In May, the Securities and Exchange Commission (SEC) and the Financial Crimes Enforcement Network (FinCEN) of the U.S. Department of the Treasury initiated rulemaking to enhance anti-money laundering (AML) compliance and establish customer identification programs (CIPs) for certain SEC-registered investment advisers (RIAs) and exempt reporting advisers (ERAs). The proposed rule was expected, following FinCEN’s February 2024 related notice that would add certain RIAs and ERAs as financial institutions subject to the Bank Secrecy Act (BSA). Taken in aggregate, these changes represent a new and more formalized regulatory wrapper for small funds, making compliance more prescriptive and resource-intensive.
On June 5, the U.S. Court of Appeals for the Fifth Circuit in National Association of Private Funds Managers, et al. v. Securities and Exchange Commission struck down and fully vacated an earlier SEC final rule that would have substantially increased private and venture capital fund adviser compliance and reporting requirements in other respects, holding that the SEC improperly interpreted its authority to regulate this activity. If that decision stands, it not only means that private fund advisers will not be required to comply with that specific rule, but the Fifth Circuit’s decision may also curtail other existing and pending regulation, including the proposed rule.
Background
The goal of the proposed rule is to deter money laundering, terrorist financing and other illicit activities by discouraging the use of false or hidden identities. The BSA subjects financial institutions to anti-money laundering/countering the financing of terrorism (AML/CFT) program requirements and Suspicious Activity Report (SAR) filing obligations. Thus, the pending February proposal would require RIAs and ERAs to comply with AML/CFT program requirements and SAR filing obligations, as well as other BSA requirements. While that February proposal stopped short of applying the BSA’s CIP requirements to those investment advisers, the latest proposed rule would do just that. Like the February proposal, the proposed rule’s requirements would not apply to investment advisers registered only at the state level.
Thus, as FinCEN and the SEC explain, the proposed rule complements that February proposal, with the aim of these two complementary proposals being “to prevent illicit finance activity in the investment adviser sector and further safeguard the U.S. financial system.”
Under the proposed rule, RIAs and ERAs would be obligated to:
- Gather identifying information from their clients. This would include basic details like names, dates of birth or formation, addresses and identification numbers. Exceptions might exist for established clients where the adviser already has a “reasonable belief” about their true identity.
- Implement procedures to verify the identities of their clients using a risk-based approach. This verification should occur within a reasonable time frame, either before or after an account is opened. The adviser’s goal is to establish a “reasonable belief” that they know the true identity of each client.
- Maintain records of the information used to verify client identities for a period of five years.
- Consult with government lists of suspected terrorists and terrorist organizations.
- Notify clients about the requirement to provide information for identity verification purposes.
Defining ‘Customer’ and ‘Account’
The proposed rule defines who qualifies as a “customer” and what constitutes an “account.” This scope potentially encompasses a broader range of interactions than some advisers might anticipate.
- Who is a customer? The proposed rule defines a “customer” as a person — including a natural person or a legal entity — who opens a new account with an investment adviser. The proposed definition focuses on the person identified as the account holder, excluding certain individuals and entities, such as existing clients with established identities. The proposed rule also contemplates situations where advisers might need to take additional steps to verify non-individual customers (e.g., partnerships and corporations) deemed to be high risk.
- What is an account? The proposed rule defines an “account” as any contractual or other business relationship between a person and an investment adviser under which the investment adviser provides investment advisory services. This broad definition could capture non-traditional arrangements beyond typical investment accounts, potentially including employee benefit plans.
- Notably, the proposed definition excludes an account that an investment adviser acquires through an acquisition, merger, purchase of assets or assumption of liabilities. Such accounts may still be subject to other AML/CFT requirements applicable to advisory activities, including activities within the scope of the February proposal, to the extent it is adopted.
Importantly, for investment advisers to private funds, an investment adviser would not generally be required to look through an account to its beneficiaries under the proposed rule; however, a private fund adviser may be required to look through the fund to its owners in certain cases, such as when an individual has authority or control over the fund account, or pursuant to AML/CFT due diligence under the February proposal.
Verification Procedures
The proposed rule outlines risk-based procedures for verifying customer information. Advisers would need to utilize documentary or non-documentary methods, or a combination of both, depending on the assessed risk level. The timing of verification would also be flexible, occurring within a reasonable time frame before or after an account is opened.
The rule acknowledges the potential for collaboration by allowing advisers to rely on CIP procedures performed by other financial institutions; however, this reliance hinges on specific conditions, including a written agreement, confirmation of the other institution’s AML/CFT compliance and annual certifications demonstrating their adherence to the adviser’s specified CIP requirements. Importantly, the ultimate responsibility for ensuring proper CIP fulfillment remains with the investment adviser. There is also specific language in the proposed rule allowing advisers to deem these CIP requirements satisfied for compliant mutual funds they advise.
Recordkeeping and Notice
As mentioned above, the proposed rule mandates recordkeeping obligations, requiring advisers to retain verification information for a specific period. Additionally, advisers would be obligated to check client information against government watch lists and notify clients about the verification process itself. The proposed rule might necessitate duplicating verification efforts already undertaken by account custodians who hold clients’ funds and securities. Even if another financial institution performs the verification, advisers would still need to establish their own procedures and maintain separate records under the CIP proposed rule.
Impact of the Proposed Rule
While many investment advisers already maintain AML/CFT policies with some elements of CIPs as a best practice, the proposed rule would usher in a much more prescriptive approach. Advisers would be required to develop and implement formal CIPs, potentially requiring dedicated personnel and technological infrastructure. While obtaining the required customer information might not be inherently difficult, the definitions of “customer” and “account” could expand the scope of CIP requirements for RIAs and ERAs. This could be another significant burden, especially for smaller firms.
Overall, the CIP requirements under the proposed rule would represent a significant change for investment advisers. While the intent of enhancing AML/CFT efforts is laudable, advisers should carefully consider the potential impact on their operations and resource allocation. Actively participating in the comment period offers a valuable opportunity to shape any final rule and ensure it strikes a balance between effective AML/CFT compliance and manageable implementation for investment advisers.
Has the SEC Exceeded its Authority to Regulate Private Funds?
A unanimous decision issued June 5 from a three-judge Fifth Circuit panel said yes, the SEC has exceeded its authority with the earlier private fund rule. In reaching its decision, the Fifth Circuit ruled that the SEC lacked the statutory authority to adopt certain rules that apply to private fund advisers. The court stated further that Congress expressly chose to impose further regulation on registered investment companies that market to and solicit investment from “retail investors” as opposed to private fund advisers who advise private funds that generally solicit investment from a smaller number of sophisticated investors.
In August 2023, the SEC adopted a rule aiming to increase oversight and investor protection. This final rule included stricter disclosure requirements, limitations on certain activities and mandated audits. Due to the increased regulatory requirements and new prohibitions, the 2023 final rule threatened to significantly alter the manner in which private fund advisers and private funds operate. In adopting the 2023 final rule, the SEC claimed statutory authority pursuant to sections 206(4) and Section 211(h) of the Investment Advisers Act of 1940.
The National Association of Private Fund Managers, and others, sued to challenge the rule, arguing the SEC lacked the legal power to enact it, claiming, among other reasons, that the SEC exceeded its statutory authority in adopting the 2023 final rule. The Fifth Circuit agreed, focusing on two key sections of the Advisers Act: 211(h) and 206(4).
The SEC’s Lack of Authority Pursuant to Section 211(h) of the Advisers Act
Regarding Section 211(h) of the Advisers Act, the Fifth Circuit noted that the Dodd-Frank Wall Street Reform and Consumer Protection Act added this section with a focus on retail investors, not private funds. Title IX of Dodd-Frank, where Section 211(h) resides, primarily addresses “retail customers” and precludes the SEC from defining “customer” to include investors in private funds managed by IRAs and ERAs. The Fifth Circuit juxtaposed this focus on retail investors with Title IV’s limited additional requirements for private fund advisers, suggesting Section 211(h) of the Advisers Act wasn’t intended for private funds. Taking into account this background, the Fifth Circuit ruled that Section 211(h) of the Advisers Act empowers the SEC to regulate practices related to sales, conflicts of interest and compensation for brokers and advisers who work with retail investors.
The SEC’s Lack of Authority Pursuant to Section 206(4) of the Advisers Act
Under Section 206(4) of the Advisers Act, the SEC is provided the authority to adopt regulation to prevent fraudulent, deceptive or manipulative business practices. Although the Fifth Circuit acknowledged that Section 206(4) does indeed confer on the SEC’s authority to adopt regulation reasonably designed to prevent fraud or deception — even if the acts themselves are not fraudulent — it ultimately determined that the SEC failed to establish a clear connection between the new rule’s provisions and preventing fraud. The Fifth Circuit emphasized Section 206(4)’s requirement for the SEC to define the fraudulent act before enacting preventative regulations, something absent in the 2023 final rule.
Additionally, the Fifth Circuit reasoned the final rule lacked a “close nexus” between a lack of disclosure and fraud, highlighting that a duty to disclose arises from the adviser-client relationship, not toward individual fund investors. Accordingly, the Fifth Circuit ruled that the SEC failed to act with the specificity required by Congress.
The Fifth Circuit noted that Section 206(4) doesn’t authorize broad disclosure and reporting mandates, contrasting it with other sections of the Advisers Act that explicitly grant such authority.
Conclusion
Because the Fifth Circuit’s decision now restricts the SEC’s authority to promulgate rules via Section 206(4) or Section 211(h), several of the SEC’s recently proposed regulations targeting private fund advisers that rely on either Section 206(4) or Section 211(h) of the Advisers Act for the SEC’s statutory authority could be called into question, especially if that ruling survives appeals. The SEC used similar legal justification in creating this rule as it did for several others including SEC Rules 206(4)-10 (Private Fund Audit Rule), Rule 211(h)(1)-2 (Quarterly Statements Rule), Rule 211(h)(2)-1 (Restricted Activities Rule), Rule 211(h)(2)-2 (Adviser-Led Secondaries Rule) and Rule 211(h)(2)-3 (Preferential Treatment Rule). These rules may also come under legal challenge based on the Fifth Circuit’s decision. The SEC still has the ability to seek en banc review with the full Fifth Circuit or appeal the Fifth Circuit’s decision to the United States Supreme Court.
Under the proposed rule, the SEC did not specifically rely on Section 206(4) and Section 211(h) of the Advisers Act. Given the Fifth’s Circuit propensity to challenge the SEC’s broad approach to its regulatory authority, the proposed rule may also be vulnerable to challenge because the SEC is using a broad interpretation of its authority as legal basis for the proposed rule.
Complicating matters still further, on June 28, the Supreme Court overturned the longstanding Chevron doctrine, which told courts to defer to an agency’s interpretation of a statue when a law is vaguely written. The precedent is the background of administrative law and has been cited by federal courts more than 18,000 times. Moving forward, courts are to exercise “independent judgment in deciding whether an agency has acted within its statutory authority.”
Until the regulatory framework is fully settled, private fund advisers should continue to be mindful of the rapidly evolving legal landscape.
Stinson LLP partners Rich Lomuscio and Eric Mikkelson also contributed to this article.
John Willding is a partner in Stinson LLP’s Dallas office. He has more than 20 years of corporate and securities including significant experience advising boards of directors with respect to corporate governance and fiduciary duties. He frequently serves as lead counsel for buyers and sellers in mergers and acquisitions and assists clients with the establishment and operation of private equity funds. Willding also has extensive experience representing investment managers and their sponsors and advising real estate developers and their capital partners in the negotiation of joint venture agreements.
Donta Dismuke is an associate in Stinson LLP’s Dallas office. His practice is focused on all areas of corporate finance, including mergers and acquisitions, venture capital transactions, private equity transactions, capital markets, securities law compliance, securitization, and corporate governance.