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Carol I. Buckmann
Sullivan & Cromwell
125 Broad Street
New York, New York 10004-2498
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Dear Ms. Buckmann:
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This is in response to your request for an information letter under section
406(a) of the Employee Retirement Income Security Act of 1974 (“ERISA”)
as to whether initial capital contributions from employee benefit plan
investors transferred for the purpose of venture capital investments will be
treated as “plan assets” at any time after transfer on the “initial
valuation date,” within the meaning of Department of Labor Regulation 29
C.F.R. § 2510.3-101 (“the plan assets regulation”).
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You represent that you are writing on behalf of a law firm that serves as
counsel to a number of investment managers who establish, market, and
provide investment management services to pooled investment vehicles
intended to be venture capital operating companies (“VCOCs”) within the
meaning of the plan assets regulation and to ERISA covered plans investing
in VCOCs.
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You indicate that in the course of representing such parties, the law firm
is regularly asked to render advice as to whether an entity constitutes a
VCOC as of a particular date and to advise the entity or the ERISA plan
investors how to avoid prohibited transactions. In this regard, you are
concerned with the application of the “look-through” rule in the plan
assets regulation for VCOCs that do not require capital contributions from
investors prior to the date of the initial venture capital investment.(1)
You represent that the entities you represent seek the most attractive
investment opportunities for initial investments, and often propose to
purchase their initial investment on the same date initial capital
contributions are made from a “party in interest,” within the meaning of
ERISA, or a “disqualified person,” within the meaning of the Internal
Revenue Code (“the Code”), with respect to an ERISA plan investor in the
VCOC.
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You represent that, in the transactions on which the law firm renders
advice, the General Partner(2) of a VCOC
and its affiliates are not investment fiduciaries for any plan portfolio to
be invested in the VCOC and are not involved at all in any decision by an
independent fiduciary as to whether or not to invest in the VCOC. You
acknowledge that the law firm advises General Partners always to be
extremely careful to follow this rule because they and their affiliates will
be receiving fees from the VCOC on an ongoing basis. You note that, if
General Partners and their affiliates were to invest plan portfolios for
which they have investment responsibility in VCOCs that they also manage,
without having an individual prohibited transaction exemption, they would be
engaged in a per se violation of Section 406(b), because they would be using
their discretion to cause themselves and their affiliates to receive
additional fees from the use of plan assets.
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You further indicate that, because of concerns regarding potential
violations of Section 406(b), the General Partner will pass the initial
investment on to the VCOC contractually at cost, at cost plus market
short-term interest (such interest representing the cost of carrying the
investment), or at current fair market value, if less than the foregoing,
and without any spread, fee, or commission. Therefore, you represent, there
will be no opportunity for a General Partner who had negotiated a first VCOC
investment prior to the first day on which the VCOC was formed to receive
fees or profit from the transaction. To the extent a General Partner or
other party in interest could be viewed as having advanced any funds
required to lock in the investment, that entity or individual would also
have assumed any risk of loss prior to the closing date of the VCOC because,
as indicated above, the VCOC will pay no more than current market value for
the initial investment.
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You indicate that, as a practical matter, it is not possible for initial
capital contributions to be timed so that they are simultaneous with the
closing of the first long-term investment, so that even if capital
contributions are not made prior to the initial valuation date, there may be
some part of the initial valuation date during which initial contributions
are held by the VCOC entity pending their application toward the purchase
price of the first investment. Therefore, you are concerned that, even if
all of the above described precautions are taken, capital contributions that
are transferred on the initial valuation date to a party in interest may be
in violation of section 406(a) of ERISA and section 4975 of the Code. You
ask therefore whether, for the purposes of the application of section 406(a)
of ERISA and section 4975 of the Code, initial contributions received on any
portion of the initial valuation date must be treated as “plan assets”
for that period of time, and whether the “period prior” to the first
long-term investment, as described in Advisory Opinion 89-15A, can be
construed to include any part of the initial valuation date.
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The plan assets regulation (29 C.F.R. § 2510.101) defines when a plan’s
investment in another entity causes that entity’s underlying assets to be
“plan assets.” The plan assets regulation imposes a “look-through
rule” based on the premise that, with certain exceptions, when a plan
indirectly retains investment management services by investing in a pooled
investment vehicle, the assets of the vehicle should be viewed as plan
assets and managed according to the fiduciary responsibility provisions of
ERISA. The regulation distinguishes pooled investment vehicles, which are
subject to the look-through rule, from operating companies, which are not.
Because venture capital companies may have characteristics of both pooled
investment vehicles and operating companies, a specific VCOC definition is
included in the regulation to provide guidance in determining when the
operating company exclusion exception is available for a venture capital
company.
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In general, the plan assets regulation provides that, in the case of a
plan’s investment in an equity interest of an entity that is neither a
publicly-offered security nor a security issued by an investment company
registered under the Investment Company Act of 1940, its assets include both
the equity interest and an undivided interest in each of the underlying
assets of the entity, unless the entity is an operating company or equity
participation in the entity by benefit plan investors is not significant (29
C.F.R. § 2510.3-101(a)(2)). The term “operating company” is generally
defined in 29 C.F.R. § 2510.3-101(c) as an entity that is primarily
engaged, directly or through a majority-owned subsidiary or subsidiaries, in
the production or sale of a product or service other than the investment of
capital. The operating company exclusion also applies to entities that are
separately defined as VCOCs.
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To qualify as a VCOC under the Department’s plan assets regulation, an
entity must invest at least 50 percent of its assets in “venture capital
investments” and, in the ordinary course of its business, actually
exercise “management rights” with respect to one or more of the
operating companies in which it invests. The 50 percent test must be met as
of the first date the entity makes an investment that is other than a
short-term investment pending long-term commitment, and, thereafter, on any
day during a preestablished annual valuation period (29 C.F.R. §
2510.3-101(d)). A qualifying “venture capital investment” is an
investment in an operating company (other than a venture capital operating
company) as to which the investing entity has or obtains management rights.
“Management rights” are contractual rights directly between the investor
and an operating company to substantially participate in, or substantially
influence the conduct of, the management of the operating company.
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In Advisory Opinion 89-15A (Aug. 3, 1989), the Department addressed the
status of initial capital contributions by employee benefit plans to a newly
formed venture capital company that proposed to invest in short-term money
market investments pending long-term capital commitments. The Department
concluded that the VCOC exception did not apply to the venture capital
company during the period preceding its first qualifying venture capital
investment. The Department reasoned that it would be inconsistent with the
plan assets regulation to extend the VCOC exception to the time before the
venture capital company had undertaken the types of activities required to
qualify as a VCOC. Consequently, the Department concluded that, unless some
other exception applied, the initial capital contributions from employee
benefit plans would constitute plan assets, and persons exercising
discretionary authority or control over the assets of the venture capital
company would be fiduciaries of plans that initially transferred capital to
the company during the period preceding its first qualifying venture capital
investment. See also Advisory Opinion 95-04A (May 3, 1995).
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As noted in Advisory Opinion 95-04A, the plan asset look-through rule is
triggered at the time of an employee benefit plan’s investment in an
equity interest of another entity. 29 C.F.R. § 2510.3-101(a)(2). The VCOC
exception to the plan asset look-through rule is effective for the period
beginning on the initial valuation date. 29 C.F.R. § 2510.3-101(d)(1). The
initial valuation date is the first date on which an entity makes an
investment that is not a short-term investment of funds pending long-term
commitment. 29 C.F.R. § 2510.3-101(d)(5)(i). Therefore, it is the view of
the Department that, to the extent that employee benefit plan funds are
transferred to a venture capital company on the initial valuation date
solely for the purpose of the acquisition of an equity interest in a
qualifying venture capital investment such funds would not constitute plan
assets on that date.
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We hope this information is of assistance to you.
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Sincerely,
Susan G. Lahne
Acting Chief, Division of Fiduciary Interpretations
Office of Regulations and Interpretations
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You note that some of these
contributions may be made by an escrow agent who may be holding funds
representing the mutual contributions in escrow on behalf of
investors. See Advisory Opinion 95-04A.
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You indicate that most VCOCs are
partnerships, and therefore for convenience you refer to the fiduciary
managing the partnership as the General Partner. You indicate that the
typical fact pattern would not differ if the VCOC were a corporation
or a limited liability company.
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