Count-Down: Update on Money-Laundering Initiatives - That Means You, Unregistered Investment Companies

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Count-Down: Update on Money-Laundering Initiatives - That Means You, Unregistered Investment Companies
Published by MFA Reporter
Jeffrey S. Giddings
December 1, 2002



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) ( 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.

Highlights of the Article:

(...) Although the economy is doing well, companies that want to conduct business in the global market should not throw caution to the wind, said Gene Smith, founding partner of Smith Brandon International, specializing in international investigative services. A significant sale can go sour after the product is delivered due to a lack of background knowledge and business intelligence, she told delegates. (...)

"Some business gurus advise Western-based businesses to set foreign sales targets of 40 percent of all business revenues. But any global ventures must take into consideration the potential risks as well as rewards," she said. (...)

The Internet enables companies to do business around the world by connecting them, but global connections also "create serious security concerns," said Harry Brandon, founding partner of Smith Brandon International. The "Love Bug" virus was created in the Philippines but quickly swamped computer networks around the world, he reminded delegates. "Is the credit information you have on file secure from hackers?" he asked the delegates. (...)

Even with the risks associated with the Internet, Brandon says companies have "no choice" but to embrace electronic commerce. "The goal is to do it right, in a safe, secure, protected environment." (...)

For the full article see below.

If credit managers felt they were somehow immune to the business effects of the digital revolution, electronic commerce innovation and global economic transformation, they discovered differently at "Exploring the New Frontier", NACM-Canada's second annual Credit Conference and Expo held in Toronto, Ontario on October 11 and 12.

The Internet brings disparate cultures together for social and commercial interactions. Global communication at Web speed changes both the nature of societies and the culture of business, conference speakers told the NACM delegates. In a world where almost every new business venture begins with an "E", geographic boundaries are disappearing, and companies are open 24 hours a day.

Instant digital connectivity creates a host of business opportunities and challenges, delegates were told. Credit managers need to protect corporate financial interests while supporting the development of new opportunities. Armed with new digital tools, they can process information faster and make decisions quicker. At the same time, they are dealing with more information from more sources than ever before. That's life on the new frontier.


When it comes to overall financial matters, "the global outlook for the next 18 months or so continues to be upbeat, not withstanding the sharp increases in oil and natural gas prices," Dr. Lloyd Atkinson, chief investment officer for Perigee Investment Counsel Inc., an investment and money management solutions firm, told conference delegates.

Growth is driven by the technology revolution, and the pre-emptive action taken by central banks, most notably the US Federal Reserve, to keep inflation in check. The result: US productivity has increased significantly at inflation-safe speeds. Inflationary pressures have been contained and there have been real gains in wages, salaries and corporate earnings.

While there will be economic slow downs, "they will be much more muted than in the past, and there is no recession in the five year forecast... Barring economic accidents, such as occurred in Asia in 1997, we continue to be very optimistic about the longer term," Atkinson said.

While business-to-consumer e-commerce ventures such as have received a great deal of media play, Atkinson called them "small potatoes" compared to business-to-business e-commerce. The old economy--automotive, financial services and other traditional sectors--are using the tools of the new economy to change the way they do business. For instance, General Motors will use the Internet to reduce distribution costs by 30 percent over three years. This is a direct benefit to General Motors and suppliers who adapt to the news ways of doing business in the digital age will also benefit.


Although the economy is doing well, companies that want to conduct business in the global market should not throw caution to the wind, said Gene Smith, founding partner of Smith Brandon International, specializing in international investigative services. A significant sale can go sour after the product is delivered due to a lack of background knowledge and business intelligence, she told delegates.

Even though there are risks, "there is no option to sit out e-commerce." Forecasters indicate that e-commerce will generate $ 1.3 trillion dollars in global sales in 2003. "Some business gurus advise Western-based businesses to set foreign sales targets of 40 percent of all business revenues. But any global ventures must take into consideration the potential risks as well as rewards," she said.

To successfully tap global markets, companies require strategic plans that integrate e-commerce into their overall business strategies before they build secure, transactional-based Web sites. And they cannot afford to overlook due diligence. "A classic case of 'it's too good to be true' is often accompanied by an online request--or even demand--to evaluate a proposal quickly and sign the necessary papers at once," she said. "If the prospect is so compelling, it can wait until it is given adequate review."

If a new client places an order from your web site, how do you determine who they are, if they have the authority to place such an order and if their company has the ability to pay? A company can "proceed on faith," or it can sort out all potential transactional dilemmas before hanging its shingle in cyberspace. The Internet is making it easier for companies to conduct business in foreign countries, and it is making it easier for companies to conduct credit checks on foreign companies, said Julie Gage, business project manager, Dun & Bradstreet Canada, a NACM-Canada Credit Conference sponsor. Companies like Dun & Bradstreet can help credit managers adopt to the new global reach of the Internet by providing them with background and credit information online or by e-mail, she said. Scott Blakeley, partner with Blakeley & Blakeley LLP, concurred. The most dramatic effect on the Internet "is the shortening of the credit cycle," he said. Vendors are using the Internet to conduct background and credit checks on com panies, cutting dramatically into the time required to approve credit.


The Internet enables companies to do business around the world by connecting them, but global connections also "create serious security concerns," said Harry Brandon, founding partner of Smith Brandon International. The "Love Bug" virus was created in the Philippines but quickly swamped computer networks around the world, he reminded delegates. "Is the credit information you have on file secure from hackers?" he asked the delegates.

Companies are even posting order acknowledgement forms and invoices on secure web sites that customers can access. While clients enjoy the freedom of accessing information any time, they want to be assured their credit and purchasing history is secure, or they will look for other vendors.

"Computers are efficient, and they empower employees, but there are downsides," Brandon said. Fraud cost North American businesses $ 350 billion in 1990 and $ 400 billion in 1999. Computer fraud grew exponentially over this same time. Damages pegged at $ 300 million in 1990 hit $ 50 billion in 1999. Over 25 percent of Fortune 500 companies are computer crime victims, and employees have perpetrated many of the crimes.

Risk avoidance is obligatory. Firewalls and virus protection are required to keep hackers out. ID, passwords and other internal measures, including forensic audits, are required to prevent or track down illegal activity by employees.

Even with the risks associated with the Internet, Brandon says companies have "no choice" but to embrace electronic commerce. "The goal is to do it right, in a safe, secure, protected environment."


Using technology to do it right also includes employing information technology systems to make the credit department more efficient, says Brian Cheney, vice president technology, IHS Solutions Limited, an information management solutions technology company. Companies can increase collection efficiency without increasing operational collection costs using technology, he said.

Companies moved from paper-based document management to microfiche and then to CD-ROM. Now they are moving to Web-based data that puts information in the hands of clients. For example, if a vendor establishes a secure e-business web site, clients can search for the status of orders or for lost invoices based on purchase order number, product code or other criteria. Centralized credit databases and computer networks allow credit managers to fax or e-mail "lost" invoices from their desktop to overdue accounts while on the phone. This gives the credit manager the opportunity to say: "It's there now, so let's talk about the bill."

Information management automation is not a process than can be implemented overnight. Companies must review existing business practices and define ideal practices and then build systems that meet defined needs. Staff input is important if they are to buy into, rather than resist, automation, Clients also have to be kept in the loop and reassured that credit and payment information is secure.

Automating the credit department and integrating back office databases with web sites can be expensive propositions. The results, however, can include streamlined business practices, improved productivity and a higher rate of closure on outstanding accounts, Cheney said. "But why stop there?" asked Mark Visic, vice-president sales, Kubra Data Transfer Ltd., a document fulfillment, management and e-commerce company. Although companies have automated many aspects of traditional "print and mail" bill presentment, they still spend time and money printing invoices, stuffing and stamping envelopes and mailing bills. The post office then takes time delivering bills, which customers lose or claim they did not receive. Some companies have outsourced the entire print and mail process, which means a third party has to spend time doing what internal staff once did. And the post office is still involved in the equation. An automated electronic bill presentment and payment (EBPP) can reduce the time it takes to get invoice s in the hands of customers and payment in the bank, Visic said.

EBPP is an emerging technology that will eventually replace mail, fax and electronic data interchange (EDI). "EBPP offers corporations the ability to send invoices or statements to consumers via the Internet and process an electronic payment. Companies employing EBPP can post bills on their web site, with a financial institution or a third party clearinghouse. The client receives a secure notification and can view and pay bills online using credit cards, debit cards or other forms of electronic payment, trimming time off the invoice-to-payment cycle. The electronic bill is traceable from the moment the client receives notification, Visic said.

While 7 in 10 companies indicate that billing cost reductions are key to EBPP, the process can also be used to bring clients to a vendor's web site, allowing the vendor to market its brand and continue to sell to the client. "Now bill payment can be used to increase brand awareness, loyalty and sales," Visic said. "This represents a new opportunity for businesses to strategically use billing to sharpen their competitive edge in the new electronic economy."

EBPP is not yet simple or inexpensive to implement. "There is considerable sticker shock," said Visic. The return on investment is not there for every company considering it. Even so, the future holds some form of EBPP for most companies.

If you are still skeptical, look back over the last five years and review how the digital revolution has influenced the way your company does business, and the way you work. "When it comes to advances in technology, we haven't seen anything yet," said Dr. Atkinson. "In five to ten years, we'll look back at the technology we are using today the way we look back at dinosaurs." In other words, companies and credit departments will continue to evolve with the digital world and global economy, or face extinction.

Paul Lima is a freelance journalist and workshop leader based in Toronto, Ontario.

As companies begin to conduct e-commerce in the global market place and move to online billing and payment systems, they must tackle the issue of international law head- on, speakers at NACM-Canada's second annual Credit Conference and Expo told delegates in Toronto.

"In the virtual world, as in the paper world, commerce is based on contracts," said Marie-Pierre Simard, copyright lawyer with the law firm Brouillette Charpentier Fortin. Before a dispute over a virtual contract arises, credit managers need to know what makes virtual contracts acceptable to the courts. "Sometimes it seems as if the law cannot keep up with the information age. Yet, people involved in e-commerce must be able to identify the laws upon which e-commerce relies so that [virtual contracts] may be seen as a valid, enforceable, credible way to do business."

The federal governments in Canada and the US are developing national standards to govern e-commerce transactions, but many provinces and states have different laws, as do different jurisdiction around the world.

In some countries, only contracts with handwritten signatures are allowed in court. In other countries, an electronic signature (fax, scanned document, use of a PIN or password) is acceptable. Other jurisdictions--particularly in North America and Western Europe--will accept digital or encrypted signatures to prove a client ordered a product, and the vendor shipped in good faith.

In the US, electronic signatures cannot be "denied legal effect, validity or enforcement solely because it is in electronic form", said Scott Blakeley of Blakeley & Blakeley LLR. However, an electronic signature does not mean a company will win its case. All other laws for commerce come into play.

Blakeley also warned credit managers to be careful about what they write in email, especially if discussing a client's credit information with a third party. E-mail is easy to send, receive and forward, and sometimes people forget slander and conspiracy laws that cover the printed word, he said.

There are risks and opportunities associated with doing business in the global economy. When dealing with new clients in foreign countries, companies can protect themselves by insuring receivables, explained Angela Boston, business development manager, Export Development Corporation, which is a Canadian crown corporation that helps credit managers mitigate risk in 160 countries.

Her thoughts were echoed by Mark Hall, associate broker and credit insurance specialist with Dan Lawrie Insurance Brokers Ltd. Hall, which offers credit insurance for both domestic and global markets. "This is not a replacement for due diligence or a well-managed credit department," he said. "But it adds another layer of security."

If companies are having difficulty collecting uninsured payables, they can use training or technology to improve their ability to collect, or outsource collectables.

"Effective training can show people how to be assertive, not aggressive and collect more while retaining customers they want to keep," said Tim Paulsen of T. R. Paulsen & Associates, a company specializing in "creative receivables management."

Automating the collection process can boost the rate of return, says David Phillips, Guthrie Phillips Group (GPG) president and CEO. GPG's CAT2000 recovery system puts complete customer history in the hands of each staff member and schedules follow-up correspondence and calls. It can be connected to the company accounting system and updated the moment an invoice has been paid, so collectors are working from current information.

If collectables get out of hand and hiring more staff is not an option, then companies might look to outsourcing some or all the responsibility, says Robert Ingold, president of The Commercial Collection Corp. He admits some companies resent having bills turned over to collection agencies. However, his company can "work as an extension of the credit department" so the overdue client doesn't know the account has been turned over to a collection agency.

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