The War against Terrorism continues quietly, but deliberately and in earnest, on the financial front. There are no giant leaps forward on this front. But there are persistent, incremental steps by the U.S. Government to track down and identify suspect sources of funds. This is a broad-based campaign that mandates the cooperation of financial professionals.

In late September 2002, following up on prior regulations, the U.S. Treasury Department and the Financial Crimes Enforcement Network (FinCEN) issued the proposed rule on Anti-Money Laundering Programs for Unregistered Investment Companies, including hedge funds and commodity funds (which can be found at 31 CFR Part 103, RIN 1506-AA26). Unregistered investment companies are investment companies that lack a federal functional regulator. This could include a large range of entities from hedge funds, private equity funds, venture capital funds, commodity pools, and real estate investment trusts to investment clubs. The formal definition appears in the Treasury Department’s Proposed Rules.

Comments to the U.S. Treasury regarding the proposed rule were made on November 25, 2002; a final rule will be drafted and go into force shortly thereafter. Once the final rule is in place, managed funds and other unregistered investment companies must have an anti-money laundering program in place by 90 days following the final rule.

It is worth noting that this Proposed Rule must be distinguished from the Final Rule issued on the same date (9/26/02) on the anti-money laundering requirements relative to foreign shell banks and correspondent accounts for foreign banks. (This matter is addressed in 31 CFR Part 103, RIN 1505-AA87.) Comments under this regulation had previously been submitted to the U.S. Treasury regarding the proposed rule by various trade associations, financial institutions (both domestic and foreign) and by members of Congress. The rule went into effect in late October 2002.

So, how far along is your firm in developing its legally mandated anti-money laundering program?

In April 2002, Managed Funds Association issued the “Preliminary Guidance for Hedge Funds and Hedge Fund Managers on Developing Anti-Money Laundering Programs.” This preliminary guidance provides excellent information. But it should as such: as a guide. MFA states that hedge fund managers must create their own anti-money laundering program specifically tailored to their firm since “one size does not fit all.”

The pressure is on to have an anti-money laundering program in place. And, if you don’t have one under development already, you best get moving. Having a program in place is very specific and fundamental in addressing the concerns of the U.S. Government. It requires these four key elements: 

1. Designation of an anti-money laundering compliance officer.
2. Establishment of policies and procedures for subscriber/investor identification.
3. Establishment of an ongoing employee-training program.
4. Development of an independent audit function to test the program.

MFA's preliminary guindance goes into each step thoroughly, but the process, the actual "how to," is up to the fund manager. The following are some examples of what should be done for each step.

Designation of an Anti-Money Laundering Compliance Officer

This is a relatively basic step to take, but it’s not a clerical function and certainly not a snap decision. It must take into account the responsibilities and requirements that go with the position. The responsibilities of the compliance officer are described in Section 1.4 of MFA’s Guidance. The ideal background for this position is someone in the general counsel’s office of the hedge fund. However, a hedge fund manager or anyone who is a senior officer with the fund could also take on this role. Keep in mind, MFA recommends “the Anti-Money Laundering Compliance Officer should not be responsible for functional areas within the organization where money laundering activity may occur” (p. 5, Section 1.4). This might include the person in charge of business development or the person responsible for opening new accounts, for example.

The responsibilities of the compliance officer are certainly significant and carry the weight of federal regulatory requirements, under any circumstances. These responsibilities and requirements can be daunting to some firms, based on current staffing, breadth of activities, or other demands within hedge fund activities. In certain cases, an outside firm specializing in anti-money laundering compliance could be used to assist in complying with the requirements of and responsibility for the anti-money laundering program. In other words, someone at the hedge fund will be designated the “Anti-Money Laundering Compliance Officer,” but some or all the steps for the anti-money laundering program could be performed by an outside firm, reporting back to the compliance officer. However, the compliance officer must be an executive of the hedge fund itself.

Establishment of Policies and Procedures for Subscriber/Investor Identification

This is the core requirement under any established anti-money laundering program. (It is described in some detail in Section II of the MFA Guidance.) These policies and procedures could affect the entire operation of a particular hedge fund, while other fund companies might not be so significantly affected. This depends on the types of investors/subscribers associated with a fund, the record-keeping maintained by a particular fund, the initial subscription documents already required to be filled out by the client/subscriber, or other fund-specific factors.

A key element of this step is to perform some level of due diligence on all subscribers/investors in the fund. Some individuals or entities will require more scrutiny than others. At a bare minimum, each subscriber/investor should be cross-checked against the list of Specially Designated Nationals and Blocked Persons maintained and disseminated by the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) (www.treas.gov/ofac/). This list is not static; it is frequently updated with new entities added and other entities deleted as the U.S. Government’s investigations continue with massive input from its own resources and input from foreign allied sources. Therefore, this list should be checked frequently and compared with the hedge fund’s internal list of subscribers and investors. This can be a difficult task if the fund has limited resources, in terms of manpower and/or financial resources. MFA suggests that the hedge fund manager “may wish to consider using a third-party compliance service for assistance with monitoring prohibited lists” (Footnote 12, p. 10).

Some subscribers/investors will require more scrutiny; these may be considered “High Risk Investors” (Section 2.4, pp. 10-11) or other entities the hedge fund manager has some questions or concerns about. This level of due diligence will virtually always require more in-depth investigations and may demand assistance from outside professionals. When in doubt as to whether a certain person or entity merits more in-depth scrutiny, the internal anti-money laundering compliance officer or an external professional resource ought to be consulted as to the specific situation.

MFA has suggested various steps that a fund manager should take with regard to investor identification policies and procedures, such as due diligence checklists. However, it is up to the hedge fund manager to determine what should be included or addressed in the checklist for a particular fund. An issue arises where Section 326 of the USA PATRIOT Act requires all financial institutions, hedge funds included, to have policies and procedures for “verifying the identity of any person seeking to open an account to the extent reasonable and practicable.”

MFA has described the “reasonable and practicable” for the different types of investors a hedge fund might have to deal with (natural persons, corporations, etc.). Again, it indicates that “reasonable steps” are needed, but it leaves it up to the hedge fund manager to determine what these reasonable steps should be. Obviously, this may be especially difficult for some funds since many funds deal only with other financial institutions or other third parties and do not know who the ultimate investor is. What is “reasonable and practicable” in these cases?

An important part of the Treasury’s proposed rule is dealing with third parties such as administrators and correspondent banks. In fact, the proposed rule even offers some forms that might be reviewed and taken into consideration. According to the proposed rule, a fund can “delegate” some elements of the compliance program to these third parties but the fund itself remains responsible for the effectiveness of the program (instituted and implemented by the third party) and for assuring compliance with the third-party’s program. A simple letter from a third party proclaiming that they have an adequate anti-money laundering program in place is not enough. These third parties will also be subject to U.S federal inspectors. According to the proposed rule: “[I]t would not be sufficient for an unregistered investment company simply to obtain a certification from its delegate that the company ‘has a satisfactory anti-money laundering program.’” So what does a fund manager do to meet the requirements? This is going to be a topic of intense debate before the final ruling, but fund managers should start thinking of how they propose to address this issue. For example, some funds are designing detailed anti-money laundering questionnaires or checklists for their third parties to fill out. Others are seeking an independent due diligence on the third party and more intense scrutiny of the third-party entity, its principals and its operations.

Establishment of an Ongoing Employee Training Program

This is another relatively basic function of the anti-money laundering program. The mandated training program does not have to be a week-long, document-intensive course; a half day or day seminar is probably all you need to address the legal requirements. This training program should be required for all employees working in areas pertinent to the anti-money laundering program and functions susceptible to money laundering. Certain employees such as analysts might not be required to attend, but it is a good idea for all full-time employees or part-time employees with critical responsibilities in a firm to attend the program. If the anti-money laundering compliance officer is unsure of what topics should be addressed in this program and who should participate, there is external professional advice and counsel available. The program should include a “handbook” which employees could refer to that is specific to their fund company. Procedures for review of the initial training program and recurrent training should also be established as Treasury adopts various new rules or in the event the fund company changes its structure (for example, by taking on international subscribers).

Development of an Independent Audit Function to Test the Program

The independent audit is another area that remains rather undefined at the moment. The proposed rules state the fund company must “provide for independent testing for compliance by the investment company’s personnel or by a qualified outside party.” This is more difficult than it sounds. If the company’s personnel conducts the audit, there might be a conflict of interest since this personnel would have to be intimately knowledgeable with the Treasury’s rules yet remain independent to the anti-money laundering function. Using a qualified outside party would be the best solution. However that outside party must be extremely knowledgeable of not only the Treasury’s rules but knowledgeable about the managed funds industry and the intricacies of the fund company being audited itself.

This audit should, at the minimum, entail having an independent party evaluate the current anti-money laundering program. In addition, the final Treasury rules regarding the audit may require detailed “testing” of the program. These “tests” could come in many different forms and the details on the “tests” will need to be finalized. However, an independent audit function should take this into consideration.

The audit section of the proposed rules for the managed funds industry is complex. Complying with the rules will require technical anti-money laundering experience, knowledge of the industry including offshore and global facets, and familiarity with the U.S. Treasury’s rules, yet remain independent at the same time. This is best done by an outside party familiar with all these aspects.

Issues with the Proposed Rule

The Treasury proposed rule goes into what it is looking for in the four steps of the anti-money laundering program. It goes into transactions that might be suspect and indications of money laundering activities, and these should be noted in your program. The proposed rule states the program must be approved in writing by its Board of Directors, and its trustees or its general partners, and the program must be available for inspection by the Department of the Treasury.

The proposed rule, in addressing numerous recently enacted provisions of the Bank Secrecy Act (BSA), makes numerous references to the Act and to the fact some of the BSA requirements may very well apply to unregistered investment companies. It is interesting to note the proposed rule mentions that, “Unregistered investment companies may become subject to some BSA requirements such as performing customer and investor identification and verification and filing suspicious activity reports.” A key word here is the “may,” and we will see what the final rule has to say about this.

Another issue managed funds and other unregistered investment companies may have with the proposed rule is Treasury would like each firm to file a “Notice” with FinCEN, the repository of mega-data on financial transactions in the U.S. This “Notice Requirement” is not overwhelmingly difficult to complete (data such as names of executives and amount under management) but this is new to many managed funds companies which are not used to filing with the U.S. Government other than for tax purposes. The simple requirement for filing any type of form with the U.S. Government may be considered onerous. Some might see this as a start to the regulation of managed funds by the U.S. Government. The U.S. Treasury argues this is the only method it can use to find out who is actually out there and active in the financial arena since “…unregistered investment companies are not necessarily registered with or identifiable by Treasury or another Federal functional regulator”. This will also be the topic of debate, but FinCEN will need to have something to go by to identify individual fund companies.
In any case, all managed fund companies are going to be required by law to have an anti-money laundering program in place within 90 days of the final ruling.

Many fund companies have already started creating their program, have you? The clock is ticking loudly, and the countdown has begun.

Jeffrey S. Giddings is the managing director of the New York office of Smith Brandon International, Inc., an investigations and risk avoidance firm based in Washington, DC. Activities of Smith Brandon International include anti-money laundering compliance and due diligence.