Tag Archives: ERISA

Cole Frieman & Mallon 2017 End of Year Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.


December 15, 2017

Clients, Friends, Associates:

Holiday celebrations bring welcomed joy and excitement to the busiest time of year for most investment managers.  As we prepare for a new year, we also reflect on an eventful 2017 year that included the emergence of a new asset class, a steady upswing in the stock market, and proposed legislation to revise the United States tax code. Regardless of all of the changes to the investment management space, year-end administrative upkeep and 2018 planning are always particularly important, especially for General Counsels, Chief Compliance Officers (“CCO”), and key operations personnel. As we head into 2018, we have put together this checklist and update to help managers stay on top of the business and regulatory landscape for the coming year.

This update includes the following:

  • Cryptocurrency Leadership
  • Annual Compliance & Other Items
  • Annual Fund Matters
  • Annual Management Company Matters
  • Regulatory & Other Changes in 2016
  • Compliance Calendar


Cryptocurrency Leadership:

This year digital assets and cryptocurrencies have emerged in force as a separate and distinct asset class. An increased interest in this asset class from fund managers, financial institutions and various government leaders and regulators throughout the world has led to an exponential growth of cryptocurrency investments, the CFTC’s approval of two exchanges to trade Bitcoin futures contracts has increased attention on the asset class.

For SEC registered investment advisers who are adding cryptocurrencies to their fund investment programs and for cryptocurrency focused fund managers who may be relying on SEC exemptions from registration, the need to understand the regulatory implication of certain practices is of utmost importance. Specifically, managers face uncertainty regarding the application of the qualified custodian requirement under Rule 206(4)-2 (“Custody Rule”) under the Investment Advisers Act of 1940, as amended (“Advisers Act”).  Under the Custody Rule, if a registered investment adviser has custody of “client funds or securities”, then it must maintain those client assets with a qualified custodian (generally a bank, broker-dealer, FCM or other financial institution), subject to certain exceptions. Currently we know of only one qualified custodian capable of holding certain cryptocurrencies or digital assets. Our firm participated in a meeting with the SEC in November about custody issues for cryptocurrency managers and continues to engage with the SEC on this issue as well as work with the SEC and other service providers in this space to help lead the way to comply with SEC rules and regulations.


Annual Compliance & Other Items:

Annual Privacy Policy Notice. On an annual basis, registered investment advisers (“RIAs”) are required to provide natural person clients with a copy of the firm’s privacy policy if (i) the RIA has disclosed nonpublic personal information other than in the connection with servicing consumer accounts or administering financial products; or (ii) the firm’s privacy policy has changed.

Annual Compliance Review. On an annual basis, the CCO of an RIA must conduct a review of the adviser’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management. We recommend that firms discuss the annual review with their outside counsel or compliance firm, who can provide guidance about the review process as well as a template for the assessment and documentation. Advisers should be careful that sensitive conversations regarding the annual review are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Form ADV Annual Amendment. RIAs or managers filing as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority, must file an annual amendment to Form ADV within 90 days of the end of their fiscal year. For most managers, the Form ADV amendment would be due on March 31, 2018. This year, because March 31st is a Saturday and March 30th is a market holiday, annual amendments to the Form ADV shall be filed no later than the business day following the 90-day deadline (April 2, 2018). RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an offer to provide the complete brochure) to each “client”. Note that for SEC-registered advisers to private investment vehicles, a “client” for purposes of this rule includes the vehicle(s) managed by the adviser, and not the underlying investors. State-registered advisers need to examine their state’s rules to determine who constitutes a “client”.

Switching to/from SEC Regulation.

SEC Registration. Managers who no longer qualify for SEC registration as of the time of filing the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of their fiscal year by filing Form ADV-W. Such managers should consult with their state securities authorities to determine whether they are required to register in the states in which they conduct business. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of filing the annual amendment.

Exempt Reporting Advisers. Managers who no longer meet the definition of an ERA will need to submit a final report as an ERA and apply for registration with the SEC or the relevant state securities authority, if necessary, generally within 90 days after the filing of the annual amendment.

Custody Rule Annual Audit.

SEC Registered IA. SEC registered investment advisers (“SEC RIAs”) must comply with certain custody procedures, including (i) maintaining client funds and securities with a qualified custodian; (ii) having a reasonable basis to believe that the qualified custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant.

SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited financial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Statements must be sent to the fund or, in certain cases, investors in the fund, within 120 days after the fund’s fiscal year-end. Managers should review their custody procedures to ensure compliance with the rules.

California Registered IA. California registered investment advisers (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets must, among other things, (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualified custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certified public accountant to conduct surprise examinations of assets. CA RIAs to pooled investment vehicles may avoid the independent party and surprise examinations requirements by having audited financial statements prepared by an independent public accountant registered with the PCAOB and distributing such audited financial statements to all limited partners (or members or other beneficial owners) of the pooled investment vehicle, and to the Commissioner of the California Department of Business Oversight (“DBO”).

Other State Registered IA. Advisers registered in other states should consult with legal counsel about those states’ custody requirements.

California Minimum Net Worth Requirement and Financial Reports.

RIAs with Custody. Every CA RIA that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000. Notwithstanding the foregoing, the minimum net worth is $10,000 for a CA RIA (i) deemed to have custody solely because it acts as general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (ii) that otherwise complies with the California custody rule described above (such advisers, the “GP RIAs”).

RIAs with Discretion. Every CA RIA that has discretionary authority over client funds or securities, whether or not they have custody, must maintain at all times a minimum net worth of $10,000.

Financial Reports. Every CA RIA that either has custody of, or discretionary authority over, client funds or securities must file an annual financial report with the DBO within 90 days after the adviser’s fiscal year end. The annual financial report must contain a balance sheet, income statement, supporting schedule, and a verification form. These financial statements must be audited by an independent certified public accountant or independent public accountant if the adviser has custody and is not a GP RIA.

Annual Re-Certification of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the CFTC are required to re-certify their eligibility within 60 days of the calendar year-end. CPOs and CTAs currently relying on relevant exemptions will need to evaluate whether they remain eligible to rely on such exemptions.

CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the NFA, as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and file their fourth quarter report for each commodity pool on Form CPO-PQR, while CTAs must file their fourth quarter report on Form CTA-PR. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 12 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be corrected promptly, and the corrected version must be distributed promptly to pool participants.

Trade Errors. Managers should make sure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be finalized, and if the manager is required to reimburse any of its funds or other clients, it should do so by year-end.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.

Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and separately managed accounts (“SMAs”)) that are beneficial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13D or 13G. Passive investors are generally eligible to file the short form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to file Schedule 13G and is due 10 days after acquisition of more than 5% beneficial ownership of a registered voting equity security. For managers who are also making Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for the first quarter.

Section 16 filings are required for “corporate insiders” (including beneficial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.

Form 13F. A manager must file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of the year in which the manager reaches the $100 million filing threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet the SEC’s large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to file an initial Form 13H with the SEC within 10 days of crossing the threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on Form 13H will require interim amendments following the calendar quarter in which the change occurred.

Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must file Form PF. Smaller private advisers (fund managers with less than $1.5 billion in RAUM) must file Form PF annually within 120 days of their fiscal year-end. Larger private advisers (fund managers with $1.5 billion or more in RAUM) must file Form PF within 60 days of the end of each fiscal quarter.

SEC Form D. Form D filings for most funds need to be amended on an annual basis, on or before the anniversary of the most recently filed Form D. Copies of Form D is publicly available on the SEC’s EDGAR website.

Blue Sky Filings. On an annual basis, a manager should review its blue sky filings for each state to make sure it has met any renewal requirements. Several states impose late fees or reject late filings altogether. Accordingly, it is critical to stay on top of filing deadlines for both new investors and renewals. We also recommend that managers review blue sky filing submission requirements. Many states now permit blue sky filings to be filed electronically through the Electronic Filing Depository (“EFD”) system, and certain states will now only accept filings through EFD.

IARD Annual Fees. Preliminary annual renewal fees for state-registered and SEC-registered investment advisers are due on December 18, 2017. If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check or wire now.

Pay-to-Play and Lobbyist Rules. SEC rules disqualify investment advisers, their key personnel and placement agents acting on their behalf, from seeking to be engaged by a governmental client if they have made political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the definition of “placement agents” (people who act for compensation as finders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with offering or selling investment advisory services to a state public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers offering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties.

State laws on lobbyist registration differ widely, so we recommend reviewing your reporting requirements in the states in which you operate to make sure you are in compliance with the rules.

Annual Fund Matters:

New Issue Status. On an annual basis, managers need to confirm or reconfirm the eligibility of investors that participate in initial public offerings or new issues, pursuant to both FINRA Rules 5130 and 5131. Most managers reconfirm investor eligibility via negative consent (i.e. investors are informed of their status on file with the manager and are asked to inform the manager of any changes). A failure to respond by any investor operates as consent to the current status.

ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers confirm or reconfirm on an annual basis the ERISA status of their investors. This is particularly important for managers who may be deemed a fiduciary under the Department of Labor’s (“DOL”) Fiduciary Rule (as further discussed below).

Wash Sales. Managers should carefully manage wash sales for year-end. Failure to do so could result in embarrassing book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversion. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.

Redemption Management. Managers with significant redemptions at the end of the year should carefully manage unwinding positions so as to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.

NAV Triggers and Waivers. Managers should promptly seek waivers of any applicable termination events set forth in a fund’s ISDA or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year (NAV declines are common counterparty agreement termination events).

Fund Expenses. Managers should wrap up all fund expenses for 2017 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion in the NAV for year-end performance.

Electronic Schedule K-1s. The IRS authorizes partnerships and limited liability companies taxed as partnerships to issue Schedule K-1s to investors solely by electronic means, provided the partnership has received the investor’s affirmative consent. States may have different rules regarding electronic K-1s and partnerships should check with their counsel whether they may still be required to send state K-1s on paper. Partnerships must also provide each investor with specific disclosures that include a description of the hardware and software necessary to access the electronic K-1s, how long the consent is effective and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.

“Bad Actor” Recertification Requirement. A security offering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors”. Fund managers must determine whether they are subject to the bad actor disqualification any time they are offering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements or undertakings in a questionnaire or certification. If an offering is continuous, delayed or long-lived, however, issuers must update their factual inquiry periodically through bring-down of representations, questionnaires, and certifications, negative consent letters, periodic re-checking of public databases and other steps, depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform such an update at least annually.

U.S. FATCA. Funds should monitor their compliance with U.S. Foreign Account Tax Compliance Act (“FATCA”) U.S. FATCA reports are due to the IRS on March 31, 2018 or September 30, 2018, depending on where the fund is domiciled. Reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S. may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying U.S. FATCA requirements applicable to different jurisdictions, managers should review and confirm the specific U.S. FATCA reporting requirements that may apply. As a reminder for this year, we strongly encourage managers to file the required reports and notifications, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.

CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the Cayman Islands and British Virgin Islands are required to register with the respective jurisdiction’s Tax Information Authority and submit returns to the applicable CRS reporting system by May 31, 2018. Managers to funds domiciled in other jurisdictions should also confirm whether any CRS reporting will be required in such jurisdictions. CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the  Automatic Exchange of Information portal.  We recommend managers contact their tax advisors to stay on top of the U.S. FATCA and CRS requirements and avoid potential penalties.

Annual Management Company Matters:

Management Company Expenses. Managers who distribute profits on an annual basis should attempt to address management company expenses in the year they are incurred. If ownership or profit percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.

Employee Reviews. An effective annual review process is important to reduce the risk of employment-related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals and other employee-facing matters at the firm. It is not too late to put an annual review process in place.

Compensation Planning. In the fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity programs should be effective on the first of the year. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes.

Insurance. If a manager carries D&O insurance or other liability insurance, the policy should be reviewed on an annual basis to ensure that the manager has provided notice to the carrier of all claims and all potential claims. Newly launched funds should also be added to the policy as appropriate.

Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can be minimized by structuring the investment manager as a limited partnership. Managers can take several steps to optimize their tax liability, including: (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate, terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (the “Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate these options.

Regulatory & Other Changes in 2017:

SEC Updates.

SEC Adopts Form ADV Amendments. On July 1, 2017, a technical amendment to Form ADV and ADV-W was implemented to reflect a new Wyoming Law that now requires investment advisers with $25 million to $100 million in RAUM and a principal place of business in Wyoming to register with the state as an investment adviser instead of the SEC.

On October 1, 2017, additional SEC amendments to Form ADV went into effect, which will apply to both RIAs and ERAs. Among other technical amendments, the new Form ADV requires investment advisers to provide detailed information with regard to their separately managed accounts SMAs, including aggregate level reporting of asset types across an adviser’s SMAs and reporting of custodian information under certain circumstances. Investment advisers that utilize borrowing or derivatives on behalf of SMAs will also need to report the RAUM attributable to various levels of gross notional exposure and corresponding borrowings and derivatives exposure. The SEC noted that advisers may not need to report this SMA information until its annual amendment. The SEC concurrently adopted an amendment to the books and records rule (Rule 204-2 under the Advisers Act), requiring RIAs to keep records of documentation necessary to demonstrate the performance or rate of return calculation distributed to any person as well as all written performance-related communications received or sent by the RIA. Advisers who have questions on any changes to the new Form ADV should contact their compliance groups.

SEC Action Against Outsourced CCO. On August 15, 2017, the SEC reached a settlement with an outsourced CCO and his consulting firm, which offered compliance consulting and outsourced CCO services to investment advisory firms. The outsourced CCO served as CCO for two registered investment advisers (collectively, “Registrants”). The SEC found the Registrants either filed their Form ADV annual amendments late or not at all, and the outsourced CCO relied on and did not confirm estimates provided by the Registrants’ CIO. It was established that the RAUM and number of advisory accounts reported on the Form ADV was greatly overstated. The SEC held that the outsourced CCO violated the Advisers Act by failing to amend the Form ADV annually and willfully submitting a false statement. The SEC suspended the outsourced CCO from association or affiliation with any investment advisers for one year and ordered him to pay a $30,000 civil penalty. Outsourced compliance persons solely relying on internal estimates of RAUM and number of advisory contracts, without further confirmation, should be aware of the risk of filing false reports and potential SEC enforcement actions.

CFTC and NFA Updates.

CFTC Amendments to Recordkeeping Requirements. On August 28, 2017, amendments to Regulation 1.31 allow the manner and form of recordkeeping to be technology-neutral (i.e. not requiring or endorsing any specific record retention system or technology, and not limiting retention to any format).

Digital Asset Updates.

CFTC Grants Permission for Bitcoin Futures Trading. On December 1, 2017, the CFTC issued a statement granting permission to the Chicago Mercantile Exchange Inc. (“CME”) and the Chicago Board Options Exchange Inc. (“CBOE”) to list Bitcoin futures contracts on the respective exchanges. Less than two weeks after the release of CFTC’s statement, Bitcoin futures contracts trading began on the CBOE futures exchange on December 10, 2017. Early reports suggest a strong interest in Bitcoin futures contracts set to expire in early 2018. CME is set to begin Bitcoin futures contracts trading next week.

CFTC Grants SEF and DCO Registration to LedgerX. The CFTC granted LedgerX registration status as both a swap execution facility (“SEF”) and a  derivative clearing organization. Now that the exchange is live, LedgerX is the first CFTC-approved exchange to facilitate and clear options on digital assets. Previously, the CFTC granted SEF registration to TeraExchange, which offers forwards and swaps on Bitcoin. LedgerX offers physically-settled and day-ahead swaps on Bitcoin to U.S.-based eligible contract participants and has a fully-collateralized clearing model where customers must post collateral to cover maximum potential losses prior to trading.

Other Updates.

DOL Implements Fiduciary Rule. On June 9, 2017, the DOL partially implemented its amended fiduciary rule (the “Fiduciary Rule”), which expands the definition of a “fiduciary” to apply to anyone that makes a “recommendation” as to the value, disposition or management of securities or other investment property for a fee or other compensation, to an employee benefit plan or a tax-favored retirement savings account such as an individual retirement account (“IRA”) (collectively “covered account”) will be deemed to be providing investment advice and, thus, a “fiduciary”, unless an exception applies. Fund managers with investments from covered accounts or that wish to accept contributions from covered accounts will need to consider whether their current business activities and communications with investors could constitute a recommendation, including a suggestion that such investors invest in the fund. The Fiduciary Rule provides an exception for activity that would otherwise violate prohibited transaction rules, which is applicable to investments made by plan investors who are represented by a qualified independent fiduciary acting on the investor’s behalf in an arms’ length transaction (typically for larger plans). The Fiduciary Rule also contemplates a Best Interest Contract (“BIC”) Exemption, which permits investment advisers to retail retirement investors to continue their current fee practices, including receiving variable compensation, without violating prohibited transactions rules, subject to certain safeguards. Managers with questions regarding the applicability of these exemptions should discuss with counsel.

Two New California Employment Laws Limit Inquiries into Certain Information During the Hiring Process. In October, California Governor Jerry Brown approved Assembly Bill No. 168 and Assembly Bill No. 1008, restricting certain information a California employer may inquire about and consider during its hiring process. Assembly Bill No. 168 restricts employers from requiring prospective employees to disclose salary history. An employer may not inquire or rely on such information when deciding whether to extend an offer to a job applicant or deciding an amount to offer to a job applicant. Assembly Bill No. 1008 restricts California employers with five or more employees from including, inquiring and considering information about an employee applicant’s criminal history until a conditional offer has been extended to a job applicant. Assembly Bill No. 1008 further provides certain requirements an employer must comply with after such information has been legally acquired and is taken into consideration when deciding whether to hire a job applicant, as well as certain procedures to comply with when deciding a job applicant is not suitable for the position. Both laws become effective January 1, 2018. With respect to California employees, you should review before year end, your job application, offer letter template, and compliance manual if they contain questions regarding salary or criminal history.

MSRB Establishes Continuing Education Requirements for Municipal Advisors. Beginning January 1, 2018, the Municipal Securities Rulemaking Board (“MSRB”) will implement amendments requiring municipal advisors to maintain a continuing education program in place for “covered persons”. The amendment will require an annual analysis to evaluate training needs, develop a written training plan, and implement training in response to the needs evaluated. The amendments promote compliance with the firms record-keeping policies regarding the continuing education program. Municipal advisors will have until December 31, 2018 to comply with the new requirements.

SIPC and FINRA Adopt Streamlined Reporting Process. As of September 1, 2017, investment advisory firms who are members of both the Securities Investor Protection Corporation (“SIPC”) and the Financial Industry Regulatory Authority (“FINRA”) now only need to file one annual report to both agencies through FINRA’s reporting portal. This will ease the reporting burden as well as cut down on compliance costs, for firms.

SEC Provides Guidance to Address MiFID II. On October 26, 2017, the SEC issued three no-action relief letters to provide guidance on the Markets in Financial Instruments Directive II (“MiFID II”). Effective January 3, 2018, MiFID II most notably introduces the requirement for UK broker-dealers to “unbundle” investment research from trading commissions, requiring distinct pricing for each of the services rendered. The first no-action letter provides that for the first 30 months from when MiFID II becomes effective, U.S. broker-dealers will not be considered an investment adviser upon accepting payments from an investment manager. The second no-action letter states that broker-dealers may continue to rely on the safe harbor under Section 28(e) of the Securities and Exchange Act of 1934, as amended, for payments made from client assets made alongside payments for execution to an executing broker-dealer. The final no-action letter addresses MiFID II’s various payment arrangements surrounding research activities and provides that an investment adviser may aggregate client orders, although research payments may differ for each client.

Tax Cuts and Jobs Act Impact on Hedge Funds. In late 2017, the House Ways and Means Committee and the Senate Finance Committee passed companion legislation in an attempt to reform the US tax system. One of the proposed revisions included in H.R. 1 or the Tax Cut and Jobs Act (“Tax Act”) is a reduction in the tax rate for a pass-through entity’s “capital percentage” business income. The applicable tax rate would be 25%, with the non-professional services entity’s “capital percentage” business income capped at 30%, and the remaining amount of income characterized as “labor”.

Offshore Updates.

Cayman and BVI Update Beneficial Ownership Regimes. Amendments to the Cayman Islands beneficial ownership laws went into effect on July 1, 2017, which require certain entities, including exempted funds, to take reasonable steps to identify their beneficial owners (generally persons holding more than 25% interests in such an entity). Of interest to fund managers, the following types of funds are exempted from the scope of these amendments: funds that are regulated by the Cayman Islands Monetary Authority, that employ a Cayman regulated administrator, or funds that are managed by an adviser regulated in an approved jurisdiction, such as a state or SEC RIA. The British Virgin Islands (the “BVI”) also implemented amendments to its beneficial ownership regime effective July 1, 2017, which requires registered agents of non-exempt BVI companies, such as unregulated private funds, to input beneficial ownership information into a platform called the BOSS (Beneficial Ownership Secure Search) System. The BOSS System is accessible only to select regulators and fulfills BVI commitments to the United Kingdom under the UK Exchange of Notes Agreement.

U.K. Transitions from U.K. FATCA to CRS. The U.K. transitioned from U.K. FATCA to CRS on July 1, 2017, and now joins more than 85 countries, including the Cayman Islands and the BVI, in the automatic exchange of information between participating countries. The full list of signatory countries is available here. Similar to U.S. FATCA, CRS sets forth a standard by which signatory countries can more easily and automatically exchange certain reportable tax information. We recommend that managers consult their tax advisors to determine whether they are subject to any CRS reporting requirements.

Cayman Islands Introduces New AML Regulations. New Cayman Islands AML regulations came into effect on October 2, 2017. The new regulations expand AML/CFT (anti-money laundering/ countering the financing of terrorism) obligations to unregulated investment entities and  additional  financial  vehicles,  which  are  seen  to  align  more  closely  with  the Financial Action Task Force (FATF) recommendations and global practice. In a shift to a risk- based approach to AML regulations, there will be two separate due diligence procedures depending on the risk assessment of investors. Certain investors that are deemed to be high-risk, such as politically exposed persons, will be required to go through a more extensive verification process, while low-risk investors will be able to submit to a simplified due diligence process. If you have any questions, we recommend that you reach out to your administrator or offshore counsel.

New PRIIPs Disclosure Requirements for EEA Retail Investors. Regulation (EU) No 1286/2014 (“Regulation”), effective January 1, 2018, requires manufacturers of Packaged Retail and Insurance-based Investment Products (“PRIIPs”) to make available Key Information Documents (“KIDs”) to “retail investors” (generally any investor that does not meet the “professional client” status) in member states of the European Union and the Economic European Area (collectively, “EEA”). If a PRIIP manufacturer, such as a fund manager, accepts additional investments or a new investment from an EEA retail investor on or after January 1, 2018, it must comply with the Regulation’s technical requirements pertaining to KIDs. “Retail investors” under the Regulation can include investors such as high net worth individuals, who are not traditionally considered retail investors. Fund managers should consider the applicability of the Regulation given the types of EEA investors they may be marketing to, and managers who wish to forego complying with the Regulation should not accept investments from EEA retail investors and implement additional procedures to ensure such investors are not marketed to or admitted in the fund.  Fund managers with questions regarding the Regulation should discuss with counsel.

Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

Deadline – Filing

  • December 18, 2017 –  IARD Preliminary Renewal Statement payments due (submit early to ensure processing by deadline)
  • December 26, 2017 – Last day to submit form filings via IARD prior to year-end
  • December 31, 2017 – Review RAUM to determine 2018 Form PF filing requirement
  • January 15, 2018 – Quarterly Form PF due for large liquidity fund advisers (if applicable)
  • January 31, 2018 – “Annex IV” AIFMD filing
  • February 15, 2018–  Form 13F due
  • February 15, 2018 – Annual Schedule 13G updates due
  • February 15, 2018 – Annual Form 13H updates due
  • February 28, 2018 – Deadline for re-certification of CFTC exemptions
  • March 1, 2018 – Quarterly Form PF due for larger hedge fund advisers (if applicable)
  • April 2, 2018 – Annual ADV amendments due (for December 31st fiscal year end)
  • April 2, 2018 – Annual Financial Reports due for CA RIAs (if applicable)
  • April 18, 2018 – FBAR deadline for certain individuals with signature authority over, but no financial interest in, one or more foreign financial accounts
  • April 29, 2018 – Annual Form PF due for all other advisers (other than large liquidity fund advisers and large hedge fund advisers)
  • Periodic – Form D and blue sky filings should be current
  • Periodic – Fund managers should perform “Bad Actor” certifications annually


Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached 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.


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.


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.


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


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.


  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.


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:

Investment Adviser Pay to Play Rules

SEC Proposal Would Ban Third Party Solicitors from Seeking Public Monies

Back in July there was much discussion about new “pay to play” rules proposed by the SEC.  The proposed “pay to play” rules would limit the ability of investment managers (including hedge fund managers) to make political contributions and would also limit the ability of third party marketers to raise capital for managers from state and federal pension plans.

There have been many interesting comments on these proposed rules so far, and, as some have noted, it seems to me that these rules may hinder the first-amendment rights of these money managers.  The comment period ends October 6, 2009 and the SEC may choose to vote on the rule thereafter, but I would not expect for any rule to be finalized before the end of this year.  However, hedge fund managers may want to review their investment advisory compliance manual to make sure they have discussed this issue.  Hedge fund managers who are not yet registered with the SEC as investment advisers will likely deal with this issue when they register.

I have included below (i) a definition of pay to play below, (ii) the SEC press release announcing the proposal, and (iii) a discussion of pay to play from 1999, the last time the SEC had a proposal to regulate these activities.

Mallon P.C. will be commenting on the proposal so please let us know your opinions below.


Pay to Play Definition (see old SEC release, reprinted below)

When I refer to pay-to-play, I am talking about the practice of requiring, either expressly or implicitly, municipal securities participants to make political contributions to municipal officials in order to be considered for an award of underwriting, advisory, or related business from the municipality. In most cases these practices do not amount to outright bribery – which is already prohibited under state and federal law, since there is no express quid pro quo – but it is simply an understanding that if you don’t give, you don’t get business.


SEC Proposes Measures to Curtail “Pay to Play” Practices


Washington, D.C., July 22, 2009 — The Securities and Exchange Commission today voted unanimously to propose measures intended to curtail “pay to play” practices by investment advisers that seek to manage money for state and local governments. The measures are designed to prevent an adviser from making political contributions or hidden payments to influence their selection by government officials.

The proposals relate to money managed by state and local governments under important public programs. Such programs include public pension plans that pay retirement benefits to government employees, retirement plans in which teachers and other government employees can invest money for their retirement, and 529 plans that allow families to invest money for college.

To help manage this money, state and local governments often hire outside investment advisers who may directly manage this money and provide advice about which investments they should make. In return for their advice, the investment advisers typically charge fees that come out of the assets of the pension funds for which the advice is provided. If the advisers manage mutual funds or other investments that are options in a plan, the advisers receive fees from the money in those investments.

Investment advisers are often selected by one or more trustees who are appointed by elected officials. While such a selection process is common, fairness can be undermined if advisers seeking to do business with state and local governments make political contributions to elected officials or candidates, hoping to influence the selection process.

The selection process also can be undermined if elected officials or their associates ask advisers for political contributions or otherwise make it understood that only advisers who make contributions will be considered for selection. Hence the term “pay to play.” Advisers and government officials who engage in pay to play practices may try to hide the true purpose of contributions or payments.

“Pay to play practices can result in public plans and their beneficiaries receiving sub-par advisory services at inflated prices,” said SEC Chairman Mary Schapiro. “Our proposal would significantly curtail the corrupting and distortive influence of pay to play practices.”

Andrew J. Donohue, Director of the SEC’s Division of Investment Management, added, “Pay to play serves the interests of advisers to public pension plans rather than the interests of the millions of pension plan beneficiaries who rely on their advice. The rule we are proposing today would help ensure that advisory contracts are awarded on professional competence, not political influence.”

The rule being proposed for public comment by the SEC includes prohibitions intended to capture not only direct political contributions by advisers, but other ways advisers may engage in pay to play arrangements.

Restricting Political Contributions

Under the proposed rule, an investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

The rule would apply to the investment adviser as well as certain executives and employees of the adviser. Additionally, the rule would apply to political incumbents as well as candidates for a position that can influence the selection of an adviser.

There is a de minimis provision that permits an executive or employee to make contributions of up to $250 per election per candidate if the contributor is entitled to vote for the candidate.

Banning Solicitation of Contributions

The proposed rule also would prohibit an adviser and certain of its executives and employees from coordinating, or asking another person or political action committee (PAC) to:
1. Make a contribution to an elected official (or candidate for the official’s position) who can influence the selection of the adviser.
2. Make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

Banning Third-Party Solicitors

The proposed rule also would prohibit an adviser and certain of its executives and employees from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser.

Restricting Indirect Contributions and Solicitations

Finally, the proposed rule would prohibit an adviser and certain of its executives and employees from engaging in pay to play conduct indirectly, such as by directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser, if that conduct would violate the rule if the adviser did it directly. This provision would prevent advisers from circumventing the rule by directing or funding contributions through third parties.

* * *

Public comments on today’s proposed rule must be received by the Commission within 60 days after their publication in the Federal Register.

The full text of the proposed rule will be posted to the SEC Web site as soon as possible.
# # #


U.S. Securities and Exchange Commission

Speech by SEC Staff:
Pay-To-Play and
Public Pension Plans
Remarks of
Robert E. Plaze
Associate Director, Division of Investment Management,
U. S. Securities and Exchange Commission

At the Annual Joint Legislative Meeting of
The National Association of State Retirement Administrators,
National Conference on Public Employee Retirement Systems and
The National Council on Teacher Retirement, Washington, D.C.

January 26, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.

Thank you for inviting me to address this meeting of the group of state pension administrators. My father was a state retiree and lived on his pension for a number of years. I know how the importance the security of a pension plan is to millions of persons like my Dad, and how important your jobs are.

I am a member of the staff of the Commission. But my remarks this afternoon are my own, and I am not speaking for the Commission or my colleagues on the staff.

When Arthur Levitt became Chairman almost six years ago, among his goals was the reform of the municipal securities markets. Since then, a series of initiatives have improved investor disclosure in the municipal securities markets. A second area of reform – and one most relevant to why you have invited me here today – has been the curbing of pay-to-play practices.

When I refer to pay-to-play, I am talking about the practice of requiring, either expressly or implicitly, municipal securities participants to make political contributions to municipal officials in order to be considered for an award of underwriting, advisory, or related business from the municipality. In most cases these practices do not amount to outright bribery – which is already prohibited under state and federal law, since there is no express quid pro quo – but it is simply an understanding that if you don’t give, you don’t get business.

Chairman Levitt, and several SEC officials have been involved in the municipal securities markets. They knew that pay-to-play practices had been pervasive and corrupting to the market for municipal securities. And if you ask them, they will tell you stories about checks left on the table at a dinner. They may even know the minimum required contributions in a particular jurisdiction to be eligible for public contracts.

Pay-to-play creates the impression that contracts for professional services are awarded on the basis of political influence rather than professional competence. It harms the citizens of the municipality and the investing public asked to purchase the securities. It brings discredit on the businesses and professionals who participate in the practice.

In 1993, the first in a series of steps to end pay-to-play practices began when a group of investment banks voluntarily agreed to swear off making contributions for the purpose of obtaining municipal business. In 1994, the SEC approved MSRB rule G-37 – which is known as the pay-to-play rule.1

G-37 prohibits municipal securities dealers from engaging in the municipal securities business with an issuer two years after contributions are made to an official of an issuer by the dealer or its employees engaged in municipal finance business. The prohibition applies equally to officials who are incumbents and those who are candidates. There is a de minimis exception, which permits contribution of up to $250 to candidates for whom they can vote.

The rule was met with howls of protest from some state and municipal officials. Some argued that it violated their First Amendment rights to make and solicit political contributions. These claims were soon tested in the federal courts, and in an important decision, a federal court of appeals held that G-37 was a constitutionally permissible restraint on free speech – because it serves a compelling governmental interest of rooting out corruption in the market for municipal securities.2

As we meet this afternoon, the American Bar Association is considering proposals to bar the practice of lawyers obtaining business through political contributions. Deans of 47 law schools across the country have joined Chairman Levitt in calling for an end to what the San Francisco Chronicle called “a sleazy practice that costs taxpayers.” 3 We hope that my profession will adopt a strong and effective ban.

Bringing an end to pay-to-play practices thus has been a step-by-step process.

Recently, Chairman Levitt has asked my Division to look into the question of whether the Commission needed to address pay-to-play in the public pension area. We are now in the fact-gathering stage of this project, which could very well lead to a rule proposal.

What have we found? So far, we see strong indicators that pay-to-play can be a powerful force in the selection of money managers of public pension plans. There are public reports of pay-to-pay problems with the management of public money in 12 states – and many of these are the largest states.

* In one small state a former state treasurer raised over $73,000 in campaign contributions, virtually all from contractors for the state retirement system 4

* The controller of a large state has raised $1.8 million from pension fund contractors, many of which are out-of-state 5

* In another state, a former state treasurer raised contributions from contractors, one of whom received a five-fold increase in the custody fees it charged. The treasurer’s candidate lost and the contract was terminated by the new treasurer.6

* The Executive Director of the MSRB has been quoted in the Wall Street Journal as saying that “the conflicts of interest in the [public pension business] are as bad as anything we’ve seen in the muni-bond market.7

* An elected state official has told me that she thought that G-37 has resulted in the movement of some pay-to-play activity over to the public pension area. Phone calls from some advisers have confirmed this.

Claims that pay-to-play really isn’t a problem are refuted by the findings of states and plans that have taken on the issue. Vermont and Connecticut have enacted legislation.8 Both were concerned that awards of advisory contracts were being made on the basis of political favoritism rather than expertise. They concluded that even where no actual corruption occurred, the appearance of impropriety was intolerable.

CalPERS has acted in California, and the records of its rulemaking proceeding and subsequent litigation are particularly instructive about how pay-to-play works and its insidiousness.

It is heartening to see some of the plans and jurisdictions putting an end to the culture of pay-to-play. As you know, it takes two to tango, and it takes two to participate in these practices – the payer and the payee. Our concern is with the activities of the payers – investment advisers, whom we regulate under the Investment Advisers Act of 1940.9

The Advisers Act imposes a federal fiduciary duty on advisers with respect to their clients and prospective clients.10

* When the process of the selection of an investment adviser is corrupted, the duties of an adviser to his client are compromised.

* When the selection process is corrupted and advisers are selected based not on their merit but on the amount or their political contributions, the ultimate clients of advisers – the pension pools they manage – are harmed and the benefits of retirees threatened.

A similar harm occurs when advisers are not chosen because they have not made the requisite amount of contributions.

We at the Commission believe that G-37 is working pretty well. And I have to believe, based on the evidence we have collected so far, that the burden will fall on those who argue that the Commission should not apply the core principles of G-37 to investment advisers and the public pension plan area.

We have spoken with your representatives from NASRA, and we have discussed the matter with some of your colleagues. They have described the difficult position in which a professional manager is placed when it becomes apparent that the decision-making process is being skewed by considerations of political contributions. You have a unique perspective from which to help us understand the issues.

I look forward to further discussions with you and look forward to hearing your views.

Thank you.

1 Self-Regulatory Organizations; Municipal Securities Rulemaking Board, Securities Exchange Act Release No. 34-33868 (Apr. 7, 1994).

2Blount v. SEC , 61 F.3d 938 (1995), cert. denied , 517 U.S. 1119 (1996).

3A Sleazy Practice That Costs Taxpayers , San Francisco Chron., Aug. 1, 1997, at A26.

4See Office of Vermont State Treasurer James H. Douglas, If You Play, You Pay: New Campaign Finance Legislation Prohibits Contracts for Wall Street Firms Contributing to State Treasurer Races, a Provision Pushed by Douglas (06/16/97) http://www.state.vt.us/treasurer/press/pr970616.htm.

5 Clifford J. Leavy, Firms Handling N.Y. Pension Fund Are Donors to Comptroller , N.Y. Times, Oct. 3, 1998, at A16)

6See Steve Hemmerick, See You in Court,’ Bank Tells Its Client: State Street Sues over Custody Contract, Pens. & Inv., Feb. 23, 1998, at 2.

7 Charles Gasparino and Jonathan Axelrod, Political Money May Sway Business of Public Pensions , Wall St. J., Mar. 24, 1997, at C1.

8 Conn. Gen. Stat. § 9-333 o (1997); Vt. Stat. Ann. tit. 32, § 109 (1997).

9 15 U.S.C. 80b.

10SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180 (1963).



Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  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 have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

Pension Security Act of 2009

At the very beginning of this year a bill was introduced to change the Employee Retirement Income Security Act of 1974 (ERISA) to require defined benefit plans to disclose their interest in hedge funds.  The definition of hedge fund for the purposes of the act is very broad and would likely include private equity funds, VC funds, real estate hedge funds and other pooled investment vehicles.  In the event that this bill was passed the DOL is likely to issue regulations providing more color on how and in what manner the disclosures will be made.

The Pension Security Act of 2009 was part of a broader flurry of bills introduced this year which are designed to increase regulation of the investment management industry in general, and hedge funds specifically.  I have included the full text of the act below and have also provided links to the various other bills which have been introduced since the recession began.

A hat tip to Doug Cornelius at Compliance Building for reporting this story a couple of weeks ago.


Pension Security Act of 2009 (Introduced in House)

HR 712 IH


1st Session

H. R. 712

To amend title I of the Employee Retirement Income Security Act of 1974 to require in the annual report of each defined benefit pension plan disclosure of plan investments in hedge funds.


January 27, 2009

Mr. CASTLE introduced the following bill; which was referred to the Committee on Education and Labor


To amend title I of the Employee Retirement Income Security Act of 1974 to require in the annual report of each defined benefit pension plan disclosure of plan investments in hedge funds.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,


This Act may be cited as the `Pension Security Act of 2009′.


(a) In General- Section 103(b) of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1023(b)) is amended–

(1) in paragraph (3)(C), by striking `value;’ and inserting `value, including, in the case of a defined benefit pension plan, a separate schedule identifying each hedge fund (as defined in paragraph 5) in which amounts held for investment under the plan are invested as of the end of the plan year covered by the annual report and the amount so invested in such hedge fund;’; and

(2) by adding at the end the following new paragraph:

`(5) For purposes of paragraph (3)(C), the term `hedge fund’ means an unregistered investment pool permitted under sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1), (7)) and section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)) and Rule 506 of Regulation D of the Securities and Exchange Commission (17 CFR 230.506).’.

(b) Effective Date; Regulations- The amendments made by subsection (a) shall apply with respect to annual reports for plan years beginning on or after the date of the enactment of this Act. The Secretary of Labor, in consultation with the Securities and Exchange Commission, shall issue initial regulations to carry out the amendments made by subsection (a) not later than 1 year after the date of the enactment of this Act.


Other bills introduced into Congress:

Other hedge fund law articles related to ERISA and hedge funds:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  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, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Investors and Increased Due Diligence: GAO Report

This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here. Continue reading

SEC Emphasizes Importance of Hedge Fund Investment Advisor Compliance

The SEC’s Lori Richards, Director, Office of Compliance Inspections and Examinations, spoke last week at an event and emphasized the importance of compliance during these volatile markets.  For chief compliance officers (CCOs) at registered investment advisory firms, the following speech transcript should be required reading.  Hedge fund managers registered as investment advisors must be especially aware of the fiduciary obligation they have to their client.  Specifically Richards noted that examiners will be focusing investment programs to make sure there is no style drift in their portfolios and that valuation is done pursuant to the manager’s stated valuation procedures.

Richards also discussed a number of areas which compliance officers should be focusing on during this time.  Specifically she advocated that a firm’s CCO: make sure following all securities laws and regulations, including the Form SH filings; make sure there is no market manipulation or insider trading; review and update if necessary the following Form ADV, Form ADV Part II, performance advertising, marketing, fund prospectuses and any other information provided to clients; review best execution and any soft dollar programs.  Richards noted that in keeping with the “culture of compliance,” the CCO “should insist on absolute compliance with policies and procedures, there should be no possibility of ‘suspending’ compliance. And it would be timely for you to remind firm employees of your presence and make clear to every employee in the firm that no shortcuts will be allowed.”

Richards also noted that the examiners will be looking for undisclosed payments by and to hedge fund investment advisors.  This is especially interesting in light of the recent case brought by the DOL against a registered investment adviser for failing to disclose payments from a hedge fund manager.  Please see DOL Sues Investment Advisor for ERISA violation.

If a registered hedge fund manager’s CCO has not considered any of the above issues the manager should immediately contact a hedge fund attorney or compliance professional.  It is likely that a hedge fund manager will be audited given the SEC’s “risk-based” model of audits.  I have posted some regular articles below.  The full text of the speach is reprinted below and can also be found here.


Speech by SEC Staff:
Compliance Through Crisis: Focus Areas for SEC Examiners and Compliance Professionals

by Lori A. Richards
Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission
National Society of Compliance Professionals
National Meeting
Philadelphia, Pennsylvania

October 21, 2008

Good Morning. I’m very pleased to be with you here today at the National Meeting of the National Society of Compliance Professionals. I believe that this is the largest professional organization of compliance professionals in the securities industry, so you carry a lot of clout!

Before I begin, I am required to state that the views I express today are my own, and do not necessarily represent the views of the Commission or any other member of the staff.

This event and others like it are so important — they provide an opportunity to share information about cutting edge compliance practices, about emerging compliance risks, and about strategies to help establish strong compliance programs and instill a healthy culture of compliance. Your role as compliance professionals is critical in any market environment, but in today’s turbulent times, it is essential. Your job each day is to educate, to guide, to investigate, to test and sometimes to insist on adherence to the law and to the firm’s policies, and sometimes, to just say no! Your job is important in any environment, and it is just as or more important now.

The compliance function within firms is critical in helping to assure operations in compliance with the law, and it must continue to be fully and adequately resourced. While not profit centers, firms must remember that their compliance programs (and related legal functions, as well as the information technology programs that support a well-run compliance program) are essential to their operations — reductions in resources to these programs would be ill-advised. Securities firms cannot now afford to reduce vigilance in compliance.

In today’s environment, perhaps the most important thing you can do as a compliance professional is to remind firm employees of their obligations to investors — for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with clients, customers, and investors. In addition to this reminder, however, there are areas where you will want to pay particular attention to compliance obligations. I will describe some of those this morning. Finally, you cannot let slip the other ongoing compliance responsibilities that the firm has, I will describe some of these priority areas as well.

As I speak to you today, our markets are undergoing unprecedented change. Once large firms no longer exist, and others have been acquired or merged. Securities firms that once stood alone are now parts of large banks. A money market fund has broken a dollar, and the Treasury has implemented a new program to guarantee certain money market funds from loss and the government has taken unprecedented steps to buy troubled assets and shore up credit markets. These are sudden and significant changes, and while we won’t see their full impact for some time, today, in the securities compliance world, our work could not be more important.

It’s worth remembering, for all of us who work administering compliance programs under the securities laws, that the underlying tenets of the securities laws are quite simple and provide meaningful protections to every investor every day:

  • Companies publicly offering securities to investors must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing — enabling investors to make informed investment decisions.
  • People who sell and trade securities and provide investment advice — brokers, dealers, advisers and exchanges — must treat investors fairly and honestly, putting investors’ interests first.

In the current credit crisis, the SEC has been aggressively working to police the markets, and to ensure that the “rules of the road” for public companies and market participants include full disclosure to investors and promote healthy capital markets. While a small agency (only 3,800 staff), the SEC packs clout through its experienced and dedicated staff. Addressing the extraordinary challenges facing our markets, the SEC has issued new regulations to strengthen capital markets and protections for investors, taken enforcement measures against market manipulation (including a landmark enforcement action against a trader who spread false rumors designed to drive down the price of stock), initiated examination sweeps, communicated with investors, and collaborated with domestic and foreign regulators around the world.

The SEC is an aggressive police force too — we bring hundreds of enforcement actions each year to protect public investors from fraud.  Indeed in just this last year, we brought more than 650 enforcement actions, more than the year before, involving all types of fraud that harm investors — corporate non-disclosure, ponzi schemes, insider trading, failures to value assets correctly, and other types of frauds. The protections of the securities laws are meaningful and have real consequences for investors. In just the last year alone, we returned over one billion dollars to harmed investors — making the protections of the federal securities laws mean something to those investors who have been defrauded.

And, in the Office of Compliance Inspections and Examinations, we are keenly focused on issues that present risk to investors. I wanted to highlight some of the areas that SEC examiners will be focusing on in the months ahead in our examinations of registered investment advisers, investment companies, and broker-dealers — and suggest that these are areas that you might focus attention on as well.

Let me start with the “landscape” because the sheer number of registered firms subject to our examinations impacts our actions quite directly. At the start of FY 2009:

  • There are approximately 11,300 registered investment advisers and 950 fund complexes with over 8,000 mutual fund portfolios (this is a highly transient population: approximately 1,200 advisers became registered and 750 de-registered in FY 2008).
  • There are approximately 5,600 broker-dealers, 174,000 branch offices, and 676,000 registered representatives (as more firms have consolidated, the broker-dealer registrant pool has declined slightly in recent years, while the number of branch offices has increased dramatically). And, there are approximately 410 SEC-registered transfer agents.

Our program is risk-based, which means that we seek to accord resources to those firms and issues that present the greatest risk to investors. Our overall examination plan consists of numerous complementary components: routine and periodic examinations of those advisers (about 1,000) that are considered “higher risk;” routine examinations of large broker-dealer firms to evaluate their internal controls; “oversight” examinations of broker-dealers to evaluate the SROs’ regulatory programs; cause exams based on indications of violations; “sweep” exams focused on particular risk areas; random examinations of lower risk advisers; and visits to newly-registered advisers. In addition to these types of examinations, we will also closely monitor the compliance activities and controls of certain large advisers and broker-dealers.

We’ve also sought to leverage compliance results from firms’ own compliance programs by encouraging firms’ own compliance professionals to be aggressive in assuring compliance with the securities laws. In the coming year, we will continue this work as well — we will continue our CCOutreach programs for chief compliance officers. Our National Seminar for adviser and fund CCOs is November 13, and we just announced that our National Seminar for broker-dealer CCOs, in coordination with FINRA, will be held on March 10, 2009. We will also continue to issue ComplianceAlerts that summarize results of recent examinations so that all firms can benefit from our insights into both what can go wrong, and also, what particular practices seem to help make things go right.

Our examination program includes focus areas and exam initiatives that are particularly critical in today’s market environment. While these are not new areas, they are timely now and examiners will be paying special attention to compliance in these areas. These areas include:

  • Portfolio management: recent losses may provide an impetus for portfolio managers to trade more aggressively than they should or to deviate from investment objectives in order to make up losses, and perhaps also to catch-up on performance-based fees. This is an area where compliance personnel should be active.
  • Financial controls, including compliance with net capital and customer control requirements by broker-dealers, as well as these firms’ risk management and internal control procedures. While the Division of Trading and Markets will no longer be supervising the holding companies of large broker-dealer firms — OCIE examiners will continue to focus attention on controls within the registered broker-dealer, which are intended to protect investors’ accounts with a broker-dealer. And, if you’re an adviser in precarious financial condition — you must disclose this fact to clients. This is an area where your focus is warranted.
  • Valuation, at all types of registrants, including controls and procedures for valuation of illiquid and difficult-to-price securities at all registrants. Reluctance to fair value or mark down prices cannot take precedence over the firm’s pricing procedures — investors and fund shareholders have a right to know the current value of their holdings. If you work for a broker-dealer that provides quotes or for an investment adviser or other user of broker quotes — be particularly alert to and look for the possibility of “accommodation quotes” — which don’t reflect prices at which the security could actually be sold. At its worst, this could be fraudulent conduct. A reminder too — under accounting rules (FAS 157), issuers must classify their assets within a hierarchy. For those assets valued by using a broker’s quote or a price from a pricing service — you should be sure that you understand whether the quote or price is based on actual transactions, reflects the willingness of the broker to trade at that price, or is based on a model or another methodology.  Among strong practices in this area are to require multiple sources of pricing information, and also to regularly go back and compare the actual prices realized on any sale to the fair values used: then, determine the reasons for any wide gaps and implement improvements in pricing processes. This is an area where your focus is needed now — be sure that your firm is implementing its controls and its oversight over pricing.
  • Sales of structured products by broker-dealers and advisers. Of special note — given that investors may be particularly looking for lower-risk investment products, examiners will focus on products marketed as being relatively “safe,” such as principal protected notes and other products, and will review the adequacy of disclosures concerning credit risk, liquidity, and investment risk. Conversely, investors may be looking to recoup losses, and may be more vulnerable to sales of high-risk, high-return products. You will want to focus on both types of products and make sure that representations are accurate and that your firm is treating investors fairly.
  • Controls and processes at recently merged or acquired firms, both advisers and broker-dealers. This is an area where compliance staff must be active — to help make sure that controls and processes do not fall through the cracks in a merged organization.
  • Money market funds, including, at a minimum, compliance with Rule 2a-7 regarding the creditworthiness of portfolio securities, shadow pricing, and compliance oversight — and more broadly, whether funds’ are stretching for yield and subjecting the fund to excessive undisclosed risk. We have examinations underway. The problems experienced by money market funds should be seen as cautionary for all managers and CCOs of money market funds.
  • Short selling and compliance with Regulation SHO and filings of Form SH. Examiners are also focusing on firms’ policies and procedures to prevent employees from knowingly creating, spreading, or using of false or misleading information with the intent to manipulate securities prices, and will be concluding a sweep of broker-dealers and hedge fund advisers in this area.

Beyond these specific compliance risk issues, in times of financial strain, people may act in uncharacteristic ways — in order to conceal losses, inflate revenues or profits, to stay in business or just to avoid delivering bad news. Examiners will be alert for indications of fraud and “acts of desperation” by individuals and firms that are under financial duress. As compliance personnel, however, you are much closer to the scene than we are — and you should be aware of and alert to the increased possibility that individuals under stress may take fraudulent or deceptive actions. Checks and balances are critical in this environment. You should insist on absolute compliance with policies and procedures, there should be no possibility of “suspending” compliance. And it would be timely for you to remind firm employees of your presence and make clear to every employee in the firm that no shortcuts will be allowed.

In addition to these focus areas, OCIE examiners will also be focusing on other compliance risks, and so too must you. We cannot afford to pay less attention to any of these issues. Let me describe several of these areas:

  • Suitability and appropriateness of investments for clients: Examiners will focus on whether securities recommended and investments made for clients and funds are consistent with disclosures, the client’s investment objectives and any investment restrictions, and with the broker or adviser’s obligations to clients to only recommend securities that are suitable or appropriate. We’ll focus in particular, on how firms are interacting with their senior customers and clients. We’ll also focus on structured products and other complex derivative instruments, variable annuities, niche ETFs, managed pay-out funds, and 130/30 funds.
  • Disclosure: Examiners will focus on ADVs, performance advertising, marketing, fund prospectuses and any other information provided to clients. This is a good time for you to review your firm’s disclosures to investors and shareholders. Make sure that any steps the firm has taken in recent days or weeks to deal with the credit crisis are consistent with the firm’s disclosures. Examiners will be specifically looking at how the firm represents its participation in Treasury’s money market guarantee program, the existence of SIPC coverage, and at advertised performance figures. Consider your disclosures as your “Constitution” — even in a crisis, it’s your governing document, and it must match your practices.
  • Controls to prevent insider trading: We’re focusing on the adequacy of policies and procedures, information barriers, and controls to prevent insider trading and leakage of information including the identification of sources of material non-public information, surveillance, physical separation, and written procedures. Controls to prevent insider trading should be strong in any environment.
  • Trading, brokerage arrangements and best execution: We’ll be looking at whether brokerage arrangements are consistent with disclosures, whether the firm seeks best execution, and whether soft dollars are used appropriately (consistent with disclosures), Reg NMS and direct market access arrangements. We will particularly scrutinize the use of an affiliated broker-dealer or any undisclosed relationships with a broker-dealer for excessive commissions, kick-backs and other conflicted relationships. Your best execution committees will want to particularly review execution quality in current markets.
  • Proprietary and employees’ personal trading: This is a basic part of any compliance program — when we find weaknesses in this area, it makes us wonder about the firm’s commitment to addressing other conflicts of interest. This is not an area to be overlooked.
  • Undisclosed payments: Examiners are looking for compensation or payment arrangements that may be part of revenue-sharing, or other undisclosed arrangements with third parties. These payments may be made to increase fund sales or assets under management (such as fund networking fees and payments by advisers to broker-dealers for obtaining space on the firms’ recommended adviser list). Undisclosed payments may also involve misappropriation of adviser/fund/broker-dealer assets by, for example, creating fictitious bills and expense items, or receiving kick-backs from a service provider.
  • Safety of customer assets: Examiners will look at whether brokers, funds and advisers have effective policies and procedures for safeguarding their clients’ assets from theft, loss, and misuse. This is a good time for you too to assess controls in this area. Make sure that advisory clients’ money is with a qualified custodian and review prime brokerage relationships. You may want to ensure that the process for sending account statements to clients has controls to ensure that the account statements cannot be intercepted or falsified. Examiners will also continue to focus on controls for compliance with Regulation S-P with respect to customer information.
  • Anti-money laundering: Examiners will look at whether funds and broker-dealers are complying with obligations under the securities laws, the Patriot Act and Bank Secrecy Act to have effective policies and procedures to detect and deter money-laundering activities, whether these policies and procedures are regularly tested for continued effectiveness, and whether actual practices are consistent with the policies and procedures.
  • Compliance, supervision, and corporate governance: While this is the last item I’ll list, it’s the most important — because it underpins all the other compliance responsibilities that firms have. In the coming year, examiners will focus in particular on supervisory procedures and practices at large branch offices of broker-dealers and at advisory branch offices, on supervision and controls over traders, whether funds have appropriately-constituted boards and have considered required matters (e.g., fair value procedures), and whether firms have implemented effective internal disciplinary processes. Also, we’ll examine: firms that advertise themselves as allowing maximum independence to registered representatives; for abuses in transferring customer accounts as registered representatives move to new firms; supervision of producing branch managers; bank broker-dealer branches; and the adequacy of firms’ testing to detect unsuitable or aberrant trades.

For advisers and mutual funds, in that this is the fifth year of both the Compliance Rule and our CCOutreach efforts for adviser and fund CCOs, we hope to see improvements in firms’ compliance programs, and in particular, that significant deficiencies were identified promptly and corrected appropriately by firms.

* * *

These are challenging times, no doubt. The SEC has been and will continue to guard the interests of investors. Industry compliance professionals too play an indispensable role in fostering and assuring investor protection and the integrity of our markets. As I said at the outset, I think that the first thing that you might do in the current environment is to is to remind firm employees of their obligations to investors — for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with investors.

I have shared with you today some of the issues that SEC examiners will be focusing on in the coming months — and these are areas where I hope you too will focus your attention. Finally, you cannot let slip the other ongoing compliance responsibilities that the firm has, and I have described some of these priority areas as well.

I hope this information will be helpful to you in your work, and I look forward to continuing to work with you to help improve and assure strong compliance practices in the securities industry.

Thank you.

Overview of Issues Related to ERISA Hedge Fund Investments

This article outlines the issues which are central to ERISA plans when such plans invest in hedge funds. The information comes from a report prepared by the Government Accountability Office and provides hedge fund managers with a good informational foundation of the issues which matter to ERISA plans. As ERISA is a very important set of federal laws a hedge fund manager should be especially diligent about making sure all proposed transactions are lawful. In a recent ERISA article we discussed how a hedge fund’s assets were frozen because of an unlawful transaction between the hedge fund manager and an ERISA fiduciary .

Please also note that with regard to the article below, HFLB has not prepared any of the items in here but we have added titles and brackets.  A complete copy of the GAO report can be found here.  If a manager has a specific ERISA question the manager should talk to an attorney to discuss the specific facts of the ERISA matter.

ERISA Prudent Man Standard

Private sector pension plan investment decisions must comply with the provisions of ERISA, which stipulates fiduciary standards based on the principle of a prudent man standard. Under ERISA, plan sponsors and other fiduciaries must (1) act solely in the interest of the plan participants and beneficiaries and in accordance with plan documents; (2) invest with the care, skill, and diligence of a prudent person with knowledge of such matters; and (3) diversify plan investments to minimize the risk of large losses. Under ERISA, the prudence of any individual investment is considered in the context of the total plan portfolio, rather than in isolation.*

Hence, a relatively risky investment may be considered prudent, if it is part of a broader strategy to balance the risk and expected return to the portfolio. In addition to plan sponsors, under the ERISA definition of a fiduciary, any other person that has discretionary authority or control over a plan asset is subject to ERISA’s fiduciary standards.** The Employee Benefit Security Administration (EBSA) at Labor [the U.S. Department of Labor] is responsible for enforcing these provisions of ERISA, as well as educating and assisting retired workers and plan sponsors. Another federal agency, the Pension Benefit Guaranty Corporation (PBGC), collects premiums from federally insured plans in order to insure the benefits of retirees if a plan terminates without sufficient assets to pay promised benefits.

* ERISA’s prudent man standard is satisfied if the fiduciary has given appropriate consideration to the following factors (1) the composition of the plan portfolio with regard to diversification of risk; (2) the volatility of the plan investment portfolio with regard to general movements of investment prices; (3) the liquidity of the plan investment portfolio relative to the funding objectives of the plan; (4) the projected return of the plan investment portfolio relative to the funding objectives of the plan; and (5) the prevailing and projected economic conditions of the entities in which the plan has invested and proposes to invest. 29 C.F.R. § 2550.404a-1(b) (2007).

** Under ERISA, a fiduciary is a person who (1) exercises discretionary authority or control over plan management or any authority or control over plan assets; (2) renders investment advice regarding plan moneys or property for direct or indirect compensation; or (3) has discretionary authority or responsibility for plan administration. 29 U.S.C. §1002(21).

Discussion of State Sponsored Plans

In the public sector, governments have established pension plans at state, county, and municipal levels, as well as for particular categories of employees, such as police officers, fire fighters, and teachers. The structure of public pension plan systems can differ considerably from state to state. In some states, most or all public employees are covered by a single consolidated DB [defined benefit] retirement plan, while in other states many retirement plans exist for various units of government and employee groups. Public sector DB plans are not subject to funding, vesting and most other requirements applicable to private sector DB plans under ERISA, but must follow requirements established for them under applicable state law. While states generally have adopted standards essentially identical to the ERISA prudent man standard, specific provisions of law and regulation vary from state to state. Public plans are also not insured by the PBGC, but could call upon state or local taxpayers in the event of a funding shortfall.

Hedge Fund Investments Allowed under ERISA; Due Diligence Required; 25% Threshold

Although ERISA governs the investment practices of private sector pension plans, neither federal law nor regulation specifically limit pension investment in hedge funds or private equity. Instead, ERISA requires that plan fiduciaries apply a prudent man standard, including diversifying assets and minimizing the risk of large losses. The prudent man standard does not explicitly prohibit investment in any specific category of investment.* Further, an unsuccessful individual investment is not considered a per se violation of the prudent man standard, as it is the plan fiduciary’s overall management of the plan’s portfolio that is evaluated under the standard.** In addition, the standard focuses on the process for making investment decisions, requiring documentation of the investment decisions, due diligence, and ongoing monitoring of any managers hired to invest plan assets.

*However, ERISA may indirectly limit a pension plan’s ability to invest in specific hedge funds or private equity funds. Under Labor’s plan asset regulation, if the aggregate investment by benefit plan investors in the equity interest of a particular entity is “significant,” and that equity interest is not (i) a publicly-offered security, (ii) issued by a registered investment company, such as a mutual fund, nor (iii) issued by an operating company, then the assets of that entity are deemed assets of each benefit plan investor (i.e., plan assets). See 29 C.F.R. § 2510.3-101 (2007). As a result, any person who exercises management authority over the entity now deemed to hold plan assets will become subject to ERISA’s fiduciary standards. The equity investments by benefit plan investors are considered “significant” if at any time the aggregate investment of the benefit plan investors represents 25 percent or more of the value of any class of equity in the entity. According to one industry expert, in order to avoid being deemed a plan fiduciary (and assuming all of the liabilities that accompany that status), many managers of hedge funds, which generally are not publicly-traded, not registered investment companies, nor operating companies, carefully monitor the level of investments in the hedge fund by benefit plan investors to ensure that their aggregate investment remains below the 25 percent threshold. Prior to the Pension Protection Act of 2006 (PPA), the calculation of the 25 percent threshold pertained to investments by ERISA plans and certain non-ERISA covered plans, such as public sector and foreign retirement plans. However, in accordance with section 611(f) of the PPA, investments by certain plans, including public sector and foreign retirement plans, are now excluded from the calculation. Pub. L. No.109-280, § 611(f), 120 Stat. 780, 972 (codified at 29 U.S.C. § 1002(42)). This modification may facilitate an increase in the level of investments by pension plans in hedge funds and private equity funds.

**With some exceptions, ERISA does prohibit plans from investing more than 10 percent of plan assets in the sponsoring company’s stock. See 29 U.S.C. § 1107. In addition to requiring plan fiduciaries to adhere to certain standards of conduct, ERISA also prohibits plan fiduciaries from engaging in specified transactions. See 29 U.S.C. § 1106.

Best Practices in Hedge Fund Investing

Although there are no specific federal limitations on pension plan investments in hedge funds, two federal advisory committees have, in recent years, highlighted the importance of developing best practices in hedge fund investing. In November 2006, the ERISA Advisory Council recommended that Labor publish guidance describing the unique features of hedge funds, and matters for consideration in their adoption for use by qualified pension plans.* To date, Labor has not acted on this recommendation. According to Labor officials, an effort to address these recommendations was postponed while Labor focused on implementing various aspects of the Pension Protection Act of 2006.**

However, in April 2008, the Investors’ Committee established by the President’s Working Group on Financial Markets, composed of representatives of public and private pension plans, endowments and foundations, organized labor, non-U.S. institutions, funds of hedge funds, and the consulting community, released draft best practices for investors in hedge funds.*** These best practices discuss the major challenges of hedge fund investing, and provide an in-depth discussion of specific considerations and practices that investors in hedge funds should take. While this guidance should serve as an additional tool for pension plan fiduciaries and investors to use when assessing whether and to what degree hedge funds would be a wise investment, it may not fully address the investing challenges unique to pension plans leaving some vulnerable to inappropriate investments in hedge funds.

*The ERISA Advisory Council was created by ERISA to provide advice to the Secretary of Labor. 29 U.S.C. § 1142.

**The PPA is the most recent comprehensive reform of federal pension laws since the enactment of ERISA. It establishes new funding requirements for DB pensions and includes reforms that will affect cash balance pension plans, defined contribution plans, and deferred compensation plans for executives and highly compensated employees.

***Principles and Best Practices for Hedge Fund Investors: Report of the Investors’ Committee to the President’s Working Group on Financial Markets, April 15, 2008. The President’s Working Group on Financial Markets includes the heads of the U.S. Treasury Department, the Federal Reserve, the SEC, and the Commodity Futures Trading Commission.

How Hedge Funds Report Investments to Labor

Labor does not specifically monitor pension investment in hedge funds or private equity. Labor annually collects information on private sector pension plan investments via the Form 5500, on which plan sponsors report information such as the plan’s operation, funding, assets, and investments. However, the Form 5500 includes no category for hedge funds or private equity funds, and plan sponsors may record these investments in various categories on the form’s Schedule H. In addition, because there is no universal definition of hedge funds or private equity and their strategies vary, their holdings can fall within many asset classes. While EBSA officials analyze Form 5500 data for reporting compliance issues—including looking for assets that are “hard to value”—they have not focused on hedge fund or private equity investments specifically.* According to EBSA officials, there have been several investigations and enforcement actions in recent years that involved investments in hedge funds and private equity, but these investments have not raised significant concerns.

*“Hard to value” assets are those that are not traded on an exchange. “Hard to value” assets may include hedge funds, private equity funds, and real estate. It is difficult to distinguish the type of investment with the information provided. Federal agency officials use the Form 5500 report data to enforce ERISA pension requirements, monitor plan compliance, develop aggregate pension statistics, and conduct policy and economic research.

Other related HFLB articles:

DOL Sues Investment Adviser for Receiving Undisclosed Fees from Hedge Fund

The case below provides a great example of why registered investment advisors and hedge funds need to have competent legal counsel advising them on all aspects and arrangements of their business.  Basically a registered investment advisor (RIA) had a selling arrangement with a hedge fund where the RIA would receive a portion of the performance fees earned by the fund on those assets which the RIA directed to the fund.  The RIA directed ERISA assets and did not disclose the arrangement with the hedge fund.  The DOL is seeking remedial action on many fronts and is asking that the RIA be banned from acting as a fiduciary to ERISA assets in the future.  The SEC has also frozen the hedge fund’s asset.

I am actually shocked by this story.  Not because of what the RIA or the fund did, but because it actually happened.  I would assume that an RIA with over $500 million in assets (including ERISA assets) would have an attorney review all of the transactions which it contemplated.  I am also in disbelief that the hedge fund manager did not run the proposed transaction through its own attorney.  If an attorney had seen this transaction in proposed form, it would not have gone through.  In addition to the potential ERISA issues, there are potential broker-dealer issues for the RIA as it is essentially acting as a broker in this transaction and if the firm is not registered as a broker, there may be more issues the RIA will have to face with the SEC.

This case highlights the importance of having competent legal counsel and discussing all issues and proposed transactions with counsel on a regular basis.  The consequences are real and severe – the fund’s assets are frozen and now both of these firms have sullied names.  The press release can be found here.

Release Date: October 24, 2008
Release Number: 08-1536-SAN
Contact Name: Gloria Della/Richard Manning
Phone Number: 202.693.8664/202.693.4676

U.S. Labor Department sues California investment advisor and executives to recover losses and hidden fees charged to employee benefit plans

San Francisco – The U.S. Department of Labor has sued Zenith Capital LLC of Santa Rosa, California, and its executives for allegedly investing the assets of 13 retirement plan clients in the hedge fund Global Money Management LP while receiving undisclosed incentive fees from the hedge fund’s sponsor and manager.
The lawsuit alleges that Zenith Capital and executives Rick Lane Tasker, Michael Gregory Smith and Martel Jed Cooper violated their fiduciary obligations under the Employee Retirement Income Security Act (ERISA). The defendants allegedly made investment decisions for their ERISA plan clients. From April 1999 to September 2003, the defendants caused the plans to invest in Global Money Management and received undisclosed incentive fees from LF Global Investments LLC, the general partner and manager of Global Money Management.

In 2004, Zenith Capital LLC was a registered investment advisor with 1,214 clients and approximately $538 million in assets under management. In addition to paying Zenith incentive fees not disclosed to the 13 ERISA plan clients, LF Global held an ownership interest in Zenith. The U.S. Securities and Exchange Commission has frozen the remaining assets of Global Money Management and secured the appointment of a receiver.

The Labor Department’s suit seeks a court order requiring the defendants to restore all losses owed to the plans, requiring them to undo any transactions prohibited by law and permanently barring them from serving in a fiduciary or service provider capacity to any employee benefit plan governed by ERISA. The suit was filed in the U.S. District Court for the Northern District of California.

“We will vigorously pursue investment advisors who try to line their own pockets by illegally steering pension investments. Fiduciaries must invest solely in the interests of the workers to whom these funds ultimately belong,” said Bradford P. Campbell, assistant secretary for the Labor Department’s Employee Benefits Security Administration (EBSA).

The suit resulted from an investigation conducted by the San Francisco Regional Office of EBSA as part of EBSA’s Consultant Adviser Project. Employers and workers may contact EBSA’s San Francisco office at 415.625.2481 or toll-free at 866.444.3272 for help with problems relating to private sector pension and health plans. In fiscal year 2007, EBSA achieved monetary results of $1.5 billion related to pension, 401(k), health and other benefits for millions of American workers and their families.

Zenith Capital LLC, Civil Action Number C-08-4854 (EMC)

U.S. Department of Labor news releases are accessible on the Department’s Newsroom page. The information in this news release will be made available in alternate format (large print, Braille, audio tape or disc) from the COAST office upon request. Please specify which news release when placing your request at 202.693.7828 or TTY 202.693.7755. The Labor Department is committed to providing America’s employers and employees with easy access to understandable information on how to comply with its laws and regulations. For more information, please visit the Department’s Compliance Assistance page.

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Please contact us if you have any questions or need to contact a hedge fund attorney.

Hedge Fund Side Letters

The side letter is one of the most important items for a hedge fund manager.  While the hedge fund will run pursuant to the terms of the hedge fund offering documents drafted, the side letter will give the manager some flexibility to go outside the terms of the documents for certain investors.

A hedge fund side letter is simply an agreement between the hedge fund manager and the investor that outlines different terms that will apply to the investor’s investment into the fund.  The side letter is drafted by the hedge fund attorney and will be signed by the investor at the same time that the investor signs the hedge fund subscription documents.

Overview of side letter provisions

Below are some of the reasons a hedge fund manager may use a side letter arrangement

Reduced Fees – the hedge fund manager will reduce or waive the management fees or performance fees for the investor.

Lock-up and liquidity – the hedge fund manager may reduce or waive the lock-up for a specific investor.  The manager may also allow for greater liquidity (i.e. monthly withdrawals instead of quarterly withdrawals).

Information – the manager may agree to provide an investor with greater informational rights such as the ability to request a description of the exact positions of the fund at any given time.

Most favored nation’s clause – this allows an investor to get the best deal that the manager gives to any other investor.  This clause is usually reserved for very large or very early investors.

There are many different ways which any of the above concepts can be implemented into the side letter and generally it will depend on the business points negotiated by the manager and the investor.  As an alternative to a hedge fund investment and side letter arrangement, an investor may simply enter into a separately managed account (known as a “SMA”) arrangement with the hedge fund manager.

Side letters and raising money for the hedge fund

The hedge fund side letter can be an important tool for raising assets.  Typically the letter will be used to entice early investors to invest in the fund; it can also be used to attract investors who will contribute a large amount of assets to the fund.  The side letter can also be used to try to get a current investor to contribute more assets to the fund.

What the SEC says about side letters

During the late part of 2007 and the early part of 2008, there was a lot of chatter within the hedge fund industry that the SEC would increase its investigation of hedge fund side letters.  Presumably they would have tried to accomplish this through audits of hedge fund managers registered as investment advisors.  While there was much concern within the industry at the time, that concern has subsided as the market events of 2008 began to take on greater importance.

Testimony from SEC regarding hedge fund side letters

The following comes from testimony by a SEC official to Congress regarding hedge funds and side letters:

Side Letter Agreements. Side letters are agreements that hedge fund advisers enter into with certain investors that give the investors more favorable rights and privileges than other investors receive. Some side letters address matters that raise few concerns, such as the ability to make additional investments, receive treatment as favorable as other investors, or limit management fees and incentives. Others, however, are more troubling because they may involve material conflicts of interest that can harm the interests of other investors. Chief among these types of side letter agreements are those that give certain investors liquidity preferences or provide them with more access to portfolio information. Our examination staff will review side letter agreements and evaluate whether appropriate disclosure of the side letters and relevant conflicts has been made to other investors.

ERISA considerations

Hedge funds which are ERISA hedge funds will need to be careful about their side letter activities and should always consult with their hedge fund attorney before entering into such arrangements.  Specifically, the Department of Labor is concerned about different informational rights, especially with regard to plans which have subordinated rights.

If you have any questions regarding side letters, please contact us.