National Risk Assessment of Money Laundering for Jersey – Investment Funds Sector

Observations and commentary on the conclusions drawn in relation to the Investment Funds Sector in Jersey

The National Risk Assessment for Jersey in connection with money laundering risk was published in September 2020 (the Assessment). The Assessment reviews all of the key sectors of the financial services industry in Jersey and the regulatory and law enforcement infrastructure dedicated to combatting financial crime linked to the island.

Set out below are some personal observations and commentary on the material and conclusions in the Assessment relating to section 10 of Part B of the Assessment which deals with the investment funds sector in Jersey. This is not a comprehensive review of the totality of the Assessment which ranges across the whole financial services sector; nor even a comprehensive treatment of section 10. The following observations and commentary are offered principally from a “lessons to learn” perspective and to highlight certain money laundering risk aspects which continue to be a priority focus for fund operators in Jersey. 

ML Typologies for Funds

A theme which is repeated a number of times in section 10 relating to the funds sector in Jersey is the complexity and diversity of the funds and funds structuring encountered in Jersey. How and where to start would have been key questions for the Assessment team responsible for undertaking the review exercise. And indeed the Assessment itself notes that this complexity and diversity gives rise to many possibilities in terms of the approach and types of analysis which could be deployed to interpret the data collated on the funds industry.

I think the Assessment could perhaps have benefited from identifying more clearly at the outset the money laundering typologies which encapsulate the areas of vulnerability of the funds sector in Jersey. These appear to fall into three broad categories – the risk that investors may use funds to invest the proceeds of their own criminal activity (unconnected with the fund) to generate investment returns on these proceeds via the funds; secondly, the risk that funds may become tainted from the criminality of the activities of counterparties with whom the funds interact as part of their investment mandate, particularly where funds invest in high risk countries or asset classes with associations to heightened levels of criminality; and thirdly, the possibility that fund structures could in certain conditions be diverted from legitimate investment activity by controlling parties (for example, promoters or investors with controlling interests) to become vehicles to undertake criminal activities, such as fraud or market abuse.

Using this sort of categorization makes it easier when reading the body of section 10 to contextualize some of the specific data sets and concerns highlighted by the Assessment relating to the funds sector.

An example of this would be the statement in the Assessment that the “Fund industry’s complexities mean their main AML/CFT vulnerability is by being part of the layering and concealment process, which makes the proceeds of crime difficult to trace and prosecute”. This may well be true in the context of a fund within the third category described above where the fund itself is being used as a vehicle to perpetrate unlawful activity. But it would not generally be true of genuine fund arrangements within the first two categories described. Genuine fund arrangements often have very complex structures to cater for bona fide commercial and other reasons to do with cross-border investment, tax structuring and performance fee capture.

Public Funds, Private Funds & Structural Classification of Funds

A striking feature of section 10 of the Assessment is that it is constructed around the regulatory architecture for funds in Jersey. That in itself is perhaps not surprising but as a consequence it influences heavily the focus of analysis. The data collated is examined predominantly through the lens of the regulatory classifications for funds ( which essentially focusses on the differences between Public Funds and Private Funds) and not by analysis of the structural classification of funds (Open-ended versus Closed-ended).

This means (a) there is a considerable emphasis on the nature and numbers of the investors across the public to private funds divide and (b) an underweighting on structural factors, particularly those related to closed-ended fund status which are generally accepted as helpful to reduction of money laundering vulnerability, at least in relation to the first category of funds in the typology described above.

Taking each of these points in turn:

The Assessment highlights that most fund products in Jersey are aimed at professional /sophisticated investors. While the preponderance of funds are non-retail in nature, the Assessment records that over half the investors in Public Funds are individuals who are classified as retail investors. But over 30% of investors in Public Funds are invested in the most highly regulated fund products ( Recognized Funds) of which there are only five in existence. The Assessment acknowledges that the vast majority of these retail investors are classified as lower or standard risk and can be assumed to constitute a cohort of passive investors with no controlling influence over the funds they are invested in. This concentration on retail investors in a small rump of Public Funds should not deflect us from our broader perspective that the Jersey fund sector’s most significant client base is located amongst professional and institutional investors who are spread across both Public and Private Funds.

At the other end of the scale away from retail Recognized Funds, the Assessment notes that “club” type investment arrangements amongst small groups of investors using Private Fund products represents a higher money laundering risk due to the concern that these groups of investors have control over the private fund. But in practice that concern is counterbalanced by the closer relationship that fund administrators will generally have with these smaller groups of investors and the greater information that administrators will hold on these investors as a result of the diligence processes applied.

Because the approach to funds regulation in Jersey operates by reference to the number and type of investors targeted for a fund product, there is relatively little comment in the Assessment addressing the significance of the distinction between Open-ended and Closed-ended funds. It is a generally accepted view that Closed-ended funds are less appealing products for many launderers as they are unable to freely access and redeem their capital from such funds. It is not drawn out in the data presented in the Assessment that the majority of both Public and Private Funds in Jersey are closed-ended.

The redemption facility available to investors in Open-ended Public Funds is noted in the Assessment as a risk factor. But those involved in the funds sector will be aware of the operational features and safeguards present in many open-ended fund structures which, to a fair degree, mitigate this concern, for example, notice periods for and limitations on redemption, no cash or cash equivalent subscriptions or redemptions, payments to and from bank accounts in the registered investors’ names and no third party payments.

Trust Company Service Providers appointed to Private Funds

The Assessment airs a concern on the part of the authorities that in certain cases Private Funds can be administered by a regulated trust company service provider ( TCSP) in Jersey which is licensed only as a trust company business and which does not hold a Fund Services Business ( FSB) licence  in addition. The concern in this context is that such TCSPs , not being in the mainstream of fund administration for Public Funds ( which would entail an FSB licence) may not be as familiar with investment fund activities and risk issues related to them as their FSB regulated brethren can be expected to be. In addition the pressure on and scarcity of experienced compliance staff within Jersey is highlighted as an aggravating factor.

As flexibility and diversity are hallmarks of the funds sector in Jersey and account in good measure for its appeal and success, it would be counterproductive to curtail the rights of TCSPs to act as administrators to these closely-held Private Funds. But there is a clear message here for the governance boards of Private Funds to review and oversee with care the quality and effectiveness of the risk management and anti-money laundering responsibilities delegated by them to their TCSP and for the management of TCSPs to continue to invest in high quality training and know-how development for their fund administration staff and compliance personnel in particular.

Exemptions for Supported Fund Operators

In recent years there has been some debate as to the justification for certain exemptions from parts of the anti-money laundering due diligence procedures which apply to the governance bodies of Private Funds in Jersey taking the form of limited partnerships or private unit trusts. These exemptions simplify to a restricted extent the risk assessment exercises that general partners and private trustees of these funds must undertake to avoid duplication of effort at different levels within the fund structure. The context and rules in question are indeed very complex but they represent a pragmatic reduction of burden in respect of mandatory risk assessment exercises. It is heartening to see that the Assessment mounts a stout defence of the current limited exemptions for what are termed Supported Fund Operators and argues that these exemptions do not dilute the requirement for full anti-money laundering due diligence to be conducted on the relevant Private Fund and its investors. It is to be hoped that Moneyval will acknowledge and accept the appropriateness of the Supported Fund Operators exemptions when they next undertake a review of Jersey’s AML/CFT rules and practices.

Omnibus Holding Arrangements

Omnibus and pooled investor accounts whereby a nominee unitholder of record acts as the registered holder of interests in a fund on behalf of a pool of underlying beneficial participants in a fund is a well established and necessary feature of the institutional and professional investor landscape. Many institutionally promoted funds raise subscription monies for their funds from other institutional asset managers and banks who in turn are responsible for managing and investing the assets of pension fund clients, insurance companies and private wealth portfolios. Omnibus and pooled holdings are an essential mechanism of the custody framework used for holding interests of multiple beneficial owners where their assets are under discretionary management or allocation by intermediate asset managers and advisors. Strict application of a look-through approach to ascertain the identity and risk profile of every beneficial participant underlying an omnibus holding will not be practical in many cases. So the strict approach is tempered with a limited number of exemptions that can in appropriate cases be used to curtail the need to apply a look-through approach. To transparency purists this causes disquiet and fuels concern that funds are placing an over reliance on these due diligence exemptions. The debate on whether and to what extent funds can legitimately reduce application of a full look-through by reliance on these exemptions is not yet resolved.

It is noteworthy that the Assessment tip-toes around this topic in recognition of its sensitivity. The Assessment records that, as has been acknowledged in recent years, fund managers and administrators in Jersey have decreased their reliance on the Article 16 MLJO Obliged Persons exemption ( where a regulated third party who has already completed due diligence on a mutual customer provides a money laundering assurance to the fund in respect of the mutual customer). The reduction in use of this exemption is due to the onerous requirements of operating the Obliged Persons exemption. But the Assessment also acknowledges exemptions and simplified due diligence are still relied upon to a material extent through application of Article 18 MLJO ( regulated business customer /equivalent foreign regulated business customer) and Article 17B MLJO ( simplified due diligence relating to underlying third parties of a regulated customer of record). To defend the continued existence of these exemptions and simplified diligence procedures, stakeholders in Jersey need to continue to participate in the ongoing debate on the need for these provisions and arrive at a mature understanding of the role these provisions play in the funds sector, the circumstances when it is clearly justifiable for funds to utilize these measures and the procedures needed to manage risks arising from their application. Compliance teams and client-facing funds personnel need to continue to develop their technical understanding of these exemptions and simplified procedures which are complex and not easy to understand.

Unregulated Funds

The Unregulated Funds category in Jersey does not fair too well in the results of the Assessment – which is not surprising. And one wonders whether finally this isn’t the beginning of the end for Unregulated Funds.

Unregulated Funds date back to what might be viewed as an experiment by Jersey in 2008 to emulate the very light touch regulation available at that time to Cayman domiciled hedge funds. But Unregulated Funds, by their very name, did not sit comfortably with Jersey’s positioning of itself as a jurisdiction committed to meaningful regulation and prudential control; and indeed the listed variant of Unregulated Funds succumbed to a degree of peer pressure a number of years ago and is no longer available as a fund structuring option. This leaves only the Unregulated Eligible Investor Fund as part of Jersey’s offering of non-regulated fund products.

While Unregulated Funds are subject to the anti-money laundering regime in Jersey and the Unregulated Fund itself is required to implement anti-money laundering checks and due diligence on its investors, the Assessment highlights certain limitations in the effectiveness of the oversight and supervision powers of the regulator in respect of these funds. As there are only 128 Unregulated Funds representing 5.4% of the aggregate value of the Jersey funds reported on, there must be a question mark over the continuation of this fund category. As most fund administrators these days operate to a single or common service level standard irrespective of the regulatory classification of an individual fund, the possibility of conversion from unregulated to a regulated fund category may not be too large a leap to contemplate for these funds. At the very least one can envisage a sunset provision for them in the offing.

Outsourcing to Non-Jersey Delegates

Outsourcing of fund functions and the procedures for the oversight and control of the same is a subject dear to the hearts of funds technicians. Outsourcing and delegation of functions is touched upon by the Assessment in a review of typical fund architecture which traces the delegation of a fund’s anti-money laundering responsibilities to its Jersey-based manager or administrator and which emphasizes the continuing governance responsibility of the fund’s governance body to monitor discharge of the delegated functions. However, one aspect of delegation which is likely to be material to the Jersey fund sector is not addressed by the Assessment. That topic is the off-island delegation of anti-money laundering due diligence duties to non-Jersey based administrators or registrars. I am not aware of any statistics which give an accurate insight of the extent to which such off-island delegation takes place but anecdotally it is a recognizable option within the range of fund structuring that is present in Jersey. Sub-contracting of Jersey fund anti-money laundering processes to off-island agents who are located in a different jurisdiction and subject to foreign anti-money laundering rules  begs the question as to which laws and standards a foreign agent is following when carrying out services for a Jersey fund which needs to be able to demonstrate that its service providers are meeting the requirements of the Jersey money laundering legislation. If as may commonly be the case an off-island agent operates in accordance with its domestic law requirements the possibility of gaps and mismatches with the stipulations of the regime in Jersey governing the Jersey fund is an area which will need review; as also whether there may be any complications in accessing from Jersey due diligence data held in another jurisdiction. Suffice to say the comments in the Assessment relating to delegation are a starting point for wider consideration by fund operators of the effectiveness and compliance of all outsourcing and delegation arrangements they have an involvement with for their client funds.

This document is provided for general information purposes and to promote discussion.  It should not be relied upon or treated as legal advice.

Simon Howard – Howard Consulting Limited

October 2020


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