FinCEN Proposes Significant Expansion of AML/CFT Obligations to RIAs and ERAs

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15-minute listen

Amy Caiazza, a Partner at Wilson Sonsini, came on the Vcheck podcast to discuss a new proposal by FinCEN that would see a significant expansion of AML / CFT obligations for Registered Investment Advisers, Venture Capital Advisers, and Private Fund Advisers. This could mean a significant addition to advisers’ obligations when screening potential investors. Here is a link to the recent alert that the firm published on the proposed rule as well as a link to Amy’s bio and contact information. Amy is leader of the firm’s fintech and financial services group, which is recognized as a leading U.S. fintech practice by Chambers FinTech.

A Recap of FinCEN’s Proposal

FinCEN is proposing major changes that would impact investment advisers as it relates to AML and KYC screening requirements. Historically, investment advisers have not been considered a financial institution and as such have not been subject to the same requirements placed on financial institutions by the Bank Secrecy Act for conducting AML and KYC screenings to prevent money laundering. FinCEN’s proposal would include both Registered Investment Advisers (RIAs) and Exempt Reporting Advisers (ERAs) within the same AML regime applied to financial institutions, requiring them to conduct their own AML screenings, institute the relevant policies and procedures, and notify FinCEN when they encounter suspicious activity. If passed, this proposal could create a significant burden on RIAs and ERAs as well as have other unintended consequences such as closing off the market to investors who do not have the resources to implement these changes.

While the risk posed by bad actors looking to exploit RIAs or ERAs appears to be low and despite that FinCEN has been unsuccessful at pushing through similar initiatives in the past, there does seem to be real momentum behind this proposal.

How Real is the Risk of Bad Actors Exploiting RIAs or ERAs?

The risk appears to be relatively low for several reasons.

  1. Usually when an asset manager is managing money there is another party such as an investment bank or broker involved in the money flow and those third-party institutions are already governed by the Bank Secrecy Act making an additional screening redundant.
  2. The assets managed by a private equity firm or a venture capital firm (Exempt Reporting Advisers) are extremely illiquid. Limited Partners invest in these funds and do not see a return on their investment for periods that can range from 5 – 7 years or more, so it is an inefficient way to launder money.

A Hypothetical Scenario

FinCEN is concerned that a bad actor such as a Chinese investor tied to the government would invest in a fund managed by a private equity or venture capital firm and potentially learn about sensitive technologies coming to market and that would in some way advantage the Chinese government. However, this is also not consistent with how ERAs operate where LPs are not involved in the day-to-day operations of a GPs portfolio company and usually are not being granted access to behind-the-scenes information that would not be publicly available anyway. Another issue with FinCEN’s proposal is that this scenario is more of a national security concern that is governed by CFIUS and is not related to AML.

How Prepared Are ERAs to Conduct Enhanced Due Diligence on LPs?

Most ERAs are doing a basic level of Know Your Customer (KYC) checks, which is required under the OFAC regime, but most do not have the procedures in place like a large asset manager to conduct enhance due diligence on Limited Partners or implement the measures that would be required should FinCEN’s proposal come to fruition. Additionally, the costs to implement these programs will be burdensome for ERAs particularly if they need to conduct deeper-dive diligence on an investor. Some things that ERAs can do to prepare themselves for future requirements could include:

  • Reviewing and enhancing the agreements they have with investors, such as the ERA’s ability to obtain information from investors such as confirming their identities and ultimate beneficial ownership.
  • Review the documentation they have required investors to submit in the past and consider if any more information needs to be submitted going forward to confirm their identifies and beneficial ownership.
  • Review and improve their record keeping processing because there is both civil and criminal liability associated with AML screening.
  • Consider contracting with third parties who specialize in the above areas to relieve some of the initial burden of these screenings and enhanced reviews.

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