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.