The SEC has proposed rules and issued a notice that it intends to raise the qualification requirements of persons who can pay performance based compensation to registered investment advisers. Generally, SEC registered investment advisers are not permitted to share in their clients' capital gains or capital appreciation, but Rule 205-3 under the Investment Advisers Act of 1940 allows advisers to receive such compensation (commonly referred to as "performance fees" or "incentive allocations") from "qualified clients." If the client is a pooled investment vehicle, then each of its equity owners must be a qualified client. Currently, a qualified client means a person that the adviser reasonably believes meets either of the following criteria:

  • a net worth of more than $1.5 million at the time the advisory contract is entered into
  • at least $750,000 under the adviser's management immediately after entering into the contract

 The Dodd-Frank Act required that the SEC issue an order by July 21, 2011, to adjust the dollar amount tests in Rule 205-3 for inflation. Accordingly, the SEC intends to issue an order to increase the net worth test to $2 million and the assets-under-management test to $1 million. The SEC has also proposed that the net worth standard be amended to exclude the value of a natural person's primary residence and debt secured by the property. The proposal would not affect advisory agreements validly entered into before the rule changes take effect or before the adviser registers with the SEC.