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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:

San Francisco Hedge Fund Industry Event

BAHR Panel Discussion on Global Investing Trends
By Bart Mallon of Cole-Frieman & Mallon LLP

The Bay Area Hedge Fund Roundtable convened again today at the Sens Restaurant in San Francisco to discuss the global investing trends and how those trends are affecting the hedge fund industry. The presentation was moderated by Ron Resnick (ConselWorks LLC) and included the following panel participants:

John Burbank (Passport Capital LLC)
John Shearman (Albourne America, LLC)
Matt Kratter (Kratter Capital LLC)
Patrick Wolff (Clarium Capital Management, LLC)

Overall the panel discussion was very interesting and I think that Ron did a very good job of moderating in a kind of “Meet the Press” type of way. The speakers all had interesting viewpoints and were able to keep the audience interested in the topics. Below I will give a very high level run-down of the major topics discussed – if anything does not make sense, it is likely a mistake in my hearing so please do not hold that against any of the speakers.

Additional note: this is not in any way an advertisement for any hedge fund and is not an offering of any interests in a hedge fund. I have never talked to any of the named speakers and everything I am writing below is on my own volition.*


John Burbank

The discussion was started when Ron asked John was his fund was investing in. John said that he is now investing in the United States in the same stuff as he was before. However, he spent a good deal of time discussing liquidity and how it will affect investment decisions going forward. Central to his discussion were his views on deflation. He ended this part of the discussion by noting that governments (especially the U.S. government) has so many tools to effect the financial markets (in addition to simply printing money) and that many actions are driven by the current liquidity situation.

Matt Kratter

I infer that Matt started his own hedge fund last year because he was asked whether it was a good or a bad time to start a hedge fund within the last twelve months. He noted that it was not the best time to be on your own but that the times serve as a good proving ground that a manager can withstand market downslides. Matt talked about variability of inflation going forward and that he is currently net short. He thinks that multiples are likely to retract in the future.

John Shearman

John was asked whether investor’s hedge fund expectations have changed. He said that investor expectations have come down a bit, but beleives that the forcase for the future has never been better. Post 2008 he sees that there has been a shifting of power back to hedge fund investors and he mentioned two buzzwords – lower fees and transparency. While fees have not really come down recently, there have been huge gains made in expectations of transparency. This is especially true with regard to valuation and verification of assets. Hedge funds have made these changes and it is relatively easy for them to say yes to such requests (as opposed to requests for fee decreases).

John seemed to indicate that there is more opportunity for investors to come together and present a united front with regard to what they want to see in these vehicles, but it has just not happened. A central reason is that foundations and endowments (two of the largest groups of hedge fund investors) are not really in a position to be an agent of change because they are examining the funds they are already invested in. He also mentioned a general increase in separately managed accounts noting that the central driving force is the investor’s need for control of assets – liquidity without conditions.

Patrick Wolff

Patrick was asked point blank while his group did not do as well this year. He said that, unfortunately, they had the wrong investments this year and that the drawdown was not a result of their risk management policies and procedures. Patrick talked about macro themes including China, volitility, carry trades over the last year and the fundamentals of major government players (centrally China and the U.S.). He feels there is a current bubble in China which is likely to last in the near term. He thought that a major macro issue moving forward will be how the governments will continue to be involved in the credit markets. Patrick believes that the U.S. has huge off balance sheet liabilities.

Other Question and Answers

What are the major trends moving forward?

John Burbank – governments changing the rules of the game as it is being played. What is going to happen will be driven by governments subject to: the price of the dollar, commodities, or China.

Why did gold hit an all-time high today?

Matt Kratter – I don’t know, but this is a question which everyone is asking – even the garbageman.

How is capital flowing?

John Shearman – there are a lot of opportunities in hedge funds – lots of alpha and distressed assets. Macro discretionary is a good play right now and there is a lot of interest in commodities.

How is fund raising in this environment?

Matt Kratter – fundraising has been slow since last year but there is more activity at the margins. Fundraising will probably stay difficult for awhile.

Are investors more interested in the investment side or infrastructure side during due diligence conversations?

John Burbank – all investor due diligence is taking longer. Current investors are coming back and asking questions they should have asked earlier. It is now similar to 2003 – there is a lot of excitement. Which makes sense because investors essentially have three choices: mutual funds, do-it-yourself, or hedge funds.

[Someone mentioned that capital is not there for a start up and the question arose as to whether two guys and a Bloomberg really had a chance to raise capital in this environment. John said that start up managers should not be afraid to start out small – he started with about $1MM in AUM and slowly grew to $12MM after three years (his firm now manages over $2 billion). John emphasized that over time good managers will be able to demonstrate their strategy and if the numbers are good, investors will eventually find such managers.]

What about hedge fund regulation?

Patrick Wolff – over hedge fund regulation is not a huge deal. If you are registering with the SEC you are going to be required to do things that, as a good business, you should be doing anyway. The key to regulation is that it needs to be sensible. Regulation itself is not bad.

Questions from the audience

When Ron asked the audience if there were any questions there was a long pause. I eventually asked the panel what they thought about the headlines recently regarding the U.S. dollar and whether it would remain the world’s reserve currency. Patrick responded first that worry about the dollar is overhyped. However, he did note that his fund has had some investors request share classes in a different currency.** John noted the practical limitations of moving toward another currency and noted that if a government needs to get a billion U.S. dollars it can happen, but that wouldn’t be the case with other currencies.

Note on People Who I Met

After the panel there was time to discuss the presentation and do some networking. I had the distinct pleasure of talking with a number of people at the event, including:

  • Jenny West of Probitas Partners (fund placement services)
  • Mason Snyder of Catalina Partners (risk advisory to investment management industry)
  • Rosemary Fanelli of CounselWorks (regulatory consulting for financial institutions)
  • Ron Resnick of CounselWorks(regulatory consulting for financial institutions)
  • Maria Hall of M.D. Hall & Company (CPA services for small funds)

* If you are a named speaker and would like your name and information taken out of this article, please contact me.

** I am in the process of writing an article on this topic – if you are a hedge fund manager who wants to create another class of fund interests denominated in another currency, please feel free to contact me to discuss.


Bart Mallon, Esq. of Cole-Frieman & Mallon LLP 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 register as an investment advisor, please contact us or call Mr. Mallon directly at 415-868-5345.  Other related hedge fund law articles include:

Raising Hedge Fund Capital is Not Easy

I have written before that the biggest issue start-up and emerging hedge fund managers face is raising capital for their funds.  I seem to have the same conversation on a weekly basis – the “how to do I grow my fund” conversation.  Unfortunately I do not have the guaranteed step-by-step guide to raising boatloads of capital, but that is not to say that smaller managers cannot raise capital.  I have seen plenty of groups who have made it over the proverbial hump by working ridiculously hard.

The article below (written by Richard Wilson of Hedge Fund Blogger) discusses some ideas that managers will want to consider when developing a program to raise hedge fund capital.  Richard’s group provides consulting services and helps managers to raise money for their hedge funds.


This is Bad News: There is NO Magic Bullet
Richard Wilson

The bad news is there is no magic bullet to raising capital. I spoke with at least a dozen managers this past week at our Hedge Fund Premium networking event in Chicago. Most were looking for capital raising help of some type and we discussed many roadblocks that managers are seeing between them and the AUM levels they are trying to achieve.

Our firm provides some capital raising tools, but I believe that daily action and discipline is the best thing that a fund can do to raise capital. They must take responsibility for marketing their fund and have someone reaching out to new investors on a daily basis, if they do not they will forever remain in the bottom 20% of the industry in terms of assets. Very few funds gain their initial assets through a super powerful third party marketing firms, third party marketers like to typically work with managers which have some AUM momentum or foundation underneath them.

To raise capital I believe that managers need to have superior tools and processes when compared to their competitors. This means superior investor cultivation processes in place, superior investor relationships management, superior marketing materials, superior outreach efforts, superior email marketing, and superior focus on investors which actually have the potential of making an investment. Each of those topics mentioned above could be discussed for a whole conference and all of these moving parts need to be in place to compete in today’s industry. While this does not mean you need to out-spend others you do need to strategically plan your marketing campaign.

There is a good quote that I heard which goes something like “If you want to have what others don’t you have to do what others won’t” In other words if you want to grow assets you must put in the extra work, planning, and strategy that others skip over.

Every morning I try to listen to a 45 minute custom MP3 audio session of business lessons, marketing tips and positive thinking notes. One great quote I hear every morning by our friend Brian Tracy, “Successful people dislike to do the same things that unsuccessful people dislike to do, but successful people get them done anyways because that is what they know is the price of success.” This is connected to an interview Brian conducts in which a multi-millionaire says that success is easy, “you must decide exactly what it is you want, and then pay the price to get to that point.”

All of this may sound wishy washy or non-exact but I think it is very important to realize that there is no one single magic bullet for raising capital. It takes hard work, trial and a superior effort on all fronts to stand out from your competition.

Read dozens of additional articles like this within our Marketing & Sales Guide.

– Richard


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.

Securitizing Life Settlement Investments

New Investment Opportunities for Hedge Funds

A recent New York Times article discusses how some investment banks are planning to securitize life settlement policies.  The article explains that there is likely to be a strong demand for such securities.  Much like the securitization of mortgages, life settlement securities would have different tranches which would have different risk profiles.

We have talked earlier about the definition of life settlements and about life settlement hedge funds.  Over the past couple of months I have talked with a number of people involved in this aspect of the alternative investment industry and it seems to continue to be quite a lively little niche.  I believe that if these investments are securitized, this new asset class will be attractive for some hedge fund managers – either as a central investment program or as a compliment to their current hedge fund investment program.

It will be interesting to see how this plays out and how the SEC and various states will react.


Other articles related to hedge funds and life settlements 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 (including a fund focused on life settlement investments or premium finance), please call Mr. Mallon directly at 415-296-8510.

Investment Advisory Fees | Hedge Fund Performance Fees and Management Fees

Review of State Investment Advisory Fee Rules

One of the things I have tried to emphasize within this blog is that there is no “one size fits all” legal solution to hedge fund formation.  Each client/manager has a unique set of circumstances and will be subject to a potentially different sets of laws or regulations depending on those circumstances.  This is especially true with regard to those managers who must register in a state that requires hedge fund manager registration.  Because no two sets of state laws and regulations are the same, the manager must make sure that he understands the rules which are specific to his state.

High Asset Management Fees and Disclosure

One issue which comes up every now and again is whether or not disclosure will be required when the manager charges an annual asset management fee in excess of 3% of AUM.  Generally regulators will require that certain disclosures be made to investors through the manager’s disclosure documents (generally in both the Form ADV and the hedge fund offering documents).  Sometimes the regulator will require such disclosures based on a general provision (see CO IA fee rule discussion below) or on more explicit provisions (see 116.13(a) of the Texas Administrative Code).  In either case managers will generally be required to make a prominent disclosure to investors that a 3% (or higher) annual asset management fee is in excess of industry norms and that similar advisory services may be obtained for less (whether or not this is true).  While such a disclosure would, in most instances, be a best practice, managers should be aware that it may also be required if they are registered with a particular state.

State Performance Fee Rules

Like management fee disclosures, the rules for performance fees may differ based on the state of registration.  For example, here are how four different states deal with performance fee issue:

Texas – Like most states, Texas allows state-registered investment advisers to charge performance fees only to those investors in a fund which are “qualified clients” as defined in Rule 205-3 of the Investment Advisers Act. This means that a hedge fund manager can only charge performance fees to investors in the fund which have a $1.5 million net worth or who have $750,000 of AUM with the manager (can be in the fund and through other accounts).  See generally  116.13(b) of the Texas Administrative Code reprinted below.

New Jersey – Many states adopted laws and regulations based on the 1956 version of the Uniform Securities Act and have yet to make the most recent update to their laws and regulations (generally those found in the 2002 version of the Uniform Securities Act).  Under the New Jersey laws a manager can charge performance fees to those clients with a $1 million net worth.

Indiana – similar to New Jersey, Indiana has laws which allow a manager to charge performance fees to those investors with a $1 million  net worth.  Additionally, Indiana allows a manager to charge performance fees or to those investors who have $500,000 of AUM with the manager (can be in the hedge fund and through other separately managed accounts).  Indiana also has an interesting provision which specifies the manner in which the performance fee may be calculated – it requires that the fee be charged on a period of no less than one year.  This rule is based on an earlier version of SEC Rule 205-3.  What this means, essentially, is that managers who are registered in Indiana cannot charge quarterly performance fees, but must charge their performance fees only on an annual basis (or longer).

Michigan – Unlike any other state, Michigan actually forbids all performance fees for Michigan-registered investment advisors.  The present statute is probably an unintended consequence of some sloppy drafting.  Nonetheless, it is a regulation on the books.  Hedge Fund Managers registered with Michigan, however, should see the bright spot – Michigan is in the process of updating its securities laws and regulations.  This means that sometime in late 2009 or early 2010 it should be legal for investment advisors in Michigan to charge their clients a performance fee under certain circumstances (likely to mirror the SEC rules).

New York – Sometimes, states will have some wacky rules.  In the case of New York, there are no rules regarding performance fees.

Other Issues

With regard to performance fees, the other issue which should be discussed with your hedge fund lawyer is whether or not the state “looks through” to the underlying investor to determine “qualified client” status.  Generally most states will follow the SEC rule on this issue and look through the fund to the underlying investors to make this determination.

While these cases are just a couple of examples of the disparate treatment of similarly situated managers, they serve as a reminder that investment advisor (and securities) laws may differ wildly from jurisdiction to jurisdiction.  Managers should be aware of the possibility of completely different laws and should be ready to discuss the issue with legal counsel.

The various rules discussed above have been reprinted below.


Texas Rule

The full text of the Texas IA fee rules can be found here and are copied below.

§116.13.Advisory Fee Requirements.

(a) Any registered investment adviser who wishes to charge 3.0% or greater of the assets under management must disclose that such fee is in excess of the industry norm and that similar advisory services can be obtained for less.

(b) Any registered investment adviser who wishes to charge a fee based on a share of the capital gains or the capital appreciation of the funds or any portion of the funds of a client must comply with SEC Rule 205-3 (17 Code of Federal Regulations §275.205-3), which prohibits the use of such fee unless the client is a “qualified client.” In general, a qualified client may include:

(1) a natural person or company who at the time of entering into such agreement has at least $750,000 under the management of the investment adviser;

(2) a natural person or company who the adviser reasonably believes at the time of entering into the contract:  (A) has a net worth of jointly with his or her spouse of more than $1,500,000; or (B) is a qualified purchaser as defined in the Investment Company Act of 1940, §2(a)(51)(A) (15 U.S.C. 80a-2(51)(A)); or

(3) a natural person who at the time of entering into the contract is: (A) An executive officer, director, trustee, general partner, or person serving in similar capacity of the investment adviser; or (B) An employee of the investment adviser (other than an employee performing solely clerical, secretarial, or administrative functions with regard to the investment adviser), who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar function or duties for or on behalf of another company for at least 12 months.

CO Rule

The full text of the Colorado laws and regulations can be found here.  The fee discussion is reprinted below.

51-4.8(IA) Dishonest and Unethical Conduct


A person who is an investment adviser or an investment adviser representative is a fiduciary and has a duty to act primarily for the benefit of its clients. While the extent and nature of this duty varies according to the nature of the relationship between an investment adviser and its clients and the circumstances of each case, an investment adviser or investment adviser representative shall not engage in dishonest or unethical conduct including the following:

J. Charging a client an advisory fee that is unreasonable in light of the type of services to be provided, the experience of the adviser, the sophistication and bargaining power of the client, and whether the adviser has disclosed that lower fees for comparable services may be available from other sources.

New Jersey

The full text of the New Jersey performance fee rules can be found here and are copied below.

13:47A-2.10 Performance fee compensation

(b) The client entering into the contract subject to this regulation must be a natural person or a company as defined in Rule 205-3, who the registered investment advisor (and any person acting on the investment advisor’s behalf) entering into the contract reasonably believes, immediately prior to entering into the contract, is a natural person or a company as defined in Rule 205-3, whose net worth at the time the contract is entered into exceeds $1,000,000. The net worth of a natural person shall be as defined by Rule 205-3 of the Investment Advisors Act of 1940.



The Indiana rule can be found here and is reprinted below.

(f) The client entering into the contract must be either of the following:

(1) A natural person or a company who immediately after entering into the contract has at least five hundred thousand dollars ($500,000) under the management of the investment adviser.

(2) A person who the investment adviser and its investment adviser representatives reasonably believe, immediately before entering into the contract, is a natural person or a company whose net worth, at the time the contract is entered into, exceeds one million dollars ($1,000,000). The net worth of a natural person may include assets held jointly with that person’s spouse.


The current law (until October 1, 2009) can be found here and is copied below.

451.502 Investment adviser; unlawful practices.

(b) It is unlawful for any investment adviser to enter into, extend, or renew any investment advisory contract unless it provides in writing all of the following:

(1) That the investment adviser shall not be compensated on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client.

New York

No laws regarding performance fees for state registered investment advisers.


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, Cole-Frieman & Mallon LLP, 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.

Deal Book: New Hedge Fund with Questionable Name

The New York Times Deal Book today ran a story about a new hedge fund named Ground Zero Strategic Commodities.  The author of the story noted that:

Putting the words “Ground Zero” in a hedge fund name may disturb many people as it undoubtedly conjures up images of the site where the World Trade Center was destroyed nearly eight years ago.

We agree.  Raising assets for hedge funds can be hard enough – a manager should try to choose a name for their fund that is not likely to put off potential investors.  We have written about hedge fund names before and while it is always advisable to try to have a name which represents the manager or strategy or outlook in some way, it should not be a distraction.


Other related hedge fund law articles include:

The Future of Hedge Funds: A Look at the Industry and Opportunities for Women

What the Future Holds for Women in the Hedge Fund Industry

Occasionally we will have readers submit potential articles for publication on this website which is the case with the post below.  If you are interested in having your article re-published on our website, please contact us.

Hedge Fund Research, Inc. (HFRI) recently conducted a study that shows a recent increase in quarterly assets invested in the hedge fund industry as well as a rise in the number of funds.   This data leads some experts to remain hopeful that the industry as a whole can sustain the impact of the financial crisis, and it begs the question as to how newcomers to the industry will be impacted by the new the impetus for regulation and transparency.

Kelly Chesney, and industry expert and co-founder of a well-known investment management company, maintains that the move towards regulation and transparency will be a good thing for the industry as a whole, but the cost of such regulation may raise the barrier to for women trying to enter a largely male-dominated industry. Currently, only three percent of hedge funds are led by women.  Opinions vary as to how the high costs of running a fund will impact women trying to enter the industry and run their own business. Typically, smaller and newer funds will have a more difficult time trying to keep up with the rising costs of compliance given their relatively low assets under management. Opinions vary as to how the high costs of running a fund will impact women trying to enter the industry and run their own business.  Some experts, like Chesney, remain hopeful that opportunities do exist out there for women and perhaps the future will find more female hedge fund managers than we see today.

The article published by The Glass Hammer can be found here and is also reprinted in full below.


The Future of Hedge Funds

by Liz O’Donnell (Boston)

New data from Hedge Fund Research, Inc., (HFRI) shows assets invested in the industry increased by $100 billion in the second quarter of 2009, ending at $1.43 trillion. This is the first quarterly increase in assets since second quarter of 2008. HFRI attributes the growth to gains shown during the quarter. The HFRI Fund Weighted Composite Index returned 9.13 percent. This is the best quarterly gain since the last quarter of 1999, although still below the highest peak, reached in 1997. And while investors are still redeeming capital, the pace of the redemptions has slowed from recent years.

But looking past the most current returns, what does the future hold for the hedge fund industry given the tremendous impact of the global financial crisis and amid discussions of government regulations? And what about the outlook for women? Will the recent inflow mean more opportunities or will women still be virtually missing from the industry this time next year?

“Right now hedge funds are a hot topic,” says Kelly Chesney, principal and co-founder of Pluscios Management LLC, a women-owned investment management firm. “I think they really got some negative press and sentiment last year and they are starting to turn around. There is more publicity when hedge funds don’t perform well, but they did much of what was expected.”

Following what she calls “an economic tsunami”, Chesney, and others, see consolidation and regulation as key issues that will impact the industry. “I think it will be choppy and we’ll have various events happen over the next few years. We need to be nimble and adaptive and hedge funds are good at that,” Chesney says.

Certainly the industry has already seen the beginnings of consolidation. After a rapid growth spurt, (the number of funds grew from 610 in 1990 to approximately 9,000 today) 15 percent of funds have disappeared. State Street, in its recently released report “Alternatives: New Views of the Hedge Fund Industry” says that half of all hedge funds may disappear before the crisis shakes out.

Eloise Yellen Clark, founder and CEO of OmniQuest Capital LLC, agrees consolidation will be a continuing trend. “More and more money is going to the bigger players where traditionally there was a bunch of little players. It gets awfully expensive for smaller (funds) to survive.”

As far as what the future holds, Clark says, “Everybody’s talking regulation. I really don’t think it’s a big deal and I think it’s a good idea.” Clark points out that many hedge funds and many managers are already registered with the SEC. She believes more regulation around the issue of transparency would be valuable. Of course, just how far the government takes regulation could be an issue. “On the whole, reasonable regulation that respects fair markets is good. Transparency is good. But limiting the ability to buy and sell is bad,” said Clark.

Chesney says “absolutely” regulation will be a factor moving forward. “It’s not like there hasn’t been regulation.” But that regulation could increase. “It depends on what it is,” she says. “It could be wide ranging — from every fund must register—or it could be a ban on short selling.”

Some funds are “hedging” their bets. Aimee McCarty, marketing director for Ascentia Capital Partners, LLC, says her firm closed its hedge fund and now offers a mutual fund. According to McCarty, the new product combines the benefits of hedge funds with the features of mutual funds to offer a product that is “regulated, transparent, and liquid.” AQR Capital Management LLC added a mutual fund to its product offering earlier in the year.

Diversification might spell survival for some financial firms. Chesney believes it will get more expensive to run a fund, as compliance with regulations will add a new level of management. “There will be a higher barrier to entry,” she says.

That high cost of entry might not bode well for women. Already, there are very, very few women in the hedge fund industry. Currently only three percent of hedge funds are led by a woman. A recent report from The National Council for Research on Women, which we reported on here , asserts that one of the major reasons there are so few women in the industry is that gaining access to capital is harder for women than it is for men.

Chesney says,

“Typically women who get frustrated in other industries go out and start their own thing. But it’s tougher for women on Wall Street (because of) getting assets to manage.” None the less, Chesney is hopeful about the future of women in hedge funds. “I think there are going to be a lot of opportunities.”

Clark, who currently sees very few women in the business, says: “It’s my belief that women are different in business than men. Any organization that combines that is optimal.”

Chesney agrees. “Key in any fund management is diversification.” Whether that diversification extends beyond the fund and to the fund managers, is still to be seen.


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

Hedge Fund Hotels

Office Space, IT, Trading For Start up Hedge Funds

The term hedge fund hotel generally describes the offering of office space, IT and consulting services (including, potentially, capital introduction) for start up hedge fund managers.  Most of these relationships are established as turn-key solutions for managers which provide them the back-office infrastructure to run a hedge fund without the headaches of managing the development and maintenance of such infrastructure.  Many times the rent is discounted and the managers are encouraged to utilize the services of the group that is providing the hedge fund hotel.  Groups which typically provide these hedge fund hotel relationships include prime brokers, banks, and other hedge fund service providers or consultants.  These relationships are not without controversy and

Issues with Hedge Fund Hotels

One of the major issues with hedge fund hotels is that they will pay below market rate for office space and IT which implicates issues is similar to soft dollar issues.  Managers who use soft dollars need to be very cognizant of the conflicts of interest which may arise in soft-dollar contexts, especially if the manager has any ERISA fiduciary duties.  Likewise, managers who have hotel relationships need to be cognizant of issues related to conflicts of interests with regard to brokerage and execution.  Because managers will normally choose (and periodically review) their brokers based on a variety of criteria (such as pricing/speads/commissions, execution of orders, financial strength of the broker, available research, etc.), the fact that they receive (in certain cases) reduced rent should not influence the manner in which they decide upon brokerage.  In theory it is easy to say, but in practice it is hard to do.  As such, there have been a few recent controversy’s which have acknowledge the potential conflict of interest issues with these relationships.

Hedge Fund Hotel Controversy

In 2007 the Massachusetts Securities Division filed an action against UBS for its activities related to it running a hedge fund hotel.  Below are a couple of excerpts from the UBS Hedge Fund Hotel Administrative Complaint:

Other than hedge fund adviser, prime brokers are the primary third party service providers to hedge funds.  Prime brokers provide a suite of services essential to the successful implementation of hedge funds’ individual objectives.  Prime Brokers generate substantial revenue from those hedge fund clients in exchange for these services.  UBS competes for prime brokerage revenue in part by providing a range of benefits to the advisers of those hedge fund clients to induce the advisers to bring and keep the hedge fund business with UBS.  Among the methods UBS used to influence or reward hedge fund advisers and their principals are: Provision of office space to hedge fund advisers at rates that are substantially below market rate; Free access to information technology personnel and other office personnel; Introductions to potential new clients (that would increase management fees for the adviser); Low interest personal loans; and Tickets to sporting events and other forms of entertainment.

Unbeknownst to the pension funds, university endowments, charitable foundations, institutional investors and individuals who invest in hedge funds, the rewards for the hedge fund advisers come implicit and sometimes explicit quid pro quos.  UBS requires the hedge fund advisers to cause the hedge funds they manage to meet certain benchmarks of profitability for UBS or ensure they do not use other prime brokers.

Page 2-3 of the complaint

Later on in the complaint, the Enforcement Section of the Massachusetts Securities Division provides the following definition of prime brokerage and the fees generated by prime brokers.

“Prime Brokerage is a service provided by certain broker-dealers to facilitate the clearance of securities trades and other services to substantial retail and institutional customers, including hedge funds.  The services offered by Prime Brokers may include: trading, securities lending, margin lending, customized reporting; research; valuation; technology; operations services; and other services needed by hedge funds or other large clients.

Prime Brokers generate revenue on hedge fund business from commissions, spreads, administrative fees, ticket charges, stock loans and credit interest earned from providing position financing and arranging securities loans (“Prime Fees”).

In the Prime Brokerage relationship, the client who pays the Prime Fees is the hedge fund.  The Hedge Fund Adviser is an agent of the hedge fund, acts on behalf of the hedge fund and has fiduciary duties to the hedge fund.

Page 9 of the complaint


Hedge fund hotels actually can provide valuable services to start up hedge funds during a very important part of the hedge fund life cycle.  However, there are a number of disclosure issues which must be addressed and which should be discussed in detail in the hedge fund offering documents.  The managers should discuss their brokerage/hotel relationship with their hedge fund attorney who will help them to identify and properly disclose the various compliance and conflicts issues which may be present.  Additionally, when a hedge fund and manager reaches a certain place in the fund growth/lifecycle, they may want to explore paying market rates for their space and/or moving to another location.  These issues should be contemplated by management in consultation with the hedge fund attorney.


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.

Hedge Funds and Rehypothication

Ongoing Legal Issues For Hedge Fund Managers

While many of the posts on this blog deal with start-up and regulatory issues that hedge fund managers face, we also are aware that there are many ongoing legal issues which affect the business of the fund.  Below is a guest post from Karl Cole-Frieman on hedge fund rehypothication and the prime brokerage relationship.


What is Rehypothication?
By Karl Cole-Frieman, www.colefrieman.com

One of the most frequent questions that I am asked these days is to explain the term “rehypothication” in the context of a prime brokerage agreement.  The concept of rehypothication has been imbedded in the credit arrangements of prime brokerage agreements for years, but until 2008 and the collapse of Bear Sterns and Lehman Brothers, it was rarely discussed (except by certain lawyers who negotiate these agreements).  In the simplest terms, hypothication is the posting of securities or other collateral to a prime broker in exchange for credit or margin.  Rehypothication is the further pledging or lending by the prime broker of the already hypothecated securities or other collateral by the customer for its own purposes.

Prime Brokerage and Rehypothication

In modern prime brokerage, rehypothication is deeply ingrained in the business model of the major prime brokers.  Typically, hedge fund customer assets are rehypothicated to other banks to raise cash for the prime brokers.  Allowing the prime brokers to rehypothicate assets has historically kept down the cost of borrowing money for hedge fund managers.  In recent years, hedge funds have benefited from this arrangement by obtaining very cheap margin pricing.

Bankruptcy of a Prime Broker

The problem for hedge fund managers is that if there is a bankruptcy filing of their prime broker, hedge funds may have difficulty getting their rehypothicated assets back, particularly if these assets are held by the prime broker’s London affiliate, as the UK has more relaxed rules regarding rehypothication.  A number of highly successful managers had to literally shut their doors in September 2008 because their assets were tied up in Lehman Brothers’ London affiliate.  Lehman filed for bankruptcy in September 2008, and Pricewaterhouse Coopers, Lehman’s European administrator, currently estimates that assets may be returned to clients in the first quarter of 2010 – a year and a half later.

Hedge Fund Managers and Rehypothication

It is important for hedge fund managers to understand this concept of rehypothication for several reasons.  First, managers need to take ownership of their prime brokerage arrangements and understand them in general.  It has been my experience that many managers that take extreme care in making portfolio decisions pay absolutely no attention to their prime brokerage or custody arrangements.  As the events of 2008 demonstrated, they do so at their peril.  Imagine being up for the year, and then losing everything because the manager neglected to monitor their prime brokerage and custody arrangements.

Second, investors are asking about it.  The concept of rehypothication entered the hedge fund vernacular in 2008 and is here to stay.  Investors now frequently ask about rehypothication, and other prime brokerage concepts/arrangements, in due diligence, and there are a lot of misconceptions about the term.  Nevertheless, especially in the current environment, a lack of understanding about prime brokerage, custody, etc . . . can make the difference in receiving an allocation from an investor or cause a manager to fail operational due diligence.  Managers need to be prepared to discuss these concepts and be aware of the terms in their own prime brokerage agreements.

To find out more about rehypothication and other topics relating to prime brokerage or custody, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or [email protected]


Other related hedge fund law and start up articles include:

SEC Supports Private Funds Transparency Act of 2009

Testimony Concerning Regulating Hedge Funds and Other Private Investment Pools

The SEC released a testimony from Andrew J. Donohue before the U.S. Senate about the regulation of hedge funds and other private investment pools.  According to Mr. Donohue’s statement, securities laws have not kept pace with the growth market and thus the SEC has very little oversight authority over these advisors and private funds with regards to conducting compliance examinations, obtaining material information, etc primarily because these requirements only apply to those advisors  and entities registered with the SEC.  Because advisors to private funds have the option to ‘opt out’ of registration, they can easily bypass any monitoring and oversight. The Commission strongly supports the enforcement of the new Private Funds Transparency Act of 2009,* which attempts to close this regulatory gap by requiring advisors to private funds to register under the Advisers Act if they have at least $30 million of assets under management.  The Commission also notes that in order to be effective, the new regulatory reform should acknowledge the differences in the business models pursued by different types of private fund advisers and should address in a proportionate manner the risks to investors and the markets raised by each.

The various compliance requirements on advisors to private funds as set forth by this new legislation is outlined in the testimony, reprinted in full below.

*Note: this testimony was given the same day that the Treasury announced the Private Fund Investment Advisers Registration Act of 2009 which is very similar to the Private Funds Transparency Act of 2009.


Testimony Concerning Regulating Hedge Funds and Other Private Investment Pools
by Andrew J. Donohue
Director, Division of Investment Management
U.S. Securities and Exchange Commission

Before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs
July 15, 2009

Chairman Reed, Ranking Member Bunning and Members of the Subcommittee:

I. Introduction

Thank you for the opportunity to testify before you today. My name is Andrew Donohue, and I am the Director of the Division of Investment Management at the Securities and Exchange Commission. I am pleased to testify on behalf of the Commission about regulating hedge funds and other private investment pools.1

Over the past two decades, private funds, including hedge, private equity and venture capital funds, have grown to play an increasingly significant role in our capital markets both as a source of capital and the investment vehicle of choice for many institutional investors. We estimate that advisers to hedge funds have almost $1.4 trillion under management. Since many hedge funds are very active and often leveraged traders, this amount understates their impact on our trading markets. Hedge funds reportedly account for 18-22 percent of all trading on the New York Stock Exchange. Venture capital funds manage about $257 billion of assets,2 and private equity funds raised about $256 billion last year.3

The securities laws have not kept pace with the growth and market significance of hedge funds and other private funds and, as a result, the Commission has very limited oversight authority over these vehicles. Sponsors of private funds—typically investment advisers—are able to organize their affairs in such a way as to avoid registration under the federal securities laws. The Commission only has authority to conduct compliance examinations of those funds and advisers that are registered under one of the statutes we administer. Consequently, advisers to private funds can “opt out” of Commission oversight.

Moreover, the Commission has incomplete information about the advisers and private funds that are participating in our markets. It is not uncommon that our first contact with a manager of a significant amount of assets is during an investigation by our Enforcement Division. The data that we are often requested to provide members of Congress (including the data we provide above) or other federal regulators are based on industry sources, which have proven over the years to be unreliable and inconsistent because neither the private funds nor their advisers are required to report even basic census-type information.

This presents a significant regulatory gap in need of closing. The Commission tried to close the gap in 2004—at least partially—by adopting a rule requiring all hedge fund advisers to register under the Investment Advisers Act of 1940 (“Advisers Act”).4 That rulemaking was overturned by an appellate court in the Goldstein decision in 2006.5 Since then, the Commission has continued to bring enforcement actions vigorously against private funds that violate the federal securities laws, and we have continued to conduct compliance examinations of the hedge fund advisers that remain registered under the Advisers Act. But we only see a slice of the private fund industry, and the Commission strongly believes that legislative action is needed at this time to enhance regulation in this area.

The Private Fund Transparency Act of 2009, which Chairman Reed recently introduced, would require advisers to private funds to register under the Advisers Act if they have at least $30 million of assets under management.6 This approach would provide the Commission with needed tools to provide oversight of this important industry in order to protect investors and the securities markets. Today, I wish to discuss how registration of advisers to private funds under the Advisers Act would greatly enhance the Commission’s ability to properly oversee the activities of private funds and their advisers. Although the Commission supports this approach, there are additional approaches available to that also would close the regulatory gap and provide the Commission with tools to better protect both investors and the health of our markets.

II. The Importance and Structure of Private Funds

Private funds are generally considered to be professionally managed pools of assets that are not subject to regulation under the Investment Company Act of 1940 (“Investment Company Act”). Private funds include, but are not limited to, hedge funds, private equity funds and venture capital funds.

Hedge funds pursue a wide variety of strategies that typically involve the active management of a liquid portfolio, and often utilize short selling and leverage.

Private equity funds generally invest in companies to which their advisers provide management or restructuring assistance and utilize strategies that include leveraged buyouts, mezzanine finance and distressed debt. Venture capital funds typically invest in earlier stage and start-up companies with the goal of either taking the company public or privately selling the company. Each type of private fund plays an important role in the capital markets. Hedge funds are thought to be active traders that contribute to market efficiency and enhance liquidity, while private equity and venture capital funds are seen as helping create new businesses, fostering innovation and assisting businesses in need of restructuring. Moreover, investing in these funds can serve to provide investors with portfolio diversification and returns that may be uncorrelated or less correlated to traditional securities indices.

Any regulatory reform should acknowledge the differences in the business models pursued by different types of private fund advisers and should address in a proportionate manner the risks to investors and the markets raised by each.

III. Current Regulatory Exemptions

Although hedge funds, private equity funds and venture capital funds reflect different approaches to investing, legally they are indistinguishable. They are all pools of investment capital organized to take advantage of various exemptions from registration. All but one of these exemptions were designed to achieve some purpose other than permitting private funds to avoid oversight.

A. Securities Act of 1933

Private funds typically avoid registration of their securities under the Securities Act of 1933 (Securities Act) by conducting private placements under section 4(2) and Regulation D.7 As a consequence, these funds are sold primarily to “accredited investors,” the investors typically receive a “private placement memorandum” rather than a statutory prospectus, and the funds do not file periodic reports with the Commission. In other words, they lack the same degree of transparency required of publicly offered issuers.

B. Investment Company Act of 1940

Private funds seek to qualify for one of two exceptions from regulation under the Investment Company Act of 1940 (Investment Company Act). They either limit themselves to 100 total investors (as provided in section 3(c)(1)) or permit only “qualified purchasers” to invest (as provided in section 3(c)(7)).8 As a result, the traditional safeguards designed to protect retail investors in the Investment Company Act are the subject of private contracts for investors in private funds. These safeguards include investor redemption rights, application of auditing standards, asset valuation, portfolio transparency and fund governance. They are typically included in private fund partnership documents, but are not required and vary significantly among funds.

C. Investment Advisers Act of 1940

The investment activities of a private fund are directed by its investment adviser, which is typically the fund’s general partner.9 Investment advisers to private funds often claim an exemption from registration under section 203(b)(3) of the Advisers Act, which is available to an adviser that has fewer than 15 clients and does not hold itself out generally to the public as an investment adviser.

Section 203(b)(3) of the Advisers Act contains a de minimis provision that we believe originally was designed to cover advisers that were too small to warrant federal attention. This exemption now covers advisers with billions of dollars under management because each adviser is permitted to count a single fund as a “client.” The Commission recognized the incongruity of the purpose of the exemption with the counting rule, and adopted a new rule in 2004 that required hedge fund advisers to “look through” the fund to count the number of investors in the fund as clients for purposes of determining whether the adviser met the de minimis exemption. This was the rule overturned by the appellate court in the Goldstein decision. As a consequence, approximately 800 hedge fund advisers that had registered with the Commission under its 2004 rule subsequently withdrew their registration.

All advisers to private funds are subject to the anti-fraud provisions of the Investment Advisers Act, including an anti-fraud rule the Commission adopted in response to the Goldstein decision that prohibits advisers from defrauding investors in pooled investment vehicles.10 Registered advisers, however, are also subject to periodic examination by Commission staff. They are required to submit (and keep current) registration statements providing the Commission with basic information, maintain business records for our examination, and comply with certain rules designed to prevent fraud or overreaching by advisers. For example, registered advisers are required to maintain compliance programs administered by a chief compliance officer.

IV. Options to Address the Private Funds Regulatory Gap11

As discussed below, though there are different regulatory approaches to private funds available to Congress, or a combination of approaches, no type of private fund should be excluded from any new oversight authority any particular type of private fund. The Commission’s 2004 rulemaking was limited to hedge fund advisers. However, since that time, the lines which may have once separated hedge funds from private equity and venture capital funds have blurred, and the distinctions are often unclear. The same adviser often manages funds pursuing different strategies and even individual private funds often defy precise categorization. Moreover, we are concerned that in order to escape Commission oversight, advisers may alter fund investment strategies or investment terms in ways that will create market inefficiencies.

A. Registration of Private Fund Investment Advisers

The Private Funds Transparency Act of 2009 would address the regulatory gap discussed above by eliminating Section 203(b)(3)’s de minimis exemption from the Advisers Act, resulting in investment advisers to private funds being required to register with the Commission. Investment adviser registration would be beneficial to investors and our markets in a several important ways.

1. Accurate, Reliable and Complete Information

Registration of private fund advisers would provide the Commission with the ability to collect data from advisers about their business operations and the private funds they manage. The Commission and Congress would thereby, for the first time have accurate, reliable and complete information about the sizable and important private fund industry which could be used to better protect investors and market integrity. Significantly, the information collected could include systemic risk data, which could then be shared with other regulators.12

2. Enforcement of Fiduciary Responsibilities

Advisers are fiduciaries to their clients. Advisers’ fiduciary duties are enforceable under the anti-fraud provisions of the Advisers Act. They require advisers to avoid conflicts of interest with their clients, or fully disclose the conflicts to their clients. Registration under the Advisers Act gives the Commission authority to conduct on-site compliance examinations of advisers designed, among other things, to identify conflicts of interest and determine whether the adviser has properly disclosed them. In the case of private funds, it gives us an opportunity to determine facts that most investors in private funds cannot discern for themselves. For example, investors often cannot determine whether fund assets are subject to appropriate safekeeping or whether the performance represented to them in an account statement is accurate. In this way, registration may also have a deterrent effect because it would increase an unscrupulous adviser’s risk of being discovered.

A grant of additional authority to obtain information from and perform on-site examinations of private fund advisers should be accompanied with additional resources so that the Commission can bring to bear the appropriate expertise and technological support to be effective.

3. Prevention of Market Abuses

Registration of private fund advisers under the Advisers Act would permit oversight of adviser trading activities to prevent market abuses such as insider trading and market manipulation, including improper short-selling.

4. Compliance Programs

Private fund advisers registered with the Commission are required to develop internal compliance programs administered by a chief compliance officer. Chief compliance officers help advisers manage conflicts of interest the adviser has with private funds. Our examination staff resources are limited, and we cannot be at the office of every adviser at all times. Compliance officers serve as the front-line watch for violations of securities laws, and provide protection against conflicts of interests.

5. Keeping Unfit Persons from Using Private Funds to Perpetrate Frauds

Registration with the Commission permits us to screen individuals associated with the adviser, and to deny registration if they have been convicted of a felony or engaged in securities fraud.

6. Scalable Regulation

In addition, many private fund advisers have small to medium size businesses, so it is important that any regulation take into account the resources available to those types of businesses. Fortunately, the Advisers Act has long been used to regulate both small and large businesses, so the existing rules and regulations already account for those considerations. In fact, roughly 69 percent of the investment advisers registered with the Commission have 10 or fewer employees.

7. Equal Treatment of Advisers Providing Same Services

Under the current law, an investment adviser with 15 or more individual clients and at least $30 million in assets under management must register with the Commission, while an adviser providing the same advisory services to the same individuals through a limited partnership could avoid registering with the Commission. Investment adviser registration in our view is appropriate for any investment adviser managing $30 million regardless of the form of its clients or the types of securities in which they invest.

B. Private Fund Registration

Another option to address the private fund regulatory gap might be to register the funds themselves under the Investment Company Act (in addition to registering their advisers under the Advisers Act). Alternatively, the Commission could be given stand-alone authority to impose requirements on unregistered funds. Through direct regulation of the funds, the Commission could impose, as appropriate, investment restrictions or diversification requirements designed to protect investors. The Commission could also regulate the structure of private funds to protect investors (such as requiring an independent board of directors) and could also regulate investment terms (such as protecting redemption rights).

C. Regulatory Flexibility through Rulemaking Authority

Finally, there is third option that in conjunction with advisers’ registration may be necessary to address the regulatory gap in this area. Because it is difficult, if not impossible, to predict today what rules will be required in the future to protect investors and obtain sufficient transparency, especially in an industry as dynamic and creative as private funds, an additional option might be to provide the Commission with the authority that allows for additional regulatory flexibility to act in this area. This could be done by providing rule-making authority to condition the use by a private fund of the exceptions provided by sections 3(c)(1) and 3(c)(7) of the Investment Company Act. These conditions could impose those requirements that the Commission believes are necessary or appropriate to protect investors and enhance transparency.13 In many situations, it may be appropriate for these requirements to vary depending upon the type of fund involved. This would enable the Commission to better discharge its responsibilities and adapt to future market conditions without necessarily subjecting private funds to Investment Company Act registration and regulation.

V. Conclusion

The registration and oversight of private fund advisers would provide transparency and enhance Commission oversight of the capital markets. It would give regulators and Congress, for the first time, reliable and complete data about the impact of private funds on our securities markets. It would give the Commission access to information about the operation of hedge funds and other private funds through their advisers. It would permit private funds—which play an important role in our capital markets—to retain the current flexibility in their investment strategies.

The Commission supports the registration of private fund advisers under the Advisers Act. The other legislative options I discussed above, namely registration of private funds under the Investment Company Act and/or providing the Commission with rulemaking authority in the Investment Company Act exemptions on which private funds rely, should also be weighed and considered as the Subcommittee considers approaches to filling the gaps in regulation of pooled investment vehicles.

I would be happy to answer any questions you may have.


1 Commissioner Paredes does not endorse this testimony.

2 The National Venture Capital Association (NVCA) estimates that 741 venture capital firms and 1,549 venture capital funds were in existence in 2007, with $257.1 billion in capital under management. NVCA, Yearbook 2008 at 9 (2008). In 2008, venture capital funds raised $28.2 billion down from $35.6 billion in 2007. Thomson Reuters & NVCA, News Release (Apr. 13 2009). In 2007, the average fund size was $166 million and the average firm size was $347 million. Id. at 9.

3 U.S. private equity funds raised $256.9 billion in 2008 (down from $325.2 billion in 2007). Private Equity Analyst, 2008 Review and 2009 Outlook at 9 (2009) (reporting Dow Jones LP Source data.

4 Investment Advisers Act Release No. 2333 (Dec. 2, 2004).

5 See Goldstein v. S.E.C., 451 F.3d 873 (D.C. Cir. 2006).

6 Section 203A(a)(1) of the Act prohibits a state-regulated adviser to register under the Act if it has less than $25 million of assets under management. The Commission has adopted a rule increasing the $25 million threshold to $30 million. See Rule 203A-1 under the Advisers Act. The threshold does not apply to foreign advisers. Section 3 of the Private Fund Transparency Act would establish a parallel registration threshold for foreign advisers, which would prevent numerous smaller foreign advisers that today rely on the de minimis exception, which the Act would repeal, from being required to register with the Commission.

7 Section 4(2) of the Securities Act of 1933 provides an exemption from registration for transactions by the issuer of a security not involving a public offering. Rule 506 of Regulation D provides a voluntary “safe harbor” for transactions that are considered to come within the general statutory language of section 4(2).

8 “Qualified purchasers” generally are individuals or family partnerships with at least $5 million in investable assets and companies with at least $25 million. The section 3(c)(7) exception was added in 1996 and specifically anticipated use by private funds.

9 Private funds often are organized as limited partnerships with the fund’s investment adviser serving as the fund’s general partner. The fund’s investors are limited partners of the fund.

10 See Rule 206(4)-8 under the Advisers Act.

11 Commissioner Casey does not endorse the approaches discussed in sections IV. B and C.

12 The Private Fund Transparency Act includes some important although technical amendments to the Advisers Act that are critical to the Commission’s ability to collect information from advisers about private funds, including amendments to Section 204 of the Act permitting the Commission to keep information collected confidential, and amendments to Section 210 preventing advisers from keeping the identity of private fund clients from our examiners.

13 For example, private funds might be required to provide information directly to the Commission. These conditions could be included in an amendment to the Investment Company Act or could be in a separate statute.



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.  Mallon P.C. helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions.  If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510.  Other related hedge fund law articles include: