The Securities and Exchange Commission (SEC) has issued an order approving adjustments to the “qualified client” threshold that will have the effect of imposing tighter restrictions on the ability of investment advisers to charge performance-based fees to their advisory clients.
Section 205(a)(1) of the Investment Advisers Act of 1940 (Advisers Act) generally provides that a registered investment adviser cannot enter into, extend, renew or perform any investment advisory contract that provides for compensation to the investment adviser based on a share of capital gains on, or capital appreciation of, the investments of a client (Performance Fees). Section 205(e) of the Advisers Act allows the SEC to specify which clients do not need the protections afforded by this prohibition based on factors such as financial sophistication, net worth, income and other considerations.
Prior regulations allowed investment advisers to charge performance fees to “qualified clients” which, under Rule 205-3 under the Advisers Act, include clients with at least $750,000 under management by an investment adviser (assets under management test), and clients with a net worth of more than $1.5 million (net worth test). The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) passed in July 2010 required the SEC to adjust the dollar amount thresholds under the assets under management test and the net worth test for inflation by July 21, 2011, and every five years thereafter.
In the order issued on July 12, 2011, the SEC complied with the Dodd-Frank Act by raising the threshold under the assets under management test from $750,000 to $1 million, and by raising the threshold under the net worth test from $1.5 million to $2 million. The order is effective as of September 19, 2011.
Several related rule changes remain under consideration by the SEC. Specifically, in its proposed rules issued on May 10, 2011, the SEC proposed to amend Rule 205-3 to exclude the value of a client’s primary residence for purposes of determining whether such client is a “qualified client” under the net worth test. While this change was not mandated by the Dodd-Frank Act, the SEC has noted that it parallels the Dodd-Frank requirement that the definition of “accredited investor” in the rules promulgated under Securities Act of 1933 be revised to exclude the value of an investor’s primary residence.
In the current depressed real estate environment in most markets, the exclusion of an investor’s principal residence is unlikely to have a significant impact on these determinations.
In addition, the May release also proposed two “transition rules” that would have the effect of grandfathering certain arrangements entered into by investment advisers and their clients before the effective date of the new rules. For example, under proposed rule 205-3(c)(1), if a client meets the definition of a “qualified client” under either or both of the assets under management or net worth tests at the time that it enters into an advisory contract, such client will be deemed to continue to satisfy such tests even after the new thresholds take effect on September 19, 2011. Similarly, under proposed rule 205-3(c)(2), contractual arrangements entered into by an investment adviser that was previously exempt from registration will not be subject to the restrictions on performance fees even after the adviser becomes a registered investment adviser.
The transition rules, if adopted, will make the data collected during the subscription process even more important. That is because the status of an investor will be measured on the date the subscription becomes effective.
The foregoing revised and proposed rules have an immediate impact on advisers to all private funds, including venture capital, private equity and hedge funds that are currently engaged in marketing and fundraising efforts. The subscription agreements pursuant to which investors subscribe for interests in such funds will need to be revised to reflect the new qualified client thresholds (in addition to the existing ones) as well as the potential that the proposed transition rules may or may not ultimately be adopted. For example, a subscription agreement will need to obtain information from a prospective investor that is sufficient for an investment adviser to determine whether such investor meets the applicable tests both before and after the new rules take effect on September 19, and whether or not any arrangements entered into between the investment adviser and its investors prior to such date are exempt from the new rules pursuant to the proposed transition rules.