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A Matter of Definition: U.S. Treasury Issues Anti-

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WASHINGTON (–The applicability of rules under the USA PATRIOT Act for hedge funds has now been more narrowly defined by the U.S. Treasury Department, with its issuance of a set of proposed rules yesterday.

Under these rules hedge funds are subject to the PATRIOT Act as a non-registered investment company and will be required to register with the Treasury department. The agency laid out essential elements that hedge funds would need to implement to meet anti-money laundering requirements.

The definition applies to hedge funds with more than US$1 million in assets and/or with lock-ups of two years or longer. The idea behind the lock-up requirement was that funds with longer lock-ups are less likely to be used in the “placement stage” of the money laundering process, according to the Treasury department.

“It’s a hidden risk, but at the end of the day can cause the collapse of the hedge fund,” James Harmon, founder of The Harmon Firm LLC, a company that performs due diligence, told hedge funds and institutional investors at an industry conference earlier this year. Hedge funds are an attractive refuge for money launderers since they are secretive, lightly regulated, have hefty minimums and are often offshore entities, Mr. Harmon said.

In its guidelines, the Treasury points out that a one-size-fits all approach to PATRIOT Act compliance won’t work for the industry.. Regardless, the Managed Funds Association released in April a set of generic guidelines for its hedge fund membership detailing “know-your-investor” guidelines and ways to set up an internal compliance program.

In setting up its guidelines, the Treasury worked closely with the staffs of the Securities and Exchange Commission and the Commodity Futures Trading Commission. The SEC reportedly has been investigating the hedge fund industry.

The Treasury’s proposed rules are asking hedge funds to implement policies, procedures and internal controls reasonably designed to prevent unregistered investment companies from being used to launder money or finance terrorist activities. Compliance programs will differ from company to company depending on each firm’s business structure, officials say in the proposal.

The agency also warns that investor and customer identification and verification under other areas of the PATRIOT Act may come to bear in the hedge fund industry. Implementation of that type of program may be delegated to outside hedge fund service providers such as prime brokers or fund administrators.

The second major guideline stipulates that a firm must provide independent testing for compliance to be done by company personnel or a qualified outside party. Third, an unregistered investment company will need to designate a person responsible for implementation and monitoring of the operations and internal controls of the compliance program. And last, ongoing training will be a must for the appropriate persons within the company.

Hedge funds may also be subject to registration with the U.S. Treasury. “Without a notice registration of some kind the Treasury would lack the means to examine for and enforce compliance,” the proposed rules state.

A registration statement would include a company’s name, address and contact information, the dollar amount of assets under management and the number of participants in the fund. Notice information will be required to be on file within the 90 days of the rule becoming final.

The proposed rules are just that, so the industry is expected to submit written comments within 60 days of the rules publication in the Federal Register. That publication may be as early as Friday, according to a Treasury spokeswoman.