Recent media reports have speculated that President Biden may revive attempts to apply Anti-Money Laundering requirements to investment advisers. David Katz and J. Keith Ausbrook argue that such a move would strengthen the United States financial system.
In 2015, during the Obama administration, FinCEN proposed a rule that would require certain registered investment advisers to establish anti-money laundering (AML) programmes to close a gap in the United States financial system that allows an open path for money launderers and terrorist financers into the system.
The proposed rule, which laid dormant the last four years, would also require these investment advisers to file suspicious activity reports (SARs) and Currency Transaction Reports (CTRs) with FinCEN.
Currently, investment advisers including those who manage hedge funds, private equity funds, and other private funds are not obligated to maintain such programmes or file SARs and CTRs like financial institutions such as banks, mutual funds, and broker-dealers.
FINCEN had proposed a similar rule in 2003 that languished until it was withdrawn in 2008. The Biden administration, however, may pick up where the last Democratic administration (his own) left off and push this one across the line.
And if the recently passed Corporate Transparency Act (CTA) as part of the 2021 National Defense Authorization Act is a harbinger, there may be momentum and an appetite on both sides of the aisle to support such a rule.
We believe that investment advisers managing offshore funds are particularly vulnerable to money laundering activities
The CTA now requires U.S. corporations and limited liability companies to file beneficial ownership information with FinCEN. Without this disclosure requirement, bad actors can hide their identities using U.S. shell companies to engage in illegal activities, including money laundering.
Investment advisers provide various services including portfolio management and financial planning to clients such as high net worth individuals, hedge funds, private equity funds, trusts, mutual funds, and other private funds.
The proposed rule, if revived and adopted, would cover investment advisers who are registered or are required to be registered with the SEC under the Investment Advisors Act of 1940, exempting investment advisers who manage less than $100 million.
The main requirements for an AML program under the proposed rule would have been as follows:
- The implementation of policies, procedures, and controls reasonably designed to achieve AML compliance.
- The designation of an AML compliance officer
- Independent testing of the program for compliance
- The establishment of ongoing AML training for appropriate personnel
- The approval of the AML program in writing by the Board of Directors or its functional equivalent
Although FinCEN did not propose requiring that an AML program include a customer identification program, a new proposal very well might.
Money laundering risks created by the regulatory gap.
Based on our experience, we believe that investment advisers managing off-shore funds are particularly vulnerable to money laundering activities because they operate in off-shore tax and secrecy havens, which are attractive to those involved in foreign political corruption, tax evasion, and illicit drug activity. These bad actors often use foreign shell companies and trusts to mask their identity when investing.
In an FBI intelligence report leaked last summer, the FBI expressed concerned that bad actors were placing investments with hedge funds, private equity firms, and other private funds as vehicles for laundering money, exploiting the investment adviser regulatory gap in the financial system.
The report noted that if investment advisers had AML programmes designed to identify beneficial owners of investments, this would reduce the appeal for using these investment vehicles.
Trillions of dollars enter and move through the U.S. financial system via investment advisers. Although it is unknown how much of this money is illicit, some amount of these trillions of dollars poses serious money laundering risks to the U.S. financial system.
Some have argued that imposing Bank Secrecy Act (BSA) requirements on investment advisers is too costly and that the requirements are unnecessary and redundant because investment advisers in most instances are dually registered with broker-dealers or work through financial institutions subject to AML requirements, including banks and broker-dealers. Others have argued that the lack of liquidity of certain managed funds such as hedge funds and private equity funds make the investment vehicle unattractive to money launders.
However, when weighing the burdens and costs to SEC registered investment advisers, all of whom manage $100 million in assets or more, they pale in comparison to the risks in leaving this gap unattended. First, the costs to a large segment of the industry may not be significant; many investment advisers have already voluntarily implemented AML programmes, and others have agreed to perform certain AML compliance functions consistent with BSA requirements as a condition of doing business with banks and/or broker-dealers.
The costs may be significant for a subset of investment advisers who have avoided instituting AML programmes, either by dealing with broker-dealers and other financial institutions that do not require them or by engaging in activities that escape regulatory scrutiny. These investment advisers, however, are precisely the targets of money launderers and the true target of the rule. Indeed, the AML programmes even among those not required by regulation to have them may have forced money launderers to seek out entities that lack significant AML controls.
Second, extremely wealthy bad actors such as corrupt autocrats may be willing to invest some of their illicit funds in longer term investments. They are wealthy enough not to need the liquidity.
Third, banks and broker-dealers have had periodic lapses in effectively implementing and following their own AML policies and procedures, which further supports an additional layer of security. Regulators over the last two decades have frequently brought enforcement actions against banks and broker-dealers for breakdowns in AML compliance. In 2020, for example, U.S. regulators fined banks over $1.5 billion related to AML violations. So relying on them alone to detect and monitor for money laundering seems insufficient.
Most importantly, investment advisors are better positioned to know more about their clients’ business and transaction activities than banks or broker-dealers.
For example, when an adviser sends an order to a broker-deal for execution, the broker-dealer may not even know the identity of the investor.
The same may be true if a bank holds custody of an asset for the managed fund. In other words, the banks and broker-dealers may have insufficient information to conduct adequate AML screening for the activities of investment advisers.
Even a small number of investment advisers who can offer access to the financial system might justify further protections to prevent money laundering abuses.
FinCEN’s proposed rule, if revived and adopted, would squeeze out bad actors who seek to participate in money laundering and offer needed protection to the U.S. financial system. The additional costs and culture shock for those without AML programmes may be warranted.
David Katz and J. Keith Ausbrook are both Senior Managing Directors at Guidepost Solutions.