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Employee Benefits Security Administration

Advisory Opinion

March 26, 2002

Ms. Melanie Franco Nussdorf
Steptoe & Johnson, LLP
1330 Connecticut Ave., N.W.
Washington, D.C. 20036
Howard M. Bergtraum
O’Sullivan, Graev & Karabell LLP
30 Rockefeller Plaza, 24th Floor
New York, New York 10112

2002-01A
ERISA Sec. 401(b)

Dear Ms. Nussdorf and Mr. Bergtraum:

This is in response to your request for an advisory opinion on behalf of your client regarding the application of the plan assets regulation (29 C.F.R. § 2510.3-101) issued by the Department under the Employee Retirement Income Security Act of 1974, as amended (ERISA), to an entity seeking to qualify as a venture capital operating company (VCOC) as defined in that regulation. Specifically, you ask whether the set of rights described below that have been negotiated by your client are management rights as defined in 29 C.F.R. § 2510.3-101(d)(3)(ii).

You represent that your client, JPMP Global Investors L.P., a Delaware limited partnership, proposes to purchase an equity interest in another entity (the Company) that qualifies as an operating company under 29 C.F.R. § 2510.3-101(c). The Company generally will be a private entity, but in some instances may be a public entity.(1)  You describe the following rights that your client will have as a Significant Investor in the Company.

First, with respect to financial statements and other information, the Company shall deliver to each Significant Investor: (1) as soon as available and in any event within 45 days after the end of each of the first three quarters of each fiscal year of the Company, consolidated balance sheets of the Company and its subsidiaries as of the end of such period, and consolidated statements of income and cash flows of the Company and its subsidiaries for the period then ended prepared in conformity with generally accepted accounting principles in the United States applied on a consistent basis, except as otherwise noted therein, and subject to the absence of footnotes and to year-end adjustments; (2) as soon as available and in any event within 120 days after the end of each fiscal year of the Company, a consolidated balance sheet of the Company and its subsidiaries as of the end of such year, and consolidated statements of income and cash flows of the Company and its subsidiaries for the year then ended prepared in conformity with generally accepted accounting principles in the United States applied on a consistent basis, except as otherwise noted therein, together with an auditor’s report thereon of a firm of established national reputation; and (3) to the extent the Company is required by law or pursuant to the terms of any outstanding indebtedness of the Company to prepare such reports, any annual reports, quarterly reports and other periodic reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 actually prepared by the Company as soon as available.(2)

Second, with respect to inspection and access, the Company and its subsidiaries shall provide to each Significant Investor, true and correct copies of all documents, reports, financial data and other information as a Significant Investor may reasonably request. Additionally, the Company shall permit any authorized representatives designated by the Significant Investor to visit and inspect any of the properties of the Company and its subsidiaries or any of its subsidiaries, including its and their books of account, and to discuss its and their affairs, finances and accounts with its and their officers, all at such times as a Significant Investor may reasonably request.

Finally, each Significant Investor shall have the right to consult with and advise the management of the Company and its subsidiaries, upon reasonable notice at reasonable times from time to time, on all matters relating to the operation of the Company and its subsidiaries.

You represent that a Significant Investor possesses the above-described rights under a written agreement between the Significant Investor and the Company pursuant to which the Significant Investor purchases an interest in the Company. You explain that the form of that agreement will vary according to the business form of the Company (for example, if the Company is a corporation, the Significant Investor will derive these rights from a stock purchase agreement). You represent that you are aware of no further limitations on a Significant Investor’s ability to exercise any of these rights other than contained in your description.

You represent that the set of rights described above is greater than the rights normally obtained by institutional investors in portfolio companies. You explain that such investors normally do not have specific, enforceable rights to consult with and advise management. If they do have such rights to consult, their rights cannot be exercised on as frequent a basis as your client’s rights. You further explain that such investors normally have no right to inspect company books, records, or facilities. Moreover, the documents to which institutional investors have inspection rights normally do not include all quarterly and annual consolidated balance sheets of a company and its subsidiaries, all quarterly and annual consolidated statements of income and cash flows of the company, and all reports required by law or under the terms of any outstanding indebtedness of the company. You ask whether the set of rights obtained by your client as a Significant Investor, as described above, is consistent with the term management rights as defined in 29 C.F.R. § 2510.3-101(d)(3)(ii).

The plan assets regulation 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 pre-established 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 defined in 29 C.F.R. § 2510.3-101(d)(3)(ii) to mean 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.

The preamble to the proposed plan assets regulation provides additional guidance regarding the types of rights to substantially participate in, or substantially influence the conduct of, the management of an operating company that would constitute management rights. Specifically, the preamble to proposed regulation provides in relevant part:

The Department is also considering, however, whether it is possible to identify specific characteristics that are indicative of venture capital investments (that is, investments with respect to which the holder has rights to participate in, or influence the conduct of, the management of the entity to which the investment relates) which could be used in developing a more precise and easily applied definition of the term venture capital operating company. For example, it appears that the fact that the holder of corporate securities has the right to appoint one or more directors of the corporation would indicate that the securities are venture capital investments, as would the fact that a representative of the holder of such securities serves as a corporate officer. Other factors may also indicate that an investment is a venture capital investment. These might include the fact that the investment is an equity investment acquired directly from an issuer who does not have outstanding any publicly-offered securities during its formative or start-up period, the fact that the investment constitutes a significant portion of the equity capitalization of a nonpublic issuer, and the fact that the holder of an investment has special rights to examine the books and records of the nonpublic entity to which the investment relates.

50 Fed. Reg. 961, 965 (Jan. 8, 1985).

Whether the individual rights obtained by an investor in an operating company constitute management rights under the plan assets regulation is an inherently factual question that must be determined taking into account the particular facts and circumstances of each case. Advisory Opinion 89-04A (March 30, 1989); 50 Fed. Reg. at 965. We believe that, depending on the circumstances, the rights described in the preamble to the proposed plan assets regulation, as quoted above, may constitute management rights under the plan assets regulation. We also believe, however, that the term management rights should not be interpreted so broadly as to include virtually any investment in an operating company. See 51 Fed. Reg. 41262, 41273 (Nov. 13, 1986). In order for an investor to acquire management rights under the plan assets regulation, the investor must acquire rights with respect to the management of the operating company that are more significant than those normally negotiated by institutional investors with respect to investments in established, credit-worthy companies. See 29 C.F.R. § 2510.3-101(j), Example (6); 50 Fed. Reg. at 965-966. In this regard, we note that the rights of your client as a Significant Investor in the Company, as you have described them, are similar to the rights described by the Department in the preamble to the proposed regulation. In addition, you have represented that those rights are more significant than those normally obtained by institutional investors in portfolio companies. Therefore, based on your representations, we believe that such rights constitute management rights under the plan assets regulation.

This letter constitutes an advisory opinion under ERISA Procedure 76-1, 41 Fed. Reg. 36281 (Aug. 27, 1976). Accordingly, it is issued subject to the provisions of that procedure, including section 10 thereof relating to the effect of advisory opinions.

Sincerely,
Louis Campagna
Chief, Division of Fiduciary Interpretations
Office of Regulations and Interpretations


Footnotes

  1. For purposes of this request, you explain that, with respect to a Company, the term public means an entity that is required to file financial reports and proxy statements with the Securities and Exchange Commission under the Securities Exchange Act of 1934, and that the term private means an entity that is not required to file financial reports and proxy statements with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

  2. You represent that where the Company is a non-U.S. company, the information provided pursuant to the foregoing may be in conformity with generally accepted accounting principals of other countries.