Treasury Department Proposes Rule on Anti-Money Laundering Programs for Unregistered Investment Companies

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1 Treasury Department Proposes Rule on Anti-Money Laundering Programs for Unregistered Investment Companies NOVEMBER 1, 2002 The Financial Crimes Enforcement Network ( FinCEN ) of the Department of the Treasury ( Treasury ) has issued a proposed rule (the Proposed Rule ) under the Bank Secrecy Act (the BSA ) to: implement the anti-money laundering provisions of Section 352 of the USA Patriot Act 1 with respect to unregistered investment companies as defined in the Proposed Rule; and require subject unregistered investment companies to file a written notice with FinCEN to identify themselves and provide certain other information. The Proposed Rule is substantially similar to Treasury s interim final rule regarding anti-money laundering programs of mutual funds (open-end management investment companies registered under the Investment Company Act of 1940, as amended (the 1940 Act )). It requires each subject company to develop and implement, within 90 days of the publication of the final rule, an anti-money laundering program (an AML Program ) reasonably designed to prevent the company from being used to launder money or finance terrorist activities and to achieve and monitor compliance with relevant law and regulation. At a minimum, each AML Program must include: 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 the program. Although subject companies must file a written notice with FinCEN setting forth certain information to establish their identity, they need not disclose the identities of their investors. The following is a summary of the key provisions of the Proposed Rule. Scope of the Proposed Rule Proposed Definition of Unregistered Investment Company The Proposed Rule defines an unregistered investment company as: an issuer that, but for the exclusions provided in sections 3(c)(1) and 3(c)(7) of the 1940 Act, would be an investment company under the 1940 Act; a commodity pool; or a company that invests primarily in real estate and/or interests therein 2. Limitations to Scope of Definition Two-Year Lock-up The proposed definition does not cover unregistered investment companies that prohibit redemptions of any portion of an STROOCK & STROOCK & LAVAN LLP NEW YORK LOS ANGELES MIAMI 180 MAIDEN LANE, NEW YORK, NY TEL FAX

2 investor s ownership interest (other than interests acquired with reinvested dividends pursuant to a dividend reinvestment plan offered by the company) for at least two years after the purchase of the interest. This provision would exclude most private equity funds and venture capital funds. The definition also would exclude entities whose interests are sold only on a secondary market, since such entities generally do not have a direct relationship with their investors and are not in a position to monitor money laundering activity. Because hedge funds generally offer redemption on a periodic basis and do not have lock-up periods (or have lock-up periods of less than two years), most would fall within the proposed definition of unregistered investment company. $1,000,000 or More in Assets The proposed definition is limited to unregistered investment companies that, as of the most recently completed calendar quarter, have total assets of $1,000,000 or more. Jurisdictional Limitation Relating To Certain Offshore Funds Certain offshore funds would be excluded from the proposed definition of unregistered investment company, which covers only entities that: are organized in the United States; sell ownership interests to U.S. persons as defined in Rule 902(k) under the Securities Act of 1933, as amended; or are organized, operated, or sponsored by U.S. persons. The inclusion of offshore funds organized, operated or sponsored by U.S. persons within the definition of unregistered investment company is likely to be controversial, because it could implicate a large number of offshore funds and may have negative competitive implications vis-à-vis offshore funds sponsored by non-u.s. persons. FinCEN has requested comment on whether the jurisdictional limitation is appropriate. Exclusions from the Definition The following types of entities also are excluded from the proposed definition of unregistered investment company: family companies as defined in Section 2(a)(51)(A)(ii) of the 1940 Act; employees securities companies as defined in section 2(a)(13) of the 1940 Act; employee benefit plans not construed as pools under Rule 4.5(a)(4) under the Commodity Exchange Act, as amended; and any person otherwise required to have an AML Program pursuant to the BSA, such as a brokerdealer. Requirements for AML Programs Policies, Procedures and Controls The Proposed Rule requires an AML Program to include detailed written policies and procedures, including the responsibilities of the individuals and departments involved. The Proposed Rule is intended to provide flexibility so each subject unregistered investment company can tailor its AML Program to fit its business, taking into account factors such as size, location, activities and risks or vulnerabilities to money laundering. In developing the policies and procedures, an unregistered investment company must: identify the vulnerabilities to money laundering and terrorist financing activity inherent in its particular business structure or business activities; understand the applicable requirements under the BSA 3 ; design procedures and controls that will reasonably assure compliance with the requirements of the Proposed Rule and the BSA; and periodically assess the effectiveness of these procedures and controls to ensure they are reason- 2

3 ably designed to detect activities indicative of money laundering. The Proposed Rule highlights examples of activities indicative of money laundering, including the following: the use of questionable checks and unusual wire activity, such as transactions involving the account of a third party unrelated to the investor; investor difficulty in describing the reasons for frequent wire transfers to unfamiliar bank accounts or jurisdictions other than the investor s home country; frequent purchases of interests in unregistered investment companies followed by redemptions, particularly if the resulting proceeds are wired to unrelated third parties or bank accounts in foreign countries; non-economic transfers, such as the purchase of an interest for a large dollar amount followed by redemption with indifference as to penalty amounts charged; transfers to accounts in high-risk jurisdictions, including countries where drug trafficking is known to occur; and the transfer of a monetary instrument or an investment interest from a foreign government to a private person. If an unregistered investment company identifies suspicious activity, it must take reasonable steps to determine if its suspicions are justified and, if so, take appropriate action, which may include refusing to enter into a transaction that appears designed to further illegal activity. Under the Proposed Rule, the AML Program must be approved in writing by the board of directors or trustees of the unregistered investment company or, if there is none, the general partner, sponsor, organizer, operator, or other person with a similar function. However, approval could be given at the company s first regularly scheduled meeting after the AML Program is adopted. In the future, unregistered investment companies may become subject to additional BSA requirements, including customer and investor identification and verification requirements and requirements to file reports of suspicious activity. Independent Compliance Testing The Proposed Rule would require: compliance testing of the AML Program by personnel knowledgeable of the company s money laundering risks and applicable BSA requirements; and a written assessment or report on the results of compliance testing, with any recommendations to be implemented promptly or submitted to the board of directors or trustees, the general partner or, in the absence of the foregoing, senior management for consideration. Employees of the unregistered investment company may perform testing, so long as these employees are not involved in the operation or oversight of the AML Program. Designation of Compliance Officer Under the Proposed Rule, subject unregistered investment companies would assign the responsibility for overseeing the AML Program to an individual or committee. The Proposed Rule states that such individual or committee should be: competent and knowledgeable regarding BSA requirements and money laundering issues and risks; and empowered with full responsibility and authority to develop and enforce appropriate policies and procedures throughout the company. Although implementation and operation of the AML Program may be conducted by entities (and their 3

4 employees) other than the unregistered investment company, ultimate responsibility for supervision of the overall AML Program should be vested in an officer, trustee, general partner, organizer, operator, or sponsor of the unregistered investment company. Ongoing Training of Appropriate Personnel The Proposed Rule would require subject unregistered investment companies to train their employees (and the employees of any affiliated and third party service providers) regarding BSA requirements relevant to their functions and regarding the signs of money laundering that could arise in the course of their duties. Training should address both general awareness of money laundering issues and job-specific guidance, could include computer-based training, and could be conducted by outside or in-house seminars. The level, frequency, and focus of such training would depend on the responsibilities and activities of such employees and should include updates and refresher training relating to the AML Program. Contractual Delegation of Compliance Because unregistered investment companies often conduct their activities through separate entities such as fund administrators, investment advisers, commodity pool operators ( CPOs ), commodity trading advisors, broker-dealers (including prime brokers), and futures commission merchants, the Proposed Rule would permit unregistered investment companies to delegate contractually to these separate entities the performance of some elements of AML Program compliance. Notwithstanding any such delegation, the unregistered investment company would remain fully responsible for: the effectiveness of the AML Program; ensuring that federal examiners are able to obtain information and records relating to the AML Program and to inspect such third party delegate; assuring compliance with the final rule; taking reasonable steps to identify the aspects of its operations that may give rise to BSA regulatory requirements or that are vulnerable to money laundering or terrorist financing activity; developing and implementing a program reasonably designed to achieve compliance with such regulatory requirements and to prevent such activity; monitoring the operation of its AML Program; and assessing AML Program effectiveness. A subject unregistered investment company would not satisfy these obligations merely by obtaining and relying on a certification from its delegate to the effect that such delegate has instituted a satisfactory AML Program. Required Notice to FinCEN Because unregistered investment companies typically are not registered with or identifiable by Treasury or another federal functional regulator, the Proposed Rule would require all subject unregistered investment companies to file a notice (the Notice ) with FinCEN so that Treasury could assure, through examination or enforcement, that such companies are in compliance with the final rule. The Notice would include: the name, address, address and telephone number of the unregistered investment company; the name, address, address, telephone number and registration number of any investment adviser, commodity trading advisor, CPO, organizer or sponsor of the unregistered investment company; the name, address and telephone number of the designated AML Program compliance officer; the dollar amount of assets under management held by the unregistered investment company; and the number of participants, interest holders or 4

5 security holders in the unregistered investment company (but not information as to the identities of such individual participants, interest holders or security holders). Each subject unregistered investment company would be required to file a Notice with FinCEN within 90 days after it becomes subject to the final rule. Under the Proposed Rule, Notices could be mailed or filed by entering the appropriate information via FinCEN s Internet website at Each subject unregistered investment company would have a duty to amend its Notice within 30 days after any change to the information contained in the filed Notice, other than: the amount of assets under management; and the number of participants, interest holders or security holders. The Proposed Rule would require a subject unregistered investment company to withdraw its Notice within 90 days after ceasing to be subject to the provisions of the final rule. Comment Period The comment period for the Proposed Rule expires on November 25, For further information about this Stroock Special Bulletin, please contact your Stroock attorney or Hillel M. Bennett, a partner in Stroock's Investment Management Practice Group at , Bradley G. Kulman, a partner in Stroock's Mergers,Acquisitions and Joint Ventures Practice Group at , or Janna Manes, a partner in Stroock's Investment Management Practice Group at Scott Sukovich, an associate at Stroock, assisted with the preparation of this Special Bulletin. 1. The United and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of Subject to certain limitations discussed in this article, the proposed definition would encompass investment vehicles such as hedge funds, which typically operate pursuant to exclusions from registration under the 1940 Act. As used herein, hedge fund refers to a privately offered investment vehicle that pools contributions of participants and invests in a portfolio of securities, commodities contracts, or other assets. 3. The only BSA requirement currently applicable to unregistered investment companies is the obligation to report on Form 8300 the receipt of cash or certain noncash instruments totaling more than $10,000 in one or more related transactions. NEW YORK 180 Maiden Lane New York, NY Tel: Fax: MIAMI First Union Financial Center 200 South Biscayne Boulevard Suite 3300 Miami, FL Tel: Fax: LOS ANGELES Floors 16 and Century Park East Los Angeles, CA Tel: Fax: This Stroock Special Bulletin is a publication of Stroock & Stroock & Lavan LLP 2002 Stroock & Stroock & Lavan LLP. All Rights Reserved. Quotation with attribution is permitted. This publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Stroock & Stroock & Lavan LLP is a law firm with a national and international practice serving clients that include investment banks, commercial banks, insurance and reinsurance companies, mutual funds, multinationals and foreign governments, industrial enterprises, emerging companies, and technology and other entrepreneurial ventures. For further information about Stroock Special Bulletins or other Stroock publications, please contact Richard Fortmann, Legal Publications Editor, at