The SEC is proposing (see SEC Release No. IA-3198) to issue an order adjusting the dollar amount tests with respect to qualifying as a “qualified client” under Rule 205-3 (Rule) under the Advisers Act.
Under the Advisers Act, an investment adviser is prohibited from entering into, extending, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client (Sec. 205(a)(1) of the Advisers Act). These types of fees, also known as performance compensation or performance fees, were prohibited to protect clients from compensation arrangements that might influence advisers to take excessive risks with client funds. In 1985, the SEC adopted the Rule to provide an exemption from the performance compensation prohibition provided the client was a qualified client, having at least $500,000 (later changed in 1998 to $750,000) under management with the adviser or a net worth of more than $1 million (later changed in 1998 to $1.5 million).
Under Dodd-Frank, the SEC is required, prior to July 21, 2011, and every five years thereafter, to adjust for inflation the dollar amount tests included in the Rule.
The SEC is proposing to increase the assets-under-management test to $1 million and the net worth test to $2 million in order to be a qualifying client under the Rule. In addition, for the purposes of the net worth test, the SEC is proposing to exclude from the calculation, the value of the natural person's primary residence and the debt secured by that property that is no greater than the property's current market value. This adjustment to the net worth calculation is consistent with the proposal by the SEC to adjust the net worth calculation for determining if a natural person qualifies as an “accredited investor” under Regulation D of the Securities Act of 1933.
The SEC has proposed that for an adviser who was previously exempt from investment adviser registration with the SEC and subsequently is required to register, the prohibition under Sec. 205(a)(1) of the Advisers Act would not apply to contractual arrangements with a client who authorized performance compensation if that arrangement was entered into when the adviser was exempt from registration. For example, if an adviser to a private fund who entered into arrangements with investors of the fund to receive performance compensation when the adviser was exempt from registration, but then subsequently became registered with the SEC, it could continue to collect the performance fee from such investors. However, for any new investors in the private fund after the adviser becomes registered, such investors would have to be qualified clients by meeting the enhanced net worth or assets under-management tests.
The SEC's proposal is open for comment until July 11, 2011.