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The Patriot Act's Anti-Money Laundering Rules: What Private Funds and Investment Advisers Need to Know

Client Advisory

May 14, 2003

The Patriot Act's Anti-Money Laundering Rules:
What Private Funds and Investment Advisers Need to Know

The USA PATRIOT Act of 2001 ("Patriot Act"),[1] intended to prevent and detect money laundering and funding of terrorist activities, will create enhanced compliance burdens for some private investment vehicles, and their sponsors and investment advisers.  Title III of the Patriot Act includes two provisions of potential concern to these entities: Section 352, requiring the establishment of an anti-money laundering program, and Section 326, regarding customer identity verification.

Section 352.  Section 352 of the Patriot Act requires covered "financial institutions" to establish anti-money laundering programs.  On September 18, 2002, the U. S. Treasury Department ("Treasury") issued a proposed rule that would apply Section 352 to (i) issuers that would be investment companies under the Investment Company Act of 1940 if not for Section 3(c)(1) or Section 3(c)(7) thereof, (ii) commodity pools, and (iii) companies investing primarily in real estate or interests therein.  According to the proposal release, this includes "hedge funds, private equity funds, venture capital funds, commodity pools and real estate investment trusts."[2] 

The proposed Section 352 Rule has two major exemptions applicable to some private investment vehicles, especially private equity and venture capital funds.

Most importantly, the proposed Section 352 Rule only applies to investment vehicles that permit an investor to redeem any portion of the investor's interest within two years of purchase.  Issuers of non-redeemable securities were excluded from the regulation on the rationale that illiquid investments are usually less useful to money launderers.  A typical private equity or venture capital fund does not permit investors to redeem any portion of their interests within two years of purchase and therefore would not be required to adopt an anti-money laundering program under the proposed Section 352 Rule.  Many private funds of other types (hedge funds, for instance) have far shorter minimum investment periods.

The second major limitation is that the proposed Section 352 Rule would apply only to funds that are organized in the U.S., that are organized, operated or sponsored by a U.S. person, or that sell ownership interests to any "U.S. Person" as defined by Regulation S.[3]  Thus, funds organized and operated offshore and sold strictly to non-U.S. Persons are not covered.

Funds subject to the proposed Section 352 Rule are required to develop and implement a written anti-money laundering program.  This program must be approved by the fund's board of directors or trustees, or, if it has none, then by its general partner, sponsor, organizer or similar person.  At a minimum, an anti-money laundering program under Section 352 is required to:

  • money laundering or the financing of terrorist activities;

  • Provide for independent testing of the anti-money laundering program;

  • Designate a person responsible for implementing and monitoring the anti-money laundering program; and

  • Provide ongoing training for appropriate persons. [4]

A fund required by the proposed Section 352 Rule to adopt such a program must file a prescribed form of notice with the Financial Crimes Enforcement Network (colloquially, "FinCEN") within 90 days of becoming subject to the rule.  A fund must also notify FinCen if it ceases to be subject to the rule.

A more recently proposed rule, issued by FinCEN on April 29, 2003, brings certain U.S.-based investment advisers within the purview of Section 352 of the Patriot Act, regardless of whether the funds they advise are covered.  Under this "Investment Advisers Rule," investment advisers are brought for the first time within the ambit of the Bank Secrecy Act, which does not by its own terms specifically apply to investment advisers.[5]

The Investment Advisers Rule applies to registered and unregistered advisers.  In both cases, the Investment Advisers Rule applies only to persons within the definition of investment adviser in the Investment Advisers Act of 1940 (the "Investment Advisers Act")[6] that currently have assets under management (regardless of whether the adviser's management authority with respect to such assets is discretionary).

In the case of investment advisers registered with the SEC under the Investment Advisers Act, the Investment Advisers Rule applies to those advisers that have their principal office and place of business in the United States.

In the case of investment advisers not federally registered, the Investment Advisers Rule applies only to those advisers that (i) have $30 million or more under management, and (ii) rely on an exemption from federal registration provided by Section 203(b)(3) of the Investment Advisers Act.[7] 

An adviser covered by the Investment Advisers Rule would be required to develop and implement an anti-money laundering program "reasonably designed to prevent the firm from being used to launder money or finance terrorist activities."  More specifically, the Investment Advisers Rule would require an anti-money laundering program to address the same four points required by to be addressed by the proposed Section 352 Rule and listed above.  The adviser's anti-money laundering program may exclude any pooled investment vehicle that is itself already subject to the Patriot Act's anti-money laundering requirements.

Because the applications of the proposed Section 352 Rule and the Investment Advisers Rule are keyed to different facts, there are instances where a private fund will be exempted from compliance with Section 352 but its adviser will not be.  This will be the case, for example, with most private equity and venture capital funds.  As noted above, these funds are often exempt from complying with the proposed Section 352 Rule because they typically do not permit investors to redeem their interests within two years of purchase.  An investment adviser to such fund may nonetheless be required to comply with the Investment Advisers Rule, if that rule's (different) criteria are met.

The proposed Section 352 Rule and the more recent Investment Advisers Rule are for the moment proposals only.  Thus, covered private investment vehicles and investment advisers are not yet required to comply, but these rules are fairly certain of adoption in the future.

Section 326.  Section 326 of the Patriot Act requires financial institutions to adopt procedures for verifying the identity of new customers.  Treasury and other agencies have issued proposed rules under Section 326 applicable to banks, trust companies, savings associations, credit unions, broker-dealers, mutual funds, futures commission merchants and futures introducing brokers.  While none of the foregoing proposed rules would apply to privately offered investment vehicles or their sponsors or advisers, such a rule may be proposed in the future. 

The proposed rules for the institutions named above do not require the collection of substantially more information about a customer than is already collected in the ordinary course of dealing with such customer.  In addition, the verification procedures required are no more than most such institutions typically perform at present. Thus, it is not anticipated that, if Section 326 is made applicable to such funds and their sponsors and advisers, the marginal compliance burden would be severe.


If you have questions about how to put together an AML compliance program for your firm, our staff will be pleased to assist you.  We have done this kind of work for other clients and have a model set of procedures that we can help you adapt to your specific needs.

For further information, please contact: Mary Joan Hoene, John W. Kaufmann, Robert A. McTamaney (212-238-8711), Andris J. Vizbaras (212-238-8698), Faith Colish (212-238-8873), Valentino Vasi, Anna Maria Vistica (212-238-8858), or Paulette B. Smith, Legal Assistant, Broker-Dealer and Investment Adviser Specialist, (212-238-8616).  All of our emails are lastname@clm.com.


Endnotes

[1]Public Law 107-56, codified at 31 U.S.C. §§ 5318, inter alia.  The acronym "USA PATRIOT" stands for "Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism."

[2] Proposed § 352 Rule, page 6.

[3] 17 C.F.R. § 230.902(k) .

[4] Proposed § 352 Rule, § 103.132(c).

[5] See 31 U.S.C. § 5312(a)(2) (2003).  The Bank Secrecy Act permits Treasury to enumerate, as it has done in this instance, additional types of businesses within the definition of financial institution.  31 U.S.C. § 5312 (2)(Y).  Treasury has done so in this instance solely for purposes of Section 352 of the Patriot Act.

[6] See 15 U.S.C. § 80b-2(a)(11), defining an investment adviser as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities."  The foregoing definition is subject to several exceptions.

[7] This section, codified at 15 U.S.C. § 80b-3(b)(3), exempts advisers that have had fewer than 15 clients in the preceding twelve months from the federal registration requirement if they do not hold themselves out generally to the public as investment advisers.  Investment advisers to pooled investment vehicles frequently fall under the exemption provided by Section 203(b)(3), since they often have only one client (the fund).  Some observers predict that Congress or the SEC, which have expressed interest in regulating private funds to a greater degree, may modify or eliminate Rule 203(b)(3)-1, which allows advisers to count a fund as a single client for purposes of this exemption.



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2014 Carter Ledyard & Milburn LLP.
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