Sources have conjectured that the terrorist operations perpetrated on Sept. 11, 2001 were financed to the tune of US$500,000 to US$1 million. The funds swirled through bank accounts and banking institutions around the world, triggered by international wire transactions and conveyed through Internet communications. Many of the actors and movers of funds apparently were able to use anonymous monetary instruments and facilities that helped to conceal their ultimate objective: wholesale destruction of human life.
The US. Government acted swiftly to address one of the core issues related to the use of anonymous financial sources and nameless financial accounts. On Oct. 26, 2001 the U.S. Congress enacted and President George W. Bush signed the "USA PATRIOT Act" into law. This Act addresses a wide range of topics including domestic security, anti-terrorism, money laundering, and surveillance procedures. Of particular importance is Title III - "lnternational Money Laundering Abatement and Anti-Terrorist Financing Act of 2001." Sections 312 and 352 of the Act require all financial institutions, including investment companies, within 180 days after enactment of the Act, to develop programs that at a minimum: develop internal policies, procedures and controls to address specific "source of funds" issues; designate a compliance officer to oversee the anti-money laundering program; establish an ongoing employee training program related to the specific issues and necessary compliance; and have an independent audit function to test the compliance program that is established.
The deadline for having an anti-money laundering program in place is April 24. Are you ready for the Feds?
The USA PATRIOT Act of 2001, also known as the "Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism" Act, contains several sections that address monetary transactions through correspondent banks and private bank - within and outside the US - Section 312 creates a requirement for "special due diligence for correspondent accounts and private banking accounts."
Hedge funds, including offshore funds, are not exempt from the Patriot Act, its tracking or reporting requirements. In fact, the Wall Street Journal reported shortly after the events of 9/11 that the U.S. Federal Bureau of Investigations was investigating whether terrorist groups invested or laundered money through hedge funds, perhaps unwittingly. According to Senator Jon Corzine (D/NJ), "If I were trying to launder money, I would use a hedge fund rather than an SEC-registered firm. It's a good way to move large blocks of money. There's no supervision and you don't have to reveal who your friends are" ("FBI Is Scrutinizing Whether Terrorists Used Hedge Funds," Wall Street Journal, Nov. 21, 2001, pg. A8).
The Patriot Act was rapidly drafted as a framework for efforts directed at a vague, but huge problem - global money laundering. It uses a broad approach in terms of its reach and its issues. It is subject to the drafting of extensive regulations, including interim rules, proposed rules and requirements that provisions must be complied with even in the absence of specific regulations.
While there is a fair share of confusion over the Patriot Act, pertinent rules and regulations, the deadline is clearly stated on certain requirements. Furthermore, some provisions are clearly stated and mandated. For example, provisions of the Patriot Act stipulate that the pertinent financial institutions and entities:
- Obtain accountholder identification and complete appropriate verification (Section 326).
- Conduct Due Diligence with respect to private banking accounts and correspondent accounts (Section 312).
- Not do business with shell banks (Section 313).
- Obtain additional ownership information for foreign banks (Section 319).
In addition, the Act authorizes certain special measures be undertaken by the Treasury Department (Section 311).
The applicability of these provisions to hedge funds or how these provisions should be implemented is not fully determined as of today's date. The Patriot Act does not yet have requirements for hedge funds specifically, yet hedge funds come under the broad provisions of the Act, as a financial institution.
Minimum Required Steps
Since hedge funds are considered financial institutions, what should be done by the manager of a hedge fund to not only comply with the Patriot Act, but also to take proactive steps to prevent money laundering? At a minimum the following steps need to be in place to set up an anti-money laundering program:
Assign an anti-money laundering compliance officer.
- Set up polices and procedures for investor identification ("know your investor" policies).
- Set up an employees' training program in money laundering detection and prevention.
- Have an independent audit function to test the program.
Many hedge funds or commodity trading advisers might think that since they know each subscriber and investor, they do not need to set up a formal anti-money laundering program or that the provisions of the Patriot Act don't apply to them. This may result in a false - and dangerous - sense of complacency. Not only are all financial firms required to comply with the Patriot Act and its provisions, there are instances where you may think you "know your investor" when in fact you don't know "the investor's investors, partners or other associates." A detailed questionnaire to the potential investor/subscriber might cause the disclosure of information relevant under the Act.
However, if you were considering investment in a hedge fund, and your partner is known to you to have terrorist connections or other questionable associations, would you put that associate's name (terrorist or just a person with suspicious affiliations) on the application? Further due diligence may be required by the fund to develop the necessary details on financial sources and financial relationships.
Extent of Due Diligence - What Should Be Done
Many investment firms may think that they know their subscribers and investors sufficiently, so that there is no need for additional due diligence. This may result from confusing the actual, personal point of contact with the entity. Do you really know the client, that person, that family trust, or that bank? At a minimum, a check should be performed to compare the investor, the investor's contact person or company, and any other identifiable financial relationships provided by the investor with the list of restricted persons maintained and promulgated by the Treasury Department's Office of Foreign Assets Control on its Specially Designated Nationals and Blocked Persons list (www.treas.gov/ofac). Additionally, a media check should be completed to see if any of the subscribers or investors are related in any way to people or entities on the OFAC list. As Senator Jon Corzine said about investors in hedge funds, "...you don't have to reveal who your friends are." However, these "friends" and other noteworthy associates can be identified with proper, reasoned, deliberate due diligence.
Foreign subscribers or investors may require thorough examination on their names alone. For example, many names are spelled differently in different languages, especially those in different scripts (like Arabic, Cyrillic and Hindi) and can have many variations in English. Simply checking the last name of an investor to the OFAC list isn't enough. That last name on your database might be the middle (or even the first) name of a person in their home country and a simple check of the last name would not be sufficient. A more advanced search is needed to take spelling, and other cultural factors (like placement the surname), into account.
Also, particular scrutiny should be undertaken as to investors and subscribers located in countries subject to OFAC-Administered Sanctions (see details on www.treas.gov/ofac), Financial Action Task Force Non- Cooperative Countries and Territories (see details on www1.oecd.org/fatf), and countries where money laundering advisories have been issued by the Financial Crimes Enforcement Network of the Department of the Treasury (see details on www.treas.gov/fincen).
If some questions remain about a target entity after the initial review, whereby basic due diligence does not eliminate all concerns or suspicions, a more thorough due diligence investigation should be performed. It may well serve the fund to go with your basic instincts. The failure to address any such concerns may well cause a major setback, while further review and verification may bring a measure of reassurance. Our recommendation: consider using a qualified, outside firm that brings an objectivity as well as a level of experience and expertise in the conduct of expanded due diligence investigations, particularly where the trail of relationships may lead to difficult foreign venues.
Due diligence needs to be performed on every single investor or subscriber you have, be it an individual, family, trust fund, bank or corporate entity. Some aspects of that due diligence might be simple, efficient and easy to complete. Some of it might require more in-depth investigations, and lead to unfamiliar territory. The decision on degree of due diligence is currently left with the Anti-Money Laundering Compliance Officer that each fund company must have. When in doubt, if one of your investors or subscribers needs extensive scrutiny, consider consulting a professional services or investigative firm that specializes in due diligence.Correspondent Accounts and Third-Party Administrators: Can You Trust Them? And Are They Doing Their Jobs?
Sanctions under the Patriot Act can include the forfeiture of funds. This is no small matter to contemplate.
Money that is transferred from correspondent banks and other financial institutions can be just as risky as money from individual investors. Just because a bank or financial institution is large and well known, you cannot proceed on blind faith that it has the proper safeguards and controls in place to ensure compliance with all provisions of the Patriot Act or to ensure that its funds are beyond reproach or "clean." Request copies of their anti-money laundering policies and procedures and attempt to ascertain if they are following these procedures. In many circumstances, a due diligence investigation of the correspondent bank or financial institution is in order. This may be particularly true where the entity is not well known and operates outside the United States. The last thing you want to be dealing with is a shell bank, which falls under a very specific prohibition in the Patriot Act (under "Prohibition on United States Correspondent Accounts with Foreign Shell Banks"). But how do you know if the investing bank is a shell bank or not? You need to take steps to determine this, looking at the actual status, location, facilities and operations of the target bank, through a thorough investigation into the institution, and not simply accepting the information provided by the bank.
When using third-party administrators, particularly offshore administrators, hedge fund managers need to scrutinize these operations as well. Even though many of these administrators reside in countries to which the Patriot Act does not apply, the hedge fund in the United States must still make sure the administrator complies with international money laundering standards. This is required under the Patriot Act. Ask your administrators about their anti-money laundering policies and procedures and consider if they are enough to satisfy standards set forth under the Patriot Act or other recognized anti-money laundering codes or legislation. Again, attempt to ascertain if your administrators are following these procedures.
A professional services firm that specializes in due diligence may be the most qualified resource to determine whether a correspondent bank, financial institution or third-party administrator is the entity it purports to be. In addition, an investigative firm, working in conjunction with legal counsel, may provide the optimal combination of resources to ensure that the proper anti-money laundering procedures are in place under the Patriot Act - or other internationally recognized anti-money laundering laws - and that your financial associates are actually in compliance with these laws.Hedge Funds That Do Not Reside or Operate in the United States
Although hedge funds that do not reside in the United States and are not subject to the USA PATRIOT Act (unless they have a branch or do business in the United States), many countries have developed or are developing similar anti-money laundering initiatives. One of the major international proponents of anti-money laundering is the Financial Action Task Force, which is under the Organization for Economic Cooperation and Development. Members of the FATF come from 29 countries (including the United States), as well as the European Commission and the Gulf Cooperation Council. The FATF has drafted "The 40 Recommendations" for its member countries and regions. Countries in Asia, southern Africa, and the Caribbean have also created regional anti-money laundering organizations.
In addition, several regional bodies have established anti-money laundering standards for their member countries. These bodies include the European Union, Council of Europe and the Organization of American States.
The standards that will apply, or have been applied, to hedge funds located outside the United States are very similar to the requirements of the Patriot Act. In fact, the Patriot Act borrows much of its standards and requirements from similar policies already established in Europe. With the global concern over terrorism and money laundering activities in general, the policies already established outside of the United States are getting more attention. It may be assumed that they may be given more official support and allotted greater resources, which would mean more efficient and effective enforcement.Outsourcing Certain Requirements Under the USA PATRIOT Act
Some managed fund firms may not have the resources - time, personnel or funding - to establish an anti-money laundering program themselves. However, there are consulting firms that can assist in creating a program or support already established programs. Some of the services include due diligence (both basic and enhanced), creation of an investor questionnaire, development of a training program for employees, an independent audit function, program testing, and other services. The hedge fund manager or the general counsel could become the "Anti-Money Laundering Compliance Officer," but when time or budget doesn't allow, an outside firm, working with corporate counsel, could perform much of the required work. These services can be provided at a reasonable cost and do not necessarily have to involve independent legal counsel.
The Treasury Department has established 20 working groups to address the different regulations required under the provisions of the Patriot Act, according to testimony by Richard Spillenkothen, director, Division of Banking Supervision and Regulation of the Federal Reserve Board, before the U.S. Senate Committee on Banking, Housing and Urban Affairs (Jan. 29). This is a massive, unprecedented effort within the U.S. government, crossing jurisdictional lines and lines of authority in a way that is typical only under a war-time regime. Under such a complex, critical system, you can be assured that professional advice may be critical to establish and implement the necessary program and procedures under the Patriot Act.
Although the Patriot Act does not contain provisions specifically targeting the hedge fund community, it does establish the basic requirements that all financial institutions in the United States will have to meet. Similar requirements will most likely be put in place, or are already in place, in jurisdictions outside the United States. Each fund company has different needs, varying resources and different levels of preparedness. One size does not fit all and one anti-money laundering program for one fund company may not be suitable for another. But a program must be in place.
So-are you ready for April 24? Do you have a formal money laundering prevention and detection program in place? Does that program provide for the designation of an Anti-Money Laundering Compliance Officer? Do you have formal policies and procedures in place for investor identification? Do you have a training program for your employees in money laundering detection and prevention? Do you have an independent audit function to test the program? If not, you better get moving. Without an anti-money laundering program in place, hedge funds and other managed funds face possible Federal government intervention. The nature of this intervention could range from bad publicity to the seizure of funds. And that is a nightmare that nobody wants to face.
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. Activities of Smith Brandon International include due diligence investigations and assisting in designing compliance programs for financial service firms and law firms.