The U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) recently withdrew proposed rules that would have required certain investment advisers as well as certain privately offered funds to adopt anti-money laundering (“AML”) programs. The withdrawal of these proposed rules, while welcomed by some, does not end the need for advisers and private funds to consider money laundering risks and, in appropriate cases, adopt AML programs, as many already have done. Indeed, many advisers and funds will continue to face pressure from counterparties and investors to have such programs in place. Moreover, FinCEN’s action does not alter the obligation of investment advisers and private funds to comply with AML requirements of non‑U.S. jurisdictions that may apply because of foreign subsidiaries, operations or funds or, more importantly, with the sanctions requirements of the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”). As if to emphasize this point, shortly after FinCEN’s action, OFAC issued two pieces of guidance specifically targeting the securities industry, which advisers and private funds should not ignore.
FinCEN’s AML Proposals
In 2002, FinCEN proposed rules for certain investment advisers and private funds similar to those applicable to other securities industry participants, such as broker-dealers and mutual funds. Those rules would have required advisers and private funds to adopt AML programs, including establishing written AML policies and procedures, designating an AML compliance officer and conducting regular training and testing.
The proposed rules would have imposed these AML program obligations on a wide range of advisers and private funds. The obligations were intended to apply to SEC-registered advisers with a principal place of business in the United States and unregistered advisers with at least $30 million of assets under management that rely on the exemption from registration under the Investment Advisers Act of 1940 available to certain private advisers with fewer than 15 clients. The proposed rule targeting unregistered investment companies was designed to encompass many hedge funds, private equity funds, commodity pools and real estate investment trusts. Among others, the proposal applied to (a) funds relying on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940; (b) commodity pools; and (c) funds investing in real estate, provided that they (1) permitted ownership interests to be redeemed within two years of purchase; (2) had total assets of at least $1 million; and (3) were organized in the United States, organized and operated or sponsored by a U.S. person, or sold ownership interests to U.S. persons.
After several years of non-action on the proposals, FinCEN decided to withdraw them citing, in part, the passage of time. In its October 30, 2008 press release, FinCEN left open, however, the possibility of proposing new rules to require advisers and private funds to adopt AML programs. Accordingly, the rulemaking process may well be revisited in the future.
Advisers and Funds’ Continuing AML Obligations
The withdrawal of the AML program proposals does not mean advisers and private funds may safely ignore money laundering risks or that they are not subject to any money laundering legal requirements. Indeed, many advisers and private funds have adopted AML programs to guard against AML risks and protect themselves from legal liability. The withdrawal of FinCEN’s proposed rule is unlikely to affect the rationale underlying these voluntary measures.
Continuing AML Obligations
As an initial matter, notwithstanding the withdrawal of the AML program proposal, advisers and private funds as well as their officers and employees are subject to U.S. criminal anti-money laundering laws. Specifically, sections 1956 and 1957 of the U.S. criminal code make it illegal for any person or entity to participate “knowingly” in the transfer of funds that are the proceeds of various types of specified unlawful activities (e.g., drug trafficking, mail fraud). The federal courts consistently have permitted evidence of “willful blindness” to show knowing participation in an illegal transfer. Consequently, firms and individuals involved in financial transactions risk criminal prosecution if they were willfully blind to or consciously avoided learning about financial transactions that may involve criminal funds.
Criminal penalties aside, the mere allegation that an adviser or fund has participated in money laundering activities can pose serious reputational risks, particularly where advisers or funds are alleged to have been willfully blind to evident “red flags.” The risks posed by reputational damage are perhaps most significant in the current economic environment, when many funds and advisers already are facing economic pressures on their businesses.
Advisers and private funds also are subject to affirmative U.S. AML reporting obligations. For example, advisers and private funds generally must report (a) any cash and monetary instrument (e.g., travelers checks, money orders) transactions over $10,000 (admittedly an exceedingly rare occurrence for most); (b) transportation of currency or monetary instruments over $10,000 into or out of the United States; and (c) interests in foreign financial accounts over $10,000. Although advisers and private funds are unlikely to become subject to the first two reporting requirements because they typically do not receive cash, they may hold interests in foreign financial accounts that trigger the third filing requirement. In broad terms, an adviser or private fund must submit a Form TD F 90-22.1 Report of Foreign Bank and Financial Accounts if it holds a financial interest in or has signature or other authority over any financial account(s) in a foreign country, and the aggregate value of such account(s) exceeds $10,000. In addition, advisers and private funds that are affiliated with banks are subject to suspicious activity reporting requirements with respect to any transaction involving or aggregating at least $5,000 in funds or other assets.
Many advisers also may be subject to AML regulation in non-U.S. jurisdictions where they conduct business or investment activities. Also, a private fund organized off-shore may be subject to AML rules in the off-shore jurisdiction in which the fund is based or the fund’s administrator is located.
AML Program Responses
To safeguard against the criminal and reputational risks, and to ensure that they comply with those affirmative AML obligations to which they are subject, many advisers and private funds already have adopted AML programs similar to what would have been mandated had the proposed FinCEN rules been finalized.
They also have done so because – in our experience – many custodial banks, broker-dealers, prime brokers and institutional investors require advisers and private funds to represent that they have in place well-functioning AML programs. These counterparties and investors have their own, sometimes detailed and extensive, AML obligations and have determined not to conduct business with advisers and private funds whose lack of AML programs may expose the counterparties and investors to money laundering risks and criticism from regulators that oversee their activities.
OFAC Obligations and Recent Guidance
The withdrawal by FinCEN of the proposed AML program rule also does not negate the need for advisers and private funds to comply with the sanctions regimes administered by OFAC. As noted above, OFAC recently issued new guidance to the securities industry regarding opening securities and futures accounts (“Account Guidance,” available here) and revised existing guidance on risk factors for OFAC compliance in the securities industry (“Risk Guidance,” available here). In so doing, OFAC made clear that such guidance applies broadly – not only to broker-dealers and futures commission merchants, but also to investment advisers.
Advisers of all kinds, including private fund managers, will want to devote particular attention to incorporating these recent OFAC pronouncements into their compliance programs and, in doing so, may wish to revisit OFAC’s 2004 “Foreign Assets Control Regulations for the Securities Industry” (the “2004 Guidance,” available here), which briefly addressed concerns specific to the private fund industry. This imperative is even greater for SEC-registered advisers, given that OFAC compliance program materials are among the items listed in the “Core Initial Request for Information” for investment adviser examinations recently issued by the SEC’s Office of Compliance Inspections and Examinations. Below, following an overview of the principal features of OFAC, we review both the 2004 Guidance and OFAC’s more recent releases.
OFAC Generally
OFAC administers the U.S. government’s economic and trade sanctions. Such sanctions generally prohibit or limit specified types of transactions involving certain countries (such as Cuba, Iran and Sudan), certain groups and factions within countries (such as the Taliban) and certain individuals and entities (such as those engaged in terrorism and narcotics trafficking) that are called “Specially Designated Nationals” or “SDNs.” OFAC publishes a comprehensive list of all such individuals and entities that can be found here. In addition, descriptions of OFAC country sanctions programs can be found here.
The coverage and detail of the various sanctions programs vary considerably. In most cases, OFAC’s sanctions programs require the blocking of (and reporting to OFAC regarding) all property and interests of sanctions targets, and they also prohibit all dealings with targets, including the facilitation, brokering, financing or guaranteeing of any transactions involving them. Property is anything of value, and property interests may be direct, indirect, present, future or contingent.
The OFAC sanctions regimes long have been an important part of meeting the United States’ foreign policy and national security goals. Since September 11, 2001, OFAC sanctions have garnered additional attention; shortly after the terrorist attack, President Bush signed Executive Order 13224, which blocked assets of individuals and organizations, including certain charitable organizations, involved in terrorism.
The liability for OFAC violations is strict and penalties can be large. A fund or adviser violates OFAC sanctions by engaging in a transaction with a prohibited party whether or not the firm knew that the party was subject to OFAC sanctions. Criminal violations of the statutes administered by OFAC can result in fines of up to $1 million and, for individuals, up to 20 years in prison. OFAC also has authority to impose civil penalties of up to $250,000 or twice the amount of the transaction that is the basis of the violation. The strength of a firm’s compliance program, however, may be a consideration in determining whether OFAC decides to pursue an enforcement action and what sanctions to impose if it does.
2004 Guidance
The 2004 Guidance included specific reference to hedge funds and alternative investments and cautioned such funds and their managers that they could be targeted by persons who are subject to OFAC sanctions. The 2004 Guidance also made clear the breadth of OFAC’s coverage: “all investments and transactions in the United States or involving U.S. persons anywhere in the world . . . need to comply with OFAC regulations,” and “U.S. companies and their offshore offices are responsible for maintaining identifying information concerning all clients, investors, and beneficiaries as well as for knowing the source of investment funds.”
The 2004 Guidance set forth the steps to be taken in (a) reviewing new and existing clients, investors and beneficiaries, (b) assessing securities held, (c) reviewing outgoing wire transfer instructions, (d) handling accounts and securities blocked in accordance with OFAC requirements, and (e) administering OFAC compliance programs. The 2004 Guidance also outlined OFAC compliance program recommendations, including the designation of an OFAC compliance officer, the establishment of identification verification procedures, the incorporation of compliance requirements into operating procedures and the need for OFAC compliance awareness initiatives and employee training.
New Account and Risk Guidance
The Account Guidance reiterates that all U.S. securities firms, including registered and private advisers, are subject to OFAC’s economic and trade sanctions programs. The Account Guidance recommends that securities firms establish and maintain effective, risk-based OFAC compliance programs and indicates that OFAC will consider the strength of a firm’s OFAC compliance program when determining the severity of potential enforcement actions.
Screening Focus . The Account Guidance identifies two stages of client/investor relationships on which firms should focus in their OFAC compliance programs: (a) the client/investor acceptance process, and (b) the selection of new investments. The Guidance recommends firms screen new clients/investors and proposed transactions against OFAC’s sanctions lists and maintain records of screening results to evidence OFAC compliance. (The Financial Industry Regulatory Authority, Inc. maintains a useful “OFAC Search Tool,” which is available here.) OFAC also recommends that, depending on a firm’s specific risk profile, periodic screening regarding other parties, such as beneficiaries, guarantors or principals, also may be warranted.
Identity Verification . OFAC also recommends the use of risk-based measures to verify the identity of each new client/investor. In establishing procedures, firms are directed to consider many factors, including their size (e.g., total assets under management), location, client/investor base, the types of relationships they maintain, the methods by which client/investor relationships can be opened (e.g., in person or otherwise) and the types of identifying information available for each client/investor. Firms also should assess risks posed by each client/investor and transaction.
Risk Factors . The Risk Guidance identifies possible risk factors that may warrant heightened OFAC scrutiny. These risk factors include, among others, a high number of international transactions; a large number of non‑U.S. customers or accounts, particularly in high-risk jurisdictions; investments in foreign investment funds or securities; and very high net worth institutional accounts and intermediary relationships that lack transparency regarding investments and beneficial owners. In particular, the risk factors reference hedge funds, funds of hedge funds, and other alternative investment funds such as private equity and venture capital funds, including those where there is a lack of transparency regarding securities/investments and beneficial owners, as well as U.S. hedge funds with an offshore related fund whose beneficial owners are offshore investors and subscription funds that originate from or are routed through an account maintained at an offshore bank.
OFAC Compliance and AML Customer Identification Programs . Some advisers may already be familiar with FinCEN’s Customer Identification Program (“CIP”) requirements because they have mutual fund clients or bank or broker-dealer affiliates that must maintain specific CIP procedures for identifying and verifying the identity of their customers. The Account Guidance notes that a strong OFAC compliance program and a CIP share certain common characteristics, including procedures to assess the risks posed to the firm by each client/investor and transaction. The Guidance cautions, however, that there are differences between OFAC and CIP requirements.
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Looking Through Certain Accounts . FinCEN has stated that firms typically do not need to look through accountholders for CIP purposes to perform due diligence on the beneficial owners of accounts; OFAC’s sanctions, however, apply broadly to all property and interests in property of a sanctions target in the possession or control of a U.S. person. Consequently, for OFAC purposes, it may be necessary to look through accounts to underlying beneficial owners. This issue may be heightened for certain types of client/investor relationships, such as those involving non-U.S. persons or entities located in high risk jurisdictions or those that involve opaque structures (such as personal investment companies)\ that may present a higher risk of sanctions violations.
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Delegation of Compliance Duties . While FinCEN has indicated that it will not take action against clearing firms for failing to perform CIP due diligence on certain accounts introduced on a fully disclosed basis, this relief does not extend to OFAC compliance. Firms that delegate OFAC compliance responsibilities to third parties remain liable for any OFAC violations that occur due to the third parties’ negligence, although OFAC will take a firm’s role and access to customer information into account in making decisions regarding enforcement action.
Organizational Focus . The Account Guidance urges firms to examine OFAC compliance in the context of relationships they maintain with affiliates, such as banks, insurance companies, investment advisers or broker-dealers. For any relationship, or for any given transaction, firms should know who is actually undertaking OFAC screening and other monitoring with respect to a transaction, and who owns the relationship with the client/investor.
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Investment advisers and private funds may have breathed a sigh of relief at having avoided the additional compliance burden posed by FinCEN’s proposed AML program rulemaking (at least for the time being, since FinCEN did not foreclose the possibility of future action on AML programs for advisers and private funds). That sense of relief may, however, be misplaced. The scope and detail of the new OFAC guidance will require significant attention from investment advisers and private funds, as well as other securities industry participants. Advisers and private funds may also find that this is an opportune time to revisit past appraisals of their AML risks to determine whether it may be appropriate to implement an AML program or modify an existing one.