Hedge Funds Risk Biden-Era End to Money-Laundering Loophole

Neil Weinberg

Fri, February 5, 2021, 

(Bloomberg) -- Private-equity and hedge funds face an increased risk that the U.S. will close a longstanding money-laundering loophole for assets they manage. All it would take is the Biden administration to quickly revive a rule that was developed during Barack Obama’s term but left unused by Donald Trump.

The U.S. has intensified its crackdown on dirty money in recent years, requiring banks, brokerages and mutual funds to monitor clients and report suspicious activity. But investment advisers overseeing trillions of dollars in private equity and hedge funds are exempt from such rules, and the Federal Bureau of Investigation says that’s attracted more cash from Mexican drug lords, countries under U.S. sanctions and companies with suspected Russian mob ties.

Regulators sought to close that loophole in 2015 with a new set of reporting requirements, but the proposal wasn’t enacted before Obama left office and it lay dormant while Trump was president. With Democrats back in control of the White House and bipartisan support for more scrutiny of illicit funds, the Treasury Department’s Financial Crimes Enforcement Network may seek to revive the anti-money-laundering proposal.

“We’re advising clients to expect that during the Biden administration, FinCEN will finalize the AML rule for registered investment advisers,” said Michael Buffardi, a managing director in the financial services practice at FTI Consulting. “We can’t anticipate the timing, but think it’ll be sooner rather than later.”

After the November election, the non-partisan Financial Accountability & Corporate Transparency Coalition called on Joe Biden to enact the 2015 rule in his first 100 days in office to help safeguard the financial system and plug a key U.S. vulnerability to money laundering. “The rule has already undergone the comment process and could be quickly finalized,” the coalition said.

Janet Yellen, who was sworn in as Biden’s Treasury Secretary Jan. 26, said in a staff memo that “fighting illicit finance” would remain part of department’s “usual business” while it confronts the long-term consequences of the global pandemic, climate change, systemic racism and the lingering economic crisis.

It’s still early days for Biden’s team at the department, which hasn’t spelled out any new money-laundering measures or indicated whether it would revive the 86-page Obama-era proposal for SEC-registered investment advisers who oversee private equity and hedge funds. A spokeswoman said Treasury officials were unable to provide a timetable for the anti-money laundering regulation.

And even if the department does move ahead, the change wouldn’t likely occur right away. The White House issued an inauguration-day memo that pauses most new regulations, withdraws rules released but not yet formally published, and asks agencies to consider a 60-day delay for rules that have been published in the Federal Register.

Groups representing private equity and hedge funds don’t want for any such rule to move forward. They say their money is already tracked by regulated financial institutions and doesn’t need additional oversight, despite the FBI report suggesting the problem requires urgent attention.

In a May 2020 Intelligence Bulletin, the FBI said financial criminals are tapping hedge funds and private equity firms “to launder money, circumventing traditional anti-money laundering programs.” Without stricter oversight, the funds provide “ever-increasing opportunities for threat actors to co-opt investment funds without being overly scrutinized,” the agency said. The FBI didn’t respond to a request for comment.

‘Real’ Risks

“The risks highlighted in the FBI assessment are quite real,” said Ali Burney, a partner at Steptoe & Johnson whose practice focuses on cases of financial crime. “Investment vehicles always offer an attractive target, not only to launder funds but also as conduits for bribery and other schemes.”

Concern about the risks has already gotten the attention of regulators and lawmakers.

Just last year, the U.S. Securities and Exchange Commission -- which would have been the chief monitor of compliance under the 2015 proposal -- cited anti-money laundering as one of its top priorities for oversight activities designed to identify risks to investors and the integrity of U.S. markets.

In 2018, FinCEN enacted its Customer Due Diligence Rule requiring banks, brokerages, mutual funds and futures commission merchants to verify the identity of individual account holders and the beneficial owners behind corporate customers.

And in January, Congress passed a law requiring owners of certain types of anonymous shell companies -- a popular tool for laundering money -- to disclose their names, addresses and other identifying information. The resulting government database will be accessible by intelligence agencies, law enforcement, regulators and financial institutions.

Opponents of anti-money laundering requirements for managers of private funds have argued that they don’t take physical custody of client assets. Instead, those assets are held by banks, brokerages or other “qualified custodians,” which are already required to monitor for signs of money laundering and report suspicious activity.

“Hedge funds present relatively limited money-laundering risks,” with the vast majority of investment advisers already using internal measures to track dirty money, the Managed Funds Association, which represents hedge funds, said in its 2015 written response to the FinCEN proposal.

‘Poor Vehicles’

Private-equity managers’ practice of requiring investors to tie up capital for long periods make their funds “poor vehicles for money laundering and terrorist financing,” and should be excluded from FinCEN’s proposed rule, American Investment Council, which represents the industry, said in its 2015 written response.

Jason Mulvihill, the council’s chief operating officer and general counsel, said that SEC-registered private fund advisers already provide detailed information about their activities, so adding anti-money laundering requirements is unnecessary. “The new legislation is not going after investment advisers and funds that are regulated,” he said. “It’s focus is on things that are less transparent.”

The FBI expressed a different view in its report last year. “The proliferation of private investment funds has made the industry less rigid as to the structure of the investment in an effort to attract more capital,” it wrote. “Furthermore, the profit motive does not incentivize the private investment fund manager to scrutinize the source of funds or the underlying beneficial owner.”

Self-policing by private equity and hedge funds is “not as robust as it would be if the 2015 proposal was adopted,” said Mederic Daigneault, a senior director with National Regulatory Services, a compliance consulting firm. That means the industry’s defenses could be strengthened through mandatory requirements for monitoring and reporting money laundering red flags, Daigneault said.

(Updates with comment from Ali Burney.)

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