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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 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.