On February 15, 2012, the Securities and Exchange Commission (the “SEC”) adopted amendments (the “Amendments”) to its rule on investment advisory performance fees under the Investment Advisers Act by revising the dollar amount thresholds used to determine whether an investor is a “qualified client.” In addition, the Amendments: (i) require the SEC to issue an order every five (5) years adjusting for inflation the dollar amount thresholds under the qualified client standard, (ii) raise the net worth requirement for investors who pay performance fees by excluding the value of the investor’s home from the net worth calculation, and (iii) provide certain transition provisions that preserve existing client and investor arrangements. These Amendments will become effective May 22, 2012.
Under Advisers Act Rule 205-3, registered investment advisers may only charge performance fees to “qualified clients.” In order to be deemed a qualified client, an investor’s net worth or assets under management by the adviser must meet certain dollar thresholds. These standards are designed to limit the availability of performance fee arrangements to clients who are financially experienced and able to bear the risks involved in such arrangements. The Amendments will require qualified clients to have at least $1 million of assets under management with the adviser or a net worth of at least $2 million. These thresholds were raised from $750,000 and $1 million, respectively. The Amendments codify the changes already made to the dollar amount thresholds by the SEC in an order issued in July 2011. The increase in the dollar amount thresholds was required by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The Amendments also provide that the SEC will issue an order every five (5) years adjusting the dollar thresholds to account for the effects of inflation.
In determining whether an individual is a qualified client, the Amendments exclude the value of an individual’s primary residence and the debt secured by that residence, up to the fair market value of the residence, from the net worth calculation.1 The revision is intended to maintain consistency with changes the SEC has made to the “accredited investor” net worth calculation. Under the revised rule, debt secured by the primary residence will generally not be included as a liability in the net worth calculation, except to the extent it exceeds the estimated value of the primary residence. In a significant change to the proposed rules, the Amendments also require that any increase in the amount of debt secured by the primary residence in the 60 days before the advisory contract is entered into must be included as a liability. The change is intended to prevent the manipulation of net worth in order to meet the requirements of a qualified client. The Amendments do provide an exception to the 60 day look-back provision for increases in debt secured by the residence where the debt resulted from the purchase of the primary residence. Without this exception, an individual would have been required to include the full amount of the mortgage incurred in acquiring the residence as a liability, while simultaneously excluding the full value of the primary residence in a net worth calculation.
Finally, the Amendments also provide transition provisions that allow an investment adviser and its clients to maintain existing performance fee arrangements that were permissible at the time the advisory contract was entered into, but would be subsequently restricted under the Amendments. These “grandfather” provisions ensure that restrictions on performance fees apply only to new contractual arrangements and do not apply to existing investments by clients who met the definition of qualified client when they entered into the advisory contract. Accordingly, these clients do not need to satisfy the revised qualified client definition in order to supplement their existing investments, but must do so in order to enter new advisory contracts. Similarly, a new party to an existing contract is not covered by the grandfather provisions and must meet the current net worth threshold. The transition provisions also permit newly-registered investment advisers who were previously exempt from registration to continue charging performance fees in contractual arrangements that existed prior to registering. Further, in response to comments received to the proposed rule, the Amendments allow for limited transfers of equity ownership interests (where such transfers are gifts, bequests, or are made pursuant to a legal separation or divorce) from a qualified client to a person that was not a party to the contract and is not a qualified client at the time of the transfer. Where such transfers occur, the beneficial owner of the interest will be considered to be the person who transferred the interest. The transferee then receives the benefits of the pre-existing contractual arrangement and may retain the investment. The Amendments’ adopting release did not address whether such a transferee would be able to make an additional investment without satisfying the qualified client definition.
The SEC’s final rule may be found here.