On May 10, 2011, the Securities and Exchange Commission (the “SEC”) announced its intention to issue an order raising the dollar amounts of the “net worth test” and the “assets-under-management test” contained in Rule 205-3 (the “Rule”) under the Investment Advisers Act of 1940. The Rule sets forth the conditions under which a registered investment adviser may charge a performance-based fee to so-called “qualified clients.” This proposal responds to directives contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) that the SEC is required to take action on by July 21, 2011. The proposal would make certain other changes required by Dodd-Frank and seeks to coordinate aspects of the Rule with other changes in Dodd-Frank. The SEC’s release does not mention that the proposed changes to the definition of a “qualified client” will expand the scope of persons that must register as investment adviser representatives (“IARs”) under state law. Note that the comment period is open on these proposals until July 11, 2011.
Revised Qualified Client Thresholds and Inflation Indexing
Section 418 of Dodd-Frank requires the SEC issue an order increasing the dollar amounts of the assets under management and net worth thresholds for “qualified clients” in order to reflect the effects of inflation since 1998. Under the proposed new thresholds, a client must have at least $1 million in assets under management with the adviser (increased from $750,000) or at least $2 million in net worth (increased from $1.5 million) to be a “qualified client.” Under the proposed rules, the new thresholds will be effective 30 days after the SEC’s order. The SEC is requesting comments regarding whether this period should be longer.
The proposal indicates the SEC arrived at the new inflation-adjusted threshold figures by analyzing the historic and current levels of the Personal Consumption Expenditures Chain-Type Price Index (“PCE”). Dodd-Frank sets a five-year cycle for future adjustments to the thresholds, and the SEC proposes to delegate this future updating to its staff with instructions to apply the PCE to future updates, use the thresholds adopted in 1998 as a baseline, and round the amounts to the nearest multiple of $100,000.
Treatment of Primary Residence For Net Worth Calculation
The SEC also proposes to exclude the value of primary residences and debt secured by the property in calculating a person’s net worth when determining “qualified clients.” This revision is not mandated by Dodd- Frank. Instead, the SEC is attempting to conform the method of calculating net worth for the “qualified client” test to the new method for calculating net worth in the “accredited investor” standard under the Securities Act of 1933 imposed by Dodd-Frank. Similar to the calculation for the “accredited investor” standard, the net positive value of a primary residence is not included in the calculation of a person’s net worth, but any net negative value of the home including the mortgage would be subtracted from the person’s net worth. As a result, a mortgage on a person’s primary residence won’t be included in assessing net worth unless, at the time of the calculation, the outstanding debt on the mortgage exceeds the market value of the residence. Any amount in excess of the market value of the house would be considered a liability in calculating net worth under the proposed amendments to the Rule.
The SEC also proposed two transition provisions allowing an SEC-registered investment adviser and its clients or private fund investors to maintain existing performance fee arrangements that were permissible when the parties entered into the advisory contract, regardless of whether the performance fee would be permitted under the amended Rule. Under the first of these “grandfathering” provisions, an SEC-registered investment adviser who entered into a contract satisfying the conditions of the Rule that were in effect when the contract was executed, would be deemed to satisfy the conditions of the proposed amended Rule. If a new party is added to that contract at a later date, the conditions of the Rule that are in effect at the time the new person becomes a party would apply to that new person. The second transition provision, which applies to investment advisers previously exempt from registration that subsequently register with the SEC, provides that the Section 205(a)(1) performance fee prohibition would not apply to the contractual arrangements an adviser entered into when it was exempt.
Surprise! Advisers Have More IARs to Register
In addition, the proposed changes to the definition of “qualified client” may impact the business of some advisers because the changes will expand the scope of persons that must register as IARs under state law. Rules implementing the National Securities Markets Improvement Act of 1996 define the term “investment adviser representative” for purposes of determining whether supervised persons of an SEC-registered investment adviser must register as IARs with the various states. That definition is based, in part, on calculating the number and percentage of natural person clients of a supervised person, and it excludes from the count of natural person clients anyone that is a “qualified client” under the Rule. Therefore, any supervised person of an SEC-registered investment adviser that currently relies upon one or more of their natural person clients being “qualified clients” in order to fall below the five in number or 10 percent threshold for natural person clients so that the supervised person may avoid IAR registration will need to review whether their natural person clients meet the new “qualified client” thresholds. The result may be that some supervised persons will need to newly register as IARs, and this may require them to pass qualifying examinations such as the Series 65. The time involved in conducting this analysis and registering additional IARs may form a basis to suggest that a 30-day effectiveness period for the changes in the “qualified client” thresholds may be insufficient.
Conclusion and Action Steps
The proposed updates to the Rule are not unexpected, as the dollar thresholds have not been changed since 1998. However, the SEC’s new thresholds hold the potential to be disruptive to investment advisers whose clients might not meet the new requirements. The SEC’s grandfathering provisions, if enacted as proposed, will largely blunt the harm to these investment advisers, at least in relation to existing clients, while shrinking the pool of potential new clients who qualify under the new thresholds. Thus far, however, it appears that the SEC has not considered the impacts of these changes on supervised persons that will newly need to register as IARs. This may be a topic ripe for comments on the proposal. At a minimum, advisers should promptly undertake a review of existing natural person clients with this issue in mind.
For more details regarding the proposed changes, please refer to the SEC’s Release “Investment Adviser Performance Compensation,” SEC Release No. IA-3198; File No. S7-17-11.