Poor defense


Given its underground nature, it's very hard to establish a clear picture of the scale of money laundering around the world. However, the International Monetary Fund has estimated that the aggregate total of the illegal practice globally could be somewhere between two and five percent of the world's gross domestic product (source: money-laundering. com).

Small wonder, then, that financial regulators are keeping a watchful eye on firms to make sure that measures are in place to prevent them becoming repositories of black market money. What's more, this watchful eye has burned a hole through the flimsy defence mechanisms erected by certain private equity firms.

On 8 August, the UK's Financial Services Authority (FSA) reported that it spent several weeks visiting 11 unidentified private equity firms to assess their compliance and anti-money laundering controls. Its findings were then sent in a letter to private equity firms around the UK. Although it reported some general compliance weaknesses – such as out-of-date manuals and insufficient controls on outsourcing – over half of all the key weaknesses it identified related to anti-money laundering procedures.

Three failings in particular were highlighted by the report:

  • ? Lack of knowledge: serious gaps in the knowledge of compliance officers and executives when dealing with the mass of legislation, FSA rules and industry guidance relating to money laundering.
  • ? Failure to make annual reports:FSA rules require a firm's Money Laundering Reporting Officer to make a formal compliance report each year to senior management. The FSA found some firms slow to complete reports, while others ignored the requirement completely.
  • ? Poor record keeping: some firms were unable to demonstrate that they had carried out all the checks they should have done. This is a potentially grave omission as a failure to keep proper records can in some instances be deemed a criminal offence.
  • The significance of the findings was expressed in a statement by British Venture Capital Association (BVCA) chairman Vince O'Brien, who said:?The FSA has a track record of bringing enforcement proceedings against firms where it believes that they have ignored important messages communicated by direct letters of this kind. In other words, member firms had better start complying now because the FSA clearly means business.

    Martin Webster, a partner at UK law firm Pinsent Masons who advises companies and their boards on corporate governance issues, says that the situation confronting private equity firms could soon become worse as a result of more complex guidelines. A few months ago, the JointMoney Laundering Steering Group (JMLSG) – a body setup by the British Bankers Association to provide money laundering guidelines for banks – began issuing specific advice to private equity firms. The JMLSG's ?Guidance Notes are due to be completely revised by the end of the year, with increased confusion likely to result.

    Given that the FSA has issued its own handbook on the subject [described by Webster as ?several feet thick?], as well as the additional existence of statutory requirements relating to money laundering procedures, private equity firms might well protest that, while they are keen to comply with the rules, it is nonetheless rather difficult to know where to begin.

    However, what is clear is that complexity will not be seen as an excuse for inaction, and punishment for non-compliance could be severe. ?The FSA could deliver sanctions in various ways, such as a public censure and consequent damage to a firm's reputation, the cancellation of a firm's FSA authorisation or the imposition of fines, says Webster. When the FSA found anti-money laundering procedures at certain UK banks to be lax a few years ago, some were handed ?seven-figure fines, says Webster. He warns:?The risk is the FSA are in ?let's make an example? mode, where they might levy a huge fine to make the point that this is an area firms need to spend a bit of time and resource on.?

    Webster says the actual danger of private equity being a conduit for illicit capital is fairly small – therefore, it is not surprising that banks came under the spotlight several years before the private equity industry. ?If you're a retail bank, the drug dealer on the corner will at some point try to put money through a bank account. It would take an extra level of sophistication to invest in a private equity fund, he contends. However, he adds that the prospect of receiving capital from ?elaborate setups that look like legitimate businesses but are a front for something else is not entirely farfetched.

    Besides which, what is at issue is the ability of private equity operations to devise and maintain appropriate defence mechanisms rather than the likelihood of a criminal mastermind sitting on an LP advisory board. Having identified shortcomings, the FSA will not let the matter drop: in its letter to UK private equity firms, it said it was ?planning a new round of visits to firms before the year end.?