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Anti-money laundering and anti-bribery and corruption systems and controls in the alternative investment management sector

Scott Geddes, Senior Manager, and Sandrine Frison, CFA, Senior Manager

Deloitte

Q4 2013

 

Financial crime represents a real and significant threat to the integrity of our financial system. The UN estimates that criminal proceeds total $870 billion globally each year, and criminals continually seek to exploit financial institutions as vehicles to obfuscate the proceeds of their crimes. To date, much of the previous regulatory action pertaining to financial crime has focused on banks and insurers; however the UK Financial Conduct Authority (FCA) published a thematic review on 31 October, which provides an assessment of the anti-money laundering (AML) and anti-bribery and corruption (ABC) systems and controls across asset management and platform firms. This was the first time this sector had been looked at thematically, and it has placed a new focus on the way investment managers manage their risks in these areas.

This article considers some of the challenges alternative investment managers face in defending against money laundering and bribery and corruption threats. It looks at some of the investment management sector’s common weaknesses identified in the FCA’s report and actions firms can take to address these.

 

Challenges in defending against money laundering and bribery and corruption threats

Successfully operationalising legal and regulatory requirements into effective AML and ABC frameworks is complex and challenging. This is confirmed by the level of regulatory intervention that we have observed over the past six years. Notably, a large number of the most egregious interventions have related to regulatory breaches as a result of inadequate systems and controls, rather than the discovery of criminal activity. However, the two now often result in similar penalties. Thus, firms must not only maintain a robust suite of systems and controls to address the risks faced; they must also be able to readily demonstrate this to regulators. While the FCA’s report notes that some good practice was observed in the firms visited, it highlights many areas where there is more work to do, and refers to common weaknesses observed across the sector.

 

The adoption of a risk-based approach

One of the weaknesses highlighted in the report is the way firms assess their money laundering and bribery and corruption risks. A common assumption is that the alternative investment management sector has an inherently low risk exposure in both areas, as most firms do not directly handle client money. However, the sector as a whole presents many attributes that may be attractive to a criminal. For money laundering purposes, these may include: the widespread use of offshore vehicles; transactions that are normatively high in value; a lack of face to face contact between the client and both the hedge fund and the administrator, and at times, the use of less established administrators; and, the increased plausibility of close links between investors and overseas governments and states. For a criminal, these factors may outweigh the inconvenience of lower liquidity. Similarly, attributes that may imply an increased bribery and corruption risk exposure include sales activities in jurisdictions where there is a higher association with this activity; the use of intermediaries to secure new business; and the often observed intense competition for a small list of high value mandates.

These attributes may not be relevant to all firms. It is therefore crucial that alternative investment managers base their conclusions on money laundering and bribery and corruption risks on a robust assessment, which takes all relevant factors into consideration. Ignoring higher risk factors, for example for specific relationships or products, may lead to ill-designed systems and controls as well as an unknown and unmitigated risk exposure.

 

Implementing effective Customer Due Diligence measures based on customer risk

The FCA’s report also highlighted shortfalls in controls that, if effective, help to protect organisations from the threats they face. For example, failures were noted in the way firms identify and assess client and investor risks. This can weaken not only the initial Customer Due Diligence (CDD) performed, but also the on-going monitoring performed throughout the customer lifecycle.  For alternative investment managers, this is an important finding for two reasons. Firstly, reliance is often placed on administrators, which were included within the scope of the FCA review, or other third party firms to conduct CDD on their behalf. It is therefore vital to have assurance over the effective operation of the outsourced controls. Secondly, when the CDD is performed in-house, for example in relation to segregated accounts, complex structures and higher risk scenarios may be encountered that should be fully investigated and understood. This may include corporate structures where it is necessary to identify the ultimate beneficial owner. This may never be considered if the wrong risk rating is applied, resulting in the manager contracting with an entity controlled by an individual it has not identified.

Clients and investors should be assessed based on the money laundering risks that they, as an individual or entity, present to the financial institution. Assessments based on a single attribute, such as domicile, may not represent the actual risk that the firm is accepting. An inadequate level of CDD and on-going monitoring may expose the firm to unnecessary risk and could ultimately increase compliance costs if a higher risk rating is applied inappropriately. A comprehensive assessment of client or investor risk can ensure the correct level of due diligence is applied and that the appropriate acceptance decision can be made at take-on.

 

Compliance with the UK Bribery Act

In addition to the common shortfalls observed across the sector in relation to the assessment of bribery and corruption risk, the FCA noted that there is still work to do to ensure the risks identified are appropriately mitigated. Despite the Bribery Act coming into force in 2011, many ABC programmes remain far less mature and embedded than those for AML within an organisation. Many firms have delegated responsibility for AML and ABC to different functions, which operate like ‘organisational silos’. These may have benefited from being more integrated, within an appropriate governance framework.

Alternative investment managers, particularly those with a US presence or parent, may point to the US Foreign Corrupt Practices Act (FCPA) as the standard they adhere to. However, importantly, the UK Bribery Act goes beyond the FCPA’s requirements. It extends to both the government and private sectors, has no carve out for facilitation payments and introduced the corporate offence of failure to prevent a bribe being paid. To defend against the latter offence, a firm requires adequate and risk based procedures, which naturally requires a robust assessment of risks. It is not enough to rely solely on an ABC policy, regardless of its perceived efficacy.

 

Responsibility as stewards of the industry

While international standards, laws, regulations and industry guidance are all vital elements in the prevention of illegal activities, their effectiveness is predicated on firms building and maintaining strong defences, not only to protect themselves from the risks they face, but as stewards for the industry and the financial system. Alternative investment firms are firmly within the purview of the regulators and should take note of previous regulatory issues and interventions given the commonality of the underlying causes across the sector and the wider industry.

This will require firms to assess and manage atypical risks that may be unique to their firm. The need for, and value of, a thorough risk assessment should not be under-estimated as it impacts the adequacy of systems and controls to protect not only the threat of regulatory non-adherence, but also the risk of the firm being used as a vehicle by criminals.

 

sgeddes@deloitte.co.uk

safrison@deloitte.co.uk

www.deloitte.co.uk

 

 

 

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