The Fidelity Law Journal

Transcription

1 The Fidelity Law Journal published by The Fidelity Law Association Volume XIV, October 2008 Cite as XIV Fid. L.J. (2008)

2 The Fidelity Law Journal is published annually. Additional copies may be purchased by writing to: The Fidelity Law Association, c/o Wolff & Samson PC, One Boland Drive, West Orange, New Jersey The opinions and views expressed in the articles in this Journal are solely of the authors and do not necessarily reflect the views of the Fidelity Law Association or its members, nor of the authors firms or companies. Publication should not be deemed an endorsement by the Fidelity Law Association or its members, or the authors firms or companies, of any views or positions contained herein. The articles herein are for general informational purposes only. None of the information in the articles constitutes legal advice, nor is it intended to create any attorney-client relationship between the reader and any of the authors. The reader should not act or rely upon the information in this Journal concerning the meaning, interpretation, or effect of any particular contractual language or the resolution of any particular demand, claim, or suit without seeking the advice of your own attorney. The information in this Journal does not amend, or otherwise affect, the terms, conditions or coverages of any insurance policy or bond issued by any of the authors companies or any other insurance company. The information in this Journal is not a representation that coverage does or does not exist for any particular claim or loss under any such policy or bond. Coverage depends upon the facts and circumstances involved in the claim or loss, all applicable policy or bond provisions, and any applicable law. Copyright 2008 Fidelity Law Association. All rights reserved. Printed in the USA. For additional information concerning the Fidelity Law Association or the Journal, please visit our website at Information which is copyrighted by and proprietary to Insurance Services Office, Inc. ( ISO Material ) may be included in this publication. Use of the ISO Material is limited to ISO Participating Insurers and their Authorized Representatives. Use by ISO Participating Insurers is limited to use in those jurisdictions for which the insurer has an appropriate participation with ISO. Use of the ISO Material by Authorized Representatives is limited to use solely on behalf of one or more ISO Participating Insurers.

3 ERISA BONDING REQUIREMENTS AND THE FIDELITY INSURER Edward G. Gallagher I. INTRODUCTION In 1974 Congress enacted The Employee Retirement Income Security Act (ERISA) 1 to provide comprehensive, integrated, uniform federal regulation of the private employee benefit system. 2 In an effort to protect the ability of qualified employee benefit plans ( Plans ) to make the payments promised to their participants, ERISA Plan fiduciaries are required to carry out detailed duties and are personally liable for damages caused by their breaches of such duties. 3 To provide further protection for Plan participants, ERISA requires each fiduciary or other person who handles Plan assets to be bonded. This paper addresses ERISA s bonding requirement and the exposure of sureties on such bonds. II. STATUTORY REQUIREMENTS With the limited exceptions discussed below, ERISA provides that every person who handles funds or other property of a Plan must be 1 Codified at 29 U.S.C (1974), et seq. 2 New York State Conference of Blue Cross & Blue Shield Plans v. Travelers Ins. Co., 514 U.S. 645 (1995); Mertens v. Hewitt Assocs., 508 U.S. 248 (1993); Pilot Life Ins. Co. v. Dedeaux, 481 U.S. 41 (1987); Shaw v. Delta Air Lines, Inc., 463 U.S. 85 (1983). 3 Mertens, 508 U.S. 248; Mass. Mut. Life Ins. Co. v. Russell, 473 U.S. 134 (1985). Edward G. Gallagher is General Counsel of The Surety & Fidelity Association of America in Washington, D.C. 247

4 248 Fidelity Law Association Journal, Vol. XIV, October 2008 bonded. 4 The bonding provision, section 412 of ERISA, codified at 29 U.S.C. 1112, 5 generally requires that the bond be for not less than 10% of the amount of funds handled (but not less than $1,000 nor more than $500,000 unless the Secretary of Labor holds a hearing and requires a bond over $500,000). There are four statutory exceptions to this general rule. First, if the benefits are paid only from the general assets of an employer or union, the Plan s administrator, officers and employees do not have to be covered by a bond. 6 Presumably, Congress reasoned that if there were no Plan assets to be stolen, there was nothing for the bond to protect, and the benefits would be payable from the other general assets of the employer or union even if some of those assets were stolen. Second, banks and insurance companies subject to federal or state supervision or examination do not have to be covered by a bond if they have capital and surplus in excess of $1 million. 7 Employees of such banks or insurers are also exempt. Subparagraph (a)(3) of 412 states, no bond shall be required of a fiduciary (or of any director, officer, or employee of such fiduciary) if such fiduciary.... Presumably, Congress was satisfied that regulated banks and insurance companies with over $1 million of assets would be good for the Plan s loss, and such banks are required to have fidelity bonds to help protect the bank, and therefore the public, from the consequences of employee dishonesty. The bank or insurer would also be responsible for the actions of its employees in a situation in which the bank or insurer was itself the fiduciary of the Plan. Third, in the Pension Protection Act of Congress amended section 412 to exempt registered brokers and dealers if the broker or 4 The ERISA preemption provision, 29 U.S.C. 1144, prevents states from requiring other or additional bonds from a Plan. Minnesota Chamber of Commerce & Indus. v. Hutch, 672 F. Supp. 393 (D. Minn. 1987). 5 The ERISA statute as enacted was divided into sections, and 412 was the bonding requirement. When the statute was codified, 412 of the Act became 1112 of title 29 of the United States Code U.S.C. 1112(a)(1) U.S.C. 1112(a)(3). 8 P.L at section 611(b).

5 ERISA Bonding Requirements and the Fidelity Insurer 249 dealer is required by a self regulatory organization to have a fidelity bond. The proponents of this amendment argued that the combination of protection by the Securities Investor Protection Corporation (SIPC) and the fidelity bond required by the National Association of Securities Dealers (NASD) 9 was sufficient protection for a Plan s assets. As originally proposed, this exemption would also have applied to registered investment advisers, but the eventual amendment was limited to brokers and dealers. The 2006 amendment did not, however, explicitly exempt the directors, officers or employees of the broker or dealer. As a matter of statutory construction, this omission is glaring because subsection (3) includes the directors, officers and employees of banks and insurers, while subsection (2), related to brokers and dealers, does not. On the other hand, it is the individual person handling Plan assets that has to be covered by a bond, and there does not seem to be much point in exempting the broker dealer but making its employees have a bond. The Labor Department is expected to issue guidance recognizing that the exemption was intended to apply to employees of the broker dealer. Fourth, the Pension Protection Act of also increased the cap on the amount of the required bond to $1 million if the Plan holds employer securities. 11 That is, if the Plan holds employer securities, the amount of the bond will still be 10% of assets handled, but the cap on the bond amount will be $1 million in place of $500,000. From the statute, it appears that this increased cap on the required bond amount will apply to anyone handling assets of the Plan even though he or she handles no employer securities and was not involved in the decision to include such securities in the Plan s assets. An investment in a mutual fund or similar pooled investment vehicle that in turn owns a small amount of employer securities should not trigger the increased bond amount. The bond should protect the Plan against loss by reason of acts of fraud or dishonesty on the part of the Plan official, directly or through connivance with others. 12 The surety must be on the Treasury List, 13 9 NASD is now part of FINRA, the Financial Industry Regulatory Authority. 10 P.L at section 622(a) U.S.C. 1107(d)(1) defines employer securities U.S.C. 1112(a).

6 250 Fidelity Law Association Journal, Vol. XIV, October 2008 and neither the Plan nor a party in interest 14 under the Plan can control or have a significant financial interest in either the surety or the agent/broker through whom the bond is written. ERISA enforces the bonding requirement by making it unlawful to allow anyone to handle Plan assets without being bonded. Section 412(b) states: It shall be unlawful for any plan official to whom subsection (a) of this section applies, to receive, handle, disburse, or otherwise exercise custody or control of any of the funds or other property of any employee benefit plan, without being bonded as required by subsection (a) of this section and it shall be unlawful for any plan official of such plan, or any other person having authority to direct the performance of such functions, to permit such functions, or any of them, to be performed by any plan official, with respect to whom the requirements of subsection (a) have not been met. Pursuant to subsection (a), anyone handling Plan assets is a plan official, so it is unlawful for anyone who is not covered by a bond to handle Plan assets. Section 412 does not include a bond form or dictate the form the bond must take but provides: Any bond shall be in a form or of a type approved by the Secretary, including individual bonds or blanket forms of bonds which cover a group or class. 13 Acceptable sureties on bonds required by federal statutes and regulations, and the dollar limit of their authority, is determined by the Surety Bond Branch of the Treasury Department s Financial Management Service, and a list of such sureties is available on the Treasury website at The Regulations implementing ERISA provide exceptions for underwriters at Lloyds, London (29 C.F.R ) and companies authorized by the Treasury to act as reinsurers (29 C.F.R ). 14 See 29 U.S.C. 1002(14) for the definition of a party in interest.

7 ERISA Bonding Requirements and the Fidelity Insurer 251 Finally, Subparagraph (e) of section 412 provides that The Secretary shall prescribe such regulations as may be necessary to carry out the provisions of this section. Although Subparagraph (e) specifically mentions regulations exempting a plan from the bonding requirement if other bonding arrangements or the financial condition of the plan are adequate to protect the plan s beneficiaries and participants, the Secretary has not used this authority to exempt individual plans. The regulations do, however, provide more detailed guidance on a number of ERISA bonding issues. III. REGULATIONS The Secretary prescribed a temporary regulation 15 at 29 C.F.R , which states, in part: (a) Pending the issuance of permanent regulations with respect to the bonding provisions under section 412 of the Employee Retirement Income Security Act of 1974 (the Act), any plan official, as defined in section 412(a) of the Act, shall be deemed to be in compliance with the bonding requirements of the Act if he or she is bonded under a bond which would have been in compliance with section 13 of the Welfare and Pension Plans Disclosure Act, as amended (the WPPDA), and with the basic bonding requirements of subparts A through E of part 2580, title 29 CFR. In effect, the temporary ERISA bonding regulation 16 adopted the bonding regulations issued pursuant to the predecessor statute (the WPPDA) but goes on to provide that terms shall have the meaning used in ERISA. Specific Regulations will be discussed below. 15 The temporary regulation was first promulgated in 1975, but no permanent regulation has yet been issued C.F.R through

8 252 Fidelity Law Association Journal, Vol. XIV, October 2008 IV. WHO IS REQUIRED TO PROVIDE A BOND? A common argument by an insured seeking coverage it did not purchase is that ERISA required the coverage and the bond was supposed to comply with ERISA. One manifestation of this strategy is to argue that the insurance policy should be read to cover everyone that ERISA required to be bonded without regard to the actual provisions of the policy. The central fallacy of this argument is its assumption that ERISA compliance must be obtained via a single bond. Section 412(a) provides that, Every fiduciary of an employee benefit plan and every person who handles funds or other property of such a plan (hereafter in this section referred to as plan official ) shall be bonded as provided in this section.... The requirement is directed to every person who handles Plan assets. The trigger for a bond is a person handling Plan assets. The Plan is not directed to be bonded or to purchase a bond. In Musso v. Baker, 17 the court rejected the proposition that government debt obligations belonging to the Plan could be deposited with the Secretary of Labor pursuant to 31 U.S.C in lieu of the ERISA bond and stated: In the instant situation, it is the trustees, not the Fund, who must give a surety bond. Therefore, section 9303(a) would be relevant only if the trustees were proposing to deposit bonds owned by the trustees with the Secretary of Labor. 19 The same bond does not have to cover every person handling a Plan s assets. Indeed, there could be as many bonds as there are persons handling assets. The applicable Regulation, 29 C.F.R (c), states: F.2d 78 (3rd Cir. 1987) U.S.C (a) states, If a person is required under a law of the United States to give a surety bond, the person may give a Government obligation as security instead of a surety bond F.2d at 80 (emphasis in original).

9 ERISA Bonding Requirements and the Fidelity Insurer 253 (c) Use of separate bonds. The choice of whether persons required to be bonded should be bonded separately or under the same bond, whether given plans should be bonded separately or under the same bond, whether existing bonds should be used or separate bonds for Welfare and Pension Plans Disclosure Act bonding should be obtained, or whether the bond is underwritten by a single surety company or more than one surety company, either separately or on a cosurety basis, is left to the judgment of the parties concerned, so long as the bonding program adopted meets the requirements of the Act and the regulations in this part. There is simply no basis in ERISA, the Regulations or the case law for an argument that because a Plan was insured under a policy, that policy must obligate the insurer to indemnify the Plan for all losses caused by anyone handling the Plan s assets. V. WHO IS REQUIRED TO BE COVERED BY A BOND With the exceptions discussed above, section 412(a) requires that every fiduciary and every person who handles funds or other property of the Plan be bonded. ERISA defines fiduciary at 29 U.S.C. 1002(21)(A): Except as otherwise provided in subparagraph (B), a person is a fiduciary with respect to a plan to the extent (i) he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets, (ii) he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or (iii) he has any discretionary authority or discretionary responsibility in the administration of such

10 254 Fidelity Law Association Journal, Vol. XIV, October 2008 plan. Such term includes any person designated under section 1105(c)(1)(B) of this title. 20 In Mertens v. Hewitt Associates, 21 the Court stated: The statute provides that not only the persons named as fiduciaries by a benefit plan, see 29 U.S.C. 1102(a), but also anyone else who exercises discretionary control or authority over the plan s management, administration, or assets, see 1002(21)(A), is an ERISA fiduciary. The applicable regulation, 29 C.F.R , emphasizes that the bond must cover the natural persons performing the fiduciary duties so that if a Plan Administrator or other fiduciary is an artificial entity (a corporation or partnership, for example), its employees who actually provide the services to the Plan must be covered by a bond. In addition, even a non-fiduciary who handles funds must be bonded. 29 C.F.R states that a person is handling Plan funds: 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, acting either alone or in collusion with others. Subject to this general rule, the Regulation then gives examples of criteria of handling including: physical contact, power to control, power to transfer to oneself or others or to negotiate, authority to disburse funds, authority to sign or endorse checks, and supervisory or decision making responsibility. In Brennan v. Wheeler, 22 decided under a predecessor statute, 23 the Court stated: 20 The exception in the definition ( 1002(21)(B)) is for registered investment companies (mutual funds) and the addition, 1105(c)(1)(B), is for persons to whom the fiduciary delegates duties U.S. 248 (1993).

11 ERISA Bonding Requirements and the Fidelity Insurer 255 The powers given to the Advisory Committee by the agreement and in particular the powers over the disbursement of funds give rise to the possibility that fraud or dishonesty on appellants part will cause loss to the fund. To safeguard against such loss it is the clear intent of the [WPPDA, the predecessor statute] that the bonding requirements apply to the Advisory Committee. The Sixth Circuit Court of Appeals in International Union, United Auto Workers v. Greyhound Lines, Inc., 24 interpreted the requirement as follows: Handling of funds encompasses physical contact with the funds, the power to secure possession of cash or checks from the fund, the power to transfer to oneself or a third party title to fund property, the actual disbursement of funds by the signing or endorsing of checks, or the supervisory power to order that such disbursements be made. The net effect is a functional test which looks at the person s actual duties and access to Plan funds and, particularly, to the possibility that his or her fraud or dishonesty could cause a loss for which the bond would provide a source of recovery F.2d 960 (7th Cir. 1974). 23 The ERISA bond requirement is taken from the Welfare and Pension Plans Disclosure Act ( WPPDA ). See House Conference Report, No , P.L , 1974 U.S. Code Congressional and Administrative News, pp which states in part, this provision generally is identical to section 13 of the Welfare and Pension Plans Disclosure Act and it is intended that the construction given to the bonding requirements before enactment of [ERISA] would continue. Because the temporary ERISA bond regulation simply incorporates the WPPDA regulations, cases decided under the WPPDA should still be persuasive F. 2d 1187 (6th Cir. 1983).

12 256 Fidelity Law Association Journal, Vol. XIV, October 2008 VI. WHAT ARE FUNDS OR OTHER PROPERTY OF A PLAN? Although ERISA does not define funds or other property of the Plan, the applicable Regulation, 29 C.F.R , provides that money becomes funds of the Plan when it is transferred to an independent (i.e., not the employer) administrator or trustee or when it is placed in a segregated account separate from the general assets of the employer. Mere withholding from employees without such transfer or segregation is not sufficient to convert the money into Plan assets. If benefits are purchased from a third party (such as an annuity or a health insurance policy) the contract with the third party is not property of the Plan for bonding purposes, and the mere entitlement to benefits is not property of the Plan. If benefits are paid to the Plan (rather than to the participant directly), however, they become funds of the Plan subject to handling while in the custody of the Plan. The existence and amount of funds or other property control the need for a bond and its limit of liability. The valuation of the Plan assets, however, is addressed by other ERISA sections, and determining the value of such assets should not be a problem in connection with the bonding statute. VII. THE AMOUNT OF THE BOND The minimum amount of the Bond is 10% of the funds handled, but not less than $1,000 nor more than $500,000 ($1 million if the plan holds employer securities ). The amount is set at the beginning of the Plan year based on the funds handled in the preceding reporting year. Even if a multi-year Bond is purchased, the amount must be reviewed annually and adjusted or supplemented if necessary to provide the required minimum amount of coverage. 25 All persons who handle funds are not required to be covered under a single bond, and separate bonds can be provided to comply with the ERISA requirements. Subject to the cap of $500,000 (or $1 million) and the minimum of $1,000, the amount 25 See 29 C.F.R &

13 ERISA Bonding Requirements and the Fidelity Insurer 257 of the bond is 10% of the funds handled by the particular person or persons covered, not 10% of the entire value of the Plan s assets. If multiple Plans are covered under one bond, the Regulation, 29 C.F.R , requires that liability limits be purchased and loss payments shared so that each Plan has at least the statutory minimum amount of protection. Thus, if one Plan is required to have $50,000 of protection and another $10,000, they can be joint insureds on one bond, but the bond penalty cannot be less than $60,000 and loss payments must be held in trust or shared pro rata to assure that not less than the statutory minimum is received by each Plan. This could require a bond with a liability limit exceeding the maximum coverage required for any one Plan. For example, if a person covered by the bond handled $5 million of one Plan s funds and $100,000 of another Plan s funds, a Bond on which the Plans were joint insureds would have to have a limit of at least $510,000. VIII. THE FORM OF THE BOND Neither the Statute nor the Regulations require a particular bond form. As long as the enumerated minimum requirements are met, the parties are free to contract for other coverage or to use whatever forms they choose. For example, 29 C.F.R allows an annual term or multi-year bond as long as the liability limit is re-examined at the beginning of each Plan reporting year. The Regulations also allow use of a blanket bond, a position schedule bond or individual bonds. Use of an employer s existing bonds is specifically allowed if a Rider is added to make the Bond conform to the Statute and Regulations. 29 C.F.R (b) states: Insofar as a bond currently in use is adequate to meet the requirements of the Act and the regulations in this part or may be made adequate to meet these requirements through rider, modification or separate agreement between the parties, no further bonding is required. The Statute and Regulations at least implicitly approve the various provisions found in the usual standard form bonds. Notice, proof

14 258 Fidelity Law Association Journal, Vol. XIV, October 2008 of loss, suit limitations, automatic termination, and subrogation provisions, for example, are in almost all bonds, and nothing in ERISA or the Regulations prevents their enforcement. Where Congress or the Labor Department wanted to require a particular provision, for example a one year discovery period, 26 they said so. The Regulations also forbid any clause in violation of the law of the State in which the Bond was executed. 27 Any fidelity form properly submitted to and approved by State authorities, therefore, should be acceptable for use by an ERISA Plan as long as it is brought into conformance with the following specific requirements by use of an Endorsement or Rider. A. Deductible 29 C.F.R forbids a deductible applicable to a loss sustained by a Plan. Commercial fidelity bonds virtually always have deductibles, but the common ERISA Endorsements and Riders make the deductible inapplicable to a Plan loss. The Commercial Crime Policy Endorsement simply makes the deductible inapplicable. The Financial Institution Bond Rider, however, waives the deductible, but only up to the amount of coverage required by ERISA. Thus, if ERISA required only $50,000 of coverage, the deductible would be applied to any Plan loss starting at the $50,000 level. As long as an appropriate Endorsement or Rider is used, the standard bond forms comply with the no deductible requirement of the Regulations. B. Joint Insureds 29 C.F.R permits the use of a single bond to insure more than one Plan but requires that in case of any loss each Plan will receive at least its separate statutory minimum coverage amount. The common Endorsements and Riders for Financial Institution Bonds and Crime Policies modify the standard forms to comply with this requirement. If an Endorsement or Rider is used, the bond or policy should be in compliance as long as the insured purchases a sufficient limit of insurance C.F.R C.F.R (c).

15 ERISA Bonding Requirements and the Fidelity Insurer 259 C. Named Insureds Both Standard Form No. 24 and the Commercial Crime Policy provide that any loss suffered by any insureds will be adjusted with the first named insured who will act on behalf of all insureds. The ERISA Regulation, at 29 C.F.R , requires that the Plan be able to enforce recovery or that a Rider or other agreement provide that any recovery be for the use and benefit of the Plan. The standard Endorsements and Riders comply with the Regulation by providing that the first named insured will hold any loss payment for the use and benefit of the Plan. The Plan has to be an insured, but the Regulation does not require any specific method of identifying insureds. Therefore, the Plan or Plans can be listed by name or identified in a properly written omnibus insured clause. D. Discovery Period The Regulation at 29 C.F.R requires a discovery period of not less than one year following termination or cancellation of the bond. For a loss sustained policy, such a one year discovery period is standard. For example, the Crime General Provisions (Loss Sustained) 28 of the joint SFAA/ISO Commercial Crime Policy, provided at General Condition 5: Extended Period to Discover Loss: We will pay only for covered loss discovered no later than one year from the end of the policy period. For discovery policies, such as the Financial Institution Bond, an additional discovery period does not make sense, and the insured should not need an extended discovery period since its bond or policy for the following year will cover any losses discovered during its term even though they were sustained prior to the commencement of the bond or policy. The solution usually has been to provide a one year discovery period from the end of the policy but also to provide that this extended discovery period terminates upon the insured s purchase of a 28 Form CR

16 260 Fidelity Law Association Journal, Vol. XIV, October 2008 replacement policy. Thus, if there is no replacement policy, the insured has an additional year to discover losses sustained during the term of the policy. If a replacement policy is purchased, it covers losses sustained in prior years but discovered during the term of the replacement policy. IX. CLAIMS AND CASE LAW The obligation to comply with ERISA is on the person handling Plan assets. Subsection (b) of section 412 makes it unlawful for anyone to receive or handle Plan property without being bonded. In United Association Union Local No. 290 v. Federal Insurance Co. 29 the court rejected the insured s argument that the policy language should be disregarded because it allegedly did not provide the amount of coverage required by ERISA and stated, ERISA, on the other hand, does not regulate insurance policies. Although the statute does mention bonding requirements, this is a directive towards the plans themselves not the insurers. It is extremely important to remember that both ERISA (29 U.S.C. 1112(a)(2)) and the regulations (29 C.F.R through ) require only a bond covering loss through fraud or dishonesty. The bond is not conditioned on faithful performance of the Plan fiduciaries duties or on compliance with ERISA. Title 29 C.F.R states: The bond required under section 13 is limited to protection for those duties and activities from which loss can arise through fraud or dishonesty. It is not required to provide the same scope of coverage that is required in faithful discharge of duties bonds under the Labor- Management Reporting and Disclosure Act of 1959 or in the faithful performance bonds of public officials. Because ERISA forbids, and provides a civil remedy for, a large gamut of prohibited transactions (29 U.S.C and 1132), it can be very significant that the bond is not conditioned on compliance with ERISA or faithful performance of a fiduciary s duties. On the other WL (D. Ore. Aug. 11, 2008) at slip opinion p. 19.

17 ERISA Bonding Requirements and the Fidelity Insurer 261 hand, it is a crime to file false ERISA reports or knowingly to make false statements in documents that ERISA requires to be published or kept as part of Plan records. 30 Thus, a companion of a loss will often be a criminal false report or false entry to conceal the missing assets. See, for example, United States v. Furst, 31 in which the defendant was convicted of knowingly making false statements in ERISA records to cover up a loss caused by a poor but honest investment decision. Presumably, plaintiffs will point to the criminal act as evidence of fraud or dishonesty. A false report, however, does not cause a loss. The ERISA bond is to protect Plans against loss by reason of acts of fraud or dishonesty. If a poor investment or negligence or other act short of fraud or dishonesty causes a loss, the loss should not be covered by the bond merely because a subsequent report or document describing the transaction contains a false statement. Only if the alleged misconduct causing the loss rises to the level of fraud or dishonesty can a claim be made on the bond, and the Regulation, in effect, provides a circular definition of fraud and dishonesty. 29 C.F.R states, in part: 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. As usually applied under state laws, the term fraud or dishonesty encompasses such matters as larceny, theft, embezzlement, forgery, misappropriation, wrongful abstraction, wrongful conversion, willful misapplication or any other fraudulent or dishonest acts. For the purposes of section 412, other fraudulent or dishonest acts shall also be deemed to include acts where losses 30 Title 18 U.S.C F.2d 558 (3d Cir. 1989). This was a criminal case and did not involve a bond claim.

18 262 Fidelity Law Association Journal, Vol. XIV, October 2008 result through any act or arrangement prohibited by title 18, section 1954 of the U.S. Code. 32 This reliance on state law for the definition of fraud or dishonesty, the very thing the bond protects against, is inconsistent with the intent of Congress to have one, uniform law governing ERISA Plans. Congress included in ERISA a very strong preemption provision 33 for the express purpose of assuring such uniformity. While the subject of ERISA preemption is beyond the scope of this paper, it has been extensively litigated and discussed in part because of its unusual breadth. 34 The reliance upon state law to define fraud and dishonesty suggests the theoretical possibility of a given act committed in one state giving rise to a covered claim when the same act in another state would not. This theoretical possibility is unlikely to occur because the surety industry s longstanding use of standard form bonds has resulted in very little variation in state law interpreting the bonds. Although the case law on ERISA bonds is not extensive, it is instructive. A. Jurisdiction For Suit Insureds will often seek to litigate the insurer s obligation in state court, and diversity jurisdiction may or may not permit removal of the action to federal court. For example, in Employers-Shopmens Local 516 Pension Trust v. Travelers Casualty and Surety Co. of America, Title 18 U.S.C provides criminal penalties for anyone who gives, receives or solicits a bribe, kickback, fee, commission or other thing of value to influence the operation of an employee benefit plan. 33 Title 29 U.S.C states, in part, that ERISA shall supersede any and all State laws insofar as they may now or hereafter relate to any employee benefit plan See, e.g., Cal. Div. of Labor Standards Enforcement v. Dillingham Construction N.A., Inc., 519 U.S. 316 (1997); New York State Conference of Blue Cross & Blue Shield Plans v. Travelers Ins. Co., 514 U.S. 645 (1995); Southern Cal. IBEW-NECA Trust Funds v. Standard Indus. Elec. Co., 247 F.3d 920 (9th Cir. 2001); and Leo Finnegan Constr. Co., Inc. v. Northwest Plumbing & Pipefitting Indus. Health Welfare & Vacation Trust, 2008 WL (Wash. Ct. App. July 22, 2008) WL (D. Or. July 6, 2005).

19 ERISA Bonding Requirements and the Fidelity Insurer 263 several Plans sued their insurers and the Plans own brokers in state court. The defendants removed the case, but the District Court remanded it. The court noted that there was no diversity jurisdiction (one of the Plans and one of the brokers were citizens of the same state) and federal question jurisdiction depended on whether resolution of the case turned on a substantial federal question or ERISA preemption. The court concluded that the correct test was preemption and that ERISA did not preempt state law applicable to the action. The answer to this issue is 28 U.S.C. 1352, which provides: The district courts shall have original jurisdiction, concurrent with State courts, of any action on a bond executed under any law of the United States, except matters within the jurisdiction of the Court of International Trade under section 1582 of this title. Thus, it is not necessary for the insurer to rely on diversity or general federal question jurisdiction. An ERISA bond is required by federal law, and the U.S. District Court has jurisdiction over a suit on the bond without regard to the citizenship of the parties or the amount in controversy. B. Who Can Submit A Claim In Isola v. Hutchinson, 36 the court allowed a participant in an ERISA Pension Plan to sue the fiduciaries insurers. The insurers argued that the plaintiff lacked standing and that only the insured, the Plan itself, could make a claim. The court noted a Congressional purpose to protect Plan participants and held: Plaintiff s requested relief, with respect to defendant Insurance Companies, is to have the issues of fraudulent and dishonest conduct adjudicated and, if successful, have the insurance policy proceeds paid to the Plan.... Plaintiff is not alleging that the Insurance Companies directly owe him insurance proceeds. As the Plan does not seek to collect proceeds from defendant F. Supp (N.D. Cal. 1991).

20 264 Fidelity Law Association Journal, Vol. XIV, October 2008 Insurance Companies, plaintiff s requested relief is entirely appropriate. If his allegations are in fact true, the requested relief will serve to enforce those provisions of ERISA which have been violated. On the other hand, in Bernstein v. Ideal Handbag Frame Mfg. Corp., 37 the court granted the insurer s motion to dismiss a direct suit by a Plan participant on the ground that the Plan was the insured and the policy excluded any rights or benefits to anyone else. In re Healthsouth Corp., 38 denied a motion to intervene filed by ERISA plan participants who were suing the ERISA plan and its fiduciaries in another action. The plan participants sought to intervene in insurance litigation in which insurers sought to rescind various policies, including ERISA fidelity policies, on grounds of fraud and material concealments during the underwriting process. The plan participants argued that they would be harmed if the insurance coverage was rescinded. The court held that this was not a direct, significant, and legally protectable interest in the outcome of the litigation and, in any case, the existing parties adequately represented any interest the plan participants had in the outcome of the insurance litigation. It is certainly true that an administrator or trustee is unlikely to make a claim accusing himself of fraud or dishonesty. On the other hand, if each time a participant alleges wrongdoing by the fiduciary he can drag the insurer into a lawsuit, defense costs will become a significant burden and presumably be reflected in premiums charged. A better rule would be that a dissatisfied participant should have to seek removal of the trustee or administrator and court appointment of a substitute fiduciary who could then make a claim on the predecessor fiduciary s bond. 39 This would weed out frivolous claims before they can be asserted against the surety, while still preserving the protection of the bond for Plans which have suffered fraud or dishonesty losses. by participants F. Supp. 862 (E.D.N.Y. 1994) F.R.D. 688 (N.D. Ala. 2004). 39 ERISA provides at 29 U.S.C and 1132(a)(2) for such suits

21 ERISA Bonding Requirements and the Fidelity Insurer 265 C. Discovery of Loss In Alleyne v. McCusker, 40 the policy expired on September 8, It had a one year discovery tail following the end of the policy period. The administrator of the Plan was removed from office in October 1981, and the Plan s receiver sued for losses allegedly caused by the administrator s dishonesty. The insurer argued that the claim was discovered after the one year period expired. The receiver admitted that the loss was not discovered until after the end of the discovery period, but argued that the dishonest administrator s control over the insured Plan made timely discovery impossible. The court looked at non-erisa cases involving adverse domination of the insured and denied the insurer s summary judgment motion: The Court finds that given the purposes of ERISA s bonding requirement, to protect the beneficiaries of covered trusts, that plaintiffs may not be barred from recovery here as long as they can prove that the wrongdoers, who caused the losses, so controlled the trust as to make discovery within the contractual period impossible. This result is especially disturbing because the ERISA Regulations explicitly sanction a one year discovery period. Of course, the Court did not hold that the discovery period itself was unenforceable, but it used the adverse domination theory to avoid it. D. Loss In Wallace v. Hartford Fire Insurance Co., 41 a doctor and his pension plan invested Plan assets through a limited partnership whose general partner was an accountant. The investments were profitable, but the accountant provided false statements that exaggerated the profits. There was no evidence the accountant stole any of the Plan s funds. The Plan claimed a loss of the difference between the amount the accountant represented the investment was worth and the actual amount Mar. 13, 2008) F.R.D. 688 (C.D. Cal. 1983). 41 Case No. CV (District Court for Washoe County, Nev.

22 266 Fidelity Law Association Journal, Vol. XIV, October 2008 recovered from liquidation of the limited partnership. The court granted summary judgment to the insurers because the Plan did not suffer a covered loss. The court held that loss under the policy had to be an actual depletion of the insured s assets, as opposed to a theoretical or bookkeeping loss. There was no loss because the Plan assets were not depleted by the false statements. E. Notice and Suit Limitations In Indiana Regional Council of Carpenters Pension Trust Fund v. Fidelity & Deposit Co. of Maryland, 42 a fiduciary of the Plan was indicted for a kickback scheme on September 5, The Plan sued the fiduciary on December 23, The Plan sued on the ERISA bond on January 27, The insurer moved for summary judgment based on the policy requirement that suit be filed within two years of discovery of the loss. The Plan cross-moved for summary judgment on the limitations defense. The court held that Indiana law applied because the suit was filed pursuant to diversity jurisdiction and that under Indiana law, an official bond cannot shorten the otherwise applicable general statute of limitations. Therefore the general statute of limitations for breach of contract applied, and the suit was timely. F. Limit of Liability In United Association Union Local No. 290 v. Federal Insurance Co., 43 the plaintiff Plans alleged losses as a result of fraud by an investment adviser. The policy covered everyone handling Plan assets and had a liability limit of $1 million. The policy included a Total Liability clause which provided that the limit applied to any loss or losses caused by any Employee or in which such Employee is concerned or implicated. The plaintiffs did not dispute that the investment adviser s CEO was implicated in the entire fraud but nevertheless argued that the policy limit was not a limit on their recovery. The insurer tendered the single policy limit and the Plans sued. The court granted summary judgment to the insurer and rejected each of the insured s three arguments. First, the insured argued that the WL (N.D. Ind. Mar. 2, 2007) WL (D. Or. Aug. 11, 2008).

23 ERISA Bonding Requirements and the Fidelity Insurer 267 Declarations page said the $1 million was the limit of Any One Loss and each theft could be a separate loss. The court held that reading the policy as a whole, including the Total Liability clause quoted above, the only reasonable interpretation was that the $1 million limit applied to all loss or losses in which the CEO was implicated. Second, the insured argued that it should receive separate $ 1 million limits for each policy period. The court reasoned that if there was one continuous policy, there was only one limit. If there were three separate policies, however, the loss was discovered too late to claim under the first and before the commencement of the third, so only one policy would apply. Third, the insured argued that the terms of the policies should be disregarded because, it alleged, ERISA required broader coverage and the policies were written to comply with ERISA. The insured asserted that ERISA required $2.15 million of coverage, not $1 million, and that ERISA required recovery of at least as much as would have been available under separate annual bonds. The insured, therefore, argued that the various non-accumulation provisions should be read out of the policies. The court held that ERISA does not regulate insurance policies or require insurers to provide any particular coverage. The statute is directed to the Plans not the insurers and requires the Plans to have compliant coverage. The court concluded, If ERISA required a greater amount of coverage than that provided by defendant s policy, it was plaintiff s responsibility to seek greater coverage. G. Dishonesty of Third Parties In Carroll L. Wood, III D.D.S. v. CNA Insurance Cos., 44 the administrator of a retirement Plan sued on the Plan s fidelity insurance policy. The problem was succinctly stated by the court as follows: From April 1985 until April 1986, CNA insured Wood, his professional dental corporation, and its pension and profit sharing plans. The insurance satisfied the requirements of ERISA. As administrator and principal beneficiary of the pension and profit sharing plan, Wood invested $150,000 of plan funds in certificates of deposit with Alliance Federal Savings and Loan Association F.2d 1402 (5th Cir. 1988).

24 268 Fidelity Law Association Journal, Vol. XIV, October 2008 In August 1985 the Federal Savings and Loan Insurance Corporation and the Federal Home Loan Bank Board placed Alliance Federal in receivership. The plans, as owners of certificates of deposit in the failed institution, sustained a loss of nearly $50,000. Wood sought recovery of that loss from CNA. Not surprisingly, Dr. Wood did not accuse himself of fraud or dishonesty. Instead, he argued that Alliance or its employees were fiduciaries, Plan officials or employees under ERISA and, therefore, CNA was liable for their alleged fraud. The court held: Albeit ingenious, this argument lacks persuasion. Alliance Federal acted neither as a fiduciary, trustee, administrator, officer, nor employee of the fund. It did not handle the funds of the plans; only Wood did. He invested those funds in certificates of deposit of Alliance Federal. The loss resulting from the institution s failure was not covered by the CNA policy. There seems to be no argument with the court s conclusion, but a more interesting question would have been presented if the Plan had sued alleging fraud or dishonesty by Dr. Wood in his capacity as Plan Administrator. Unless some sort of self-dealing or kickback was present, 45 Dr. Wood s investment in certificates of deposit in excess of the federal deposit insurance maximum might be negligence but should not be fraud or dishonesty. In Rosenbaum v. Hartford Fire Insurance Co., 46 Dr. Rosenbaum and his wife were Trustees of the pension plan of Dr. Rosenbaum s professional corporation. Hundreds of thousands of dollars of Plan assets were invested in second mortgages on California residential property through an unrelated company known as Property Mortgage Company, Inc., which in turn was controlled by one Stanley Glickman. The court acknowledged that there was at least an issue of fact as to whether Mr. Glickman was a fiduciary of the Plan under the ERISA 45 There is no hint of anything of the sort in the reported decision F.3d 258 (9th Cir. 1996).

25 ERISA Bonding Requirements and the Fidelity Insurer 269 definition, but rejected Dr. Rosenbaum s theory that Hartford s bond covered anyone whom ERISA required to be bonded in regard to the Plan assets. Instead, the court analyzed the language of the bond and found that it covered loss from the fraud or dishonesty of only Employees or the Plan Trustees (Dr. and Mrs. Rosenbaum). In Employers-Shopmens Local 516 Pension Trust v. Travelers Casualty and Surety Co. of America, 47 several union-related Plans sued their brokers and the insurers on commercial crime policies issued to the Plans. The Plans sought to recover losses arising out of the Plans dealings with an independent investment adviser. The Court granted summary judgment to one of the insurers and held that neither the investment adviser nor its employees were employees as defined in the insurance policies, that the investment adviser was an independent agent, and that the policy did not purport to provide all coverage that ERISA might require, just certain coverage as specified in the policy. In a separate opinion dated April 16, 2007, the court granted summary judgment to another insurer for the same reason. The case has been appealed to the Oregon Court of Appeals. X. CONCLUSION From the insurer s point of view, the good news is that ERISA requires a bond to protect the Plan against loss from fraud or dishonesty, rather than from every violation of ERISA. The Act and Regulations permit use of the standard forms of fidelity bonds with minor changes by Endorsements or Riders. Since there is a history of loss experience and litigation with these forms, the insurer can have some confidence that it knows the extent of the risks it is assuming as long as courts continue to enforce the clear, unambiguous policies and reject the argument that ERISA creates liability beyond the policy terms. 47 Case No (Circuit Court of Oregon for Multnomah County Dec. 19, 2006).