WASHINGTON–Hedge funds are attractive vehicles to money launderers, according to a report released to Congress by the U.S. Treasury Department, Securities and Exchange Commission and the Board of Governors of the Federal Reserve System at the end of the year.
The report provides information on the various types of investment companies, registered and unregistered alike, and the regulations proposed and existing for each. While much of the document focuses on proposed regulations for mutual funds, hedge fund managers could find a brief glimpse into the Treasury’s reasoning behind its recommended anti-money laundering rules.
The biggest issues for the industry to date are questions concerning which funds should be required to comply and the ramifications of hedge funds becoming registered and regulated entities.
According to the Treasury’s release last fall, designation as an unregistered investment company for compliance purposes applies to hedge funds with more than US$1 million in assets and/or lock-ups of less than two years. The idea behind the lock-up requirement is 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.
In the report to Congress, regulators say that compared to the lock-up period imposed by other unregistered companies, such as private equity and venture capital funds, the lock-up period imposed by hedge funds is relatively short. Because money laundering has become more expensive (estimated to cost 8% to 10% of the amount of money being laundered), money launderers might be attracted to investing their assets for a limited period in a fund that generates a return rather than a loss.
The structure of hedge funds also means they could be more vulnerable to criminal activity, and this poses problems for U.S. regulators. Currently, in the case of hedge funds with no anti-money laundering compliance responsibilities, the hedge fund has no responsibility to determine the source of an investor’s funds or to analyze whether the source of these funds is questionable, according to the report.
Offshore hedge funds pose even more problems. The report stated, “The potential availability of ‘anonymous’ investment and the inability of law enforcement to obtain information about the beneficial ownership of the corporate entities in certain jurisdictions make this type of hedge fund particularly attractive to money launderers.”
Under the current proposed regulations, the Treasury is only extending the USA PATRIOT Act rules to funds that are organized in the United States, sponsored or organized by a U.S. person or sold to U.S. investors. The report stated that the Treasury’s proposed rules have a long jurisdictional reach to prevent money launders from easily shifting operations to a hedge fund organized in a jurisdiction that didn’t have adequate laws prohibiting money laundering.
The hedge fund industry was given until Nov. 25, 2002 to give its comments on the anti-money laundering regulations. And some are not pleased with the long reaching rules the Treasury is proposing for offshore entities. Officials at law firm Dechert Price & Roads in Washington expressed their concerns in a memo to the Financial Crimes Enforcement Network on Nov. 25.
Dechert, which works with a number of hedge funds both domestic and offshore, believes that the proposed rules could have an unintentional substantial effect on operators of U.S. unregistered funds and non-U.S. participants in the U.S. financial services industry. The firm said in its memo to FinCEN that the rules “…could have the effect of driving certain investment operations out of the United States (notwithstanding such funds’ compliance with strict anti-money laundering regulations imposed by other jurisdictions) or causing them to prohibit investments by U.S. persons.”
One of the other big questions remaining is who will ultimately have the authority to enforce the proposed Treasury rules. Stephanie Pries vice president and senior legal counsel, Managed Funds Association, a Washington-based lobbying organization, said at a roundtable discussion last year that by default the federal inspection authority would go to the Internal Revenue Service, but other agencies such as the SEC and the Commodity Futures Trading Commission could also be interested in compliance oversight.
Other snags also have yet to be addressed in the proposed anti-money laundering rules. As proposed, the regulations would also apply to offshore funds and administrators (if they have at least one U.S. investor). Also if the anti-money laundering responsibility were delegated to third parties, then those organizations would be subject to inspection of records even if they were located outside of the United States, Ms. Pries said.
The final anti-money laundering rules from the Treasury are not expected to be in place until later this year. The Treasury said in its statement on the Congressional report that it plans to issue further regulations consistent with the report’s recommendations in the near future.