Fidelity Bonds

The fidelity bond is a member firm's insurance against insider losses. It does not cover market risk, customer-relationship losses, or fraudulent investments. It covers the structural risks that arise when a firm holds customer assets and depends on employees to handle them honestly: theft by employees, forged signatures, misplaced certificates, computer-system fraud. The fidelity-bond requirement sets the minimum coverage every member must carry and ties the minimum to the firm's net-capital requirement.

What the Bond Covers

A fidelity bond insures the firm against specified employee-related and operational perils:

• Employee dishonesty (theft, embezzlement, fraud by employees)
• Misplaced or lost securities certificates
• Forgery of signatures on customer or firm documents
• Other specified perils (e.g., computer-system fraud, transit losses)

The bond does NOT cover:

• Customer market losses (decline in value of investments)
• Customer-suitability losses (poor recommendations)
• Operational errors that do not involve dishonesty (clerical mistakes that do not rise to fraud)

Think of it this way: The fidelity bond is the firm's protection against the people working at the firm. It assumes that even with good controls, an employee somewhere will at some point steal, forge, or otherwise misappropriate. The bond is the financial backstop that lets the firm cover the loss without depleting its capital. The fidelity-bond requirement ensures every firm has that backstop in proportion to its size.

Minimum Coverage Tiers

Coverage scales with the firm's net capital requirement (NCR) under the net-capital rule:

The "Greater of" Test for Small Firms

For firms with NCR less than $250,000, the bond floor is the greater of:

• 120% of the firm's NCR, OR
• $100,000

A firm with a $50,000 NCR (introducing firm) faces:

• 120% of $50,000 = $60,000
• vs. $100,000 floor
• The greater is $100,000, so the bond must be at least $100,000

A firm with a $200,000 NCR faces:

• 120% of $200,000 = $240,000
• vs. $100,000 floor
• The greater is $240,000, so the bond must be at least $240,000

The Table for Larger Firms

Firms with NCR of $250,000 or more follow a tabular schedule that scales upward. As NCR increases, required bond coverage increases in step. Firms in the higher tiers carry $1M, $5M, $10M, or larger bonds depending on where they fall on the schedule.

Exam Tip: Gotchas

• For firms with NCR less than $250,000, the bond is the GREATER of 120% of NCR or $100,000. Common exam trap: students forget the $100,000 floor and apply only the 120%. A firm with a $50,000 NCR has a $100,000 bond requirement, not $60,000.
• The bond is sized to the NET CAPITAL REQUIREMENT, not actual net capital. A firm with a $250,000 minimum but $5M of actual net capital sizes its bond off the $250,000 floor (per the table); growth above the minimum does not automatically inflate bond requirements.

Per-Loss Coverage and the No-Aggregate-Limit Requirement

For firms with NCR of $250,000 or more, the bond must provide per-loss coverage with no aggregate limit of liability.

What "Per-Loss" Means

Per-loss coverage means each separate loss event is covered up to the bond's per-loss limit. The firm can recover for multiple loss events without depleting a shared aggregate cap. This contrasts with a typical commercial insurance policy that has both a per-loss limit and an aggregate annual limit.

Why No Aggregate Limit

Without the no-aggregate-limit requirement, a firm hit by multiple losses in the same policy year could exhaust its aggregate cap and be left without coverage for later losses. The fidelity-bond requirement's structure ensures each loss has its full coverage available, regardless of how many other losses have occurred.

Exam Tip: Gotchas

• For firms with NCR of $250,000+, the bond must be PER-LOSS with NO AGGREGATE LIMIT. A standard commercial policy with an aggregate cap does not satisfy the fidelity-bond requirement for firms in this tier. The rule wants each loss to have full coverage available.

Deductibles: 25% Cap with a 10% Trigger

The bond may include a deductible up to 25% of the coverage amount. Any deductible above 10% must be deducted from net worth in the firm's net-capital computation under the net-capital rule.

The Logic of the 10% Trigger

A small deductible (under 10%) is treated as immaterial: the firm is still substantially insured, and the deductible amount is small enough not to threaten the firm's solvency in a loss event. Above 10%, the deductible amount is large enough that it effectively reduces the firm's regulatory capital cushion, so the SEC's net-capital computation reflects that reduction by deducting the excess deductible from net worth.

Real-world example: Firm has a $1M bond with a 15% deductible = $150,000 deductible. The first 10% ($100,000) is fine. The excess $50,000 (15% - 10% on $1M) is deducted from net worth in the firm's net-capital computation. So the firm's net capital is reduced by $50,000 to reflect the higher deductible.

Exam Tip: Gotchas

• The deductible is capped at 25% of coverage. A firm cannot satisfy the fidelity-bond requirement with a 30% deductible. The exam may probe higher deductible levels; 25% is the ceiling.
• Deductibles above 10% are deducted from NET WORTH in the net-capital computation. Common exam trap: students assume all deductibles are net-capital-neutral. Above 10%, the excess reduces regulatory capital.

Annual Recalibration

The firm's highest net capital requirement during the prior 12 months sets the bond floor for the next 12 months.

Why "Highest" and Not "Current"

A firm's NCR can vary during a year as the firm's business mix changes (e.g., from introducing-firm status to carrying-firm status). The rule prevents firms from gaming the bond floor by shrinking back to a smaller NCR for the bond-renewal period. The bond is sized to the firm's peak NCR over the prior 12 months.

Renewal Process

Each year, the firm:

1. Reviews its NCR over the prior 12 months
2. Identifies the highest NCR reached during that window
3. Sizes the bond to satisfy the fidelity-bond requirement's tier for that highest NCR
4. Renews or amends the bond to reflect the appropriate coverage

Exam Tip: Gotchas

• The bond is sized to the HIGHEST net capital requirement during the prior 12 months, not the current NCR. A firm whose business shrank during the year does not get to lower its bond to match the lower current NCR; the bond must still cover the peak.