Alert February 21, 2012

SEC Adopts Changes to Advisers Act Rule Permitting Performance-Based Advisory Fees

The SEC adopted amendments (the “Amendments”) to 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 when it would otherwise be prohibited by the Advisers Act, e.g., when charged with respect to a fund that relies on Section 3(c)(1) under the Investment Company Act of 1940 (a “3 (c)(1) Fund”) (such fees being permitted by the Advisors Act with respect to a fund that relies on Section (c)(7) of the Investment Company Act and certain other types of clients).  In relevant part, the Rule allows an adviser to charge a performance-based advisory fee to a “qualified client” who either has a threshold amount of assets under management (“AUM”) with the adviser or meets a net worth test.  (The Rule also provides that a “qualified purchaser” under the Investment Company Act is a qualified client.)  The Amendments codify a July 12, 2011 SEC order setting those amounts at $1 million and $2 million, respectively, and effect a related mandate under the Dodd-Frank Act by providing that the SEC will issue an order every five years that adjusts the AUM and net worth tests for inflation.  The Amendments also (a) 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 (b) revise the Rule’s transition provision to create grandfather provisions that address changes in the Rule’s conditions and performance-based fee arrangements entered into prior to an adviser’s registration with the SEC. 

AUM and Net Worth Tests.  The Dodd-Frank Act required the SEC to revise the dollar amounts used in the Rule by July 21, 2011 and to do so every five years thereafter to adjust for the effects of inflation.  The SEC will 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.  In calculating a client’s AUM, an adviser may 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 has revised the Rule to exclude from the qualified client net worth calculation the fair market value of a primary residence and the amount of debt secured by the property not to exceed the property’s value; the amount of related debt in excess of the property’s value is included as a liability in the net worth calculation.  This modification to Rule 205‑3 resembles the exclusion of the value of a primary residence and related debt from the net worth calculation adopted by the SEC for purposes of the “accredited investor” definitions in Rules 215 and 501 under the Securities Act of 1933 (as discussed in the January 10, 2012 Financial Services Alert).  Mirroring the amended “accredited investor” definitions, the Amendments also include an exception under which any increase in the amount of debt secured by a primary residence, other than in connection with its purchase, in the 60 days before an advisory contract is entered into must be included as a liability in the net worth calculation, even if the estimated value of the primary residence exceeds the aggregate amount of its related debt.

Grandfathering – Future Changes in the Rule’s Conditions.  Under the Amendments, compliance with the Rule’s conditions for charging a performance-based advisory fee to a client are 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 must only 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 will not affect the adviser’s ability to rely on the Rule with respect to that investor. 

Grandfathering - Previously Unregistered Advisers.  The Amendments grandfather performance-based fee arrangements in the situation where an adviser that was not required to register with the SEC subsequently registers (a “Formerly Exempt Adviser”).  Under the Amendments, a Formerly Exempt Adviser may continue to charge a performance‑based fee in a client relationship that pre-dates its registration without meeting the Rule’s conditions.  A Formerly Exempt Adviser will, 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 must only 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 may 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 must meet the Rule’s conditions in effect at the time of initial investment for each post-registration investor.

Certain Transfers of Interests in 3(c)(1) Funds.  The Amendments include a provision that allows an interest in a 3(c)(1) Fund to be transferred from a qualified client by gift or bequest, or pursuant to an agreement related to a legal separation or divorce, to a transferee that is not a qualified client at the time of the transfer without affecting compliance with the Rule by the 3(c)(1) Fund’s adviser.  The adopting release notes that the SEC took a similar approach in Rule 3c‑6 under the Investment Company Act of 1940 with respect to the determination of beneficial owners following certain transfers of ownership interests in a 3(c)(1) Fund.

Effective Date.  The Amendments are effective May 22, 2012.