Broker-dealers that rely on investment advisers to perform customer identification program (“CIP”) requirements now have new conditions that must be met before May 1, 2011. On January 11, 2011, the SEC Division of Trading and Markets (“Division Staff”) agreed to extend for two years a position it had taken in a 2004 No-Action Letter permitting broker-dealers to rely upon investment advisers to perform CIP (the “2011 No-Action Letter”), subject to certain conditions.1 The extension is a result of the Securities Industry and Financial Markets Association’s (“SIFMA’s”) January 11, 2011, request on behalf of its member broker-dealers for No-Action relief with respect to reliance provisions in the CIP Rule applicable to broker-dealers issued pursuant to Section 326 of the USA PATRIOT Act (the “PATRIOT Act”).
Ordinarily, the PATRIOT Act allows one financial institution to rely on CIP due diligence performed by another financial institution subject to the Act. However, although FinCEN proposed AML Program rules for investment advisers in 2003, it has never adopted those rules, and indeed in 2008 FinCEN officially withdrew its AML Program proposal for investment advisers. It is unclear if or when investment advisers will ever become subject to formal AML Program requirements. In 2004, Division Staff first provided no-action relief allowing a broker-dealer to rely upon a registered investment adviser to perform some or all of its CIP obligations, and subsequently extended the no-action relief in 2005, 2006, 2008 and 2010. Over the years, Division Staff has modified the conditions to which it will permit no-action relief; the 2011 extension also has new conditions.
Notably, the 2011 Letter requires broker-dealers to undertake appropriate due diligence of the investment adviser at the beginning of its relationship and update that due diligence. The 2011 Letter also requires the investment adviser to enter into an agreement wherein it agrees to promptly produce its books and records related to its performance of the customer identification procedures to the Commission, a self-regulatory organization (“SRO”) that has jurisdiction over the broker-dealer, or to any authorized enforcement agencies at the request of any of those parties.
In order to have time to comply with the new conditions of the 2011 Letter, Division Staff extended the relief granted in 2010 until May 1, 2011; after which the new terms of the 2011 Letter will control. Broker-dealers need to ensure that their procedures and reliance agreements address each of the conditions imposed in the 2011 Letter.
To understand why Division Staff has imposed additional conditions in granting the no-action relief, one only has to look at the SIFMA request. In that request, SIFMA notes that it had been advised by the Division Staff that “given the withdrawal of the AMLP Rule and the fact that an RIA is not a defined covered financial institution, the Staff would not recommend the extension of the No-Action Letter unless additional conditions were added to the No-Action Letter, which would, in the Staff’s view, enhance the ability of a broker-dealer to ascertain the reasonableness of its reliance on the RIAs in order to comply with its own anti-money laundering obligations.”2
The fact that the Division Staff insisted on new conditions before extending no-action relief on this topic is not surprising. The Division Staff had the very same concerns before extending the no-action relief in 2010.3 Indeed, in granting the extension in 2010, Division Staff stated that “[t]he no-action position taken by this letter will be withdrawn without further action on January 10, 2011.”4
Conditions Required in Order to Rely Upon the No-Action Letter
Under the 2011 Letter, the Division will not recommend enforcement action to the Commission under Exchange Act Rule 17a-8 if a broker-dealer treats an investment adviser as if it was subject to an AML program for the purpose of paragraph b(6) of the CIP Rule, provided that the other provisions of the CIP rule are met and:
(a) it has implemented its own AML Program consistent with the requirements of 31 U.S.C. 5318(h) and will update such AML Program as necessary to implement changes in applicable laws and guidance;
(b) it (or its agent) will perform the specified requirements of the broker-dealers CIP in a manner consistent with Section 326 of the PATRIOT Act;
(c) it will promptly disclose to the broker-dealer potentially suspicious or unusual activity detected as part of the CIP being performed on the broker-dealer’s behalf in order to enable the broker-dealer to file a Suspicious Activity Report, as appropriate based on the broker-dealer’s judgment;
(d) it will certify annually to the broker-dealer that the representations in the reliance agreement remain accurate and that it is in compliance with such representations; and
(e) it will promptly provide its books and records relating to its performance of CIP to the Commission, to an SRO that has jurisdiction over the broker-dealer, or to authorized law enforcement agencies, either directly or through the broker-dealer, at the request of (i) the broker-dealer, (ii) the Commission, (iii) an SRO that has jurisdiction over the broker-dealer or (iv) an authorized law enforcement agency.5
A. Due Diligence Requirements of Broker-Dealers
The Division Staff informed broker-dealers intending to rely upon the 2011 Letter that it believes reliance on an investment adviser is only reasonable if the broker-dealers “undertake appropriate due diligence on the investment adviser that is commensurate with the broker-dealer’s assessment of the anti-money laundering risk presented by the investment adviser and the investment adviser’s customer base.”6 This due diligence must be conducted at the outset of the broker-dealer’s relationship with the investment adviser, and updated during the course of the relationship.7 The letter does not indicate how often the updating must occur.
The conditions imposed by the Division Staff demonstrate the concerns it expressed prior to extending the no-action relief. Although the prior conditions of the no-action relief always required the broker-dealer's reasonable reliance upon the investment adviser, in the 2011 Letter, the Division Staff has made it clear, at a minimum, what a broker-dealer must do to ensure it is reasonably relying upon the investment adviser. Specifically, broker-dealers must assess the AML risks of the investment adviser and its customer base as a threshold matter.8 Broker-dealers that rely upon the relief will need to establish procedures to address how they will conduct the requisite due diligence, and in particular the AML risks associated with both the investment adviser and its customer base.
Division Staff notes that as a result of the new conditions, some broker-dealers may decide not to rely upon the no-action relief. Not relying on the no-action relief does not preclude a broker-dealer from contractually delegating the implementation and operation of its CIP to an investment adviser.9 In those instances, however, the broker-dealer remains solely responsible for assuring compliance with the CIP Rule. Indeed, in the 2011 Letter, Division Staff noted that under those circumstances the broker-dealer must actively monitor the operation of its CIP and assess its effectiveness.10
Along those same lines, Division Staff notes that as a result of these new conditions, some broker-dealers may cease to enter into reliance agreements with investment advisers. Under those circumstances, broker-dealers that had been obtaining forward-looking certifications need not obtain further certifications.11
B. Books and Records of the Investment Adviser
Unlike prior extensions of the no-action relief regarding CIP reliance, the 2011 Letter specifically addresses to whom the investment adviser must agree to provide books and records relating to its performance of CIP. Given that the investment adviser must be registered with the Commission, the fact that its records must be made available to the Commission is no surprise. Given the widespread use of the no-action relief and existing language in the reliance agreements, many investment advisers already agree to produce their books and records to the broker-dealer upon a request from the broker-dealer’s SRO, such as FINRA. Nevertheless, the language of the 2011 Letter suggests that the investment adviser must produce its records even upon a request directly from an SRO (FINRA) to the investment adviser, even though FINRA does not have jurisdiction over the investment adviser.12 It is unclear what authority FINRA has to make a request to a registered investment adviser for its books and records, and it is equally unclear whether this type of provision should be promulgated by rulemaking rather than a no-action letter.
By May 1, 2011, broker-dealers relying upon the 2011 Letter should adopt adequate procedures to address their due diligence requirements before entering into an agreement with an investment adviser to perform some or all of its CIP program. In addition, broker-dealers should review their reliance agreements to determine whether they contain the requisite conditions that the 2011 Letter imposes, including the requirement that the investment adviser agree to provide its books and records upon a request from the Commission, an SRO or law enforcement agencies. For those broker-dealers that do not rely upon the no-action relief provided in the 2011 Letter, they are solely responsible for assuring compliance with the CIP Rule.
For additional information concerning this alert, please contact the following lawyers:
This article was originally published by Bingham McCutchen LLP.