The securities industry is facing increased regulation for record keeping, disclosure and proxy voting, amongst an array of other federal rules. However, since Sept. 11, 2001, one ruling that has gotten significant attention amongst industry participants is the USA Patriot Act.
The USA Patriot Act was established post-Sept. 11 with the intent of examining financial institutions for possible money laundering of terrorist funds. However, the definition of "financial institutions" was initially vague, leaving the industry confused regarding which firms needed to comply and how best to do so.
It was not until recently that the U.S. Department of the Treasury made clear that many buy-side firms will be affected by the Patriot Act as well, and must demonstrate a similar level of compliance as the sell side.
Mutual funds are included in the recently refined definition of financial institutions, forcing investment managers to evaluate their ability to prove to regulators that they are performing due diligence in weeding out money launderers. Additionally, a recently proposed ruling to include unregistered investment advisers in the Patriot Act, such as hedge funds, has sent a new segment of buy-side firms scrambling to reach compliance.
Brokerage firms paid extensive attention to the Patriot Act early on because of their interaction with retail customers, who were seen as the greatest threat of money-laundering activities. Sell-side firms continue to spend significant amounts of money on technology in order to ensure that they are not caught out of compliance.
In fact, the Massachusetts-based consulting firm TowerGroup estimates that by 2005, broker/dealers will spend nearly $700 million on compliance technologies for the Patriot Act.
Neil Katkov, a senior analyst with Celent Communications, explains that buy-side firms are typically late adopters of technology, and will be especially inclined to follow that pattern with the Patriot Act regulation since it is still evolving. "It will be interesting see how much new technology will be added and when, especially since most large investment managers are not dealing with retail investors directly," he says.
While many of the details are still undefined, one thing is clear: investment managers of all shapes and sizes will need to pay close attention to Uncle Sam in the next few months, or they may find him knocking on their door.
MUTUAL FUNDS ALREADY MANDATED
One firm that is taking the initiative on ensuring its regulatory compliance is Texas-based HD Vest, a non-bank subsidiary of Wells Fargo & Company with $16 billion in assets under management.
Daniel Wright, senior manager of operations at HD Vest, says that the firm is in its final stages of evaluating technologies to meet the Patriot Act requirements.
"It's pretty obvious that we're going to have to be in compliance, and we want to be ahead of those requirements, as opposed to behind it, at least to the extent that we can be," he explains. "There are still some gray areas, but we think it is in the firm's best interest to take a proactive approach."
HD Vest is actively exploring a technology solution by Comprehensive Software Solutions (CSS), a Colorado-based securities-processing software provider, Wright says. The front-office solution, called Q, will aggregate the firm's clients' information into single, consolidated accounts, easily accessible for possible regulatory audit or inspection, according to the vendor's chief executive officer, Chris Poelma.
In addition, Poelma notes that Q has the ability to comply with the most recent know-your-customer regulations by retaining scanned physical documentation of a customers' identities within their accounts.
Wright explains that leveraging existing vendor relationships can be a beneficial way of keeping costs contained, while still maintaining Patriot Act compliance. In HD Vest's case, he says, the firm was already using the older version of the vendor's front-office system, Sabil.
"The information is already contained, so we don't need to deal with exporting the data or securing a relationship with a new third-party firm," he says. Wright adds that the only detractor from the solution is its inability to meet particular reporting needs due to HD Vest's use of a transfer agent to keep the firm's books and records. A spokesperson for CSS says that the vendor is working to meet the firm's specific requirements.
In addition, Wright notes that added value goes a long way in the case of buy-side firms that have less money than a large sell-side firm to spend on technology. For example, he says that CSS offers substantial flexibility such as data-sorting information.
Wright says that the firm's alternatives included investing in an entirely new technology for compliance, or building an in-house model, both of which would have proven costly and time-consuming.
HEDGE FUNDS A PROBABILITY
With the Department of Treasury's recently proposed ruling for unregistered investment advisers to be included in the Patriot Act guidelines, hedge funds are only beginning to make sense of the implications.
According to a report submitted to congress by the Secretary of the Treasury, the Board of the Federal Reserve Commission and the Securities and Exchange Commission, hedge funds are viewed as potential vehicles for money-laundering because of their liquidity and structure.
Robert Bixby Green, Jr. - a principal at Richard H. Morrison LLC, a California-based hedge fund with $60 million in assets - says that his fund's experiences lead him to believe the opposite of what the report speculates. "We have less than 100 clients," he explains. "We have much closer contact with our clients than a huge mutual fund. If something illegal was going on, it would be easier for us to determine that."
Pirate Capital LLC, a Connecticut-based hedge fund with $25 million in assets, is also examining the seemingly inevitable regulations. "We've always operated with a transparent strategy and have remained successful, even in the down market," notes Richard Silberberg, the newly appointed compliance officer for the fund, adding that the Patriot Act may help to clean up more secretive operations. "This regulation will help weed out the hedge funds that are behaving unethically that give the rest of us a bad name."
PRIME BROKERS TO THE RESCUE?
Larger hedge funds might explore outfitting themselves with technology for AML compliance; however, most hedge funds, such as Pirate, will look to their prime brokers to undertake the responsibility of monitoring the fund's transactions. In an increasingly competitive market for prime brokers to win over hedge funds, Silberberg says, he trusts that prime brokers will add Patriot Act compliance to their already extensive list of technology services for hedge funds.
Some prime brokers are already outfitted with AML technologies, such as Searchspace's transaction-monitoring solution, says the vendor's chief executive officer Konrad Feldman. Feldman explains that hedge funds can be designated within the solution as an investment vehicle requiring heightened scrutiny, just as the technology might devote more attention to an investment originating in a certain country.
Pirate Capital's Silberberg explains that, at the end of the day, due-diligence to know the customer falls upon the hedge fund. "There is increased pressure in your partnerships with a fund administrator and prime broker," he says. "Ultimately, we have the liability to the regulators."
The Patriot Act and You
According to Section 326 of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA Patriot) Act of 2001, mutual funds will be required to implement reasonable procedures for:
Source: U.S. Department of Treasury