When is a Registered Investment Advisor Required to Obtain an ERISA Bond?

Thursday, May 02, 2013 09:49
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When is a Registered Investment Advisor Required to Obtain an ERISA Bond?
The protection of client assets is critical to securities regulation, especially in the wake of Dodd Frank and the need to boost investor confidence.  The bulk of the regulations fall to “qualified custodians,” who have custody of client assets such as: broker dealers[1], banks[2], savings associations[3] and futures commission merchants. [4] 

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However, recent regulations have shifted some of that burden to investment advisors who do not have traditional “custody” of client assets. 
 
“Custody” vs. “Handling”
 
While several states have expanded (if not completely rewritten) the definition of “custody;” at the SEC/Federal level, “custody” means an individual or entity holding “directly or indirectly, client funds or securities or [has] any authority to obtain possession of them[5].”  In particular, “custody” includes:
  • Possession of client funds or securities (but not of checks drawn by clients and made payable to third parties) unless the recipient receives them inadvertently and returns them within three business days of receipt;
  • Any arrangement (including a general power of attorney) under which an adviser is permitted to withdraw client funds or securities maintained with a custodian upon its instruction to the custodian; and
  • Any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives a registered investment adviser legal ownership of or access to client funds or securities. [6]
A registered investment adviser meeting any of the above-three prongs is required to submit to additional regulatory obligations, including annual surprise audits of the affected account(s).  
 
It would stand to reason that a registered investment adviser who does not meet any of the above three prongs should not be required to submit to surprise examinations or bonding requirements – specifically because that advisor does not seem to have the capacity to abscond with client funds. 
 
However, registered investment advisers who “handle” ERISA funds (generally: 401(k); 403(b) Employee Stock Ownership Plans; and Profit Sharing Plans) are required to post an ERISA bond.  In particular, 29 CFR § 2580.412-1 states:
 
Every administrator, officer and employee of any employee welfare benefit plan or of any employee pension benefit plan subject to this Act [ERISA] who handles funds or other property of such plan shall be bonded as herein provided;
 
The definition of “handling,” is broader than custody.  “Handling” includes any relationship that “can give rise to a risk of loss through fraud or dishonesty.  [7]” In particular, under 29 CFR § 2580.412-6, “handling” includes:
  1. Physical contact with cash, checks or similar property;
  2. Power to exercise physical contact or control;
  3. Power to transfer to oneself or a third party or to negotiate for value;
  4. Disbursement of funds or property
  5. Signing or endorsing checks or negotiable instruments; and
  6. Supervisory or decision making responsibility.
While Items (1) through (5) generally fall within the traditional definition of “custody,” Item (6) is a complete game-changer.  A registered investment adviser has “supervisory or decision making responsibility” if he or she actually exercises “final responsibility for determining whether specific disbursements, investments, contracts, or benefit claims are bona fide, regular and made in accordance with the applicable trust instrument or other plan documents.”  Accordingly, any registered investment adviser with the capacity to transact on behalf of its client in either a discretionary or non-discretionary manner is deemed to be “handling” ERISA funds.  By way of further example, the following would constitute “handling” of ERISA funds:
  • Acting in the capacity of plan “administrator” and having ultimate responsibility for the plan within the meaning of the definition of “administrator”
  • Exercising close supervision over corporate trustees or other parties charged with dealing with plan funds or other property; exercise such close control over investment policy that they, in effect, determine all specific investments;
  • Conducting, in effect, a continuing daily audit of the persons who “handle” funds;
  • Regularly reviewing and having veto power over the actions of a disbursing officer whose duties are essentially ministerial.

On the other hand, the following would not constitute “handling” of ERISA funds:

  • Conducting a periodic or sporadic audit of the persons who “handle” funds;
  • Having duties with respect to investment policy are essentially advisory;
  • Making a broad general allocation of funds or general authorization of disbursements intended to permit expenditures by a disbursing officer who has final responsibility for determining the propriety of any specific expenditure and making the actual disbursement;
  • Having the day to day functions of administering the plan as a bank or corporate trustee;
  •  Not performing specific functions with respect to the operations of the plan.
How Much is the Bond?
 
The bond amount depends upon the amount of funds that are “handled.” Under 29 U.S.C. § 111, the amount of the bond shall be fixed at the beginning of each fiscal year of the plan, which shall not be less than 10% of the amount of funds handled. In no case shall such bond be less than $1,000 nor more than $500,000, except in extraordinary circumstances.
 
Notable Exception – Solo 401(k)
 
Under 29 CFR § 2510.3-3(b), plans that do not have statutorily defined “employees” are not subject to ERISA and the corresponding bonding requirement.  29 CFR § 2510.3-3(c) exempts a solo owner of a business and/or a spouse from the statutory definition of “employee”:
  1. An individual and his or her spouse shall not be deemed to be employees with respect to a trade or business, whether incorporated or unincorporated, which is wholly owned by the individual or by the individual and his or her spouse. . .
Accordingly, the owner of a “solo 401(k)” is not required to post an ERISA bond.


[1] Rule 206(4)-2(d)(6). “Qualified custodian” includes any broker-dealer that is registered with and regulated by us under the Securities Exchange Act of 1934, holding the client assets in customer accounts.
 
[2] Rule 206(4)-2(d)(6)(i). A “bank” under section 202(a)(2) of the Advisers Act [15 U.S.C. § 80b-202(a)(2)] includes national banks, members of the Federal Reserve System, and other banks and trust companies having similar authority to national banks and supervised by state or federal banking agencies.
 
[3] A “savings association” is a financial institution as defined in section 3(b)(1) of the Federal Deposit Insurance Act [12 U.S.C. § 1813(b)(1)] and insured and supervised by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act [12 U.S.C. 1811].
 
[4] Rule 206(4)-2(d)(6)(iii). Futures commission merchants are registered with the Commodity Futures Trading Commission (“CFTC”) under section 4f(a) of the Commodity Exchange Act [7 U.S.C. § 6f(a)] and regulated by the CFTC. “Qualified custodian” includes a registered futures commission merchant holding the client assets in customer accounts. Registered investment advisers that also provide clients with advice about futures, including “security futures,” may also be subject to CFTC rules; CFTC rules require that “customer funds” be custodied with a futures commission merchant. See rule 4.30 [17 CFR 4.30] under the Commodity Exchange Act. See also Commodity Futures Modernization Act (Pub. L. No. 106-554, 114 Stat. 2763 (2000)) (security futures are both securities and futures). The rule also allows advisers to maintain client securities with a futures commission merchant to the extent the securities are incidental to client futures transactions.
 
[5] Rule 206(4)-2(d)(2)
[6] Rule 206(4)-2(d)(2)
[7] 29 CFR 2580.412-6

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