Hedge Fund. Anti-Money Laundering. The LAW REPORT. The Patriot Act Changes the Anti-Money Laundering Landscape

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1 hedge LAW REPORT fund law and regulation Anti-Money Laundering Do s Really Pose a Money Laundering Threat? A Decade of Regulatory False Starts Raises Questions By Michael B. Himmel and Matthew M. Oliver, Lowenstein Sandler PC If terrorists and drug runners need to launder illicit gains, are hedge funds the perfect vehicle? Since 2001, regulators and legislators have debated subjecting hedge funds to anti-money laundering rules like those in place for banks, broker-dealers and other financial institutions. Despite the promulgation of specific rules and significant legislative pressure, hedge funds remain largely outside the purview of anti-money laundering regulations. Now, new moves from U.S. financial regulators suggest that, after a decade of false starts, hedge funds may be brought into the fold. The history of these proposed regulations sheds light on the question of whether hedge funds even pose the kind of threat the rules were designed to ameliorate. This article provides a comprehensive overview of U.S. anti-money laundering legislation and regulation over the past decade, and concludes with a discussion of recent anti-money laundering developments that have direct bearing on hedge funds, hedge fund managers and investors. The Patriot Act Changes the Anti-Money Laundering Landscape In response to the September 11, 2001 terrorist attacks, Congress passed, and President Bush signed into law, the USA PATRIOT ACT (Patriot Act). Title III of the Patriot Act, the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001, imposed a host of antimoney laundering obligations on financial institutions. Title III altered existing law primarily by amending the Money Laundering Control Act of 1986, which set criminal penalties for money laundering, and the Bank Secrecy Act of 1970 (BSA), a reporting statute aimed at banks. Section 326 of the Patriot Act required financial institutions to collect specified information from entities seeking to open an account. Financial institutions were also required to comply with 352 by implementing anti-money laundering programs by April 24, Hedge funds were exempted from the 326 requirements pending further study, and exempted from 352 requirements until October 24, Section 352 required the implementation of specific antimoney laundering programs, ostensibly to assist in the war on terror. The programs were to include: (1) internal policies; (2) a required compliance officer; (3) ongoing training; and (4) independent audits to test the policies in place. Commentators disagreed on whether hedge funds were covered by the 352 regulations. Citing the legislative history and the broad definition of financial institution, as well as comments from Treasury, some commentators believed that Title III and its components applied to hedge funds. Then- Senator Jon Corzine was a main proponent of applying antimoney laundering regulations to hedge funds, stating that hedge funds are probably one of those places where you can [launder illicit money] most efficiently and anonymously. Other commentators saw hedge funds as outside the language of Title III. They looked to the BSA s definition

2 of financial institution, which included broker-dealers and investment companies. Investment companies, according to the Investment Company Act of 1940, do not include hedge funds, which usually fall within select exemptions. The conclusion drawn was that hedge funds would not be required to create anti-money laundering programs under 352. Though Treasury clearly supported regulation, time would tell that hedge funds would remain beyond the anti-money laundering regulations. The Treasury Department s Financial Crimes Enforcement Network (FinCEN) was charged with creating rules to bring unregistered investment companies into compliance with Title III. FinCEN administers anti-money laundering regulations under the BSA. The BSA grants Treasury, and thereby FinCEN, jurisdiction over financial institutions. Although hedge funds are not included in the existing definition, the Treasury secretary may, in his or her discretion, add entities to the category of financial institution. On September 26, 2002, FinCEN issued proposed rules regulating unregistered investment companies. The proposed rules would have subjected hedge funds to the requirements of 352 and 326. Some hedge funds and other industry participants started anti-money laundering compliance programs, intending to get out ahead of the anticipated new rules. On October 25, 2002, FinCEN issued an interim final rule extending the hedge fund exemption from Title III compliance. The stated purpose of the extension was to allow Treasury to continue to study what risks, if any, were posed by hedge funds and other unregistered entities before setting out anti-money laundering requirements for such entities. The October 25, 2002 notice exempted hedge funds from creating anti-money laundering programs until final rules were established. After further study, and with comments from regulatory and industry participants, Treasury issued a report on the money laundering risks of investment companies on December 31, The report discussed the perceived money laundering risks of multiple types of investment companies, including mutual funds, real estate investment trusts and hedge funds. Treasury concluded that among the unregistered investment companies, hedge funds were likely the most susceptible to abuse by money launderers because of their structure and liquidity. The report concluded that the rules require hedge funds to establish anti-money laundering programs, as 352 originally envisioned, and that the rules require hedge funds to implement the 326 customer identification collection requirements. In April and May 2003, Treasury proposed further regulations to implement the Patriot Act anti-money laundering requirements. Treasury proposed regulations requiring investment advisers to establish anti-money laundering programs in line with the 352 requirements. The proposed regulations were seen as another way of bringing hedge funds, and like entities, under the anti-money laundering compliance rules. But the proposals would not be the final word on the matter. The Proposed Regulations Languish, and Are Withdrawn After the flurry of activity in 2002 and 2003, culminating in proposed regulations that would have imposed antimoney laundering compliance requirements and customer

3 identification data collection requirements on hedge funds and investment advisers, the proposed regulations still remained proposals in banks, for their financial and monetary activities, they are not completely unregulated as regards money laundering. Others have offered different explanations. In 2007, Senators Carl Levin, Norm Coleman, Ken Salazar and Sheldon Whitehouse, as well as then-senator Barack Obama, proposed a bill that, among other things, aimed to force Treasury to adopt the regulations proposed in 2002 and require hedge funds to implement anti-money laundering compliance programs. The bill, S.681, died in the Senate Committee on Finance. Senator Charles Grassley proposed a bill to require hedge fund managers to register under the Investment Advisers Act of 1940, a step in requiring antimoney laundering regulations. That bill died in the Senate Committee on Banking, Housing and Urban Affairs. Having languished for six years, the proposal to apply antimoney laundering programs to unregistered investment companies, investment advisers and others was withdrawn by Treasury on November 4, By withdrawing the proposal, Treasury took anti-money laundering regulation of hedge funds off the table. For more on this history, see James H. Freis, Jr., Director of FinCEN, Delivers Speech to the Eighth Annual Florida International Bankers Association Anti-Money Laundering Compliance Conference, The Law Report, Vol. 1, No. 1 (Mar. 3, 2008). Why the Withdrawal and Delay? Why, after six years languishing un-enacted, did Treasury decide to withdraw the proposed rules? And for that matter, what caused the delay? Neither answer is clear. In its entry to the Federal Register, Treasury provided one possible reason for the withdrawal, noting that since investment advisers, hedge funds and similar entities must use regulated entities, such as A FinCEN agency spokesperson, William Grassano, indicated that FinCEN was prioritizing issues and that hedge fund antimoney laundering rules were simply not on the top of the list. The re-prioritization came on the heels of then-treasury Secretary Hank Paulson s push for effectiveness and efficiency in the department. With FinCEN s limited resources, oversight of hedge funds would be inefficient considering the potential difficulties of laundering money via a hedge fund. Other possible explanations have been floated by commentators. Some viewed the regulations as simply stale, and lacking a necessary impetus for passage. In this view, the original proposed regulations were a response to the panic of the moment, but as time went on and no hedge fund money laundering scandal occurred, there was no longer a good reason to think hedge funds were being used for money laundering and hence little purpose for the regulations. Another explanation is that the proposed rules were proposed without an eye for implementation. The hedge fund industry is not regulated in the same manner as traditional banking institutions, or mutual funds, and so anti-money laundering regulations would be difficult to implement. Without a dedicated examiner to enforce the regulations on unregistered actors, the regulations would have lacked efficacy. There is also a perhaps more fundamental reason the regulations did not move forward: the risk simply wasn t there. Terror groups may find hedge funds too risky or too illiquid to be of real use. Terrorists requiring money on an

4 as-needed basis would be unlikely to lock up cash in a hedge fund because of typical hedge fund provisions restricting redemptions. See, e.g., What Are Hybrid Gates, and Should You Consider Them When Launching Your Next Hedge Fund?, The Law Report, Vol. 4, No. 6 (Feb. 18, 2011). In addition, existing regulations requiring hedge funds to investigate their investors to determine suitability, and check the identities of investors against the Office of Foreign Assets Control database, would require significantly more disclosures from would-be launderers than one would expect them to be willing to provide. Contrary to the view espoused in Treasury s October 25, 2002 report, hedge funds are simply not a good vehicle for money laundering. In the wake of the withdrawn proposed rules, Senator Levin, this time with Senator Grassley, attempted another legislative response. Senator Levin introduced the Hedge Fund Transparency Act, S. 344, on January 29, 2009, which would have, among other things, applied anti-money laundering compliance duties to hedge funds. See Levin and Grassley Introduce Bill that would Require Hedge and Other Private Funds to Register to Avoid Regulation as Investment Companies, The Law Report, Vol. 2, No. 5 (Feb. 4, 2009). The bill died in the Senate Committee on Banking, Housing and Urban Affairs. With that, the idea of applying anti-money laundering rules to hedge funds ended at least for a while. Regulations Resurrected James Freis, Jr., Director of FinCEN, resurrected the possibility of applying anti-money laundering rules to hedge funds in a speech to the American Bankers Association on November 15, Director Freis indicated that FinCEN was revisiting the topic of requiring investment advisers to comply with anti-money laundering provisions. For coverage of that speech, see FinCEN Working on a Proposed Rule That Would Require Investment Advisers to Establish Anti-Money Laundering Programs and Report Suspicious Activity, The Law Report, Vol. 5, No. 4 (Jan. 26, 2012). Regulating unregistered entities such as hedge funds could be next. Changes in the financial regulatory framework after the Dodd-Frank Act and the implementation of that Act by SEC rules have altered the environment for new anti-money laundering regulations. Commentators have noted that while investment advisers are not listed under the BSA s jurisdiction, they can be added by the Treasury secretary. Freis remarks have led some to wonder whether this will herald a new aggressiveness by FinCEN in rulemaking regarding antimoney laundering regulations. Director Freis remarks suggest that a decade after the Patriot Act, Treasury may finally be prepared to put in place rules requiring hedge fund compliance with anti-money laundering requirements. A separate takeaway from the history of these regulations is that despite FinCEN s report that hedge funds posed a significant risk of money laundering, the regulations themselves were allowed to languish for six years, and then were repeatedly rejected. The history raises serious questions about whether hedge funds pose a money laundering threat in the first instance, and about how effective any new regulations will be in combating money laundering generally. Michael B. Himmel is a Member of Lowenstein Sandler PC and Chair of the firm s Litigation Department and the White Collar Criminal Defense Practice Group. Himmel has developed a national practice in white collar criminal defense in matters involving tax

5 fraud, securities fraud, the Foreign Corrupt Practices Act, political corruption, antitrust, bank fraud, and environmental matters. His clients have included private and public corporations in various industries including life sciences and the financial sector, officers and directors of private and public corporations, professionals and state and federal officials. He also has assisted corporate clients with internal investigations. Himmel, who is also well known for his work in complex business litigation, has recently won several multi-billion dollar class action securities fraud cases. Himmel was formerly an Assistant District Attorney in Bronx County, New York, and later served as an Assistant U.S. Attorney for the District of New Jersey. During his years as a federal prosecutor, Himmel successfully prosecuted numerous high visibility white collar criminal cases that resulted in the convictions of a New Jersey state senator, a former speaker of the New Jersey Legislature and a number of union officials. Matthew M. Oliver is a Member of Lowenstein Sandler s Litigation Department and a member of the firm s White Collar Criminal Defense and Securities Litigation and Enforcement Practice Groups. Oliver defends public and private companies, and their directors, officers, and employees, in federal and state criminal and regulatory investigations, as well as in complex commercial litigation matters, including securities class actions and shareholder derivative suits. He regularly conducts internal investigations on behalf of corporations and board committees, and also represents individuals in connection with such investigations.