Strike out – sec throws a curve ball – ftse global markets money laundering officer

Richard phillips, a partner of kirkpatrick lockhart LLP, supports moves by the US securities and exchange commission [SEC] to force hedge fund managers to register as investment advisers. “why exclude hedge fund advisers? They can have a significant impact on the market,” he says.

Existing rules require an investment adviser to register if it has more than $30m under management and more than 14 clients. A hedge fund counts as one client, no matter how many investors the fund has. The SEC proposes to change the definition so that advisers “look through” and count the hedge fund’s investors, which would capture most US-based advisers.

It doesn’t stop there. The proposed rule has extra-territorial reach. “if applied literally, a non-US manager operating a fund based in a non-US jurisdiction would have to register if it takes in US investors,” says michael tannenbaum, president of the hedge fund association and a partner of tannenbaum helpern syracuse hirtschritt LLP, “what if an adviser is already regulated by the financial services authority in the UK?Money laundering officer

there needs to be reciprocity.” he worries that non-US managers might not enter the US market. “I don’t think that’s good for the economy or investors,” he says.

Hedge fund advisers would have to file form ADV, which requires information about who controls the adviser, how much money it manages, fees and trading strategies. “they must make accurate and complete disclosures that are subject to SEC review and public scrutiny,” says richard phillips, “that’s an important discipline. And the SEC examines registered advisers on a regular basis.”

The industry opposes the idea and has rallied some important support. In testimony before congress, alan greenspan was sceptical that registration alone is worthwhile. Republican SEC commissioners paul atkins and cynthia glassman have also voiced doubts. But on march 5, SEC chairman william donaldson told a conference he favoured registration, forming a majority with democratic commissioners harvey goldschmid and roel campos, who support the proposal.Money laundering officer

“the SEC thought the fund management industry could handle the conflicts,” says richard choi, a partner of foley lardner LLP, “the mutual fund scandal has shown it can’t.”

Opponents say the SEC should not devote resources to protect the sophisticated investors who buy hedge funds. “about 90m american families own mutual funds,” says tannenbaum, “the number of accredited investors is much smaller. Given the relative numbers, they should be focusing on mutual funds.” the latest available internal revenue service data, for the year 2000, show 2.8m federal tax returns with adjusted gross income over $200,000, the threshold for accredited investors.

Phillips dismisses the idea that all hedge fund investors know what they are doing. “$5m net worth of investors are not necessarily sophisticated,” he says, “that’s just an ordinary doctor or lawyer in his later years.” people like that sometimes make $25,000-$50,000 investments without much investigation.Money laundering officer “they’ll do it on a tip from a friend. If it doesn’t work out, it won’t hurt them much,” phillips says.

“hedge funds are getting to the little guy,” says john auerbach, associate managing director and director of anti-money laundering services in new york at kroll, inc., “the investor base is increasingly institutions like pension funds or endowments, whose clients are not sophisticated.”

Hedge fund advisers argue that registration will let the camel’s nose under the tent and lead to further regulation. “absolutely right,” says phillips, “it will be gradual. It could be five or ten years before a full programme is in place, but disclosure regulation is coming.”

Phillips acknowledges that large investors need less protection, but the 1998 collapse of long term capital management showed that sophisticated investors do not always avoid disaster. “they can’t conduct an inspection,” he says, “even the fat cat investor would benefit from registration.”

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Advisers would have to register, but not the funds. “I think if hedge funds go mainstream, then funds themselves may have to register,” says choi, “but we’re a long way from that.”

The SEC wants to know more about an industry that is growing fast. “they can’t police something they can’t really see,” says auerbach, “they don’t have reliable information.”

The SEC is not the only regulator worried about hedge funds. Congress instructed the US treasury department to apply anti-money laundering rules under the bank secrecy act to all “financial institutions,” including investment advisers.

Money laundering has three phases: placement, when dirty cash enters the financial system, layering, a series of transactions that distances the money from its origin, and integration, when the money appears to have come from a legitimate source. Terrorist financiers use similar techniques to hide their identity even if the original money is legitimate.Money laundering officer hedge funds are not suitable for placement because they rarely handle investors’ cash, but money launderers could use investment advisers for layering or integration.

“the theory of anti-money laundering rules is that you have to apply them across the board because the money will move to where the holes are,” says alan sorcher, associate general counsel of the securities industry association.

“it is regulatory arbitrage,” says auerbach, “money launderers look for different standards, either within an industry or geographically.”

The proposed rules cover both registered advisers and unregistered advisers like hedge funds if they have $30 million or more under management. Advisers must have written procedures designed to prevent money laundering, designate a chief compliance officer, train their employees, and submit the procedures to independent testing.Money laundering officer

“they have to know their customers,” says betty santangelo, a partner at schulte, roth zabel LLP. “they must check where the funds are coming from. They have to monitor the OFAC list,” she says. The office of foreign assets control, which administers US sanctions, keeps track of targeted foreign countries, terrorists, international narcotics traffickers, and those engaged in weapons proliferation.

In a rare display of flexibility, the regulators allow organisations to tailor their procedures to the risks they face. “companies can say, ‘here’s the biggest vulnerability, that’s where I’ll focus my attention,’” sorcher says.

How far should the investigation go? “that’s the question all our clients ask, and I don’t have a good answer,” says auerbach, “it’s the flip side of a loosely-defined law. It’s the key subjective component.”

The rules require more scrutiny for any non-US source.Money laundering officer “foreign customers ratchet up the inquiry,” says sorcher, “foreign financial institutions even more so.”

The financial action task force on money laundering, an inter-governmental body that develops and promotes policies to combat money laundering and terrorist financing, maintains a list of non-cooperating countries. What should a hedge fund do if a middle eastern investor transfers money from a bank in london? “that doesn’t raise too many questions,” santangelo says, “local money laundering laws comply with FATF. You have to worry if the money’s coming from a non-cooperating country.”

Auerbach sees a risk in so-called “physically exposed persons”, corrupt foreign political figures, including not only prominent leaders but also lesser officials who may be relatively unknown. “they are tough people to track,” he says, “if their activity doesn’t jibe with what they say their business is, you may want to do more due diligence.” they can afford to be patient.Money laundering officer hedge funds’ limited liquidity may not deter peps who are still in office.

Independent testing verifies that firms follow their stated procedures. Examiners also look for frequent redemptions, investors who ignore early withdrawal penalties, and wire transfers to third parties, all common money laundering techniques. “there are really only two points of concern for hedge funds,” auerbach says, “when money comes in and when it goes out.”

Santangelo downplays that risk. “nobody expects much trouble with purchases and redemptions,” she says, “the identity of offshore customers is the main concern.”

The cost of an investigation depends on fund size, but auerbach says it runs to “tens of thousands” for kroll’s clients, who typically manage at least $500m. Most hedge fund advisers run lean organisations that hate to spend money unless it benefits the bottom line, but the risk of a damaged reputation far outweighs the cost.Money laundering officer “look at the mutual fund scandal,” auerbach says, “hedge funds have more to fear from appearing on the front page of the financial times, the new york times or the wall street journal than from regulators.”