The US Treasury's Financial Crimes Enforcement Network is proposing to make rules to make investment advisors report to it for anti-money-laundering and terrorist financing purposes. This is not the first time that it has proposed to do so.

FinCEN proposes to subject investment advisors that are (or should be) registered by the Securities and Exchange Commission (SEC) to rules that it (and its parent, the US Treasury) issues under the Bank Secrecy Act 1970. This would put them on an equal footing with financial institutions, forcing them to send Currency Transaction Reports (CTRs, which have to be reported whenever an institution has to process a transaction of anything more than $10,000 – a figure chosen because that was the average American's annual earnings in 1970) off to the Internal Revenue Service's database in Detroit (to which FinCEN and other agencies have access) and to keep records relating to the transmission of funds. FinCEN is proposing to delegate its authority to examine investment advisors for compliance with these requirements to the SEC, whose 'examiners' (inspectors) have an appalling track-record of ineptitude. Comments from interested parties are welcome until 2 November.

Generally speaking, FinCEN wants investment advisors' AML controls to cover all their advisory activity, including advisory services that do not include the management of client assets; subadvisory services; and advisory services provided to real estate funds.

Some of the advisory services that investment advisors provide include portfolio management, financial planning, and pension consulting. An advisor, for FinCEN's purposes, might or might not have “discretionary authority” and might or might not manage assets on a discretionary basis. If it does, that means that it has the authority to decide which securities to purchase and sell for the client. An advisor also has discretionary authority if it has the leeway to decide which investment advisors to retain on behalf of the client. Last year, 11,235 investment advisors were registered with the SEC, reporting approximately $61.9 trillion in assets for their clients. Many advisors already work with financial institutions that do BSA-related reporting, e.g. when executing trades through broker-dealers to buy or sell client securities, or when directing custodial banks to transfer assets. Many of them, of course, are also affiliated with firms subject to the BSA.

'Regulation lite'

This is to be 'light touch' regulation in that FinCEN is not proposing to impose customer identification programmes or CIPs on its new victims-to-be, nor to subject them to the AML “programme requirements” provisions it began to plan last year to impose on other financial institutions. AML “programmes” there will nonetheless have to be.

It is section 352 Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act 2001 that calls for anti-money-laundering programmes which must include:

• the development of internal policies, procedures and controls;
• the designation of compliance officers;
• never-ending training regimes for employees; and
• independent audits to test them.

The 'CIP rule' of identity verification, rejected by the US Congress in 1999, was issued by seven federal financial regulators in 2005 under provisions smuggled rather opportunistically into section 326 USA PATRIOT Act just after the attacks on the World Trade Centre. Its aim is to give institutions the reasonable apprehension that the people they deal with are who they say they are. A person who becomes the co-owner of an existing deposit account is a “customer” subject to the CIP rule because that person is establishing a new account relationship with the bank. If if a parent opens an account for a minor, i.e. for someone who lacks legal capacity, the bank’s customer is held to be the parent. The CIP rule does not apply to any part of an American (or unAmerican) bank located outside of the United States.

FinCEN is not calling on investment advisors to send off suspicious transaction reports if doing so would go against the Investment Advisors Act 1940 or the wishes of the SEC, although it is hard to think of any instance where this might be the case.

The $5,000 threshold and other reporting rules-to-be

The proposal is to amend Chapter X of Title 31 of the Code of Federal Regulations. In particular, FinCEN wants to change or add section 1031.320 which governs reports by investment advisors of suspicious transactions, forcing every investment advisor to send FinCEN a report of any suspicious transaction "relevant to a possible violation of law or regulation." Any investment advisor could also send FinCEN a report of any suspicious transaction that it believes is relevant to the possible violation of any law or regulation, but FinCEN is not planning to insist on that. If the relevant bill goes through, a transaction will require reporting if it is conducted or attempted by, at, or through an investment advisor; if it involves or aggregates funds or other assets of at least $5,000; and if the investment advisor knows, suspects, or has reason to suspect that:

• the transaction involves funds derived from illegal activity or is intended to hide or disguise such funds;
• it has no business purpose or apparent lawful purpose;
• it is not the sort of transaction in which the customer in question would normally be expected to engage, and the investment advisor knows of no reasonable explanation for it having heard the customer's reasons.
• This last appears crucial for wealth managers, as vast numbers of transactions that high-net-worth individuals want to execute are unusual and quirky.

Two or more investment advisors might be obliged to report the same transaction under s1031.320, in which case no more than one report need be sent off by them and any other financial institution(s) involved in the transaction, as long as that report contains all relevant facts, including the name of each financial institution and the words ‘joint filing’ in the narrative section, and each institution maintains a copy along with supporting documents, if any.

The requirement for a programme

The so-called "AML programme requirement" that FinCEN wants to impose is to be flexible and based on risk. The idea is to give investment advisors discretion to design their programmes to meet the specific risks of the advisory services they provide and the clients they advise. For example, FinCEN reasons, large firms should follow policies, procedures and internal controls that centre on the responsibilities of the individuals and departments that carry out each part of their AML programmes, while smaller firms are likely to tailor their procedures to their simpler, more centralised organizational structures.

Subadvisory services

The proposal for FinCEN's new rule states that an investment advisor providing subadvisory services to a client should tackle these services in its AML programme and monitor such services for potentially suspicious activity. FinCEN acknowledges that in requiring an investment advisor to address the subadvisory services it performs for certain types of clients in its AML programme may result in some duplication of effort, such as when the primary advisor is subject to the proposed rule. The regulator is worried that there may be some instances in which an investment advisor provides subadvisory services to a client that has a primary advisor not subject to the AML programme and suspicious activity reporting requirements it is proposing, such as certain middle-sized advisors that do not meet the criteria for SEC registration.

Real-estate funds

The proposed rule seeks to require each investment advisor to make its AML programme cover the advisory activity it provides to any publicly or privately offered real estate fund. It does not require a real estate fund to establish and implement its own AML programme and does not provide for any explicit limitations or exceptions for the advisory activity provided to a real estate fund.

Types of customer

FinCEN has definite ideas about how an investment advisor’s AML programme may address the financial crime-related risks that certain types of advisory client present and indeed that certain advisory services present. It is concerned about:

• non-pooled investment vehicle clients (e.g. individuals and institutions, managed accounts);
• registered open-ended fund clients (thought to pose a low money-laundering risk);
• registered closed-end fund clients; and
• private fund clients/unregistered pooled investment vehicle clients.

FinCEN also harbours expectations for the risk-based approach regarding advisory services to "wrap fee programmes."

The advisory services provided to registered open-end fund clients, specifically mutual funds, are admittedly less risky than the advisory activities provided to other types of pooled investment vehicles, such as private funds and other unregistered pooled investment vehicles, because registered open-end investment companies are subject to the full panoply of the rules that FinCEN administers under the aegis of the BSA. The advisory activity provided to a closed-end fund also present a lower risk than other types of advisory activity. Purchases and sales of closed-end fund shares are executed through broker-dealers or banks, and these entities are already required to run BSA 'programmes.'

This brings us to private fund clients/unregistered pooled investment vehicles. An investment advisor that is the primary advisor to a private fund or other unregistered pooled investment vehicle is required to make a risk-based assessment of the money laundering and terrorist financing risks presented by the investors in such investment vehicles by considering the same types of relevant factors, as appropriate, as the advisor would consider for clients for whom the advisor manages assets directly, as discussed above.

Generally speaking, such an advisor should have access to information about the identities and transactions of the underlying or individual investors. FinCEN notes, however, that there may be a lack of transparency regarding the entities that invest in private funds and other unregistered pooled investment vehicles. Some vehicles, of course, may present lower risks than others, so FinCEN is not expecting any investment advisor to risk-rate the advisory services it provides to a pooled investment vehicle that presents a lower risk the same as it might rate the advisory services it provides to other types of pooled investment vehicles that may present higher risks for attracting crime.

If any of the investors in the private fund or other unregistered pooled investment vehicle for which the investment advisor is acting as the primary advisor are themselves private funds or some other type of unregistered pooled investment vehicles (an 'investing pooled entity'), the investment advisor will have to assess the AML/TF risks associated with these investing pooled entities using a risk-based approach. Investment advisors acting as primary advisors may provide advisory services to a private fund or other unregistered pooled investment vehicle that operates offshore. That is, investment advisors may advise a private fund or other unregistered pooled investment vehicle that may be organized in the United States or in a foreign jurisdiction, and interests in these pools may be offered to U.S. and/or foreign investors. In the rule FinCEN is proposing, regardless of offshore formation or offering, an investment advisor should apply the same policies and the procedures as discussed above to any private fund or other unregistered pooled investment vehicle for which the investment advisor provides advisory services.

Wrap fee programmes

In a so-called wrap fee arrangement or “programme,” investment advisory and brokerage execution services are provided for a single (i.e. 'wrapped', as in 'bundled') fee that is not based on the number of transactions executed in a client’s account. An investment advisory plan or "programme" under which all clients pay traditional, transaction-based commissions is not a wrap fee programme. Similarly, a programme under which clients' assets are allocated among mutual funds is not a wrap fee programme because normally there is no payment for brokerage execution.

Wraps are well-suited to the requirements of HNWs. Investopedia states: "The advantage of a wrap is that it protects you from overtrading. This is when your broker trades your account excessively to make more commission. Furthermore, because the broker gets a flat annual fee, then he or she only trades when it is advantageous to you. A traditional wrap typically requires an initial investment of at least $50,000 to $100,000."

In some instances, the sponsoring securities broker-dealer of a wrap fee programme may be dually registered as an investment advisor. FinCEN says that it expects such an investment advisor to address the money laundering or terrorist financing risks of the underlying clients in the so-called "programme." In other instances, the advisor may provide advisory services to a wrap fee programme that is sponsored by an unaffiliated broker-dealer and in such circumstances might have less access to information about investors and transactions, but it may still have access to enough information to help it spot money-laundering or other illicit activities.

The second attempt

We have been here before. It was in 2003 that FinCEN originally published a notice of proposed rule-making in the Federal Register, proposing to require certain investment advisers to set up AML programmes; after a very long pause, it withdrew the idea in 2007.

The old proposals contained a bifurcation between registered and unregistered advisors; since the passage of the Dodd-Frank Act 2010, the SEC now registers the latter and the distinction is moribund. The proposed coverage this time remains the same as previously.

Indeed, the sky is the limit for future coverage. As FinCEN notes in its notice of proposed rule-making, the next target for inclusion could be state-registered investment advisors.