Seemingly lost amid the fervor over the Securities and Exchange Commission's redemption fee rule, its recent guidance on soft dollars, and reports from chief compliance officers to mutual fund boards is yet another regulatory deadline that the money management industry must soon meet: anti-money laundering measures.

Not unlike its peers, anti-money laundering regulations have been met with some degree of trepidation. Most funds and advisors embrace the intent of the rule, which is to thwart terrorists and other criminals from laundering or making money for nefarious activities in U.S. capital markets, but some of its finer details have drawn concern.

Specifically, Section 312 of the rule demands that funds and their advisors perform due diligence to ensure that an anti-money laundering, or AML, program is operational and effective, either in-house or at the agent that conducts trades on their behalf. In other words, the Federal government is demanding that money managers know their customers.

That process, however, can be time consuming and costly. For starters, there's a significant technology investment, as well as extensive employee training to spot suspect investors and transactions. As a result of these demands, the industry has been slow to fully meet the rule's requirements.

Further complicating matters is what appears to be a redundancy in the rule. In short, a fund or advisor must "know its customers," but sometimes that due diligence has already been performed at, for example, a broker/dealer or a bank.

"The concern among funds is logistics," said Robert Tull, a senior consultant with SEC Compliance Consultants in Philadelphia. "There is an aspect of it that is technically intensive, an aspect that is manually intensive, and when you're dealing with situations where you might duplicate work, everyone wants to make it as efficient as possible. They want to strike the perfect balance."

A short list of what's expected from the money management industry, according to Tull, is the development of internal policies, procedures and controls reasonably designed to prevent the advisor from being used to finance terrorists activities; the designation of an AML officer, who would be responsible for implementing and monitoring the operations and internal controls of the program; an ongoing employee training program; and independent testing for compliance with AML regulations.

And again not unlike its peers, the AML rule does not allow funds or advisors to shirk responsibility onto a service provider that has been given responsibility for running an AML program.

"Much in the spirit of other compliance rules, just because a fund has a service provider doesn't mean they are not responsible for ensuring that the service provider has an adequate and effective AML program," Tull said.

This situation led powerful industry lobbyists like the Investment Company Institute and the Securities Industry Association to urge postponement of the rule by the U.S. Treasury, which, along with the SEC, the NASD and various other state entities, is tasked with its enforcement. The Treasury recently granted their requests, pushing the date ahead from April 2 to July 5. Any further extension isn't likely, said Treasury spokeswoman Candice Pratsch.

The chief stumbling block for the industry has been a tiny piece of unfamiliar language that's contained in Section 312. The rule states that funds must perform due diligence on "correspondent accounts." Typically a foreign financial institution, these accounts are higher risk areas where, in short, the Treasury is asking funds "to know their customers even better." But it's a banking term that has had a lot of funds and advisors scratching their heads.

"It's just not a rule we're familiar with," said Bob Grohowski, senior counsel for international affairs at the ICI. "[Funds] don't have a lot of these accounts. They're usually held at a U.S. broker/dealer."

So to avoid any redundancies, the ICI submitted another request to the Treasury asking that it exclude accounts cleared and settled through the National Security Clearing Corp.'s FundServ system. The ICI contends that due diligence on FundServ accounts would have already been performed by another NSCC member firm, most likely a broker/dealer. So, in short, the ICI asked that all FundServ accounts be treated as domestic accounts, even if the trades were affected for a foreign institution. It would be a sizeable chunk of work, too, as FundServ handles about 475,000 trades each day that amount to about $7.5 billion.

"What we're saying is if it's a foreign institution, we'll do everything asked of us, but if they're not, the broker/dealer should perform the due diligence," Grohowski said.

That request was recently granted, and now the industry is wrestling with identifying foreign accounts, another task that's not as easy as it might seem.

For example, Grohowski offered, the U.K. hedge fund Millennium Partners would be considered a foreign investor, but there's nothing in its name that would tip off a front-end account opener.

"Funds are really struggling with that," Grohowski said. "The Treasury says you'll know a foreign account when you see it, but that definition is hardly good enough from a legal standpoint. As a result, people are being very conservative in the their interpretation of a foreign account."

Despite these challenges, funds and advisors should have a lion's share of the legwork for Section 312 complete, Grohowski said. Funds and advisors should also be prepared to meet a second, and perhaps even more laborious, AML deadline. On Oct. 2, they'll be required to order their transfer agents to scrub every account on the books for evidence of money laundering or a questionable investor.

"Anytime you tell a TA to look at all of your accounts, it's a big undertaking," Grohowski remarked.

In the near term, the SEC expects to roll out an AML examination procedure this summer that harmonizes the different approaches of the various regulatory entities.

That would be a welcome development, Tull added. "A lot of frustration has been communicated to me informally that this rule has multiple regulators, and it isn't clear what is expected from each of them," he said. "Right now, I've been told, it's like driving down the road and not knowing the speed limit."

Perhaps equally disconcerting is that SEC scrutiny has already begun.

Lori Richards, the SEC's chief compliance inspector, said in a recent speech, "Examiners are now looking at such issues as how a firm considers its enterprise-wide functions and risks, including its branch offices and foreign business relationships; the impact of new business acquisitions and outsourced activities on firms' AML compliance programs; AML in the introducing-clearing relationship; relationships with foreign financial institutions; and finally, AML training."

Richards offered some advice. For starters, many firms of various sizes aren't examining their whole business, or in other words, approaching it on an enterprise-wide basis. Expect examiners to take a close look at that issue, she said. Examiners will also be scrutinizing outsourcing relationships, as well as recent mergers and acquisitions.

In terms of monitoring suspicious activity, firms should know if their automated processes are providing a clear picture of a customer's flow of funds and what sort of documentation the firm keeps on hand to back up its decision-making process.

Firms should also be able to demonstrate knowledgeable of AML efforts in the introducing and clearing context, and somehow provide an accurate assessment of a firm's relationships with foreign financial institutions. Training is vitally important, too, but a firm should not be using a "one-size-fits-all" approach, Richards said.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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