Legal Alerts

SEC Raises Bar on Investment Advisers’ Ability to Charge Performance-Based Compensation

04.01.12

The Securities and Exchange Commission ("Commission") has adopted amendments to Rule 205-3 of the Investment Advisers Act of 1940 (the "Advisers Act") that tighten registered investment advisers' ability to charge performance-based fees by raising the requirements for clients that can be considered "qualified." The Commission originally issued an order on July 12, 2011 increasing the "qualified client" dollar thresholds under the net worth and assets under management tests. This order became effective on September 19, 2011. The amendments to Rule 205-3 codify the revisions to the dollar amount thresholds that the Commission issued by order on July 12, 2011, provide that the Commission will issue an order every five years to adjust the dollar amount thresholds for inflation, exclude the value of a person's primary residence and certain associated debt from the determination of net worth, and add certain transition provisions. The Rule 205-3 amendments are effective on May 22, 2012. 

Executive Summary

  • Registered investment advisers are generally prohibited from charging performance-based compensation except to "qualified clients." 
  • Effective September 19, 2011, the Commission changed the definition of qualified client to mean investors that have a net worth of at least $2 million, or have at least $1 million of assets under management with the investment adviser, compared to previous thresholds of $1.5 million in net worth and $750,000 in assets under management, respectively.
  • The value of a client's primary residence and the debt secured by the residence, up to the fair market value of the residence, must be excluded from the net worth calculation. Debt secured by the primary residence, to the extent it exceeds the fair market value of the residence, must be included as a liability in the net worth calculation. Additionally, any debt secured by the primary residence in the 60 days before an advisory contract is entered into must be included as a liability.
  • Grandfather provisions in the new rules allow registered investment advisers to continue to charge performance-based fees to clients that were considered qualified before September 19, 2011. The grandfather provisions also allow newly registered advisers to continue to charge performance fees if they were already charging the fees before they were required to register with the Commission.
  • If an owner of an interest in a private investment company transfers an interest by gift or bequest, or under an agreement related to a legal separation or divorce, the transferee will not have to meet the definition of a "qualified client" under Rule 205-3.
  • Advisers that charge performance fees should review their investor questionnaires and documentation from clients on net worth and assets under management to ensure compliance with the new rules.

Section 205 and Rule 205-3 of the Investment Advisers Act 
Section 205(a)(1) of the Advisers Act generally prohibits investment advisers from charging compensation based on a share of capital gains on, or capital appreciation of, the funds of a client (also known as "performance compensation" or "performance fees") except to "qualified clients." A qualified client was defined as a client with at least $750,000 under management with the investment adviser ("assets under management test"), or a client with a net worth of more than $1.5 million ("net worth test"). The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") required the Commission to adjust the dollar amount thresholds under the assets under management test and the net worth test for inflation by July 21, 2011, and every five years thereafter. 

Increased Thresholds for "Qualified Clients" 
The Commission complied with Dodd-Frank by raising the threshold under the assets under management test from $750,000 to $1.0 million, and by raising the threshold under the net worth test from $1.5 million to $2.0 million. The Commission originally increased the "qualified client" dollar thresholds under the net worth and assets under management tests pursuant to an order issued on July 12, 2011 and effective September 19, 2011. The amendments to Rule 205-3 codify these revisions to the dollar amount thresholds and provide that the Commission will issue an order every five years to adjust the dollar amount thresholds for inflation. 

Exclusion of Primary Residence from "Net Worth Test" 
The Commission also determined to exclude the value of a natural person's primary residence and certain debt secured by the property for the net worth test. Although this change was not required by Dodd-Frank, the Commission noted that it is similar to the Dodd-Frank requirement that the definition of "accredited investor" under the Securities Act be revised to exclude the value of an investor's primary residence. Under Rule 205-3, the value of a client's primary residence and the debt secured by that residence, up to the fair market value of the residence, must now be excluded from the net worth calculation. Debt secured by the primary residence, to the extent it exceeds the fair market value of the residence, must be included as a liability in the net worth calculation. Additionally, any debt secured by the primary residence in the 60 days before an advisory contract is entered into must also be included as a liability. This look-back provision for incremental debt requires investors to identify any increase in mortgage debt over the 60-day period prior to entering into an advisory contract and treat that debt as a liability in calculating net worth, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by the residence. 

Grandfather Provisions 
The amendments also provide two new transition provisions that "grandfather" certain existing arrangements between registered investment advisers and their clients in existence before September 19, 2011, the effective date of the Commission's original order. The new restrictions on performance fees apply only to new contractual arrangements between registered investment advisers and clients. The rules do not apply to new investments by clients who met the definition of "qualified client" when they entered into the advisory contract, even if they subsequently do not satisfy the dollar amount thresholds. Under the new rules, if a client met the definition of a "qualified client" under either or both of the assets under management or net worth tests at the time that the client entered into the advisory contract, such client will continue to be considered a qualified client under the new rules for so long as that contract is in effect. If the client enters into a new advisory contract, the client would have to satisfy the new rules for the adviser to charge a performance fee. Likewise, if a new client becomes party to an existing advisory contract, the revised dollar amount thresholds will apply to the new client when he or she becomes a party to the contract. 

New advisers that must register this year under Dodd Frank may continue to charge performance-based fees if they were already charging such fees pursuant to existing contracts prior to registration. Consequently, newly registered hedge or private equity funds that have existing contractual relationships that permit the performance-based fee may continue to charge a performance fee. 

Limited Transfers of Interest 
The amendments to Rule 205-3 also allow for limited transfers of interest from a qualified client to a person who was not a party to the advisory contract and is not a qualified client at the time of the transfer. If an owner of an interest in a private investment company transfers an interest by gift or bequest, or pursuant to an agreement related to a legal separation or divorce, the transferee will not "become a party" to the contract and will not have to meet the definition of a "qualified client" under Rule 205-3. 

What to Do Now 
These rule changes have an immediate impact on registered advisers to all private funds, including private equity and hedge funds that are currently engaged in marketing and fundraising efforts that intend to charge performance-based fees. State-registered advisers may also be affected by these rule changes since many state agencies have similar restrictions on performance-based compensation and incorporate by reference the rules of the Advisers Act. Subscription agreements should be examined and revised to reflect the new qualified client thresholds, which became effective on September 19, 2011, and the primary residence exclusion and incremental debt 60-day look-back period, which will become effective on May 22, 2012. 

Advisers to hedge and private equity funds that are exempt from registration because they solely manage private funds and have less than $150 million in assets under management are exempt from registration and exempt from the performance fee prohibition. 

Investment advisers should determine whether or not any arrangements with investors, entered into prior to September 19, 2011, are exempt from the new rules pursuant to the transition provisions. The status of an investor is measured on the date the subscription agreement becomes effective. The full text of the Commission's final rule on investment adviser performance compensation is available at http://www.sec.gov/rules/final/2012/ia-3372.pdf

Contact
LaFromboise, Antoine J.
Communications and Brand Manager
T 612.371.3269

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