Tag Archives: AML

Stop Tax Haven Abuse Act Introduced by Senator Levin

Bill Would Have Significant Impact on Private Funds

On July 12, 2011, United States Senator Carl Levin (D – Michigan) introduced the Stop Tax Haven Abuse Act of 2011 (the “Bill”). A prior version of the Bill was introduced in 2009. The Bill contains several provisions of interest to private fund managers, including provisions that:

  • Treat foreign corporations whose management and control occur primarily in the United States as U.S. domestic corporations for income tax purposes;
  • Clarify under the Foreign Account Tax Compliance Act (“FATCA”) when foreign financial institutions and U.S. persons must report foreign financial accounts to the IRS;
  • Treat Credit Default Swap (“CDS”) payments sent offshore from the United States as taxable U.S. source income; and
  • Require Anti-Money Laundering (“AML”) programs for hedge funds, private equity funds, and formation agents to ensure screening of offshore clients.

The Bill also authorizes the Treasury Secretary to take special measures against foreign jurisdictions or financial institutions that impeded U.S. tax enforcement as well as imposes additional disclosure requirements on multinational corporations by requiring them to include basic information on a country-by-country basis in their filings with the SEC. Notably, the Bill does not include a controversial proposal in the 2009 bill that specifically identified 34 “Offshore Secrecy Jurisdictions,” including the Cayman Islands and British Virgin Islands.

Foreign Corporations Treated as Domestic Corporations

Section 103 of the Bill prevents companies that are run from the United States from claiming foreign tax status if those foreign corporations

have gross assets of $50 million or more. The provisions indicate that gross assets includes “assets under management for investors, whether held directly or indirectly.” For corporations primarily holding investment assets, the management and control is treated as occurring primarily in the United States if “decisions about how to invest the assets are made in the United States.” These provisions if enacted could potentially eliminate any benefits of establishing offshore funds, which are primarily established for offshore and U.S. tax-exempt investors.

Strengthening FATCA Provisions

The U.S. Foreign Account Tax Compliance Act (“FATCA”) imposes a 30% withholding tax on U.S. persons holding offshore accounts on certain “withholdable payments” to “foreign financial institutions” which do not provide information about their U.S. accounts to the Internal Revenue Service. A “withholdable payment” is generally any U.S. source income, such as interest, dividends, rents, royalties and other fixed or determinable income (“FDAP”). Non-U.S. private funds will generally qualify as foreign financial institutions (“FFI”). In order for an offshore fund to avoid withholding, it must enter into an agreement with the U.S. Treasury to identify its U.S. investors, if there are any.

Section 102 of the Bill would expand the definition of a foreign financial institution to include entities that engage in derivative transactions. Section 102 also creates presumptions of U.S. control for purposes of certain legal proceedings for entities with accounts opened at non-FATCA institutions when those entities are established by or receive assets from U.S. persons.

Treatment of Credit Default Swaps

Existing tax laws allow CDS payments to avoid taxation if sent from the United States to persons offshore, such as an offshore hedge fund or foreign bank. Section 104 of the Bill would treat CDS payments sent offshore from the United States as taxable U.S. source income.

Anti-Money Laundering Programs for Hedge Funds

Sections 203 and 204 of the Bill would impose anti-money laundering requirements on unregistered investment companies, including hedge funds and private equity funds, and formation agents. Hedge funds would be required to establish AML programs; ascertain the identity of investors, including beneficial owners of foreign entities; and submit suspicious activity reports. Agents engaged in the business of forming corporations or other legal entities would also be required to establish AML programs.

Our Thoughts

The Bill will still need to survive a vote by both the Senate and the House and ultimately be signed by the President before becoming law.  There is likely to be some time before this Bill moves forward (especially considering the current focus on the debt ceiling) which means plenty of time for the industry to lobby against this effort.  However, the bill highlights the unpopularity of the investment management industry with certain members of Congress and it is no surprise we see proposed taxing provisions- the U.S. needs more tax revenue and investment managers are an easy group to target.  We see this every couple of years when various members of Congress propose to increase the carried interest for fund managers.  It will be interesting to see how this plays out and we will provide periodic updates on the situation.

For more information about the Bill, refer to Senator Levin’s July 12, 2011 press release.  Senator Levin has also released a summary of the bill as well as his floor statement introducing the bill.

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Cole-Frieman & Mallon LLP is a law firm which provides advice with respect to domestic and offshore hedge fund operations.  Bart Mallon can be reached directly at 415-868-5345; Karl Cole-Frieman can be reached at 415-352-2300.

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Congress to examine Hedge Fund AML Requirements Next Year

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In an article yesterday we discussed the withdrawal of proposed rules which would require hedge funds to implement anti-money laundering compliance programs (see Hedge Funds and AML Requirements).  Yesterday Senator Carl Levin, a democrat from Michigan, released a statement condemning the withdrawal of proposed hedge fund AML rule by the Treasury.  Senator Levin statement said, “The Administration’s five-year failure to extend anti-money laundering controls to hedge funds with offshore money – despite the hedge fund industry’s willingness to accept those controls – is inexplicable, ill-timed, and unwise.”  Futher, Sentor Levin noted that Congress will face the issue in the future.   “The absence of anti-money laundering controls on hedge funds is another regulatory gap that the Congress will have to tackle after the election.”  The full statement, reprinted below, can be found here.

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FOR IMMEDIATE RELEASE
November 3, 2008
Contact: Press Office
Phone: 202.228.3685

Statement of Senator Carl Levin on Treasury Withdrawal of Proposed Rule to Require Anti-Money Laundering Controls at Hedge Funds

Senator Carl Levin, Chairman of the U.S. Senate Permanent Subcommittee on Investigations, today released the following statement regarding anti-money laundering controls at hedge funds. Section 202 of S. 681, a 2007 bill Levin introduced to stop a wide range of offshore abuses, would require Treasury to issue a final rule requiring hedge funds to implement anti-money laundering controls.

“Last week, with no warning, the Bush Administration revoked a 2002 proposed rule to require hedge funds to install anti-money laundering controls. Hedge funds are unregulated financial companies that can handle millions of dollars in offshore money without any legal obligation to check who is behind the funds or report suspicious activities. A 2006 investigation by my Subcommittee showed how hedge funds can bring suspect offshore funds into the United States, highlighted the lack of hedge fund regulation, and recommended Treasury finalize its proposed anti-money laundering rule.

“But instead of plugging the hedge fund regulatory gap by issuing a final rule, the Administration went the opposite way, withdrew its anti-money laundering proposal, and offered nothing in its place. The Administration’s five-year failure to extend anti-money laundering controls to hedge funds with offshore money – despite the hedge fund industry’s willingness to accept those controls – is inexplicable, ill-timed, and unwise. The absence of anti-money laundering controls on hedge funds is another regulatory gap that the Congress will have to tackle after the election.”

Other HFLB articles:

Hedge Funds and Anti-Money Laundering (AML) Requirements

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Hedge fund managers are often confused about their anti-money laundering (AML) obligations and seem to receive different information from various sources.  In general, domestic hedge fund managers do not have any AML obligations.  Additionally, it is unlikely that domestic hedge funds will be subject to any AML requirements in the near future.

The rise of the AML regulations came from the PATRIOT ACT, which required financial institutions to adopt AML procedures.  These regulations did not apply to domestic hedge funds specifically, but the Treasury promulgated proposed rules which would have applied the AML requirements to domestic hedge funds.  The proposed rule would have required hedge funds to (i) have internal AML polices, procedures and controls, (ii) have an AML officer, (iii) have ongoing compliance training for employees and (iv) have an annual audit of the AML program.

An article by the Washington Post recently announced that the Treasury has withdrawn the proposed AML requirements for hedge funds. The article states that the central reason why the AML requirements for hedge funds did not go through is that it is unlikely that terrorist groups would use hedge funds as a way to launder money.  The article states that hedge funds may be too risky for terrorists.

This announcement does not affect other financial institutions, such as banks and broker-dealers, which have specific AML and Know Your Customer (KYC) requirements.  The fact that the proposal was withdrawn does not mean, however, that hedge funds are free from any sort of AML.  As noted above, banks and broker-dealers are subject to their own AML requirements and may require their customers (hedge funds) to also implement AML policies.  If a bank or BD does require this, then the hedge fund manager should discuss the situation with the fund’s attorney to determine the appropriate next steps.  Offshore hedge funds, too, are subject to the anti-money laundering regulations of the jurisdiction in which they are domiciled.  The withdrawal of the proposed AML requirements does not affect these offshore hedge funds.

Please also note that state securities commissions may try to require hedge funds to incorporate AML requirements.  Currently we do not know of any state securities commissions with these requirements, but Texas has tried to implement a requirement like this in the past.

Please contact us, or another hedge fund attorney, if you have any questions.  Other related HFLB articles include:

Hedge Fund Administrator – What is a Hedge Fund Administrator?

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A hedge fund administrator is a service provider to the hedge fund; the main job of the administrator is to provide certain accounting and back office services to a hedge fund as detailed below.

Hedge fund administrator services

Generally, administrators will provide a variety of services to the hedge fund manager.  The central service is monthly or quarterly accounting of investor contributions and withdrawals and computing the profits and losses for the accounting period.  The administrator may also provide other back end services such as transfer agent services (handling the subscription documents and making sure checks are cashed or wires are appropriately handled).

A relatively new service which some administrators provide is a “second signer” service which is designed to give investors greater confidence that a hedge fund manager will not run off with their money.  Under a “second signer” agreement, the hedge fund manager will need to get a sign off from the administrator before the manager can make a transfer or a withdrawal from the fund’s account.

In addition to the above, the hedge fund administrator may perform the following duties:

  • calculating the management fee and performance fee
  • working with the auditor
  • keeping certain financial records
  • may act as the registered agent and registrar (offshore hedge funds)
  • Anti Money Laundering review (generally only for offshore hedge funds)

Three types of hedge fund administrators

Small administration firms – these types of administrators are very lean organizations which are controlled and run by one or two people.  Typically the one or two people will have significant experience in the hedge fund industry, many times with other administration firms, hedge fund audit firms and hedge fund consultants.  The typical client will be a start-up hedge fund.  While these administrators can handle funds with assets of up to and sometimes beyond $500 million, most of their clients will generally start with less than $50 or $100 million.

These administrators are going to be the most cost-effective solution for a start up hedge fund.  Additionally, these administrators often provide some of the best customer service – usually the manager will be able to talk to the principal at any time.  For these administrators, the manager will be looking at a start-up fee of anywhere from $500 – $1,500 and then a monthly administration fee of $750 – $1,500.

Medium-sized firms – these firms are usually established businesses with strong structure, have been around for a while, and have a fairly large and established client base.  It is expected that a medium-sized firm would have one to two principals with 10-20 years of experience in the hedge fund industry.  These firms will have clients that range in size from $50 to $500 million and may have clients which have $2 to $5 billion in assets.

Medium-sized firms will charge a start-up fee of $1,500 or more and will usually base their administration fee as a percentage (basis points) of AUM, subject to a minimum monthly fee which is usually around $2,000.

Large firms – these firms are well-established within the hedge fund industry and are thriving businesses themselves.  These firms may be subsidiaries of large international banks or (former) investment banks.  The principals of these firms are well-connected to the major players in the industry and most of the clients of these firms are the large hedge funds.  If a hedge fund uses a large firm for administration, the fund should expect to pay a minimum of around $5,000 a month.  Because of the relatively high costs of the large administrators, it may not make sense for a fund with less than $250 million to use such an administrator.

Offshore hedge fund administration

Offshore hedge fund administration generally refers to the administration of an offshore hedge fund.  Typically the process and function will be the same, but there are more issues that come into play with an offshore hedge fund.  Because offshore hedge fund fees can be structured in a variety of ways, the administrator may want to discuss the structure with the hedge fund attorney if there are any uncertainties with the structure.

Questions on hedge fund administrators

1.  How do I find a hedge fund administrator?

There are many ways you can find a hedge fund administrator and other hedge fund service providers.  Your hedge fund attorney can help recommend a administrator based on the needs of your fund.  Please note that not all administrators offer services to all types of hedge funds.  Please contact us if you would like us to recommend a hedge fund administrator (or if you have any other hedge fund administration questions).  Additionally, you can reference this survey of hedge fund administrators.

2.  Who pays for the costs of the administrator?

As I noted in an article on hedge fund expenses, the costs of the administrator are usually paid by the fund and not by the management company.  Some managers may choose to pay the administration costs so that these costs will not be a drag on performance.  You should discuss this issue with your attorney.  Additionally, please note that the costs above are general guidelines – if your strategy requires more in-depth valuation practices  (i.e. the fund trades hard to value instruments), the administration costs may be higher.

3.  Does a start-up hedge fund need an administrator?

Yes.  While there is no law that requires a domestic hedge fund to have an administrator, there is no real good reason why a hedge fund should not have an administrator.  Outside verification of a hedge fund’s numbers, especially given the current state of the capital markets, is becoming a requirement for hedge fund investors.  Additionally, there are law firms which will not work with start-up hedge funds that do not have an administrator.  Another consideration is the audit – if there are no independent third party numbers to review, the audit becomes more difficult and potentially more costly.

SEC cracks down on lax AML implementation

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Yesterday the SEC ordered E*Trade to comply with the AML rules which requires brokers to know the identity of their clients. The order found that E*Trade did not verify the identities of 65,442 secondary accountholders. While this is a major breach of the AML rules, it also shows that the SEC is continuing to be vigilant in this time of economic uncertainty and market turmoil.

The full text can be found below and at: http://www.sec.gov/news/press/2008/2008-156.htm

SEC Orders E*Trade Brokerage Firms to Comply With Anti-Money Laundering Rule

FOR IMMEDIATE RELEASE
2008-156

Washington, D.C., July 30, 2008 — The Securities and Exchange Commission today charged E*Trade Clearing LLC and E*Trade Securities LLC (collectively, E*Trade) for failing to comply with an anti-money laundering rule that requires broker-dealers to verify the identities of their customers and document their procedures for doing so.

The SEC’s order finds that E*Trade failed to accurately document certain Customer Identification Program (CIP) practices and verify the identities of more than 65,000 of its customers as required by the USA PATRIOT Act and SEC rules. E*Trade agreed to settle the SEC’s enforcement action without admitting or denying the allegations, and will pay $1 million in financial penalties.

“E*Trade is one of the largest online brokerage firms in the world, and a compliance lapse of this type has the potential to undermine the nation’s anti-terrorism and anti-money laundering efforts,” said Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement. “The penalty and undertakings imposed in today’s enforcement action reflect the critical nature of anti-money laundering rules, and will provide greater assurance that future compliance will be seriously and continuously monitored.”

Cheryl Scarboro, Associate Director in the SEC’s Division of Enforcement, added, “On several occasions, E*Trade personnel discovered and rediscovered its CIP deficiency. However, E*Trade did not initiate any corrective action until the problem resurfaced almost two years after the compliance deadline. E*Trade’s 20-month period of noncompliance clearly resulted from a disjunctive organizational structure and inadequate management of its CIP responsibilities.”

The SEC’s order finds that E*Trade established, documented and maintained a CIP that specified that it would verify all accountholders in a joint account. However, during a 20-month period, E*Trade failed to follow the verification procedures set forth in its CIP. The order finds that E*Trade did not verify the identities of secondary accountholders in newly opened joint accounts. Consequently, the order finds that E*Trade’s documented procedures differed materially from its actual procedures.

The SEC’s order specifically finds that, from October 2003 to June 2005, E*Trade did not verify the identities of 65,442 secondary accountholders in joint accounts as required by the CIP rule and its own procedures. The SEC’s order further finds that E*Trade’s compliance failure was systemic, resulting from lack of a cohesive organizational structure, lack of adequate management oversight, and miscommunications among personnel in several E*Trade business groups.

E*Trade consented to the issuance of an order instituting administrative and cease and desist proceedings for violations of Section 17(a) of the Securities Exchange Act of 1934 and Rule 17a-8 thereunder. In addition to the financial penalties, E*Trade agreed to a censure and to retain a qualified independent compliance consultant to verify the adequacy of its CIP rule compliance program.

In advance of settling this matter, E*Trade stated that it submitted the secondary accountholder information on joint accounts originally missed to its third-party vendor for verification. According to E*Trade, the verification process did not identify any joint accounts that should not have been opened.