Note on the Plan Asset Regulation and VCOCs

Joseph W. Bartlett, Founder of VC

In organizing an investment partnership, the sponsors are compelled to take into account the identity of certain types of investors, principally pension funds and offshore entities. A dramatic, at least in relative terms, rise in investment partnership investing is largely traceable to the infusion of pension assets, as the managers of tax-exempt funds have discovered the attractiveness of investment capital returns. However, that growth has not been facilitated by the erratic performance of the Department of Labor in wrestling with the issue of whether the managers of the investment capital pools-the general partner or partners-should be deemed managers of "plan assets" under the Employee Retirement Income Security Act of 1974 (ERISA). [1] If the manager of the pool were deemed to be managing "plan assets" in a fiduciary capacity under ERISA, then the statute and the Department of Labor regulations would impose various constraints drafted with the Central States Teamsters Fund in mind, requiring in turn largely unacceptable changes in how investment managers traditionally go about their business. The fiduciaries overseeing the investment of pension assets are barred from participating, for example, in the profits of the partnerships within their stewardship. Indeed, newspaper headlines reflect with monotony the indictment of yet another corrupt union official for taking a surreptitious "piece of the action" in the investments made on behalf of the union members. The very nature of the relationship between a fund manager and the investors, however, is one of profit sharing. Moreover, again because the legislative language was drafted in a different context and culture, ERISA contains stern prohibitions on conflicts of interest. In many investment partnerships, on the other hand, the investors are content, indeed enthusiastic, about co-investment in portfolio opportunities with the managers, who are often leading figures in investment in their own right.

The narrow technical issue facing the Labor Department is whether only the limited partnership interests constitute "plan assets" or whether the investments the partnership makes are "plan assets." If ERISA entities hold less than 25 percent of each class of equity interest in an investment partnership, then the partnership is unaffected; its assets are not "plan assets." The managers making the partnership's portfolio investments, the individual general partners, would be one step removed from the process, akin to the officers of an industrial company (e.g., General Motors), in which pension funds and the funds of millions of other investors are commingled. If, on the other hand, impelled by the omnipresent "thin edge of the wedge" or Pandora's Box synðdrome, the Labor Department were to disregard the investment partnerships as pass-through entities-again with the Central States Teamsters in mind-fiduciary responsibilities would land on the shoulders of the general partners, an ill-fitting suit. The Department has wrestled with this problem from 1979 to 1986, [2] when it published its final position. [3]

The " Final Regulation " first provides a general de minimis test. If ERISA entities hold less than 25 percent of the interests in an investment partnership, then the partnership is unaffected; [4] its assets are not "plan assets." (In fact, the threshold is actually 20 percent, more or less, because the general partner(s) "'carried" interest is excluded from the calculation). The good news is that the Pension Protection Act of 2006 reversed the "regulate `em into the ground" trend, overruling DOL Advisory Op. No. 89-16A and excluding government plans and foreign funds and easing the burden on funds with fund-of-fund investors. Thus, if 20 percent of Fund X is held by a fund of funds and the fund of funds is an ERISA entity because 50 percent of its interests are hold by ERISA entities, only 50 percent of the interest in Fund X ( i.e. 10 percent) is counted towards the Fund X "significant participation " test.

Note a trap for the unwary. If Fund X is close to the line and a fund of funds investor increases its ERISA "significant participation" (e.g. a new ERISA entity invests), then Fund X "significant participation" percentage increases. With respect to ERISA entities, the Regulation defines an entity called an venture capital operating company (VCOC) [5] ; as long as an investment partðnership qualifies as a VCOC, the managers of the partnership are not ERISA fiduciaries. Like the Investment Company Act scheme, the test is an asset test - 50 percent of the VCOC partnership's portfolio, measured at cost, must be invested in "investment capital investments" or "derivative investments" (investments which grow out of investment capital investments). [6] Temporary liquid investments do not count against the partnership. [7] An "investment capital investment" is an operating company in which the partnership enjoys "management rights," that is, contractual rights directly between the investor and all operating company" to substantially participate in" or "substantially influence" the management of the portfolio investment. [8] The rights must be specific to the fund in question; a fund cannot take advantage of the fact that the lead investor in a group has management rights. [9] This means that each investment fund will need a contractually provided board seat, or other equivalent rights, in each investment. [10]

An operating company is defined as "an entity primarily engaged, directly or through its majority owned subsidiary or subsidiaries in the production or sale of a product or service other than the investment of capital." That definition can raise some thorny questions: For example, if the investment is in a very early stage company, testing its products at the beta test stage, is that company engaged in "the production or sale of a product or service?" Alternatively, what if the company plans to license the intellectual property it develops, rather than selling it? There is no clear answer to these questions; but presumably the Department of Labor did not mean to disqualify start ups.

As a VCOC starts selling off its investments, there may be a problem in having at least 50 percent of its assets invested in operating companies. The trick is to establish a " distribution period," which may be set up at any time after the fund has distributed the proceeds of at least 50 percent of its investments. The distribution period ends on the earlier of the date the VCOC (which is unlikely) makes a new portfolio investment (not including follow ons) or ten years after the beginning of the distribution period.

A "fund of funds" (an investment fund that invests in other investment funds) cannot be a VCOC, since an investment partnership's investment as a limited partner in another investment partnership will not be a qualified investment for purposes of the 50 percent test. [11] Investment partnerships will be able to hold the stock in companies which have implemented their exit strategy (i.e., have merged or completed an IPO) and thereby extinguished the contractual board seat or other rights for 30 months after the exit strategy was implemented (or 10 years after initial investment, whichever is later). [12]

Perhaps the most difficult problem facing newly organized funds arises from a DOL advisory opinion [13] discussing the issue whether a newly organized limited partnership aspiring to be a "venture capital operating company" within the meaning of § 101(b) of the Regulation can qualify at all times if the money is raised on day one and is invested in the manner suggested in the Regulation ( i.e., 50 percent of the assets valued at cost in "investment capital investments") as of some time shortly after day one. The Department of Labor has read the language of the Regulation literally and advised the inquiring law firm that, to be an investðment capital operating company from inception, the new partnership must qualify by investing 50 percent of its funds in investment capital investments immediately. It is arguable that DOL has misread its own statute-that the only requirement as of the "initial valuation date" is that 50 percent or more of the funds be invested in something other than short-term investments and that the subsequent addition of "management rights" (within the meaning of § 101(b)(3)(ii) to 50 percent of the long-term investments would retroactively qualify the partnership as an Investment Capital Operating Company. The point, however, is that, in DOUs view, the clock starts running from the time the first funds are contributed and invested in short-term instruments; there is no retroactivity. Even though the partnership's funds are shortly put to work in investment capital investments, there will be a period of time during which the partnership is not an "Investment Capital Operatðing Company." The cure to this problem has taken two forms. First, arrange the initial closing as a so-called "dry closing": No money taken down until an investðment can be found. Or, secondly, time the initial closing so as to coincide with the closing of an investment capital investment, meaning that an investment must be warehoused. There is no explicit requirement the first investment be relatively substantial in terms of the entire amount of capital being raised; if DOL is going to live and die by the exact terms of the statute, then investment funds should be able to go forward on the basis of literal compliance. However, some firms will not give comfort to the VCOC issue unless the initial investment is nontrivial.

Finally, in Advisory Opinion 95-04A, 29 C.F.R. § 2510.3-101, the DOL has provided guidance on several issues relating to the structure and operation of a VCOC, namely: (1) the use of escrow arrangements to hold capital contributions pending a VCOC's first qualifying investment; (2) the nature of VCOC management rights; and (3) the structuring of indirect VCOC investments.

Thus, to expedite the calling of capital on the date needed, some VCOCs establish an escrow arrangement to hold capital contributions outside of the VCOC until the date of the first qualifying investment. The Advisory Opinion confirms that such an arrangement will not result in the VCOC being deemed to hold plan assets prior to its first investment, provided the escrow arrangement makes it clear that (1) the plan's investment in the entity is contingent upon the entity satisfying all of the requirements to be a voc, and (2) until the conditions precedent are met for transferring the monies held in escrow to the VCOC, the escrow account will itself be subject to ERISA, making the escrow holder a fiduciary to the plan.

With respect to those management rights which a VCOC must obtain from the operating companies it its portfolio, the Opinion makes clear that a VCOC need not obtain the power to direct management decisions, thereby confirming an example in the Regulation of a VCOC that has the right to "routinely consult informally with" or "advise" the management of a portfolio company.

The fund Plan Asset Regulation, in a controversial section, disqualified investments by a fund in another PIV as "good" investments for purposes of measuring VCOC status. The "fund of funds" prohibition has left some question as to whether indirect investments in operating companies are permitted, for example, through a wholly owned subsidiary of the VCOC. The Advisory Opinion clarifies that a VCOC may count investments in operating companies through a wholly owned subsidiary, provided the VCOC obtains the requisite direct management rights. The DOL limited its opinion to investments through a wholly owned subsidiary, so there may still be uncertainty regarding other tiered investment structures, such as joint ventures between VCOCs. However, the Advisory Opinion does note that, in determining whether an entity is a wholly-owned subsidiary, a de minimis holding by a general partner, can be disregarded.

[1] Employee Retirement Income Security Act of 1974, 29 U.S.C. §§ 1001-1461. The person who exercises control over plan assets is a "fiduciary" under ERISA according to § 3(21), and a fiduciary is held to a high standard of care, § 404, and loyalty, § 406.

[2] What the Department of Labor refers to as the "Final Regulation" is officially a series of Interðpretive Bulletins amending 29 C.F.R. pts. 2509, 2510, 2520, and 2550. The text of the Final Regðulation (the Regulation) appears in 51 Fed. Reg. 41262 (Nov. 13, 1986). The Regulation became, with certain exceptions, effective on Mar. 13, 1987. DOL Reg. § 2510.3-101(k).

[3] The Regulation does not apply to entities "in existence on March 13, 1987." DOL Reg. § 2510.3ð101 (k).

[4] The test is whether, immediately after the most recent acquisition of an interest, 25% or more of the value of any class of equity interests in that entity is held by benefit plan investors. DOL Reg. § 2510.3-101(f)(1). Accordingly, the Regulation creates an ongoing responsibility to patrol values whenever the interests of the partners shift inter sese. If the venture fund is publicly held, its assets will not be plan assets. Id. § 2510.3- 10 1 (a)(2).

[5] An operating company is defined as "an entity primarily engaged . in the production or sale of a product or service other than the investment of capital." There are questions involved in this definition which have been clearly answered. What if a company has invented a product and then licenses it to others, that isn't either production or sale, is that company a "operating company?" How about a start up which is just getting going and has not yet engaged in the production or sale of a product? How about a company complex which includes a parent which owns 80 percent of a first tier subsidiary which in turn owns 80 percent of a second tier subsidiary? The definition talks about entities as operating companies which are engaged in production or sale "directly or through its majority owned subsidiary or subsidiaries." Presumably a second tier subsidiary would qualify if the chain is over 51 percent at each level.

[6] Id. § 2510.3-101(d)(1)(i).

[7] "Short-term investments pending long-term commitment" or "distributions to investors" are excluded. Id. § 2510.3-101(d)(i). Note 29 to the Regulation suggests "short-term investments" include "commercial paper and similar investments" but that a portfolio of the same cannot be held indefinitely. Compare the definition in § 3(a)(3) of the Investment Company Act of 1940 ("government securities and cash items").

[8] Id. § 2510.3-101(d)(3)(ii).

[9] DOL Reg. § VI,B(2)(a).

[10] The only example cited in the preamble to the Regulation defining "management rights" mentions 11 a contractual right to appoint a member of the portfolio company's board." DOL Reg. § V1,13(l)(c). In such a situation, it is incumbent on the partnership actually to exercise the right of these on one occasion or "not on a sporadic basis"-the Regulation is not clear. Id.

[11] Id. The "fund of funds" phenomenon will continue, it can be predicted, the managers eschewing the notion of a partnership and seizing the option of registering as investment advisers, qualifying under the recent loosening of the Investment Advisers Act of 1940.

[12] DOL Reg. Id. The "fund of funds" phenomenon will continue, it can be predicted, the managers eschewing the notion of a partnership and seizing the option of registering as investment advisers, qualifying under the recent loosening of the Investment Advisers Act of 1940. 2510.3-101(d)(4).

[13] No. 89-16A, reproduced in 16 Pens. Rep. (BNA) 1612 (Sept. 4, 1989).