On February, 15, 2012, the Securities and Exchange Commission (the “Commission”) adopted amendments to Rule 205-3 under the Investment Advisers of 1940, as amended (the “Advisers Act”), that included increases to the “assets under management” and “net worth” dollar thresholds used to determine whether an individual or company is a “qualified client” for purposes of enabling an investment adviser (including an investment adviser to Section 3(c)(1) funds)1 to charge performance-based compensation. These increased dollar thresholds codify the increased thresholds that the Commission issued in its July 12, 2011 order as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act2 (the “Dodd-Frank Act”).  

The amendments to Rule 205-3 also provide that the Commission will issue an order every five years in the future adjusting the dollar amount thresholds for inflation, exclude the net equity of a person’s primary residence from the calculation of “net worth” in a manner mirroring that used to determine if a person is an “accredited investor” under the Securities Act of 1933, as amended (the “Securities Act”),3 and add certain transitional and grandfathering provisions that provide relief to existing advisory arrangements.  

The increased dollar thresholds were effective on September 19, 2011. Other revisions to Rule 205-3 pursuant to the February 15 release will be effective May 22, 2012.  

Amendments to Dollar Thresholds; Periodic Adjustments and Calculations

The Dodd-Frank Act amended Section 205(e) of the Advisers Act to provide that, by July 21, 2011, and every five years thereafter, the Commission shall adjust for inflation the dollar amount thresholds included in rules issued under Section 205(e), rounded to the nearest $100,000.4 There are two dollar amount thresholds provided in rules issued under Section 205(e)—the “assets under management” and “net worth” tests used to determined whether a person or company is a “qualified client” in Rule 205-3. Accordingly, the Commission issued an order on July 12, 2011 increasing the dollar amount thresholds for these two tests.

As provided in the Commission’s July 12, 2011 order, and as is now provided in amended Rule 205-3, an individual or company will qualify as a “qualified client” if such individual or company has assets under management with the investment adviser immediately after entering into the contract that equals or exceeds $1 million (up from $750,000 previously) or if such individual or company has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2 million (up from $1.5 million previously).

The Commission also amended Rule 205-3 to provide that the Commission will issue an order every five years that adjusts for inflation the dollar amount thresholds of the assets-undermanagement and net worth tests of the Rule. While the Dodd-Frank Act amended Section 205(e) of the Advisers Act to require the Commission to adjust the dollar amount thresholds in rules under Section 205, the Rule amendments explicitly state that the next order will be issued on or about May 1, 2016, with subsequent orders issued approximately every five years thereafter. Importantly, any adjustments in the dollar thresholds in Rule 205-3 will apply prospectively to contractual relationships entered into on or after the effective date of any order, and not retroactively to contractual relationships in existence prior to such adjustments.  

Exclusion of the Value of Primary Residence From Net Worth Calculation; 60-Day Look-Back

Similar to recent amendments to the definition of “accredited investor” under the Securities Act, amended Rule 205-3 requires that for the purpose of calculating net worth under Rule 205-3, a person’s primary residence shall not be included as an asset.5 Accordingly, net worth is to be calculated excluding any positive equity that an individual may have in his or her primary residence. In making this calculation, indebtedness secured by the person’s primary residence (e.g., first and second lien mortgages, certain home equity lines of credit) generally is offset against the estimated fair market value of the primary residence. Such debt generally is not included as a liability in calculating a person’s net worth under the Rule, except to the extent it exceeds the estimated fair market value of the residence (i.e., an underwater mortgage).

Like the amended definition of accredited investor, amended Rule 205-3 also includes a 60-day look-back provision requiring that any indebtedness secured by the primary residence that has been added within 60 days prior to entering into an advisory agreement be included as a liability of the advisory client (or 3(c)(1) fund investor) in calculating net worth (unless the indebtedness was added as a result of the acquisition of the primary residence). Such recently acquired debt generally must be included as a liability in calculating net equity in a primary residence. The look-back provision is intended to thwart efforts to game the net worth standard by borrowing against the primary residence for the purpose of artificially inflating net worth to meet the “qualified client” definition in the Rule. Absent such provision, an advisory client (or 3(c)(1) fund investor) could effectively convert home equity—which must be excluded from net worth—into cash or other assets permitted to be included in net worth.  

Transitional Provisions; Relief for 3(c)(1) Fund Advisers

The Commission adopted certain transitional provisions designed to allow investment advisers and their clients to maintain existing performance fee arrangements that were permissible when the advisory contract was entered into, even if the performance fees would not be permissible under the contract if it were entered into as a later date.

  • Rule 205-3(c)(1), as amended, provides that a registered investment adviser will be considered to satisfy the conditions of the Rule if the adviser entered into a contract and satisfied the conditions of the Rule that were in effect when the contract was entered into. In other words, an individual or company would generally be subject to the conditions of the Rule that were in effect when they became a party to the advisory contract. This revision is beneficial where an existing client no longer meets the dollar thresholds of the Rule and it permits not only the maintenance of the existing arrangement but permits additional contributions to be made by such person.

If a natural person or company that was not a party to the contract becomes a party, the conditions of the rule in effect at the time they become a party will apply to that person or company. We note that while measurement of net worth or assets under management for purposes of Rule 205-3 occurs only once (generally at the time the advisory arrangement is entered into), measurement of a person’s net worth for purposes of determining a person’s status as accredited investor under the Securities Act is generally required each time an existing investor makes additional contributions to a private fund. Thus, while an adviser to a 3(c)(1) fund may be able to continue charging a performance fee under the Advisers Act based on an investor’s initial net worth, subsequent changes in a person’s net worth that cause an investor to lose “accredited” status may prevent such investor from making further contributions to a fund or otherwise may impact an issuer’s offering of securities and reliance on Regulation D under the Securities Act if they were to take new contributions from an investor after such person loses accredited status.

  • Rule 205-3(c)(2), as amended, provides that if a registered investment adviser previously was not required to register with the Commission pursuant to Section 203 of the Advisers Act, and did not so register, Section 205(a)(1) of the Act will not apply to an advisory contract that the now-registered adviser entered into and to accounts of 3(c)(1) investors that were established when the adviser was not registered with the Commission. This revision benefits 3(c)(1) fund advisers that recently registered with the Commission due to the elimination of the Section 203(b)(3) private adviser exemption from registration as it allows existing 3(c)(1) fund investors to make additional contributions into funds in which they are currently invested. Section 205(a)(1) will apply, however, to new investors in existing 3(c)(1) funds and to investments made by current investors in other funds managed by such advisers after the date of their registration with the Commission.
  • Rule 205-3(c)(3) has been revised to provide that if an owner of an interest in a 3(c)(1) fund transfers his or her fund interest to another person by gift or bequest, or pursuant to an agreement related to a legal separation or divorce, the transfer will not cause the transferee to become a party to the contract and will not cause Section 205(a)(1) to apply to such transferee. This revision is consistent with Rule 3c-6 under the Investment Company Act of 1940, as amended (which addresses how funds relying on Section 3(c)(1) and 3(c)(7) may treat such events for purposes of reliance on those exceptions).