incremental,” says Kim Mann, a partner with the law firm Pillsbury Winthrop Shaw Pittman’s corporate and securities practice. “Now that we have gotten more advisers registered and subjected to additional rules and regulations, this is just one more look inside advisers and their funds.”
Aaron Hutman, Mann’s colleague at Pillsbury, sees the proposed rules as a side effect of “a surge in the AML space outside of core banking.”
“Regulators have been hitting casinos for AML violations,” he says. “They have gone after money services businesses and virtual currencies. There is real concern that there are more ways where money can slip through the cracks. Investment advisers are another opaque wall, behind which regulators would like to look and have confidence that there really is good oversight.”
The proposal would require investment advisers to implement and maintain a written AML program, adapted to its business and clients on a risk-adjusted basis. Specific requirements include:
Filing suspicious activity and currency transaction reports;
Creating and maintaining records for each transmittal of funds greater than $3,000 and informing the next financial institution in the chain;
Filing Suspicious Activity Reports (SARs) for transactions involving $5,000 or more in cash or other assets, if there is reason to suspect that the funds were derived from illegal activity, the transaction is structured to avoid BSA requirements, or it has no apparent legitimate business purpose.
Filing Currency Transaction Reports (CTRs) for transfers of more than $10,000 in currency in the course of one business day, including multiple transactions by an individual or parties acting on their behalf.
“The best advice I can give is to be vigilant at account on-boarding to identify who an individual is, who they are transacting with, where their assets are coming from and what they are doing with those assets.”
Micah Willbrand, Director of Global AML Product Marketing, NICE Actimize
Even for firms that already have an AML framework in place, a new rule would bring new costs and challenges.
In Aggregate, a Challenge
Costs may come from having a designated AML officer, bringing in external expertise, or appointing in-house SAR teams. “For some advisers, it will be a matter of human resources and human capital,” Mann says. “Because compliance officers are stretched very thin right now, advisers are a little reluctant or unable to add staff to handle the additional regulatory requirements.”
The costs may be disproportionate for smaller firms, but “expensive for the big guys too,” Hutman says. “They are going to have to engage in an AML risk assessment that goes beyond what they are already doing.”
One challenge is likely to be the aggregation of transactions and identifying when a SAR or CTR must be filed, plus what information needs to be included with it.
“These reports, even for experienced financial institutions, can be difficult to produce and populate with all of the required information,” Willbrand says. “The best advice I can give is to be vigilant at account on-boarding to identify who an individual is, who they are transacting with, where their assets are coming from and what they are doing with those assets. The problem financial institutions get into, when they are not vigilant about the identification of their customers, business partners and assets, is that once an unidentified relationship or transaction enters the system, it’s very difficult to trace back and identify.”
PLUGGING THE GAP
The following is an excerpt from the Financial Crimes Enforcement Network’s proposed money laundering rules for investment advisers.
As of June 2, 2014, there were 11,235 investment advisers registered with the Securities and Exchange Commission, reporting approximately $61.9 trillion in assets for their clients.
As long as investment advisers are not subject to AML program and suspicious activity reporting requirements, money launderers may see them as a low-risk way to enter the U.S. financial system.
It is true that advisers work with financial institutions that are already subject to BSA requirements, such as when executing trades through broker-dealers to purchase or sell client securities, or when directing custodial banks to transfer assets. But such broker-dealers and banks may not have sufficient information to assess suspicious activity or money laundering risk.
When an adviser orders a broker-dealer to execute a trade on behalf of an adviser’s client, the broker-dealer may not know the identity of the client. When a custodial bank holds assets for a private fund managed by an adviser, the custodial bank may not know the identities of the investors in the fund. Such gaps in knowledge make it possible for money launderers to evade through investment advisers rather than through broker-dealers or banks directly.
In addition to offering services that could provide money launderers, terrorist financers, and other illicit actors the opportunity to access the financial system, investment advisers may be uniquely situated to appreciate a broader understanding of their clients’ movement of funds through the financial system because of the types of advisory activities in which they engage. If a client’s advisory funds include the proceeds of money laundering, terrorist financing, and other illicit activities, or are intended to further such activities, an investment adviser’s AML program and suspicious activity reporting may assist in detecting such activities. Accordingly, investment advisers have an important role to play in safeguarding the financial system against fraud, money laundering, terrorist financing, and other financial crime.
Thompson also questions whether there will be regulatory redundancy because advisers conduct financial transactions through other financial institutions, such as banks and broker-dealers, that are already subject to AML requirements. Does it make sense to have the same compliance requirements at both the advisory and custodial firm level?
FinCEN did at least try to address redundancy, says Thomas Bock of K2 Intelligence, an investigative consultancy with an AML practice. The proposed rule says that if two parties are involved in a transaction, only one SAR needs to be filed. A related change may be more problematic. Historically, banks, broker-dealers, and mutual funds have shared SARs within their organizational walls. The proposed rule prohibits investment advisers from doing so in the absence of future FinCEN guidance.
The proposal doesn’t require Customer Identification Programs, an odd omission given the focus on Know Your Customer requirements for other financial institutions. “It likely will be coming down the pike,” Mann predicts. “It is really hard to imagine an effective program that doesn’t incorporate some sort of KYC policies and procedures.”
“I don’t know if FinCEN is perhaps thinking this is something they want to expand to other areas and other entities that have to file SARs, but that is a very unique omission here,” says Dana Syracuse, former associate general counsel of the New York State Department of Financial Services, now managing director of K2 Intelligence’s AML practice.
And with new requirements also come new fears of CCO liability—a subject under much discussion at the SEC this summer, with dueling commissioners saying that fear is real or exaggerated. “These new requirements will likely bring more liability concerns to the CCOs of investment advisers, primarily because it reclassifies these firms as financial institutions which brings a higher level of scrutiny,” Willbrand says.
While firms await the final rule, and take part in the ongoing public comment process, there are some steps to start considering. “Many of the large investment advisers do have, in some shape or form, AML policies and procedures in place,” Bock says. “They should be taking a closer look to make sure that everything is covered and meets what the final rules may be.”
Now is the time, he says, to develop a comprehensive understanding of all the different businesses and industries they work at and to develop a comprehensive, firm-wide approach.
Thompson is hopeful that FinCEN will act judiciously and consider the costs and challenges. “If you are an investment adviser out in Peoria, Illinois with $101 million under management and just barely eligible to register with the SEC, you might be a little bit perplexed,” he says. “I hope FinCEN looks at either de minimus requirements or at specific business models to assess where the highest risk is to allow for reasonable carve-outs and exemptions for firms that don’t pose any remote kind of threat.”