The SEC issued a rule proposal that would amend Rule 205-3 under the Investment Advisers Act of 1940, which permits a registered adviser to charge a performance-based advisory fee, i.e., one based on a share of capital gains on, or capital appreciation of, a client’s account. In relevant part, the Rule allows an adviser to charge a performance-based advisory fee to a “qualified client” who has either a threshold amount of assets under management (“AUM”) with the adviser, currently $750,000, or meets a net worth test, currently $1 million. The proposal would:
- increase the AUM threshold and the net worth test to $1 million and $2 million, respectively;
- provide that the SEC may issue an order every five years that adjusts those tests for inflation;
- exclude the value of a primary residence, and related debt up to the current market value of the residence, from the qualified client net worth calculation; and
- revise the Rule’s transition provision to grandfather fee arrangements that were compliant with the Rule’s conditions (if applicable) at the time clients and advisers entered into the arrangements.
AUM and Net Worth Tests. The Dodd-Frank Act requires the SEC to revise the dollar amounts used in the Rule by July 21, 2011 and every five years thereafter to adjust for the effects of inflation. The SEC proposes to make these adjustments using a formula based on the Personal Consumption Expenditures Chain-Type Price Index, or its successors, published by the United States Department of Commerce. The proposing release notes that in calculating a client’s AUM an adviser could include amounts the client has made a bona fide contractual commitment to invest in the adviser’s private funds, provided the adviser has a reasonable belief the commitment will be met.
Primary Residence and Related Debt. Although not required to do so by the Dodd-Frank Act, the SEC proposes to exclude from the Rule’s net worth standard the value of a primary residence and the amount of debt secured by the property not to exceed the property’s current market value; the amount of debt in excess of the property’s value would be included as a liability in the net worth calculation. This proposed modification to Rule 205‑3 resembles the SEC’s proposal to exclude the value of a primary residence and related debt from the net worth calculation for purposes of the “accredited investor” definitions in Rules 215 and 501 under the Securities Act of 1933 (as discussed in the February 1, 2011 Alert); both SEC proposals refer to IRS guidance for identifying a primary residence.
Transition Rule for Registered Advisers. Under the proposal, compliance with the Rule’s conditions for charging a performance-based advisory fee to a client would be determined based on whether the conditions in effect at the time the adviser entered into the relationship with the client were met. Because the Rule looks through a fund that relies on Section 3(c)(1) under the Investment Company Act of 1940 (a “3(c)(1) Fund”) to treat each investor as a client, the adviser to a 3(c)(1) Fund who wishes to charge a performance-based fee would only need to ensure that an investor met the qualified client conditions in effect at the time of initial investment; subsequent changes in the Rule’s AUM and net worth tests would not affect the adviser’s ability to rely on the Rule with respect to that investor.
Transition Rule for Advisers Previously Exempt from Registration. The proposal would also grandfather performance-based fee arrangements in the situation where an adviser that is exempt from registration with the SEC subsequently registers with the SEC (a “Formerly Exempt Adviser”). Under the proposal, a Formerly Exempt Adviser could continue to charge a performance-based fee in a client relationship that pre-dates the adviser’s registration without meeting the Rule’s conditions. A Formerly Exempt Adviser would, however, need to meet the Rule’s conditions for each post‑registration client charged a performance-based fee, although, as discussed above, the Rule’s conditions would only need to be met at the time the client entered into the relationship with the adviser. Because of the manner in which the Rule “looks through” 3(c)(1) Funds, a Formerly Exempt Adviser would be able to disregard the Rule’s conditions as to pre-registration investors in a 3(c)(1) Fund with a performance-based fee (including as to any additional investments made post-registration), but would need to meet the Rule’s conditions in effect at the time of initial investment for each post-registration investor.
Public Comment. The proposing release requests comment on many aspects of the proposal, including with respect to a transition period or delayed compliance date. Comments must be received by July 11, 2011.