Anti-Money Laundering: The Importance of Rigid Due Diligence

A Presentation given by Dermot S. L. Butler at the
Hedge Fund Administration & Prime Brokerage Conference"
held at the Westin Hotel, Dublin
on Thursday, 13th February 2003.

Good afternoon ladies and gentlemen.

I am here to talk about the importance of due diligence with regard to anti-money laundering and I am going to discuss this partially in the context of the procedures for verifying the bona fides of investors in hedge funds. But before getting on to that subject, I am briefly going to discuss the risks of not carrying out proper anti-money laundering due diligence, as those risks might effect a service provider.

Let us be absolutely clear - anti-money laundering regulations, as applied in most jurisdictions and, indeed, probably all jurisdictions that have such regulations - carry criminal sanctions and those sanctions are levied against those that fail to follow the prescribed procedures.

These sanctions include not only substantial fines against companies, but potential jail terms for individuals. I am not talking about jailing the actual money launderers here - I mean the jailing of staff of the Administrator, or the Custodian, or the Investment Manager who, whether because of ignorance, stupidity or just inefficiency, fails to report a suspicious event, or in some other way unwittingly aids and abets a money launderer.

There are numerous examples, of service providers falling foul of the regulators, but perhaps the recent and, in my mind, most striking one was the fine of seven hundred and fifty thousand pounds Sterling - over one million Dollars - imposed by the UK Financial Service Authority (the "FSA") against the Royal Bank of Scotland - Europe's second largest bank.

This fine was imposed because the bank had lacked suitable anti-money laundering ("AML") procedures and controls.  What was interesting was that the FSA went on to say that:

(i)            the fine was imposed because the bank's AML procedures and controls were inadequate;

(ii)           no instance of any money laundering was discovered; and

(iii)          if the Royal Bank of Scotland had not been as cooperative as they were, then the fine would have been substantially larger.

The risks that you, as regulated service providers, face by not taking anti-money laundering due diligence seriously include both a Compliance Risk and a Reputational Risk.

No one wants their company's name, or any members of their staff's names, spread across the newspapers because of prosecution for something like inadequate controls.  Apart from the embarrassment, it is possible that investors and other clients of the institution may ask - "If the controls are inadequate with regard to money laundering, how adequate are they elsewhere".  And, of course, the damage to a company's reputation, if it is actually involved in a money-laundering event, however innocently, will be substantial.

Of course, for those of us who have lived and operated in this area in Ireland or the United Kingdom this is "old hat".  The anti-money laundering regulations imposed in Ireland or the United Kingdom, and for that matter in Switzerland, have been extremely rigorous for many years now and, as I have already mentioned, in the case of both the UK (where, as we have seen, the FSA has recently been honing its "broadsword") and Ireland, with which I am more familiar, they carry draconian criminal penalties.  These include potential jail sentences for those who do not report something suspicious.  And, even if you have reported something suspicious, you can still go to jail, if you advise the client that you have reported them because you are suspicious.

This in itself can cause problems when trying to explain why you have not paid a client his redemption proceeds, when the reason is because you are not satisfied with the information you have received from that client, or because be insists on it being paid to an unacceptable bank.  The problem is that you cannot tell the investor that you are not allowed to repay his money, because the account has been blocked and his behavior reported, because that would be "tipping off", which is, itself, a jailable offence.

So it is "old hat" to most of us - but what is new - new that is, since October 2001 - is the introduction of the USA PATRIOT Act, which is an acronym for:

"Uniting and Strengthening America by Providing the Appropriate Tools to Intercept and Obstruct Terrorism Act".

This Act came into being following the awful terrorist attacks on the World Trade Centre in September 2001 and it is somewhat ironic to note that for the first time the United States, who have been the indirect driving force behind the introduction of anti-money laundering regulations in the rest of the world, have now introduced anti-money laundering legislation that will eventually effect the US Hedge Fund industry.

To a great extent the regulatory requirements under the USA PATRIOT Act are not expected to be very much more onerous, and in some cases possibly less onerous, than those required under the UK or Irish regulations.  However, in the standard manner, with which some of you may be already familiar, the US authorities have written the Act so as to have extra territorial jurisdiction with regards to any funds that have what is known as a "US Nexus".  A hedge fund will be deemed to have a US Nexus if it has any US investors, or, even if it doesn't have any US investors, if it has a US Investment Manager, prime broker or other service provider, or even if it trades on the US markets.  This broad definition of a US Nexus will bring numerous European funds into the US regulatory net, whether they like it or not.

From an investors point of view this will not be a major problem, except that the US authorities will require and deem it their right to be able to review the books and records of the fund and, particularly, the share register, to determine whether any of the investors are laundering money and, currently, higher on the US regulatory horizon, whether they are involved in terrorist financing.

From a service provider's point of view, and particularly from the point of view of a US Hedge Fund Manager, there is one other important fact to be borne in mind.

Under the USA PATRIOT Act the US Investment Manager is responsible for carrying out the anti-money laundering due diligence.  The Manager is free to delegate the function to a third-party, as is the case in Ireland, where the Administrator of a fund generally collates all the anti-money laundering documentation.  However, the US Investment Manager would still remain responsible and could be penalized if the Administrator, or the other entity to whom the Investment Manager delegated the function of anti-money laundering due diligence, either fails to do it at all, or doesn't carry it out properly.   Think back to the Royal Bank of Scotland.  In the UK and Ireland a Manager would be deemed to have acted responsibly, if it had appointed a regulated body, such as my company, which is an Irish based and, therefore, Irish regulated fund Administrator, to carry out the due diligence and taken reasonable steps to check that it was being done.

The US regulators do not take the same attitude as the rest of the world with regard to avoiding duplication of effort in this context, which in Ireland and the UK is recognized as being an unnecessary and expensive waste of resources.  This ability to delegate the responsibility that is commonly accepted in Europe, extends also to the concept of a "Designated Body".  This is a financial institution, such as a bank, with whom a client investor may have an account and through whom they pay their subscription into the fund.  We as Administrators are permitted to accept a letter of comfort from a Designated Body, providing they are in good standing and are resident within, what are called, the FATF (Financial Action Task Force) approved jurisdictions.  (See Table 1).

Under Irish regulations the Designated Body must also confirm that it will disclose that information to us as the Administrator or the Irish, (or other appropriate) Regulator, if requested.  You may say that this is little different to the requirements that the US Treasury wishes to impose with regard to the USA PATRIOT Act and it is a valid point.  I would however suggest (and maybe I am being naive here) that it is likely that the Irish Government will restrict their request for information to particular named investors and will not go on a general "fishing expedition", whereas the US Treasury and State Departments are known for their "angling expertise" and lack of discretion.

I recall one instance, some years ago now, when the US Government published a list of clients with accounts at a certain bank in either the Cayman Islands or, perhaps Miami, even though they were only interested in evidence of wrong doing with regard to one of those clients.  All the other clients woke up one morning to find their names plastered across the New York Times and Miami Herald.

As I have already mentioned it is acceptable to outsource or delegate the anti-money laundering procedures in almost all jurisdictions, providing the person to whom it is being outsourced is qualified.  However, this is subject to the caveat that, under the USA PATRIOT Act, even if you have outsourced to someone with impeccable credentials, you still remain ultimately responsible with the ultimate penal liabilities that can be imposed under the Act.

As I mentioned in my opening preamble, I am going to talk about the anti-money laundering verification requirements and in this regard I am just going to draw your attention to the Client Verification Requirements list (see Table 2) that we use at Custom House and which we believe complies with the Irish regulations.

The requirements in Dublin are, in my belief, as strong as they are in any other jurisdiction, with the possible, but unlikely, exception of the US.  I say "possible exception", because, as yet, the final regulations in the USA have not been published.  The Americans have a habit of introducing new law and then taking a considerable amount of time to publish the regulations under which that law will operate.  With the USA PATRIOT Act we have now been waiting close to eighteen months to get definitive regulations with regard to Hedge Funds.

Having said that, on December 31 last the US Treasury issued a Report to Congress in which they specified that a US Investment Manager or US Hedge Fund, or an Offshore Hedge Fund with a US Nexus, would be required to compile a checklist of information and outline the verification procedures they have gone through, which are much the same as we already do in Ireland, except for the new requirement to maintain a filenote documenting the verification process and how, or why it was decided to accept, or reject the investor.

What should be noted is that, if a US Investment Manager does not agree to delegate the responsibility for obtaining the anti-money laundering due diligence, relating to all investors into their fund, to the Administrator, because of the Manager's ultimate liability under US law, then both the Investment Manager and that Administrator will have to comply with the USA PATRIOT Act regulations and compile their files accordingly - which I suggest is an unnecessary duplication of effort.

Finally I want to talk about something that is a particular interest of mine and that is a uniform approach to anti-money laundering procedures.  I, wearing my hat as Deputy Chairman of AIMA and as a Council Member for Ireland, have entered into discussions with other Administrators in Ireland with the view that all Irish Administrators should have a uniform approach to anti-money laundering procedures that they will apply to all funds, which would, of course, comply with Irish regulations.

In this context I understand that for some time now Citco has been complying with the Irish regulations in all of their offices regardless of where they actually have carried out the function.  Citco, as many of you will know, have offices all round the world in the United States, Canada, various places spotted around the Caribbean, as well as Dublin, Luxembourg, Holland and, I believe, Switzerland.  They operate all over the place.  It is my understanding, as advised by one of their senior executives, that they have imposed the Irish standard, because it is the most rigorous of all anti-money laundering procedures.

The most problematic area of anti-money laundering is the persuasion of clients to provide the information required, but I believe that is just a matter of time and education.

Most investors in Irish and, for that matter, UK offshore (Channel Islands, Isle of Man, Bermuda and Caribbean) funds are used to being asked to provide a certified copy of their passport and a recent utility bill, to identify them individually and confirm their place of residence.  In many other jurisdictions, including the United States, investors have never been asked and so are not familiar, with the now, fairly - or soon to be fairly - standard AML requirements.  Strict compliance with such KYC ("Know Your Client") procedures is essential - but always tempered with some flexibility, if required.  For example, in some places mail is only sent to a P.O. Box Number, rather than a street address and so a utility bill will prove nothing about the client's residence.

In some jurisdictions there are cultural problems.  For example, investors take offence at, what they see as, someone questioning their reputation.  On the other hand, it appears that some investors have yet to realise the seriousness of the anti-money laundering requests and treat the whole matter in a somewhat cavalier fashion.

As I have already said, I believe that this is a matter of education and I have no doubt that, within the few years, most investors all over the world will understand and accept that the provision of anti-money laundering due diligence information is just another essential and unavailable hassle in everyday life.  Having said that, I was astounded to learn (and this probably also demonstrates my naivety), that despite the European Union's strong directives with regard to anti-money laundering, they are still imposed in a somewhat desultory fashion in some of the European jurisdictions, including, I understand, France.

Again this is an irony, similar to the irony of the US now introducing the USA PATRIOT Act, because FATF is a Paris-based organization and, as I understand it, is largely run by French bureaucrats, with evangelical tendencies, but then attitudes to anti-money laundering by the so called "developed" or "civilized" world have always been subject to the "Do as I say, not do as I do" syndrome.  Having said that, I suspect that the recent investigations into Barclays, in France, concerning poor controls, which enabled money laundering between France and Israel at the end of 2001 and AXA, also in France, with regard to the PanEuroLife investigation, both of which received substantial publicity, will have woken up quite a few people in France to the importance of compliance with anti-money laundering regulations.

Anyway, be that as it may, I still believe that it would be of a great advantage to all of us if there was a uniform approach and standard with regard to, not only:

(i)           The client verification requirements and procedures - the information that is needed and how you get it - but also

(ii)           Freedom to disclose that information to the authorities, which is restricted in some jurisdictions, such as Switzerland, Luxembourg and the Cayman Islands, because of local secrecy laws.  (This can be a very difficult problem, which we at Custom House have attempted to solve, by inserting a clause in the offering documents and subscriptions forms of funds that we act for.  This clause requires any Designated Body, acting as a nominee investor, to undertake to obtain permission from the beneficial owner for whom they are acting as Nominee, to disclose their AML Due Diligence file to any competent regulator, if they are asked to do so, thus, the investor will, effectively, waive their protection under bank secrecy laws in these specified circumstances).

(iii)          I would also like to see uniform procedures that should be followed in order to comply with the regulations, such as only paying by wire transfer to the remitting bank, as required in Ireland, and never issuing cheques or bank drafts to pay redemption proceeds.  I, personally, believe that this is the most important AML tool for hedge funds.  Money laundering, by definition, requires the ability to move money from dirty hands into clean hands.  If all redemptions are paid back to the original remitting bank - that is the bank account out of which the original subscription came - then it is impossible to use a hedge fund (or any other fund for that matter) to launder any money.

As an aside, it is my belief that it is only a matter of time before bank secrecy laws, as we know them today, become an historical anachronism.  I believe that the report that I read, on one of the Net news services, this morning that Switzerland and the United States have entered into an Exchange of Information Agreement with regard to sixteen types of tax offences, is the first serious chink in the bank secrecy armour.

In conclusion, I would like to summarise why I think it is important to carry out proper anti-money laundering due diligence.

Firstly, the prevention of money laundering is an absolute necessity.  Why

Let's put this in perspective.  The US authorities have stated that, in their estimation, the money laundering industry "washes" over one trillion dollars every year and, presumably, that is growing, or would if it could.  I believe that is over ten times the GDP of Ireland.  And remember we are talking about the proceeds of crime.

So firstly there is the moral issue.

Secondly, even if you are not convinced by (or not concerned with) the moral issue, there is the selfish reason for carrying out efficient AML due diligence - namely the huge risks of not doing so.  These risks I have already discussed in general, but they can be categorized under four headings:

    * Firstly, the Compliance Risk - the risk of prosecution, with severe penalties, for failing to implement and operate effective AML procedures and controls; and
    * Secondly the Reputational Risk - the risk of your company being publicly associated with, either a prosecution for inadequate compliance or, even worse, having actually participated, knowingly or unwittingly, in a money-laundering scheme.

      And remember, in the latter case it will make little difference if that assistance was given unwittingly, by default, or intentionally by a member of your staff - your reputation will suffer hugely in any event;
    * Thirdly, the Financial Risk - the risk of substantial fines for failure to comply with AML procedures;  and
    * Fourthly, Jail.

I hope you understand why I am convinced of the importance of Rigid Anti-Money Laundering Due Diligence.

Thank you.

Dermot S. L. Butler
12-02-03

Dermot S. L. Butler, who is the Deputy Chairman of AIMA, has worked in the investment industry since 1970. He is the Chairman of Custom House Administration & Corporate Services Limited ("Custom House"), which specialises in advising and assisting clients on the structure and the incorporation of offshore funds and, once established, providing a full administrative service. In December 2002, Custom House was the first hedge fund administrator in the world to be awarded a Moody's Baa1 MQ Rating, which is the investment grade equivalent of the new Moody's Management Quality Rating. Custom House is authorised by the Financial Regulator, (formerly the Central Bank of Ireland), under the Investment Intermediaries Act, 1995. For further information, please visit the Custom House Website at www.customhousegroup.com.