EXPERT TALK
FUND RELATIONSHIP COMPLEXITIES: WHO ARE YOU
REALLY DOING BUSINESS WITH?
By Martin Woods
Ultimate beneficial ownership (UBO) is a high priority in compliance
matters, since it impacts the Know Your Customer (KYC) due diligence
process in the battle to counter money laundering and terrorism
financing. However, knowing who is managing your assets is as
important as knowing whose assets you are managing.
September 2015 saw litigation in Switzerland settled in favor
of investors1 in a case involving ‘investments’ made with Madoff
Securities. The issues of ‘who knows who’, ‘who knows what’ and ‘who
needs to know what’ were highlighted as critical requirements in the
management of funds, assets and wealth. This case revealed just
how deep and complex the fund management industry can be. Many
investors were previously unaware their funds and assets had in fact
been managed - or in the Madoff case, stolen - by a party who was not
known to them and who they had no idea they were dealing with.
Of course, this extended (and often broken) chain of knowledge runs
two ways: it is as important for asset/fund managers to know who they
are dealing with as it is for investors to know who is looking after their
funds, assets, interests and personal data. Some of this undoubtedly
conflicts with the legitimate commercial interests of certain fund
managers acting as middle men investing their clients’ assets and
funds into other funds. There is therefore a need for some reliance on
other parties within the chain, but what is this based on and how do the
parties know who they can rely on?
MADOFF
The fraudulent scheme operated by the now infamous Bernie Madoff
has become a case study for many who subsequently learned they too
had no idea where their own funds and assets were being invested. In
his desperate attempts to raise additional funds to keep his scheme
afloat, Madoff was in no position to be choosy; or to apply any form
of KYC process, any source of wealth determination or any source of
funds assessment. Madoff was in no position to say ‘No’ to anybody’s
money, all of which highlights the KYC risks within the industry of asset
management and the world of funds.
Many investors were horrified to learn their funds had been ‘invested’
with, or rather stolen by, Madoff. Many had never even heard of him and
were subsequently challenged as to how their losses had arisen. The
answer was through the fund of funds system and the feeder funds,
through which asset managers invest client funds and assets with
other funds. Thus, in relation to Madoff, many fund managers saw the
‘returns’ apparently being generated by Madoff funds and simply rode
on the back of the same. Of course, not all of the managers informed
their investors of this simple strategy, as to do so could risk investors
going directly to Madoff, by-passing the asset/fund manager and
taking away revenue, essentially doing away with the middle man.
FUND OF FUNDS
Many funds are entirely made up of funds contributed by other funds.
This model, sometimes referred to as a fund of funds, also incorporates
feeder funds, but within this fund management supply chain, who
knows who and who needs to know what? These supply chains are
often far longer than investors know or imagine. Logically, the chains
all start with the individual investors, but how can others be sure
these investors do not represent the interests of third parties and their
assets? In some instances, small but nonetheless substantially wealthy
groups pool their funds, but who are they? Who screens such persons
against sanction and PEP lists and confirms none of the individuals are
narco kingpins or despot leaders who have looted public reserves? This
can extend to unregulated family offices - after all, some current and
deposed PEPs have allegedly stolen, and subsequently wish to invest,
billions of US$ for themselves and their families.
In the majority of instances investors place their funds and their
confidence with an asset/fund manager, who is more often than
not regulated - hence the confidence. The investors are enticed by
the manager’s prior investment record and the proposals, which
are commonly set out within a prospectus or offering document.
The prospectus sets out the investment criteria, including KYC
requirements. Consequently, the prospectus can be an important
document for others within the supply chain. Many managers
outsource the actual KYC process to an administration agent and
ordinarily these agents are themselves regulated. The agents are
seldom exclusive and provide their services to a number of firms. It is
the agent who identifies the investor (normally by way of receipt of a
copy of a passport) and applies screening as referenced above. Fund
managers need to ensure the agent undertakes a risk assessment
of each individual investor and applies an appropriate level of due
diligence. Where necessary, the due diligence should assess the source
of wealth and determine the source of funds.
Once an investor has been approved, the length of the chain can extend
from fund to fund to fund and all along the chain the individual fund
managers need to know one of two things: the identity of the client
(to facilitate screening); or that one or more of the other managers
knows the investor and (perhaps through an administration agent) has
applied due diligence and screening.
Continued
1
http://www.reuters.com/article/2015/09/04/us-swiss-madoff-idUSKCN0R41PW20150904
The views and opinions expressed in this paper are those of the author and do not
necessarily reflect the official policy or position of Thomson Reuters.
EXPERT TALK | FUND RELATIONSHIP COMPLEXITIES: WHO ARE YOU REALLY DOING BUSINESS WITH?
COUNTERPARTIES
The chain extends when the fund managers make investments and
trade with counterparties to generate returns. Some fund managers
have prime brokerage relationships, through which they access and
trade with yet more counterparties. Of course the brokers themselves
need to be satisfied the fund manager knows the investors or that
adequate due diligence and screening have been performed. To reduce
costs and exploit better opportunities and potential returns, many
fund managers have multiple counterparty relationships to access
multiple markets, in order to trade multiple securities, currencies and
commodities.
CONCLUSION
The diversification of investments extends the chain and, logically,
increases the risk. The risk to be avoided is one of presumption that
someone, somewhere in the chain is undertaking the necessary KYC
due diligence and screening. In the event that, within the chain, there
is an administration agent or an outsourced KYC provider with a robust
process, a reliable service and a good reputation, the others in the
supply chain can leverage the same and transact with confidence.
AUTHOR BIO:
Martin Woods serves as the Head of Financial Crime for regulated transaction businesses within Thomson Reuters. He is an anti-money
laundering subject matter expert. As a former detective in the National Crime Squad, Martin investigated and arrested money launderers.
He is an innovator in financial crime and anti-money laundering systems and controls. Recently he advised upon the drafting of the
Global Policy and Standards for Thomson Reuters’ Org ID KYC Managed Service. He has previously been engaged by a number of parties,
including the United Nations to advise upon and support investigation and litigation strategies. He was called by the UK Parliament to
submit evidence to the Parliamentary Commission on Banking Standards in respect of the conduct and behaviour of bankers. He has
previously delivered training to the FSA on the subject of anti-money laundering and hedge funds.
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