On June 14, 2016, the U.S. Securities and Exchange Commission (“SEC”) issued an order increasing the net worth threshold for “qualified clients” under the Investment Advisers Act of 1940 (“Advisers Act”).1 This change, made pursuant to the SEC’s obligation to revise the qualified client thresholds to account for inflation, stands to impact investment advisers who contract with clients (and fund investors) for performance-based compensation.2 The adjustment, effective August 15, 2016, increases the net worth threshold from $2,000,000 to $2,100,000. The current assets-under-management threshold of $1,000,000 is unchanged.

Qualified Clients

The definition of “qualified client” provides an exception from the Advisers Act’s prohibition against investment advisers entering into, extending, renewing, 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.3 Practically speaking, investment advisers to qualified clients have the ability to contract for performance-based fees – otherwise prohibited by the Advisers Act – with clients who meet the definition.4

The two tests under which an advisory client can meet the definition of qualified client are known as the net worth test and the assets-under-management test. The net worth test is based on the client’s net worth immediately prior to entering into the advisory contract. The assets of spouses may be combined for purposes of the net worth test, but a person’s primary residence is excluded from the net worth calculation. An investment adviser’s reasonable belief that a client meets the net worth threshold will satisfy the net worth requirement for purposes of the qualified client definition. The assets-under-management test examines the client’s assets under management immediately after entering into the advisory contract. The current thresholds for the net worth and assets-under-management tests are $2,000,000 and $1,000,000, respectively. As indicated above, the net worth threshold will increase by $100,000, effective August 15, 2016, and the assets-under-management threshold will remain at $1,000,000.

Considerations for Advisers

Investment advisers who rely on the qualified client exemption to contract for performance-based fees should evaluate the bases under which their clients meet the qualified client definition. For clients who qualify based on the assets-under-management test, the adjustment should not have a direct impact. For those clients who meet the definition based on the net worth test, investment advisers shouldconfirm that such clients will continue to meet the threshold after the adjustment. The increased threshold will generally not apply retroactively to any performance-based fee contract existing before August 15, 2016.5 However, any subsequent modifications or renewals to such a contract would be evaluated under the increased net worth threshold. Additionally, investment advisers should review theirpolicies and procedures, including questionnaires or form documents to ensure ongoing compliance with the increased net worth threshold. Violations of Section 205(a)(1) can result in censures and monetary penalties, but advisers can help reduce the risks of reviewing their compliance procedures prior to the effective date of the adjustment.