Regulatory Roundup: Understanding FinCEN’s New Proposals

The latest development from the Financial Crimes Enforcement Network (FinCEN) has issued a Notice of Proposed Rulemaking (NPRM) that could significantly alter the compliance framework for investment advisers. This newly proposed rule aims to fortify the U.S. financial system against the threats of illicit finance and national security concerns, and understanding the nuances of the proposed changes is crucial for maintaining operational integrity and avoiding the pitfalls of non-compliance. Senior Advisor Michele McGurk unpacks what the proposals mean for managers and the key takeaways to navigate compliance effectively.

Navigating FinCEN’s Proposed AML/CFT Rule: A Guide for Investment Managers

On February 13, 2024, the Financial Crimes Enforcement Network (FinCEN) issued a Notice of Proposed Rulemaking (NPRM) that proposes significant changes for investment advisers to bolster the U.S. financial system against illicit finance and national security threats.

Despite some investment advisers already adhering to Anti-Money Laundering/Countering the Financing of Terrorism (AML/CFT) requirements, the 2024 Investment Adviser Risk Assessment performed by the US Treasury underscored a critical gap in the industry’s defense against illicit financial activities. Notably, it highlights the role of investment advisers as potential conduits for illicit proceeds associated with corruption, fraud, and tax evasion. How illicit proceeds are laundered through investment advisers and private funds may differ, but they typically involve concealing the illegitimate source of funds. These funds are often combined with legally obtained ones, creating pools of capital used to invest in various U.S. assets, including securities and real estate.

The risk assessment report also points to the strategic use of advisers by foreign states, such as China and Russia, to gain access to technologies and services that pose long-term national security implications. As highlighted in their findings, the absence of comprehensive AML/CFT standards across the sector exposes the investment adviser industry to increased vulnerability.

Below, we’ll delve into the highlights of the proposed rule, explore the implications, and provide a guide for investment managers to ensure you’re staying ahead in compliance.

Key Components of the Proposed Rule
The overarching goal is to enhance transparency, combat money laundering, and facilitate law enforcement in identifying and thwarting illicit proceeds entering the U.S. economy. Currently, there are no Federal or State regulations requiring investment advisers to maintain AML/CFT programs.

Applicability and Classification
The proposed rule has a broad scope, covering SEC-registered investment advisers (RIAs) and exempt reporting advisers (ERAs) by redefining them as “financial institutions” under the Bank Secrecy Act (BSA). Notably, ERAs advising solely private funds and having less than $150 million in assets under management or venture capital funds are considered financial institutions subject to the AML/CFT program requirements under the proposed rule. The scope of the proposed rule would also cover certain non-US investment advisers located abroad, without staff or a branch in the U.S., but are nonetheless required to register with the SEC as an RIA or file Form ADV as an ERA. However, the proposed rule does not cover state-registered investment advisers.

Incorporating Risk-Based AML/CFT Programs
As described in FinCEN’s Factsheet, a core component of the rule is the implementation of risk-based AML/CFT programs tailored to the specific risks and client profiles of investment advisers. This mandates the development of written internal policies, procedures, and controls tailored to meet the requirements of the BSA. It also requires the appointment of an AML/CFT compliance officer, who would be responsible for implementing and monitoring the operations and internal controls of the program. The rule would also require establishing an ongoing employee training program and soliciting independent tests for compliance from integral components of this proposed regulatory framework. The approval of the AML/CFT program must be documented in writing, either by the board of directors or trustees. In cases where no formal board exists, the responsibility falls on the sole proprietor, general partner, trustee, or individuals performing functions akin to a board of directors.

Filing Requirements and Recordkeeping
The proposed rule requires RIAs and ERAs to file Suspicious Activity Reports (SARs) and Currency Transaction Reports (CTRs) with FinCEN. Additionally, adherence to Recordkeeping and Travel Rule obligations under the BSA will necessitate maintaining detailed records related to the transmittal of funds.

The proposed rule introduces significant reporting and recordkeeping requirements for covered investment advisers. It necessitates the reporting of suspicious transactions by covered investment advisers. Instances involving at least $5,000 in funds or assets require reporting if there’s knowledge, suspicion, or reason to believe the transaction involves illicit funds, evades BSA requirements, lacks apparent lawful purpose, or facilitates criminal activity. Covered investment advisers must develop a robust suspicious transaction monitoring program aligned with their specific money laundering risks. Additionally, CTRs would be mandatory for transactions exceeding $10,000 in currency during a business day. It would also require adherence to the Recordkeeping and Travel Rules, retaining specific information for fund transmittals exceeding $3,000.

Investment managers must understand the SAR electronic filing and notification procedures. Suspicious transactions must be reported to FinCEN through SAR within 30 days of detection, with provisions for an additional 30-day delay if no suspect is identified. Immediate notification to law enforcement is mandatory for situations demanding urgent attention, such as suspected terrorist financing or ongoing money laundering schemes. Voluntary reporting to FinCEN’s Resource Center is also an option for transactions potentially linked to terrorist activity. Covered investment advisers should carefully evaluate and adapt their practices to these proposed requirements, considering the implications on their operations and client relationships.

Information Sharing & Delegation of Examination Authority
FinCEN proposes a strategic move by delegating examination authority to the SEC, to leverage its specialized expertise in overseeing investment advisers. FinCEN’s proposal includes provisions for information sharing between FinCEN, law enforcement agencies, and certain financial institutions and reflects a collaborative approach to enhancing oversight and ensuring regulatory compliance within the sector. Special measures aligned with Section 311 of the USA PATRIOT Act may also be applied under specific circumstances.

Timelines and Compliance
The comment period for the NPRM is open until April 15, 2024, and covered investment advisers would be required to comply with the rule within 12 months from the final rule’s effective date.

Key Takeaways for Investment Managers
Investment managers should prioritize establishing comprehensive AML/CFT programs tailored to their specific risks and client demographics. This proactive approach is vital for ensuring robust defenses against illicit financial activities. AML/CFT programs should include client risk assessment protocols, which identify and evaluate client-specific money laundering risks such as source of funds, local jurisdiction, and regulatory framework of that jurisdiction. Additionally, the adviser’s past interactions with the client and references from other financial institutions could also be considered as relevant factors.

AML/CFT programs must also incorporate vigilant suspicious activity monitoring through advanced systems capable of promptly detecting and reporting suspicious transactions, stringent record retention, and comprehensive compliance documentation that ensures accessibility and transparency. Additionally, it’s strongly recommended that investment managers actively engage with regulators and participate in the public comment process. Investment managers can actively shape and refine the proposed rule by contributing valuable insights, addressing uncertainties, and fostering a collaborative regulatory environment.

FinCEN’s proposed rule marks a pivotal moment for investment managers, underscoring the imperative of robust AML/CFT measures. As the regulatory landscape undergoes significant shifts, investment managers must proactively embrace these changes, leveraging comprehensive programs to safeguard against illicit activities. Collaboration with service providers remains a critical facet, and meticulous documentation emerges as the cornerstone of proving compliance. By proactively navigating these regulatory shifts, investment managers can ensure the resilience and success of their firms in the dynamic financial regulatory landscape.

SEC’s New Dealer Definition: What it Means for Investment Advisers in Treasury Markets

On February 6, 2024, the SEC adopted new rules that modify the definition of “as a part of a regular business”, and consequently impact the definitions of “dealer” and “government securities dealer”. These changes are expected to have a significant impact on investment funds and proprietary trading firms (PTFs) involved in trading Treasuries.

The SEC proposed the new rule in March 2022 to strengthen investor protection and foster market integrity, resiliency, and transparency. However, since the initial proposal, it’s faced skepticism within the market regarding its practicality. The regulatory move has generated concerns as it solidifies the SEC’s perspective that the definition of a “dealer” is exceedingly broad.

The SEC argues that technological advancements in electronic trading have incentivized certain PTFs, private funds, and similar market participants to enhance liquidity in the $26 trillion Treasury market – a function traditionally associated with dealers. The new rule specifically focuses on market participants engaged in profit-making through buying low and selling high within the Treasury market, which generally rely on the “trader” exception.

The SEC contends the new rule may decrease the likelihood these market participants will discontinue trading during market turbulence, enhance regulatory transparency, and, in the SEC’s view, contribute to a more level playing field. However, opponents including Commissioner Mark T. Uyeda, argue that the new rules seem to promote an outcome the SEC seeks to avoid, by significantly increasing compliance costs which will in turn result in less liquidity and higher transaction costs. Additionally, the new rules may prompt certain funds to strategically alter related investment activities to avoid being classified as a dealer.

This move, while adding to the regulatory landscape, introduces potential complexities, not only in the Treasury market but also in other sectors, such as crypto asset securities. With the influx of new regulations over the past year, the adoption of this new rule reflects another strategic move in the SEC’s ongoing regulatory efforts impacting private funds.

Summary of the New Rule
The final new rules include two qualitative standards for trading activities that have the effect of providing liquidity to other market participants:

• Regularly expressing trading interest involves consistently showing a desire to buy or sell securities at or close to the best available price on both sides of the market, ensuring accessibility to other participants.
• Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or, from capturing any incentives offered by trading venues to liquidity-supplying trading interest.

The new rules apply to any person who owns or controls at least $50 million in total assets and is not a registered investment company (under the Investment Company Act of 1940), central bank, sovereign entity, or international financial institution. In contrast, private funds and registered investment advisers are not explicitly excluded from the rule.

The new final rule also includes an “anti-evasion” provision that seeks to prevent a person from structuring activities indirectly in what would otherwise satisfy the qualitative standard or by disaggregating accounts. It also explicitly incorporates a “no presumption” clause. This means there is no automatic assumption that an individual is not a dealer solely because they are not categorized as such by the final new rule. In other words, a person could be considered a dealer if they are involved in the routine buying and selling of securities (or government securities) for their account, regardless of whether they fulfill the conditions outlined in the final rule.

The final new rule states that investment advisers trading for their “own account” could trigger dealer registration obligations and would be required to register. Nonetheless, when investment advisers trade in separately managed accounts on behalf of their clients, even those exercising discretion, such activities are likely considered fiduciary and not categorized as buying and selling for their “own account.” However, it’s important to note that the SEC emphasizes that investment advisers may still fall under dealer registration requirements if their proprietary activities meet the criteria outlined in the final new rule.

The final rules are set to become effective 60 days (about two months) after publication in the Federal Register, and the compliance date will be one year after the rule’s effective date.

Key Takeaways for Investment Managers
The SEC’s new rule represents a comprehensive effort to identify entities engaged in de facto market-making activities, reaching beyond conventional scenarios. Notably, RIAs and private funds are not exempt from dealer registration should their activities align with the qualitative standards of the rules. Also, investment managers that invest through master/feeder or multi-strategy fund structures must meticulously evaluate their trading activities across diverse strategies to determine potential dealer status. While an investment adviser trading on behalf of client accounts may still receive exemption if activities are deemed to be solely fiduciary, exceptions arise if the adviser holds the account or directly benefits from it, requiring individual assessment of client accounts. SEC guidance clarifies that periodic, rather than continuous or simultaneous, expression of trading interest on one side of the market may trigger dealer activity, with regularity dependent on security depth and liquidity.

Any person deemed to be acting as a dealer under the new rule must register with the SEC and become a member of a national securities exchange and/or the Financial Industry Regulatory Authority (FINRA) and comply with applicable SEC and exchange/FINRA rules within one year of the effective date. Such registration will result in significantly higher compliance costs and regulatory scrutiny imposed on broker-dealers, including increased recordkeeping, risk management, net capital requirements, trade reporting, self-reporting rule violations, and increased examinations and enforcement investigations.

2024 SEC Outlook

Amidst an ever-evolving regulatory environment, investment managers have faced a substantial influx of new regulations over the past year, with a continuous flow of new regulations anticipated for 2024 and beyond. Navigating this dynamic landscape requires a vigilant approach as regulatory developments continue to emerge. Firms will likely face challenges in implementing so much change at once, and the number of operational adjustments required will even prove to be demanding for firms accustomed to more regulatory oversight. Staying ahead of the curve is vital, necessitating a keen awareness of timelines to facilitate the seamless integration of necessary changes into the compliance programs of investment firms.

In early December 2023, the SEC published their Regulatory Flexibility Agenda, which sets forth the SEC’s plans for short and long-term regulatory actions. The timeline is only an estimate, and does not constitute when, and if, the SEC will act. The 2024 plan outlines 29 final rules and 14 proposed rules, which is reasonable to expect based on the 2023 actual of 25 final rules and 18 proposed rules. The following include the 2024 expected actions for both final and proposed rules that are most relevant to the investment management industry:

SEC Final Rules – 2024 Compliance Dates Approaching
T+1 Settlement
The transition to T+1 settlement is set to go into effect on May 28, 2024, as the result of the SEC rule amendments adopted in February 2023. The final rule shortens the standard settlement cycle for most broker-dealer transactions from two business days after the trade date (“T+2”) to one business day after the trade date (“T+1”). It amends certain recordkeeping requirements applicable to RIAs around the confirmation process.

RIAs are required to create and retain records for transactions falling under Rule 15c6-2(a). This includes records of each written confirmation received, along with any allocation and affirmation sent or received, featuring a date and time stamp for each transaction indicating the time it was sent or received. Electronic record-keeping is permissible, contingent upon meeting specific conditions.

Advisors commonly engage in diverse trade allocation processes, utilizing internal systems, portfolio management systems, and order management systems. While some may retain records in paper format, others, including third parties acting on an advisor’s behalf, often maintain originals or electronic copies of allocations, confirmations, and affirmations. Although advisors can delegate the record-keeping responsibility to third parties, their obligations remain the same under Rule 204-2. Importantly, the SEC mandates advisors to maintain records of allocations or affirmations sent or received, even if such records are obtained from a third party.

In preparation for T+1, its recommended investment managers:

• Coordinate with all broker-dealer counterparties to determine what is expected from investment adviser clients based on revisions to their policies and procedures;
• Revisit and review internal policies, procedures, and processes, including those that require coordination with external service providers, as appropriate, to confirm they are prepared to complete the confirmation process on the same day;
• Assess any changes that may need to be made to technology systems, operations, and processes used to communicate with broker-dealers to allow timely completion of the allocation, confirmation, or affirmation process;
• Evaluate the potential investment impact on investment strategies, particularly those in foreign currency exchange trades and ADR transactions, and
• Amend recordkeeping procedures to comply with the new amendments to maintain the new timestamped records required under the amended Rule 204-2 and ensure relevant employees are trained and prepared to implement such changes to the adviser’s daily processes.

Amendments to Form PF Reporting (1st Round)
The first round of Form PF Reporting changes issued by the SEC in a final rule in May 2023 partially went into effect on December 11, 2023, for current and quarterly event reporting, with all other changes to follow on June 11, 2024. These revisions represent the most sweeping changes made to RIA reporting since the inception of Form PF and require advisers to provide greater insight into their operations and strategy than ever before. As a reminder, the key changes in the 1st round of Form PF are:

• Require large hedge fund advisers to report certain key events within 72 hours
• Require all private equity fund advisers to report certain key events quarterly (within 60 days)
• Require enhanced reporting by large private equity fund advisers

New Private Funds Rules
The sweeping new private adviser fund rules we covered during our August 2023 regulatory roundup present significant changes that will expand oversight, disclosure, and extensive new requirements for private fund managers. Among the new changes, the new rule requiring documentation of annual review of compliance procedures and policies went into effect in late 2023. It thus will first apply to annual reviews performed in 2024. The preferential treatment, restricted activities, and the adviser-led secondary rule go into effect September 14, 2024, for advisers with greater than $1.5B AUM, and March 14, 2025, for advisers with less than $1.5B AUM. The rules related to quarterly statements and audit requirements go into effect on March 14, 2025, for all advisers, regardless of size.

Beneficial Ownership Reporting Changes – Schedule 13D/13G
The amendments to Regulation 13D-G affecting the reporting requirements for investors acquiring more than 5% beneficial ownership of a voting class of equity securities registered under Section 12 of the Exchange Act were finalized in October, as highlighted in our November 2023 regulatory round up article, with compliance dates of February 5, 2024, for the revised Schedule 13D Disclosures and Disclosures of Derivatives Securities. The compliance date for the revised Schedule 13G deadlines is September 30, 2024, and December 18, 2024, for the XML requirement for Schedules 13D and 13G.

Short Sales Rule 13f-2
The new short sales rule 13f-2, which we highlighted in our went into effect January 2, 2024, with the compliance date to follow 12 months later on or around January 1, 2025. The rule mandates institutional investment advisers exceeding specific reporting thresholds to disclose short position and activity data for equity securities on Form SHO.

Amendments to “Fund Names” Rule
The revised Investment Company Act “Names Rule” mandates that funds using terms like “growth,” “value,” or those with a thematic focus, such as ESG-focused funds, must invest a minimum of 80% of assets in line with the suggested investment focus in the fund’s name. Compliance involves quarterly reviews, and funds have up to 90 days for corrective action if they deviate from the 80% investment policy. Firms offering ESG-themed funds need to align their offerings with the amended rule, requiring a comprehensive review of fund names, investment strategies, and underlying compositions. Continuous investment monitoring and disclosure preparation are essential for compliance. Funds newly affected by the rule may need to refile prospectuses with updated criteria. The rule has tiered compliance dates, with large entities complying by December 11, 2025, and small entities by June 11, 2026. Firms should initiate a phased approach, starting with identifying impacted funds, followed by business decisions on rule implementation or fund name changes, and ultimately managing impacted funds to compliance.

Key Takeaways
2024 is expected to be a challenging year for investment managers as they adapt to the extensive new final rules facing the industry. All levels of investment management firms, from leadership to operational teams, must effectively absorb and apply the influx of new regulations and strategically allocate sources for timely and effective implementation. In an economic environment that may not be conducive to expanding compliance budget spending, investment managers must focus on the best ways to allocate resources and streamline their processes to meet compliance requirements in the most cost-effective ways. Nevertheless, firms opting to underinvest in initiatives for regulatory implementation run the risk of being ill-prepared for heightened enforcement measures, which we can also expect from the SEC over the year ahead. Firms must strike a balance, ensuring efficient compliance without compromising on preparedness for more assertive regulatory actions.

The Bottom Line

Firms must assess their current compliance strategies, engage with regulators, and prepare for the changes ahead. By doing so, investment managers can safeguard their operations, uphold the integrity of the financial system, and contribute to a collaborative regulatory environment.

If you’re seeking further guidance to support your team’s needs, learn more about how Arootah’s business advisory can support your organization.