Kirkpatrick & Lockhart LLP
ANTI-MONEY LAUNDERING
January 7, 2003
Treasury, Federal Reserve and SEC Submit Joint Report to
Congress on USA Patriot Act Application to Investment
Companies
On December 31, 2002, the Secretary of the Treasury,
the Board of Governors of the Federal Reserve
System, and the Securities and Exchange Commission
(“SEC”) jointly issued a report to Congress (the
“Report”) on the application of the USA PATRIOT
Act to investment companies. The Report covered
the following main topics:
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A review of registered investment companies
(e.g., mutual funds, “closed-end” funds and
unit investment trusts), the money laundering
risks they pose and regulations promulgated
with respect to them under the USA PATRIOT
Act;
A review of unregistered investment companies
(e.g., hedge funds, commodity pools, private
equity and venture capital funds, and real
estate investment trusts), the money
laundering risks they pose and regulations
promulgated with respect to them under the
USA PATRIOT Act; and
A brief summary of USA PATRIOT Act
regulations promulgated to date, as well as
recommendations for further regulatory action,
with respect to investment companies.
The Report also covers, among other things, the
evolution of the Bank Secrecy Act (“BSA”) as a tool
to combat money laundering and terrorist financing,
the codification of money laundering as a federal
crime, the stages of the money laundering process
and the use of investment companies in money
laundering.
The following are highlights from the Report.
REGISTERED INVESTMENT COMPANIES
Mutual Funds
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The Report reiterates that mutual funds were
required to have anti-money laundering
(“AML”) programs in place by July 24, 2002,
and that FinCEN and the SEC proposed
customer identification programs (“CIPs”) for
mutual funds in July 2002.1
The Report noted that the ready liquidity of
mutual fund investments makes them targets
for money launderers.
The Report recommends that mutual funds be
required to file suspicious activity reports
(“SARs”). The Report does not give a
timetable or any specifics for such a
requirement.
1 Under these proposed CIP regulations, a mutual fund would be required to establish procedures that would enable it to form
a reasonable belief that it knows the true identity of its customers. The proposed regulations define customer as any mutual
fund shareholder who opens a new account with the mutual fund and any person authorized to effect transactions in the
shareholder of record’s account with the fund. As part of the customer identification program, the mutual fund would be
required to collect certain information with respect to its customers, verify the identity of its customers and determine
whether a customer’s name appears on any list of known or suspected terrorists or terrorist organizations prepared by any
federal government agency and made available to the mutual fund. These proposed regulations were subject to substantial
comment and have not yet been finalized.
Kirkpatrick & Lockhart LLP
ANTI-MONEY LAUNDERING
Closed-End Funds
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The Report notes that closed-end funds
typically are not in a position to detect and
prevent money laundering because they do not
have direct account relationships with
investors.
The Report further states that purchases and
sales of closed-end fund shares are made
through broker-dealers or banks, which are
subject to AML regulations.
The Report states that closed-end funds do not
“appear to present a risk of money laundering
that would be effectively addressed by
subjecting them to additional regulations.”
The Report does not recommend new
regulations covering closed-end funds.
Unit Investment Trusts
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The Report states that “traditional” unit
investment trusts (“UITs”) are “entirely
creatures of their sponsoring brokerage firms,
which are already required by the BSA to
establish AML programs and report suspicious
transactions in connection with such entities.”
The Report further states that applying AML
rules to “traditional” UITs would not appear to
appreciably decrease a UIT’s risk of being used
for money laundering.
The Report also discusses UITs in the form of
insurance company separate accounts. The
Report notes that UIT sponsoring life
insurance companies would be required to
have AML programs under a rule proposed in
September 2002 and that another set of AML
rules applicable to the UITs would appear
“unlikely to increase protection against money
laundering.”
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The Report does not recommend new
regulations covering UITs.
UNREGISTERED INVESTMENT COMPANIES
The Report did not add significantly to the rules
proposed by Treasury on September 26, 2002
(“Proposed Rules”), regarding AML program
requirements for unregistered investment
companies.2 According to the Report, the Proposed
Rules were “carefully designed to balance the need
for a comprehensive national program to prevent
money laundering against the burdens imposed by
the BSA on business, including small businesses.”
The Report further states that the Proposed Rules’
“redeemability” requirement will likely have the effect
of excluding publicly traded real estate investment
trusts (“REITs”), a large number of special purpose
financing vehicles, and many private equity and
venture capital funds. Furthermore, according to the
Report, the jurisdictional reach of the Proposed Rules
was intended to prevent circumvention by shifting
money laundering operations to an offshore fund
organized in a jurisdiction without adequate AML
laws. The Report states that Proposed Rules’ notice
requirement will enable Treasury or its designee to
identify unregistered investment companies subject
to the rule and to monitor their compliance.
The Report recommends requiring unregistered
investment companies to establish CIPs, which
presumably will mirror those required for other
financial institutions, as discussed in footnote 1
above.
The following is a brief overview of the Report’s
conclusions regarding money-laundering risks posed
by hedge funds. The Report does not cite any
specific money-laundering risks with respect to
commodity pools, private equity and venture capital
funds and REITS.
The Proposed Rules define “unregistered investment company” as a company that (a) would be an investment company
under the Investment Company Act of 1940 (“1940 Act”) but for the exclusions provided for in sections 3(c)(1) and 3(c)(7)
of the 1940 Act, is a commodity pool or invests primarily in real estate and/or interests therein, (b) permits an owner to
redeem its ownership interest within two years of purchase of that interest, (c) has total assets as of the end of the most
recently completed calendar quarter the value of which is $1 million or more, and (d) is organized under the laws of a state or
the U.S., is organized, operated or sponsored by a U.S. person, or sells ownership interests to a U.S. person.
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ANTI-MONEY LAUNDERING
AML Risks of Hedge Funds
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According to the Report, among unregistered
investment companies, hedge funds may be the
most susceptible to abuse by money
launderers because of the liquidity of their
interests and their structure. The Report found
that, when compared to other unregistered
investment companies (e.g., private equity
funds and REITS), the lock-up period imposed
by hedge funds is relatively short.
The Report also found that the structure of
hedge funds makes them vulnerable to money
laundering. The Report noted, for example, that
the limited partner in a hedge fund could easily
transfer the proceeds of a crime into a hedge
fund without question as to the source of
funds, absent AML compliance
responsibilities. The potential availability of
“anonymous” investments, as well as the
inability of law enforcement to obtain
information about beneficial ownership of
corporate entities in certain jurisdictions, makes
certain types of offshore funds particularly
attractive to money launderers, according to
the Report.
The Report also noted (citing to the Report of
the President’s Working Group on Financial
Markets) that a significant number of hedge
funds have been established in offshore
financial centers that are tax havens and may
be engaged in or facilitating illegal tax
avoidance and other inappropriate activities.
USE OF INVESTMENT COMPANIES IN MONEY
LAUNDERING
The Report reviews the three stages of money
laundering: placement, layering and integration, and
sets forth examples of how a money launderer may
use an investment company at each stage. Such
examples include:
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Use of stolen/altered checks to establish an
account with an investment company;
Use of money orders and travelers checks in
structured amounts to avoid currency reporting
by the financial institution issuing such
instruments;
Purchase by money launderers of an initial
interest in an investment company with several
wire transfers, each in an amount under $10,000
from different banks and brokerage firms;
Use of investment company accounts by
money launderers to layer their assets by
sending and receiving money and rapidly
wiring it through several accounts and multiple
institutions;
Redeeming an interest in an investment
company originally purchased with illegal
proceeds and reinvesting the proceeds
received in another investment company;
Use of wire transfers, checks, cash, and money
orders to deposit money into an investment
account, followed by withdrawals from the
account on the same day or during the same
week; and
Purchase of an interest in an investment
company in the name of a fictitious corporation
or an entity designed to conceal the true owner.
Please contact Diane E. Ambler (202.778.9886,
dambler@kl.com) or Andras Teleki (202.778.9477,
ateleki@kl.com) if you have any questions or would
like further information.
Kirkpatrick & Lockhart LLP
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ANTI-MONEY LAUNDERING
Kirkpatrick & Lockhart LLP offers diverse experience in issues relating to money laundering. We can help
banking and diversified financial services clients assess their risk, establish and review compliance practices,
investigate potential weaknesses, perform internal investigations, and respond to regulatory inquiries and
enforcement actions while being sensitive to the privacy of each client and their customers through an
effective attorney-client privilege relationship.
In addition, we have established a website dedicated to issues relating to anti-money laundering regulatory
and legislative developments. The website is located at www.kl.com/aml/amlwrc. In addition to outlining
K&L’s enterprise-wide approach to assisting clients with money laundering compliance issues, the website
contains a resource center with over 100 carefully selected links to various informational resources on money
laundering. The resource center also includes a library of prior K&L publications on money laundering.
We invite you to contact one of the members of our cross-disciplinary anti-money laundering practice team
for additional assistance. You may also send general inquiries to antimoney@kl.com.
BOSTON
SAN FRANCISCO
Michael S. Caccese
D. Lloyd Macdonald
Stanley V. Ragalevsky
617.261.3133
617.261.3117
617.261.9203
Eilleen M. Clavere
mcaccese@kl.com
lmacdonald@kl.com Jonathan D. Jaffe
sragalevsky@kl.com David Mishel
415.249.1047
415.249.1023
415.249.1015
eclavere@kl.com
jjaffe@kl.com
dmishel@kl.com
Diane E. Ambler
Benjamin J. Haskin
Ronald A. Holinsky
Kathy Kresch Ingber
Henry L. Judy
Ivan B. Knauer
Rebecca H. Laird
Charles R. Mills
Michael J. Missal
Jeffrey B. Ritter
Francine J. Rosenberger
Robert H. Rosenblum
Ira L. Tannenbaum
202.778.9886
202.778.9369
202.778.9425
202.778.9015
202.778.9032
202.778.9468
202.778.9038
202.778.9096
202.778.9302
202.778.9396
202.778.9187
202.778.9464
202.778.9350
dambler@kl.com
bhaskin@kl.com
rholinsky@kl.com
kingber@kl.com
hjudy@kl.com
iknauer@kl.com
rlaird@kl.com
cmills@kl.com
mmissal@kl.com
jritter@kl.com
francine.rosenberger@kl.com
rrosenblum@kl.com
itannenbaum@kl.com
WASHINGTON, DC
HARRISBURG
Raymond P. Pepe
717.231.5988
rpepe@kl.com
310.552.5014
310.552.5061
310.552.5071
wbernfeld@kl.com
dschack@kl.com
wwade@kl.com
973.848.4014
alarocco@kl.com
212.536.4024
212.536.3941
212.536.4008
bkramer@kl.com
rmarshall@kl.com
lschechter@kl.com
412.355.6419
412.355.8333
hhackett@kl.com
mrush@kl.com
LOS ANGELES
William J. Bernfeld
David P. Schack
William P. Wade
NEWARK
Anthony P. La Rocco
NEW YORK
Beth R. Kramer
Richard D. Marshall
Loren Schechter
András P. Teleki
202.778.9477
ateleki@kl.com
Richard L. Thornburgh
202.778.9080
rthornburgh@kl.com
Robert A. Wittie
202.778.9066
rwittie@kl.com
PITTSBURGH
Heather Hackett
Mark A. Rush
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2002 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.