SEC Amends Rules on Advisory Performance Fee Charges

On February 15, 2012, the U.S. Securities and Exchange Commission adopted amendments to Rule 205-3 of the Investment Advisers Act of 1940 consisting of: (i) changes to the dollar amount thresholds which determine whether an individual or company is a “qualified client;” (ii) changes to the net worth test in the definition of “qualified client;” (iii) inclusion of two transition, or “grandfather,” provisions which permit investment advisers and clients to continue operating under advisory contracts entered into before adoption of these amendments.

The identification of investors as “qualified clients” is necessary to determine whether it is permissible to pay the investment adviser performance fees or other incentive compensation. All investors in funds that pay such compensation must be “qualified clients.”

“Qualified client” dollar amount thresholds increased.

Under the amended rule, Rule 205-3(d) now provides that the assets-under-management threshold is $1 million (up from $750,000), and the net worth threshold is $2 million (up from $1 million). Thus, a client, “immediately after entering into the contract,” must now have $1 million “under the management of the investment adviser.” Alternatively, the investment adviser entering into the contract must reasonably believe that the client has a net worth of more than $2 million (exclusive of primary residence).

Additionally, the amended rule provides that the SEC “will issue an order every five years adjusting for inflation” these thresholds as required. Lastly, the Personal Consumption Expenditures Chain-Type Price Index is designated as the index on which future adjustments are to be made.

Value of primary residence excluded from determining net worth.

The net worth test contained in the definition of “qualified client” under Rule 205-3 will now exclude “the value of a person’s primary residence and the debt secured by the residence, up to the fair market value of the residence, from the calculation of a person’s net worth.” The SEC adopted this change, because it believes that the value of a person’s residence is ultimately of little relevance in judging the person’s “financial experience and ability to bear the risks of performance fee arrangements, and therefore [of] little relevance to the individual’s need for the Act’s protections from performance fee arrangements.”

The amendment will also require that any “increase in the amount of debt secured by the primary residence” be included as a liability if such increases occurred within 60 days leading up to entry into the advisory contract, even if the primary residence’s estimated value “exceeds the aggregate amount of debt secured” by the residence. Therefore, investors will have to identify any increase in mortgage debt during the 60-day period and “count that debt as a liability in calculating net worth.”

“Grandfather” provisions.

Designed to “minimize the disruption of existing contractual relationships” that met the rule’s requirements at the time that the parties entered into them, the amendments include two transition provisions which allow parties to continue operation under existing contracts even if those contracts would not be permissible under the amended rule.

Under amended Rule 205-3(c)(1), a registered investment adviser who “entered into a contract and satisfied the conditions of the rule which were in effect when the contract was entered into,” will be “considered to satisfy” the rule’s conditions; however, if a person or company not previously a party to the contract then becomes a party, the conditions of the rule in effect at the  time it becomes a party will apply to that person or company.

Under amended Rule 205-3(c)(2), if “a registered investment adviser previously was not required to register with the [SEC] pursuant to §203 of the Act and did not register,” then §205(a)(1) of the Act “will not apply to the contractual arrangements into which the registered adviser entered when it was not registered with the [SEC].”

Effective Dates

Although the dollar amount threshold changes became effective September 19, 2011, the amendments adopted on February 15, 2012, codify those changes. The net worth calculation amendment goes into effect on May 22, 2012. Moreover, advisers may rely on the amended grandfather provisions ahead of their effective date of May 22, 2012.

Fund Manager Action Items

Fund managers should:

1.      Amend their subscription applications and investor questionnaires to reflect the law changes.

2.      Change their due diligence and compliance procedures to confirm compliance with the rule.