Information Letter

September 23, 1998

Carol I. Buckmann
Sullivan & Cromwell
125 Broad Street
New York, New York 10004-2498

Dear Ms. Buckmann,

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).

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.

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.

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.

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.

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.

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.

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.

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.

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).

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.

We hope this information is of assistance to you.


Susan G. Lahne
Acting Chief, Division of Fiduciary Interpretations
Office of Regulations and Interpretations


  1. 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.

  2. 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.