Private capital funds are familiar with “know your client” and “anti-money laundering” (AML) requirements. The goal is to have a system that verifies that investors are who they say they are, confirms the suitability of investing in private capital funds, and investigates investors to ensure they are the “good guys” – and not involved in terrorism, drug smuggling or some other unsavory activity. The recent rules passed by the Securities and Exchange Commission (SEC) under the JOBS Act expand on these concepts, requiring fund managers to know themselves (no bad actors involved in the management of the fund) and, if they generally solicit, to verify that their investors are accredited.
JOBS ACT
In July 2013, when the SEC lifted the ban on general solicitation in certain types of private securities offerings (including capital raising for venture capital, private equity, real estate, hedge and other types of private investment funds), it required fund managers to take extra steps to:
· ensure there are no “bad actors” involved in the issuing, selling or managing of the fund; and
· verify that investors are accredited individuals or qualified institutions, if the fund is generally soliciting.
Under the bad actors provision, the SEC prohibits persons with disqualifying acts from participating in the management of a fund. This includes directors and certain officers, general partners, and managing members of the issuer; 20 percent beneficial owners of the issuers; promoters; investment managers and principals of pooled investment funds; and persons compensated for soliciting investors as well as the general partners, directors, officers and managing members of any compensated solicitor. Disqualifying acts include, but are not limited to, criminal conviction in connection with the sale or purchase of a security, court injunctions and restraining orders in connection with a sale or purchase of a security, final orders from the Commodity Futures Trading Commission, and certain SEC disciplinary orders, among others.
Additionally, firms choosing to use general solicitation must take reasonable steps to verify that investors are accredited individuals or qualified institutions. (Note: Investor verification is not required for private capital funds that continue to market as they have traditionally – i.e., no general solicitation and only approaching accredited investors privately.) Fortunately, the SEC provided the following that issuers may use to satisfy the verification requirement for individual investors:
· Reviewing copies of any IRS form that reports the income of the investor and obtaining a written representation that the investor will likely continue to earn the necessary income in the current year.
· Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person meets the criteria for an accredited or qualified investor.
UPGRADING YOUR COMPLIANCE PROGRAM
Whether you are concerned about anti-money laundering, bad actors or verifying investors, the required process is similar and includes:
1. Develop a written policy that designates a person responsible for compliance
Private capital funds should have a written policy that establishes internal policies, procedures and controls designed to identify and prevent money laundering, identify internal bad actors, and verify that investors are accredited or qualified. The policy should designate the compliance person who is responsible for determining anti-money laundering, bad actors or to verify investors. The compliance person should have sufficient authority and resources to implement the written policy. The written policies should be reviewed annually.
2. Educate management and employees
In creating a culture of compliance, private capital funds are organizing regular training programs on various compliance issues. The training sessions should be geared to the role the person has within the fund. The training program should cover the policies, associated risks and procedures for handling concerns. For example, employees in accounting/finance and investor relations, should be sensitized to the need to do an AML check update prior to a distribution, especially if an investor requests that the distribution be made to a different address or investor name than what was provided at the time of subscription. Funds should also make it clear that reports of suspicious activities are confidential and should not be disclosed to any person involved in the suspect transaction.
3. Collect identifying materials and supporting documents
The purpose for collecting identifying materials is to verify the investor’s identity. The types of identifying materials required will vary depending on whether it is a person, trust, private company, public company, institution or an adviser. Sometimes it may be necessary to determine the underlying investors (e.g., a wealth manager that advises multiple high net-worth individuals).
With regards to AML for an individual investor, the firm will want to ascertain the person’s name, recent addresses, date of birth, and tax identification number and supporting documentation (e.g., passport, government issued photo identification). For legal entities, fund managers should take reasonable steps to obtain the entity’s name, address, formation date, tax identification number and the authority it has to make such an investment. Supporting documentation could include articles of incorporation, government-issued business license, a partnership agreement, or trust instrument, among other documents.
For investor verification, funds that are generally soliciting will also need to verify that the investor is qualified or accredited by reviewing IRS documents (e.g., tax return), a brokerage statement or a letter from an approved third party advisor (e.g., lawyer, accountant or broker-dealer) who has reasonable knowledge of the individual’s finances.
4. Diligence and evaluation
The key to setting up an acceptable AML compliance program is assessing the risk of the fund’s investor base and geographic location in which it conducts business. All investor identification documents should be examined to determine if further investigation is warranted. Factors that could lead to further investigation include: investors or investment companies located in jurisdictions considered as non-cooperative to the US, investors whose investment is routed through a foreign shell bank, investors who are in a jurisdiction designated by the Financial Action Task Force as being of concern for money laundering, or an investor who is a senior foreign political figure or any other investor who causes the fund manager or compliance officer to believe the funds may not be legitimate. Additionally, all investors should be checked against the Office of Foreign Asset Control list. On a regular basis, funds should re-evaluate its investor base to ensure there are no new AML concerns. When assets or accounts coming from prohibited sources are identified, the fund should discuss with legal counsel if it has a duty to report the incident. Further, the fund may be required to block those assets and place them into segregated accounts.
Fund managers should also perform diligence on those affiliated with the fund, including: all the investment professionals of the fund, CFO, investment committee and advisory board members, significant investors, placement agents, and others who may impact investment decisions. They should be evaluated for AML concerns as well as to insure that these individuals are in good standing with the SEC.
With regards to investor verification, if the fund has secured a tax document, brokerage statement or confirmation letter indicating the person’s income or net worth meets the standards as an accredited or qualified investor, it is operating in a safe haven and can accept this investor into the fund. If it cannot secure such documentation, the fund should discuss with legal counsel alternative methods for verifying the investor’s status as being qualified or accredited.
5. Record keeping
Funds should document and maintain a record of the actions taken by the fund, results of any investigations, and steps taken to clear or reject investors.
CONCLUSION
Recent decisions by the SEC expand on AML/KYC concepts. Funds should amend their compliance program accordingly. While many funds outsource portions of their compliance program, they are ultimately responsible for their own compliance.
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PEF Services LLC is a fund administrator for small to middle market private capital funds. Mark Heil can be reached at Mark@pefundservices.com.
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