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Regulators May Take Aim at Investment Advisor AML Gaps with Proposed Rule

FinCEN 2015 Proposed Investment Advisor Rule

Recent reports leaked to the media shed light on federal authorities’ concerns with the financial crime risks connected to investment advisors in the private investment fund industry. According to a leaked FBI intelligence bulletin prepared in May 2020, federal authorities have “high confidence” that hedge fund managers and private equity firms are vulnerable conduits for money laundering. In that report, the FBI warns that the private fund industry lacks adequate anti-money laundering (AML) controls and oversight and has privately called for greater scrutiny.

Regulators too have long considered the lack of AML regulation over investment advisors a vulnerability in the US Bank Secrecy Act/Anti-Money Laundering (BSA/AML) regime. Despite multiple attempts to close this gap, BSA/AML regulations still do not incorporate this sector. Nevertheless, recent events suggest that this may change.

In 2020, the Securities and Exchange Commission’s (SEC) Office of Compliance Investigations and Examinations (now referred to as the Division of Examinations) announced in its 2020 Examination. Priorities that it will prioritize conducting risk-based examinations of certain Registered Investment Advisors (RIAs) for AML compliance1. Moreover, Guidehouse anticipates that the Biden administration may take a more aggressive regulatory approach, likely consistent with closing the investment advisor hole in the AML regulatory regime.

This client alert summarizes the history of attempted AML regulatory oversight of investment advisors and outlines actions investment advisors in the private fund industry2 should consider.

 

History of the Investment Advisor Rule 

It has long been best practice for certain investment advisors to maintain AML programs consistent with Section 352 of the USA PATRIOT Act, even where such requirements are not imposed by law or regulation. Still, BSA/AML regulations do not require AML programs for investment advisors.
 
Attempts to mandate AML requirements were first proposed by the Financial Crimes Enforcement Network (FinCEN) in 2002 and 2003 for unregistered investment companies, commodities traders, and investment advisors. However, both proposed rules were withdrawn by FinCEN in October 2008. FinCEN’s reasoning for the withdrawal was that unregistered investment companies, investment advisors, commodities traders, and their clients conduct transactions through, and their assets are carried by, other financial institutions that are subject to BSA/AML requirements. Therefore, FinCEN reasoned, their activity was not entirely outside the current BSA/AML regulatory regime. FinCEN’s explanation fails to recognize that the broker-dealers and banks that provide accounts for hedge funds and other pooled investment vehicles often have little insight into the investors in those funds. Banks and broker-dealers frequently require those funds to provide copies of their AML compliance programs but may not be able to verify that the programs are appropriately risk-based or properly implemented. FinCEN did leave the door open to considering BSA/AML requirements for investment advisors in the future. 

The Obama administration revisited the issue and published the 2015 Proposed Rule for Registered Investment Advisers (Proposed Rule) to expand the definition of “financial institution” to cover RIAs. FinCEN reasoned that investment advisors are engaged in activities that are “similar to, related to, or a substitute for” financial services that are provided by other BSA-defined financial institutions and, therefore, should be subject to its provisions. The proposed definition included “[a]ny person who is [(1)] registered or [(2)] required to register with the SEC under Section 203 of the Investment Advisers   Act of 1940 [(Advisers Act)] (15 U.S.C. 80b-3(a)).” This typically includes primary advisors and sub-advisors with greater than USD $100 million assets under management (AUM)3. FinCEN proposed to delegate its authority to the SEC to examine investment advisors for compliance with these requirements. The Proposed Rule also left open the possibility for broader application, noting that “future rulemakings may include other types of investment advisers, such as state-regulated investment advisers or investment advisers that are exempt from SEC registration.” 

In its current form, the Proposed Rule did not incorporate Customer Identification Program (CIP) and Customer Due Diligence (CDD) requirements. For CIP, FinCEN noted that SEC rules already require investment advisors to adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act. FinCEN contemplated that investment advisors would be able to adapt existing policies, procedures, and internal controls in order to comply with the Proposed Rule. In its reasoning, FinCEN highlighted the fact that some RIAs already implemented AML programs either voluntarily or in conjunction with performing some or all aspects of a broker-dealer’s CIP obligations.

Additionally, when FinCEN issued the Proposed Rule, CDD had not yet been formally codified until May 11, 2016 (CDD Rule). The CDD Rule officially documented CDD expectations, including the identification of beneficial ownership, and may be applicable in the event the Proposed Rule is implemented. Lastly, the recent December 2020 enactment of the Anti-Money Laundering Act of 2020 (AMLA) did create beneficial ownership reporting requirements for certain entities, though the law was largely targeted toward shell companies. Pooled investment vehicles, investment companies, and investment advisors were among a list of entities specifically excluded from the AMLA’s beneficial ownership registry requirements.

The 2015 Proposed Rule was, however, never implemented by the Trump administration.

 

What Now?

Guidehouse anticipates that the Proposed Rule may be reproposed and finalized. Given the maturity of BSA/AML regulations, regulators may be less apt to give newly designated financial institutions like investment advisors a long runway to comply with a rule’s requirements if a version of the Proposed Rule is implemented. Perhaps most importantly, investment advisors should implement robust AML compliance programs for sound risk management. It is a criminal offense to facilitate laundering the proceeds of crime, whether or not there is a regulatory requirement to have a compliance program. An adequate and effective compliance program is a factor that the Department of Justice uses to determine whether to bring charges, negotiate pleas, or other agreements. Accordingly, investment advisors should consider proactively assessing if they have an appropriately risk-based program to detect and prevent money laundering, terrorist financing, and other financial crime. Investment advisors should assess:
  1. Governance of financial crime risk management by management
  2. Controls related to and connected to investors that are politically exposed persons, which may be a risk factor for laundering the proceeds of corruption
  3. Exposure to jurisdictions that are high risk for transnational organized crime and corruption
  4. Investment strategy, which includes investment periods (short, medium, or long), and liquidity of investments, whereby certain investments may be more attractive for bad actors looking to place and layer illicit funds quickly
  5. Lock-up period(s), whereby shorter periods would be more attractive vehicles to layer funds4 
  6. Customer due diligence processes to avoid accepting money from criminals and/or sanctioned individuals or entities
  7. Training
  8. Oversight of outsourced controls

 

How Can Guidehouse Help?

Guidehouse can help entities in and working with the private fund industry assess their compliance programs to prepare for regulatory updates and to mitigate risks, including developing and implementing updates to operations, policies, procedures, controls, and technology.
Its areas of relevant expertise include the following:

  • Sanctions
  • Anti-money laundering (AML)
  • AML and Sanctions program management outsourcing
  • Strategic planning
  • Risk management
  • Vendor sourcing and governance
  • Executive training 

Guidehouse can quickly review and assess your BSA/AML compliance program to determine whether it is sound, to identify gaps or weaknesses, and/or to conduct training on BSA/AML and Sanctions compliance. 

Guidehouse is well-equipped to make an individualized assessment of your unique circumstances and offer innovative advice and solutions for responding to heightened regulatory requirements.

 

Special thanks to Chelsea Simkin for contributing to this article.

1. Guidehouse notes that the SEC’s Division of Examinations may have limited resources in this space and there is a question as to whether the SEC can bring an action for noncompliance. 
2. Private funds are pooled investment vehicles that are excluded from the definition of investment company under the Investment Company Act of 1940 by Section 3(c)(1) or 3(c)(7) of that Act. As a result of the Dodd-Frank Act, many previously unregistered advisors to private funds were required to register with the SEC or the states.
3. Mid-size advisors (USD $25M to $100M AUM) and small advisors (<$25M) generally do not register with the SEC (typically registered by states) and were excluded from the proposed definition, unless an exemption from the prohibition on SEC registration is available.
4. Per Investopedia, a lock-up period is a window of time when investors are not allowed to redeem or sell shares of a particular investment. 
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