Investment Advisors Face Added Regulation That Could Potentially Impact Litigation

On February 13, 2024, FinCEN issued a Notice of Proposed Rulemaking (NPRM) to deter criminals and foreign adversaries who seek to potentially compromise the U.S. financial system and assets through investment advisors. If passed, the new rule would make investment advisors subject to the Bank Secrecy Act (BSA) by expanding the definition of “financial institution” to include investment advisors who to this point have not been regulated absent association with banks or bank subsidiaries. What are the potential impacts to investment advisory firms that find themselves subject to the new proposed anti-money laundering (AML) and countering the financing of terrorism (CFT) requirements? There may be a possibility that should the new rule pass, the Suspicious Activity Report (SAR)  privilege and the potential discovery (or not) of documents may change in connection with actions against an investment advisor entity and its registered investment advisor representatives. With that in mind, we will discuss the potentially insulating measures these investment advisory firms may face.

Investment Advisors Potentially Subject to BSA Requirements

The FinCEN fact sheet associated with the NPRM recognizes: “Thousands of investment advisers overseeing the investment of tens of trillions of dollars into the U.S. economy are generally not subject to comprehensive anti-money laundering and countering the financing of terrorism measures.”

As noted above, historically, financial advisors who provide advice to investors about securities for compensation have not been subject to AML/CFT requirements imposed on financial institutions pursuant to the BSA. However, some independent investment advisory firms representing retail investors, high-net-worth individuals, private institutions, and governmental entities have implemented voluntary compliance requirements while some have none at all. Under the proposed new rule, both registered investment advisors (RIAs) who registered with the Securities and Exchange Commission (SEC) and investment advisors who report to the SEC as exempt reporting advisors (ERAs) would be subject to new regulations including recordkeeping requirements, filing SARs, implementing an AML/CFT program and additional obligations consistent with BSA requirements. The proposed rule also includes an information-sharing component between the investment advisor and other various regulatory agencies.

With respect to litigation, most causes of action brought against investment advisors are brought under general common law rights or blue-sky laws. Indeed, the most common causes of action against investment advisors are breach of fiduciary duty, negligence, breach of contract and common law fraud. Can the proposed new law provide a potential additional layer of protection to those advisors subject to litigation? It remains to be seen considering that the deadline to provide proposed comments is April 15, 2024. It is anticipated that smaller advisory firms in the digital asset industry and with international exposure who have avoided broker-dealer registration will respond negatively to the new provision considering the extensive compliance steps that would be required.

Well-Settled Law Concerning Discovery Disputes Involving the BSA

In this article we explore not only the proposed new rule but if there is a potential impact with respect to discovery when an investment advisor is involved in an action for breach of fiduciary duty, negligence, breach of contract or common law fraud.

It is well known that under the Annunzio-Wylie Anti-Money Laundering Act, 31 U.S.C. § 5318 et seq., financial institutions are required to report suspicious transaction activities to regulatory authorities through a SAR. Generally, the rule on the discovery of SARs is clear that there is an absolute privilege preventing disclosure of a SAR or any information that would reveal the existence of SAR. 12 C.F.R. §21.11. This SAR privilege includes “[a] document or other information that affirmatively states that a SAR has been filed and any document stating that a SAR has not been filed. Fed. Trade Comm’n v. Marcus, No. 0:17-cv-60907, 2020 WL 1482250, at *3 (S.D. Fla. Mar. 27, 2020). (Involving a scheme to offer victims phony debt relief services, including fake loans, in which a receiver was appointed to recover assets and, to that end, sought discovery from a bank who argued that said requested documents, listed on a privilege log, were within the scope of the SAR privilege). Generally, the law regarding discovery with respect to the scope of the SAR privilege is that the privilege extends to SARs but not “underlying documents,” and underlying documents means any factual documents created in the ordinary course of business that my have given rise to a SAR. Id. The law in the Southern District of Florida supports a thoughtful and careful approach to distinguish “factual documents” created in the ordinary course of business that may have given rise to a [SAR] from documents that might reveal whether a SAR has been prepared or filed. Id. In Marcus, the court ultimately found the receiver’s argument without merit. The bar on disclosure does not apply to “supporting” documentation as long as such disclosure would not reveal the existence or contents of a SAR. Jasso v. Wells Fargo Bank, N.A., Case No. 2:20-cv-00858-CDS-BNW, 2022 WL 18141573, at *2 (D. Nev. Nov. 29, 2022) (Finding that questions plaintiffs’ counsel posed to a rule (30)(b)(6) witness are not covered by the SAR privilege pertaining the timing as to when bank accounts were shut down), citing United States v. Holihan, 248 F. Supp. 2d 179, 187 (W.D.N.Y. 2003) (“Although in some cases the supporting documentation may disclose the existence of a SAR and its contents, thereby thwarting the regulation’s intent, any supporting documentation which would not reveal either the fact that a SAR was filed or its contents cannot be shielded from otherwise appropriate discovery based solely on its connection to a SAR”).

Given that investment advisors in certain circumstances face exposure to claims by certain investors in the aforementioned spaces, the SAR privilege may be applicable when prior to the proposed new rule no such protections would have existed. It would be significant to see how courts handle this potential discovery issue and how frequently it arises, given that the intent of the SAR privilege is to provide certain protections from disclosure by the financial institution submitting the SAR.

Taking Preventative Next Steps Up Front

While it appears FinCEN has taken steps to minimize compliance impacts to subject investment advisors, and those at the enterprise level will likely not face any additional or redundant requirements, certain initiatives will likely have to occur to ensure that the proposed new requirements are met as examiners will likely focus their attention on any newly implemented AML/CFT compliance programs. It is recommended that impacted investments advisors consult with counsel on the appropriate AML/CFT compliance programs.

Citations:

Fact Sheet: Anti-Money Laundering Program and Suspicious Activity Report Filing Requirements for Registered Investment Advisors and Exempt Reporting Advisors Notice of Proposed Rulemaking (NPRM).

31 U.S.C. § 5318 et seq.

12 C.F.R. §21.11

Jasso v. Wells Fargo Bank, N.A., Case No. 2:20-cv-00858-CDS-BNW, 2022 WL 18141573, at *2 (D. Nev. Nov. 29, 2022).

Fed. Trade Comm’n v. Marcus, No. 0:17-cv-60907, 2020 WL 1482250, at *3 (S.D. Fla. Mar. 27, 2020).

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