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The status of anti-money laundering regulation and private equity

The USA Patriot Act that was passed in October 2001 has undergone several amendments over the last couple of years. The Financial Crimes Enforcement Network of the Department of the Treasury intends to introduce new provisions in the coming months. Gregory T Pusch discusses what this could mean for the US private equity industry.

In April the Financial Crimes Enforcement Network (‘FinCEN') of the Department of the Treasury proposed a new anti-money laundering (‘AML') rule covering investment advisers (the ‘Manager Rule'). FinCEN intends to apply provisions added to the Bank Secrecy Act (‘BSA') by the USA Patriot Act in October 2001 to nearly all managers of private equity and venture funds. This is a reversal from FinCEN's approach just last September in its proposed AML rule regulating funds themselves (the ‘Fund Rule'). The fund rule provides an exemption for funds with limited investor liquidity features, and FinCEN's discussion of that exemption seemed to acknowledge a policy intent to distinguish most private equity and venture funds from hedge funds. The proposed manager rule makes no such distinction.

The fund rule
The fund rule would apply to various unregistered investment companies, including limited partnerships and limited liability companies - such as private equity, venture capital and hedge funds - relying on exemptions from registration under the Investment Company Act. However, to preclude unnecessary regulation of funds and businesses unlikely to be used by money launderers, FinCEN narrowed the scope of the Rule through various limitations and exceptions. 

One of the limitations is that the Fund Rule would apply only to funds that give an ‘owner' a right to redeem any portion of his or her ownership interest within two years of the purchase of that interest. This reflects FinCEN's understanding, presumably from discussions with the SEC staff and others, that hedge funds generally have lock-up periods of one year or less, whereas most private equity and venture capital funds have only minimal redemption rights over the life of the fund.  The discussion in the Fund Rule proposal clearly indicated a view that the limited lifespans and limited liquidity rights of investors make most private equity and venture capital funds unsuitable for laundering.

Policy rationale for the manager rule
Notwithstanding the fund rule limitation, the manager rule effectively would  eviscerate any exemption for private equity and venture capital fund firms. It covers not only investment advisers registered with the SEC under the Advisers Act, but also managers relying on the so-called ‘private adviser' exemption from registration based on managing 14 or fewer funds. 

Assuming both the fund and manager rules are adopted largely as proposed, which seems likely in the current political and regulatory climate, what explains FinCEN's change in policy regarding private equity and venture capital activities?  The discussion in the proposal suggests three possible answers: an increased awareness of the size of the assets involved, a better appreciation of the unique role fund mangers could play in AML efforts as the only significant contacts with certain investors, and a sense that, as most other investments are subjected to AML regulation, the likelihood of money laundering through funds with relatively low investor liquidity could well increase. 

FinCEN emphasises that federally registered advisers alone control $21tn in assets.  The lack of regulation makes the exact amount of additional assets in private funds managed by unregistered managers hard to estimate, but the authors of the rule surely are aware that the hedge fund industry alone, for example, is estimated to have around $600bn in assets, and that many private equity and venture funds, even in today's economic climate, have tens and hundreds of millions of dollars in raised or committed capital.

FinCEN also notes that investment advisers such as fund managers often may be the only participants in the financial system with significant knowledge about the source of a fund monies and the nature of the investor and their investment objectives.  A related consideration appears to be a concern about the potential use of offshore funds not themselves subject to the BSA for money laundering, which the proposal discusses at some length in the context of the sliding scale of the risk of money laundering activities that fund managers will need to consider in formulating AML procedures under the rule.

AML requirements
Traditionally, money laundering involves moving money from illegal activities through the financial system to make it appear that the funds originated from legitimate sources.  The BSA now also makes the movement of funds to support terrorism or terrorist organisations a money laundering crime, even where the funds are from legitimate sources. 

The four basic requirements under the manger rule essentially are to:

• Establish and implement procedures, policies and internal controls reasonably designed to prevent money laundering or financing of terrorist activities through the fund manager.
  
  
• Independently test compliance.
  
  
• Designate a compliance officer or officers responsible for AML.
  
  
• Provide ongoing training to employees.

FinCEN emphasises that an AML program should be implemented ‘in a manner reasonably practicable in light of the firm's size and resources.'  And there is a clear recognition that the small size of many firms means that many AML programs would be fairly simple.  Yet FinCEN also focuses on the spectrum of risk faced by managers based the nature of their funds or investors.  It seems clear that in FinCEN's view even a relatively small firm will need sophisticated procedures if it manages funds susceptible to money laundering. 

In particular, managers either of offshore funds administered by another entity without an AML program, or of funds with non-US investors from countries in which drugs are produced or at high risk for terrorist financing, will need to formulate procedures in light of those factors.  For example, there are government maintained websites where the status of countries and individuals can be checked, and this would probably need to be a routine procedure when soliciting investors.  In some circumstances, it may also be considered a reasonably necessary AML procedure to look through entity investors, such as a funds of funds or other entities, and attempt to ascertain the identity of the ultimate investors.

While not required by the manager rule, FinCEN ‘encourages' advisers to implement procedures to file suspicious activity reports and report suspected terrorist activities.  FinCEN also suggests that suspicious activities reporting and other provisions of the BSA, such as specific requirements for accountholder verification, are likely to be applied to investment advisers in the future.

Many fund managers undoubtedly will hire specialised third party service providers to handle AML compliance, or utilise the services of a fund administrator or other current service provider.  While contractual delegation is permissible, the manager remains responsible for its AML compliance.  Therefore it will be crucial to tailor compliance procedures and policies to a particular business to ensure they are neither unnecessarily burdensome nor inadequate given the nature of the managed funds and their investors. 

Notice filing and the SEC's role
Within 90 days of the effectiveness of the manager rule, unregistered investment advisers will be required to make a notice filing with FinCEN.  This will include contact information, assets under management (calculated in accordance with the SEC 's Form ADV registration statement), and total number of clients.  The information must be updated annually and within 30 days of any change to the contact information.

FinCEN proposes to delegate examination and enforcement to the SEC, which therefore will have access to the notice filings.  In conjunction with similar fund notices filed under the fund rule, this will for the first time provide the SEC with a comprehensive picture of the size of the private fund industry.  SEC examiners, if only for a limited purpose, will be able to review the business practices of nearly all unregistered fund managers. 

Given recent discussions at the SEC, most hedge fund managers may soon be fully subject to SEC registration and examination in any event.  But this will be a significant change for private equity and venture capital managers that may remain exempt from general SEC registration.  For example, private equity and venture capital firms will formally be notifying the SEC that they have a specific number of clients, and will therefore need to be certain that there is no inconsistency between that representation and their claim to exempt status by virtue of having 14 or fewer clients.

The fund rule could be finalised and adopted at any time since its notice and comment period has run (though there would be an initial compliance transition period).  The manager rule theoretically could be finalised and effective by the last quarter of this year.

Copyright © 2003 Edwards & Angell

Gregory T Pusch is a member of the corporate practice group of Edwards & Angell.

Edwards & Angell is a full service law firm focusing on financial services, private equity, and technology.  With more than 270 attorneys, the firm has seven US offices in the New England and New York areas, as well as Florida. For more information please visit www.ealaw.com

The above article has also been published in the August 2003 edition of Venture Capital Journal.