Author: Kenyon Shubert
Earlier this year, FinCEN postponed the effective date of the Anti-Money Laundering/Countering the Financing of Terrorism Program and Suspicious Activity Report Filing Requirements for US registered investment advisers and exempt reporting advisers (IA AML Rule), pushing out the requirements, expressing an intention to revisit the scope, and putting off thoughts of compliance for those impacted for at least another twelve months.But whatever the compliance date or revised scope may be, would the IA AML Rule really make much of a difference for US alternative investment managers and the industry expectations for AML policies and procedures for their private funds?
Industry expectations for alternative investment managers to have AML controls in place do not entirely replace the contents of the IA AML Rule in all its specifics. However, the reality is that counterparty AML requirements, the need for anti-fraud controls to avoid identity theft and other crimes, and Cayman Islands and other international AML regimes create a structured set of drivers that lead alternative investment managers to much the same place in terms of needing an AML program for US private funds as the IA AML Rule otherwise would.
Industry counterparties have high expectations for private fund AML programs, regardless of the specific regulatory mandates imposed on either the fund or its manager. Prime brokers, banks, and other fund administrators want to know that AML is being performed on US private fund investors. They want to know that:
(1) a substantive AML program is in place for the fund and its investors, including training for those responsible for performing AML controls;
(2) the fund has conducted due diligence to establish the identity of its investors, their beneficial owners and controllers, and identity documentation records evidencing due diligence are appropriately retained; and
(3) the parties identified in due diligence are being screened to identify any PEPs (politically exposed persons), sanctions activity, shell banks or other high-risk funding sources.
Finally, if the fund has an administrator, they want to know who the administrator is and that their AML program meets the above generally accepted standards for key risk mitigation measures. Why do fund counterparties want these assurances? Because the same regulations that would have been extended to registered investment advisers through the IA AML Rule already apply to them as US financial institutions. In other words, if they’re going to process transactions or custody securities for a private fund, they want to know that the money flowing through the fund into accounts held on its behalf has been assessed for AML risk and that any identified risk has been mitigated before it flows through their systems.
While AML risk has the potential to be significant, it can be mitigated effectively, and counterparty requirements can be satisfied, with appropriate due diligence activities, screening tools, and ongoing monitoring of investor transactions. The risk of fraudulent money movement, however, is persistent and constantly evolving – particularly where high-net worth investors are concerned – and regulators expect alternative investment managers to be on their toes. Even without this regulatory pressure, the risk of monetary loss associated with business email compromise, identity theft and fraud are always on the minds of funds and fund administrators.
Thankfully, established AML practices and the anti-fraud and identity theft protocols necessary to help mitigate the risk of fraudulent transactions are mutually reinforcing. Having verified the identity of investors and authorized signers at subscription, administrators lay the groundwork for understanding who is authorized to instruct trade activity or make changes to demographic information going forward. With authorized contact information such as phone numbers and email addresses on file, changes to wire details or demographic information are more easily verified. Regulators also expect these identity theft red flag measures to be in place; without the ability to leverage AML due diligence, information gathering and verification controls would have to be implemented from scratch. In addition, the same training to identify suspicious activity for AML purposes – which emphasizes attention to unusual amounts, payment destinations, or other red flags – reinforces the heightened awareness necessary to identify an interaction or a request where something seems amiss. In turn, routine security awareness training also reinforces suspicious activity awareness, completing the circle and helping the fund avoid both AML and fraud risk in tandem.
Many alternative investment managers, particularly those working with institutional investors, provide investment vehicles for foreign and non-profit investors in the form of funds domiciled in Cayman Islands or other international jurisdictions. Unlike US private funds, Cayman Islands funds are regulated and subject to rigorous AML controls periodically evaluated by fund-level AML officers, and often ultimately overseen by a board of directors. While Cayman Islands regulation is not applicable to the US funds that are typically included in blended fund structures, such as master-feeders and mini-masters, and while AML programs built to comply with US industry norms and Cayman Islands regulation inevitably diverge, the higher standards of one vehicle with regulatory and governing body oversight often shape expectations for those vehicles associated with it. Much like international standards for tax transparency and data privacy, international AML standards raise the bar for other vehicles managed by the same advisor, despite the lack of direct regulation.
Whether AML standards for alternative investment managers or their private funds emerge from the postponement of the IA AML Rule intact, adjusted in scope, or not at all, the reality in the interim is the same: Fund counterparty AML requirements, the need for identity theft and anti-fraud controls, and the influence of AML regimes in other jurisdictions relevant to the private fund space serve as strong forces driving managers in a single direction. Despite the lack of direct regulation, US private funds are expected to have AML programs with high standards, and fund managers are well served by a capable partner who can help them find the right path to attaining them.