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How Funds Can Control Money Laundering Risk

Since Sept. 11, 2001, governments in the U.S. and abroad have moved aggressively to combat the problem of money laundering and terrorist financing at financial institutions. To this end, Title III of the USA Patriot Act introduces many new classes of financial institutions to many of the same anti-money laundering (AML) control requirements that banks have had to comply with for many years under the Bank Secrecy Act and other laws.

The primary goal of these new efforts is to restrict the practice of "regulatory arbitrage" on the part of financial criminals. Just as a market arbitrageur gains on inconsistencies in financial markets, launderers seek to find areas of weak control across jurisdictions and industries.

Aside from government pressures, there are compelling reasons for a mutual fund to take steps to protect itself against infiltration by money launderers. The greatest is protection of the company's brand and reputation.

Mutual funds are one of the most popular ways that investors participate in the securities markets. Criminals can use mutual funds at every stage of the laundering process. First, they don't require in-depth investigation into an investor, making placement easy. Second, as a Dec. 31, 2002 report to Congress by FinCen, the Federal Reserve and the SEC states, they offer ready access: "Because mutual funds offer and redeem their shares continuously, money launderers may invest in [them] due to access to their money." At the final stage, launderers integrate illicitly obtained funds into legitimate assets and/or businesses.

The specifics of Patriot Act compliance are beginning to emerge. On April 29, 2002, FinCen issued an interim final rule that requires funds to "develop and implement an anti-money laundering program reasonably designed to prevent them from being used to launder money or finance terrorist activities." It requires that funds have in place an AML compliance program which contains, 1) a designated AML compliance officer, 2) ongoing employee training in the AML policy and procedures, as well as money laundering detection methods and 3) independent compliance testing by fund personnel or by a qualified outside party. In addition, on May 9, 2003, FinCen and the SEC published a joint final rule that requires mutual funds to establish by Oct. 1 so-called customer identification programs in accordance with Section 326 of the Patriot Act. This ruling requires funds to verify the identity of each customer at the time an account is opened, as well as determine whether the person appears on any lists of known or suspected terrorists or terrorist organizations.

Getting Up To Speed

These new requirements create serious financial and logistical burdens. As mutual fund executives work to bring their AML controls and systems up to speed, there are some guiding principles from the banking industry that can help inform their decisions:

1.) AML programs need the support of the highest levels of management.

2.) There is no "one-size-fits-all" solution. Every institution's risk profile is different, driven by a multitude of factors that include the size of the customer base, its geographic distribution and volume of transactions. Failure to assess these factors carefully from the outset can result in serious over- or under-spending.

3.) Screening customers against government watch lists such as the Office of Foreign Assets Control list is a good minimum but itself may not be enough to protect against AML risk. Statistical analyses of suspicious activity reports (SARs) filed by banks reveal that only a small fraction, often less than 1%, are related to a true terrorist or money laundering watch list "hit." In many ways, financial institutions on the front line of the global economy have been deputized to root out future "blacklistees," and to confront this reality there is a new class of enhanced databases that aggregate information worldwide on potentially high-risk individuals and companies.

4.) The AML compliance function is often seen as a "necessary evil" and cost center. But if it is well designed and staffed, AML compliance can not only prevent high-risk clients from becoming customers, but also allow legitimate customers from high-risk regions to retain their accounts.

Mutual funds will face considerable financial and organizational pressures as they put these programs in place on an accelerated timetable. Strong executive leadership, risk-based planning and strategic application of technology, can mitigate these pressures. In the final analysis, though, all would agree that the potential risk of weak AML controls in the mutual fund industry far outweigh the cost of defining and implementing new standards.

-- John Auerbach is director of anti-money laundering services for Kroll, a global risk consulting company. He can be reached a

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