On July 12, 2011, the Securities Exchange Commission (the "SEC") ordered changes to the dollar amount thresholds in the "Qualified Client" definition under rule 205-3 of the Investment Advisers Act of 1940. Those changes go into effect on September 19, 2011. In addition, the SEC has proposed other changes to Rule 205-3 that are currently under consideration.
Currently, Rule 205-3 defines a "Qualified Client" as including:
- a natural person or company with at least $750,000 under management of the investment adviser immediately after entering into the contract (the "Assets Under Management Test");
a natural person or company that the investment adviser reasonably believes, immediately prior to entering into the contract:
- has a net worth (together with his or her spouse) of more than $1,500,000 at the time the contract is entered into (the "Net Worth Test"); or
- is a "Qualified Purchaser" as defined in Section 2(a)(51)(A) of the Investment Company Act.
ORDER ADJUSTING DOLLAR THRESHOLDS
On July 12th, 2011, the SEC ordered that the threshold amount under the Assets Under Management Test be increased from $750,000 to $1,000,000. Additionally, the SEC ordered that the threshold amount under the Net Worth Test be increased from $1,500,000 to $2,000,000. These new threshold amounts go into effect on September 19, 2011.
The SEC provided that an adviser could include, in determining the amount of assets under management, the assets that a client is contractually obligated to invest in private funds managed by the adviser. Only bona fide contractual commitments may be included, i.e., those that the adviser has a reasonable belief that the investor will be able to meet.
PROPOSED AMENDMENTS TO RULE 205-3
While the July 12 order increased the dollar threshold amounts, each of the following proposals is still under consideration by the SEC.
Inflation Adjustment of Dollar Amount Thresholds
In the proposed rules, the SEC proposed adding a new paragraph (e) to Rule 205-3, providing that the SEC will issue an order every five years adjusting for inflation the dollar amounts of the Assets Under Management Test and the Net Worth Test, as required by the Dodd–Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The SEC stated that the PCE Index will be the inflation index used to calculate future inflation adjustments of the dollar amount tests in the rule. The SEC also stated that it intended to revise subparagraph (d) of Rule 205-3 to reflect any administrative order adjusting dollar amounts. Furthermore, the SEC stated that it anticipated it would delegate to its staff the authority to issue inflation adjustment orders every five years in the future.
Exclusion of the Value of Primary Residence from Net Worth Determination
The SEC proposed to amend the Net Worth Test to exclude from the net worth calculation the value of a natural person's primary residence and debt secured by the property. The amendment would only exclude the value of a natural person's primary residence and the amount of debt secured by the property that is no greater than the property's current market value. The debt above the market value would be considered a liability in calculating net worth under the proposed amendment.
The proposed rules also provide two transition provisions addressing existing performance fee arrangements.
The first of such provisions proposes to grandfather clients who entered into performance fee arrangements that were permissible under the rule at the time they entered into the advisory contract with their investment adviser. It is unclear whether this would also extend to additional investments made by such clients after the effectiveness of the proposed amendments.
The second transition provision proposes to grandfather clients of investment advisers who were previously exempt from registration with the SEC, and provides that the prohibition set forth in Section 205(a)(1) would not apply to contractual arrangements entered into at the time the investment adviser was exempt. This provision may affect investment advisers who are required to register with the SEC for the first time as a result of Dodd-Frank. However, if a previously exempt adviser subsequently registers, the new thresholds would not apply to contracts entered into prior to registration.
EFFECTIVE AND COMPLIANCE DATES
With respect to the proposed rules that have yet to be officially adopted, the SEC stated that it would follow appropriate time periods before requiring compliance with the new standards. There will most likely be at least 30 days before the proposed rules would become effective.
We are hopeful that the final rule release will provide more clarity regarding the transition provisions. We expect the final rule to be adopted soon. Regardless of the date of the final rule, the final order regarding the revised dollar amount thresholds for "Qualified Clients" will be effective on September 19, 2011.