ICI Letter to Treasury on Anti-Money Laundering Rule, February 2006

William Langford
Associate Director
Regulatory Policy and Programs Division
Financial Crimes Enforcement Network
U.S. Department of the Treasury
Washington, DC

The Investment Company Institute¹ is writing to request your concurrence in our interpretation of the correspondent account provisions in the new rules under Section 312 of the USA PATRIOT Act (the "Correspondent Account Rule").²We respectfully request that Treasury concur with our view that Fund/SERV accounts (defined below) are "established, maintained, administered, or managed," as those terms are used in the Correspondent Account Rule, by the mutual fund for the NSCC member firm and not for the firm's customers.³ We believe that this interpretation is clearly supported by the rule text and fully consistent with both the policies underlying the USA PATRIOT Act and the Treasury staff's earlier interpretation of the mutual fund customer identification program rule (the "CIP Rule") in the Fund/SERV context.

Given the Correspondent Account Rule's April 4th implementation deadline for new accounts and the fundamental importance of Fund/SERV to the processing of purchases, redemptions, and exchanges of mutual fund shares, we strongly urge Treasury to respond as quickly as possible.

The Application of the Correspondent Account Rule to Fund/SERV Accounts
The Correspondent Account Rule requires every mutual fund to establish a due diligence program reasonably designed to enable it to detect and report money laundering activity involving any correspondent account established, maintained, administered, or managed by the mutual fund for a foreign financial institution.⁴

We are writing with respect to accounts opened by U.S. financial institutions with mutual funds for the purpose of effecting transactions of fund shares that are cleared and settled through the National Securities Clearing Corporation's Fund/SERV system ("Fund/SERV accounts"). We believe that the Correspondent Account Rule does not apply to a Fund/SERV account established, maintained, administered, or managed for an NSCC member firm that is a U.S. financial institution, even if the firm's customer is a foreign financial institution.⁵ In that case, the Correspondent Account Rule would apply to the account held by the NSCC member firm for the foreign financial institution. See Figure 1.

A. Background on Fund/SERV
For purposes of our analysis, we briefly describe below several characteristics that apply to all mutual fund accounts established through Fund/SERV:

Access to the Fund/SERV system is restricted to NSCC member firms. NSCC membership is limited to financial institutions domiciled or regulated in the U.S. and other firms approved by the NSCC Board of Directors.⁶Foreign financial institutions are eligible for membership in NSCC only if they fit within one of the NSCC membership categories. We understand that no foreign financial institution currently is an NSCC member firm.⁷
Mutual funds are not required to verify the identity of customers of an NSCC member firm that invest in mutual funds through the firm via Fund/SERV. In August 2003, the staff of Treasury and the SEC issued a joint FAQ that addresses the application of the CIP Rule to Fund/SERV accounts. In answer to the question of whether, in that context, the firm's customers also are customers of the mutual fund, the staff responded:
A: No. . . . If an intermediary opens an account with a mutual fund through the NSCC Fund/SERV system, the intermediary would be the person that opens the new account, and the intermediary's customers would not be customers of the mutual fund.⁸
The clearance and settlement process through Fund/SERV is completely separate and distinct from the investor's funding of his or her transactions.⁹As a result, the fund has no knowledge of the source of the investor's funds.
The investor's relationship with the NSCC member firm is such that the investor will be subject to the NSCC member firm's AML policies and procedures, including any policies and procedures with respect to correspondent accounts for foreign financial institutions. Accordingly, the NSCC member firm will have a legal duty to determine whether the investor is a foreign financial institution (as defined in the Correspondent Account Rule) and subject the investor's account to the appropriate level of due diligence required by the Correspondent Account Rule.

B. Policy Reasons for an Approach for Fund/SERV Accounts Under the Correspondent Account Rule Similar to the CIP Rule
As noted above, Treasury and SEC staff analyzed the application of the CIP Rule to NSCC member firms' customers in the Fund/SERV context in 2003, concluding that mutual funds are not required to verify the identity of NSCC member firms' customers. The same policy rationales underlying the staff interpretation on the CIP Rule apply with respect to the treatment of Fund/SERV accounts under the Correspondent Account Rule.

In our letter to the staff on the CIP Rule, we pointed out that investors in the Fund/SERV context clearly are customers of the NSCC member firm, as they must open an account with that firm in order to purchase fund shares. To the extent that the firm is a broker-dealer or other financial institution subject to CIP obligations, it verifies each investor's identity in accordance with its CIP. Thus, investors do not have access to mutual funds through Fund/SERV without undergoing verification of identity.

Similarly, foreign financial institutions only could access mutual funds through Fund/SERV by conducting transactions through a U.S. financial institution, subject to that institution's AML procedures, or by conducting transactions directly with the mutual fund, subject to the fund's AML procedures. Our interpretation thus does not create any gaps in the scope or strength of the Correspondent Account Rule's protections.

In our earlier letter, we also pointed out the needless duplication of effort and expense that would result from an interpretation of the CIP Rule that required funds to verify the identity of firms' customers. As recognized in the staff FAQ, "only limited information (if any information at all) about individual customers is provided to the mutual fund" in the Fund/SERV account context. Mutual funds have no way to "know" a firm's customers given the existing Fund/SERV account opening processes. As a result, an interpretation that funds have to identify and verify NSCC member firm's customers would have resulted in dramatic and expensive changes to the entire system of processing orders through Fund/SERV.

An interpretation that the Correspondent Account Rule applies to mutual fund accounts in the Fund/SERV context will effectively reverse the staff's position on the CIP Rule, in essence requiring mutual funds to treat certain persons as customers for correspondent account purposes that are not treated as customers for CIP purposes. It will require mutual funds to collect identifying information that they do not currently have on all NSCC member firms' customers to determine whether any of those customers are foreign financial institutions, so that the fund can fulfill the Correspondent Account Rule's requirements. As a result, such an interpretation will result in all of the same unnecessary changes, expenses, and order processing delays that we previously highlighted.¹⁰Given the Treasury and SEC staff interpretation with respect to the CIP Rule, this cannot be Treasury's intent in adopting the Correspondent Account Rule.

Request for Concurrence
For all of the reasons expressed above, we urge Treasury to concur with our view that in the Fund/SERV context, mutual funds establish, maintain, administer, and manage accounts only for NSCC member firms, rather than for the investors that are the firms' customers.

Given the April 4th implementation deadline, we respectfully request your earliest possible response. If you have any questions or need additional information, please contact me at 202/371-5430 or rcg@ici.org.

Cc: Hunter Jones, Assistant Director
Office of Regulatory Policy
U.S. Securities and Exchange Commission

1 The Investment Company Institute is the national association of the U.S. investment company industry. ICI members include 8,554 open-end investment companies (mutual funds), 654 closed-end investment companies, 162 exchange-traded funds, and five sponsors of unit investment trusts. Mutual fund members of the ICI have total assets of approximately $8.802 trillion (representing 98 percent of all assets of U.S. mutual funds); these funds serve approximately 89.5 million shareholders in more than 52.6 million households.

2 31 C.F.R. § 103.176. See also 71 Fed. Reg. 496 (January 4, 2006) (adopting the Correspondent Account Rule and 31 C.F.R. § 103.178 relating to due diligence programs for private banking accounts). In this letter, we are addressing only the Correspondent Account Rule. We are not addressing the private banking rule in 31 C.F.R. § 103.178.

3 For simplicity, we are using the terms "firm" to refer to the NSCC member firm, typically a broker-dealer, transacting via Fund/SERV on behalf of its customers and "fund" to refer to each mutual fund in which the firm invests on behalf of its customers.

5 The term "foreign financial institution" is defined in 31 C.F.R. § 103.175(h).

7 If a foreign financial institution is or becomes an NSCC member firm, the Correspondent Account Rule will require mutual funds to treat any Fund/SERV accounts relating to that firm as correspondent accounts subject to the appropriate level of due diligence and monitoring.

8 See Guidance from the Staffs of the Department of the Treasury and the U.S. Securities and Exchange Commission, Questions and Answers Regarding the Mutual Fund Customer Identification Program Rule (31 CFR 103.131), available at http://www.sec.gov/divisions/investment/guidance/qamutualfund.htm.

9 Fund/SERV streamlines the settlement process between firms and funds by calculating a net settlement figure for each participant every day, which is settled with a single wire transfer. For example, a broker-dealer may have thousands of customers who buy and sell shares of various mutual funds each day. Fund/SERV will calculate a single net amount that the broker-dealer must either wire (if its customers are net purchasers) or that NSCC will wire to the broker-dealer (if its customers are net sellers). This process is completely separate from the customer's funding of the individual transactions, which is entirely a function of the customer's relationship with the firm.

10 For a complete description of the potential costs involved, see Attachment C, the letter from the Institute to Paul F. Roye, Director of the Division of Investment Management at the SEC, and Charles Klingman, Senior Financial Economist at the U.S. Department of the Treasury, dated June 24, 2003.

The NSCC introduced Fund/SERV in 1986 to electronically connect brokerage firms and other financial institutions with fund families. Its automated process enables thousands of firms to deal with hundreds of fund families offering thousands of funds via a single, standardized clearance and settlement system.¹ More than 72 million mutual fund accounts reside on fund transfer agency systems through the use of the Fund/SERV system, and Fund/SERV processes more than 470,000 transactions daily with a daily value of over 7.5 billion dollars.

Every purchase of fund shares that is cleared and settled through Fund/SERV is essentially processed in the same way. In each case, the firm transmits trade information on its customers' behalf to the NSCC via Fund/SERV. NSCC then sorts that trade information (along with all other trade information received from all other NSCC members that day) and forwards it to the appropriate fund transfer agent for processing, which causes accounts to be opened on the transfer agent's books.²Trades over Fund/SERV typically are executed on a same-day basis, confirmed on a next-day basis, and settle no later than three days following the trade. Confirmations are automatically generated and sent back through Fund/SERV to the firms. These timelines reflect operational conventions in the fund business that fund investors and regulators have come to expect and that, in part, reflect SEC regulatory requirements.

NSCC member firms typically regard the identity of their customers as proprietary information and accordingly seek to limit or control the distribution of customer information to mutual funds and other financial institutions. The firms nonetheless may rely upon the funds in certain circumstances to perform specified recordkeeping tasks pursuant to a Networking agreement.³Importantly, these Networking Levels and associated recordkeeping arrangements do not change the account opening process described above.

1 There are approximately 500 fund families with approximately 32,000 separate CUSIPs in the Fund/SERV system. Each CUSIP represents a separate fund or fund class for routing purposes.

2 Accounts are not opened until the firms provide sufficient registration information to the funds' transfer agents. This may not occur for several days following the transaction.

3 Networking was developed separately from the Fund/SERV account opening and settlement process as a way to exchange and update non-transaction related fund data. It provides various "Levels" of recordkeeping and reporting conventions between firms and funds. Through Networking, firms can arrange for funds (or, more precisely, their transfer agents) to assume a range of tasks from preparing tax reporting forms (Network Levels One and Two) to also preparing trade confirmations and distributing account statements (Network Level Four). Under the most common Networking arrangement, Level Three (also known as "firm controlled" accounts), the firm performs all recordkeeping tasks associated with the fund transactions.