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As reported in the Winter 2002 issue of The Investment Adviser’s Counsel, on October 26, 2001, Congress enacted 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”). The Act includes a broad array of measures designed to prevent, detect and prosecute international money laundering. The Act covers all “financial institutions,” which is defined to include investment companies, futures commission merchants and broker/dealers registered with the Securities and Exchange Commission (“SEC”), but not investment advisers. The Financial Crimes Enforcement Network (“FinCEN”), a bureau of the U.S. Department of the Treasury, recently issued rules on three provisions of the Act: (1) anti-money laundering programs for mutual funds, (2) due diligence programs for correspondent and private banking accounts maintained by mutual funds and other financial institutions on behalf of foreign persons or entities and (3) suspicious activity reports by broker/dealers. In addition, the National Association of Securities Dealers, Inc. (“NASD”), the New York Stock Exchange (“NYSE”), the American Stock Exchange LLC (“AMEX”) and the National Futures Association (“NFA”) have provided guidance to their members regarding anti-money laundering programs.
Every financial institution, including broker/dealers and futures commission merchants, was required under the Act to establish an anti-money laundering program by April 24, 2002. However, on April 23, 2002, FinCEN issued “interim final rules” extending the compliance deadline to July 24, 2002 for open-end investment companies (“mutual funds”). The FinCEN also temporarily exempted investment companies other than mutual funds from the anti-money laundering program provision of the Act for up to six months. During the interim, FinCEN will consider the type of anti-money laundering programs that would be appropriate for closed-end investment companies and unit investment trusts. It is also likely that those entities excluded from the definition of “investment company” under the Investment Company Act of 1940, such as hedge funds, private equity funds and venture capital funds, will in the future be required to establish anti-money laundering programs. At a recent conference, a Department of Treasury representative indicated that the proposed rule to accomplish this is expected shortly. Other financial institutions, such as broker/dealers and futures commission merchants, were still required to have anti-money laundering programs operational by April 24, 2002.
On May 22, 2002, FinCEN issued a proposed rule implementing a provision of the Act that requires covered financial institutions to establish due diligence policies, procedures and controls reasonably designed to detect and report money laundering through correspondent accounts and private banking accounts that the covered financial institutions establish or maintain for non-U.S. persons. “Covered financial institutions” include any institution required to have an anti-money laundering program under the Act, such as mutual funds, broker/dealers and futures commission merchants (but not investment advisers). The due diligence provision of the Act is effective July 23, 2002, whether or not final rules are in place by that date, and apply to covered accounts regardless of when they were opened.
As reported in the Winter 2002 issue of The Investment Adviser’s Counsel, on December 31, 2002, FinCEN proposed a rule requiring reports to FinCEN by broker/dealers for certain types of suspicious transactions. The rule covers broker/dealers within the United States registered or required to be registered under the Securities Exchange Act of 1934 (the “Exchange Act”) and insurance companies or their affiliates that are registered broker/dealers only to permit the sale of variable annuities treated as securities under the Exchange Act. The final rule, made available June 28, 2002, generally effects the proposals with a few modifications to address industry comments received by FinCEN, and becomes effective January 1, 2003.
ANTI-MONEY LAUNDERING PROGRAMS—INTERIM FINAL RULE FOR MUTUAL FUNDS AND GUIDANCE FROM NASD AND NFA
Anti-Money Laundering Program for Mutual Funds
The interim final rule requires that each mutual fund establish an anti-money laundering program that includes the following four elements:
- Establish and implement policies, procedures, and internal controls reasonably designed to prevent the mutual fund from being used to launder money or finance terrorist activities, including but not limited to achieving compliance with the applicable provisions of the Bank Secrecy Act (“BSA”) and the implementing regulations thereunder;
- Provide for independent testing for compliance to be conducted by company personnel or by a qualified outside party;
- Designate a person or persons responsible for implementing and monitoring the operations and internal controls of the program; and
- Provide ongoing training for appropriate persons.
These four elements in the interim final rule for a mutual fund anti-money laundering program parallel the four elements applicable to anti-money laundering programs for any type of financial institution under the Act itself, as described in the winter issue of The Investment Adviser’s Counsel. In addition to the four elements in the interim final rule, however, the FinCEN release also provides additional instructions for mutual funds to help flesh out the details of a mutual fund’s anti-money laundering program. These additional instructions summarized below are set forth in FinCEN’s commentary accompanying the rule, rather than in the rule itself.
Mutual fund board approval of the anti-money laundering program is required but may be obtained at the first regularly scheduled meeting after the program is adopted. FinCEN’s commentary states that the legislative history of the Act indicates that each financial institution (including a mutual fund) should have the flexibility to tailor its program to fit its business and consider such factors as the institution’s size, location, activities and risk of exposure to money laundering.
DEVELOPMENT OF INTERNAL POLICIES AND PROCEDURES
The policies, procedures and internal controls should be reasonably designed to detect money laundering activities. Every mutual fund must:
(1) identify its vulnerabilities to money laundering and terrorist financing activity;
(2) understand the BSA requirements applicable to it;
(3) identify the risk factors relating to these requirements;
(4) design procedures and controls that will be required to reasonably assure compliance with these requirements; and
(5) periodically assess the effectiveness of the procedures and controls.
Some red flags identified in the release that a mutual fund could monitor include: (1) frequent wire transfer activity to and from a cash reserve account or (2) frequent purchases of fund shares followed by large redemptions, particularly if the proceeds are wired to unrelated third parties in foreign countries.
An anti-money laundering program should also be reasonably designed to detect and report the receipt of cash or certain noncash instruments totaling more than $10,000 in one transaction or two or more related transactions. Although the interim final rule does not include any requirement that a mutual fund obtain any additional information about individual transactions that are processed through another entity’s omnibus account, the release states that mutual funds need to analyze money laundering risks posed by particular omnibus accounts. Specifically, the fund may need to perform a “risk based” evaluation of the entity holding the particular omnibus account, including factors such as the type of entity, its location, type of regulation and the viability of its anti-money laundering program.
The release states that because mutual funds typically conduct their operations through service providers, some elements of the compliance program will best be performed by personnel of the service provider. The mutual fund may contractually delegate the implementation and operation of its anti-money laundering program to a service provider, such as a transfer agent. If the fund delegates responsibility for its anti-money laundering program to a service provider, the mutual fund must obtain a written consent which will ensure the ability of federal regulators to obtain information and records relating to the anti-money laundering program and to inspect the third party for purposes of the program.
In addition to obtaining that consent, the release states that the mutual fund remains responsible for assuring compliance with the interim final rule. That means the mutual fund must take reasonable steps to identify the aspects of its operations that may give rise to regulatory requirements or are vulnerable to money laundering, develop and implement a program reasonably designed to achieve compliance with such regulatory requirements and to prevent such activity, monitor the operation of its program and assess its effectiveness. The release states that it would be insufficient for a mutual fund simply to obtain a certification from the service provider to whom it delegates responsibility that the service provider has a satisfactory anti-money laundering program.
The release provides that mutual funds will need to update programs as the funds become subject to additional requirements under the USA Patriot Act. For example, final regulations on customer identification and verification will be issued by October 26, 2002 and will apply to mutual funds. Mutual funds also are likely to become subject to additional BSA requirements, such as filing suspicious activity reports. In the interim, mutual funds are encouraged to adopt procedures for the voluntarily filing of suspicious activity reports.
INDEPENDENT TESTING OF THE ANTI-MONEY LAUNDERING PROGRAM
According to FinCEN, a mutual fund should periodically test its program to assure it is functioning as designed. The testing can be performed by employees of the fund or service provider so long as those same employees are not involved in the operation of the program. The testing should be accomplished by personnel knowledgeable regarding BSA requirements. The frequency of the audit would depend upon factors such as the size and complexity of the mutual fund complex. A written assessment or report should be part of the review.
COMPLIANCE OFFICER
FinCEN states that a mutual fund must select to oversee its anti-money laundering program a person (or group of persons) who are competent and knowledgeable regarding BSA requirements and money laundering issues and risks. The officer must be empowered with full responsibility and authority to develop and enforce the procedures. The person responsible for the supervision of the overall program should be a fund officer.
TRAINING
Employees of the mutual fund (and any service providers) must be trained in BSA requirements relevant to their functions and in recognizing possible signs of money laundering that could arise in the course of their job duties. The training can be in-house or through outside seminars and could include computer-based training. Employees should be trained when they begin duties that bring them in contact with possible money laundering activity and should receive periodic updates. The level and frequency of the training would be determined by the responsibilities of the employees and the extent to which their functions bring them in contact with possible money laundering activity.
INVESTMENT COMPANY INSTITUTE COMMENT LETTER
On May 29, 2002, the Investment Company Institute (“ICI”) sent a letter to FinCEN commenting on the April 23, 2002 release and recommending, in general, the elimination or easing of certain requirements that the ICI sees as unnecessary or duplicative. The ICI requested that FinCEN clarify that mutual funds are not required to assess the viability of intermediaries’ anti-money laundering programs with respect to 1) omnibus accounts or 2) other similar accounts (“intermediated accounts”) for which the mutual fund may have limited customer information. The ICI also suggested that FinCEN clarify that it is appropriate for mutual fund anti-money laundering programs to take into account a variety of factors, such as the type of account, in determining the level of scrutiny of an account. Under such an approach, a retirement plan account, for example, would be scrutinized to a lesser extent than other accounts because the ICI argues that retirement plan accounts present little, if any, money laundering risk. The ICI recommended that the anti-money laundering compliance officer of the mutual fund need not be a fund officer because compliance officers in mutual fund complexes often are not fund officers. The ICI recommended that it should not be necessary that mutual funds obtain written consent for delegation of anti-money laundering compliance functions to a third party to ensure the ability of federal examiners to obtain and review records of the third party. The ICI stated that in many instances the service provider would already be required under current law to permit federal authorities access to such books and records. The ICI also recommended that FinCEN confirm that mutual fund transfer agents would generally not have to file Form 8300 for cash or non-cash instruments totaling more than $10,000 if a mutual fund’s transfer agent is a bank, broker or dealer or other financial institution subject to BSA regulation or is acting as an agent for such an entity. In such cases and other similar situations, the transfer agent would be required to file the occurrence under BSA requirements for suspicious activity reports and currency transaction reports.
NASD GUIDANCE FOR BROKER/DEALERS; NYSE AND AMEX GUIDANCE FOR MEMBERS
On April 22, 2002, the SEC approved NASD Conduct Rule 3011 and NYSE Rule 445. Both rules require their respective member organizations to develop and implement an antimoney laundering compliance program consistent with the applicable provisions of the BSA and require provisions parallel to the four elements described above for a mutual fund. The programs must be approved in writing by a member of senior management. On June 3, 2002, AMEX filed with the SEC proposed Rule 431 which is similar to the NASD and NYSE rules.
The NASD also issued a Special Notice to Members in April 2002 providing guidance to its members in developing an anti-money laundering program. Further, on June 3, the NASD announced that it is providing its member firms with an automated method of searching the U.S. Treasury’s Office of Foreign Asset Control’s “Specially Designated Nationals and Blocked Persons” list. The NASD noted that the list contains names of known and suspected terrorists, and that anti-money laundering programs require member firms to determine whether a customer’s name appears on any such list.
NFA GUIDANCE FOR FCMS AND IBS
On April 23, 2002, the NFA adopted, and the Commodity Futures Trading Commission approved, a rule and a related Interpretive Notice requiring futures commission merchants (FCM’s) and introducing brokers (IB’s) to implement anti-money laundering compliance programs. The NFA reported that the Treasury has decided, pending further study, to defer application of anti-money laundering compliance requirements to commodity pool operators and commodity trading advisers for up to six months. As is required for NASD and NYSE members, FCM’s and IB’s must develop and implement an anti-money laundering compliance program approved in writing by senior management. The program must include, at a minimum, provisions parallel to the four elements described above for a mutual fund antimoney laundering program.
DUE DILIGENCE PROGRAMS FOR CERTAIN FOREIGN ACCOUNTS
FinCEN issued a proposed rule on May 22, 2002 setting forth due diligence requirements for certain accounts maintained for non-U.S. persons by covered financial institutions, including mutual funds, broker/dealers and futures commission merchants. A covered financial institution would be required to maintain a due diligence program that includes policies, procedures and controls reasonably designed to enable the financial institution to detect and report any known or suspected money laundering in (1) any correspondent account maintained by a foreign financial institution or (2) any private banking account maintained on behalf of a non-U.S. person. “Correspondent account” is defined to include “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.” “Private banking account” is defined as an account that (1) requires a minimum aggregate amount of not less than $1,000,000; (2) is established on behalf of one or more individuals with a beneficial ownership in the account; and (3) is administered by an employee or officer of a covered financial institution.
The proposed rule provides minimum requirements for the due diligence programs. For example, procedures for covered correspondent accounts would be required to include, at a minimum:
(1) assessing whether the foreign financial institution presents a significant risk of
money laundering;
(2) considering information available with respect to the foreign financial institution;
(3) reviewing regulatory guidance regarding money laundering risks for the particular
foreign financial institution and accounts; and
(4) reviewing public information on whether the foreign financial institution has been
subject to regulatory action relating to money laundering or any criminal action.
Procedures for covered private banking accounts would be required to include, at a minimum:
(1) ascertaining the identity of all nominal holders and holders of any beneficial ownership interest in the private banking account;
(2) determining the source of the funds deposited in the account;
(3) ascertaining whether any such holder may be a senior foreign political figure; and
(4) reporting any known or suspected violation of law conducted through the account.
The proposed rule also sets forth additional due diligence requirements for correspondent accounts for certain foreign banks, including banks operating pursuant to an offshore license and certain private banking accounts for senior foreign political figures. FinCEN intends covered financial institutions to incorporate the due diligence programs into their existing programs under the BSA. Therefore, it appears that the due diligence programs can be part of the covered financial institution’s anti-money laundering program.
SUSPICIOUS ACTIVITY REPORTS BY BROKER/DEALERS
A new rule requires broker/dealers to file with FinCEN a Suspicious Activity Report-BD (“SAR-BD”) within 30 days of becoming aware of certain types of suspicious transactions. Broker/dealers will 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 if the broker/dealer knows, suspects, or has reason to suspect that the transaction (or pattern of transactions) falls within one of four classes:
- The transaction is designed to evade any requirements of regulations under the Bank Secrecy Act.
- The transaction has no apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage, and the broker/dealer knows of no reasonable explanation for the transaction after examining the available facts, including the background and possible purpose of the transaction.
- The transaction (a) involves funds derived from illegal activity or (b) is intended or conducted in order to hide or disguise funds or assets derived from illegal activity as part of a plan to violate or evade any federal law or regulation or to avoid any transaction reporting requirement under federal law or regulation.
- The transaction involves use of the broker/dealer to facilitate criminal activity. According to FinCEN, an example of such a transaction would be a transaction designed to fund terrorist activity, whether or not the source of funds is illegal activity.
The rule extends the 30-day filing deadline by an additional 30 days to allow the broker/dealer to attempt to identify the suspect, when the suspect is not initially known. Situations that involve violations that require immediate attention, such as terrorist financing or ongoing money laundering schemes, must be immediately reported by telephone to an appropriate law enforcement authority in addition to the SAR-BD filing. The rule provides a phone number for voluntary reporting of suspicious transactions to FinCEN, which a broker/dealer may use in addition to SAR-BD, or where filing is not required. The broker/dealer also is permitted, but not required, to contact the SEC in those situations.
SAR-BD will be filed with FinCEN in a central location, to be determined by FinCEN and set forth in instructions to the SAR-BD.
EXCEPTIONS
The rule provides an exception to reporting relating to violations of federal securities laws or rules of self-regulatory organizations (such as the NASD), if the broker-dealer reports the excepted violation to the SEC or self-regulatory organization (except that the exception is not available for violations of Rule 17a-8 under the Securities Exchange Act, which relates to compliance with the Bank Secrecy Act). The final rule differs from the proposal in that it includes a reporting exception for robbery or burglary that is reported to appropriate authorities.
FinCEN’s commentary on the rule states that the rule does not apply to futures commission merchants who are registered with both the Commodity Futures Trading Commission (“CFTC”) and the SEC, to the extent of their activities that are subject to the exclusive jurisdiction of the CFTC. The rule does apply, however, to activities of dual registrants involving securities future products, and to any other products over which the SEC or another federal agency also has jurisdiction, because such products are not subject to the CFTC’s exclusive jurisdiction.
FinCEN’s commentary notes that the rule does not carve out reporting of suspected violations of state or foreign laws.
CLEARING BROKERS AND INTRODUCING BROKERS
FinCEN acknowledges that securities transactions may be conducted by broker/dealers that clear their own transactions, or by introducing brokers that rely on another firm to clear the transaction. The final rule includes language to clarify that only one report is required to be filed for a reportable transaction, to avoid double reporting of the same transaction by, for example, an introducing broker and a clearing broker. FinCEN expects introducing and clearing broker/dealers will communicate with each other about transactions for purposes of sharing information and determining which broker/dealer will file the SAR-BD. (FinCEN notes, however, that communication between two broker/dealers would be inappropriate in certain circumstances. For example, if a broker/dealer suspects that it is required to report another broker/dealer, notifying the other broker/dealer of the SAR filing would reveal the filing to the suspected party.)
FinCEN notes that some broker/dealers were concerned that certain entities covered by the rule (e.g., clearing brokers) do not have the same level of knowledge about their customers as other entities covered by the rule, and would be expected to re-structure their relationships with customers in order to comply with the rule. FinCEN acknowledged that certain types of broker/dealers will have more information available to them than other types of broker/dealers, and that the rule is intended to accommodate the different operating realities in different types of financial institutions.
EXISTING SAR REQUIREMENTS
Depository institutions have been required to report suspicious activity since April 1, 1996. 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 SAR rule. Broker-dealers that are affiliates of banks or bank holding companies have also been required to report suspicious activity since that time. The new FinCEN rule applies to all broker/dealers, whether or not they are affiliates or subsidiaries of banks or bank holding companies. FinCEN has requested that federal banking authorities amend their regulations to exempt broker-dealers from reporting suspicious transactions under the bank supervisory rules.
CONCLUSION
Regulators and self-regulatory organizations continue to issue rules, proposals and guidance at an urgent pace to address the requirements of the USA Patriot Act, and additional pronouncements are expected. Investment industry professionals should familiarize themselves with the new and evolving requirements and how they apply to and affect their business, clients and industry.