NICE Actimize News

AML Law for Venture Capitalists Still Under Study at FinCEN

John Sandman

March 12, 2007

In September 2002, the Treasury Department's anti-money-laundering (AML) enforcement arm, the Financial Crimes Enforcement Network (FinCEN), determined that private equity funds, including venture capital, weren't risky enough to be subject to Title III of the USA Patriot Act, which requires the know-your-customer (KYC) and customer identification programs (CIPs) that have become a matter of course for banks, securities firms and most other sectors of financial services.

"FinCEN continues to research these complicated industries and make assessments of their relative risks compared to other financial mechanisms that could conceivably be misused for money laundering," said FinCEN spokesperson Steve Hudak. "I can't comment further on any potential schedule for the status of the proposed rule."

The Sept. 11, 2001 terrorist attacks that gave rise to the tighter AML and counterterrorism-financing (CTF) rules coincided with the bursting of the tech bubble that hit the venture capital industry hard. Though these investment activities have recovered, and private equity as a whole has been growing at a healthy clip, the enforcement approach is status quo.

These firms were made exempt from the proposed rule for Section 352, requiring an AML compliance program and an AML compliance officer, that was published in the Federal Register on Sept. 26, 2002. Treasury decided to omit venture capital and private placement firms in implementing Section 352. The National Venture Capital Association (NVCA) lobbied Treasury for the exemption on the grounds that their inherent illiquidity made them a low risk for money laundering.

Industry experts say that the determining factor is the lock-up period on invested funds, which differentiates private equity from more-liquid financial businesses. "The theory is that venture capital and private equity firms have such long redemption periods that they don't need to be covered, hence are excluded by the two-year redemption in the proposed FinCEN rule," said Ross Delston, CEO of Washington, D.C.-based consulting firm GlobalAML.com. "While I don't agree, since any opening may be exploited and since money, like water, is a universal solvent, there does not seem to be a great deal of support for changing the rule."

"We proposed carving out venture firms from the definition of an unregistered investment company to the extent they impose lock-ups of two years or more," explained FinCEN spokesperson Anne Marie Kelly. That action, she added, "does not limit our ability to propose a rule for them in the future."

Most firms have a two-year lock-up period; at some firms it is longer-even until an investment interest is sold.

Absent a final rule, a proposed rule has the force of regulation unless or until FinCEN makes the rule final. The real estate industry, for example, has not yet gone beyond the notice of a proposed rule on closings and settlement, which was issued by FinCEN in April 2003.

"Venture capitalists are not per se financial institutions," said Greg Baldwin, a former federal prosecutor and Miami-based partner in Holland & Knight's compliance practice. "What FinCEN did was issue proposed rules for unregistered investment companies. They said this is going to cover most venture capital firms. But they added qualifications, one of them being the two-year lock up. FinCEN said the redeemability requirement excludes most VC firms."

Goal of Legitimacy

"I don't agree with the basic premise that Treasury has made, mainly, that money launderers aren't investors," said Baldwin. "Money launderers and drug dealers make investments just like anybody else does."

Baldwin describes the money laundering process in stages. The first is "placement, when you take dirty money such as proceeds from the drug trade and bring it into financial institutions. That's followed by layering; moving the money around from one country to another, and from one person to the accounts of a company, then to another company, to another person and so on. ... You reach a point where it begins to look legitimate. That's the last stage, integration, where the money comes out looking clean and is invested in something acceptable."

"Treasury's decision is entirely sound concerning the placement stage," said Baldwin. The problems start in the layering stage, and "by the time money comes into a venture capital firm, it's not coming in cash, it's already in the financial system." FinCEN discussed the risks in the September 2002 report on its proposed rule and recognized that venture capital could be used for layering. But the agency "concluded it was low risk because of the lock-up provision," Baldwin said. "So how many money launderers would use venture capitalists? I'm not sure that the answer is none or very few. Money launderers plan things way in advance. They could devise a plan to enter the VC space."

Baldwin believes that disciplined and well-financed money launderers would not find it a hardship to park nine-figure balances for two years in venture capital. "I think it's analogous to the sleeper cells the U.S. government reports that terrorist organizations create" he said. "If terrorist organizations are willing to take their investment in people that they've enlisted, trained, created a mission or potential mission for, and leave them in place for years at a time, why wouldn't they do the same thing with money? And that money would become very hard to track if it has the appearance of a regular investment."

The regulators' decision on venture capital may have had the unintended consequence of drawing money launderers' attention to them. "You might catch it if it's a large amount of money coming from a strange place from somebody you find you don't know as part of the CIP process," said Baldwin, "but once you get to the investment stage, it's difficult to identify a suspicious transaction."

The NVCA describes FinCEN's 2002 proposed rule on its Web site as a "victory" for it and its members, citing the "right of redemption within two years of an investment" as the defining factor. The organization has no advice for its member firms on the AML-CTF front. Firms generally have begun to realize that there is reputational risk in not confronting the threat of money laundering.

"We don't have best practices that we've put out about that," said Jennifer Dowling, spokesperson for the NVCA in Washington. "When the rules were being drafted in 2002, we put out alerts to our members to make sure they understood their obligations as they were developing."

Amir Orad, EVP of Actimize, a New York-based vendor of AML, compliance and fraud-prevention technology, said that any threat might be limited at the layering stage, and that dirty money working its way through the financial system could find its way into a firm that had KYC and CIP safeguards. "You can't rule out a third party-a clearing firm for example-that might have a compliance infrastructure in place," said Orad.

Orad pointed out that some firms covered under the Patriot Act were still struggling with provisions that went final last year. "Customer due diligence required firms to assess risk on an ongoing basis after an account is opened," he said. "The vast majority of the U.S. market is not doing that today. There is a major emphasis by regulators and firms themselves on this topic. We have talked to firms who don't even known basic information about the client. There are still major gaps, and more data is now being required than before."