A broker-dealer is required as part of its Anti-Money Laundering (AML) procedures to develop a Customer Identification Program or “CIP.” A broker-dealer follows its CIP as it attempts to verify the identity of individuals or entities, who are in most cases its customers, wishing to conduct financial transactions with the broker-dealer.
Both the AML and CIP requirements emanate from the USA Patriot Act.
The CIP is essentially a set of risk-based procedures used when verifying the identity of each customer. The CIP should be drafted in a manner whereby following the procedures would lead the broker-dealer to form a reasonable belief that it knows the true identity of each customer.
What’s Not Clear…
Reading FINRA and SEC rules and other guidance on the subject one can reasonably make the case that the drafters did not fully consider the distinctive business patterns of a private placement broker-dealer.
A common concern among private placement broker-dealers centers on knowing the correct time at which to conduct AML, This concern emanates in my opinion largely from the lack of clarity present in relevant AML rules and written guidance, which regularly use the term customers, for example, when describing the party upon whom a broker-dealer should conduct CIP. In my experience, which is by extension the experience of my private placement broker-dealer clients, there are no “customers.”
Private placement broker-dealers use the term “client” when referring to an issuer of securities for whom they are assisting in the raising of capital. Unfortunately, they also refer to the investors from whom they are raising that capital as clients, and so, varying terminology often adds to the confusion. Especially when you’re speaking with a FINRA examiner and attempting to explain why you did or did not conduct CIP on a customer.
Let’s make this easy. The issuer is your client. The investor is simply the investor. Private placement broker-dealers work with clients and investors. They conduct CIP almost exclusively on investors. When reading the word customer in the rules, think investor.
When do Private Placement Broker-Dealers Conduct CIP?
It’s helpful to quickly review what CIP means in a retail broker-dealer setting. CIP is conducted at the time of account opening. Should the broker-dealer have thousands of accounts, and if it is conducting CIP in a timely manner, it should have conducted CIP for each one of those accounts.
There are no formal account opening processes within the private placement broker-dealer world. And literally speaking there are no accounts in this same sense. Rather, there are simply relationships – between the broker-dealer and those investors residing in that broker-dealer’s proverbial rolodex or more likely, contacts database folder.
Because of this distinction a private placement broker-dealer would not conduct CIP immediately after being introduced to or otherwise initiating or re-initiating contact with an investor (that is, during the “Account Opening” process). By extension, this would require that whenever a private placement broker-dealer received a mandate to seek funding for an issuer (the client) it would immediately conduct CIP for all investors that at such time were listed in its contact database, regardless of whether it intended to any of those investors. Simply not happening.
This is where the distinction between accounts and relationships should be stressed.
So when does the private placement broker-dealer conduct CIP? CIP should be conducted after an investor voices interest in committing, but before making the commitment binding pursuant to a writing, and, of course, before making the investment.
It could work like this:
You are working out the terms of your engagement with an issuer and conducting your issuer due diligence, and at that time you already have a good idea about which investors you know may be interested, even though those investors have not heard from you on this specific issue. You have already narrowed down the list of those investors upon whom you would ultimately conduct CIP. However, there is need to conduct CIP at this point. Read on.
It could also work like this:
You’ve entered into the agreement with the issuer. You then review your investor data base and among hundreds of potential investors you single out ten you believe may be interested. There is no need to conduct CIP at this point.
You contact all ten and thereafter cross five off the list. No need to conduct CIP at this point.
To the remaining five you provide transaction documentation of varying sorts. At this point you could (I say should) conduct CIP even though you’re not 100% certain any one investor would ultimately wish to commit to funding, but you want to be ready should one or all wish to proceed. However again, getting a head start may not be a feasible idea depending on the number of potential investors at this stage. That is simply a judgement on your part, because you could wait.
Finally, of the remaining five just two tell you they wish to commit. At this point you must conduct CIP, and such CIP must be complete prior to the investor obligating itself in a writing, and ultimately transferring funds to the issuer.
I hope I have provided you with a little clarity today.
Before you go…
My Clarity Concepts Blog posts are intentionally short and provided whenever I find a pattern of confusion or a simple lack of clarity among some of my own clients or that I see more generally occurring in the larger financial services world. They are not written as a treatise on the subject, but rather to clear the air or otherwise provide some clarity.
The information in this article and/or blog is for informational purposes only and not for the purpose of providing legal advice.