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USA PATRIOT Act Rules to Hit Offshore Hedge Funds
By James Shipton, Managing Director ComplianceAsia Consulting Pte. Ltd.

April 2003

Introduction

The U.S. Treasury has recently given notice of a proposed set of new rules, to be promulgated under the Banking Secrecy Act, that will directly and very shortly affect many offshore hedge funds. The new rules form a part of the new USA PATRIOT Act regulatory regime and are intended to promote the prevention, detection and prosecution of international money laundering connected with terrorism. They will require "financial institutions" (which will, practically speaking, include many offshore hedge funds - see below) to make a short filing with the U.S. Treasury containing basic information about the fund and its manager. In addition the rules will require an offshore fund to adopt an anti-money laundering program that, at a minimum, includes: (i) the development of internal policies, procedures and controls; (ii) the designation of an internal compliance officer; (iii) ongoing employee anti-money laundering training; and (iv) an independent review to test the sufficiency of the anti-laundering program.

We understand that the rules are to be promulgated shortly. Following promulgation offshore hedge funds caught by the regulations will have an extremely short 90 days period to comply with both the filing and compliance aspects of the regulations.

These proposed US legislative measures have a global reach and will significantly change the current regulatory regime for many offshore hedge funds. Offshore managers will soon find themselves the subject of a sophisticated set of US regulations overseen by US prosecutors and officials who have made no secret of the fact that they intend to immediately and aggressively enforce the new provisions and to take cases in legal gray areas to the courts early on to set the parameters of their powers.

Many Offshore Hedge Funds will be Caught by the New Regulations

The rules take an extremely broad definition what constitutes an applicable 'financial institution' so that it will attach to many offshore hedge funds. The new rules propose that a 'financial institution' will include offshore hedge funds when it (i) has one or more U.S. investors; or (ii) is sponsored or organized by a U.S. person. We expect that many offshore incorporated hedge funds would have at least one U.S. based investor. Accordingly a significant number of offshore hedge funds will have to comply with the new regulations should they wish to attract, or continue to attract, US investors.

The Filing Requirement

The US authorities have taken the view that, because there is little to no transparency for offshore hedge funds particularly at the US regulatory level, all funds caught by the regulations will have to make a short filing with the US Treasury within 90 days of the rule becoming effective. The filing will include information detailing:

  • Name and address of the fund
  • Name and address of the fund's manager and investment advisor
  • Name and address of the fund's designated anti-money laundering compliance officer
  • The US dollar amount of assets under management, and
  • The number of investors in the fund.

Any amendments to the details provided on the filing (other than the AUM or the number of investors in the fund) will have to be made within 30 days of any change.

The Anti-Money Laundering Program

The proposed rules will, by setting out minimum anti-money laundering standards, require funds to develop and implement anti-money laundering programs designed to prevent them from being used to unwittingly finance terrorist activities or launder illegal gains. Within the 90 day period following promulgation the relevant funds will be expected to have implemented the procedures and to be monitoring compliance pursuant to their internal regulations and the external regulations of the US Treasury.

The US Treasury also expects that a fund's individual anti-money laundering program be tailored to the particular circumstances of the hedge fund. The Treasury has explicitly said that a 'one-size-fits all' program is unsuitable. Accordingly, each fund will have to develop a written compliance program that is designed to take into account its size, location, activities, and risks or vulnerabilities to money laundering. The assessment of a fund's risks and vulnerabilities to money laundering will differ from fund to fund, particularly as some funds' geographical investor base may be more susceptible to money laundering than others. Moreover, some strategies (particularly those dealing in over the counter trades or off-market distressed debt purchases) may have increased potential exposure to money laundering transactions.

Written Policies & Procedures

Consideration of the Structure, Vulnerabilities & Risks of the Fund

The written compliance procedures will have to be approved in writing by the directors of the fund and they will have to clearly set out the details of the program including the responsibilities of the individuals and the departments involved. The development of the written procedures into an anti-money laundering manual will be no easy task. As mentioned above, the procedures will have to specifically consider the structure of the fund. We also expect that each program will have to account for the fund's structure, particularly the relationship between the management company (and often another advisory company) with the fund itself as well as with the custodian and administrator. Further structural complications will have to be considered when funds have in existence 'feeder structures' for investors in different jurisdictions (usually motivated by US tax considerations).

Assessing the Risks of Money Laundering by an Investor

The new regulations require that a fund consider the risk of money laundering by a new investor (including funds of hedge funds) by applying a risk based evaluation of relevant factors relating to the investor. These will include an analysis of the type of investor, the investment vehicle used, whether the investor has an anti-money laundering program and the terms of that program. We expect that this will mean that the fund will, as a part of the 'know your client' requirements of the anti-money laundering regime, have to review and assess the compliance procedures of each investor as well as identify any particular risk of money laundering. This is a potentially time consuming exercise that may require the use of external compliance support.

Responsibility as between a Fund, its Manager and Custodians

The US Treasury has recognised that hedge funds mostly conduct their operations through a range of vehicles and third-party providers, including investment managers, prime brokers (and secondary brokers), and administrators and custodians. It is also recognized that some elements of the compliance program will be performed by personnel of these other entities, in which case it would be permissible for a fund to contractually delegate the implementation and operation of those aspects of its anti-money laundering program to these (or perhaps other suitably qualified) entities.

Even though the rules contemplate and accept delegation of responsibilities between different entities, the fund remains ultimately responsible for the effectiveness of its compliance program. Moreover a fund, despite delegating the anti-money laundering tasks to the manager and the custodian (to the extent that it can), must take reasonable steps itself to identify potential money laundering risks as it bares ultimate responsibility. It would be prudent for the fund (and the manager) to appoint a specialist compliance firm to provide ongoing anti-money laundering support to the responsible officers of the fund to ensure that the requirements of the regulations are met.

The US Treasury is applying an extra-territorial web-like regulatory regime so that the offshore funds caught by the rules are required to be ultimately responsible for adherence to the new regulations. To this end the US Treasury has expressly stated that it would not be sufficient of a fund 'simply to obtain certification from its delegate that [it] had a satisfactory anti-money laundering program'.

Appointment of an Internally Designated Anti-Money Laundering Officer

In line with the US Treasury's wish that the fund be ultimately responsible for its anti-money laundering program, the fund must charge an individual or a committee with the responsibility of overseeing the anti-money laundering program. The appointed person(s) must have a working knowledge of the applicable US regulations and money laundering issues. The officer must be empowered with full responsibility and authority to develop and enforce the procedures in all aspects of the fund's operations. Fortunately the US Treasury recognizes that in smaller funds it will not be possible to have a dedicated full time compliance officer and the role could be tasked to an individual with other responsibilities. Nevertheless we understand that a dedicated anti-money laundering officer would be expected in larger funds with more sophisticated management structures.

Even though it is likely that a hedge fund's compliance program will be conducted by officer(s) of the management company, the fund's appointed compliance officer will remain responsible for the supervision of the overall program and the management company's performance in implementing the procedures. Given the structure of most fund companies, a practical solution to discharging this regulatory duty may be the appointment of an anti-money laundering officer who is both a director of the fund vehicle as well as being an employee, director or officer of the management company (where there is often an overlap in personnel). By having this dual role the appointed compliance officer could then discharge the responsibilities of both entities.

Periodic Compliance Reviews of Anti-Money Laundering Program

The rules also provide that periodic testing of the program must take place to ensure the program is functioning effectively. The reviews must be carried out by a person who understands the fund's money laundering risks as well as the applicable US regulations. The review may be undertaken by employees of the fund or its manager provided that those employees are not involved in the operation or supervision of the program. Given that many of offshore funds have limited resources this will mean that, in practice, the review will in most cases be carried out unaffiliated service provides.

The rules do not set out explicit review periods. Instead the frequency of compliance reviews will depend upon factors such as the size and complexity of the fund's operations and its perceived vulnerability to money laundering. We envisage that the US Treasury would expect a review, and resulting certification, at least annually.

Ongoing Anti-Money Laundering Training

The rules establish that on-going employee training is an integral part of the compliance program. The rules require that all employees of the fund and any affiliated advisers (which would capture fund management and advisory companies) must be trained in the applicable US regulations and be made aware of money laundering issues. Unfortunately the rules do not make explicit the level and frequency of the training. Instead frequency will depend on the particular responsibilities of the employees and the extent to which they are involved in securing new investors. Accordingly employees involved in the marketing of the fund will require more frequent and detailed training than pure investment officers or analysts. Nevertheless all employees are to be made generally aware of the relevant US regulations and money laundering issues.

We expect that, in practice, initial training in the new US regulations will need to take place at the same time as writing and implementing the compliance procedures (ie. Within 90 days of promulgation). We also expect that annual training sessions will, at a minimum, be considered necessary for a successful audit of the fund's anti-money laundering procedures. Any amendments to the regulatory regime will require updates to the procedures manual and may possibly warrant further training sessions.

The Practicalities of Writing & Implementing the Procedures

We expect that, because of the complexity of the procedures, the need for them to be prepared and implemented within a short time-frame and their need to be specifically tailored to the individual structure, investor base and strategy of each fund, it will be a complex and time consuming task. Accordingly, most funds will probably seek external professional advice in preparing and adopting these procedures. It is also likely that, in practice, the review and audit process will be performed by external professional service providers, especially where the manager runs a small team.

The regulatory nature of offshore hedge funds will very shortly change dramatically because of the global reach and the significant requirements of these US legislative measures. The new rules will mean that offshore hedge funds who currently have a US investor base, or who are seeking to secure US investors, have no choice but to adhere to the regulations in an extremely short period of time, particularly since the US authorities can be expected to vigorously enforce the new requirements. In order to quickly achieve compliance with the new rules managers are advised to seek the assistance of professional advisers versed both in the new US regulations and the sophisticated nature and structures of offshore hedge funds.

February 2003
ComplianceAsia Consulting Pte Ltd
in association with Eurekahedge Pte Ltd


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