Vulnerable to laundering

Regulators in the US and Europe are looking closely at the money laundering and terrorist financing risks posed by hedge funds. It could mean greater regulation, disclosure and controls for hedge fund managers, write Dominic Nixon and Rohan Bedi of PricewaterhouseCoopers

Hedge funds have distinct product and market characteristics that make them vulnerable to money laundering, fraud and even terrorist financing. They are manager skill-based, which means there is a certain level of proprietary knowledge involved in the asset selection and trading strategy of the fund. In addition, most funds are based in offshore tax havens and are not regulated, which means they are not obliged to disclose their holdings. Meanwhile, the recent trend of retail hedge funds makes these products more accessible with lower minimum investments than has historically been the case. Because of these risks, hedge funds are increasingly attracting regulator attention, and may be subject to more rigorous regulation in the near future.

Laundering risks

Hedge funds may be the most susceptible to money laundering of all unregistered investment companies (such as venture capital or private equity) because of the relative liquidity of their interests and their structures. Hedge funds typically allow investment and valuation on a monthly, quarterly or annual basis.

For instance, the guidelines for Singapore-registered hedge funds stipulate one regular dealing day per quarter. The redemption of funds usually requires a notice period, and guidelines state that redemption proceeds must be paid to the end-investor within 95 days from the dealing day the redemption request is accepted. Money launderers may be willing to invest their assets in hedge funds for a limited period to launder them in a manner that generates a return.

Money launderers seek investment vehicles that are less likely to detect or report their activity. The secrecy and weak regulation that characterises this market segment, along with the rapid proliferation of funds, have combined to create a host of circumstances that make hedge funds susceptible to perpetrators of fraud and money laundering.

Each investor must meet minimum income and net-worth standards, with funds open only to ‘qualified purchasers’ or ‘accredited investors’. Even though fund managers or administrators often know their customers through pre-existing relationships, they must gather background information on potential investors to determine whether the investors meet minimum requirements.

Nevertheless, investors often use intermediaries that do not divulge the identity of the end-investor to the fund managers. Investor intermediaries and nominees may introduce their investor clients to a hedge fund, or may invest in hedge funds on their clients’ behalf. Similarly, a fund of funds may make investments in a hedge fund on behalf of its investors.

Hedge funds typically rely on their fund administrators for the processing of subscription documents, and to ensure compliance with anti-money laundering (AML) laws and regulations applicable in the fund’s jurisdiction. These third parties often have direct contact and maintain the primary relationship with the investor, so they are in the best position to ‘know the customer’. As a result, a hedge fund may, directly or indirectly, rely upon the investor identification and verification procedures performed by such third parties. If the hedge fund does not have proper AML procedures that govern its relationship with those third-party administrators that conduct these ‘know your customer’ checks on its behalf, it exposes itself to the risk of being abused by launderers.

While domestic hedge funds are subject to local regulations, offshore funds are subject to the securities laws and regulations imposed by the jurisdiction in which they are domiciled. A significant number of hedge funds are established in offshore tax havens, many of which have relatively lax AML standards.

Specific characteristics facilitating laundering

Hedge funds are more likely to be used in an international money-laundering scheme much later into the process, in the layering or final integration stage. The layering stage is where the launderer seeks to confuse the trail; in other words, conduct multiple transactions for the sake of transacting. The integration stage is the final stage, where the launderer makes an investment with the cleansed funds in order to use the proceeds of crime that now seem clean. The usage in these stages is due to various characteristics of hedge funds and how they are normally used:

Placement

• Hedge funds usually deal in large amounts of money. The minimum opening deposit has historically been $1 million in the US, and although minimums are falling, they are still relatively high. Therefore, hedge funds are not likely to be used in the placement stage, where frequent deposits of small amounts of money are the usual tactic of launderers. However, with funds of hedge funds having lower investment amounts, usually between $10,000 and $25,000, placement risks do exist for this category of product.

• Hedge funds usually do not deal in large amounts of cash (currency or equivalents). This is another reason why they are not a likely vehicle in the placement stage. In countries such as the US, most investments are made by wire transfer from the investor’s bank to the hedge fund’s custodian or prime broker. When investors redeem their investments, most hedge funds forward the redemption proceeds to the account at the financial institution from which the initial investment was made. However, these characteristics can differ from one financial market to the other, depending on how developed the hedge fund market is and how regulated these funds are. Moreover, depending on the laxity of AML controls, a money launderer could invest in a fund-of-funds product by making deposits for the initial investment at several different banks, therefore avoiding banks’ internal or regulatory currency reporting thresholds of $10,000. The initial investment for the fund of funds could then be made by several wire transfers from each of these banks, each in amounts under $10,000. ‘One account – same account’ policies would mitigate these risks.

Layering

• Hedge funds have restrictions on the withdrawal of money. Money can only be withdrawn monthly, quarterly, or even annually. Money launderers could use hedge fund accounts to layer their funds by sending and receiving money and wiring it quickly through several hedge fund accounts and multiple hedge fund managers; or by redeeming an interest in a company originally purchased with illegal proceeds and then reinvesting the proceeds received in a hedge fund. Layering could also involve investing in funds in the name of a fictitious corporation or an entity designed to conceal the true owners.

Integration

• The launderer might not be interested in using the money right away; he/she may be more interested in stashing it away for use potentially years later. Since much secrecy surrounds hedge funds and their returns, the growth in hedge funds (both assets and returns) provides a plausible explanation for the origin of money as the returns from such an investment. In this situation, the integration step simply involves investing the money and waiting. The passing of time gives the money the appearance of legitimacy. Since hedge funds normally deal in large sums of money, often from all around the world, they make ideal final repositories for money launderer’s money.

Structure

A hedge fund’s structure also makes it vulnerable to money laundering:

• A US onshore (domestic) hedge fund is typically set up as a limited partnership (LP); it could also adopt a legal structure of either a limited liability corporation (LLC) or an S-corporation to hold a portfolio of liquid securities (some also deal in illiquid securities such as distressed debt). The fund manager acts as the general partner in an LP or as a managing member in an LLC. The investors are brought in as limited partners in an LP or as non-managing members in an LLC whose liability is equivalent to the size of their investment. The manager pools investor funds, and returns are paid out in proportional shares. The US Financial Crimes Enforcement Network believes a limited partner of a non- managing member in a US onshore fund, either an individual or a corporate investor, could easily transfer the proceeds of crime into a hedge fund.

• With respect to offshore funds, depending on the jurisdiction of incorporation, it might be impossible to identify the beneficial owners of the money invested in the funds or the source of money being invested. The possibility that investments are anonymous and the inability of law enforcers to obtain information about the beneficial ownership of corporate entities in certain jurisdictions makes offshore funds – for example, a US hedge fund with an offshore-related fund – particularly attractive to money launderers. In the US, it is proposed that US-managed offshore funds be subject to AML rules to prevent the circumvention of US AML regulations. Singapore regulations already cover hedge funds requiring beneficial ownership checks.

• A January 2004 report by Asterias, a UK firm providing product and market intelligence on hedge funds, states that a majority (57%) of Asian hedge fund managers are located across Asia-Pacific (Singapore, Hong Kong, Japan and Australia), but they manage only 42% of the total assets of Asian hedge funds. Most of the Asia-focused hedge funds are domiciled in the Cayman Islands, an offshore tax haven. The Cayman Islands was removed from the Financial Action Task Force on Money Laundering (FATF) blacklist in June 2001 with the implementation of AML regulations, although it is still vulnerable to money laundering owing to its significant offshore sector, which attracts significant investments from non-residents. This makes it more difficult to differentiate between good and bad monies given the diverse origins of these investments and the large values involved.

Offshore operations and affiliates – risk analysis of investors

A hedge fund would need to analyse the money laundering risks posed by any entity that invests in it by using a risk-based evaluation of relevant factors regarding the investing entity. Those factors include the type of entity, its operator or sponsor, its location, the type of regulation to which that entity or its operator is subject, whether the entity has an AML programme, and the terms of any such programme.

Terrorist financing

Hedge funds provide the distance, secrecy and anonymity needed for terrorist-financing money movements. Historically, there might not have been enough money in terrorist operations to meet the initial $1 million minimum, but as opening deposits drop to $100,000 or even $10,000 with funds of funds hedge funds, it might provide the right combination of secrecy and minimum size to be used by terrorists.

Fraudulent hedge funds

In many countries, there is a weak regulatory regime for hedge funds. Furthermore, a fraudulent hedge fund can be difficult to spot in an industry where many legitimate funds have short lives, regularly have predicted investment returns that are on the high side and involve performance fees of up to 20% of profits. In the US, the Securities and Exchange Commission (SEC) has taken action against hedge funds that defraud investors. Commonly in these cases, the hedge funds lied to investors about the experience of their managers and the fund’s track record. Many paid off early investors to make the scheme look legitimate. In some of the cases, the hedge funds sent phoney account statements to investors to camouflage the fact that their money had been stolen.

Regulatory focus

The European Union (EU) has initiated regulatory amendments intended to encourage hedge funds to be domiciled in the EU instead of offshore tax and regulatory havens, coaxing investors back onshore and into a more supervised environment. This partly follows on from the decision by several European countries to allow retail hedge funds to come to the market. The planned new EU rules will be lighter than for conventional investment funds, concentrating on the provision of information to investors. The proposals still have to be adopted by the EU’s Council of Ministers before they become law.

These regulations follow on from US proposals that may require hedge funds both in the US and outside who have US clients to register with the SEC. Some funds of hedge funds already register their securities with the SEC.

Meanwhile, in Singapore, hedge fund managers operate as exempt fund managers under the Securities and Futures Act, but are still subject to the Monetary Authority of Singapore (MAS) SFA Notice on Prevention of Money Laundering, which as a minimum requires a background check and identification of beneficial owners, including where overseas intermediaries are used, and the intermediaries are not regulated in a jurisdiction of equal standing with Singapore. Therefore, even where the hedge funds themselves may be incorporated in a tax haven with lax AML laws, the MAS still requires the managers operating out of Singapore to maintain strict standards.

According to Hong Kong regulations, key personnel of fund managers of single hedge funds and funds of funds must have a minimum of five years’ general experience in managing hedge funds. At least two years of this should be specific to the particular strategy applied in that hedge fund. The regulations also require a fund of funds manager to have a due diligence process in place for selecting underlying funds and monitoring their performance.

AML guidance

The US Managed Funds Association (MFA) released its preliminary AML guidelines for hedge funds and hedge fund administrators in association with the law firm Sullivan & Cromwell in April 2002. The MFA Guidance recognises the critical role of carrying out an effective AML programme, and provides detailed information on how to determine the effectiveness of a third party’s AML programme, which conducts ‘know your customer’ checks and other due diligence on behalf of hedge funds and other alternative investment funds.

It is expected that the US Patriot Act will create a fully-fledged AML programme, customer identification programme and suspicious activity report filing requirements for hedge funds. Hedge funds should account for any risks posed by any offshore operations and affiliates in developing their policies, procedures, and internal controls. The AML compliance programme is to consist, at a minimum, of the following:

• The development of internal policies, procedures and controls to detect and report money laundering activities and other US Banking Secrecy Act violations. This would necessarily include an effective ‘know your customer’ programme that would identify prospective clients, business purpose of relationship and accounts, the sources of their assets and funds and intended use of funds.

• The designation of a compliance officer. Such a person would have to be independent of any profit centre and should report to senior management and the board of directors.

• The implementation of an employee-training programme. This should cover the relevant legal and regulatory requirements, the policies and procedures for initiating and monitoring client relationships, the maintenance of appropriate records and the identification of suspicious transactions or activities.

• An independent audit function. This would review and test the implementation of the AML programme.

Conclusion

Regulators in Asia should closely follow developments in the EU and the US, including a recent SEC paper titled ‘Implications of the Growth of Hedge Funds’, published in September 2003. The US SEC is looking to ensure investor protection, and is focusing on issues such as ‘retail-isation’ of hedge funds, transparency, risk management, conflicts of interest and fraud.

Hong Kong has already brought hedge funds under a proper regulatory and disclosure framework for retail sales to the public, and hopes to illustrate to the industry that hedge funds could be made more transparent without undermining the effectiveness of their investment strategies. The money laundering and terrorist financing risks of hedge funds in Asia need to be understood and addressed at the earliest by hedge fund operators, and regulators can also keep up the pressure.

Dominic Nixon is a partner and Asia head for anti-money laundering at PricewaterhouseCoopers.
Rohan Bedi is head of anti-money laundering services at PricewaterhouseCoopers in Singapore.
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