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Volume 5, Number 7
February 16, 2012
Anti-Money Laundering
Do Hedge Funds 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,
Money Laundering Control Act of 1986, which set criminal
are hedge funds the perfect vehicle? Since 2001, regulators
penalties for money laundering, and the Bank Secrecy Act
and legislators have debated subjecting hedge funds to
of 1970 (BSA), a reporting statute aimed at banks. Section
anti-money laundering rules like those in place for banks,
326 of the Patriot Act required financial institutions to
broker-dealers and other financial institutions. Despite
collect specified information from entities seeking to open
the promulgation of specific rules and significant legislative
an account. Financial institutions were also required to
pressure, hedge funds remain largely outside the purview
comply with §352 by implementing anti-money laundering
of anti-money laundering regulations. Now, new moves
programs by April 24, 2002. Hedge funds were exempted
from U.S. financial regulators suggest that, after a decade
from the §326 requirements pending further study, and
of false starts, hedge funds may be brought into the fold.
exempted from §352 requirements until October 24, 2002.
The history of these proposed regulations sheds light on the
question of whether hedge funds even pose the kind of threat
Section 352 required the implementation of specific anti-
the rules were designed to ameliorate. This article provides
money laundering programs, ostensibly to assist in the war on
a comprehensive overview of U.S. anti-money laundering
terror. The programs were to include: (1) internal policies;
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
(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-
In response to the September 11, 2001 terrorist attacks,
Senator Jon Corzine was a main proponent of applying anti-
Congress passed, and President Bush signed into law, the
money laundering regulations to hedge funds, stating that
USA PATRIOT ACT (Patriot Act). Title III of the Patriot
hedge funds “are probably one of those places where you can
Act, the International Money Laundering Abatement and
[launder illicit money] most efficiently and anonymously.”
Anti-Terrorist Financing Act of 2001, imposed a host of antimoney laundering obligations on “financial institutions.”
Other commentators saw hedge funds as outside the
Title III altered existing law primarily by amending the
language of Title III. They looked to the BSA’s definition
©2012 The Hedge Fund Law Report. All rights reserved.
HedgeFund
The
The definitive source of
actionable intelligence on
hedge fund law and regulation
L AW R E P O RT
www.hflawreport.com
Volume 5, Number 7
February 16, 2012
of “financial institution,” which included broker-dealers and
The October 25, 2002 notice exempted hedge funds from
investment companies. Investment companies, according
creating anti-money laundering programs until final rules
to the Investment Company Act of 1940, do not include
were established.
hedge funds, which usually fall within select exemptions. The
conclusion drawn was that hedge funds would not be required
After further study, and with comments from regulatory and
to create anti-money laundering programs under §352.
industry participants, Treasury issued a report on the money
Though Treasury clearly supported regulation, time would
laundering risks of investment companies on December 31,
tell that hedge funds would remain beyond the anti-money
2002. The report discussed the perceived money laundering
laundering regulations.
risks of multiple types of investment companies, including
mutual funds, real estate investment trusts and hedge funds.
The Treasury Department’s Financial Crimes Enforcement
Treasury concluded that among the unregistered investment
Network (FinCEN) was charged with creating rules to bring
companies, hedge funds were likely the “most susceptible to
unregistered investment companies into compliance with Title
abuse by money launderers” because of their structure and
III. FinCEN administers anti-money laundering regulations
liquidity. The report concluded that the rules require hedge
under the BSA. The BSA grants Treasury, and thereby
funds to establish anti-money laundering programs, as §352
FinCEN, jurisdiction over “financial institutions.” Although
originally envisioned, and that the rules require hedge funds
hedge funds are not included in the existing definition, the
to implement the §326 customer identification collection
Treasury secretary may, in his or her discretion, add entities to
requirements.
the category of “financial institution.”
In April and May 2003, Treasury proposed further regulations
On September 26, 2002, FinCEN issued proposed rules
to implement the Patriot Act anti-money laundering
regulating unregistered investment companies. The
requirements. Treasury proposed regulations requiring
proposed rules would have subjected hedge funds to the
investment advisers to establish anti-money laundering
requirements of §352 and §326. Some hedge funds and
programs in line with the §352 requirements. The proposed
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
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
Treasury to continue to study what risks, if any, were posed
After the flurry of activity in 2002 and 2003, culminating
by hedge funds and other unregistered entities before setting
in proposed regulations that would have imposed anti-
out anti-money laundering requirements for such entities.
money laundering compliance requirements and customer
©2012 The Hedge Fund Law Report. All rights reserved.
HedgeFund
The
The definitive source of
actionable intelligence on
hedge fund law and regulation
L AW R E P O RT
www.hflawreport.com
Volume 5, Number 7
February 16, 2012
identification data collection requirements on hedge funds
banks, for their financial and monetary activities, they are not
and investment advisers, the proposed regulations still
completely unregulated as regards money laundering. Others
remained proposals in 2007.
have offered different explanations.
In 2007, Senators Carl Levin, Norm Coleman, Ken Salazar
A FinCEN agency spokesperson, William Grassano, indicated
and Sheldon Whitehouse, as well as then-Senator Barack
that FinCEN was prioritizing issues and that hedge fund anti-
Obama, proposed a bill that, among other things, aimed to
money laundering rules were simply not on the top of the
force Treasury to adopt the regulations proposed in 2002 and
list. The re-prioritization came on the heels of then-Treasury
require hedge funds to implement anti-money laundering
Secretary Hank Paulson’s push for effectiveness and efficiency
compliance programs. The bill, S.681, died in the Senate
in the department. With FinCEN’s limited resources,
Committee on Finance. Senator Charles Grassley proposed
oversight of hedge funds would be inefficient considering the
a bill to require hedge fund managers to register under the
potential difficulties of laundering money via a hedge fund.
Investment Advisers Act of 1940, a step in requiring antimoney laundering regulations. That bill died in the Senate
Other possible explanations have been floated by
Committee on Banking, Housing and Urban Affairs.
commentators. Some viewed the regulations as simply “stale,”
and lacking a necessary impetus for passage. In this view, the
Having languished for six years, the proposal to apply anti-
original proposed regulations were a response to the panic
money laundering programs to unregistered investment
of the moment, but as time went on and no hedge fund
companies, investment advisers and others was withdrawn
money laundering scandal occurred, there was no longer a
by Treasury on November 4, 2008. 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
Hedge Fund Law Report, Vol. 1, No. 1 (Mar. 3, 2008).
Why the Withdrawal and Delay?
Why, after six years languishing un-enacted, did Treasury
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.
decide to withdraw the proposed rules? And for that matter,
what caused the delay? Neither answer is clear. In its entry to
There is also a perhaps more fundamental reason the
the Federal Register, Treasury provided one possible reason for
regulations did not move forward: the risk simply wasn’t
the withdrawal, noting that since investment advisers, hedge
there. Terror groups may find hedge funds too risky or too
funds and similar entities must use regulated entities, such as
illiquid to be of real use. Terrorists requiring money on an
©2012 The Hedge Fund Law Report. All rights reserved.
HedgeFund
The
The definitive source of
actionable intelligence on
hedge fund law and regulation
L AW R E P O RT
www.hflawreport.com
Volume 5, Number 7
February 16, 2012
as-needed basis would be unlikely to lock up cash in a hedge
comply with anti-money laundering provisions. For coverage
fund because of typical hedge fund provisions restricting
of that speech, see “FinCEN Working on a Proposed Rule
redemptions. See, e.g., “What Are Hybrid Gates, and Should
That Would Require Investment Advisers to Establish
You Consider Them When Launching Your Next Hedge
Anti-Money Laundering Programs and Report Suspicious
Fund?,” The Hedge Fund Law Report, Vol. 4, No. 6 (Feb.
Activity,” The Hedge Fund Law Report, Vol. 5, No. 4 (Jan.
18, 2011). In addition, existing regulations requiring hedge
26, 2012). Regulating unregistered entities such as hedge
funds to investigate their investors to determine suitability,
funds could be next.
and check the identities of investors against the Office of
Foreign Assets Control database, would require significantly
Changes in the financial regulatory framework after the
more disclosures from would-be launderers than one would
Dodd-Frank Act and the implementation of that Act by
expect them to be willing to provide. Contrary to the view
SEC rules have altered the environment for new anti-money
espoused in Treasury’s October 25, 2002 report, hedge funds
laundering regulations. Commentators have noted that while
are simply not a good vehicle for money laundering.
investment advisers are not listed under the BSA’s jurisdiction,
they can be added by the Treasury secretary. Freis’ remarks
In the wake of the withdrawn proposed rules, Senator
have led some to wonder whether this will herald a new
Levin, this time with Senator Grassley, attempted another
aggressiveness by FinCEN in rulemaking regarding anti-
legislative response. Senator Levin introduced the “Hedge
money laundering regulations.
Fund Transparency Act,” S. 344, on January 29, 2009,
which would have, among other things, applied anti-money
Director Freis’ remarks suggest that a decade after the Patriot
laundering compliance duties to hedge funds. See “Levin and
Act, Treasury may finally be prepared to put in place rules
Grassley Introduce Bill that would Require Hedge and Other
requiring hedge fund compliance with anti-money laundering
Private Funds to Register to Avoid Regulation as Investment
requirements. A separate takeaway from the history of these
Companies,” The Hedge Fund Law Report, Vol. 2, No. 5
regulations is that despite FinCEN’s report that hedge funds
(Feb. 4, 2009). The bill died in the Senate Committee on
posed a significant risk of money laundering, the regulations
Banking, Housing and Urban Affairs. With that, the idea of
themselves were allowed to languish for six years, and then
applying anti-money laundering rules to hedge funds ended –
were repeatedly rejected. The history raises serious questions
at least for a while.
about whether hedge funds pose a money laundering threat in
Regulations Resurrected
the first instance, and about how effective any new regulations
will be in combating money laundering generally.
James Freis, Jr., Director of FinCEN, resurrected the
possibility of applying anti-money laundering rules to hedge
Michael B. Himmel is a Member of Lowenstein Sandler PC and
funds in a speech to the American Bankers Association on
Chair of the firm’s Litigation Department and the White Collar
November 15, 2011. Director Freis indicated that FinCEN
Criminal Defense Practice Group. Himmel has developed a national
was revisiting the topic of requiring investment advisers to
practice in white collar criminal defense in matters involving tax
©2012 The Hedge Fund Law Report. All rights reserved.
HedgeFund
The
L AW R E P O RT
www.hflawreport.com
The definitive source of
actionable intelligence on
hedge fund law and regulation
Volume 5, Number 7
February 16, 2012
fraud, securities fraud, the Foreign Corrupt Practices Act, political
convictions of a New Jersey state senator, a former speaker of the New
corruption, antitrust, bank fraud, and environmental matters. His
Jersey Legislature and a number of union officials.
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
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
served as an Assistant U.S. Attorney for the District of New Jersey.
class actions and shareholder derivative suits. He regularly conducts
During his years as a federal prosecutor, Himmel successfully prosecuted
internal investigations on behalf of corporations and board committees,
numerous high visibility white collar criminal cases that resulted in the
and also represents individuals in connection with such investigations.
©2012 The Hedge Fund Law Report. All rights reserved.