United States: Treasury Issues Proposed Rule Requiring Suspicious Activity Reporting by Mutual Funds

Co-authored by Linda Noonan

On January 14, 2003, the Department of the Treasury ("Treasury"), Financial Crimes Enforcement Network ("FinCEN"), sent to the Federal Register the expected proposed amendment to the Bank Secrecy Act ("BSA") regulation which would require mutual funds to file suspicious activity reports ("SARs") on the special form designed for the securities and futures industries, known as an "SAR-SF." The proposed rule is very similar to the SAR requirements for securities broker-dealers published on July 1, 2002. 67 Fed. Reg. 44068. Comments must be filed within 60 days after publication in the Federal Register.

This proposal should be read in conjunction with Treasury's interim final rule published on April 29, 2002, which requires mutual funds to develop and implement anti-money laundering programs under section 326 of the USA PATRIOT Act as of July 25, 2002 (76 Fed. Reg. 21117), and the proposed Treasury and Securities and Exchange Commission ("SEC") regulation published on July 23, 2002, which would require customer identification and verification programs as part of a mutual fund's anti-money laundering program (67 Fed. Reg. 48318).

As with the anti-money laundering program regulations, the proposed SAR requirement would apply to mutual funds, i.e., investment companies as defined in section 3 of the Investment Company Act of 1940 (the "Act") that are open-end management investment companies as defined in section 5 of the Act (15 U.S.C. §§ 80a-2 and 80a-5), and that are registered or required to be registered with the SEC under the Act. The rule would not apply to affiliates that are not mutual funds, although affiliates may be subject to other SAR regulations, such as the SAR rules for banks or broker-dealers.

Transactions that meet the reporting standards of the regulations in terms of type of activity and dollar amount involved would be required to be reported by mutual funds on an SAR-SF. For purposes of the regulation, the term "transaction" is defined very broadly and tracks the definition in the federal criminal money laundering statutes, 18 U.S.C. §§ 1956 and 1957. In the preamble, FinCEN emphasizes that a reportable transaction would not necessarily involve currency.

Under the regulations, mutual funds would be required to report any suspicious transaction relevant to a possible violation of law or regulation if the transaction is -

1. conducted or attempted,
2. by, at or through a mutual fund,
3. involves funds or other assets that aggregate to at least $5,000,
4. and the mutual fund knows, suspects or has reason to suspect the transaction (or a pattern of transactions) either

• involves funds from illegal activities or is intended or conducted in order to hide or disguise funds or assets, i.e., money laundering;
• is designed "through structuring or other means" to evade a BSA record keeping or reporting requirement;
• "[h]as no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage, and the mutual fund knows of no reasonable explanation for the transaction after examining the available facts, including the background and possible purpose of the transaction;" or

• "[i]nvolves the use of the mutual fund to facilitate criminal activity."

In the preamble, FinCEN states that the term "to facilitate criminal activity" would include transactions with legally-derived funds that are suspected of being used for criminal activity, i.e., so-called "reverse money laundering." This would include cases where legally-derived funds may be channeled to terrorist organizations. While the types of violations of law that must be reported are not discussed in the rulemaking, Treasury stated in the final SAR regulations for securities broker-dealers that reportable criminal activity for purposes of SAR reporting includes, not only violations of federal law, but all violations of law, including violations of state or foreign laws, because these violations may be relevant to a money laundering or terrorist scheme.

The requirement would be effective 180 days after the date of publication of a final regulation in the Federal Register.

The SAR-SF would be required to be filed with FinCEN within thirty (30) calendar days after initial detection by the reporting mutual fund "of facts that may constitute a basis for filing an SAR-SF." In other words, an SAR-SF would be required to be filed 30 days from an initial determination that there may be a reportable transaction within the reporting dollar thresholds. The filing may be delayed for an additional 30 days, if a suspect had not been identified when the suspicious activity initially was detected.

Without respect to the 30-day filing requirement and in addition to filing the SAR-SF, a mutual fund would be required to make a telephone report "in situations involving violations that require immediate attention, such as terrorist financing or ongoing money laundering schemes" to "an appropriate law enforcement authority." The mutual fund may, but would not be required, to notify the SEC. There is no specific time requirement in the regulation for the telephone reports.

If a transaction involved suspected terrorism or terrorist financing, a broker-dealer also would be encouraged to report the activity "voluntarily" by calling the FinCEN Financial Institution Hotline, 1-866-556-3974.

Mutual funds would be required to maintain copies of the SAR-SF and the original or "business record equivalent," e.g., photocopies, microfilm or a computerized record, of any documentation "supporting" the SAR-SF filing for five (5) years.

The supporting documentation would not be sent with the SAR-SF, but would have to be maintained by the mutual fund. Because the supporting information would be deemed to have been filed with the SAR-SF, the proposed regulation requires mutual funds to produce the information to FinCEN, to any other appropriate law enforcement agency, and to federal or state securities regulators upon request, including for purposes of examination and enforcement.

To assure that the protection from civil liability, discussed below, applies, a mutual fund should determine what it considers to be supporting documentation when an SAR-SF is filed and make a record of that determination. Only documentation considered by the mutual fund to be supporting documentation should be produced in response to an appropriate written request and without legal process.

In the preamble, FinCEN notes that mutual funds conduct activities through separate entities, e.g., transfer agents, both affiliated and unaffiliated, and that these entities may be in the best position to perform the reporting obligation. Therefore, as proposed, a mutual fund may contractually delegate the reporting responsibility to these service providers, but the mutual fund would remain responsible for assuring compliance with the rule and would be required to "actively monitor" the procedures of the other entity for reporting suspicious activity. This is comparable to the provisions on contractual delegation in the anti-money compliance program and proposed customer verification and identification regulations for mutual funds.

The regulation provides that, while the obligation to file an SAR-SF rests with the mutual fund involved in a transaction, only one report must be filed by a mutual fund or other person obligated to report on any suspicious transaction as long as the SAR-SF report contains all the relevant facts. Treasury explains this rule as follows:

[A] person such as a broker-dealer that is the service provider to the fund may have a separate suspicious activity reporting obligation with respect to the same transaction. The proposed rule would permit the mutual fund's report to satisfy that person's reporting obligation as well.

This may mean that if a bank transfer agent were required to file an SAR on a given suspicious transaction that it conducted as a mutual fund transfer agent, the mutual fund would not be obligated to file an SAR-SF to report the same transaction. In that case, it is not clear whether the bank transfer agent must use the SAR-SF or would be permitted to use the SAR form for banks. Guidance is needed on that point.

Treasury also states that if the service provider, i.e., transfer agent, identifies a suspicious transaction involving more than one mutual fund for which it provides services, only one report would be required:

Thus, a service provider to which multiple mutual funds have contractually delegated their reporting obligation may file a single report on behalf of itself and all the funds involved in the transaction.

Clarification is needed whether Treasury expects transfer agents to have monitoring systems to identify suspicious transfers involving the same shareholders in different mutual funds and how Treasury sees different mutual funds being involved in reporting these transactions.

In the preamble, FinCEN discusses some examples of suspicious activity that would require the filing of an SAR:

• A customer refuses to provide information necessary for the mutual fund to file reports or maintain records under the BSA or provides false information; or
• A customer cancels a transaction after being informed of a BSA requirement.

In other cases, a mutual fund would have to exercise its judgment on whether to file an SAR, for instance, if -

• A customer sends or receives funds transfers without "normal identifying information" (presumably, as required by the BSA, 31 C.F.R. § 103.33(e) - (g)) or in a manner that indicates an attempt to hide or disguise the identity of the originator or the beneficiary or the country of origin or destination; or
• A customer repeatedly uses a mutual fund as a "temporary resting place for funds" from multiple sources without a clear business purpose.

The implication could be that mutual funds must have monitoring systems to detect the latter two categories of activity and to review records of incoming and outgoing funds transfers. This will need to be clarified in the final regulations. Up to now, Treasury has not required any category of financial institution to review all funds transfers as part of their SAR monitoring.

Under the BSA, there is civil liability protection or a safe harbor for reporting suspicious activity, 31 U.S.C. § 5318(g)(3). That section provides that any financial institution making a report of a possible violation of law or regulation is protected from civil liability to any person for the disclosure under any cause of action under state or federal law, including in any arbitration proceeding. Consequently, the proposal provides that any director, trustee, officer, employee or agent of a mutual fund that makes a report of a possible violation of law or regulation under the regulations or on a voluntary basis would be protected from civil liability.

The regulations also state that a financial institution may make a voluntary report of a transaction relevant to a possible violation of law or regulation not within the SAR reporting criteria on an SAR-SF or otherwise, e.g., report transactions under the dollar reporting threshold, and clarifies that voluntary reports also are subject to the civil liability protection of the BSA.

The regulation includes the gag rule of 31 U.S.C. § 5318(g)(2), which provides that a financial institution may not notify any person involved in a suspicious transaction that the activity has been reported. The purpose of this provision is to assure that criminals are not tipped off to a possible criminal investigation of their activities. The regulations would prohibit mutual funds and their directors, officers, employees and agents from disclosing that they have filed an SAR-SF except to FinCEN, the SEC, or an appropriate law enforcement or regulatory agency.

If a mutual fund were requested to disclose an SAR-SF, the information in an SAR-SF, or the fact that an SAR-SF has been filed, even pursuant to subpoena, it would be required to decline to do so, citing the regulation and section 5318(g)(2). Mutual funds must notify FinCEN if anyone inquires whether an SAR has been filed or about what has been filed.

However, in the preamble, FinCEN specifies that the gag rule would not prohibit mutual funds from discussing with each other or with service providers involved in the transaction, such as investment advisors, transfer agents, principal underwriters and securities broker-dealers, suspicious transactions involving the mutual fund or the determination of which mutual fund or other entity will file an SAR.

Enforcement authority for this requirement is with FinCEN and, by delegation from FinCEN, with the SEC. In the preamble, FinCEN states that if there were a failure to report, FinCEN and the SEC may take into account the relationship between the particular failure to report and the adequacy of the implementation and operation of a mutual fund's compliance procedures.

The SAR requirement would not relieve a mutual fund from any responsibility to file other reports with the SEC.