THE USA PATRIOT ACT New Responsibilities for Institutions in the Financial Industry

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1 P THE USA PATRIOT ACT New Responsibilities for Institutions in the Financial Industry By Michael P. Malloy Reproduced by permission. resident Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the USA Patriot Act or the Act ) on October 26, The USA Patriot Act is a broad antiterrorism bill that was enacted in response to the events of September 11, It contains a number of measures aimed at curtailing terrorist activity. One section of the USA Patriot Act is designed to prevent and detect money laundering and the financing of terrorism. Investment advisers are not included in the Act s or this article s definition of financial institution, which is the term used to identify the entities governed by the new legislation. However, the Act is of keen interest to investment advisers because one provision of the Act cash reporting does apply to investment advisers and because various financial industry participants and clients of the investment adviser are subject to the Act. For example, investment companies are covered under many of the USA Patriot Act provisions. Despite indications at recent conferences to the contrary, we understand regulators are still considering the extent to which private funds (hedge funds, etc.) should be covered under the Act. It is also unclear whether offshore funds, exchange traded funds and private accounts are covered under the USA Patriot Act. Broker-dealers, futures commission merchants, commodity trading advisors and commodity pool operators are also covered under the USA Patriot Act. The Act is also of interest to investment advisers because they may be asked to provide information to assist financial institutions to comply with the Act. It is not yet clear to what extent regulators expect investment advisers to assist other institutions with their compliance obligations. Existing laws that already cover investment advisers may receive renewed attention given the new focus in this area, including suspicious activity reporting and general federal money laundering criminal penalties. The goal of this article is to provide investment advisers an overview of this evolving area.

2 ANTI-MONEY LAUNDERING PROGRAMS The most immediately pressing provision of the USA Patriot Act is the requirement that every financial institution establish an anti-money laundering program by April 24, 2002 that includes at a minimum: The development of internal policies, procedures, and controls; The designation of a compliance officer; An ongoing employee training program; and An independent audit function to test programs. The USA Patriot Act provides that prior to April 24, 2002, the Secretary of the Treasury (the Treasury ) will prescribe regulations that provide further guidance on anti-money laundering programs. However, the anti-money laundering provision becomes effective on April 24, 2002 regardless of whether the Treasury issues guiding regulations prior to the deadline. The regulations are to take into consideration the extent to which the requirements of anti-money laundering programs are commensurate with the size, location and activities of the financial institutions to which they apply. The Act also provides that the Treasury may exempt any financial institution from the requirement to have an anti-money laundering program. There are no indications that any financial institutions will be exempted from coverage under the provision. At a recent conference, federal regulators: (1) urged the mutual fund industry not to wait for the regulations but to begin formulating anti-money laundering programs; and (2) instructed the mutual fund industry to use as a reference in the interim the proposed rule on anti-money laundering programs approved by the National Association of Securities Dealers, Inc. ( NASD ) for its members which was published in the Federal Register on February 25, It is expected that the USA Patriot Act proposed rule for anti-money laundering programs for financial institutions, including investment companies, will resemble the NASD proposed rule. NASD Proposed Rule on Anti-Money Laundering Programs The NASD proposed rule requires that its members develop and implement a written anti-money laundering program on or before April 24, The anti-money laundering program must be reasonably designed to achieve and monitor the member s compliance with the requirements of the Bank Secrecy Act and regulations. The NASD proposal is similar to the USA Patriot Act anti-money laundering provision described above except that the NASD: (1) includes an additional duty to monitor for suspicious activities; (2) specifically states that the audit function can be performed by either a qualified external or internal party; and (3) requires that the program be approved in writing by a member of senior management. 2

3 NASD Regulation, Inc. expects to provide guidance in the near future to assist its member firms in developing anti-money laundering programs in a Notice to Members. SIA Guidance on Anti-Money Laundering Programs The Securities Industry Association (the SIA ) released a Preliminary Guidance for Deterring Money Laundering Activity on February 13, The SIA release is a detailed outline meant to assist broker/dealers in developing anti-money laundering programs. The SIA release also recommends the type of information that should be obtained for each type of broker/dealer customer including individual accounts, personal investment corporations or personal holding companies, offshore trusts, institutional accounts and hedge funds. VERIFICATION OF IDENTIFICATION - KNOW YOUR CUSTOMER The Treasury is also to adopt regulations setting forth minimum standards regarding a financial institution s procedures for: (1) verifying the identity of any person seeking to open an account; (2) maintaining records of the information used to verify a person s identity, including name, address, and other identifying information; and (3) reviewing lists of known or suspected terrorists and terrorist organizations to determine whether a person seeking to open an account appears on any such list. In adopting regulations, the Treasury is required to consider the various types of accounts maintained by different financial institutions, the various methods of opening accounts and the various types of available identifying information. Final regulations are required to take effect on October 26, Not later than April 24, 2002, the Treasury must issue a study to Congress recommending, among other items: (1) how to require foreign nationals to provide domestic financial institutions with verifying information; and (2) requiring foreign nationals to obtain an identification number functionally equivalent to a social security number. SHARING INFORMATION WITH OTHER FINANCIAL INSTITUTIONS AND REGULATORY AGENCIES On March 4, 2002, the Treasury issued rules to encourage further cooperation among certain financial institutions, regulatory authorities and law enforcement authorities. One provision under the Act permits certain financial institutions, after providing notice to the Treasury in the form of an annual certification, to voluntarily share information with one another in order to better identify and report to the federal government activities that may involve money laundering or terrorist activities. The financial institutions to which this provision applies includes banks and broker/dealers but not investment companies. Treasury has requested comments, however, on whether the coverage of the provision should be expanded to included other financial institutions. This provision is both an interim final rule effective March 4, 2002 and a proposed rule for which written comments must be received on or before April 3,

4 The second provision, which is a proposed rule only, encourages cooperation between financial institutions and the federal government through the exchange of information regarding individuals or entities engaged in or suspected of terrorist acts or money laundering activities. The proposed rule authorizes the Financial Crimes Enforcement Network ( FinCEN ) of the Treasury to request information regarding suspected terrorists and money laundering activities from any financial institution. The financial institution then must review its records for certain information that is specified in the proposed rule to include, among other items, all identifying information about the suspected individual or entity. Although this provision technically includes investment companies as well as broker/dealers and banks, the proposed rule states that the initial implementation of the provision generally will involve only those financial institutions that are subject to SAR reporting, which includes banks, bank affiliated investment advisers and broker/dealers as discussed below. The proposed rule cautions that other financial institutions may also be requested to provide information to FinCEN. FOREIGN SHELL BANKS The Treasury issued a proposed rule on December 28, 2001 that prohibits covered financial institutions (which includes broker/dealers but not investment companies) from providing certain types of accounts to foreign shell banks. The provision of the USA Patriot Act forbidding these accounts for foreign shell banks became effective December 25, 2001 (three days before the proposed rule was issued). On November 27, 2001, the Treasury issued Interim Guidance to help institutions comply with this provision in the absence of a rule. The Interim Guidance applied to covered financial institutions other than broker/dealers. With some exceptions, the proposed rule would codify the Interim Guidance and extend the provisions to broker/dealers. Under the proposed rule issued on December 28, 2001, a covered financial institution may not provide a correspondent account to a foreign shell bank which is not a regulated affiliate and must take reasonable steps to ensure that a correspondent account provided to a foreign bank is not being used indirectly to provide banking to a foreign shell bank which is not a regulated affiliate. The proposed rule clarifies that covered financial institution includes, among other entities, any insured bank, any commercial bank or trust company, any agency or branch of a foreign bank in the United States or any broker/dealer. A correspondent account is an account established to receive deposits from, make payments on behalf of a foreign financial institution, or handle other financial transactions related to such institution. The proposed rule broadly defines correspondent account to include virtually any type of broker/dealer account. Examples include: (1) accounts to purchase, sell, lend or hold securities; (2) prime brokerage accounts; (3) accounts for trading foreign currency; (4) custody accounts; (5) derivative accounts; and (6) futures accounts. 4

5 A foreign shell bank is a foreign bank without a physical presence in any country. A physical presence is a place of business that is maintained by a foreign bank and that is located at a fixed address in a country in which the bank is authorized to conduct business. Among other criteria, the foreign bank must have one or more full-time employees to have a physical presence. A covered financial institution is not prohibited from maintaining a covered account with a foreign shell bank that is a regulated affiliate. A regulated affiliate is a foreign shell bank that: (1) is under common control with a depository institution, credit union or foreign bank that maintains a physical presence in the United States or a foreign country; and (2) is subject to supervision by a banking authority in the foreign country regulating such affiliated depository institution, credit union or foreign bank. The Treasury Department expects that a covered financial institution will immediately terminate all correspondent accounts with any foreign bank that it knows to be a shell bank that is not a regulated affiliate. A covered financial institution that maintains a correspondent account in the United States with a foreign bank must maintain records regarding the foreign bank. The records must identify: (1) the owner of the foreign bank; and (2) the name and address of a person who resides in the United States that is authorized to accept service of legal process for records regarding the correspondent account. The proposed rule sets forth various definitions of owner (which include: (1) large direct owners; (2) small direct owners; and (3) indirect owners) and related examples of these various types of owners of foreign banks. The proposed rule does not prescribe the manner in which a covered financial institution must obtain the record-keeping information regarding foreign banks. However, a covered financial institution will be provided a safe harbor if it uses the model certification provided in the proposed rule. The Investment Company Institute sent a comment letter to the Treasury on February 11, 2002 noting, among other items, that (1) a distinction should be made between old and new customers for purposes of obtaining information concerning foreign banks and (2) raised objections on the requirement that covered financial institutions close accounts of foreign banks that do not provide the required information. The New York Clearing House, which represents many of the larger U.S. financial institutions, also submitted comments to the Treasury on February 11, 2002 requesting, among other items, that (1) the definition of correspondent accounts be refined and (2) suggesting a series of instances in which accounts should not be covered under the rule. Broker-Dealers SUSPICIOUS ACTIVITY REPORTING The Treasury issued on December 31, 2001 a proposed rule applicable to only broker/dealers implementing another provision of the USA Patriot Act. The proposed rule would generally 5

6 require all broker/dealers in securities, registered or required to be registered under the Securities Exchange Act of 1934 (the Exchange Act ), to report suspicious transactions to FinCEN. In addition, insurance companies or their affiliates that are registered broker/dealers simply to permit the sale of variable annuities treated as securities under the Exchange Act, would also be subject to reporting under the proposed rule. Broker/dealers will be required to report suspicious transactions by filing a Suspicious Activity Report-BD ( SAR-BD ). The SAR-BD will resemble the SAR presently used by banks to report suspicious transactions. A draft form of the SAR-BD will be published in the Federal Register. Broker/dealers will be required to file the SAR-BD within 30 days of becoming aware of a suspicious transaction at a yet unnamed central location to be determined by FinCEN. Final regulations are to be issued by July 2, Broker/dealers would generally be required to report on the SAR-BD suspicious transactions that are conducted or attempted by, at, or through a broker/dealer and involve or aggregate at least $5,000 in funds or other assets and for which: the broker/dealer detects any known or suspected Federal criminal violation or pattern of criminal violations committed or attempted against the broker/dealer or involving a transaction conducted through the broker/dealer; or the broker/dealer knows, suspects, or has reason to suspect that the transaction or pattern of transactions (1) involves funds derived from illegal activity; (2) is designed to evade any requirements of the Bank Secrecy Act; or (3) has no business or apparent lawful purpose. Investment Advisers Related to Banks Investment advisers that are banks or subsidiaries of bank holding companies are currently subject to the bank SAR filing requirements which are similar to the broker/dealer proposed SAR rule. REPORT ON INVESTMENT COMPANIES The USA Patriot Act provides that the Treasury, SEC and the Federal Reserve Board will jointly submit within one year of the USA Patriot Act s enactment a report to Congress on recommendations for regulations to apply the requirements of the Bank Secrecy Act to investment companies. There are indications that part of the report may include recommendations to extend SAR reporting requirements for suspicious activities, which are discussed above for broker/dealers and certain bank related investment advisers, to investment companies. DUE DILIGENCE FOR CERTAIN ACCOUNTS Financial institutions that maintain private banking accounts or correspondent bank accounts in the U.S. for non-u.s. persons beginning July 23, 2002 must establish enhanced due diligence 6

7 policies, procedures and controls that are reasonably designed to detect and report instances of money laundering through those accounts. Financial institutions need to obtain additional information about correspondent accounts, such as the identity of the owners of the foreign bank. Financial institutions are also required to obtain information on the identity of the beneficial owners and the source of the funds for private banking accounts maintained by non-u.s. persons, and must also conduct enhanced scrutiny of accounts maintained by senior foreign political figures or family members. Treasury is to further delineate, by regulation, the due diligence required for these types of accounts and is expected to clarify how these provisions apply to nonbank financial institutions. Regulations are due by April 24, SPECIAL MEASURES TO BLACKLIST AREAS OF PRIMARY MONEY LAUNDERING CONCERN The USA Patriot Act provides that the Treasury may take one or more special measures if the Treasury finds reasonable grounds exist for concluding that a foreign jurisdiction, a financial institution operating in a foreign jurisdiction or an account or transaction poses a primary money laundering concern. In such a case, the Treasury may require domestic financial institutions to take additional steps such as: (1) maintaining records or filing reports containing information about a transaction including the origination of any funds transfer and (2) obtaining information about the beneficial ownership of an account. CASH REPORTING BY FINANCIAL INSTITUTIONS AND NON-FINANCIAL TRADES OR BUSINESSES Financial institutions under the Bank Secrecy Act are generally subject to currency reporting to FinCEN and all other businesses (such as investment advisers) are subject to cash reporting to the Internal Revenue Service (the IRS ). The USA Patriot Act contains a provision adding currency reporting requirements under the Bank Secrecy Act to non-financial trades and businesses (such as investment advisers) in addition to the Internal Revenue Code provisions. The provision requires that non-financial trades and businesses report currency transactions in excess of $10,000 in one or more related transactions on a joint FinCEN/IRS form filed with the IRS. CIVIL AND CRIMINAL PENALTIES Financial Institutions Under The Act Violators of the foreign shell, due diligence or special measures provisions of the USA Patriot Act and related regulations can incur civil or criminal penalties of not less than two times the amount of the transaction and not more than $1 million. 7

8 Financial Institutions and Investment Advisers Investment advisers should keep in mind that there are general federal money laundering statutes that apply to all financial institutions, including investment advisers, that make it a criminal offense to engage knowingly or with willful blindness to the fact that a transaction involved illegal profits. The penalties for violations of the money laundering statutes include imprisonment for up to twenty years and fines amounting to the higher of $500,000 or twice the value of the property involved in the transaction. CONCLUSION Investment advisers should monitor this rapidly changing area of the financial industry as it will significantly affect them. It is to be hoped that required and expected regulations and reports will shed more light on the responsibilities of investment advisers and other industry participants. * * * Michael P. Malloy is head of and a partner in the firm s Investment Management Group. Joan Ohlbaum Swirsky, Michelle M. Lombardo, and Edward Searle, associates in the Investment Management Group, assisted with the preparation of this article. One Logan Square 18 th and Cherry Streets Philadelphia, PA (fax) michael.malloy@dbr.com Philadelphia Washington Berwyn New York Princeton Florham Park Los Angeles San Francisco This discussion is not intended to constitute legal advice regarding any client s legal problems or specific questions and should not be relied upon as such. This article first appeared in the Winter 2002 Investment Adviser s Counsel. 8