Private Fund Managers: Hello AML Compliance Officers

Chief compliance officers (CCOs) at private fund management firms could be saddled with the extra title of anti-money laundering compliance officer and a lot more work if a proposed AML rule from the FinCEN unit of the US Treasury takes effect.

FinCEN, short for Financial Crimes Enforcement Network, has resurrected its longstanding desire for many investment advisers to fall under the same policies as banks and broker-dealers when it comes to complying with anti-money laundering regulations. So far, investment advisers have been required to follow anti-fraud regulations and to avoid doing business with individuals or companies on government sanctions lists, but they have been exempted from complying with the Bank Secrecy Act (BSA) and the USA Patriot Act. Those regulations serve as the cornerstone of the US’ AML rules.

Over 15,000 fund management firms are expected to be covered under the new AML rule and as is the case with all requirements, someone has to make certain they are followed. That is where a chief AML compliance officer comes into play. FinCEN’s proposed rule calls for many US fund management firms to appoint a dedicated AML compliance officer to be in charge of designing and implementing a risk-based AML program, testing the programs independently, conducting ongoing customer due diligence, filing suspicious activity reports for transactions over US$5,000, and maintaining the appropriate records for funds transfers. FinCEN has assigned the task of ensuring fund managers do their jobs correctly to the Securities and Exchange Commission, the fund management industry’s watchdog.

FinCEN’s proposal marks the fourth time the agency has attempted to put fund management firms on a level playing field with banks and broker-dealers since 2002 with the latest one in 2015 officially withdrawn in place of the current proposal. However, some legal experts predict that the new effort might be the charm and are advising their fund management firms to prepare regardless of when the proposal takes effect. “The momentum to implement AML regulations for private fund managers has gained strength due to recent events, as highlighted by the Treasury’s concurrently published risk advisory,” explains David Adams, a partner with the law firm of Mintz in Washington, D.C.

In its risk assessment report, the Treasury asserts that US investment advisers have served as “an entry point into the US market for illicit proceeds associated with foreign corruption, fraud, and tax evasion as well as billions of dollars ultimately controlled by Russian oligarchs and their associates.” The agency claims that US investment advisers and their advised funds, particularly venture capital funds are also being used by foreign states, notably the People’s Republic of China and Russia to access certain technology and services with long-term national security implications through investments in early-stage companies.

Mutual fund managers would be exempt from FinCEN’s new regulation as they already fall under the BSA, but FINCEN has proposed to expand the definition of financial institution under the act to include other registered fund managers for hedge funds and private equity funds. Even fund managers exempt from SEC registration would be impacted. The 2015 proposal, if implemented, would only have affected SEC-registered private fund managers. In its new proposal FinCEN asks for feedback on whether fund managers which are exempt from registering with the SEC should be covered by its new rule or whether any other types of fund managers and relationships should also be exempt. Those include sub-advisory or other services that do not involve management of client assets.

It is unclear whether foreign fund managers will be covered by FinCEN’s new proposal. Legal experts predict there will be plenty of opposition to FinCEN’s desire for its AML rule to apply to foreign SEC-registered and non-registered investment advisers even if they don’t have offices or personnel in the US. By contrast, FinCEN has exempted foreign broker-dealers from falling under the BSA’s jurisdiction. FinCEN is requesting feedback on the challenges foreign advisers would have on implementing its new rule as filing SARs may conflict with foreign privacy laws. AML programs run out of the US could also be cost-prohibitive should a foreign adviser have to hire US staff, including a US-based AML director. “The foreign investment advisers will have to decide how to integrate a US AML proposed program with any existing AML program,” cautions Adams. “A foreign fund manager often will not want to operate two separate AML programs, so it might default to the most stringent AML requirements.”

US private fund managers could add the title of chief AML compliance officer to their current CCOs or hire a new employee. The decision depends on the size of the fund management firm and its current level of compliance with the proposed rule. “Smaller registered fund managers or those exempt from reporting with the Securities and Exchange Commission might decide to give their chief compliance officers an extra title while larger firms might hire a dedicated professional,” explains Casey Jennings, an attorney with the law firm of Seward & Kissel in New York focused on financial services regulation.

The potential candidates for AML compliance officers at private fund management firms can come from banks, broker-dealers, AML-specialized consultancies and law firms. Naturally, the more experienced the AML candidate the higher the potential compensation, which could pose an issue for smaller cash-strapped fund managers which are typically exempt from registration. Those include venture capital firms.

For private fund management firms which decide to keep the chief AML compliance officer title in house, the issue becomes whether the CCO can improve his or her knowledge base to include AML content within a year after FinCEN’s proposal takes effect. The deadline for responding to FinCEN’s request for comments on its proposal ends on April 15, 2024. If FinCEN takes immediate action private fund managers could be forced to answer questions on their AML practices in an SEC exam as early as the spring of 2025. The costs of hiring a new director from outside the corporate ranks could offset the potential for error if a chief compliance officer is ill-equipped to take on the new job.

It appears that regardless of size many private fund management firms are willing to take a chance on their current compliance manager. Of the ten chief compliance officers at East Coast fund management firms who spoke with FinOps Report, seven say they expect to take on the additional role of chief AML compliance officer, while the other three say their firms will hire a new director. None of the chief compliance officers wanted to discuss their level of readiness for a full-blown AML program other than to say they will rely on external legal counsel to prepare for any FinCEN rule.

Private fund management firms which want to get an early start on complying with the new regulations will have to begin with the basics. “Private fund managers must first determine whether they are covered by the new regulation,” says Charles Pine, a principal and AML compliance practice leader in the forensics, legal and compliance practice of consultancy BDO USA. “If so, they may already have a program managed by a parent firm or affiliate and if not, they will then have to figure out whether their current procedures match those required under the new FinCEN proposal.”

As drafted, FinCEN’s rule allows private fund managers falling under the jurisdiction of a bank or broker-dealer to rely on their programs. Fund management firms exempt from registering with the SEC are likely to strongly oppose falling under FinCEN’s new AML requirement and could end up being spared. So could foreign fund managers.

One critical factor that covered fund management firms must resolve is whether to continue using their fund administrators to do the AML work or to take the work in-house. Fund management firms which retain their fund administrators must still appoint an in-house AML chief compliance officer and assume legal liability even if the day-to-day tasks are completed through third-parties. The decision would then have to be made as to how to divide the responsibilities. “Private fund management firms would have to establish connectivity with their fund administrators so fund administrators would have the same real-time view of transactions necessary for determining whether SARs would need to be filed,” says Pine.

Filing a SAR requires more than just technical knowledge of the mechanics of submitting a report. An AML analyst at a private fund manager or its fund administrator would have to take a close look at any alerts issued by a transaction monitoring platform and determine whether there are sufficient grounds on which to file a SAR. An investigation might then be done to eliminate any false positives and a filing reviewed by more than just one analyst.

Whether a private fund management firm or its administrator would file a SAR remains to be seen. If a fund manager decides it is too risky to assign the task strictly to a fund administrator both may file SARs, leaving FinCEN with too many SARs with potentially incompatible information. “Defensive SAR filing is a real phenomenon. There is little risk in filing too many SARs, but firms are penalized for not filing a SAR,” says Mintz’s Adams. “Should a private fund manager decide to file a SAR on the same customer as the fund administrator there is no guarantee the information each reports separately would be identical.”

Fund managers will still have plenty of work to do even if fund administrators handle the bulk of AML tasks. “Fund managers will need to have greater oversight of their fund administrators and assign dedicated staff to do the monitoring,” says Kris Swiatek, an attorney with the law firm of Seward & Kissel in New York focused on investment adviser regulations. Fund managers already doing AML work might decide it isn’t cost- effective to outsource the effort given the need to maintain even closer interactions with their fund administrators. Those which rely on non-bank fund administrators might even be concerned about whether their fund administrator is up to doing the work.

Regardless of whether a private fund manager can adapt its existing AML program to FinCEN’s requirements or must create a new one, its new chief AML compliance officer will have to train existing compliance staff and submit his or her program to the rigors of “independent testing.” FinCEN says that testing can be done by an internal department not involved in managing the AML program or an external firm. Given that it is unlikely internal auditors at private fund management firms will have sufficient knowledge of AML regulations to conduct the appropriate testing, the task may have to be outsourced. That leaves AML compliance officers in the hot seat to prove they are doing the right job and to ask for an increase in their compliance budgets.

Using a fund administrator firm to do the AML work doesn’t relieve the fund manager from the responsibility for independent testing. Instead of the fund manager being subject to testing the fund administrator will. As FinCEN’s rule is currently proposed, a fund administrator’s certification that it is adequately running an AML program on behalf of a fund manager also won’t be enough to satisfy FinCEN.

Although FinCEN won’t prohibit the use of foreign fund administrators for US investment advisers, it cautions that such relationships will be subject to greater regulatory scrutiny because the practices of offshore fund administrators are not uniform.  They are based on local foreign requirements. FinCEN is seeking comment on the quality of AML compliance programs for foreign fund administrators and whether AML compliance officers at US investment advisers can adequately monitor them.

Without knowing how long it will take FinCEN to approve the new regulation, private fund managers are now left to wonder how quickly they should hire additional staff, do the necessary training and deal with who to select as an AML compliance officer. “Fund managers may decide to take intermediate steps before the final ruling occurs, which could mean relying on outsourced services or adding the title of AML officer to the chief compliance officer, if the chief compliance officer is experienced in AML compliance,” says Pine.

Private fund management firms could also have other worries down the road. FinCEN says it will impose know-your-customer due diligence requirements and reporting on the underlying or “beneficial ownership” of their client firms. As is usually the case for CCOs, meeting new regulatory requirements comes with the territory. “It’s all in a day’s work, or make that a day and a half squeezed into one day,” quips one CCO at a US private fund management firm.

If there is one saving grace for private fund managers, it is that implementation of any new AML rule could be delayed for quite some time. FinCEN has released 60 questions for feedback and there is expected to be plenty of pushback. “Fund managers, backed by their trade associations, could argue that there is no justification for the rule, and they will be overburdened with other compliance challenges,” says Richard Marshall, a partner at the law firm of Katten Muchin Rosenman in New York.

Among the new proposed regulations which fund managers will have to address are the SEC’s amendments to its “custody rule” to expand the types of assets for which a qualified custodian must be selected. The SEC has also proposed an “outsourcing rule” which requires fund managers to pay closer oversight to their third-party service providers. “Private fund managers shouldn’t fall into an immediate panic,” says Marshall. “They have already waited 22 years for an AML rule and there is no guarantee another 22 won’t go by before any change is made.”