SEC Extends with Additional Conditions the No Action Letter for Broker-Dealers Relying on Registered Investment Advisers for Customer Identification Program

No Comment

The SEC Division of Trading and Markets extended, but amended by increasing the conditions, for broker-dealers relying on registered investment advisers to perform customer identification program (“CIP”) requirements. On January 11, 2011, the SEC agreed to extend for two years the position taken in a 2004 No-Action Letter (and subsequent extensions in 2005, 2006, 2008 and 2010), which permitted broker-dealers to rely upon registered investment advisers to perform CIP as a result of the Securities Industry and Financial Market Association’s request for No-Action relief on behalf of its member broker-dealers. Section 326 of the USA PATRIOT Act of 2001 requires financial institutions (including broker-dealers) to obtain, verify and record information that identifies each person opening an account (see FINRA, Customer Identification Notice).

Background

The PATRIOT Act requires financial institutions to establish to establish Anti-Money Laundering Programs (“AML Program Rule”) and to have a Customer Identification Program (“CIP”), implemented by 31 C.F.R. § 103.121. The CIP regulation provides that a financial institution may rely on another financial institution subject to the Act, see 31 C.F.R. § 103.121(b)(6), but registered investment advisers are not a financial institution subject to the AML Program Rule requirements of the PATRIOT Act (rules were proposed, but withdrawn by FinCEN). The No-Action Letter issued in 2004 first provided no-action relief allowing a broker-dealer to rely upon a registered investment adviser (“RIA”) to perform some or all of its CIP obligations by treating the RIA as if were subject to the AML Program Rule, which was subsequently and modified in 2005, 2006, 2008 and 2010.

The No-Action Letter issued on January 11, 2011 (“2011 No-Action Letter”) further modifies the requirements for no-action relief by requiring that broker-dealers to undertake appropriate due diligence of the registered investment adviser (RIA) and enter into an agreement with specific performance and production obligations.

Conditions Required in Order to Rely on the 2011 No-Action Letter

In the 2011 No-Action Letter, the Division of Trading and Markets will not recommend enforcement under Rule 17a-8 under the Securities Exchange Act of 1934 if a broker-dealer treats an investment adviser as if were subject to an AML Program Rule for purposes of 31 C.F.R. § 103.121(b)(6) provided that other provisions of the CIP Rule are met, and:

  1. the broker-dealer’s reliance on the investment adviser is reasonable under the circumstances (discussed below)
  2. the investment adviser is a U.S. investment adviser registered with the SEC under the Investment Advisers Act of 1940; and
  3. the investment adviser enters into a contract with the broker-dealer in with specific performance and production obligations (discussed below)

Agreement with the Registered Investment Adviser

The broker-dealer must enter into a contract with the registered investment in which the investment adviser agrees that:

  1. 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;
  2. 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;
  3. 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;
  4. 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
  5. it will promptly provide its books and records relating to its performance of CIP to the SEC, 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 SEC, (iii) an SRO that has jurisdiction over the broker-dealer or (iv) an authorized law enforcement agency.

The 2011 No-Action Letter specifically lists whom the RIA must provide its books and records on direct request (as opposed to a request of the broker-dealer), which includes the self-regulatory agency with jurisdiction over the broker-dealers, such as FINRA.

Due Diligence Requirements

Of importance, the 2011 No-Action Letter requires that the reliance of the broker-dealer on the registered investment adviser (RIA) must be reasonable. To establish reasonableness of the reliance, a broker-dealers must undertake “appropriate due diligence on the investment adviser…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.” The due diligence must be undertaken at both “the outset” of the relationship with the RIA and “updated during the course of the relationship, as appropriate.”

In particular, prior to any reliance on the RIA, broker-dealers must assess the AML risks of the investment adviser and its customer base and must update the due diligence during relationship, depending on such risks and circumstances arising subsequent to establishment of the relationship. Therefore, broker-dealers 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, and the extent and timing of ongoing due diligence depending on such risks.

In addition, a broker-dealer may choose to not rely on the no-action relief of the 2011 No-Action Letter while still contractually delegating the implementation and operation of its CIP to a registered investment adviser, but the broker-dealer will remain solely responsible for assuring compliance with the CIP Rule; thus, a broker-dealer must actively monitor the operation of its CIP and assess its effectiveness.

Conclusion

Broker-dealers relying on the 2011 No-Action Letter should adopt reasonable procedures to address their due diligence requirements and review any existing agreements to verify such agreements contain appropriate performance and production obligations on the registered investment adviser. For additional assistance regarding due diligence procedures or drafting effective agreements with registered investment advisers, please contact Evans & Kob PC at info@eklawpc.com.

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