U.S. Anti-Money Laundering Compliance Considerations for Fund Sponsors

In this Ropes & Gray podcast, Ama Adams, Brendan Hanifin, and Emerson Siegle discuss anti-money laundering and economic sanctions considerations as well as best practices for fund sponsors, following recent reporting that U.S. law enforcement has developed concerns about potential widespread money laundering in the private equity and hedge fund industries.

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Transcript:

Brendan Hanifin: Hello, and thank you for joining us today on this Ropes & Gray podcast, during which we will be discussing U.S. anti-money laundering developments and compliance considerations for the private investment fund industry. I am Brendan Hanifin, counsel in Ropes & Gray’s Chicago office. Joining me for today’s discussion are Ama Adams, a partner, and Emerson Siegle, a senior associate, both based in our Washington, D.C. office.

Ama, to set the stage for our discussion today, could you briefly describe what money laundering is, and how it is relevant to private investment funds?

Ama Adams: Thanks, Brendan. Money laundering is the process by which a person attempts to conceal the source, ownership, or control of the proceeds of illegal activities, while retaining control over those proceeds. This is accomplished by layering the proceeds of illegal activity through a series of facially legitimate transactions—such as bank transfers or transactions that commingle the tainted funds with untainted funds—to distance the tainted proceeds from their unlawful origin. Once the prospective launderer believes that the tainted funds have been sufficiently distanced from their source, he or she may seek to deploy those funds for a purportedly legitimate purpose, such as a subscription for a limited partner interest in an investment fund. This risk is not hypothetical – according to recent news coverage of an FBI document leak, U.S. law enforcement has concerns about potential widespread money laundering in the private equity and hedge fund industries, which may be a precursor to increased scrutiny of these industries by U.S. regulators.

Emerson, could you provide an overview of the laws and regulations that the U.S. government has established to combat money laundering activity?

Emerson Siegle: The U.S. anti-money laundering regime consists of two distinct sets of laws and regulations. The first component is the criminal anti-money laundering statutes. At a high-level, these laws prohibit firms that conduct financial transactions within the United States, or through the U.S. financial system, from knowingly conducting or attempting financial transactions that involve the proceeds of certain, specified crimes. The criminal anti-money laundering statutes broadly apply to all firms conducting business in or through the United States. The second component is the affirmative anti-money laundering compliance program requirements of the Bank Secrecy Act, as amended by the USA PATRIOT Act. These regulations require covered financial institutions to establish and maintain anti-money laundering compliance programs that meet certain minimum requirements, including requirements for conducting know your customer (“KYC”) due diligence of customers and, in some cases, customers’ beneficial owners. Covered financial institutions also are required to develop procedures for monitoring and reporting suspicious activity on the part of customers to FinCEN (the Financial Crimes Enforcement Network) within the Treasury Department.

Brendan Hanifin: U.S. sponsors also must be mindful of the economic sanctions regulations administered by the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”), which are a separate—but closely related—legal regime. U.S. economic sanctions generally prohibit U.S. sponsors from transacting with parties located in comprehensively sanctioned jurisdictions, such as Cuba and Iran. In addition, U.S. sanctions generally prohibit U.S. sponsors from transacting with “blocked persons” that are either included on OFAC’s Specially Designated Nationals List; or majority owned, individually or in the aggregate, by parties included on OFAC’s Specially Designated Nationals List. For parties subject to U.S. sanctions, U.S. sponsors generally are prohibited from accepting investments, making disbursements, or providing investment management services. U.S. sponsors also must ensure compliance with OFAC’s blocking and reporting requirements. Specifically, U.S. sponsors must block (or freeze) the assets—including investment funds—of blocked persons that come within the sponsor’s control or possession. In the investment fund context, “blocking” generally involves opening a segregated, interest-bearing bank account; transferring to the account an amount representing the blocked person’s pass-through ownership percentage; and filing a report with OFAC. In addition, U.S. sponsors are required to reject proposed transactions where the transaction would be prohibited under U.S. sanctions, but there is no blockable property interest. In both situations, the sponsor would be required to file a report with OFAC.

Ama Adams: As a strictly regulatory matter, only covered financial institutions are required to adopt and maintain written anti-money laundering compliance programs, pursuant to the requirements of the Bank Secrecy Act and the PATRIOT Act regime. Currently, the definition of “financial institution” includes banks, credit unions, broker-dealers, currency exchanges, and certain insurance companies, among other examples. The definition of financial institution does not include SEC-registered investment advisers (“RIAs”). At least as a matter of U.S. law, RIAs are not subject to an affirmative, regulatory requirement to conduct KYC diligence of investors or their beneficial owners. The lack of affirmative KYC and other anti-money laundering compliance program requirements applicable to the private investment fund industry appears to be a primary concern of U.S. law enforcement, based on the recently leaked FBI bulletin. 

Emerson Siegle: As some of our listeners may recall, several years ago, there was an effort to extend certain programmatic anti-money laundering requirements to RIAs. In 2015, FinCEN published a Proposed Rule that would require certain RIAs to establish anti-money laundering compliance programs and to report suspicious activity to FinCEN. To date, the Proposed Rule has not been implemented and, for a variety of reasons, momentum behind finalizing the Rule appears to have stalled, at least for the time being. Longer term though, we do expect either FinCEN or Congress to revisit this issue, based on a number of factors including enforcement trends, recent legislative efforts targeting other industries perceived to present heightened money laundering risk (such as the art trade), and regulatory developments in other jurisdictions.

Brendan Hanifin: Although non-financial institutions are not subject to affirmative KYC requirements under U.S. law, many sponsors have voluntarily established risk-based procedures for conducting due diligence of subscribers and their significant beneficial owners, for a host of different reasons. For example, some sponsors proactively established anti-money laundering controls in anticipation of implementation of FinCEN’s Proposed Rule and subsequent rulemaking. For some sponsors whose funds are subject to the more stringent anti-money laundering regimes of other jurisdictions (such as the European Union and Cayman Islands), adoption of a firm-wide standard for conducting KYC due diligence is easier to administer than applying different standards to different funds. Still other sponsors have established KYC procedures to meet the heightened compliance expectations of financial institutions and investors, as evidenced by growing requests for completion of diligence questionnaires and robust side letter representations.

Ama, returning to the recent media reporting, and the concern that the private investment fund industry writ large is susceptible to misuse by money launderers, what steps can firms take to protect themselves?

Ama Adams: Given recent reporting, this would be an opportune time for sponsors to take stock of their current anti-money laundering and KYC procedures, to assess whether they may be vulnerable to money laundering-related risks. As an initial matter, sponsors may wish to review and re-assess the level of KYC due diligence they conduct of prospective investors. As mentioned earlier in the discussion, RIAs are not subject to affirmative KYC due diligence requirements under U.S. law. However, there are several practical reasons why sponsors may wish to collect and verify KYC information (even if not to a covered financial institution standard). Most fundamentally, KYC due diligence assists sponsors to verify the identities and the existence of prospective subscribers. Put another way, KYC diligence assists sponsors to verify that a prospective subscriber is who the subscriber claims to be, and not a party with whom the sponsor would be uncomfortable transacting for legal, reputational, or risk tolerance reasons. In this regard, except for very low-risk investors, we generally recommend that sponsors collect some form of identifying documentation, to compare against the information provided by the subscriber in its subscription agreement and publicly available information. Along similar lines, KYC diligence assists sponsors to identify the significant beneficial owners of subscribers who, in many cases, may be the true parties in interest with respect to the investment.

In addition, as Emerson will discuss in a moment, performing KYC diligence can help facilitate sponsors’ compliance with economic sanctions regulations, which are a strict liability regime in the United States.

Finally, sponsors should be mindful that ad hoc waivers of KYC requirements for individual investors—particularly if not accompanied by documentation of the reasons justifying the waiver—may undermine the efficacy of the sponsor’s anti-money laundering program from a regulator’s perspective. Where sponsors do not intend to require KYC diligence for certain categories of investors in practice, sponsors should spell out their KYC criteria and underlying reasoning in a written procedure. In the absence of documented criteria, routine exemptions from the KYC requirements specified in subscription agreements may be difficult to defend in retrospect.

Emerson Siegle: As Ama mentioned, by collecting identifying information of prospective subscribers and their significant beneficial owners, sponsors can perform restricted party screening of the individuals and entities identified, to confirm that they are not prohibited parties under U.S. sanctions. 

Including significant beneficial owners within the scope of restricted party screening is an important, but frequently overlooked, diligence step. As noted earlier in the discussion, U.S. firms are prohibited from transacting with any entity in which a sanctioned party—or multiple sanctioned parties taken together—holds a 50% or greater ownership interest. This rule, known as the “50 Percent Rule,” means that U.S. firms are prohibited from dealing with certain entities—majority-owned by sanctioned parties—that are not, themselves, included on OFAC’s Specially Designated Nationals (“SDN”) List. In cases where sanctioned parties seek access to the U.S. financial system, it is commonly through one or more shell or holding vehicles, to attempt to conceal the sanctioned parties’ involvement in the investment or transaction. 

While there is no regulatory requirement for sponsors to perform restricted party screening of investors, their beneficial owners or investment targets, the U.S. sanctions are a strict liability regime. As a practical matter, performing restricted party screening is the only effective way to ensure that you are not dealing with a sanctioned party.  

With respect to existing investors, OFAC guidance encourages firms to perform periodic re-screening, according to a risk-based approach. OFAC has not specified the required frequency of re-screening, outside of observing that the frequency should be determined based on sponsors’ individual risk profiles.

Brendan Hanifin: Most U.S. sponsors have developed subscription agreement templates that incorporate fulsome anti-money laundering and economic sanctions representations and warranties, consistent with best practice. However, as the sanctions regulations, in particular, are updated frequently, it is prudent to re-review these template provisions in connection with each new fundraise, to ensure that they are consistent with current regulations. 

Sponsors also should be mindful of the effect of side letter provisions that may significantly limit the utility of the anti-money laundering and sanctions representations contained in their subscription agreements. We commonly see prospective subscribers seek side letter provisions limiting the scope of the subscription document representations, in a manner that effectively shifts risk from the subscriber to the sponsor. Examples include “actual knowledge” qualifiers (without requirement for reasonable inquiry), “applicable law” qualifiers (particularly for non-U.S. subscribers), and provisions limiting the scope of the representations to the subscriber only (excluding beneficial owners). In assessing whether to grant such side letter requests, sponsors should be mindful that subscriber-specific considerations generally do not change sponsors’ compliance obligations under U.S. law. For example, the fact that a prospective subscriber has not performed restricted party screening of its underlying beneficial owners—and therefore may be uncomfortable making a non-knowledge-qualified representation—does not change that U.S. sanctions are a strict liability regime as applied to the sponsor. Likewise, the fact that a non-U.S. subscriber is subject to regulation in its home jurisdiction generally will not provide a complete defense to the sponsor with respect to violations of U.S. anti-money laundering laws or economic sanctions.

Ama Adams: This also is an appropriate time to re-emphasize to employees the importance of being vigilant for—and escalating—red flags that suggest that money laundering, sanctions violations, or other illegal conduct may be afoot. While RIAs are not subject to affirmative suspicious activity reporting obligations under U.S. law, repeated failure to vet suspicious activities or transactions can create a bad factual record, increasing the risk of enhanced penalties in the event of inadvertent sanctions violations. In an extreme case, an aggressive prosecutor could seek to establish the knowledge requirement of a criminal money laundering charge by showing that a firm consciously disregarded—or was willfully blind to—criminal conduct, as evidenced by repeated failure to follow up on red flags suggesting illicit activity.

According to recent reporting, the leaked FBI bulletin highlighted various red flags of U.S. law enforcement concern, including:

• fund incorporation via shell companies in secrecy-friendly jurisdictions;
• ·vehicles operating as pass-through entities, and
• funds engaging in short-term activity consisting of less than a year.

Additional red flags that our clients commonly encounter include:

• excessive frequency of contributions or requests for redemptions;
• subscription monies being wired from a non-subscribing third party, which has not completed KYC diligence;
• requests for distribution of proceeds to an account other than the original wiring account used by the investor; and
• ·news reports indicating criminal, civil, or regulatory violations on the part of the subscribers.

Emerson Siegle: Two final points warrant mention: employee training and policy maintenance. In contrast to covered financial institutions, RIAs are not required—as a regulatory matter—to provide anti-money laundering or sanctions compliance training to relevant personnel. However, our experience has been that providing training on these topics can be effective in helping employees to identify transactions that present increased risk to their firm. In addition, in May 2019, OFAC published sanctions compliance program guidance that identified “an effective training program [as] an integral component of a successful [Sanctions Compliance Program].” In the guidance, OFAC stated that sanctions training should be provided to all appropriate personnel on a periodic basis and, at minimum, annually. While the May 2019 guidance is not an affirmative requirement—in the same manner that restricted party screening is not an affirmative requirement—failure to meet OFAC’s compliance program expectations has the potential to result in more aggressive enforcement, if an inadvertent sanctions violation were to occur. 

Second, it is important that sponsors memorialize their anti-money laundering and sanctions compliance procedures in a written program that is refreshed periodically. Without a written program, it can be difficult to justify decisions—such as with respect to re-screening of existing investors or excluding certain investors from KYC requirements—if they are later questioned by a regulator. Likewise, regulators like to see that firms are periodically reviewing and refreshing their policies and procedures, as an indicator of an effectively functioning compliance program.

Brendan Hanifin: Thank you, Ama and Emerson, for joining me today for this discussion. And thank you to our listeners. For more information regarding the topics discussed today, as well as links to our recent client alerts and analyses, please visit Ropes’ anti-corruption and international risk practice page at www.ropesgray.com. If we can help you to navigate these issues, please do not hesitate to contact us. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple or Spotify. Thanks again for listening.