The Securities and Exchange Commission (the “SEC”) recently adopted amendments to Rule 205-3 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), as mandated by Section 418 of the DoddFrank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Rule 205-3 permits SEC-registered investment advisers to charge performance-based compensation to “qualified clients” meeting certain dollar thresholds relating to net worth and assets under management. The recent amendments:
- Codify the SEC’s 2011 order that increased the dollar threshold used to calculate the “qualified client” net worth and assets under management tests;
- Modify the net worth test for “qualified clients” to exclude from the calculation the value of a person’s primary residence and certain debt secured by the residence;
- Include certain transition provisions that allow advisers to maintain certain existing performance fee arrangements as long as the arrangements complied with the rule in effect at the time the advisory contract was entered into; and
- Require the SEC to issue periodic orders adjusting for inflation the dollar thresholds used to calculate the “qualified client” net worth and assets under management tests.
CODIFICATION OF ASSETS UNDER MANAGEMENT AND NET WORTH THRESHOLDS
The Advisers Act generally restricts SECregistered investment advisers from charging performance-based compensation, unless the client is a “qualified client.” Before the Dodd-Frank Act, Rule 205-3 generally defined a “qualified client” as (i) a client with at least $750,000 in assets under management with the adviser immediately after entering into the advisory contract; or (ii) a client that the adviser reasonably believed had a net worth of more than $1.5 million at the time the advisory contract was entered into. The SEC deemed such clients to be “financially experienced and able to bear the risks of performance fee arrangements.” As required by the DoddFrank Act, the SEC issued an order, effective September 19, 2011, increasing these amounts to $1 million and $2 million, respectively.
The recent amendments to Rule 205-3 codify the SEC’s order. Under amended Rule 205-3, a qualified client is defined as (i) a client having at least $1 million in assets under management with the adviser immediately after entering into the advisory contract; or (ii) a client that the adviser reasonably believes has a net worth of more than $2 million at the time the advisory contract is entered into.
EXCLUSION OF THE VALUE OF PRIMARY RESIDENCE FROM NET WORTH CALCULATION
In addition, effective May 22, 2012, the value of a client’s primary residence and the debt secured by the residence (up to the fair market value of the property) will not be included for purposes of calculating a person’s net worth. Debt secured by the primary residence will generally not be included as a liability in the net worth calculation, except to the extent that it exceeds the estimated value of the primary residence. However, any increase in the amount of debt secured by the primary residence in the 60-day period before the advisory contract is entered into generally will be included as a liability, even if the value of the residence exceeds the aggregate amount of debt secured by such residence. This 60-day look-back provision requires investors to identify any increase in mortgage debt over the 60-day period prior to entering into the advisory contract and count that debt as a liability in calculating net worth. This is intended to discourage investors from incurring short-term debt to finance their investments, while accommodating investors who have refinanced their mortgage in the ordinary course.
TRANSITION RULES
To minimize the disruption of existing contractual relationships, amended Rule 205-3 contains transition provisions that allow SEC-registered investment advisers to maintain performance fee arrangements that were permissible when entered into, even if the performance fee would not otherwise be permitted under the amended rule.
Previously Registered Advisers. Under Rule 205-3(c)(1), if a registered investment adviser entered into a contract and satisfied the conditions of Rule 205-3 that were in effect when the contract was entered into, the adviser will be considered to satisfy the conditions of the amended rule. However, where new parties become party to the contract, the thresholds in effect at the time they become a party will apply with regard to that party.
Newly Registered Advisers. Under Rule 205-3(c)(2), if a registered adviser was previously exempt from Advisers Act registration and subsequently registers, the Rule 205-3 performance fee restrictions will not apply to advisory contracts entered into when the adviser was not registered, or to an account of an equity owner of a private investment company advised by the adviser if the account was established when the adviser was not registered. The performance fee restrictions will, however, apply to advisory contracts entered into after an adviser registers with the SEC. The SEC has indicated that this provision applies to investment advisers that register either because they are no longer exempt from registration or because they voluntarily choose to register.
Successors in Interest. A person that receives an interest in a private investment company by gift or bequest, or pursuant to an agreement related to legal separation or divorce, is not required to be a qualified client at the time of transfer. Therefore, such person would be able to retain the investment under the terms of the pre-existing advisory contract without having to meet the definition of a “qualified client” under Rule 205-3.
INFLATION ADJUSTMENT OF DOLLAR THRESHOLDS
Amended Rule 205-3 requires that the SEC issue an order May 1, 2016 and approximately every five years thereafter adjusting for inflation the dollar amount thresholds of the assets under management and net worth tests of the rule. The adjusted amounts will apply to contractual relationships entered into on or after the effective date of the orders, and will not apply retroactively to contractual relationships previously in existence. These adjustments will be calculated using the Personal Consumption Expenditures Chain-Type Price Index published by the US Department of Commerce.