The document discusses money laundering risks related to hedge funds and proposed regulations for anti-money laundering compliance programs. It notes that while hedge funds can be exploited for money laundering, there is little data on the actual amount laundered through them. It summarizes proposed regulations that would require investment advisors to hedge funds to establish anti-money laundering programs and report suspicious activity. The regulations are aimed at increasing oversight of private wealth funding sources that have grown in importance for hedge funds.

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AML and Hedge Funds - 2018
#AML #Compliance #Finance #Hedge Funds #Money Laudering #Privacy
The continued advance of the hedge fund market, increase of the
corresponding investor base, and heavy reliance placed on third parties to
perform many compliance tasks highlight the importance of identifying and
managing vulnerabilities related to money-laundering risk. While there is not a
great deal of data on the amount of money laundering through hedge funds,
these vehicles can be exploited via money laundering schemes. They offer
varying degrees of secrecy, offshore accounts and the ability to place large sums
of money.
Specifically, as inflows from institutional investors
continued to follow a steady upward trend,
contributions from private wealth sources, including
high-net-worth individuals. Capital from these private
investors surpassed that of institutional investors back in
2014, marking an unprecedented development in the
alternative investment world. Given the money
laundering risks associated with these private wealth
sources, this evolution of inflows may suggest an
increase in the overall money-laundering risk to hedge
funds surrounding operations in which they invest as
well as fund service providers. Therefore, efforts to Know
Your Customer (“KYC”) and monitor for suspicious
activity are key components for fund managers to help
mitigate money-laundering risk.
Further, hedge funds are reliant on third-party providers
— such as broker-dealers, wealth managers, and
depository institutions and transfer agents —for a suite
of services and transactions that facilitate a fund’s
investment activities. These services may include
custody and valuation of assets, marketing, securities
lending, regulatory advisory, legal documentation, and
assisting fundraising and investor subscription efforts. In
discharging their responsibilities, these third parties may
be at a disadvantage because they often do not have
direct interaction with the customers or access to KYC
information. This may hinder their ability to identify
suspicious activity. Investment advisors of hedge funds,
however, are ultimately responsible for overseeing and
supervising the third parties.

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As a result, it would be prudent to re-review the
proposed rule (“Proposal”) that Financial Crimes
Enforcement Network (“FinCEN”) issued for public
comment on August 25, 2015, requiring investment
advisers registered with the SEC (“RIAs”) to establish
Anti-Money Laundering (“AML”) Programs and report
suspicious activity.
RIAs should consider that if the Proposal is implemented,
hedge funds and their Registered Investment Advisers
(“RIAs”) would become a target of the regulators.
Further, although hedge funds are currently not subject
to Bank Secrecy Act (“BSA”) requirements, they are still
subject to federal criminal money laundering statutes
and the sanctions imposed for violations. If an RIA
should violate the criminal money laundering statutes,
the Department of Justice would review the AML
Compliance Program in connection with indicting the
RIA. Further if found guilty, the U.S. Federal Sentencing
Guidelines require prosecutors to consider the
effectiveness of the AML Compliance Program in
determining sentences.
Background
The BSA requires “financial institutions” to have effective
AML Compliance Programs. “Financial institutions”
currently include banks, broker-dealers, any entity
required to register under the Commodity Exchange Act
(“CEA”) (including futures commission merchants
(“FCMs”)), introducing brokers in commodities (“IB-Cs”),
commodity trading advisors (“CTAs”), and commodity
pool operators (“CPOs”)), mutual funds, operators of
credit card systems, money services businesses,
insurance companies, casinos, loan or finance
companies, and dealers of precious metals, stones and
jewels. The AML Compliance Program rules instituted
under the USA PATRIOT Act currently do not apply to
private funds and investment advisers.
Under the Proposal, FinCEN would add “investment
adviser” to the list of entities within the general
definition of “financial institution”. “Investment adviser”
would be defined as any person registered, or required
to be registered, with the SEC under section 203 of the
Investment Advisers Act of 1940, including both primary
advisers and subadvisers.
Generally, large advisers with US$100 million or more in
assets under management are required to register with
the SEC unless an exemption from registration is
available. Mid-sized advisers with US$25 million or more
but less than US$100 million, and small advisers with less
than US$25 million in regulatory assets under
management are generally prohibited from registering
with the SEC and are instead subject to state regulations.
Of course, FinCEN may consider future rulemakings that
expand the application of the BSA to state-regulated
investment advisers or investment advisers that are
exempt from SEC registration.
Proposal Requirements
To adequately fulfill the AML Program requirements in
the Proposal, RIAs must:
1. Develop and Implement Policies, Procedures and
Internal Controls to Help Ensure Ongoing
Compliance
The RIA is to establish and implement written AML
policies, procedures and internal controls. The AML
program must be “reasonably designed to prevent
the investment adviser from being used for money
laundering or the financing of terrorist activities and
to achieve and monitor compliance with” the BSA.
Regulators want to see a “risk-based” approach in
the design of the program.
2. Designate a Qualified Person or Persons Responsible
for Implementing and Monitoring the Operation and
Internal Controls of the Program (the “AML
Compliance Officer”)
The RIA must designate an individual or committee
responsible for implementing and monitoring the
operations and internal controls of the program. The
AML Compliance Officer(s) must be “knowledgeable
and competent” regarding the regulatory
requirements and the RIA’s money laundering risks.
Depending on the size and type of services, the AML
officer need not be dedicated full time to BSA
compliance, but “should be an officer of the
investment adviser.” The Proposal does not appear
to allow the RIA to delegate the role of AML
Compliance Officer to a third party administrator
implying that this role would most likely be filled by
the fund’s current CCO.
3. Provide Ongoing Training for Appropriate Personnel
The nature, scope and frequency of training is to be
determined by the employees’ responsibilities and
the extent to which their functions bring them into
contact with the BSA’s requirements and possible
money laundering. In addition to ensuring that such
ongoing training complies with the Proposed Rule

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(e.g., tailoring training to the audience), the RIA
should document its practices and approach related
to training.
4. Conduct Independent Compliance Testing
The Proposal requires testing on a “periodic basis,”
explaining that the frequency of testing will depend
upon the RIA or Compliance Officer’s assessment of
the risks posed. Such testing, that is designed to
ensure that the program is functioning as intended,
may be conducted by a qualified outside party.
Alternatively, testing may be conducted by
employees of the RIA, provided those employees are
not involved in the operation or oversight of the
AML program.
Other AML Compliance Program Requirements
Because the Proposal subjects RIAs to the BSA, they
would also be required to:
 File Currency Transaction Reports (CTRs) with
FinCEN for transactions of more than $10,000;
 Electronically file Suspicious Activity Reports
(“SARS”) with FinCEN;
 Comply with Recordkeeping and Travel Rules
and keep a record of ‘transmittal of funds’ in an
amount equal to or greater than US$3,000 and
cross-border transfers and extensions of credit
for amounts greater than US$10,000; and,
 Reply to government requests for information
under Section 314(a) of the USA PATRIOT Act;
Note, however, that the Proposal does not require the
RIA to implement a Customer Identification Program.
Finally, the Proposal will allow RIAs to delegate the
implementation and operational aspects of the AML
Program to third parties. The RIA and not the third
parties, however, remains responsible for the
effectiveness of the AML Program and ensuring access
by Regulators to requested documents. The RIA,
therefore, is responsible for ensuring that the third party
is effectively carrying out the requirements of the AML
Program.
Items for the RIA to Consider
In addition to building or strengthening an effective
AML Program, RIAs should consider the following:
 Administration Agreements
If the RIA delegates AML responsibilities to a third
party, the RIA should ensure this is covered in the
administration agreement or the contractual
agreements with service providers. The RIA should
ensure the agreement covers not only the fund but
also the RIA.
Also, the RIA should ensure that the agreement
permits the RIA to inspect and review the
operations of the administrator with respect to the
AML functions. Perhaps periodic reporting metrics
can be built for the fund and RIA.
 Offering Memorandums
The offering memorandum should reflect the AML
laws and regulations to which the RIA is subject. It
should also be updated to reflect SAR reporting
requirements, which is a new requirement under
the Proposal.
Also, RIAs will need to disclose any additional
expenses required for the maintenance of the AML
Program.
 Subscription Agreements
The RIA may need to revise the subscription
agreement if an AML Program is implemented and
requires additional or different information from
the investors.
Conclusion
Last year, financial regulators imposed more than $2
billion in fines related to AML compliance failures1
.
With AML enforcement shifting into higher gear, hedge
funds would be well advised to ascertain a
comprehensive picture of their AML priorities so they
can effectively enhance their compliance functions.
Regulators often view hedge funds as a potential outlier
or loophole with respect to AML. Therefore, Hedge
Funds need to be on the alert for potential enforcement
actions should the Proposal be adopted.
Sources
1. 2017 Anti-Money Laundering Year in Review and 2018 Outlook.
https://www.debevoise.com/insights/publications/2018/02/2017-anti-money-laundering-year-in-review

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