United States: Treasury Issues Proposed Regulations Requiring Anti-Money Laundering Programs for Unregistered Investment Companies

On September 26, 2002, the Department of the Treasury's Financial Crimes Enforcement Network ("FinCEN") published in the Federal Register proposed Bank Secrecy Act ("BSA") regulations that would require certain unregistered investment companies to implement anti-money laundering ("AML") programs and to notify FinCEN if they are subject to the requirements. 67 Fed. Reg. 60617. Comments are due on the proposal on or before November 25, 2002.¹

Although "investment companies" have been included in the BSA statutory definition of financial institution since the BSA was enacted, Treasury had not exercised its BSA authority with respect to investment companies until the Congressional impetus of Section 352 of the USA PATRIOT Act, 31 U.S.C. § 5318(n)(1). Section 352 requires all financial institutions under the BSA statute, 31 U.S.C. § 5312(a)(2), to implement AML programs with certain minimum elements by April 24, 2002. Section 352 also authorizes Treasury to exempt categories of financial institutions not designated as financial institutions under the BSA regulations from the AML program requirement. On April 23, 2002, Treasury proposed AML programs for mutual funds (registered open-end investment companies under the Investment Company Act of 1940) and announced that it was temporarily exempting other types of investment companies and other categories of financial institutions listed in the BSA statute, but not designated as financial institutions under the BSA regulations, until October 24, 2002, pending further study.

One of the issues that Treasury, the Securities and Exchange Commission ("SEC") and the Commodities Futures Trading Commission ("CFTC") have been studying over the last several months has been what types of investment companies (other than open-end mutual funds) should be subject to the AML program requirement. Investment company is not a defined term in the BSA statute.

In drafting the proposed definition of unregistered investment company, Treasury has tried to strike an appropriate balance by covering only those funds that pose the highest money laundering risk and by excluding those investment companies that pose the least risk, e.g., investment clubs. According to Treasury, smaller funds (with assets under $1,000,000) and funds that require invested funds to be "locked up" for two years or more do not pose a high risk for money laundering. Consequently, Treasury has proposed to define an unregistered investment company as a company that:

1. Would be an investment company under the Investment Company Act of 1940 (15 U.S.C. 80a), but for the exclusions provided in sections 3(c)(1) and (c)(7) of the Act (17 U.S.C. 80a-3(c)(1) and (7)), e.g., hedge funds, private equity funds, venture capital funds, and real estate investment trusts ("REITS");
2. Is a commodity pool; or
3. Invests primarily in real estate or interests in real estate.

To come within the definition, the fund also must:

1. Permit an owner to "redeem" his or her ownership interest within two years of the purchase of that interest;
2. Have total assets, including received subscriptions to invest, of $1,000,000 or more as of the end of the most recent calendar quarter; and
3. Be organized under state or federal law, be organized, operated, or sponsored by a U.S. person, or sell ownership interests to U.S. persons.

Treasury has proposed four exceptions to the definition of unregistered investment company. Under these exceptions, an unregistered investment company would not include the following:

1. A person that is otherwise required to have an AML program, e.g., a securities broker-dealer;
2. A family company, as defined in section 2(a)(51)(A)(ii) of the Investment Company Act, but without any dollar limit;
3. An employee security company, as described in section 2(a)(13) the Investment Company Act; and
4. An employee benefit plan, as defined in 17 C.F.R. § 4.5(a)(4), that is not "construed to be a pool."

In the preamble to the proposed rule, Treasury states that the unregistered investment company definition would include only those companies that "give an investor a right to redeem any portion" of his or her ownership interest within two years after purchase. Treasury explains that this means that the fund "would have to preclude an investor from redeeming each and every investment during a two year period," e.g., impose a "lock-up" period. According to Treasury, if the investment company "permits the owner to redeem" its interest within two years, the company would be covered by the AML program rules regardless of whether, as a practical matter, the investors could find a buyer for their interest in a secondary market.

Although the meaning of right to redeem is not discussed in the preamble or defined in the proposed regulations, it is commonly understood that right of redemption means the right of an investor to require the fund, partnership or other investment vehicle to redeem or buy back the investor's interest. Based upon informal discussions with Treasury staff, however, it appears that Treasury may be considering construing redemption more broadly to include the right of an investor to transfer or sell an interest in the fund to another investor in the fund or to a third party. Because real estate partnerships, private equity funds and many other potentially-covered unregistered investment companies generally permit investors to transfer their interest to another investor or to a third party (if the transferee meets certain criteria or upon the occurrence of certain events), such an interpretation would expand substantially the coverage of the proposal and undermine the exception. As potentially affected funds and other investment companies may not be aware of this issue, if Treasury were to expand the categories of investment companies covered by the final rule, an argument could be made that Treasury has not provided adequate notice to the affected businesses.

As noted above, the application of the regulations to funds that otherwise meet the criteria and are organized outside the United States is potentially broad. As proposed, the regulation would apply to an unregistered investment company if the company were organized, operated or sponsored by a U.S. person or if it were to sell, or, arguably, offer to sell, any interest to a U.S. person, however small that interest.

The terms "operates" and "sponsored" are not defined in the proposed rule. "Operates" could include back office services and, possibly, even financial advisory services performed in the United States. Consequently, a foreign company with all foreign investors could be subject to the requirements. The meaning of these terms and the extent of the U.S. nexus should be clarified further in the final regulation.

As proposed, each covered unregistered investment company must develop and implement a written AML program, "reasonably designed" to prevent the company from being used for money laundering or the financing of terrorist activities and to achieve and monitor compliance with applicable BSA requirements. The program would have to be based upon an assessment of the money laundering risks, taking into account the company's business structure and factors such as its size, location, activities, methods of payment, and risks or vulnerabilities to money laundering.

At a minimum, the AML program should:

1. Establish and implement policies, procedures and internal controls reasonably designed to prevent the company from being used for money laundering or the financing of terrorist activities and to achieve compliance with the applicable provisions of the BSA, i.e., currently the parallel Form 8300 cash reporting requirements of the BSA and of Section 6050I of the Internal Revenue Code, the BSA requirement to report large international transportations, shipments or mailings of currency, travelers checks and other monetary instruments, and the AML program requirements;
2. Provide for independent testing of compliance to be conducted by the investment company's personnel or by a qualified outside party;
3. Designate a person or persons (e.g., a committee) responsible for implementing and monitoring the operation and internal controls of the program who could be an unregistered investment company's officer, trustee, general partner, organizer, operator or supervisor, as appropriate; and
4. Provide ongoing training for "appropriate persons," including employees of third-party service providers.

The AML Program would have to be approved in writing by the fund's board of directors or trustees or, if it does not have a board, by its "general partners, sponsor, organizer, operator or other person who has a similar function with respect to the company."

The proposed effective date would be 90 days from the date the final regulation is published in the Federal Register, e.g., probably not before April 2003. (This is the same delayed effective date period that was provided to mutual funds.)

Treasury notes that, like mutual funds, unregistered investment companies can conduct activities through separate, unrelated entities, e.g., fund administrators, investment advisors, commodity pool operators, commodity trading advisers, broker-dealers (including prime brokers) and futures commission merchants. Treasury states in the preamble that it is permissible for unregistered investment companies, like mutual funds, to delegate by contract functions under its AML program to another entity. However, Treasury cautions that the company remains "fully responsible for the effectiveness of the program" and for assuring that federal examiners are able to obtain records from and inspect the third party. Unregistered investment companies also would be responsible for training employees of third-party service providers.

Treasury recognizes that sometimes institutional investors, such as pension funds or other registered or unregistered investment companies, may invest in unregistered investments. According to Treasury, unregistered investment companies must assess the risk posed by the investing entity, including the type of entity, its operator or sponsor, its location, the type of regulation it is subject to, and whether the entity has an AML program and its terms. Unregistered investment companies would have to "account for any risks" posed by any offshore operators and affiliates in developing their AML programs.

Treasury suggests that there may be further BSA requirements applicable to unregistered investment companies. In the preamble, Treasury notes that unregistered investment companies may become subject, for example, to customer identification requirements under Section 326 of the PATRIOT Act and requirements to file Suspicious Activity Reports ("SARs"). It has been understood that Treasury would issue customer identification requirements under Section 326 for all financial institutions required to have AML programs. To the extent additional BSA requirements are imposed, Treasury states that AML programs will need to be updated to include appropriate policies, procedures, training and testing functions. Whether or not regulations are issued under Section 326 or SARs are required, an effective AML program should include appropriate risk-based policies and procedures for identifying customers and reporting suspicious activity to protect against possible money laundering, criminal and forfeiture liability.

While stopping short of requiring suspicious activity reporting, Treasury provides in the preamble a number of examples of red flags that may be indicative of suspicious transactions by unregistered investment companies. If a red flag is detected, the investment company is expected to take reasonable steps to determine if its suspicions are justified and to take "appropriate steps," including refusing to enter into a transaction. Treasury also encourages unregistered investment companies to file SARs voluntarily and to telephone the FinCEN Financial Institutions Hotline to report suspected terrorist activities.

Because FinCEN has no reliable way of knowing the full universe of unregistered investment companies that will become subject to the proposed requirements, as part of the AML program, Treasury proposes that the affected companies provide information about themselves in a "notice" to Treasury. Treasury published a proposed form for this purpose with the proposal. The notice could be filed with FinCEN by mail or email.

As proposed, the notice would have to contain the following information:

1. the name of the investment company, including all family or fund complex names, trade names or doing business as ("DBA") names;
   the complete street address, telephone number and, if applicable, e-mail address, of the investment company;
2. the name and complete street address, telephone number, and, if applicable, e-mail address and registration number of the investment adviser, commodity trading adviser, commodity pool operator, organizer, and/or sponsor of the unregistered investment company;
3. the name, telephone number and, if applicable, e-mail address of the person or persons designated as the person responsible for the AML program;
4. the dollar amount of the total assets under management at the end of the company's most recent fiscal year; and
5. the total number of participants or interest or security holders in the company.

The initial notice would be due 90 days after the effective date of the regulations, i.e., 180 days after the final regulations are published in the Federal Register, or, for new investment companies, 90 days after the investment company becomes subject to the rule. If a company ceases to be subject to the requirement, e.g., because the size of the fund diminishes to under the $1,000,000 threshold or if the fund ceases operations, it must notify FinCEN within 90 days from the change in status or "withdrawal." If there is a change to the information in items 1-4 above, the company must file an amended notice no later than 30 days from the change. All of the proposed information is called for on the proposed notice form, except the family or complex name, trade name and DBA name information.

The AML program must be made available to Treasury or its "designee" upon request. There is no discussion of who will be the designee with responsibility for BSA examination and enforcement with respect to unregistered investment companies. Apparently, this is because Treasury has not determined which entity or entities will be delegated enforcement and examination responsibility. FinCEN itself has no examination staff. Treasury staff has indicated informally that the SEC and/or the CFTC may perform this function.

Copyright © 2002 Gibson, Dunn & Crutcher LLP