On May 10, 2011, the Securities and Exchange Commission (the “SEC”) proposed amendments to Rule 205-3 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), that would: (i) increase the dollar amount thresholds in the “qualified client” definition under Rule 205-3 to account for the effects of inflation; (ii) require the SEC staff to adjust the dollar amount thresholds in the “qualified client” definition every five years to account for inflation; (iii) exclude the value of a person’s primary residence from the calculation of net worth for the purposes of the “qualified client” definition; and (iv) grandfather certain pre-existing performance fee arrangements from certain of the proposed amendments.
Section 205(a)(1) of the Advisers Act generally prohibits a registered investment adviser from entering into any advisory contract that provides for compensation based on a share of the capital gains or capital appreciation of a client’s account or any portion thereof (i.e., a “performance fee”). Rule 205-3 under the Advisers Act provides an exemption from this performance fee prohibition, permitting a registered investment adviser to enter into performance fee arrangements with certain sophisticated clients who have the capacity to bear the additional risks of such arrangements. An adviser can rely on Rule 205-3 only if performance fee arrangements are entered into with “qualified clients.” “Qualified clients” currently are defined in Rule 205-3 as persons who meet one or more of the following tests (among others):
- Natural persons or companies that have at least $750,000 under the management of the adviser (the “AUM Test”), or
- Natural persons or companies that have a net worth of more than $1.5 million (the “Net Worth Test”).
Adjustment to Dollar Amount Tests
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) directs the SEC to adjust for inflation the dollar amount thresholds in the “qualified client” definition by July 21, 2011 and every five years thereafter. Pursuant to the Dodd-Frank Act, the proposed amendments would increase the dollar amount thresholds in the AUM Test to $1 million and the Net Worth Test to $2 million. In determining eligibility under the AUM Test, the proposed amendments would include any committed capital of clients. The proposed amendments provide that the SEC will adjust the dollar amount thresholds set forth in Rule 205-3 every five years for inflation.
Exclusion of Primary Residence
The proposed amendments would amend the Net Worth Test in Rule 205-3 to exclude:
- the value of a natural person’s primary residence, and
- the amount of debt secured by such residence that is no greater than the property’s current market value.
Therefore, the mortgage on such residence would not be included in the assessment of whether a client or investor meets the Net Worth Test unless the outstanding debt on the mortgage, at the time net worth is calculated, exceeds the market value of the residence. If the outstanding debt exceeds the market value of the residence, the amount of the excess would be considered a liability in calculating net worth.
To minimize the impact on certain pre-existing performance fee arrangements, the proposed amendments would allow an investment adviser and its clients to maintain existing performance fee arrangements that were permissible when the parties entered into to the advisory contract, regardless of whether the performance fee would be permitted under the proposed amendments. In particular, the proposed amendments would grandfather the following performance fee arrangements:
- Arrangements with Existing Clients. If a registered investment adviser entered into an advisory contract that satisfied the conditions of Rule 205-3 that were in effect when the contract was entered into, the adviser would be deemed to satisfy the conditions of the proposed amended Rule 205-3.
- Arrangements with Advisers Exempt from Registration. If an adviser was previously exempt from registration as an investment adviser and subsequently registers with the SEC, Rule 205-3 would not apply to contractual arrangements that such adviser entered into when it was exempt from registration with the SEC. However, Rule 205-3 would apply to contractual arrangements into which the adviser enters after it is no longer exempt from registration.
The SEC is currently seeking public comment on various aspects of the proposed amendments until July 11, 2011.