Tuesday, 28 July 2015
Last updated 15 hours ago
May 26 2009 | 9:11am ET
By Philip Thomas, Esq. -- Of all the hedge fund-phobic reporting in the mainstream press, among the most dubious is coverage of hedge fund Anti-Money Laundering (AML) matters. General interest business magazine BusinessWeek alleges, “[w]hen drug runners and terrorists want to park illicit cash, there may be no better haven than hedge funds.” The piece then goes on to tar the sector further by claiming “the highly secretive hedge fund industry has no restrictions whatsoever,” and, incomprehensibly, avers that funds “rarely ask” the names of certain investors.
To read the foregoing, one might be forgiven for imagining that it is legal for hedge funds to further a money-laundering scheme. It is not, and at least one prominent former fund manager has been indicted for apparently sharing the quoted writer’s expansive interpretation of the law. Sections 1956 and 1957 of the U.S. Code criminalize “knowingly” participating in money laundering, and courts routinely find that being “willfully blind” amounts to the same thing. Note too, the investment advisers who run hedge funds are required to file a Currency Transaction Report on customer cash transactions of $10,000 or more, or a pattern of activity that adds up to $10,000.
Hedge funds and their advisers are also subject to formal requirements designed to prevent money laundering and terrorist financing. Significant among these is compliance with the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) rules. OFAC maintains lists of individuals, groups, and countries with which U.S. persons (including hedge funds) may not do business. Checking potential new investors against OFAC’s Specially Designated Nationals and Blocked Persons (SDN) List and List of Sanctioned Countries is central to the new account process of every U.S.-based hedge fund adviser.
For anyone unfortunate or foolish enough to engage in an OFAC “Prohibited Transaction,” the penalties can be strikingly severe. Smart advisers have instituted an OFAC compliance program, which, among other things, may mean appointing an OFAC compliance officer (OFAC recommends, but does not require these steps). It is also wise to provide training to employees to raise awareness of OFAC issues.
The extent to which internal controls need to be imposed depends on the degree of risk the adviser bears of engaging in a Prohibited Transaction. A risk assessment should be performed that considers such factors as the type of business the adviser is in, where it operates, and who and where its customers are.
A practical response for some hedge fund advisers could be to outsource OFAC responsibilities to a third party, such as a custodian or administrator. These service providers often have high-powered resources, including sophisticated software. However, liability cannot be shifted in this manner, and the adviser remains ultimately responsible.
Following the events of Sept. 11, 2001, the USA PATRIOT Act was passed into law, with measures that significantly strengthened the Bank Secrecy Act of 1970 (BSA). The BSA, more formally known as the Currency and Foreign Transactions Reporting Act, compels designated U.S. businesses to assist government agencies in detecting and preventing money laundering. The PATRIOT Act empowered Treasury to prescribe standards for financial institutions’ AML programs. Treasury did not include hedge funds or their advisers in the definition of “financial institutions” for these purposes.
Other financial businesses not previously required to maintain formal AML programs, however, then had to institute them. It is no mystery how hedge funds were excluded from the specifically-supervised entities, which include banks, mutual funds, broker-dealers, and money transfer outfits—all operations with frequent and varied transactions with the public. By contrast with such organizations, all U.S. hedge funds have required minimum credentials for investors, and all but a few place significant restrictions on liquidity (e.g., lockups and limited periodic opportunities for redemption). The high barriers to entry and exit make hedge funds a questionable choice for the “drug-runners and terrorists” of journalists’ fevered imaginations.
In May 2003, Treasury put forth Proposed Regulations that would have brought hedge fund advisers into the AML fold. These were withdrawn in late 2008 without ever being enacted. A Treasury law enforcement arm, the Financial Crimes Enforcement Network (FinCEN), oversees AML regulation. In announcing the reasons for taking the Proposed Regulations off the table, FinCEN observed that hedge fund advisers’ “activity is not entirely outside the current BSA regulatory regime,” since advisers conduct much of their business through such entities as banks and broker-dealers already covered by BSA regulations.
This brings us to another important source of AML requirements for hedge funds. Even if Treasury does not (yet) demand hedge funds have AML processes, hedge funds’ counterparties WILL insist that they do. It is probably impossible, for instance, to obtain leverage (i.e., money borrowed for the purposes of investing) from a prime broker or other provider without making significant representations about the hedge fund adviser’s “Customer Identification Program” (CIP) practices.
CIP is sometimes known by yet another acronym (the fight against money-laundering is not made easier by having its own extensive argot) “KYC,” or “Know Your Customer.” However designated, it is the due diligence that must be performed to identify a potential customer with reasonable certainty. Advisers’ customer onboarding practices are, naturally, important in carrying out KYC duties. Where there is no established relationship with the prospective customer, identities should be verified by requiring, for example, a certified copy of a natural person’s driver’s license or an entity’s certificate of good standing. KYC, though, is not a process that ends at account opening; rather, it continues throughout the customer relationship lifecycle.
The apparent demise of the Proposed Regulations by no means signals an end to lawmakers’ interest in hedge fund AML. Senators Carl Levin (Dem. – Mich.) and Charles Grassley (Rep. – Iowa) are co-sponsors of The Hedge Fund Transparency Act. This legislation, which many observers see as a lock-in to be enacted in the fourth quarter of this year, is intended to “reform” hedge fund regulation and, not surprisingly, would require most hedge funds to institute AML programs.
The past may well be prologue for hedge funds, as the new rules are likely to resemble the “old” Proposed Regulations. These, in any case, were relatively commonsense in their approach. The Proposed Regulations called for advisers, at a minimum, to (i) develop internal policies, procedures, and controls; (ii) designate an AML compliance officer (or committee) to oversee the program; (iii) institute an employee training program; and (iv) establish an independent testing function to review the adequacy and effectiveness of the AML program. Currently registered advisers may see many parallels in these requirements with the “Compliance Rule,” Rule 206(4)(7) under the Investment Advisers Act of 1940.
Although additional regulation is seldom welcomed by any industry (and haven’t investment advisers’ more highly regulated cousins, the banks and broker-dealers, run into a host of difficulties in spite of their onerous regulatory regimes?), many advisers could discover they already have most of the elements in place. As with OFAC compliance, advisers who have engaged administrators to assist with running their funds may find the outsourcing route agreeable. It is important, however, to retain in-house AML expertise to maintain a check on the third-party’s activities. Consider the reputational damage alone that could be caused by inadvertently furthering money-laundering activity.
As with the confused “hedge funds are lightly-regulated pools of capital” mantra so often recycled by pundits not familiar with the complex web of laws that govern hedge funds’ activities, the perception of hedge funds’ AML responsibilities and activities differs from reality. Our industry does not provide modern desert island hideaways for the ill-gotten booty of swashbucklers and renegades. To the contrary, most funds and their advisers are well prepared for the coming AML regulations.
Philip Thomas is an attorney in the New York office of the law firm Garrity, Graham, Murphy, Garofalo and Flinn, P.C. Thomas is a member of Garrity, Graham’s Banking and Financial Services group where he specializes in private fund legal and regulatory matters. He may be reached at email@example.com.
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