On May 10, 2011, the Securities and Exchange Commission (the “SEC”) issued proposed rules and a notice of its intention to issue an order increasing the thresholds for qualification as a “Qualified Client” under the Investment Advisers Act of 1940 (the “Advisers Act”), as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Under Advisers Act Rule 205-3, the Qualified Client standard must be met in order for a client, or an investor in a private fund, to be charged a performance-based fee.
The Advisers Act prohibits an investment adviser from entering into, extending, renewing or performing any investment advisory contract providing for compensation to the adviser based on a share of capital gains on, or capital appreciation of, client funds unless the client meets the “Qualified Client” standard set forth in Rule 205-3. In its current form, Rule 205-3 permits an investment adviser to enter into such performance fee arrangements if (i) the client has least $750,000 under management with the adviser (the “assets-under-management test”) or the adviser reasonably believes that the client has a net worth of more than $1.5 million (the “net worth test”), (ii) the client is a “Qualified Purchaser” under section 2(a)(51)(A) of the Investment Company Act of 1940 (the “1940 Act”), or (iii) the client is an executive officer, director, trustee, general partner, or knowledgeable employee of the adviser.
As required by Section 418 of the Dodd-Frank Act, the SEC announced its intention to issue an order that will adjust the dollar amount tests in Rule 205-3 to account for the effects of inflation by increasing the assets-under-management test from $750,000 to $1 million and the net worth test from $1.5 million to $2 million. In addition, the SEC proposed the following modifications to Rule 205-3:
- A new provision that will require the SEC to issue orders making future inflation adjustments every five years;
- A revision to the net worth test that excludes the value of a person’s primary residence and related mortgage debt that is no greater than the property’s current market value from the calculation of a client’s net worth; and
- A modification of the Rule’s current transition provisions to allow advisers and clients to maintain existing performance fee arrangements that were permissible when the advisory contract was entered into, as well as any such arrangements entered into by an investment adviser at a time when the adviser was exempt from registration with the SEC.
The Dodd-Frank Act requires that the SEC issue an order adjusting the dollar amount tests in Rule 205-3 to account for inflation by July 21, 2011. The SEC is accepting comments on the proposed rules until July 11, 2011.