Tag Archives: hedge fund manager

Hedge Fund Seed Deals Overview

Seed Capital Arrangements for Hedge Fund Managers

We receive numerous inquiries from new managers seeking capital sources in today’s challenging financial climate. Recent regulatory changes have increased legal and compliance costs associated with launching a hedge fund and many smaller investors are wary to invest with first time managers, despite their potential to generate alpha. One way emerging managers can secure the much needed capital is via a “seed deal” whereby a seed capital provider (the “Seeder”) makes a significant capital investment (the “Investment’) in the manager’s fund (the “Fund”) in exchange for a share of the management fees and/or incentive fees. In addition to providing the manager with start-up operating and investment capital, the manager gets additional credibility with prospective investors. This article will summarize some of the basic terms involved in seed deals, as well as a number of issues a manager should consider. Please note that each seed deal is unique and a manager should work with experienced counsel to negotiate the appropriate terms.

Seed Deal Basics

Investment.

The amount of Investment can range greatly, the initial funding can be as much as $150 million

or as little as $1 million depending on a variety of factors.

Lock-Up Period.

Depending on the size of the Investment and other negotiated terms, the Seeder will generally commit keep the Investment in the Fund for a period 2 to 4 years, subject to certain early withdrawal rights, including but not limited to:

    • Violation of proscribed investment guidelines;
    • Decline of Investment by a certain percentage;
    • Misconduct by the manager or its principals;
    • Key man provisions or change of control; and
    • Reaching a certain AUM threshold.

Share of Revenues.

In exchange for the Investment, the Seeder receives a percentage of the manager’s revenues (including management fees and/or incentive fees) lasting in perpetuity or for a specified term. This arrangement is usually accomplished in one of two ways:

1. Equity Interest: The Seeder receives a direct equity interest in the management entity and typically receives revenues “net” of expenses. In this type of deal, the Seeder will generally require limitations or consent for expenses.

2. Fee Sharing Agreement: The Seeder enters into a profit/fee sharing agreement with the manager whereby the Seeder will be entitled to a portion of the management and/or incentive fees received by the manager. Fee sharing agreements have been more common as they offer greater freedom for the manager to operate its business. In this type of arrangement, the fees will generally be calculated on a gross basis. The actual sharing percentage varies depending on the amount of the Investment; however, amounts from 15 to 30% are common.

Seeder Rights and Obligations

Depending on the size of the Investment, the Seeder may obtain certain special rights, including but not limited to:

  • Access to Fund records and accounts, including “side letters” with other investors;
  • Portfolio transparency;
  • Most Favored Nation treatment;
  • Capacity rights
  • Right of first refusal on launch of subsequent funds, service providers or corporate events;
  • Management and oversight rights, including budget approval, fund terms, investment guidelines and restrictions;
  • Special liquidity terms;
  • Notification of significant matters and periodic meetings with principals of the manager.

The Seeder may agree to serve on an advisory committee for the manager, assist in the marketing of the Fund, and/or provide office space or other specified services to the manager.

Fund Manager Obligations

Depending on the size of the Investment, the manager may agree to additional obligations, including but not limited to:

Principal Investment

Principals of the manager agree to make and maintain a certain investment in the Fund, and may be required to re-invest a portion of received inventive allocation.

Revenue Share of All Fees

The fee sharing agreement will include all fees the manager receives from its investment management related activities (including other funds or managed accounts managed by the manager).

Non-Compete/Non-Solicitation

Principals of the manager will be prohibited from forming other management companies or funds for a period of time and may agree to a specific time commitment. In addition, the principals will agree to not solicit other employees of the manger or the Seeder for a period of time after they leave.

Representations, Warranties and Covenants

The manager will be required to make certain representations, warranties and covenants relating to regulatory and compliance issues.

Indemnification

The Seeder will usually be fully indemnified by the manager against losses arising out of the seed agreement or the investment in the Fund or any Fund document.

Additional Considerations

When contemplating entering into a seed deal arrangement, the manager should also consider the following:

Buyout Rights

The manager may request the right to buyout (in whole or in part) the Seeder’s interest in the Fund, after a specified number of years or upon receiving a certain amount of fees. The buyout price can be determined ahead of time and is generally determined by a formula based on Investor receiving a certain amount of fees or a certain rate of return on the Investment.

Put Rights

Similar to the above, the Seeder may also request the right to sell its interest back to the manager.

Tag Along Rights

In the event of a sale of the manager, the Seeder may request a provision that would require the purchaser to also buy out the Seeder’s interest in the manger on a pro rata basis.

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Cole-Frieman & Mallon LLP is an investment management law firm focused on established and emerging hedge fund managers. If you have questions about hedge fund seed deals, please contact us.

 

Business Continuity Plans (Disaster Recovery Plans) | Investment Adviser Registration

The following post is part of our hedge fund compliance guide for managers who will be required to register as investment advisers with the SEC.  After the Dodd-Frank bill, managers with either $1ooM of AUM (if managing a fund and separate accounts) or $150M of AUM (if managing a fund only) will be required to register and also to implement a compliance program.  Under SEC Rule 206(4)-7 those managers will need to generally institute compliance policies and procedures (subject to annual review) and appoint a chief compliance officer.  Part of that process will be to institute a business continuity or disaster recovery plan.

Rule 206(4)-7

The full rule provides:

Rule 206(4)-7 — Compliance Procedures and Practices

If you are an investment adviser registered or required to be registered under section 203 of the Investment Advisers Act of 1940 it shall be unlawful within the meaning of section 206 of the Act for you to provide investment advice to clients unless you:

a.  Policies and procedures. Adopt and implement written policies and procedures reasonably designed to prevent violation, by you and your supervised persons, of the Act and the rules that the Commission has adopted under the Act;

b.  Annual review. Review, no less frequently than annually, the adequacy of the policies and procedures established pursuant to this section and the effectiveness of their implementation; and

c.  Chief compliance officer. Designate an individual (who is a supervised person) responsible for administering the policies and procedures that you adopt under paragraph (a) of this section

Background on BCP Requirement

While the rule does not specifically mention a “business continuity plan,” the SEC has stated that an adviser has a fiduciary obligation to protect client assets from risks resulting from the adviser being unable to provide advisory services. Thus, an adviser must create and maintain a business continuity plan which is “reasonably designed” to enable the adviser to meet client obligations in the event of a natural disaster, emergency, or significant business disruption.

In the accompanying Adopting Release Report to Rule 206(4)-7,  the SEC specifically noted that, at a minimum, policies and procedures established must address, among a number of other issues, the investment adviser’s or the fund’s business continuity plan.  [HFLB Note: Other issues the adviser’s policies and procedures should address include: (1) portfolio management, (2) trading practices, (3) proprietary trading and personal trading activities, (4) the accuracy of disclosures, (5) safeguarding client assets, (6) the accurate creation and maintenance of required records, (7) marketing advisory services, (8) process to value client holdings and assess fees based on valuations, and (9) safeguards for the privacy protections.]

The SEC did not, however, detail specific requirements for a business continuity plan, other than to state that it must adequately address the procedures necessary for the investment adviser or the fund to fulfill its fiduciary obligation to protect its clients’/investors’ interests from being placed at risk as a result of the investment adviser’s or the fund’s inability to provide investment advisory or related services after a disaster or disruption occurs.

Because the SEC did not provide direct guidance in this respect, we can, among other resources, look toward FINRA rules on this topic.

FINRA Rule 4370 (Business Continuity Plans and Emergency Contact Information)

On April 7, 2004, the SEC approved NASD Rules 3510  and 3520  requiring member firms to establish and maintain business continuity plans that meet specified requirements.  FINRA Rule 4370 superseded these rules following the consolidation of NASD and other member regulation, enforcement and arbitration functions of the NYSE regulation into FINRA.   FINRA Rule 4730 is nearly identical to the previous NASD rules.  The following sets forth the rule.

  • Establishing and Maintaining a BCP.  Requires firms to create and maintain a business continuity plan that identifies procedures related to an emergency or other significant business disruption and is “reasonably designed to enable the member [firm] to meet its existing obligations to customers.”  The business continuity plan procedures must address existing relationships with other broker-dealers and counter-parties.  The business continuity plan must be made available upon request by FINRA staff.
  • Updating Requirements.  The firm must update the business continuity plans in the event of any material change to the adviser’s operations, business, structure, or location.  In addition, the business continuity plans must be reviewed at least annually.
  • BCP Details.  The rules do not provide specific detailed requirements.  Instead, they provide a framework for minimum compliance.   The following is a non-exhaustive list of 10 key areas that the business continuity plans should address to the extent applicable and necessary.

1. Data back-up and recovery (hard copy and electronic);
2. All mission critical systems;
3. Financial and operational assessments;
4. Alternate communications between the member and its customers;
5. Alternate communications between the member and its employees;
6. Alternate physical location of employees;
7. Critical business constituent, bank, and counter-party impact;
8. Regulatory reporting;
9. Communications with regulators; and
10. How the member will assure customers’ prompt access to their funds and securities in the event that the member determines that it is unable to continue its business.

If a firm does not include one of the elements addressed above, it must document the reason.  If the firm relies on another entity to perform certain functions, it must document the relationship with that other entity.

  • Plan Approval.  The firm must designate a member of senior management who is also a registered principal to approve the business continuity plan and to conduct the annual review.
  • Disclosure Requirements.  The firm must disclose how the business continuity plan can address and how the firm will respond to future business disruptions of varying scope.   The disclosure must, at a minimum, be made in writing to customers at account opening, posted on the firm’s web site (if one exists), and mailed to customers upon request.
  • Designating Emergency Contacts. The firm must designate two emergency contact persons.   The emergency contact persons must be associated persons.  At least one contact person must be both a member of senior management and a registered principal of the firm.  If the second contact person is not a registered principal, that person must be a member of senior management who has knowledge of the firm’s business operations.  If a firm only has one associated person, then the second contact person must be an individual who has knowledge of the firm’s business operations.
  • Updating Requirements.  The firm must update the emergency contact information in the event of any material change.  In addition, the firm’s Executive Representative or designee must review and if necessary, update the information within 17 business days after the end of each calendar quarter.

Conclusion

Having an appropriately tailored business continuity plan for your business is essential from both a regulatory and best practices perspective.  Managers should have robust programs in place and be ready to show examiners that all statements in the business continuity plan are completely accurate.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides comprehensive registration and compliance services for SEC registered investment advisers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Private Fund Investment Advisers Registration Act of 2010

Full Text of PFIARA of 2010 (requiring Hedge Fund Registration)

The following is the full text of the Private Fund Investment Advisers Registration Act of 2010 which was part of the recently passed Senate financial regulation bill.  The central part of this act eliminates the Section 203(b)(3) exemption for registration for hedge fund managers (see Section 403).  The act also requires hedge fund managers to provide the SEC with certain information about their trading program and investment positions (see Section 404).

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TITLE IV—REGULATION OF ADVISERS TO HEDGE FUNDS AND OTHERS

SEC. 401. SHORT TITLE.

This title may be cited as the ‘‘Private Fund Investment Advisers Registration Act of 2010’’.

SEC. 402. DEFINITIONS.

(a) INVESTMENT ADVISERS ACT OF 1940 DEFINITIONS.—Section 202(a) of the Investment Advisers Act of1940 (15 U.S.C. 80b–2(a)) is amended by adding at the end the following:

‘‘(29) The term ‘private fund’ means an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a–3), but for section 3(c)(1) or 3(c)(7) of that Act.

‘‘(30) The term ‘foreign private adviser’ means any investment adviser who—

‘‘(A) has no place of business in the United States;

‘‘(B) has, in total, fewer than 15 clients who are domiciled in or residents of the United States;  on DSKH9S0YB1PROD with BILLS

‘‘(C) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

‘‘(D) neither—

‘‘(i) holds itself out generally to the public in the United States as an investment adviser; nor

‘‘(ii) acts as—

‘‘(I) an investment adviser to any investment company registered under the Investment Company Act of 1940; or

‘‘(II) a company that has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a–53), and has not withdrawn its election.’’.

(b) OTHER DEFINITIONS.—As used in this title, the terms ‘‘investment adviser’’ and ‘‘private fund’’ have the same meanings as in section 202 of the Investment Advisers Act of 1940, as amended by this title.

SEC. 403. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS; LIMITED INTRASTATE EXEMPTION.

Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3(b)) is amended—

(1) in paragraph (1), by inserting ‘‘, other than an investment adviser who acts as an investment adviser to any private fund,’’ before ‘‘all of whose’’;

(2) by striking paragraph (3) and inserting the following:

‘‘(3) any investment adviser that is a foreign private adviser;’’; and

(3) in paragraph (5), by striking ‘‘or’’ at the end; (4) in paragraph (6), by striking the period at the end and inserting ‘‘; or’’; and (5) by adding at the end the following: ‘‘(7) any investment adviser, other than any entity that has elected to be regulated or is regulated as a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a–54), who solely advises— ‘‘(A) small business investment companies that are licensees under the Small Business Investment Act of 1958; ‘‘(B) entities that have received from the Small Business Administration notice to proceed to qualify for a license as a small business investment company under the Small Business Investment Act of 1958, which notice or license has not been revoked; or ‘‘(C) applicants that are affiliated with 1 or more licensed small business investment companies described in subparagraph (A) and that have applied for another license under the Small Business Investment Act of 1958, which application remains pending.’’.

SEC. 404. COLLECTION OF SYSTEMIC RISK DATA; REPORTS; EXAMINATIONS; DISCLOSURES.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–4) is amended—

(1) by redesignating subsections (b) and (c) as subsections (c) and (d), respectively; and

(2) by inserting after subsection (a) the following:

‘‘(b) RECORDS AND REPORTS OF PRIVATE FUNDS.—

‘‘(1) IN GENERAL.—The Commission may require any investment adviser registered under this title—

‘‘(A) to maintain such records of, and file with the Commission such reports regarding, private funds advised by the investment adviser, as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council (in this subsection referred to as the ‘Council’); and

‘‘(B) to provide or make available to the Council those reports or records or the information contained therein.

‘‘(2) TREATMENT OF RECORDS.—The records and reports of any private fund to which an investment adviser registered under this title provides investment advice shall be deemed to be the records and reports of the investment adviser.

‘‘(3) REQUIRED INFORMATION.—The records and reports required to be maintained by a private fund and subject to inspection by the Commission under this subsection shall include, for each private fund advised by the investment adviser, a description of—

‘‘(A) the amount of assets under management and use of leverage;

‘‘(B) counterparty credit risk exposure;

‘‘(C) trading and investment positions;

‘‘(D) valuation policies and practices of the fund;

‘‘(E) types of assets held;

‘‘(F) side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors;

‘‘(G) trading practices; and

‘‘(H) such other information as the Commission, in consultation with the Council, determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk, which may include the establishment of different reporting requirements for different classes of fund advisers, based on the type or size of private fund being advised.

‘‘(4) MAINTENANCE OF RECORDS.—An investment adviser registered under this title shall maintain such records of private funds advised by the investment adviser for such period or periods as the Commission, by rule, may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

‘‘(5) FILING OF RECORDS.—The Commission shall issue rules requiring each investment adviser to a private fund to file reports containing such information as the Commission deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

‘‘(6) EXAMINATION OF RECORDS.—

‘‘(A) PERIODIC AND SPECIAL EXAMINATIONS.—The Commission—

‘‘(i) shall conduct periodic inspections of all records of private funds maintained by an investment adviser registered under this title in accordance with a schedule established by the Commission; and

‘‘(ii) may conduct at any time and from time to time such additional, special, and other examinations as the Commission may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

‘‘(B) AVAILABILITY OF RECORDS.—An investment adviser registered under this title shall make available to the Commission any copies or extracts from such records as may be prepared without undue effort, expense, or delay, as the Commission or its representatives may reasonably request.

‘‘(7) INFORMATION SHARING.—

‘‘(A) IN GENERAL.—The Commission shall make available to the Council copies of all reports, documents, records, and information filed with or provided to the Commission by an investment adviser under this subsection as the Council may consider necessary for the purpose of assessing the systemic risk posed by a private fund.

‘‘(B) CONFIDENTIALITY.—The Council shall maintain the confidentiality of information received under this paragraph in all such reports, documents, records, and information, in a manner consistent with the level of confidentiality established by the Commission pursuant to paragraph (8). The Council shall be exempt from section 552 of title 5, United States Code, with respect to any information in any report, document, record, or information made available, to the Council under this subsection.’’.

‘‘(8) COMMISSION CONFIDENTIALITY OF REPORTS.—Notwithstanding any other provision of law, the Commission may not be compelled to disclose any report or information contained therein required to be filed with the Commission under this subsection, except that nothing in this subsection authorizes the Commission—

‘‘(A) to withhold information from Congress, upon an agreement of confidentiality; or

‘‘(B) prevent the Commission from complying with—

‘‘(i) a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction; or

‘‘(ii) an order of a court of the United States in an action brought by the United States or the Commission.

‘‘(9) OTHER RECIPIENTS CONFIDENTIALITY.— Any department, agency, or self-regulatory organization that receives reports or information from the Commission under this subsection shall maintain the confidentiality of such reports, documents, records, and information in a manner consistent with the level of confidentiality established for the Commission under paragraph (8).

‘‘(10) PUBLIC INFORMATION EXCEPTION.—‘‘(A) IN GENERAL.—The Commission, the Council, and any other department, agency, or self-regulatory organization that receives information, reports, documents, records, or information from the Commission under this subsection, shall be exempt from the provisions of section 552 of title 5, United States Code, with respect to any such report, document, record, or information. Any proprietary information of an investment adviser ascertained by the Commission from any report required to be filed with the Commission pursuant to this subsection shall be subject to the same limitations on public disclosure as any facts ascertained during an examination, as provided by section 210(b) of this title.

‘‘(B) PROPRIETARY INFORMATION.—For purposes of this paragraph, proprietary information includes—

‘‘(i) sensitive, non-public information regarding the investment or trading strategies of the investment adviser;

‘‘(ii) analytical or research methodologies;

‘‘(iii) trading data;

‘‘(iv) computer hardware or software containing intellectual property; and

‘‘(v) any additional information that the Commission determines to be proprietary.

‘‘(11) ANNUAL REPORT TO CONGRESS.—The Commission shall report annually to Congress on how the Commission has used the data collected pursuant to this subsection to monitor the markets for the protection of investors and the integrity of the markets.’’.

SEC. 405. DISCLOSURE PROVISION ELIMINATED.

Section 210(c) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–10(c)) is amended by inserting before the period at the end the following: ‘‘or for purposes of assessment of potential systemic risk’’.

SEC. 406. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–11) is amended—

(1) in subsection (a), by inserting before the period at the end of the first sentence the following:

‘‘, including rules and regulations defining technical, trade, and other terms used in this title, except that the Commission may not define the term ‘client’ for purposes of paragraphs (1) and (2) of section 206 to include an investor in a private fund managed by an investment adviser, if such private fund has entered into an advisory contract with such adviser’’; and

(2) by adding at the end the following:

‘‘(e) DISCLOSURE RULES ON PRIVATE FUNDS.—The Commission and the Commodity Futures Trading Commission shall, after consultation with the Council but not later than 12 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010, jointly promulgate rules to establish the form and content of the reports required to be filed with the Commission under subsection 204(b) and with the Commodity Futures Trading Commission by investment advisers that are registered both under this title and the Commodity Exchange Act (7 U.S.C. 1a et seq.).’’.

SEC. 407. EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3) is amended by adding at the end the following:

‘‘(l) EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.—No investment adviser shall be subject to the registration requirements of this title with respect to the provision of investment advice relating to a venture capital fund. Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules to define the term ‘venture capital fund’ for purposes of this subsection.’’.

SEC. 408. EXEMPTION OF AND RECORD KEEPING BY PRIVATE EQUITY FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3) is amended by adding at the end the following:

‘‘(m) EXEMPTION OF AND REPORTING BY PRIVATE EQUITY FUND ADVISERS.—

‘‘(1) IN GENERAL.—Except as provided in this subsection, no investment adviser shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund or funds.

‘‘(2) MAINTENANCE OF RECORDS AND ACCESS BY COMMISSION.—Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules—

‘‘(A) to require investment advisers described in paragraph (1) to maintain such records and provide to the Commission such annual or other reports as the Commission taking into account fund size, governance, investment strategy, risk, and other factors, as the Commission determines necessary and appropriate in the public interest and for the protection of investors; and

‘‘(B) to define the term ‘private equity fund’ for purposes of this subsection.’’.

SEC. 409. FAMILY OFFICES.

(a) IN GENERAL.—Section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–2(a)(11)) is amended by striking ‘‘or (G)’’ and inserting the following:

‘‘; (G) any family office, as defined by rule, regulation, or order of the Commission, in accordance with the purposes of this title; or (H)’’.

(b) RULEMAKING.—The rules, regulations, or orders issued by the Commission pursuant to section 202(a)(11)(G) of the Investment Advisers Act of 1940, as added by this section, regarding the definition of the term ‘‘family office’’ shall provide for an exemption that—

(1) is consistent with the previous exemptive policy of the Commission, as reflected in exemptive orders for family offices in effect on the date of enactment of this Act; and

(2) recognizes the range of organizational, management, and employment structures and arrangements employed by family offices.

SEC. 410. STATE AND FEDERAL RESPONSIBILITIES; ASSET THRESHOLD FOR FEDERAL REGISTRATION OF INVESTMENT ADVISERS.

Section 203A(a)(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3a(a)(1)) is amended —

(1) in subparagraph (A)—

(A) by striking ‘‘$25,000,000’’ and inserting ‘‘$100,000,000’’; and

(B) by striking ‘‘or’’ at the end;

(2) in subparagraph (B), by striking the period at the end and inserting ‘‘; or’’; and

(3) by adding at the end the following:

‘‘(C) is an adviser to a company that has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940, and has not withdrawn its election.’’.

SEC. 411. CUSTODY OF CLIENT ASSETS.

The Investment Advisers Act of 1940 (15 U.S.C. 80b–1 et seq.) is amended by adding at the end the following new section:

‘‘SEC. 223. CUSTODY OF CLIENT ACCOUNTS.

‘‘An investment adviser registered under this title shall take such steps to safeguard client assets over which such adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the Commission may, by rule, prescribe.’’.

SEC. 412. ADJUSTING THE ACCREDITED INVESTOR STANDARD FOR INFLATION.

The Commission shall, by rule—

(1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and

(2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.

SEC. 413. GAO STUDY AND REPORT ON ACCREDITED INVESTORS.

The Comptroller General of the United States shall conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and shall submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study not later than 1 year after the date of enactment of this Act.

SEC. 414. GAO STUDY ON SELF-REGULATORY ORGANIZATION FOR PRIVATE FUNDS.

The Comptroller General of the United States shall—

(1) conduct a study of the feasibility of forming a self-regulatory organization to oversee private funds; and

(2) submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study, not later than 1 year after the date of enactment of this Act.

SEC. 415. COMMISSION STUDY AND REPORT ON SHORT SELLING.

(a) STUDY.—The Division of Risk, Strategy, and Financial Innovation of the Commission shall conduct a study, taking into account current scholarship, on the state of short selling on national securities exchanges and in the over-the-counter markets, with particular attention to the impact of recent rule changes and the incidence of—

(1) the failure to deliver shares sold short; or

(2) delivery of shares on the fourth day following the short sale transaction.

(b) REPORT.—The Division of Risk, Strategy, and Financial Innovation shall submit a report, together with any recommendations for market improvements, including consideration of real time reporting of short sale positions, to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of the study conducted under subsection (a), not later than 2 years after the date of enactment of this Act.

SEC. 416. TRANSITION PERIOD.

Except as otherwise provided in this title, this title and the amendments made by this title shall become effecttive 1 year after the date of enactment of this Act, except 5 that any investment adviser may, at the discretion of the investment adviser, register with the Commission under the Investment Advisers Act of 1940 during that 1-year period, subject to the rules of the Commission.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is a hedge fund law firm which provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Hedge Funds, the Secondary Market and PTP Issues

Secondary Hedge Fund Market Poses Issues for Fund Managers

Recently there have been a number of groups springing up to provide a secondary hedge fund market.  While such platforms provide investors with a potential avenue to get out of their illiquid investment (the investment in the fund may be illiquid for a number of reasons including the imposition of a gate provision), they pose problems for the hedge fund manager who will have to deal with the mechanical issues involved in a transfer of the fund interests.  Additionally, as noted in the article below, the manager may have to worry about the PTP issues involved with such potential transfer.

The following article was written by Doug Cornelius of the Compliance Building blog and is reprinted with permission.  All links in the article are from the original.

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Classification of Private Funds as Publicly Traded Partnerships

Due to the increasing incidence of fund investors who want to transfer their investment fund interests, private investment funds face a risk of being classified as publicly traded partnerships. That would mean the fund would become taxable as a corporation.

A bad result.

Under Internal Revenue Code § 7704, a partnership will be classified as a publicly traded partnership if (1) the fund interests are traded on an established securities market or (2) the fund interests are readily tradable on a secondary market or its substantial equivalent.

The big problem is determining when you have a “substantial equivalent” of a secondary market. Under the regulations, the IRS uses a facts and circumstances test to determine if “partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market.” You hate to get into a facts and circumstances discussion with the IRS.

Fortunately there are some safeguards in the implementing regulations at 26 C.F.R. § 1.7704-1.

Involvement of the Partnership

For purposes of section 7704(b), interests in a partnership are not readily tradable on a secondary market or the substantial equivalent unless (1) The partnership participates in the establishment of the market or (2) The partnership recognizes any transfers made on the market by (i) redeeming the transferor partner or (ii) admitting the transferee as a partner.

Since most fund partnerships require the general partner to approve the the transferee and then admit the transferee, they are unlikely to be able to take advantage of this safe harbor.

De Minimis Trading Safeharbor

The focus of a fund should be on the 2% de minimis safe harbor. 26 C.F.R. § 1.7704-1(j) provides for interests in a partnership to be deemed not readily tradable on a secondary market or the substantial equivalent thereof if the sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership does not exceed 2 percent of the total interests in partnership capital or profits.

You want avoid having more than 2 percent of the partnership interests changing hands each tax year.

If you get close to that number there are several transfers that are disregarded transfers for this safeharbor, including:

  • block transfers by a single partner of more than 2% of the total interests
  • intrafamily transfers
  • transfers at death
  • distributions from a qualified retirement plan
  • Transfers by one or more partners of interests representing  50 percent or more of the total interests in partnership

Private Placement Safeharbor

The regulations deem a transfer to not be a trade if it was a private placement. But the regulations have their own definition of a private placement: (1) the issuance of the partnership interests had to be exempt from registration under the Securities Act of 1933,  and (2) the partnership does not have more than 100 partners at any time during the tax year of the partnership. 26 C.F.R. § 1.7704-1(h)

The first prong should be straight-forward for most private funds. The trickier part is the second prong. In some circumstances the IRS can look through the holder of a partnership interest to its beneficial owners and expand the number of partners to include the beneficial holders of that interest.

Passive Income Safeharbor

If a fund is determined to be a Publicly Traded Partnership, it will nonetheless not be taxed as a corporation if 90% or more of the fund’s gross income is passive-type income. [26 U.S.C. § 7704(c)] Passive-type income generally includes dividends, real property rents, gains from the sale of real property, income from mining and oil and gas properties, gains from the sale of capital assets held to produce income, and gains from commodities (not held primarily for sale in the ordinary course of business), futures, forwards, or options with respect to commodities. The income test is on a taxable year basis and must be have been met each prior year.

References:

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Please also see the post on hedge fund compliance and twitter which includes another reprint of a Compliance Building article.

Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

Hedge Fund Manager Registration to Cost Taxpayers $140 Million (at least)

CBO Calculates Cost of House Hedge Fund Bill

This past week the Congressional Budge Office (“CBO”) released a cost estimate of H.R. 3818, the Private Fund Investment Advisers Registration Act of 2009.  In a number of private conversations I have had about hedge fund registration over the last 9-12 months one of the issues that was continually raised was appropriate funding for the SEC.  As we have seen recently (most notably from the Inspector General’s Madoff report), the SEC’s budget is not large enough to adequately fulfill their investor protection mandate.  Adding hedge fund registration would obviously further burden the cash-strapped agency (for more see Schumer Proposal to Double SEC Budget).  According to the CBO, and based on the SEC’s estimates that it will need to add 150 employees, the estimated outlays over four years will be equal to $140 million.

However, taxpayers should understand that this assumes that registration will only be required for those managers with at least $150 million in assets under management.   At the $150 million AUM level, the CBO expects that 1,300 hedge fund managers would be required to register.  The current draft of the Senate hedge fund registration bill calls for managers with $100 million in AUM to register – lowering the AUM exemption threshold will increase the amount of managers required to register.  Additionally, there are outstanding political issues.  First, it is unclear whether the final bill will require private equity fund managers and venture capital fund managers to register – we do not necessarily understand the arguably arbitrary carve-out for these industries.  Second, it is clear that a majority of the state securities commissions are unable and unwilling to be responsible for overseeing managers with up to $100 million in assets.  Hedge fund managers who would subject to state oversight would rightly want to be subject to SEC oversight (which does not say much for many state securities commissions).  These issues will continue to be addressed during the political sausage-making process.

Of additional interest – the CBO estimates that hedge fund registration is likely to cost around $30,000 per each SEC registrant which is welcome news to investment adviser compliance consultants and hedge fund lawyers!

For full report, please see full CBO Hedge Fund Cost Estimate.

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Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and provides hedge fund manager registration service through Cole-Frieman & Mallon LLP He can be reached directly at 415-868-5345.

Insider Trading Overview

In light of the recent focus on insider trading, we are publishing the SEC’s discussion on Insider Trading which can also be found here.  The information below contains a broad overview of some of the important aspects which hedge fund managers should understand about the insider trading prohibitions.

For a greater background discussion on the legal precedents which helped shaped the state of law today, please see Insider Trading—A U.S. Perspective, a speech by staff of the SEC.

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Insider Trading

“Insider trading” is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. For more information about this type of insider trading and the reports insiders must file, please read “Forms 3, 4, 5” in our Fast Answers databank.

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.

Examples of insider trading cases that have been brought by the SEC are cases against:

  • Corporate officers, directors, and employees who traded the corporation’s securities after learning of significant, confidential corporate developments;
  • Friends, business associates, family members, and other “tippees” of such officers, directors, and employees, who traded the securities after receiving such information;
  • Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
  • Government employees who learned of such information because of their employment by the government; and
  • Other persons who misappropriated, and took advantage of, confidential information from their employers.

Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.

The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is “aware” of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.

For more information about insider trading, please read Insider Trading—A U.S. Perspective, a speech by staff of the SEC.

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Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the Series 79 exam website.  He can be reached directly at 415-868-5345.

Secondary Loan Market | LSTA Conference

Trends for Distressed Debt Hedge Fund Managers

Distressed debt hedge funds often face a number of legal issues with regard to their investments.  Post-Lehman, understanding the rights and liabilities attached to the actual contracts has become paramount for managers.  The following article, contributed by Karl Cole-Frieman of Cole-Frieman & Mallon LLP, provides some background on a recent conference which discussed the secondary loan market.

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The LSTA Annual Conference and the Secondary Loan Market

On October 29, 2009, we attended the annual conference for the Loan Syndications and Trading Association (the “LSTA”).  Conference attendance was significantly up in 2009 from 2008, reflecting an increase in trading volume in the secondary loan market, and robust market conditions for service providers as a result of the spike in settlement on distressed documentation following Lehman’s collapse in 2008.

Secondary Loan Market Panel

Of particular interest was the panel regarding “Recent Developments in the Secondary Loan Market” moderated by Elliot Gans, Executive Vice President and General Counsel of the LSTA.  Other panelists included:

  • Linda Giannattasio, Director and Counsel in Citigroup’s Office of the General Counsel.
  • Robbin Schulsohn, Karl Cole-Frieman’s former colleague at JPMorgan Chase, where she is Executive Director and Assistant General Counsel.
  • Claire Pierce, Managing Director if Chapdelaine Credit Partners.  Claire was in-house at Bank of America for many years before joining Chapdelaine.
  • Bridget Marsh, Senior Vice President & Assistant General Counsel of the LSTA.
  • Jennifer Tallmadge, Assistant General Counsel at Bank of America.

Notably, the panel lacked a Buy Side perspective, which impacted the topics of discussion.

Buy-In/Sell-Out Provisions (“BISO”)

A relatively recent change in standard documentation for Par Trades is the inclusion in the LSTA Par/Near Par Trade Confirmation of a BISO provision for confirmations beginning February 2009.  The BISO provisions addressed the problem of counterparty risk for failure to settle a trade.   Previously, if a counterparty refused to settle a trade, there was little that the performing party could do short of litigation.  The BISO provisions, which have recently been modified, establish the circumstances under which a performing party in a Par Trade may terminate its obligations under a trade confirmation and effect a cover transaction in respect of the loans.  There is a lot of discussion about adding a BISO provision to the LSTA Distressed Trading Documents.

The panel expressed some mixed views about the success of the Par BISO provisions.  In general, the BISO provisions have been considered successful in reducing settlement times in 2009.  However, the provisions have only been in effect in a rising market, and it remains to be seen what will happen next time there is a systemic downturn in the market.  It is possible that market participants could become overwhelmed sending and responding to BISO notices.

Distressed Documents for Performing Loans

The panel also discussed the phenomenon post-Lehman of trades that settled on distressed documents for performing loans.  After the Lehman bankruptcy the loan prices fell significantly even for performing loans.  Buyers reacted by insisting that trades settle on distressed documents instead of Par documents, causing significant delays in settlements.  Generally the panel, which was dominated by Sell Side representatives, felt the market behaved irrationally in requiring distressed documents for performing loans based solely on price.  One the other hand, the distinction between par and distressed has historically been determined solely by price.  It is not clear what other objective measures loan purchasers can rely on.  From a Buy Side perspective, it might be worth spending an additional $20,000 in delayed compensation to make sure their $200,000,000 is fully protected.

Settlement Times for Loan Trades

Despite the BISO provisions in the Par confirmations, there are systemic problems causing settlement delays in 2009.  Although Linda Giannattasio indicated that 90 percent of Citibank’s par trades are settling in T+7, Elliot Gans provided raw data for 3Q 2009 that shows that problems persist.  For par trades, the average trade settled in 18 days, while the median settlement time was 11 days.  For distressed trades, the average trade settled in 45 days, while the median trades settled in 36 days.  Performing loans that trades on distressed documents post-Lehman are shifting back to Par documents, contributing to the delays.

Shift Date Rule

The LSTA plans to publish new rules for determining the “shift date,” or the date in which loans shift from Par to Distressed, and therefore must settle on distressed documents.  The existing process, which has never worked well, is that the LSTA polls dealers on the shift date.  Under the forthcoming rules, the LSTA will select the shift date and it will be binding on all parties.  Upon request, the LSTA will review trade data and other supporting material to determine the date.  Where unable to make a determination, the LSTA will assemble a Determinations Committee made up of LSTA Board members.  Elliot Gans indicated that some market participants would prefer the LSTA select a random date to the current polling system.  Nevertheless, we expect these new rules to be somewhat controversial when rolled out by the LSTA.

To find out more about the secondary loan market and other topics impacting hedge fund managers, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or karl@colefrieman.com.

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Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog and the forex registration website.  He can be reached directly at 415-868-5345.

Hedge Fund Manager Charged with Insider Trading

SEC Brings Case Against Raj Rajaratnam

Below is another case of a hedge fund manager who was alledgedly engaged in insider trading. The SEC seems particularly excited about this cased because of the high profile nature of the manager who was involved. The major charge is against Raj Rajaratnam who reportedly has a net worth in excess of $1 billion and who is a member of the Forbes 400 richest persons in the world.

There will undoubtedly be continued press in this case which is not good news for the hedge fund industry. The industry has been subject to criticism and increased calls for regulation for the last year and high profile cases like this one only serve to rile up members of congress. The SEC seems to be particularly proud about this “catch” as the agency has itself been under increasing scrutiny as the details of the fumbled Madoff case have been made public.

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SEC Charges Billionaire Hedge Fund Manager Raj Rajaratnam with Insider Trading

FOR IMMEDIATE RELEASE
2009-221

High-Ranking Corporate Executives Also Charged in Scheme That Generated More Than $25 Million in Illicit Gains

Washington, D.C., Oct. 16, 2009 — The Securities and Exchange Commission today charged billionaire Raj Rajaratnam and his New York-based hedge fund advisory firm Galleon Management LP with engaging in a massive insider trading scheme that generated more than $25 million in illicit gains. The SEC also charged six others involved in the scheme, including senior executives at major companies IBM, Intel and McKinsey & Company.

The SEC’s complaint, filed in federal court in Manhattan, alleges that Rajaratnam tapped into his network of friends and close business associates to obtain insider tips and confidential information about corporate earnings or takeover activity at several companies, including Google, Hilton and Sun Microsystems. He then used the non-public information to illegally trade on behalf of Galleon.

“This complaint describes a web of fraud that has been unraveled,” said SEC Chairman Mary L. Schapiro.

“What we have uncovered in the trading activities of Raj Rajaratnam is that the secret of his success is not genius trading strategies. He is not the astute study of company fundamentals or marketplace trends that he is widely thought to be. Raj Rajaratnam is not a master of the universe, but rather a master of the rolodex,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “He cultivated a network of high-ranking corporate executives and insiders, and then tapped into this ring to obtain confidential details about quarterly earnings and takeover activity.”

In addition to Rajaratnam and Galleon, the SEC’s complaint charges:

  • Danielle Chiesi of New York, N.Y. — a portfolio manager at New Castle Funds.
  • Rajiv Goel of Los Altos, Calif. — a managing director at Intel Capital, an Intel subsidiary.
  • Anil Kumar of Saratoga, Calif. — a director at McKinsey & Company.
  • Mark Kurland of Mount Kisco, N.Y. — a Senior Managing Director and General Partner at New Castle.
  • Robert Moffat of Ridgefield, Conn. — a senior vice president at IBM.
  • New Castle Funds LLC — a New York-based hedge fund

According to the SEC’s complaint, Rajaratnam and Galleon traded on inside information about the following events or transactions:

  • An unnamed source, identified in the SEC’s complaint as Tipper A, obtained inside information about earnings announcements at Polycom and Google, as well as a takeover announcement of Hilton. Tipper A then allegedly provided this information to Rajaratnam, who used it to trade on behalf of Galleon.
  • Goel provided inside information to Rajaratnam about certain Intel quarterly earnings and a pending joint venture concerning Clearwire Corp., in which Intel had invested. Rajaratnam then used this information to trade on behalf of Galleon. As payback for Goel’s tips, Rajaratnam, or someone acting on his behalf, executed trades in Goel’s personal brokerage account based on inside information concerning Hilton and PeopleSupport, which resulted in nearly $250,000 in illicit profits for Goel.
  • Kumar obtained inside information about pending transactions involving AMD and two Abu Dhabi-based sovereign entities, which he shared with Rajaratnam. Rajaratnam then traded on the basis of this information on behalf of Galleon.
  • Chiesi obtained inside information from an executive at Akamai Technologies and traded on the information on behalf of a New Castle fund, netting a profit of approximately $2.4 million. Chiesi also passed on the inside information to Rajaratnam, who then traded on behalf of Galleon.

The SEC also alleges that Moffat provided inside information to Chiesi about Sun Microsystems. Moffat obtained the information when IBM was contemplating acquiring Sun. Chiesi then allegedly traded on the basis of this information on behalf of New Castle, making approximately $1 million in profits.

The SEC’s complaint charges each of the defendants with violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and, except for Kumar and Moffat, violations of Section 17(a) of the Securities Act of 1933 and. The complaint seeks a final judgment permanently enjoining the defendants from future violations of the above provisions of the federal securities laws, ordering them to disgorge their ill-gotten gains plus prejudgment interest, and ordering them to pay financial penalties. The complaint also seeks to permanently prohibit Goel, Kumar and Moffat from acting as an officer or director of any registered public company.

The SEC acknowledges the assistance and cooperation of the U.S. Attorney’s Office for the Southern District of New York and the Federal Bureau of Investigation.

The SEC’s investigation is continuing.

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For more information, contact:
David Rosenfeld
Associate Director, SEC’s New York Regional Office
(212) 336-0153

Sanjay Wadhwa
Assistant Director, SEC’s New York Regional Office
(212) 336-0181

http://www.sec.gov/news/press/2009/2009-221.htm

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Other related hedge fund law articles:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund or if you are a current hedge fund manager with questions about the securities laws, please contact us or call Mr. Mallon directly at 415-868-5345.

Purchasing an ERISA Fidelity Bond

Information on How to Buy ERISA Bond

Purchasing an ERISA Fidelity Bond is essentially the same as purchasing a fidelity bond for an investment advisory firm and this article is meant to serve as guide as to cost and timing to secure one of these bonds.

Overview

Generally a manager will need to make sure that the bond is for 10% of the amount of the ERISA assets (subject to a minimum bond requirement of $1,000). This means that if the ERISA assets in the fund are $1MM, the manager will need to have a bond for at least $100,000.

However, the maximum bond amount with regard to any one plan is $500,000. This means that if the manager has ERISA assets in the fund (from one plan) of $6MM, the manager will only need to have a bond in the amount of $500,000 with respect to that plan.

Generally, if the manager had two plans in his fund – one with $6MM in assets and one with $2MM in assets, the manager would need to have $700,000 worth of coverage ($500,000 and $200,000 respectively). The best way to accomplish this is to have separate bonds for the separate ERISA plans invested in the fund.

Cost of ERISA Bond

A bond consultant or insurance broker will generally be able to provide a quote for the ERISA coverage needs. The costs are fairly reasonable – generally around $200 to $400 for every $100,000 of coverage per year. For newly formed management companies, the amount of the bond may be based on the personal credit score of an officer of such management company.

Application Process and Timing

ERISA bonds are fairly easy to purchase and can be delivered quickly. The application process is generally pretty basic – applications will require basic information about the management company, the fund and/or the officer(s) of the management company. Different bond companies will require different information or have different application processes or procedures.

In my experience, managers have been able to secure a bond within about a week of submitting an application. If you are a manager that is likely to receive an allocation from an ERISA plan, the best practice is to have the bond in place prior to the time that the ERISA assets are wired to the fund account. Accordingly, the manager should take care to make sure the bonding company has all necessary information in order to place the bond by the necessary time.

Other Notes

As with other sensitive areas of hedge fund law (like taxation) managers should take extra care when dealing with ERISA investors and ERISA requirements. I always recommend discussing any ERISA issues with an ERISA specialist.

Please also see our disclaimer with regard to the information presented on this website.

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund or if you are a current hedge fund manager with questions about ERISA, please contact us or call Mr. Mallon directly at 415-868-5345.  Other related hedge fund law articles include:

ERISA Bonding Requirement for Hedge Fund Managers

ERISA Fidelity Bond Information

Hedge fund managers who manages hedge funds which exceed the 25% ERISA threshold will need to purchase a fidelity bond.  The questions and answers below on the ERISA fidelity bonding requirements were prepared by the Department of Labor which is the governmental agency which is in charge of enforcing the ERISA laws and regulations.

The memorandum below can be found here.  We also have prepared a discussion on the costs of an ERISA fidelity bond.

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Date: November 25, 2008

Memorandum For: Virginia C. Smith
Director of Enforcement
Regional Directors

From: Robert J. Doyle
Director of Regulations and Interpretations

Subject: Guidance Regarding ERISA Fidelity Bonding Requirements

Background

ERISA section 412 and related regulations (29 C.F.R. § 2550.412-1 and 29 C.F.R. Part 2580) generally require that every fiduciary of an employee benefit plan and every person who handles funds or other property of such a plan shall be bonded. ERISA’s bonding requirements are intended to protect employee benefit plans from risk of loss due to fraud or dishonesty on the part of persons who ”handle” plan funds or other property. ERISA refers to persons who handle funds or other property of an employee benefit plan as “plan officials.” A plan official must be bonded for at least 10% of the amount of funds he or she handles, subject to a minimum bond amount of $1,000 per plan with respect to which the plan official has handling functions. In most instances, the maximum bond amount that can be required under ERISA with respect to any one plan official is $500,000 per plan. Effective for plan years beginning on or after January 1, 2008, however, the maximum required bond amount is $1,000,000 for plan officials of plans that hold employer securities.(1)

Since enactment of ERISA, the Agency has provided various forms of guidance concerning the application of ERISA’s bonding requirements. Over the past several years, however, a number of questions have been raised by our Regional Offices and others concerning the bonding rules. In addition, amendments to section 412 that were enacted in the Pension Protection Act of 2006 (PPA) have presented questions concerning the application of those changes to plan fiduciaries and other persons handling plan funds or other property. This Bulletin provides guidance, in a question and answer format, for our Regional Offices concerning the application of ERISA’s bonding requirements and the PPA changes thereto. This Bulletin is not intended to address any civil or criminal liability that may result from losses to a plan caused by acts of fraud or dishonesty or violations of ERISA’s fiduciary provisions.

Questions And Answers

ERISA Fidelity Bonds

Q-1: What losses must an ERISA bond cover?

An ERISA section 412 bond (sometimes referred to as an ERISA fidelity bond) must protect the plan against loss by reason of acts of fraud or dishonesty on the part of persons required to be bonded, whether the person acts directly or through connivance with others. ERISA § 412; 29 C.F.R. § 2580.412-1. The term “fraud or dishonesty” for this purpose encompasses risks of loss that might arise through dishonest or fraudulent acts in handling plan funds or other property. This includes, but is not limited to, larceny, theft, embezzlement, forgery, misappropriation, wrongful abstraction, wrongful conversion, willful misapplication, and other acts where losses result through any act or arrangement prohibited by 18 U.S.C. § 1954. The bond must provide recovery for loss occasioned by such acts even though no personal gain accrues to the person committing the act and the act is not subject to punishment as a crime or misdemeanor, provided that within the law of the state in which the act is committed, a court would afford recovery under a bond providing protection against fraud or dishonesty. 29 C.F.R. § 2580.412-9. Deductibles or other similar features that transfer risk to the plan are prohibited. 29 C.F.R. § 2580.412-11. [See also Bond Terms and Provisions, Q-26 through Q-30.]

Q-2: Is an ERISA fidelity bond the same thing as fiduciary liability insurance?

No. The fidelity bond required under section 412 of ERISA specifically insures a plan against losses due to fraud or dishonesty (e.g., theft) on the part of persons (including, but not limited to, plan fiduciaries) who handle plan funds or other property. Fiduciary liability insurance, on the other hand, generally insures the plan against losses caused by breaches of fiduciary responsibilities.

Fiduciary liability insurance is neither required by nor subject to section 412 of ERISA. Whether a plan purchases fiduciary liability insurance is subject, generally, to ERISA’s fiduciary standards, including section 410 of ERISA. ERISA section 410 allows, but does not require, a plan to purchase insurance for its fiduciaries or for itself covering losses occurring from acts or omissions of a fiduciary. Any such policy paid for by the plan must, however, permit recourse by the insurer against the fiduciary in the case of a fiduciary breach. In some cases, the fiduciary may purchase, at his or her expense, protection against the insurer’s recourse rights.

Q-3: Who are the parties to an ERISA fidelity bond?

In a typical bond, the plan is the named insured and a surety company is the party that provides the bond. The persons “covered” by the bond are the persons who “handle” funds or other property of the plan (i.e., plan officials). As the insured party, the plan can make a claim on the bond if a plan official causes a loss to the plan due to fraud or dishonesty. [See also Bond Terms and Provisions, Q-31 and Q-32.]

Q-4: Can I get an ERISA bond from any bonding or insurance company?

No. Bonds must be placed with a surety or reinsurer that is named on the Department of the Treasury’s Listing of Approved Sureties, Department Circular 570 (available at fms.treas.gov/c570/c570.html). 29 C.F.R. § 2580.412-21, § 2580.412-23, § 2580.412-24. Under certain conditions, bonds may also be placed with the Underwriters at Lloyds of London. 29 C.F.R. § 2580.412-25, § 2580.412.26. In addition, neither the plan nor a party-in-interest with respect to the plan may have any control or significant financial interest, whether direct or indirect, in the surety, or reinsurer, or in an agent or broker through which the bond is obtained. ERISA § 412(c); 29 C.F.R. § 2580.412-22 and §§ 2580.412-33 to 2580.412.36. If a surety becomes insolvent, is placed in receivership, or has its authority to act as an acceptable surety revoked, the administrator of any plan insured by the surety is responsible, upon learning of such facts, for securing a new bond with an acceptable surety. 29 C.F.R. § 2580.412-21(b).

Q-5: Who must be bonded?

Every person who “handles funds or other property” of an employee benefit plan within the meaning of 29 C.F.R. § 2580.412-6 (i.e., a plan official) is required to be bonded unless covered under one of the exemptions in section 412 for certain banks, insurance companies, and registered brokers and dealers, or by one of the regulatory exemptions granted by the Department in its regulations. [See Exemptions From The Bonding Requirements, Q-12 through Q-15, Funds Or Other Property, Q-17, and Handling Funds Or Other Property, Q-18 through Q-21.] Plan officials will usually include the plan administrator and those officers and employees of the plan or plan sponsor who handle plan funds by virtue of their duties relating to the receipt, safekeeping and disbursement of funds. Plan officials may also include other persons, such as service providers, whose duties and functions involve access to plan funds or decision-making authority that can give rise to a risk of loss through fraud or dishonesty. Where a plan administrator, service provider, or other plan official is an entity, such as a corporation or association, ERISA’s bonding requirements apply to the natural persons who perform “handling” functions on behalf of the entity. See 29 C.F.R. § 2550.412-1(c), § 2580.412-3 and § 2580.412-6.

Q-6: Who is responsible for making sure that plan officials are properly bonded?

The responsibility for ensuring that plan officials are bonded may fall upon a number of individuals simultaneously. In addition to a plan official being directly responsible for complying with the bonding requirements in section 412(a) of ERISA, section 412(b) specifically states that it is unlawful for any plan official to permit any other plan official to receive, handle, disburse, or otherwise exercise custody or control over plan funds or other property without first being properly bonded in accordance with section 412. In addition, section 412(b) makes it unlawful for “any other person having authority to direct the performance of such functions” to permit a plan official to perform such functions without being bonded. Thus, by way of example, if a named fiduciary hires a trustee for a plan, the named fiduciary must ensure that the trustee is either subject to an exemption or properly bonded in accordance with section 412, even if the named fiduciary is not himself or herself required to be bonded because he or she does not handle plan funds or other property.

Q-7: Must all fiduciaries be bonded?

No. Fiduciaries must be bonded only if they “handle” funds or other property of an employee benefit plan and do not fall within one of the exemptions in section 412 or the regulations. [See also Exemptions From The Bonding Requirements, Q-12 through Q-15, and Handling Funds Or Other Property, Q-18 through Q-21.]

Q-8: Must service providers to the plan be bonded?

As noted above, only those persons who “handle” funds or other property of an employee benefit plan are required to be bonded under section 412. Therefore, a service provider, such as a third-party administrator or investment advisor, will be subject to bonding under section 412 only if that service provider “handles” funds or other property of an employee benefit plan. See 29 C.F.R. § 2580.412-3(d), § 2580.412-4, § 2580.412-5 and § 2580.412-6. [See also Funds Or Other Property, Q-17, and Handling Funds Or Other Property, Q-18.]

Q-9: Must a person who renders investment advice to a plan be bonded solely by reason of rendering such investment advice?

No. A person who provides investment advice, but who does not exercise or have the right to exercise discretionary authority with respect to purchasing or selling securities or other property for the plan, is not required to be bonded solely by reason of providing such investment advice. If, however, in addition to rendering such investment advice, such person performs any additional functions that constitute “handling” plan funds or other property within the meaning of 29 C.F.R. § 2580.412-6, then that person must be bonded in accordance with section 412. [See also Handling Funds Or Other Property, Q-18 through Q-21.]

Q-10: If a service provider is required to be bonded, must the plan purchase the bond?

No. A service provider can purchase its own separate bond insuring the plan, and nothing in ERISA specifically requires the plan to pay for that bond. If, on the other hand, a plan chooses to add a service provider to the plan’s existing bond, that decision is within the discretion of the plan fiduciaries. Regardless of who pays for the bond, section 412 provides that if a service provider to the plan is required to be bonded, the plan fiduciaries who are responsible for retaining and monitoring the service provider, and any plan officials who have authority to permit the service provider to perform handling functions, are responsible for ensuring that such service provider is properly bonded before he or she handles plan funds. ERISA § 412(b). [See also Q-6, above, and Form And Scope Of Bond, Q-22 and Q-25.]

Q-11: If the plan purchases a bond to meet section 412’s requirements, may the plan pay for the bond out of plan assets?

Yes. Because the purpose of ERISA’s bonding requirements is to protect employee benefit plans, and because such bonds do not benefit plan officials or relieve them from their obligations to the plan, a plan’s purchase of a proper section 412 bond will not contravene ERISA’s fiduciary provisions in sections 406(a) and 406(b). See 29 C.F.R. § 2509.75-5, FR-9.

Exemptions From The Bonding Requirements

Q-12: Do ERISA’s bonding requirements apply to all employee benefit plans?

No. The bonding requirements under ERISA section 412 do not apply to employee benefit plans that are completely unfunded or that are not subject to Title I of ERISA. ERISA § 412(a)(1); 29 C.F.R. § 2580.412-1, § 2580.412-2.

Q-13: What plans are considered “unfunded” so as to be exempt from ERISA’s bonding requirements?

An unfunded plan is one that pays benefits only from the general assets of a union or employer. The assets used to pay the benefits must remain in, and not be segregated in any way from, the employer’s or union’s general assets until the benefits are distributed. Thus, a plan will not be exempt from ERISA’s bonding requirements as “unfunded” if:

  1. any benefits under the plan are provided or underwritten by an insurance carrier or service or other organization;
  2. there is a trust or other separate entity to which contributions are made or out of which benefits are paid;
  3. contributions to the plan are made by the employees, either through withholding or otherwise, or from any source other than the employer or union involved; or
  4. there is a separately maintained bank account or separately maintained books and records for the plan or other evidence of the existence of a segregated or separately maintained or administered fund out of which plan benefits are to be provided.

As a general rule, however, the presence of special ledger accounts or accounting entries for plan funds as an integral part of the general books and records of an employer or union will not, in and of itself, be deemed sufficient evidence of segregation of plan funds to take a plan out of the exempt category, but shall be considered along with the other factors and criteria discussed above in determining whether the exemption applies. 29 C.F.R. § 2580.412-1, § 2580.412-2.

As noted above, an employee benefit plan that receives employee contributions is generally not considered to be unfunded. Nevertheless, the Department treats an employee welfare benefit plan that is associated with a fringe benefit plan under Internal Revenue Code section 125 as unfunded, for annual reporting purposes, if it meets the requirements of DOL Technical Release 92-01,(2) even though it includes employee contributions. As an enforcement policy, the Department will treat plans that meet such requirements as unfunded for bonding purposes as well.

Q-14: Are fully-insured plans “unfunded” for purposes of ERISA’s bonding requirements?

No. As noted above, a plan is considered “unfunded” for bonding purposes only if all benefits are paid directly out of an employer’s or union’s general assets. 29 C.F.R. § 2580.412-2. Thus, insured plan arrangements are not considered “unfunded” and are not exempt from the bonding requirements in section 412 of ERISA. The insurance company that insures benefits provided under the plan may, however, fall within a separate exemption from ERISA’s bonding requirements. See ERISA § 412; 29 C.F.R. § 2580.412-31, § 2580.412-32. In addition, if no one “handles” funds or other property of the insured plan, no bond will be required under section 412. For example, as described in 29 C.F.R. § 2580.412-6(b)(7), in many cases contributions made by employers or employee organizations or by withholding from employees’ salaries are not segregated from the general assets of the employer or employee organization until paid out to purchase benefits from an insurance carrier, insurance service or other similar organization. No bonding is required with respect to the payment of premiums, or other payments made to purchase such benefits, directly from general assets, nor with respect to the bare existence of the contract obligation to pay benefits. Such insured arrangements would not normally be subject to bonding except to the extent that monies returned by way of benefit payments, cash surrender, dividends, credits or otherwise, and which by the terms of the plan belong to the plan (rather than to the employer, employee organization, or insurance carrier), were subject to “handling” by a plan official. [See also 29 C.F.R. § 2580.412-5(b)(2); Q-15, below; and Handling Funds Or Other Property, Q-18.]

Q-15: Are there any other exemptions from ERISA’s bonding provisions for persons who handle funds or other property of employee benefit plans?

Yes. Both section 412 and the regulations found in 29 C.F.R. Part 2580 contain exemptions from ERISA’s bonding requirements. Section 412 specifically excludes any fiduciary (or any director, officer, or employee of such fiduciary) that is a bank or insurance company and which, among other criteria, is organized and doing business under state or federal law, is subject to state or federal supervision or examination, and meets certain capitalization requirements. ERISA § 412(a)(3). Section 412 also excludes from its requirements any entity which is registered as a broker or a dealer under section 15(b) of the Securities Exchange Act of 1934 (SEA), 15 U.S.C. 78o(b), if the broker or dealer is subject to the fidelity bond requirements of a “self regulatory organization” within the meaning of SEA section 3(a)(26), 15 U.S.C. 78c(a)(26). ERISA § 412(a)(2). As with section 412’s other statutory and regulatory exemptions, this exemption for brokers and dealers applies to both the broker-dealer entity and its officers, directors and employees.

In addition to the exemptions outlined in section 412, the Secretary has issued regulatory exemptions from the bonding requirements. These include an exemption for banking institutions and trust companies that are subject to regulation and examination by the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, or the Federal Deposit Insurance Corporation. 29 C.F.R. § 2580.412-27, § 2580.412-28. Unlike the exemption in section 412 for banks and trust companies, this regulatory exemption applies to banking institutions even if they are not fiduciaries to the plan, but it does not apply if the bank or trust company is subject only to state regulation.

The Department’s regulations also exempt any insurance carrier (or service or similar organization) that provides or underwrites welfare or pension benefits in accordance with state law. This exemption applies only with respect to employee benefit plans that are maintained for the benefit of persons other than the insurance carrier or organization’s own employees. 29 C.F.R. § 2580.412-31, § 2580.412-32. Unlike the exemption in section 412 for insurance companies, this regulatory exemption applies to insurance carriers even if they are not plan fiduciaries, but it does not apply to plans that are for the benefit of the insurance company’s own employees.

In addition to the exemptions described above, the Secretary has issued specific regulatory exemptions for certain savings and loan associations when they are the administrators of plans for the benefit of their own employees. 29 C.F.R. § 2580.412-29, § 2580.412-30.

Q-16: Are SEPs and SIMPLE IRAs subject to ERISA’s bonding requirements?

There is no specific exemption in section 412 for SEP (IRC § 408(k)) or SIMPLE IRA (IRC § 408(p)) retirement plans. Such plans are generally structured in such a way, however, that if any person does “handle” funds or other property of such plans that person will fall under one of ERISA’s financial institution exemptions. ERISA § 412; 29 C.F.R. § 2580.412-27, § 2580.412-28.

Funds Or Other Property

Q-17: What constitutes “funds or other property” of the plan?

The term “funds or other property” generally refers to all funds or property that the plan uses or may use as a source for the payment of benefits to plan participants or beneficiaries. 29 C.F.R. § 2580.412-4. Thus, plan “funds or other property” include contributions from any source, including employers, employees, and employee organizations, that are received by the plan, or segregated from an employer or employee organization’s general assets, or otherwise paid out or used for plan purposes. 29 C.F.R. § 2580.412-5(b)(2). Plan “funds or other property” also include all items in the nature of quick assets, such as cash, checks and other negotiable instruments, government obligations, marketable securities, and all other property or items that are convertible into cash or have a cash value that are held or acquired for the ultimate purpose of distribution to plan participants or beneficiaries.

Plan “funds or other property” include all plan investments, even those that are not in the nature of quick assets, such as land and buildings, mortgages, and securities in closely-held corporations, although permanent assets that are used in operating the plan, such as land and buildings, furniture and fixtures, or office and delivery equipment used in the operation of the plan, are generally not considered to be “funds or other property” of the plan for bonding purposes. 29 C.F.R. § 2580.412-4. It is important to note, however, that ERISA’s bonding requirements apply only to persons who “handle” plan “funds or other property.” Whether a person is “handling” any given plan “funds or other property” so as to require bonding will depend on whether that person’s relationship to the property is such that there is a risk that the person, acting alone or in connivance with others, could cause a loss of such funds or other property though fraud or dishonesty. [See Handling Funds Or Other Property, Q-18.]

Handling Funds Or Other Property

Q-18: What does it mean to “handle” funds or other property of an employee benefit plan so as to require bonding under section 412?

The term “handling” carries a broader meaning than actual physical contact with “funds or other property” of the plan. A person is deemed to be “handling” funds or other property of a plan so as to require bonding whenever his duties or activities with respect to given funds or other property are such that there is a risk that such funds or other property could be lost in the event of fraud or dishonesty on the part of such person, whether acting alone or in collusion with others. Subject to this basic standard, the general criteria for determining “handling” include, but are not limited to:

  1. physical contact (or power to exercise physical contact or control) with cash, checks or similar property;
  2. power to transfer funds or other property from the plan to oneself or to a third party, or to negotiate such property for value (e.g., mortgages, title to land and buildings, or securities);
  3. disbursement authority or authority to direct disbursement;
  4. authority to sign checks or other negotiable instruments; or
  5. supervisory or decision-making responsibility over activities that require bonding.

29 C.F.R. 2580.412-6(b). [See also Funds Or Other Property, Q-17.]

“Handling” does not occur, on the other hand, and bonding is not required, under circumstances where the risk of loss to the plan through fraud or dishonesty is negligible. This may be the case where the risk of mishandling is precluded by the nature of the “funds or other property” at issue (e.g., checks, securities, or title papers that cannot be negotiated by the persons performing duties with respect to them), or where physical contact is merely clerical in nature and subject to close supervision and control. 29 C.F.R. § 2580.412-6(a)(2), § 2580.412-6(b)(1). In the case of persons with supervisory or decision-making responsibility, the mere fact of general supervision would not, necessarily, in and of itself, mean that such persons are “handling” funds so as to require bonding. Factors to be accorded weight are the system of fiscal controls, the closeness and continuity of supervision, and who is in fact charged with or actually exercising final responsibility for determining whether specific disbursements, investments, contracts, or benefit claims are bona fide and made in accordance with the applicable trust or other plan documents. 29 C.F.R. § 2580.412-6(b)(6). Again, the general standard for determining whether a person is “handling” plan funds or other property is whether the person’s relationship with respect those funds is such that he or she can cause a loss to the plan through fraud or dishonesty.

Q-19: If the plan provides that a plan committee has the authority to direct a corporate trustee, who has custody of plan funds, to pay benefits to plan participants, are the committee members “handling” plan funds or property?

Yes, if the committee’s decision to pay benefits is final and not subject to approval by someone else, the committee members are “handling” plan funds within the meaning of 29 C.F.R. § 2580.412-6, and each committee member must be bonded.

Q-20: If the committee makes investment decisions for the plan, are the committee members “handling” plan funds or other property?

Yes, if the committee’s investment decisions are final and not subject to approval by someone else, the committee members are “handling” within the meaning of 29 C.F.R. § 2580.412-6, and each committee member must be bonded.

Q-21: Are the committee members considered to be “handling” funds if the committee only recommends investments?

No, not if someone else is responsible for final approval of the committee’s recommendations. 29 C.F.R. § 2580.412-6.

Form And Scope Of Bond

Q-22: Do the regulations require that a bond take a particular form?

The Department’s regulations allow substantial flexibility regarding bond forms, as long as the bond terms meet the substantive requirements of section 412 and the regulations for the persons and plans involved. Examples of bond forms include: individual; name schedule (covering a number of named individuals); position schedule (covering each of the occupants of positions listed in the schedule); and blanket (covering the insured’s officers and employees without a specific list or schedule of those being covered). A combination of such forms may also be used. 29 C.F.R. § 2580.412-10.

A plan may be insured on its own bond or it can be added as a named insured to an existing employer bond or insurance policy (such as a “commercial crime policy”), so long as the existing bond is adequate to meet the requirements of section 412 and the regulations, or is made adequate through rider, modification or separate agreement between the parties. For example, if an employee benefit plan is insured on an employer’s crime bond, that bond might require an “ERISA rider” to ensure that the plan’s bonding coverage complies with section 412 and the Department’s regulations. Service providers may also obtain their own bonds, on which they name their plan clients as insureds, or they may be added to a plan’s bond by way of an “Agents Rider.” Choosing an appropriate bonding arrangement that meets the requirements of ERISA and the regulations is a fiduciary responsibility. See 29 C.F.R. § 2580.412-10 and § 2580.412-20. [See also ERISA Fidelity Bonds, Q-3, Q-4, Q-10, and Bond Terms and Provisions, Q-26 through Q-34.]

Q-23: Can a bond insure more than one plan?

Yes. ERISA does not prohibit more than one plan from being named as an insured under the same bond. Any such bond must, however, allow for a recovery by each plan in an amount at least equal to that which would have been required for each plan under separate bonds. Thus, if a person covered under a bond has handling functions in more than one plan insured under that bond, the amount of the bond must be sufficient to cover such person for at least ten percent of the total amount that person handles in all the plans insured under the bond, up to the maximum required amount for each plan. 29 C.F.R. § 2580.412-16(c), § 2580.412-20. [See also Amount Of Bond, Q-35 through Q-42.]

Example: X is the administrator of two welfare plans run by the same employer and he “handled” $100,000 in the preceding reporting year for Plan A and $500,000 for Plan B. If both plans are insured under the same bond, the amount of the bond with respect to X must be at least $60,000, or ten percent of the total funds handled by X for both plans insured under the bond ($10,000 for Plan A plus $50,000 for Plan B).

Example: Y is covered under a bond that insures two separate plans, Plan A and Plan B. Both plans hold employer securities. Y handles $12,000,000 in funds for Plan A and $400,000 for Plan B. Accordingly, Plan A must be able to recover under the bond up to a maximum of $1,000,000 for losses caused by Y, and Plan B must be able to recover under the bond up to a maximum of $40,000 for losses caused by Y.

Q-24: If the bond insures more than one plan, can a claim by one plan reduce the amount of coverage available to other plans insured on the bond?

No. As noted above, when a bond insures more than one plan, the bond’s limit of liability must be sufficient to insure each plan as though such plan were bonded separately. 29 C.F.R. § 2580.412-16(c). Further, in order to meet the requirement that each plan insured on a multi-plan bond be protected, the bonding arrangement must ensure that payment of a loss sustained by one plan will not reduce the amount of required coverage available to other plans insured under the bond. This can be achieved either by the terms of the bond or rider to the bond, or by separate agreement among the parties concerned that payment of a loss sustained by one of the insureds shall not work to the detriment of any other plan insured under the bond with respect to the amount for which that plan is required to be insured. 29 C.F.R. § 2580.412-16(d), § 2580.412-18.

Q-25: Can a plan or service provider obtain bonds from more than one bonding company covering the same plan or plans?

Yes. Nothing in ERISA prohibits a plan from using more than one surety to obtain the necessary bonding, so long as the surety is an approved surety. 29 C.F.R. § 2580.412-21. Persons required to be bonded may be bonded separately or under the same bond, and any given plans may be insured separately or under the same bond. A bond may be underwritten by a single surety company or more than one surety company, either separately or on a co-surety basis. 29 C.F.R. § 2580.412-20. [See also ERISA Fidelity Bonds, Q-4.]

Bond Terms And Provisions

Q-26: Can a bond provide that the one-year “discovery period” required under section 412 will terminate upon the effective date of a replacement bond?

Yes, but only if the replacement bond provides the statutorily-required coverage that would otherwise have been provided under the prior bond’s one-year discovery period. If the replacement bond does not provide such coverage, the bonding arrangement does not meet the requirements of section 412.

ERISA requires that a plan have a one year period after termination of a bond to discover losses that occurred during the term of the bond. 29 C.F.R. § 2580.412-19(b). Some bonds, such as those written on a “loss sustained” basis, may contain a clause providing for such discovery period. Other bonds, such as those written on a “discovery basis,” may not contain such a clause, but may give the plan the right to purchase a one-year discovery period following termination or cancellation of the bond. In some instances, a prior bond and a replacement bond may work in conjunction to give the plan the required one-year discovery period. The surety industry has drafted standard bond forms that are intended to work together to provide the required coverage. Thus, both the terminating bond and the replacement bond should be examined to assure that the plan is properly insured against losses that were incurred during the term of the terminating bond, but not discovered until after it terminated.

Q-27: Can a bond exclude coverage for situations where an employer or plan sponsor “knew or should have known” that a theft was likely?

No. This exclusion is unacceptable in an ERISA fidelity bond because the plan is the insured party, not the employer or plan sponsor.

Q-28: My plan cannot obtain a bond covering a certain plan official who allegedly committed an act of fraud or dishonesty in the past. What should the plan do?

Many bonds contain provisions that exclude from coverage any persons known to have engaged in fraudulent or dishonest acts. A bond may also contain a provision that cancels coverage for any person who a plan official knows has engaged in any acts of dishonesty. In such cases, the plan must exclude any such person from handling plan funds or other property if he cannot obtain bonding coverage.

Q-29: If an employee benefit plan is added as a named insured to a company’s existing crime bond, which covers employees but specifically excludes the company owner, does the plan’s coverage under the crime bond satisfy the requirements of section 412?

If the crime bond excludes the company owner, and the owner handles plan funds, then the company bond does not fully protect the plan as required by ERISA section 412 and the Department’s regulations. The company owner would then need to be covered under a separate bond or, alternatively, if the crime bond has an ERISA rider, that rider must ensure that the company owner is not excluded from coverage with respect to the plan.

Q-30: Can the bond have a deductible?

No. Section 412 requires that the bond insure the plan from the first dollar of loss up to the maximum amount for which the person causing the loss is required to be bonded. Therefore, bonds cannot have deductibles or similar features whereby a portion of the risk required to be covered by the bond is assumed by the plan or transferred to a party that is not an acceptable surety on ERISA bonds. 29 C.F.R. § 2580.412-11. However, nothing in ERISA prohibits application of a deductible to coverage in excess of the maximum amount required under ERISA.

Q-31: Must the plan be named as an insured on the bond for the bond to satisfy ERISA’s requirements?

Yes. The plan whose funds are being handled must be specifically named or otherwise identified on the bond in such a way as to enable the plan’s representatives to make a claim under the bond in the event of a loss due to fraud or dishonesty. 29 C.F.R. § 2580.412-18.

Q-32: Can bonds use an “omnibus clause” to name plans as insureds?

Yes. An “omnibus clause” is sometimes used as an alternative way to identify multiple plans as insureds on one bond, rather than specifically naming on the bond each individual plan in a group of plans. By way of example, an omnibus clause might name as insured “all employee benefit plans sponsored by ABC company.” ERISA does not prohibit using an omnibus clause to name plans insured on a bond, as long as the omnibus clause clearly identifies the insured plans in a way that would enable the insured plans’ representatives to make a claim under the bond.

If an omnibus clause is used to name plans insured on a bond, the person responsible for obtaining the bond must ensure that the bond terms and limits of liability are sufficient to provide the appropriate amount of required coverage for each insured plan. [See Amount Of Bond Q-35 through Q-42.]

Q-33: May a bond be written for a period longer than one year?

Yes. Bonds may be for periods longer than one year, so long as the bond insures the plan for the statutorily-required amount. At the beginning of each plan year, the plan administrator or other appropriate fiduciary must assure that the bond continues to insure the plan for at least the required amount, that the surety continues to satisfy the requirements for being an approved surety, and that all plan officials are bonded. If necessary, the fiduciary may need to obtain appropriate adjustments or additional protection to assure that the bond will be in compliance for the new plan year. 29 C.F.R. § 2580.412-11, § 2580.412-19, § 2580.412-21.

Q-34: If a bond is issued for more than one year, is it acceptable to use an ERISA “inflation guard” provision with regard to the amount of the bond?

Yes. Nothing in section 412 or the regulations prohibits using an “inflation guard” provision in a bond to automatically increase the amount of coverage under a bond to equal the amount required under ERISA at the time a plan discovers a loss.

Amount Of Bond

Q-35: How much coverage must the bond provide?

Generally, each plan official must be bonded in an amount equal to at least 10% of the amount of funds he or she handled in the preceding year. The bond amount cannot, however, be less than $1,000, and the Department cannot require a plan official to be bonded for more than $500,000 ($1,000,000 for plans that hold employer securities) unless the Secretary of Labor (after a hearing) requires a larger bond. These amounts apply for each plan named on a bond in which a plan official has handling functions. ERISA § 412; 29 C.F.R. §§ 2580.412-11 through 2580.412-13, § 2580.412-16, § 2580.412-17. [See also Funds Or Other Property, Q-17 and Handling Funds Or Other Property, Q-18 through Q-21.]

Q-36: Can a bond be for an amount greater than $500,000, or $1,000,000 for plans that hold employer securities?

Yes. The Department’s regulations provide that bonds covering more than one plan may be required to be over $500,000 in order to meet the requirements of section 412 because persons covered by such a bond may have handling functions in more than one plan. The $500,000/$1,000,000 limitations for such persons apply only with respect to each separate plan in which those persons have such functions. 29 C.F.R. § 2580.412-16(e). The regulations also provide that the Secretary may prescribe a higher maximum amount for a bond, not exceeding 10 per cent of funds handled, but only after due notice and an opportunity for a hearing to all interested parties. 29 C.F.R. § 2580.412-11, § 2580.412-17. Further, although ERISA cannot require a plan to obtain a bond in excess of the statutory maximums (absent action by the Secretary, as noted above), nothing in section 412 precludes the plan from purchasing a bond for a higher amount. Whether a plan should purchase a bond in an amount greater than that required by section 412 is a fiduciary decision subject to ERISA’s prudence standards. 29 C.F.R. § 2580.412-20.

In addition to the general rule described above, if a plan’s fidelity bond is intended to meet both the bonding requirements under section 412 and the enhanced bond requirement under the Department’s small plan audit waiver regulation, 29 C.F.R. § 2520.104-46, that bond must meet the additional requirements under the audit waiver regulation. Pursuant to the audit waiver regulation, in order for a small plan to be exempt from ERISA’s requirement that plans be audited each year by an independent qualified public accountant, any person who handles “non-qualifying plan assets” within the meaning of 29 C.F.R. § 2520.104-46 must be bonded in an amount at least equal to 100% of the value of those non-qualifying assets if such assets constitute more than 5% of total plan assets. For more information on the audit waiver requirements under 29 C.F.R. § 2520.104-46, go to “Frequently Asked Questions On The Small Pension Plan Audit Waiver Regulation” at www.dol.gov/ebsa/faqs/faq_auditwaiver.html.

Q-37: If a person handles only $5,000 in one plan, so that 10% of the funds he handles is only $500, can the bond be in the amount of $500?

No. The minimum amount of a bond is $1,000, even if 10% of the amount of funds handled is less than $1,000. ERISA § 412; 29 C.F.R. 2580.412-11.

Q-38: Is every plan whose investments include employer securities subject to the increased maximum bond amount of $1,000,000?

No. Section 412(a), as amended by section 622 of the Pension Protection Act of 2006, provides that “[i]n the case of a plan that holds employer securities (within the meaning of section 407(d)(1)), this subsection shall be applied by substituting ‘$1,000,000’ for ‘$500,000’ each place it appears.” The Staff Report of the Joint Committee on Taxation contains a technical explanation of this provision, which states that “[a] plan would not be considered to hold employer securities within the meaning of this section where the only securities held by the plan are part of a broadly diversified fund of assets, such as mutual or index funds.”(3) Accordingly, it is the Department’s view that a plan is not considered to be holding employer securities, for purposes of the increased bonding requirement, merely because the plan invests in a broadly-diversified common or pooled investment vehicle that holds employer securities, but which is independent of the employer and any of its affiliates.

Q-39: Must a bond state a specific dollar amount of coverage?

No. There is no requirement in the regulations that a bond state a specific dollar amount of coverage, so long as the bond provides the required statutory amount per plan of at least 10% of funds handled, with minimum coverage of $1,000, for each plan official covered under the bond. For example, assume that X is the administrator of a welfare benefit plan for which he handled $600,000 in the preceding year. The bond may state that X is covered under the bond for the greater of $1,000 or 10% of funds handled, up to $500,000.

Q-40: My company’s plan has funds totaling $1,000,000, and nine employees of the plan sponsor each handle all of those funds. If all nine employees are covered under the same bond, for what amount must the bond be written?

ERISA requires that each of the nine plan officials handling the $1,000,000 be bonded for at least 10% of the amount of funds he or she handles, or $100,000, to protect the plan from losses caused by those plan officials, whether acting alone or in collusion with others. As noted in Q-39, bond amounts may be fixed either by referencing the statutory language of 10% of funds handled up to the required maximums, or by stating a specific dollar limit of coverage.

The bonding regulations allow flexibility in the form of bonds that can be used to insure the plan. Bond forms, such as individual, name schedule, position schedule, and blanket bonds, vary as to how persons covered under the bond are identified, how the bond amount is stated, and in the amount of recovery a plan can obtain for any single act of theft. 29 C.F.R. § 2580.412-10. For example, name schedule bonds and position schedule bonds generally cover named individuals, or occupants of positions listed in the schedule, in amounts that are set opposite such names or positions. Blanket bonds, on the other hand, generally cover all of an insured’s officers and employees in a blanket penalty. The following examples illustrate how the differences between a blanket bond and a schedule bond might affect a plan’s recovery:

If a plan sponsor purchases a blanket bond on which the plan is a named insured, covering all of the plan sponsor’s officers and employees who handle the $1,000,000, the stated bond amount must be at least $100,000. That amount applies to each plan official covered under the bond. The bond terms, however, would generally specify that the $100,000 limit is an “aggregate penalty” which applies “per occurrence.” This means that if two of the bonded plan officials act together to steal $300,000 from the plan, that loss would generally be considered one “occurrence” for which the plan could recover only $100,000 under the bond. See 29 C.F.R. § 2580.412-10(d)(1).

A schedule bond, on the other hand, gives separate coverage for each plan official covered under the bond, whether that person is named individually or covered under a named position. Thus, if the plan is insured on a schedule bond, and each named individual or position listed on the schedule is covered in the amount is $100,000, the net effect would be the same as though a separate bond were issued in the amount of $100,000 for each plan official covered under the bond. Unlike the blanket bond described above, these types of bonds generally do not limit recovery to an aggregate amount “per occurrence.” Accordingly, where, as in the above example, two plan officials act together to steal $300,000, the plan should be able to recover $200,000 under the schedule bond (i.e., $100,000 for each of the two named individuals who caused the loss to the plan). See 29 C.F.R. § 2580.412-10(b) and (c).

Schedule bonds generally cost more than aggregate penalty blanket bonds with the same stated limits of liability ($100,000 in the above examples) because of the potential for a higher recovery under the schedule bond. Both aggregate penalty blanket bonds and schedule bonds are permissible forms of bonds if they otherwise meet the requirements of section 412 and the Department’s regulations. It is ultimately the responsibility of the plan fiduciary or plan official who is procuring the bond to ensure that the type and amount of the bond, together with its terms, limits, and exclusions, are both appropriate for the plan and provide the amount of coverage required under section 412.

Q-41: What happens if the amount of funds handled increases during the plan year after the bond is purchased—must the bond be updated during the plan year to reflect the increase?

No. The regulations require that, with respect to each covered person, the bond amount be fixed annually. The bond must be fixed or estimated at the beginning of the plan’s reporting year; that is, as soon after the date when such year begins as the necessary information from the preceding reporting year can practicably be ascertained. The amount of the bond must be based on the highest amount of funds handled by the person in the preceding plan year. ERISA § 412; 29 C.F.R. § 2580.412-11, § 2580.412-14, § 2580.412-19.

Q-42: How can the plan set the bond amount if there is no preceding plan year from which to measure the amount of funds each person handled?

If the plan does not have a complete preceding reporting year from which to determine the amounts handled, the amount handled by persons required to be covered by a bond must be estimated using the procedures described in the Department’s regulation at 29 C.F.R. § 2580.412-15.

Questions concerning this guidance can be directed to the Division of Coverage, Reporting and Disclosure, Office of Regulations and Interpretations, at 202.693.8523.

Footnotes

  1. Pension Protection Act of 2006, Pub. L. No. 109-280, 120 Stat. 780 (2006).
  2. 57 Fed. Reg. 23272 (June 2, 1992) and 58 Fed. Reg. 45359 (August 27, 1993).
  3. Joint Committee on Taxation, Technical Explanation of H.R. 4, the “Pension Protection Act of 2006,” as Passed by the House on July 28, 2006, and as Considered by the Senate on August 3, 2006 (JCX-38-06), Aug. 3, 2006.

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund or if you are a current hedge fund manager with questions about ERISA, please contact us or call Mr. Mallon directly at 415-868-5345.  Other related hedge fund law articles include: