The Biden administration’s proposed anti-money laundering rules will land hardest on private fund managers, but the industry may only be able to blunt the impact, not avoid it.
If adopted as written, the February 15 proposal from the Department of Treasury’s Financial Crimes Enforcement Network would require nearly all investment advisers, registered and exempt, to write, implement and enforce “risk-based” anti-money laundering programs tailored to their business models; to test those programs independently and regularly; to designate an AML officer, possibly someone who lives and works in the US; to train their staff on the firm’s AML policies; to conduct ongoing customer due diligence; and to track and file suspicious activity reports for transactions above $5,000.
The rules will cost up to $9.3 billion over the next 10 years, FinCEN’s regulators say in their proposal. Most of it will land on private fund managers. As written, the proposal affects more than 11,000 private fund advisers, more than half of them Securities and Exchange Commission-exempt advisers. In a report released the same day as its launched its money-laundering proposals, FinCEN says there is “a material risk investment advisers could be misused for illicit finance.” The biggest risk comes through exempt fund advisers. The next biggest risk comes through registered private fund advisers, FinCEN claims.
More rules are on the way. The February 15 proposal doesn’t impose know-your-customer requirements on investment advisers. FinCEN says that will come in a separate rulemaking notice, with the SEC. It also doesn’t require fund managers to gather data on the beneficial owners of their clients. Those are being developed separately, too. The new rules also wouldn’t apply to mutual funds, because they’re already subject to AML rules.
Back in scope
Under the Bank Secrecy and Patriot acts, FinCEN is allowed to require “financial institutions” to build, enforce, monitor and train their staff on anti-money laundering policies, to file suspicious activity reports and to comply with know-your-customer rules. Banks and broker-dealers have been subject to much more rigorous versions of the rules for two decades.
“Private funds managed by RIAs represented $284 billion in equity beneficially owned by non-US investors where the RIA did not know, and could not reasonably obtain information about, the non-US beneficial ownership…”
FinCEN risk report
Investment advisers have been exempt from those reporting requirements for two decades. It’s made the sector a conspicuous target, not just for corporate reformers, but for its cousins in the financial services industry.
“Coverage of investment advisers under the Bank Secrecy Act should help to promote trust and transparency in the American financial system,” the Bank Policy Institute said in a statement published immediately after FinCEN announced its new rules proposal, “and we strongly support this effort.”
FinCEN’s February 15 proposal would expand the definition of “financial institution” to include investment advisers. Regulators define an investment adviser as any “person who is registered or required to register with the SEC under section 203 of the [Investment] Advisers Act, or any person that currently is exempt from SEC registration under section 203(l) or 203(m) of the Investment Advisers Act.”
Money laundering is already a federal crime. It’s also a crime to do business with anyone on Treasury’s sanctions list. Sanctions, in fact, are subject to strict liability – those who break the law are guilty regardless of intent.
FinCEN’s proposal says it’s no longer enough for private fund managers not to launder money or help sanctioned oligarchs hide their cash; they must help authorities prevent money laundering, tax dodging and sanctions-evasion. It delegates much of FinCEN’s oversight to the SEC, which means that by the spring of 2025, private fund managers could well be answering questions about their anti-money laundering compliance as a routine part of their commission exams.
This is at least the fourth time this century that FinCEN has tried to expand anti-money laundering requirements to cover investment advisers. In the George W Bush years, FinCEN offered separate proposals, in 2002 and again in 2003, that would’ve covered registered and exempt fund advisers. Regulators scrapped those efforts in 2008, under industry pressure.
In 2015, FinCEN came back with a fresh rule proposal that would’ve applied only to registered investment advisers. That effort died on the vine after Donald Trump won the presidency in 2016.
Congress has occasionally picked up the anti-money laundering mantle. In late 2022, the so-called Enablers Act was stripped out of a defense authorization bill. It would’ve expanded Bank Secrecy Act regulations not just to investment advisers but also to trust companies, lawyers, art dealers and other “middlemen.”
Lawyers’ groups including the American Bar Association lobbied furiously against it, but the fact that the senator seen as most responsible for killing the bill – Pennsylvania Republican Pat Toomey – joined the board at Apollo Global Management months after the act died hasn’t helped private equity advocates’ messaging.
Industry’s answers
Private equity advocates are in a tough position here. Backers of the proposed rules have chipped away, down through the years, at funds’ central argument against the rules – namely, that the long-time horizons and illiquid structure of private equity investments don’t lend themselves to drug dealers, terrorists, tax cheats and others who need their cash cleaned quickly.
Russia’s invasion of Ukraine, followed by world sanctions on Russian oligarchs and, around the same time, by revelations in the Panama Papers that kleptocrats were using America’s markets as a place to park their ill-gotten gains, have given anti-money laundering advocates the cover they need to bring the rule proposal back. The Biden administration is the first in American history to declare “corruption” a threat to national security.
“The invasion of Ukraine has crystalized and brought a popular understanding about why money laundering is a threat to national security. We understand, as a country, that we have a dirty money problem,” says Erica Hanichak, director of government affairs for the FACT Coalition, a nonprofit group based in Washington, DC, that lobbies for financial reform. “It’s a pervasive threat in a sense that when advisers don’t have to answer these types of questions, they automatically become the attractive port-of-call for bad actors.”
In its risk report, FinCEN claims that American 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.”
Investment advisers, FinCEN claims, “and their advised funds, particularly venture capital funds, are also being used by foreign states, most 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.”
If industry doesn’t have an answer to all this, FinCEN claims, it’s because it hasn’t been forced to ask the right questions.
As of the fourth quarter of 2022, regulators claim in the risk report, “private funds managed by RIAs represented $284 billion in equity beneficially owned by non-US investors where the RIA did not know, and could not reasonably obtain information about, the non-US beneficial ownership because the beneficial interest was held through a chain involving one or more third-party intermediaries.”
Good news
The good news is, the new rule proposal, as radical as it may be in scope, is not all that radical in its principles.
Banks, broker-dealers and many fund administrators have been running anti-money laundering programs for decades. For that reason, fund managers that already use third-party administrators might be in the best position to implement any new rules, Lowenstein Sandler partner Rob Johnston says.
There is also an army of third-party consultants who have automated programs more-or-less ready to pour. (FinCEN’s proposal would allow fund managers to outsource their AML programs, but reminds them they’re ultimately responsible for any problems.)
“The registered investment advisers, many of them probably have concepts of this at least in their head, given that this is the fourth time we’ve seen something like this,” says Paul Tyrrell, a former senior FINRA and CFTC lawyer who is now a partner with Sidley Austin.
“You’re going to have an AML program. You’re going to have a sense of who your customers are. You’re not going to have some of the prescriptive requirements that you see with broker-dealers and others, but you’re going to have to have a better sense, from a risk standpoint, of who your customer is.”
After the 2015 proposal, many fund managers voluntarily adopted new anti-money laundering programs. Those voluntary programs may not be robust enough for funds to get through future exams, says Melissa Goldstein, a former FinCEN lawyer who is now a partner with Schulte Roth & Zabel.
“The industry as a whole does have anti-money laundering compliance procedures that they can rely on, but those industry practices are less than what will be required under this rule proposal,” she tells Private Funds CFO.
Bad news
The bad news is the new rules will be a heavy lift, especially for small private equity managers who don’t already have a third-party administrator.
The thorniest matter, experts agree, is likely to be the suspicious activity reports. That’s going to require fund managers to educate themselves quickly.
“The SAR itself isn’t that complicated. It’s basically a form you fill out,” Lowenstein’s Johnston says. “But to get to the position of filing a SAR, you have to be able to recognize a potentially troublesome transaction in the first place. If an investor comes in and out of the fund frequently or makes a subscription and then the next quarter makes a withdrawal, someone is going to have to be trained to recognize that as a potentially suspicious activity, and then it has to be escalated and analyzed.”
The next thorniest issue is likely to be the requirement that funds audit their AML programs, says Ross Delston, a lawyer and court-certified expert who concentrates his practice on anti-money laundering.
“The industry as a whole does have anti-money laundering compliance procedures that they can rely on, but those industry practices are less than what will be required under this rule proposal…”
Melissa Goldstein
Schulte Roth & Zabel
“The level of scrutiny from the SEC will be exponentially greater, and the expectations that all four pillars of an anti-money laundering program will be implemented, similarly increased,” Delston tells Private Funds CFO. “One pillar in particular, the need for a periodic independent AML audit, is often overlooked by RIAs with voluntary programs and should be a primary focus here.”
FinCEN says fund managers can do their independent testing in-house, so long as the people they designate to test the policies “are not involved in the operation and oversight of the program” and so long as the people are “knowledgeable” about how anti-money laundering is supposed to work. For practical purposes, that may require outsourcing, Delston says.
“The independent audit,” he says, “is the most painful and expensive part of an AML program. Painful because you have somebody independent looking at your program and who wants to deal with that? Expensive because if you’re like most managers you’re not going to have an audit department with expertise in AML. You have to go outside and go out of pocket to do it.”
Other open questions
FinCEN says it’s open, at least in principle, to changing its mind about some of the rules it’s proposing. Among the questions regulators ask in the rulemaking notice are whether exempt funds ought to be subject to the new rules, and if not, why not.
It’s also an open question about whether foreign fund managers will have to hire someone in the US to run their anti-money laundering programs, Schulte’s Goldstein says.
Delston, the AML expert, says whatever fund managers think about the new rule proposal, they probably shouldn’t count on it going away. That’s not just because of the what behind the moment, but the who.
“I wouldn’t bet against Andrea Gacki,” he says, referring to FinCEN’s newest director, a Treasury Department veteran. “It looks to me like she has taken a chainsaw to the logjam of proposed regs that have been piling up at FinCEN for the last 20 years or so. I’d say it was about time, but it never is.”
FinCEN will take comments on its rule proposal until April 15. You can do so here.
‘Who’s going to bear the burden of this?’
Industry’s reaction to the latest FinCEN proposal has been muted. The Investment Adviser Association said it “is concerned that the sweeping proposal, which will capture virtually all investment advisers regardless of risk or gaps in the current framework,” won’t accomplish its backers’ goals “because it lacks sufficient tailoring to the unique business models and risk profiles of investment advisers.”
“Adding these sweeping and duplicative requirements could unnecessarily burden advisers without providing significant additional benefit,” the association said.
Some industry advocates appeared to cautiously welcome the proposal.
“Alternative asset managers take AML issues seriously and maintain controls to guard against money laundering, including the use of fund administrators and other service providers that are keenly focused on preventing money laundering,” Managed Funds Association president and CEO Bryan Corbett said in an e-mail statement after FinCEN announced the rulemaking notice. “Private fund investments also typically are funded with assets from financial institutions subject to strong AML regimes. MFA looks forward to participating in the FinCEN comment process.”
If previous iterations of the February 15 proposal had critics, this one has skeptics. An air of inevitability has crept into some advocates’ voices.
“Obviously, this is an idea they keep coming back to, so I guess at some point it’s going to be a reality,” Lowenstein’s Johnston says. “I’m sure that this will play well in certain political corners. I think that what people don’t appreciate about this industry is that while there are certainly a lot of wealthy people, there’s also a lot of institutional money that’s supposed to make sure that fire fighters, teachers and police officers can retire comfortably. Who’s going to bear the burden of this?”
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