The Application of the USA Patriot Act to Private Equity Funds

Part one of this article discussed the temporary exemption to the Patriot Act for investment companies and the proposed rule for unregistered investment companies. Part two examines proposed new anti-money laundering programs and their effect on fund manager liability.

Fund Managers and the New Proposed Anti-Money Laundering Programs

Another issue that may be applicable to private equity funds under the Patriot Act is the new proposed Anti-Money Laundering Programs for Investment Advisers proposed by FinCEN on May 5, 2003. 68 Fed. Reg. 23,646 (proposed May 5, 2003). It is possible that a manager of a fund may be considered an “investment adviser” for purposes of this particular proposed rule, depending on the amount of assets under management.

The Proposed Rule: Anti-Money Laundering Programs

Section 103.150(a) of the proposed rule defines two groups of advisers located within the United States required to have anti-money laundering programs:

The first group consists of advisers that:

1. have a principal office and place of business in the United States;

2. are registered with the SEC, and

3. report to the SEC that they have assets under management.

This group includes advisers registered with the SEC that have either discretionary or non-discretionary authority to manage client assets. It excludes advisers that are not registered with the SEC, as well as advisers that are registered with the SEC, but do not manage client assets.

The second group consists of advisers in the United States that are not registered with the SEC, but have $30 million or more of assets under management and are relying on the registration exemption provided by section 203(b)(3) of the Advisers Act (15 U.S.C. '80b-3(b)(3)) (unregistered advisers).

In the definitions section of the Investment Advisers Act, 15 U.S.C. '80b-3(b)(2), “investment adviser” is defined as follows:

“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.

15 U.S.C. '80b-2(11).

Further, the term “security” is defined in the Investment Advisers Act as follows:

“Security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guaranty of, or warrant or right to subscribe to or purchase any of the foregoing.

15 U.S.C. '80b-2(18).

The registration exemption in the Investment Advisers Act, section 203(b)(3), states that advisers that have fewer than 15 clients and do not hold themselves out generally to the public as investment advisers are exempted from SEC registration. As stated in the proposed rule, many advisers that use this registration exemption may control substantial client assets, either because they have a few individual clients with very large accounts or because they advise certain types of pooled investment vehicles, such as limited partnerships. The SEC rule permits the adviser to count the partnership or other pooled investment vehicle as a single client, rather than count each limited partner or other investor as a client. 17 C.F.R. '275.203(b)(3). As a result, the adviser may have only one or two pooled investment funds yet manage tens or hundreds of million dollars. The proposed rule, however, would require an investment adviser within the definition set out above and regardless of the SEC exemption to establish and maintain an anti-money laundering program. It is still unclear whether “assets under management,” as used in the proposed rule, would include uncalled capital commitments.

The proposed rule would exclude those entities that would qualify as unregistered advisers but that are otherwise required to have an anti-money laundering program under the BSA because they are dually registered as a financial institution in another capacity and are examined by a federal regulator for compliance with the requirement in that other capacity. In some instances, investment advisers that would be subject to the proposed rule advise pooled investment vehicles that are themselves required to maintain anti-money laundering programs under BSA rules, such as mutual funds, or that are sponsored or administered by financial institutions subject to such requirements. To prevent overlap, the proposed rule would permit investment advisers covered by the rule to exclude from their anti-money laundering programs any investment vehicle they advise that is subject to any anti-money laundering program requirement under BSA rules.

In sum, the proposed rule appears to require certain private equity fund managers, as unregistered investment advisors, to adopt anti-money laundering programs, despite the other proposed rule that might otherwise exempt their underlying funds from establishing anti-money laundering programs. Whether a private equity fund manager is subject to the rule depends on whether it is an investment adviser within the definition as set out in the Investment Advisers Act. The private equity fund manager would not have to establish an anti-money laundering program, however, if its underlying fund is already subject to an anti-money laundering program or it already complies with an anti-money laundering program as a result of being dually registered.

Elements of Anti-Money Laundering Program

The elements of the proposed anti-money laundering program for investment advisers are similar to those proposed for unregistered investment companies. They are:

1. Establish and implement policies, procedures, and internal controls reasonably designed to prevent the investment adviser from being used to launder money or finance terrorist activities, including but not limited to achieving compliance with applicable provisions of the BSA and FinCEN's implementing regulations;

2. Provide independent testing of 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; and

4. Provide ongoing training for app -ropriate persons.

The proposed rule also has a provision under which FinCEN would generally delegate examination authority to the SEC, to enable the SEC to examine investment advisers' compliance with the anti-money laundering program requirement.

Conclusion

As of this date, neither of the proposed rules has been implemented by the Treasury. If the proposed rule governing unregistered investment companies becomes effective in its current form, then some investment funds will be required to adopt an anti-money laundering program. Further, if the proposed rule governing investment advisers becomes effective in its current form, then some private equity fund managers may be required to adopt an anti-money laundering program as well. It is also possible that these proposed rules may be revised, and the final versions that become effective may impact the rules' applicability to private equity funds and their managers. Accordingly, the conclusions in this memorandum are subject to change as rules are adopted, modified and clarified.

Part one of this article discussed the temporary exemption to the Patriot Act for investment companies and the proposed rule for unregistered investment companies. Part two examines proposed new anti-money laundering programs and their effect on fund manager liability.

Fund Managers and the New Proposed Anti-Money Laundering Programs

Another issue that may be applicable to private equity funds under the Patriot Act is the new proposed Anti-Money Laundering Programs for Investment Advisers proposed by FinCEN on May 5, 2003. 68 Fed. Reg. 23,646 (proposed May 5, 2003). It is possible that a manager of a fund may be considered an “investment adviser” for purposes of this particular proposed rule, depending on the amount of assets under management.

The Proposed Rule: Anti-Money Laundering Programs

Section 103.150(a) of the proposed rule defines two groups of advisers located within the United States required to have anti-money laundering programs:

The first group consists of advisers that:

1. have a principal office and place of business in the United States;

2. are registered with the SEC, and

3. report to the SEC that they have assets under management.

This group includes advisers registered with the SEC that have either discretionary or non-discretionary authority to manage client assets. It excludes advisers that are not registered with the SEC, as well as advisers that are registered with the SEC, but do not manage client assets.

The second group consists of advisers in the United States that are not registered with the SEC, but have $30 million or more of assets under management and are relying on the registration exemption provided by section 203(b)(3) of the Advisers Act (15 U.S.C. '80b-3(b)(3)) (unregistered advisers).

In the definitions section of the Investment Advisers Act, 15 U.S.C. '80b-3(b)(2), “investment adviser” is defined as follows:

“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.

15 U.S.C. '80b-2(11).

Further, the term “security” is defined in the Investment Advisers Act as follows:

“Security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guaranty of, or warrant or right to subscribe to or purchase any of the foregoing.

15 U.S.C. '80b-2(18).

The registration exemption in the Investment Advisers Act, section 203(b)(3), states that advisers that have fewer than 15 clients and do not hold themselves out generally to the public as investment advisers are exempted from SEC registration. As stated in the proposed rule, many advisers that use this registration exemption may control substantial client assets, either because they have a few individual clients with very large accounts or because they advise certain types of pooled investment vehicles, such as limited partnerships. The SEC rule permits the adviser to count the partnership or other pooled investment vehicle as a single client, rather than count each limited partner or other investor as a client. 17 C.F.R. '275.203(b)(3). As a result, the adviser may have only one or two pooled investment funds yet manage tens or hundreds of million dollars. The proposed rule, however, would require an investment adviser within the definition set out above and regardless of the SEC exemption to establish and maintain an anti-money laundering program. It is still unclear whether “assets under management,” as used in the proposed rule, would include uncalled capital commitments.

The proposed rule would exclude those entities that would qualify as unregistered advisers but that are otherwise required to have an anti-money laundering program under the BSA because they are dually registered as a financial institution in another capacity and are examined by a federal regulator for compliance with the requirement in that other capacity. In some instances, investment advisers that would be subject to the proposed rule advise pooled investment vehicles that are themselves required to maintain anti-money laundering programs under BSA rules, such as mutual funds, or that are sponsored or administered by financial institutions subject to such requirements. To prevent overlap, the proposed rule would permit investment advisers covered by the rule to exclude from their anti-money laundering programs any investment vehicle they advise that is subject to any anti-money laundering program requirement under BSA rules.

In sum, the proposed rule appears to require certain private equity fund managers, as unregistered investment advisors, to adopt anti-money laundering programs, despite the other proposed rule that might otherwise exempt their underlying funds from establishing anti-money laundering programs. Whether a private equity fund manager is subject to the rule depends on whether it is an investment adviser within the definition as set out in the Investment Advisers Act. The private equity fund manager would not have to establish an anti-money laundering program, however, if its underlying fund is already subject to an anti-money laundering program or it already complies with an anti-money laundering program as a result of being dually registered.

Elements of Anti-Money Laundering Program

The elements of the proposed anti-money laundering program for investment advisers are similar to those proposed for unregistered investment companies. They are:

1. Establish and implement policies, procedures, and internal controls reasonably designed to prevent the investment adviser from being used to launder money or finance terrorist activities, including but not limited to achieving compliance with applicable provisions of the BSA and FinCEN's implementing regulations;

2. Provide independent testing of 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; and

4. Provide ongoing training for app -ropriate persons.

The proposed rule also has a provision under which FinCEN would generally delegate examination authority to the SEC, to enable the SEC to examine investment advisers' compliance with the anti-money laundering program requirement.

Conclusion

As of this date, neither of the proposed rules has been implemented by the Treasury. If the proposed rule governing unregistered investment companies becomes effective in its current form, then some investment funds will be required to adopt an anti-money laundering program. Further, if the proposed rule governing investment advisers becomes effective in its current form, then some private equity fund managers may be required to adopt an anti-money laundering program as well. It is also possible that these proposed rules may be revised, and the final versions that become effective may impact the rules' applicability to private equity funds and their managers. Accordingly, the conclusions in this memorandum are subject to change as rules are adopted, modified and clarified.