New Cayman fund AML roles: The advantages of an independent depositary led solution

Changes to the Cayman Islands AML regime

In response to Financial Action Task Force’s (“FATF”) recommendations to combat money laundering and terrorist financing, there have been significant changes to the anti-money laundering (“AML”) laws and practices in the Cayman Islands.

The Anti-Money Laundering Regulations (2018 Revision) of the Cayman Islands (“AML Regulations”) have expanded the scope of the local AML regime. Previously only investment funds registered with the Cayman Islands Monetary Authority (“CIMA”) were in scope of AML rules, but this has now been expanded to include private equity and other closed-ended funds which are not registered with CIMA.

The AML Regulations have introduced a new risk-based approach to AML, which requires entities subject to the rules to take appropriate steps to identify, assess, and understand the money laundering and terrorist financing risks in relation to each investor, the country or region in which the investor resides or operates, the types of individuals/entities that make up the investor base of the investment fund, source of funds, and redemption terms.

New requirements for individuals to undertake designated AML roles

One new requirement is for an investment entity to designate a managerial level individual to act as its Anti-Money Laundering Compliance Officer (“AMLCO”), Money Laundering Reporting Officer (“MLRO”) and Deputy Money Laundering Reporting Officer (“DMLRO”).

The deadline for these appointments is 30 September 2018 (for entities which existed prior to 1 June 2018). Any new entities established after 1 June 2018 must comply immediately.

The AMLCO is required to understand the investment activities of the fund in order to evaluate the AML and terrorist financing risks that may be associated with the fund’s activities. The role therefore goes beyond investor related AML issues and compliance. It is expected that sample checks of underlying AML documentation will be undertaken to assess compliance.

The designated individual will be required to take measures to develop and maintain systems and controls, regularly reporting to and advising the board of directors of the investment entity about issues that should be addressed. The individual will also be responsible for liaising with, and responding to requests from, the relevant regulatory bodies and authorities.

The MLRO and DMLRO will serve as the key points of contact for all suspicious activity reports and will be responsible for reporting such incidents to the appropriate authorities.

The same person can act as the AMLCO and either the MLRO or DMLRO.  The MLRO and DMLRO must be separate individuals.

All persons designated by the fund must have adequate and appropriate resources, seniority, knowledge and expertise to perform the function, and should demonstrate autonomy when carrying out their designated function.

More guidance is expected from CIMA however the Cayman Islands will be at pains to demonstrate its enhanced AML regulations are effective. Therefore, compliance should not be viewed as a mundane rubber stamp exercise, but an obligation that requires a robust and meaningful solution. Adopting a laissez-faire attitude inflates the risk of a serious breach or law violation unfolding, causing serious damage to the industry’s reputation.

How will investment entities comply?

The boards of directors and investment managers of existing investment funds are currently considering their options for compliance by 30 September 2018. These options include the appointment of individuals that are:

  • Fund directors;
  • Managers within the fund manager;
  • Representatives of the fund administrator; and
  • Representatives of a service provider offering to provide MLRO services as a stand-alone service to a fund.

Indicative costs of these solutions (to undertake all three MLRO roles) are in the region of $5,000 – $6,000 per Cayman fund structure (e.g. Master/ Feeder fund, where there is an existing third-party fund administrator).

Feedback from firms with whom INDOS has consulted indicates that:

  • Many fund directors, lacking the infrastructure and capacity to adequately carry out the roles effectively themselves, will wish to delegate the roles;
  • Some managers, particularly those with established internal compliance teams, will be prepared to take on the roles;
  • Only some fund administrators are willing to provide the service. Several leading global fund administrators (including two of the top three global firms by assets under administration) have stated they will not provide the service, despite already performing the AML function over fund investors. Regardless, several managers have questioned the independence of fund administrators when fulfilling the MLRO rules, and the robustness of a model whereby the fund administrator is monitoring its own activities; and
  • Given the choice, managers would prefer not to appoint additional service providers, for practical reasons as well as a desire to minimise the risks around data breaches in the post General Data Protection Regulations (“GDPR”) era.

An independent depositary led solution – the best option

Since the Alternative Investment Fund Managers Directive (“AIFMD”) was introduced in 2014, many Cayman Islands domiciled funds managed by European managers have appointed a depositary as a prerequisite to market their vehicles to European investors.

In broad terms, the role of the depositary is to independently monitor the operations of a fund, perform daily monitoring of fund and investor cash flows (with an emphasis on the identification of ‘significant or unusual transactions’), safe keeping, record keeping and ownership verification of fund assets, and oversight over compliance with the fund prospectus including the correct processing of investor subscriptions and redemptions.

The depositary:

  • has existing access to the accounting and investor records of the fund maintained by the fund administrator. It should already visit the fund administrator for periodic on-site visits during which it will perform an independent assessment of the fund administrator’s accounting and investor services’ functions controls. Depositaries are already required to monitor all capital activity with investors;
  • is already familiar with the managers’ compliance policies and procedures and broader operations of the fund;
  • monitors all banks, custodians, prime brokers and other counterparties of the fund for the purposes of continuous daily cash flow oversight throughout the year, and undertakes regular asset reconciliation and verification;
  • will already engage with the board of directors of the fund, including regular quarterly reporting to the board; and
  • will possess the infrastructure and experienced resources to effectively carry out the MLRO duties.

While additional procedures would need to be implemented to fully address the requirements of the new MLRO functions, the extent of the depositary’s existing oversight, monitoring and access provides a significant advantage over other service providers to effectively fulfil the duties.

Depositaries are frequently affiliated to the fund administrator, but in some cases, firms are entirely independent of the fund administrator.

Independent depositaries will have several advantages over affiliated firms when undertaking the AML functions. They possess:

  • a track record of identifying issues and control weaknesses at fund administration businesses. They are free of the conflicts of interest inherent in an affiliated depositary model. For example, INDOS has in the past identified numerous NAV related issues which have been reported to the AIFM and fund boards. By contrast funds that have appointed a depositary that is affiliated to the fund administrator report that they rarely see issues related to the fund administrator flagged by the depositary;
  • the ability to compare AML practices across different fund administrators, identifying best practices and challenge areas of risk or weakness in an administrator. For example, INDOS has in the past identified and reported weaknesses in the AML processes of a bank owned administrator relative to its industry peers which resulted in the administrator completing a remediation project to bring its AML procedures up to industry standard; and
  • the ability to perform independent screening of investors as required, using a different system and data set to that used by the fund administrator for AML screening of investors. In contrast, the administrator led MLRO solution would not use a separate system or data set. INDOS uses a system called Spear Watch, which enables it to screen against a broader set of data in comparison to the systems commonly used by administrators. In the past the system has identified politically exposed persons (“PEPs”) which have not been flagged by the administrator’s screening process.

Despite the advantages of a depositary led solution, few depositaries are expected to provide MLRO services.

Depositaries that are affiliated to fund administrators which are not providing MLRO services are unlikely to do so through their depositary business.

Depositaries will be hesitant about offering MLRO services on a standalone basis since to implement a robust solution they would need to leverage their existing knowledge and oversight of a fund’s activities. Some may, however, see the service as a “value add” to larger clients.

If depositaries are willing to provide the service independently, the solution will tick many boxes. The depositary is already well-versed in the operating models of its fund clients and their service provider and counterparty relationships. An independent depositary will not face the same conflicts of interest as an administrator based solution, while it will also be able to compare AML policies and procedures across multiple providers, allowing it to share best practices across the industry.

The cost of appointing an independent depositary to conduct meaningful AML oversight and checks is going to be more than the costs being proposed by the alternative solutions. Nonetheless, the regulatory and reputational fall-out that may arise as a result of anything less than robust AML practices could be severe and some fund boards and managers will consider this a price worth paying.