By Stanley M. Johnson, Loeb & Loeb LLP, New York
In the aftermath of the attacks on the United States on September 11, 2001, the U.S. Congress enacted the Uniting and Strengthening America Act by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act of 2001 (the “Patriot Act”). The Patriot Act amended the Bank Secrecy Act (the “BSA”) by, amongst other things, extending its “know your customer” provisions to “financial institutions”, a term which, according to U.S. Department of the Treasury officials, is broad enough to include private equity funds. Fund sponsors have until April 24, 2002 to comply with the Patriot Act.
Fund sponsors can expect compliance with the Patriot Act to be a checklist item for institutional investors and gatekeepers at least with respect to capital formation after April 24, and may find that it is a hot button item for institutional investors at annual meetings of investors. No institutional investor (or, perhaps more significantly, no individual or gatekeeper working for an institutional investor) in private equity funds is likely to risk the reputational smear of allegations that the institution has invested in funds that do not comply with anti-terrorism laws. Compliance may also become a due diligence checklist item for lenders and co-investors in connection with portfolio investments.
The Patriot Act will require fund sponsors to establish anti-money laundering programs by April 24, 2002. At a minimum, these programs must include:
· Internal policies, procedures and controls
· The designation of a compliance officer
· The implementation of an ongoing employee training program
· The creation of an independent audit function to test the anti-money laundering program
New capital formation
In connection with capital raising, fund sponsors will be required to know their investors in the way that banks are presently required to know their customers. This means that sponsors will need to investigate and determine (a) the source of all monies coming into the fund, and (b) the persons investing and the nature of their business and affiliations. With respect to established U.S. institutional investors such as CALPERS, NYSTRS, General Motors pension plans, major insurance companies and others similarly situated, compliance might easily be assured by adding a simple representation to standard subscription documents. With respect to individual investors, a similar representation plus a notation in the sponsor’s files that the individual investor is known to the sponsor group and is vouched for might suffice. Funds of funds and other such investors which are themselves pooled equity vehicles should be required to certify to the sponsor that such pooled equity vehicle has in turn assured its own compliance with the Patriot Act. Non-U.S. funds, corporations and individuals that are unknown, or little known, to the sponsor will require a greater level of due diligence, which might include references from major international banks and the like.
As part of the implementation of the required internal policies, procedures and controls, it is recommended that fund sponsors conduct an examination of their current investors and obtain the representations and certifications, and where appropriate obtain the references, outlined above with respect to new capital formation. Some sponsors may not want to offend current investors. However, compliance with the Patriot Act is required by all sponsor groups and will rapidly become routine for all investors.
New portfolio investments
Although it is not clear from the Patriot Act, sponsors may be required in connection with new portfolio investments to know their seller(s)—even passive non-management sellers—to ascertain whether they are associated with any of the terrorist groups on the government’s lists. Banks acting as lenders in connection with a portfolio investment may impose this added level of due diligence on sponsors, in part because banks are already subject to the “know your customer” rules of the BSA.
While the U.S. Department of the Treasury is expected to promulgate regulations this spring to implement the Patriot Act, such regulations may not come out prior to April 24. Pending release of those regulations, private equity sponsors and their lawyers will have to make do with a common sense approach to compliance based on the nature of the fund(s) in question and the composition of their investors.
Stanley M. Johnson is a partner in the New York office of Loeb & Loeb LLP. He represents a number of private equity sponsor groups and their funds.