On August 25, 2015, the Financial Crimes Enforcement Network
(FinCEN) issued a notice of proposed rulemaking
(NPRM) prescribing anti-money laundering (AML) program requirements
for investment advisers required to be registered with the U.S.
Securities and Exchange Commission (SEC). FinCEN, a bureau of the
U.S. Treasury, administers regulations under the Bank Secrecy Act
(BSA) requiring financial institutions to implement AML policies
and procedures, keep records, and file reports on certain financial
transactions.
The NPRM is not FinCEN's first attempt to establish AML
requirements for investment advisers. Following enactment of the
USA PATRIOT Act, which amended the BSA, FinCEN issued proposed
rules in 2002 and 2003 to regulate certain
investment advisers and unregistered investment companies, but
subsequently withdrew the proposals in 2008 because, in part, the
assets of investment advisers and unregistered investment companies
were carried at financial institutions already subject to FinCEN
rules.
According to the NPRM, however, the regulatory environment for
investment advisers has changed since the passage of the Dodd-Frank
Act in 2010, which required certain formerly unregistered advisers
to hedge, private equity, and other private funds to register with
the SEC. FinCEN therefore proposed the current NPRM within this new
regulatory context out of continued concern that money launderers
might seek out investment advisers as a way to enter the U.S.
financial system (notwithstanding that many advisers provide
services to FinCEN-regulated financial institutions).
We provide below a brief summary of the NPRM, which proposes three
key regulatory changes: (1) including investment advisers within
the scope of regulated entities, (2) requiring investment advisers
to establish AML programs, and (3) requiring investment advisers to
report suspicious activity to the U.S. government. Comments to the
NPRM are due on or before November 2, 2015.
Scope of the NPRM—Defining Investment Advisers as Financial Institutions
Under the Bank Secrecy Act, FinCEN has the authority to
establish AML requirements for "financial institutions."
The NPRM proposes to define investment advisers registered with or
required to be registered with the SEC pursuant to the Investment
Advisers Act of 1940 as "financial institutions" subject
to some—but not all—of FinCEN's AML requirements.
Given SEC registration requirements, the rule would apply primarily
to large-sized advisers—those with $100 million or more under
management. Mid-sized and small-sized advisers are not permitted to
register with the SEC, unless an exemption exists, and would
therefore not be covered by the proposed rule. FinCEN has stated,
however, that it reserves the power to extend the scope of the rule
in the future to include other types of investment advisers, such
as state-regulated investment advisers.
Investment advisers, as noted by FinCEN, provide advisory services
to a variety of clients, including "individuals, institutions,
pension plans, corporations, trusts, foundations, mutual funds,
private funds, and other pooled investment vehicles." Covered
investment advisers will include many different types of advisers,
such as:
- Dually registered investment advisers, and advisers that are affiliated with or subsidiaries of entities required to establish AML programs;
- Certain foreign investment advisers;
- Investment advisers to registered investment companies;
- Financial planners;
- Pension consultants; and
- Entities that provide only securities newsletters and/or research reports.
According to the NPRM, investment advisers that already meet the definition of a class of financial institution (e.g., a broker-dealer) would not be required to establish a separate AML program "so long as a comprehensive AML program covers all of the entity's advisory" and other financial institution services.
Proposed AML Requirements for Covered Investment Advisers
The NPRM requires each covered investment adviser to implement a
written AML program reasonably designed to prevent the investment
adviser from being used to facilitate money laundering or terrorist
finance, as outlined below.
AML Program Requirements. The written AML
program must be approved by the adviser's board of directors,
or if there is no board, the adviser's sole proprietor, general
partner, trustee, or other person with authority similar to that of
a board. The minimum requirements for a written AML program
include:
- Development of internal policies, procedures, and controls;
- Designation of a compliance officer;
- An ongoing employee training program; and
- An independent audit function to test the program.
Of particular importance, FinCEN would require the AML program
to be "risk-based," and tailored to the investment
adviser's products and services. According to FinCEN,
investment advisers should be able to adapt existing policies,
procedures, and internal controls required by SEC rules to cover
the additional AML requirements proposed in the NPRM. Thus, the
NPRM concludes that investment advisers can build on their current
SEC compliance programs. Given this goal, and the SEC's
experience in this area, FinCEN proposes to delegate examination
authority for compliance with such AML requirements to the
SEC.
Suspicious Activity Reporting. The NPRM
requires investment advisers to file SARs for "suspicious
transactions that are conducted or attempted by, at, or through an
investment adviser and involve or aggregate at least $5,000 in
funds or other assets." Thus, investment advisers would be
required to implement monitoring programs to review transactions
for suspicious activity (such as a client account that shows a
pattern of "inexplicable and unusual withdrawals, contrary to
the client's stated investment objectives."). The SAR
reporting requirements may present particular challenges for hedge
funds and other, similar entities with active trading
strategies.
Reporting and Recordkeeping. The NPRM
also establishes a number of recordkeeping and reporting
requirements for covered investment advisers:
- Under FinCEN's Recordkeeping and Travel Rules, investment advisers must "create and retain records for transmittals of funds, and ensure that certain information pertaining to the transmittal of funds 'travels' with the transmittal to the next financial institution in the payment chain."
- Whereas investment advisers were previously required to file Form 8300s for certain transactions, the NPRM would require advisers to file currency transaction reports (CTRs) instead for any transaction involving the transfer of more than $10,000 in currency during any one business day.
Key Considerations for Investment Advisers
The NPRM seeks comment on a number of specific issues as well as
the proposed rule as a whole. In addition to addressing
FinCEN's questions, we suggest that the following issues be
considered when reviewing the NPRM.
Implementing a Risk-Based Program. One of
the biggest challenges investment advisers will face under the
proposed rule is designing and implementing an AML program that is
appropriately tailored to address the AML risks of the
adviser's geographic location, strategies, products, services,
and customers. Although developing a "risk-based" program
sounds simple in theory, the day-to-day application of this
principle is difficult.
Under the rule, investment advisers must "risk-rate"
their customers, and then design and implement controls to account
for such risk. Applying rules originally drafted for banks will
raise substantial issues when applied to investment advisers. For
this reason, industry members subject to the proposed regulations
should pay particular attention to definitions of
"customers," "clients," and
"investors."
While the NPRM does not require a formal customer identification
program (CIP), the reality is that it will be difficult for
investment advisers to implement risk-based programs without using
a CIP to determine appropriate risk, except to the extent an
investment adviser arranges to rely on the CIP used by an entity
subject to the full AML program requirements, such as a bank or
broker-dealer. Similarly, where the NPRM states that "the
burden" of establishing an AML program will depend on the
adviser's risk profile, many investment advisers will likely
feel pressure to implement aggressive controls to minimize
potential regulatory risk. The effect will be that investment
advisers, like other regulated entities, may find it prudent for
their AML compliance program to exceed what would otherwise be
required by their actual risk profiles to avoid SEC scrutiny.
Delegation of Authority. The NPRM
provides that an investment adviser may "delegate
contractually the implementation and operation" of certain
aspects of its AML program to agents or third-party service
providers. The ability to delegate, however, which is also found in
other FinCEN programs, has proved difficult to apply in practice.
As explained by the NPRM, an investment adviser that delegates
implementation of aspects of its program would remain "fully
responsible for the effectiveness of the program." Thus, many
financial institutions find that the ability to delegate provides
limited benefit in terms of simplifying day-to-day operations and
regulatory risk.
Costs of Implementation. The NPRM's
regulatory analysis states that FinCEN expects investment advisers
to spend an average of three hours establishing an AML program.
This figure, in our estimation, greatly underestimates the time and
effort that investment advisers will need to establish compliant
AML programs. Proper implementation of an AML program includes a
detailed analysis of business operations, identification of risk,
careful tailoring of appropriate policies and procedures, and
modifications or enhancements to current infrastructure, personnel,
and technology. As noted above, "regulatory creep" will
likely push investment advisers (especially larger ones) to
implement comprehensive policies and procedures, including
electronic monitoring software designed to monitor for suspicious
activity. Establishing these programs will require the dedication
of significant staff time and financial resources.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.