Saturday, February 18, 2012
SEC Changes Client Qualification Requirements For Investment Adviser Performance-Based Compensation
On February 15, 2012, the U.S. Securities and Exchange Commission (SEC) adopted amendments to Rule 205-3 under the Investment Advisers Act of 1940, addressing circumstances in which an investment adviser may charge performance-based fees. To protect clients from arrangements that might encourage advisers to take undue risks with client funds in order to increase advisory fees, the Advisers Act prohibits an investment adviser from entering into, extending, renewing or performing any investment advisory contract with a client that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of the client. The SEC is authorized, however, to create an exemption from the compensation prohibition if the advisory contract is made with persons the SEC determines do not need the protection. In 1985, the SEC adopted Rule 205-3 to provide an exemption from the performance-based compensation prohibition when the person entering into the advisory contract is a “qualified client,” as defined in the rule.
The February 2012 amendments to Rule 205-3 address the principal alternative criteria for qualified client status, namely, the assets-under-management test and the net worth test. Before the current amendments, the threshold dollar amounts to satisfy these tests were $750,000 and $1.5 million, respectively. As an adjustment for inflation mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC has raised these threshold amounts to $1 million and $2 million. The inflation adjustments were actually made by an order issued in July 2011, and the amendments to Rule 205-3 just adopted only confirm that previous order as a rule. The SEC took a further step in amending the rule to provide for an order every five years adjusting the dollar amounts for inflation.
Manner of calculating net worth amended
The significance of the February 2012 amendments to Rule 205-3 under the Advisers Act is not the inflation-adjusted assets-under-management and net worth numbers, but rather the changes in the manner of calculating net worth for purposes of qualified client status. The amendments change the calculation of the net worth standard by requiring exclusion of the value of a natural person’s primary residence and certain debt secured by the property. With these amendments, “qualified client” status based on the net worth test will now be determined in accordance with the following requirements:
These changes to the net worth test are significant. The SEC estimates that up to 1.3 million households will no longer qualify as “qualified clients” under the net worth test, and will thus be restricted from performance fee arrangements with advisers. The pool of qualified clients for advisers will be reduced.
Ahead of the adoption of these amendments to the net worth test, many commentators argued that the exclusion of the value of a person’s primary residence from the calculation of net worth would limit the investment options of less wealthy investors and unduly restrict their access to advisory relationships that include performance-based fees. The SEC responded, however, with its view that the value of a person’s residence actually has little relevance to a person’s financial experience and ability to bear the risks associated with a performance fee arrangement, or in assessing the need for protection from these arrangements. Moreover, the SEC concluded that exclusion of the value of an individual’s primary residence from the calculation of net worth is consistent with Dodd-Frank mandated rule amendments, the best example being modification of the “accredited investor” net worth standard now a part of rules under the Securities Act of 1933.
The new net worth test will be effective in May 2012. To minimize the disruption of existing contractual relationships that met applicable requirements at the time the parties entered into them, the amendments include transition provisions making the amended “qualified client” standard applicable only to new contractual arrangements. Also, they 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 meet the dollar thresholds,. In addition, the transition provisions permit newly registering investment advisers to continue charging performance fees to those clients that were already being charged.
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