The red flags of foreign investment—purposeful obfuscation and lack of a legitimate business purpose—are prominent in today’s media. Advisors of lower-market private equity funds must find the cacophony of public condemnation and scrutiny surrounding the Panama Papers and the more recent Paradise Papers disconcerting. Should advisors of lower-market funds be concerned about money laundering? Does a lower-market fund even have an obligation to adopt an anti-money-laundering program (AML program)? For purposes of this article, a “lower-market fund” shall be deemed to have less than $25 million in assets under management and is exempt from the Investment Company Act of 1940, and in connection with its offering did not utilize the services of either a broker or an investment adviser registered with the Securities and Exchange Commission (SEC).
The answer to the first question is simple. Money laundering is a crime under federal and state law, each of which provides for civil and criminal prosecution as well as significant penalties. Advisors to lower-market funds therefore have reason to be concerned. The answer to the second question requires a more thorough analysis.
Money Laundering Defined
Money laundering involves the purposeful concealment of the true origin of the proceeds of illegal activities and occurs when money from illegal activity is moved through the financial system in a manner to make those illegal funds appear to have been derived from legitimate sources. Money laundering involves three stages: placement, layering, and integration. “Placement” occurs when the cash is first placed into the financial system. “Layering” involves the creation of complex layers of financial transactions following the placement stage in order to distance the illegal proceeds from, and to hide, their criminal source. “Integration” occurs when the illegal funds, the true source of which has been obfuscated as a result of the “layering” process, now appear to be derived from a legitimate source.
The initial, primary deterrent to money laundering was the Currency and Foreign Transactions Reporting Act of 1970, commonly known as the Bank Secrecy Act (the BSA), at 31 U.S.C. § 5311, et seq. The BSA established the framework for anti-money-laundering (AML) obligations imposed on specified “financial institutions.” In addition, with the adoption of the U.S. Money Laundering Control Act of 1986, as amended, 18 U.S.C. §§ 1956, 1957 (MLCA), money laundering became a criminal offense under federal law. More recently, the federal authorities, particularly the U.S. Treasury (the Treasury), were provided additional weapons in the war on money laundering following the adoption of the Patriot Act (full name the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001). Section 361 of the Patriot Act also created the Financial Crimes Enforcement Network (FinCEN) as a bureau within Treasury. As noted on its website, “FinCEN’s mission is to safeguard the financial system from illicit use and combat money laundering and promote national security through the collection, analysis, and dissemination of financial intelligence and strategic use of financial authorities.”
Title III of the Patriot Act gave the Treasury the authority to impose significant AML requirements on “financial institutions.” Specifically, section 352 of the Patriot Act requires financial institutions to establish and implement an AML program and grants the authority to the Secretary of the Treasury (the Treasury Secretary), after consultation with the appropriate “Federal functional regulator” (as defined in section 509 of the Gramm-Leach-Bliley Act), to implement, administer, and enforce compliance with the BSA and all associated regulations, including prescribing minimum standards for AML programs required by the BSA. In 2014, the Treasury Secretary officially delegated to the director of FinCEN the authority to implement, administer, and enforce compliance with the BSA and all associated regulations under Treasury Order 180-01 (July 1, 2014).
Section 5312(a)(2)(Y) of the BSA authorizes the Treasury Secretary (i.e., the Director of FinCEN by delegation) to include additional types of businesses or persons in the definition of “financial institution” subject to the purview of the BSA so long as the Treasury Secretary (or the Director of FinCEN by delegation) determines that such businesses or persons are engaged in an activity similar to, related to, or that is a substitute for any of the “financial institutions” that are currently subject to the AML requirements imposed by the BSA. Thus, the director of FinCEN, as chief enforcement officer of the BSA, has broad latitude and discretion in enforcing the BSA and establishing its jurisdiction. As of the beginning of 2018, however, the director of FinCEN has not added any additional businesses or persons to the definition of “financial institutions” subject to the BSA. This should not be interpreted to mean that FinCEN has been idle. Acting under this delegated authority, FinCEN has issued regulations requiring financial institutions subject to the BSA to keep records, adopt and implement customer due diligence policies, and file reports on financial transactions in order to ensure that their operations comply with the BSA and to otherwise assist the authorities with the investigation and prosecution of money laundering and other financial crimes.
In addition, FinCEN has targeted two groups in particular since its establishment: (1) investment advisers registered with the SEC pursuant to the Investment Adviser Act of 1940, as amended (RIAs), and (2) loan and finance companies. FinCEN proposed in 2003 to amend the BSA regulations to require RIAs to establish AML programs, to establish minimum requirements for such programs, and to delegate FinCEN’s authority to examine RIAs for compliance with these AML requirements to the SEC at 68 Fed. Reg. 23646-23653 (May 5, 2003). FinCEN later withdrew its 2003 proposal after concluding, among other reasons, that RIAs already had to conduct financial transactions for their clients through financial institutions subject to the BSA regulations at 73 Fed. Reg. 65568-65569 (Nov. 4, 2003), and therefore they were not entirely outside the then-current BSA regulatory regime. Undaunted, FinCEN again proposed in September 2015 rules that would require RIAs to adopt and implement AML policies in order to comply with the BSA, but to date those proposed rules have not been adopted.
The other group that has come under FinCEN scrutiny is “loan or finance companies,” which ironically is already a grouping included in the definition of “financial institutions” subject to the BSA regulations. However, as even FinCEN has noted, the term “loan or finance companies” is not defined in any BSA regulation or FinCEN rules and has no legislative history. FinCEN partially addressed this definitional gap in 2002 by temporarily exempting loan and finance companies (and certain other categories of BSA-defined “financial institutions”) from having an obligation to establish AML programs under the BSA at 67 Fed. Reg. 21110-21112. In addition, FinCEN further addressed this definitional gap in February 2012 when it issued a final rule at 77 Fed. Reg. 8148-8160 defining nonbank residential mortgage lenders and originators (RMLOs) as “loan and finance companies” for purposes of the BSA, thereby subjecting them to the AML requirements of the BSA.
More important for lower-market funds, however, is what else FinCEN disclosed in its 2012 final rule; FinCEN noted that:
- the term “loan or finance company” “can reasonably be construed to extend to any business entity that makes loans to or finances purchases on behalf of consumers and businesses [emphasis added]” (i.e., not just consumer transactions, but also commercial transactions); and
- “the term ‘loan or finance company’ should be limited, at this time, to RMLOs, and that AML program and SAR requirements should be applied first to these businesses [i.e., RMLOs], and later—as part of a phased approach—applied to other consumer and commercial loan and finance companies [emphasis added].”
Therefore, even though lower-market funds are generally not required at this time to adopt an AML program because they do not currently fall within the definition of “loan or finance companies” for purposes of the BSA, FinCEN was very clear in 2012 that this is subject to change in the future.
FinCEN’s recent efforts to enforce the BSA have also gone beyond simply targeting RIAs and RMLOs. In May 2016, FinCEN issued final rules under the BSA at 81 Fed. Reg. 29398-29458 to clarify the customer due diligence requirements for “covered financial institutions,” which includes banks, brokers or dealers in securities, mutual funds, and futures commission merchants and introducing brokers in commodities. The 2016 final rules contain explicit customer due diligence requirements for those covered financial institutions and include a new requirement that such institutions identify and verify the identity of beneficial owners of legal entity customers, subject to certain exclusions and exemptions. The deadline for covered financial institutions to comply with these final rules is May 11, 2018.
Finally, FinCEN was particularly active in August 2017 when it issued:
(i) A Geographic Targeting Order (GTO) requiring U.S. title insurance companies to identify the natural persons behind shell companies purchasing high-end residential real estate in seven metropolitan areas. A GTO is an order issued by FinCEN under the BSA that imposes additional recordkeeping or reporting requirements on financial institutions or other businesses in a specific geographic area—in this instance, U.S. title insurance companies. The major U.S. geographic areas included in this GTO were the following: (1) all boroughs of New York City; (2) Miami-Dade County, Broward County, and Palm Beach County; (3) Los Angeles County; (4) three counties comprising part of the San Francisco area (San Francisco, San Mateo, and Santa Clara counties); (5) San Diego County; and (6) the county that includes San Antonio, Texas (Bexar County). However, most lower-market funds do not serve as title insurance companies, due in large part to the increase in federal consumer protection laws for residential mortgage loans following the adoption in July 2010 of The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. 111–203, H.R. 4173). Consequently, lower-market funds are generally not impacted by these GTOs.
(ii) An advisory encouraging (but not requiring) real estate brokers, escrow agents, title insurers, and other real estate professionals to voluntarily report suspicious transactions involving real estate purchases and sales.
Even though there is generally no AML program requirement currently imposed on lower-market funds, presumably competent and risk-adverse advisors to lower-market funds desire to avoid any involvement in money-laundering activities. So how do advisors to these funds protect themselves against money laundering? The answer is that they typically only seek (or maybe more aptly only have available) funding from either “family and friends” or from someone with whom one of the founders has a “preexisting, substantial relationship.” In other words, most lower-market funds have (consciously or unconsciously) their own unofficial “know-your-investor” policy in place.
Depending on the circumstances, however, more substantial policies and procedures may be warranted. In some instances, it may be prudent for an advisor to a lower-market fund to adopt and implement a formal AML program, which should include, at a minimum, the following:
- the development of written internal policies, procedures, and controls commensurate with the level of risk and reasonably designed:
- to identify and verify the investor; to identify and verify any beneficial ownership; to corroborate that the prospective investor has the requisite financial circumstances and sophistication; to corroborate that the prospective investor qualifies as an accredited investor; to corroborate that the lower-market fund or person acting on its behalf has sufficient information to make these determinations; and to corroborate that the lower-market fund or person acting on its behalf has made these determinations; and
- to allow the advisor to the lower-market fund to understand the true nature and purpose of each investor’s investment in that fund, including policies and procedures to detect and cause the reporting of suspicious transactions subject to 31 U.S.C. § 5318(g) (and the implementing regulations thereunder);
- the appointment of an AML compliance officer who is knowledgeable and competent on the regulatory requirements;
- an ongoing AML training program; and
- an independent audit function (generally done on an annual basis) to test the fund’s AML program.
In conclusion, a lower-market fund generally has no legal obligation to adopt and implement any specific AML program, but prudent advisors to such funds will ensure that their funds adopt and implement appropriate procedures and controls to avoid becoming an unwitting accomplice to money-laundering activities.