The USA Patriot Act and Private Equity Funds

2. the designation of a compliance officer;

3. an ongoing employee training program; and

4. an independent audit function to test programs.

31 U.S.C. '5318(h)(1).

Section 5318(h)(2) of the BSA allows the Secretary of the Treasury to prescribe minimum standards for the anti-money laundering programs set out in Section 5318(h)(1) and to exempt certain financial institutions not otherwise subject to BSA regulation.

The definition of a “financial institution” under the BSA includes an investment company; however, the term “investment company” is not defined in the BSA or any rule adopted by either the Treasury or the Financial Crimes Enforcement Network (FinCEN), the division of the Treasury responsible for some of the regulations under the Patriot Act. The Investment Company Act of 1940 (1940 Act) does define the term, and subjects registered investment companies to regulation by the SEC.

A. Temporary Exemption for Investment Companies (other than mutual funds)

In April 2002, FinCEN issued an interim final rule governing investment companies that are “mutual funds.” By separate interim rule effective November 6, 2002, the Treasury temporarily exempted investment companies (other than mutual funds) from having to establish anti-money laundering programs. Anti-Money Laundering Programs for Financial Institutions, 67 Fed. Reg. 67,547 (Nov. 6, 2002) (codified at 31 C.F.R. '103.170). Specifically, 31 C.F.R. '103.170 provides, in part:

'103.170 Exempted anti-money laundering programs for certain financial institutions:

* * * * *

(b) Temporary exemption for certain financial institutions.

(1) Subject to the provisions of paragraph (c) and (d) of this section, the following financial institutions (as defined in 31 U.S.C. '5312(a)(2) or (c)(1)) are exempt from the requirement in 31 U.S.C. '5318(h)(1) concerning establishment of anti-money laundering programs:

* * * * *

(xii) Investment company.

* * * * *

(c) Limitation on exemption. The exemptions described in paragraphs (a)(2) and (b) of this section shall not apply to any financial institution that is otherwise required to establish an anti-money laundering program by this subpart I.

(d) Compliance obligations of deferred financial institutions. Nothing in this section shall be deemed to relieve an exempt financial institution from its responsibility to comply with any other applicable requirement of law or regulation, including title 31 of the U.S.C. and this part.

31 C.F.R. '103.170 (67 F.R. 67,546 Nov. 6, 2002; 67 F.R. 68935, Nov. 14, 2002).

The limitation set out in Section 103.170(c) above mentions that the exemption does not apply to any financial institution otherwise required by subpart I to establish an anti-money laundering program. Subpart I currently requires the following financial institutions to establish anti-money laundering programs:

• Financial institutions regulated by a federal functional regulator or a self-regulatory organization, and casinos (31 C.F.R. '103.120);
• Money services businesses (31 C.F.R. '103.125);
• Mutual funds (31 C.F.R. '103.130); and
• Operators of credit card systems (31 C.F.R. '103.135).

Accordingly, the temporary exemption should apply to unregistered investment companies that are otherwise not required to establish and maintain an anti-money laundering program.

B. The Proposed Rule for Unregistered Investment Companies

On September 26, 2002, FinCEN issued a proposed rule “Anti-Money Laundering Programs for Unregistered Investment Companies”, 67 Fed. Reg. 60,617 (proposed Sept. 26, 2002). The proposed rule would define an “investment company” to include certain investment vehicles not subject to regulation under the 1940 Act and require these entities to establish anti-money laundering programs similar to the guidelines FinCEN established for mutual funds.

1. Definition of unregistered investment company

The proposed rule defines “unregistered investment company” as follows:

1. an issuer that, but for the exclsions provided in sections 3(c)(1) and 3(c)(7) of the 1940 Act, would be an investment company under the 1940 Act (Section 3(c)(1) excludes from the definition of “investment company” any issuer that is not engaged in or proposing to engage in a public offering and whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons. 15 U.S.C. '80a-3(c)(1));

2. a commodity pool; and

3. a company that invests primarily in real estate and/or interests therein.

67 Fed. Reg. 60,617.

This definition would include several types of investment companies not registered under the 1940 Act, including private equity funds, hedge funds, venture capital funds, commodity pools and real estate investment trusts (REITs).

2. Limitations

(a) Redemption rights

Under the proposed rule, the definition of “unregistered investment company” would include “only those companies that give an investor a right to redeem any portion of his or her ownership interest within two years after that interest was purchased.” As stated in the proposed rule, this redeemability requirement is likely to exclude entities that require lengthy investment periods without the ability to redeem assets, including many private equity and venture capital funds, private REIT's and a large number of special purpose financial vehicles. The reason for structuring the rule with this redeemability limitation may be explained by FinCEN's note in the proposed rule that private equity funds “are not likely to be used by money launderers.” FinCEN had requested comment on whether the two-year period should be longer or shorter.

As it pertains to an unregistered investment company, the redemption limitation raises two questions: 1) does allowing the manager of the investment company the sole discretion to redeem an investor's investment constitute giving the investor the right to redeem; and 2) does allowing transfers to a third party constitute a right to redeem?

(1) Redemptions of Investors at Sole Discretion of Fund Manager

An investment company will often have the right to unilaterally redeem an investor's investment. While this does not specifically appear to give an investor a right to redeem so as to fall within the proposed rule, the proposed rule is unclear whether it means that the investor has to be specifically given the right to demand a redemption or if it includes situations where there is even a possibility of redemption within the first two years of the investment period. Since the proposed rule is unclear as to the meaning of the “right to redeem,” one protective measure is to provide that the discretion of the manager to redeem an investor's interest cannot be exercised until two years after the date of the purchase of the investment.

(2) Transfers to Third Parties

While the proposed rule focuses on whether the investor has the right to “redeem,” it does not mention the ability of an investor to transfer its ownership to another party inside the two-year period from the date of purchase of the investment.

To bolster an argument that the right to redeem does not include transfers to third parties, footnote 16 to the proposed rule states that if the unregistered investment company “permits an owner to redeem,” the proposed rule would apply regardless of whether its investors have the opportunity to (or do) sell the fund's securities in secondary market transactions. It goes on to state: “[t]he existence of an informal or formal secondary market for the fund's securities would not affect the applicability of the definition.”

Further, on December 31, 2002, the Secretary of the Treasury, the Board of Governors of the Federal Reserve System, and the Securities and Exchange Commission submitted a joint report to Congress regarding effective regulations to apply to investment companies. The report noted that private equity funds are long-term investments that provide little, if any, opportunity for investors to redeem their investments. The report went on to note that there is not a formal secondary market for shares in private equity funds, but a small informal secondary market that consists of private equity funds buying interests in established funds. The report also mentioned that in 1999 five private equity funds raised $1.6 billion for purchases of secondary interests in other private equity funds.

In contrast, however, and to support that the right to redeem does include transfers to third parties, an article discussing the proposed rule was published in October 2002 after the rule's release but before the December 2002 report to Congress. The article mentioned informal discussions with Treasury staff on the meaning of “right to redeem”:

Based upon informal discussions with Treasury staff, however, it appears that Treasury may be considering construing redemption more broadly to include the right of an investor to transfer or sell an interest in the fund to another investor in the fund or to a third party.

Amy R. Rudnick & Linda Noonan, “Treasury Issues Proposed Regulations Requiring Anti-Money Laundering Programs for Unregistered Investment Companies,” at www.gdclaw.com/practices/publications/detail/id/619/?pubItemId=6715 (October 10, 2002). The article also noted that because many real estate partnerships and private equity funds generally permit investors to transfer their interest to third parties, such an interpretation would expand substantially the coverage of the proposed rule and undermine the exception. It is important to note, however, that the report to Congress was issued after the article mentioned this possible expansion of the definition. The report made no mention of the inclusion of such transfers in the meaning of “right to redeem.” Further, the fact that the report acknowledged the existence of secondary markets, yet made no attempt to say that transfers in these secondary markets were a significant concern or were to be construed within the meaning of the proposed rule, leads to a possible conclusion that such transfers would not be considered as a “right to redeem.”

(b) Minimum assets

The proposed rule would not apply to companies that, as of the most recently completed calendar quarter, have total assets of less than $1,000,000. FinCEN has requested comment on whether this minimum threshold is appropriate.

(c) Offshore funds

The proposed rule contains a jurisdictional limitation. The definition of an “unregistered investment company” includes only an entity:

1. that is organized in the United States;

2. sells ownership interests to a U.S. person (as defined in 17 CFR 230.902(k); or

3. is organized, operated, or sponsored by a U.S. person.

3. Exceptions

There are a number of entities that are excepted from the “unregistered investment company” definition:

1. companies owned by one family without regard to the amount of assets owned by the companies;

2. employee securities companies, which are investment companies established by employers for the benefit of the employees; and

3. employee benefit plans that are excluded by CFTC Rule 4.5(a)(4) from the commodity pool definition.

4. Required elements of anti-money laundering program for unregistered investment companies

Unregistered investment companies subject to the proposed rule would have to develop anti-money laundering programs within 90 days after publication of the final rule. The proposed rule does not set out the complete structure of the anti-money laundering program, and FinCEN notes “the requirement to have an anti-money laundering program is not a one-size-fits-all requirement” and “each financial institution should have the flexibility to tailor its program to fit its business, taking into account factors such as size, location, activities and risks or vulnerabilities to money laundering.”

The proposed rule requires the following elements in an anti-money laundering program:

1. Establish and implement policies, procedures, and internal controls reasonably designed to prevent unregistered investment companies from being used to launder money or finance terrorist activities, including, but not limited to, achieving compliance with the applicable provisions of the BSA and the implementing regulations thereunder. Written policies and procedures, which form the basis of any compliance program, should set forth clearly the details of the program, including responsibilities of the individuals and departments involved.

2. Provide for independent testing for compliance to be conducted by company personnel or by a qualified outside party.

3. Designate a person or persons responsible for implementing and monitoring the operations and internal controls of the program.

4. Provide ongoing training for appropriate persons.

The proposed rule permits unregistered investment companies subject to the proposed rule to delegate implementation of their anti-money laundering program to third parties; however, the unregistered investment company is still fully responsible for the program and for ensuring hat regulators can get program-related information and records.

Further, because unregistered investment companies are not necessarily registered with or identifiable by the Treasury or another federal regulator, the proposed rule would require that each unregistered investment company file a short notice with FinCEN identifying itself and providing the following basic information: the name, address, email address, and telephone number of the unregistered investment company; the name, address, email address, telephone number of any investment adviser, commodity trading advisor, commodity pool operator, organizer or sponsor of the unregistered investment company; the name, email address, and telephone number of the designated anti-money laundering program compliance officer; the dollar amount of assets under management held by the unregistered investment company; and the number of participants, interest holders or security holders in the unregistered investment company.

An unregistered investment company would have to file its notice within 90 days after it first becomes subject to the proposed rule. Amendments would have to be filed within 30 days after any change in such information. An unregistered investment company would have to withdraw its notice within 90 days after ceasing to be subject to the proposed rule.

Next issue: Proposed anti-money laundering programs and their impact on fund managers.

The Patriot Act (official title: The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, Public Law 107-56) was signed into law by President Bush on October 26, 2001. Title III of the Act impacts the anti-money laundering provisions of the Bank Secrecy Act (BSA). The amendments were made to promote the prevention, detection, and prosecution of international money laundering and the financing of terrorism.

The Patriot Act amended section 5318(h) of the BSA and requires “financial institutions” to carry out anti-money laundering programs, including at a minimum:

1. the development of internal policies, procedures, and controls;

2. the designation of a compliance officer;

3. an ongoing employee training program; and

4. an independent audit function to test programs.

31 U.S.C. '5318(h)(1).

Section 5318(h)(2) of the BSA allows the Secretary of the Treasury to prescribe minimum standards for the anti-money laundering programs set out in Section 5318(h)(1) and to exempt certain financial institutions not otherwise subject to BSA regulation.

The definition of a “financial institution” under the BSA includes an investment company; however, the term “investment company” is not defined in the BSA or any rule adopted by either the Treasury or the Financial Crimes Enforcement Network (FinCEN), the division of the Treasury responsible for some of the regulations under the Patriot Act. The Investment Company Act of 1940 (1940 Act) does define the term, and subjects registered investment companies to regulation by the SEC.

A. Temporary Exemption for Investment Companies (other than mutual funds)

In April 2002, FinCEN issued an interim final rule governing investment companies that are “mutual funds.” By separate interim rule effective November 6, 2002, the Treasury temporarily exempted investment companies (other than mutual funds) from having to establish anti-money laundering programs. Anti-Money Laundering Programs for Financial Institutions, 67 Fed. Reg. 67,547 (Nov. 6, 2002) (codified at 31 C.F.R. '103.170). Specifically, 31 C.F.R. '103.170 provides, in part:

'103.170 Exempted anti-money laundering programs for certain financial institutions:

* * * * *

(b) Temporary exemption for certain financial institutions.

(1) Subject to the provisions of paragraph (c) and (d) of this section, the following financial institutions (as defined in 31 U.S.C. '5312(a)(2) or (c)(1)) are exempt from the requirement in 31 U.S.C. '5318(h)(1) concerning establishment of anti-money laundering programs:

* * * * *

(xii) Investment company.

* * * * *

(c) Limitation on exemption. The exemptions described in paragraphs (a)(2) and (b) of this section shall not apply to any financial institution that is otherwise required to establish an anti-money laundering program by this subpart I.

(d) Compliance obligations of deferred financial institutions. Nothing in this section shall be deemed to relieve an exempt financial institution from its responsibility to comply with any other applicable requirement of law or regulation, including title 31 of the U.S.C. and this part.

31 C.F.R. '103.170 (67 F.R. 67,546 Nov. 6, 2002; 67 F.R. 68935, Nov. 14, 2002).

The limitation set out in Section 103.170(c) above mentions that the exemption does not apply to any financial institution otherwise required by subpart I to establish an anti-money laundering program. Subpart I currently requires the following financial institutions to establish anti-money laundering programs:

• Financial institutions regulated by a federal functional regulator or a self-regulatory organization, and casinos (31 C.F.R. '103.120);
• Money services businesses (31 C.F.R. '103.125);
• Mutual funds (31 C.F.R. '103.130); and
• Operators of credit card systems (31 C.F.R. '103.135).

Accordingly, the temporary exemption should apply to unregistered investment companies that are otherwise not required to establish and maintain an anti-money laundering program.

B. The Proposed Rule for Unregistered Investment Companies

On September 26, 2002, FinCEN issued a proposed rule “Anti-Money Laundering Programs for Unregistered Investment Companies”, 67 Fed. Reg. 60,617 (proposed Sept. 26, 2002). The proposed rule would define an “investment company” to include certain investment vehicles not subject to regulation under the 1940 Act and require these entities to establish anti-money laundering programs similar to the guidelines FinCEN established for mutual funds.

1. Definition of unregistered investment company

The proposed rule defines “unregistered investment company” as follows:

1. an issuer that, but for the exclsions provided in sections 3(c)(1) and 3(c)(7) of the 1940 Act, would be an investment company under the 1940 Act (Section 3(c)(1) excludes from the definition of “investment company” any issuer that is not engaged in or proposing to engage in a public offering and whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons. 15 U.S.C. '80a-3(c)(1));

2. a commodity pool; and

3. a company that invests primarily in real estate and/or interests therein.

67 Fed. Reg. 60,617.

This definition would include several types of investment companies not registered under the 1940 Act, including private equity funds, hedge funds, venture capital funds, commodity pools and real estate investment trusts (REITs).

2. Limitations

(a) Redemption rights

Under the proposed rule, the definition of “unregistered investment company” would include “only those companies that give an investor a right to redeem any portion of his or her ownership interest within two years after that interest was purchased.” As stated in the proposed rule, this redeemability requirement is likely to exclude entities that require lengthy investment periods without the ability to redeem assets, including many private equity and venture capital funds, private REIT's and a large number of special purpose financial vehicles. The reason for structuring the rule with this redeemability limitation may be explained by FinCEN's note in the proposed rule that private equity funds “are not likely to be used by money launderers.” FinCEN had requested comment on whether the two-year period should be longer or shorter.

As it pertains to an unregistered investment company, the redemption limitation raises two questions: 1) does allowing the manager of the investment company the sole discretion to redeem an investor's investment constitute giving the investor the right to redeem; and 2) does allowing transfers to a third party constitute a right to redeem?

(1) Redemptions of Investors at Sole Discretion of Fund Manager

An investment company will often have the right to unilaterally redeem an investor's investment. While this does not specifically appear to give an investor a right to redeem so as to fall within the proposed rule, the proposed rule is unclear whether it means that the investor has to be specifically given the right to demand a redemption or if it includes situations where there is even a possibility of redemption within the first two years of the investment period. Since the proposed rule is unclear as to the meaning of the “right to redeem,” one protective measure is to provide that the discretion of the manager to redeem an investor's interest cannot be exercised until two years after the date of the purchase of the investment.

(2) Transfers to Third Parties

While the proposed rule focuses on whether the investor has the right to “redeem,” it does not mention the ability of an investor to transfer its ownership to another party inside the two-year period from the date of purchase of the investment.

To bolster an argument that the right to redeem does not include transfers to third parties, footnote 16 to the proposed rule states that if the unregistered investment company “permits an owner to redeem,” the proposed rule would apply regardless of whether its investors have the opportunity to (or do) sell the fund's securities in secondary market transactions. It goes on to state: “[t]he existence of an informal or formal secondary market for the fund's securities would not affect the applicability of the definition.”

Further, on December 31, 2002, the Secretary of the Treasury, the Board of Governors of the Federal Reserve System, and the Securities and Exchange Commission submitted a joint report to Congress regarding effective regulations to apply to investment companies. The report noted that private equity funds are long-term investments that provide little, if any, opportunity for investors to redeem their investments. The report went on to note that there is not a formal secondary market for shares in private equity funds, but a small informal secondary market that consists of private equity funds buying interests in established funds. The report also mentioned that in 1999 five private equity funds raised $1.6 billion for purchases of secondary interests in other private equity funds.

In contrast, however, and to support that the right to redeem does include transfers to third parties, an article discussing the proposed rule was published in October 2002 after the rule's release but before the December 2002 report to Congress. The article mentioned informal discussions with Treasury staff on the meaning of “right to redeem”:

Based upon informal discussions with Treasury staff, however, it appears that Treasury may be considering construing redemption more broadly to include the right of an investor to transfer or sell an interest in the fund to another investor in the fund or to a third party.

Amy R. Rudnick & Linda Noonan, “Treasury Issues Proposed Regulations Requiring Anti-Money Laundering Programs for Unregistered Investment Companies,” at www.gdclaw.com/practices/publications/detail/id/619/?pubItemId=6715 (October 10, 2002). The article also noted that because many real estate partnerships and private equity funds generally permit investors to transfer their interest to third parties, such an interpretation would expand substantially the coverage of the proposed rule and undermine the exception. It is important to note, however, that the report to Congress was issued after the article mentioned this possible expansion of the definition. The report made no mention of the inclusion of such transfers in the meaning of “right to redeem.” Further, the fact that the report acknowledged the existence of secondary markets, yet made no attempt to say that transfers in these secondary markets were a significant concern or were to be construed within the meaning of the proposed rule, leads to a possible conclusion that such transfers would not be considered as a “right to redeem.”

(b) Minimum assets

The proposed rule would not apply to companies that, as of the most recently completed calendar quarter, have total assets of less than $1,000,000. FinCEN has requested comment on whether this minimum threshold is appropriate.

(c) Offshore funds

The proposed rule contains a jurisdictional limitation. The definition of an “unregistered investment company” includes only an entity:

1. that is organized in the United States;

2. sells ownership interests to a U.S. person (as defined in 17 CFR 230.902(k); or

3. is organized, operated, or sponsored by a U.S. person.

3. Exceptions

There are a number of entities that are excepted from the “unregistered investment company” definition:

1. companies owned by one family without regard to the amount of assets owned by the companies;

2. employee securities companies, which are investment companies established by employers for the benefit of the employees; and

3. employee benefit plans that are excluded by CFTC Rule 4.5(a)(4) from the commodity pool definition.

4. Required elements of anti-money laundering program for unregistered investment companies

Unregistered investment companies subject to the proposed rule would have to develop anti-money laundering programs within 90 days after publication of the final rule. The proposed rule does not set out the complete structure of the anti-money laundering program, and FinCEN notes “the requirement to have an anti-money laundering program is not a one-size-fits-all requirement” and “each financial institution should have the flexibility to tailor its program to fit its business, taking into account factors such as size, location, activities and risks or vulnerabilities to money laundering.”

The proposed rule requires the following elements in an anti-money laundering program:

1. Establish and implement policies, procedures, and internal controls reasonably designed to prevent unregistered investment companies from being used to launder money or finance terrorist activities, including, but not limited to, achieving compliance with the applicable provisions of the BSA and the implementing regulations thereunder. Written policies and procedures, which form the basis of any compliance program, should set forth clearly the details of the program, including responsibilities of the individuals and departments involved.

2. Provide for independent testing for compliance to be conducted by company personnel or by a qualified outside party.

3. Designate a person or persons responsible for implementing and monitoring the operations and internal controls of the program.

4. Provide ongoing training for appropriate persons.

The proposed rule permits unregistered investment companies subject to the proposed rule to delegate implementation of their anti-money laundering program to third parties; however, the unregistered investment company is still fully responsible for the program and for ensuring hat regulators can get program-related information and records.

Further, because unregistered investment companies are not necessarily registered with or identifiable by the Treasury or another federal regulator, the proposed rule would require that each unregistered investment company file a short notice with FinCEN identifying itself and providing the following basic information: the name, address, email address, and telephone number of the unregistered investment company; the name, address, email address, telephone number of any investment adviser, commodity trading advisor, commodity pool operator, organizer or sponsor of the unregistered investment company; the name, email address, and telephone number of the designated anti-money laundering program compliance officer; the dollar amount of assets under management held by the unregistered investment company; and the number of participants, interest holders or security holders in the unregistered investment company.

An unregistered investment company would have to file its notice within 90 days after it first becomes subject to the proposed rule. Amendments would have to be filed within 30 days after any change in such information. An unregistered investment company would have to withdraw its notice within 90 days after ceasing to be subject to the proposed rule.

Next issue: Proposed anti-money laundering programs and their impact on fund managers.