On July 14, 2008, the US Department of Labor (the DOL) published a series of frequently asked questions (the FAQs) that favorably limit the scope of the DOL’s November 2007 final regulation regarding the annual reporting obligations of ERISA investors in private investment funds. The 2007 regulation was generally scheduled to become effective on January 1, 2009 and, among other things, would have significantly increased the amount of disclosure that ERISA investors must provide to the DOL and the IRS regarding the fees paid to service providers of the private investment funds in which they invest. Although the reporting obligations created by the 2007 regulation (and clarified by the FAQs) are imposed on ERISA investors themselves, many ERISA investors will likely look to private fund sponsors as the primary source for obtaining the required information.
Under the 2007 regulation, the DOL required that, as of January 1, 2009, ERISA investors report the total amount of compensation indirectly paid to the service providers of private investment funds in which the ERISA investor has invested. In what was a surprise to some practitioners, based on the preamble of the regulation, these rules appeared to apply to all private investment funds regardless of whether they held “plan assets” (i.e., “under 25%” funds, venture capital operating companies and real estate operating companies were not exempt from these particular rules as one would expect). So, for example, if a Pension Plan invested in a Hedge Fund (an “under 25%” fund), which executed and settled trades through a Broker, the Pension Plan would have had to report a pro rata share of the brokerage fees paid by the Hedge Fund to the Broker as compensation paid indirectly by the Pension Plan to the Broker. Although there were some potential exceptions to this treatment, it is not clear whether qualifying for the exceptions would have been practicable in all cases.
In addition, the 2007 regulation arguably required the reporting of any compensation that service providers to investment funds received from third parties (i.e., other than from the fund or the ERISA investor). So, in the example above, the Pension Plan could have been required to report a portion of any soft dollars credited by the Broker to the account of the manager of the Hedge Fund. Moreover, if the amount of soft dollars credited exceeded $1,000, the Pension Plan could have been required to report the identity of the Broker payor.
The FAQs clarify these requirements in two favorable respects. First, the FAQs state that compensation received in connection with managing or operating venture capital operating companies (VCOCs) and real estate operating companies (REOCs) is generally exempt from being reported as indirect compensation under the new reporting requirements. Second, the FAQs note that fees paid to fund service providers for “ordinary operating expenses” (such as attorneys’ fees, accountants’ fees, printers’ fees) are exempt from disclosure. The FAQs explicitly note that a fund’s brokerage costs associated with effecting securities transactions within its portfolio would be considered ordinary operating expenses. So, in the example above, the brokerage fees paid by the Hedge Fund to the Broker would be exempt from disclosure by the Pension Plan. It appears, however, that the soft dollars credited to the account of the Hedge Fund’s manager continue to be reportable because these “costs” would not be considered ordinary operating expenses.
For Funds that Remain “Under 25%” Funds
Although the FAQs are a helpful interpretation of the 2007 regulation, certain details regarding the interaction of the FAQs with the 2007 regulation remain unclear. In general, however, it appears that the primary category of reportable items by the ERISA investor will be management and performance fees, any placement agent fees and any compensation paid to an investment fund manager or general partner by a third party (note the soft dollars example mentioned above).
For those items that remain reportable, there is a simplified alternate reporting method that may be available provided that certain general disclosures (most importantly, the identity of the service provider and the amount or estimate of the compensation) are provided to the ERISA investor. Under the alternate reporting method, the amount of compensation that the ERISA investor has paid would not be reportable—only the identity of the service provider and certain other general information would need to be disclosed. Many private placement memoranda (PPM) may already contain much of the information needed to qualify for the alternate reporting method. For example, to the extent a PPM states the amount of the management fee and performance fee payable to the fund manager, this should be sufficient in most cases. In this case, the ERISA investor would report only the name of the fund manager and limited general information. However, the FAQs state that the document containing the information that is used to qualify for the alternate reporting method (the PPM or similar document) needs to state explicitly that the compensation related disclosures are intended to satisfy the alternate reporting method.
Thus, private investment fund sponsors that have ERISA investors should consider reviewing the compensation paid and received in connection with their investment funds to determine whether they can qualify for the alternate reporting method and, if not, what disclosures they will likely be requested to provide.
For Funds that Can Qualify as VCOCs or REOCs
Given the broad exception in the FAQs for VCOCs and REOCs, there may be an advantage to qualifying an investment fund as a VCOC or REOC even though it could otherwise be structured as an “under 25%” fund. While this likely will not help existing funds that opted to stay under the 25% threshold or cannot meet the requirements as a VCOC or REOC, this option would be available to new funds where operating as a VCOC or REOC is possible and not itself viewed as so onerous as to outweigh the benefits of not having to comply with the reporting obligations the fund may have to its ERISA investors.
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