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Article


AN ANTI-MONEY LAUNDERING RULE FOR INVESTMENT ADVISORS IN THE US: IS IT COMING?




By Samantha Welch

JULY 12, 2022

JULY 12, 2022

ARTICLE
An Anti-Money Laundering Rule for Investment Advisors in the US: Is it Coming?


As we approach the 20th anniversary of the first proposed anti-money laundering
(AML) rule for investment advisors (IAs) next year, we reflect on whether an IA
rule may finally be passed, and what firms can do to prepare.

 

CURRENT STATE OF ANTI-MONEY LAUNDERING (AML) REGULATION FOR US SECURITIES AND
EXCHANGE COMMISSION (SEC) REGISTERED INVESTMENT ADVISORS

Currently, there is no AML Program Rule in the US for SEC Registered Investment
Advisors (RIAs) or their administrators. Custodians such as banks and
broker-dealers do have a program requirement that has been in place for some
time, and many advisors voluntarily comply in the interest of maintaining such
relationships or as part of a broader enterprise AML Program. Furthermore,
broker-dealers dully registered as RIAs may also implement AML Programs across
their businesses for enterprise risk management.

 

IS A FORMAL RULE FOR RIAS COMING?

The idea of a formal rule for RIAs has been part of political discourse since
May 2003, when the Financial Crimes Enforcement Network (FinCEN) issued a
proposed rule for IAs1, which never came to fruition. Twelve years later, in
September 2015, FinCEN published a notice of proposed rulemaking that would
require RIAs to have an AML Program2 and file reports on suspicious activity. 
Given past unsuccessful attempts to finalize an AML rule for this industry, what
makes us think one may actually be implemented in the future? Let’s take a look
at the signs that suggest more formal regulation is gaining momentum.

A series of key events beginning in 2016 signaled an increased likelihood of a
final rule: 

In April 2016, the International Consortium of Investigative Journalists3
(ICIJ)  published its investigation into leaked documents from the Panamanian
law firm Mossack Fonseca. Dubbed the “Panama Papers” investigation, it
highlighted the amount of wealth managed in offshore banking jurisdictions. The
ICIJ later published investigations into similar leaks, the Paradise Papers in
November 2017 and the Pandora Papers in October 2021. The investigations
identified corporate structures established for several politicians, royals, and
business executives.

In December 2016, the Financial Action Task Force (FATF) published its Mutual
Evaluation of the U.S. FATF determined that “the regulatory framework has some
significant gaps, including minimal coverage of certain institutions and
businesses (IAs, lawyers, accountants, real estate agents, trust and company
service providers, other than trust companies),” and specifically that
“[i]nvestment advisors (a part of the securities industry which manages over USD
67 trillion in assets) are not directly covered by BSA obligations4.” FATF
concluded that the US should extend reporting requirements to investment
advisors and notes that FinCEN has proposed regulations that would extend
AML/Combatting the Financing of Terrorism (CFT) requirements explicitly to all
IAs.

In March 2020, FATF issued a re-rating of the US, which suggested that the US
government was taking steps to evaluate how to close the gaps identified in
2016. In the section devoted to recommendations partially compliant (PC) or not
compliant (NC), FATF references sectors not covered by regulation5:


“The US has reported progress on other Recommendations rated PC/NC, such as R.1,
R.12, R.16, R.20, R.24, R.25, and R.28. Actions underway include, among others,
undertaking a systemic review of its AML/CFT system to more effectively address
identified risks, including with respect to some sectors currently uncovered.”

In June 2020, an FBI bulletin released as part of a leak of confidential6
documents dubbed “BlueLeaks” assessed with “high confidence” that “[t]hreat
actors use the private placement of funds, including investments offered by
hedge funds and private equity firms” to reintegrate dirty money into the
legitimate global financial system. The report identifies gaps on AML coverage
for private equity (PE) firms and hedge funds. The report cites real-world
examples of large schemes conducted to launder money and evade sanctions, with
the underlying commonality that both PE firms and hedge funds do not require the
disclosure of beneficial owners.

On October 8, 2021, a bill was introduced in the US House of Representatives
titled the Establishing New Authorities for Businesses Laundering and Enabling
Risks to Security (ENABLERS) Act. The ENABLERS Act broadens the definition of a
“financial institution” under the Bank Secrecy Act (BSA) to include certain
“gatekeepers,” such as investment advisors, attorneys, and accountants. If
signed into law, the ENABLERS Act would require the US Treasury Secretary to
promulgate rules for the newly covered entities to report suspicious
transactions, establish AML programs, identify and verify account holders, and
establish due diligence programs, among other requirements.

In December 2021, pursuant to presidential order, the White House issued the
“United States Strategy on Countering Corruption8.” One pillar of the strategy,
titled “Curbing Illicit Finance,” states that “lines of effort” will be focused
on prescribing minimum reporting standards for investment advisors and other
types of equity funds. Specifically, the report highlights a concern that
corrupt actors can invest their ill-gotten gains in the US financial system
through hedge funds, trusts, private equity funds, and other advisory services
or vehicles offered by investment advisors that focus on high-value customers.
Additionally, the lack of regulatory oversight of these industries means that,
as the Treasury stated in its 2015 Notice of Proposed Rulemaking (NPRM), “[I]t
[is] possible for money launderers to evade scrutiny more effectively by
operating through investment advisors rather than through broker-dealers or
banks directly.” It further stated the Treasury will re-examine the 2015 NPRM.
The Treasury will further consider whether to cover private placement funds,
including investments offered by hedge funds and private equity firms.

In February 2022, the Treasury Department published the US National Money
Laundering Risk Assessment. The assessment focused in part on the vulnerability
of the IA sector due to the segmentation inherent in the business. In addition
to the lack of an AML program requirement, it states:

“The use of third-party custodians by RIAs separates the advisory functions of
an RIA’s business from the actual movement or transfer of client funds. The use
of third-party custodians, when combined with the practice of pooling customer
funds into omnibus accounts for trading and investment, can impede transparency,
which is core to AML/CFT effectiveness. The 2015 FinCEN RIA NPRM stated, for
example, that “[w]hen an advisor orders a broker-dealer to execute a trade on
behalf of an advisor’s client, the broker-dealer may not know the identity of
the client. When a custodial bank holds assets for a private fund managed by an
advisor, the custodial bank may not know the identities of the investors in the
fund.”

The assessment, supported by a handful of case studies, further states that fund
administrators are often “located in offshore financial centers where private
funds are routinely registered, usually for tax or other commercial or
non-AML/CFT regulatory advantages” and qualified custodians can be subject to
varying levels of oversight.

On May 13, 2022, The US Treasury Department issued its 2022 National Strategy
for Combating Terrorist and Other Illicit Financing (2022 Strategy)9. As part of
the 2022 Strategy, the document outlines the need to assess further “action,”
which suggests more concrete steps will be taken. Specifically Supporting Action
#3 states: 

“Assess Need for Additional Action on Sectors Not Subject to Comprehensive
AML/CFT Measures Certain types of financial intermediaries, gatekeepers, and
other professions or sectors are not covered by comprehensive and uniform
AML/CFT obligations, and face varying levels of illicit finance risk exposure.
These include financial intermediaries, such as investment advisors advising
private investment funds and gatekeepers such as Trust or Company Service
Providers that facilitate the creation of, and provide services for, certain
legal entities. This uneven AML/CFT coverage can create opportunities for
regulatory arbitrage.” 

The 2022 Strategy sets out benchmarks for progress to be evaluated in 2024 that
include taking action to “reinvigorate” the efforts to finalize a rule, or
document why a rule is not necessary.

Most recently, in June 2022, the ENABLERS Act described above was included in
the National Defense Authorization Act10 for fiscal year 2023.

If an AML Program Rule is on the horizon, what should RIAs be doing to prepare?
The answer depends on your current risk management program, and the depth and
breadth of your operations.

 

WHAT YOU SHOULD ALREADY BE DOING FOR GOOD GOVERNANCE AND SOUND RISK MANAGEMENT

Some RIAs are already indirectly covered through affiliations with banks, bank
holding companies, and broker-dealers, when they implement groupwide AML rules
or in case of outsourcing arrangements. These institutions may voluntarily
comply with program requirements in the interest of maintaining relationships
with banks or broker-dealers as part of a broader enterprise AML program.

For RIAs that do not, even absent an AML rule, you should consider these risks
and those germane to your business, e.g., are investments in areas subject to
corruption, is the strategy long or short term (the latter being more attractive
to launderers); do you have lockups, and are you monitoring investors that
redeem despite such lockups and any associated penalties? It is a crime to be
willfully blind to facilitating money laundering, even without a regulatory
obligation to implement a compliance program.

 

AML PROGRAM FRAMEWORK

Many investment advisors and asset managers have designed and implemented an AML
compliance program in the absence of a regulatory requirement. These
institutions will be ahead of the game. Furthermore, the Department of Justice
(DOJ) guidance regarding the Evaluation of Corporate Compliance
Programs11 states that an adequate and effective compliance program is a factor
that the DOJ uses to determine whether to bring charges, negotiate pleas, or
other agreements. Accordingly, RIAs may wish to consider proactively assessing
if they have an appropriately risk-based program to detect and prevent money
laundering, terrorist financing, and other financial crimes.

There are elements of an AML Program that an RIA should consider applying right
now. 

Management Oversight and Governance and AML Compliance Officer

Perform a risk assessment to identify areas of greatest AML risk. Document
escalation paths and decision-making authorities, and update your staffing
assessment. Job descriptions and performance management processes should be
updated to align to new responsibilities and management expectations.

Know Your Customer (KYC), which includes Customer Identification Program,
Customer Due Diligence, and Enhanced Due Diligence

Determine who your customer is, based on the services you offer, and what
parties you need to perform due diligence on as a function of risk management
(e.g., fund/fund of funds, investors, separately managed portfolio clients, and
finders or other intermediaries).

Suspicious Activity Monitoring and Reporting

Analyze the unique aspects of the RIA business (e.g., lockups, long-term vs.
short-term strategies, and differences in activity in applications and
redemptions accounts vs. investment accounts) to determine what patterns of
unusual activity may require additional review.  Identify red flags and
typologies, such as penalties for breaking a lockup, or if an investor or client
is operating through shell companies established outside the beneficial owner’s
home jurisdiction. Even without an obligation to file a suspicious activity
report, this information will help you identify risk in your customers’
activities for your institution’s risk management.

Training and Communication

You want your employees to say something if they see something, so you will need
to identify the types of activity in your business that could indicate risk. AML
training should be both general and tailored to specific roles and business
lines as appropriate. Consider training the board of directors and senior
management to ensure they understand the requirements and the impact on their
duties for oversight and risk management.

Independent Testing

All compliance programs should be tested periodically to determine if the
controls are reasonably designed and appropriately implemented. The requirement
for an independent test of an AML program will be a part of any final rules.
Identify whether an internal audit function exists, or if your firm will need to
identify a qualified third party to review the AML program. Ensure that the
independent test is completed by a department or company with experience in AML,
and how the rules would apply to the RIA business.

 

WHAT ADDITIONAL STEPS YOU MAY NEED TO TAKE

Even without knowing specific requirements, there are preparatory actions RIAs
can take to be ready to implement new requirements. Preparedness begins with
having a thorough understanding of your entity’s existing risk management
practices to be able to identify where gaps in coverage might surface when new
regulations are enacted. 

 * Socialize the possibility with the board of directors, senior management, and
   key stakeholders.
   
   Summarize the information released to date, and identify the potential impact
   to your company if a rule is passed.  
   
   
 * Map your operational processes.
   
   Identify where third-party service providers (such as administrators and
   custodians) are part of your ecosystem, and consider your oversight of such
   third parties and the contracts you have in place with them. Focus on
   onboarding of both clients and investors, and the associated fund flows
   throughout the business. For example, if an administrator completes your KYC
   on your fund, do you have oversight? Do you know what they do, the procedures
   they follow, and if they have an audit or testing program in place? Is
   potentially suspicious activity or negative news escalated to you?
   
   
 * Consider your existing risk management practices.
   
   Determine if there are existing risk management processes and controls that
   can be leveraged or modified to gain efficiencies in implementation. For
   example, investor or transaction data that is pertinent to AML may be
   captured for other reasons, and systems used to capture and/or screen
   information may be able to be modified. Consider your existing risk
   management and compliance process related to sanctions, anti-bribery and
   corruption, anti-fraud, reputational risk, and general due diligence.

In addition to identifying economies of scope, consider economies of scale. Are
there enterprise risk management considerations such as global advisor
affiliates, or other covered financial institutions within the organizational
structure that have an AML Program that can be leveraged?

 

CONCLUSION

Although the rules have not been finalized, RIAs can start planning now to make
sure that they are ready when the time comes.

Guidehouse can help. Our team of subject matter experts has decades of
experience in both AML and within the investment advisory industry. We can help
guide you through the task of strategically scoping and designing your AML
Program through implementation and execution.

 
This article was co-authored by  Kristin Wenske.

--------------------------------------------------------------------------------

1 The proposed rule in May 2003 was published following a rule for unregistered
investment companies in September 2002. Visit the Federal Register website for
more information. In the preamble to the 2015 proposal, FinCEN noted that,
following regulations promulgated pursuant to the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank) in 2010, certain formerly unregistered
advisors were required to register with the SEC. The 2015 rule therefore would
provide substantially the same coverage as the two proposed rules promulgated
prior to the passage of Dodd-Frank.
2
https://www.federalregister.gov/documents/2015/09/01/2015-21318/anti-money-laundering-program-and-suspicious-activity-report-filing-requirements-for-registered#footnote-20-p52683
3 https://www.icij.org/
4
https://www.fatf-gafi.org/media/fatf/documents/reports/mer4/MER-United-States-2016.pdf
5
https://www.fatf-gafi.org/media/fatf/documents/reports/fur/Follow-Up-Report-United-States-March-2020.pdf
6
https://www.reuters.com/article/bc-finreg-fbi-laundering-private-equity/fbi-concerned-over-laundering-risks-in-private-equity-hedge-funds-leaked-document-idUSKCN24F1TP
7
https://www.federalregister.gov/documents/2015/09/01/2015-21318/anti-money-laundering-program-and-suspicious-activity-report-filing-requirements-for-registered
8
https://www.whitehouse.gov/wp-content/uploads/2021/12/United-States-Strategy-on-Countering-Corruption.pdf
9
https://home.treasury.gov/system/files/136/2022-National-Strategy-for-Combating-Terrorist-and-Other-Illicit-Financing.pdf 
10
https://joewilson.house.gov/media-center/press-releases/enablers-act-included-in-ndaa
11 https://www.justice.gov/criminal-fraud/page/file/937501/download


CONTRIBUTING AUTHORS

Samantha Welch, Partner

Alma Angotti, Partner

Gene Bolton, Associate Director

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