On February 15, 2012, the Securities and Exchange Commission ("SEC") adopted amendments to Rule 205-3 under the Investment Advisers Act of 1940 (the "Advisers Act"), which governs the manner in which investment advisers may enter into a performance-based compensation arrangement with their clients.1 Specifically, Rule 205-3 allows an investment adviser to enter into such arrangement only with those clients that come within the definition of a "qualified client." Prior to the amendments, a "qualified client" includes, among other things, (i) a client that immediately after entering into a contract with an investment adviser has at least $750,000 under management with such investment adviser (the "AUM Test"); or (ii) a client that the investment adviser reasonably believes has a net worth of more than $1.5 million at the time the advisory contract is entered into (the "Net Worth Test"). The amendments to Rule 205-3 revise the qualified client definition by increasing the dollar amount thresholds for the AUM Test from $750,000 to $1 million, and for the Net Worth Test from $1.5 million to $2 million.2 These changes to Rule 205-3 conform the Rule's dollar thresholds to the levels set by an SEC order on July 12, 2011 ("July 2011 Order").

Revised Rule 205-3 also provides for the SEC to issue an order adjusting these dollar-amount thresholds for inflation every 5 years based on the Personal Consumption Expenditures Chain-Type Price Index that is published by the Department of Commerce, commencing on or about May 1, 2016.

Exclusion of the Value of Primary Residence from Net Worth Determination

Rule 205-3, as revised, also adopts the same primary residence exclusion used in the recently amended definition for an "accredited investor" under Regulation D of the Securities Act of 1933.3 For purposes of revised Rule 205-3's calculation of the Net Worth Test, the following exclusions will apply:

  • The value of a person's primary residence will not be included as an asset
  • Indebtedness secured by a person's primary residence that is in excess of the fair market value of the residence will be included as a liability

However, any increase in the amount of debt secured by a primary residence in the 60 days before the time of sale of securities to a person generally will be included as a liability, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by such primary residence. In other words, at the time the advisory contract is entered into, the 60-day look-back provision requires an advisory client to identify any increase in mortgage debt over the 60-day period prior to entering into an advisory contract, and to count that debt as a liability in calculating net worth.4

Transition/Grandfather Provisions

The SEC has included the following transition or "grandfather" provisions in the amendments to Rule 205-3:

  1. A registered investment adviser and its clients may maintain existing performance fee arrangements that were permissible when the advisory contract was entered into, even if the performance fees would not be permissible under the contract if it were entered into at a later date. Thus, a client who met the qualified client definition at the time the contract was executed will be grandfathered even if such client does not currently satisfy the increased dollar amount thresholds of Rule 205-3. For example, if a person met the $1.5 million Net Worth Test in effect before the effective date of the SEC's July 2011 Order (i.e., September 19, 2011) and entered into an advisory contract with a registered investment adviser prior to such date, such person could continue to maintain assets (and invest additional assets) with the adviser under that contract even though the Net Worth Test was subsequently increased to $2 million, and such person does not meet the new dollar amount threshold of such test. If, however, a person enters into a new contract or becomes a party to an existing contract with an investment adviser, then the new Net Worth Test will apply to such person when he or she becomes a party to such contract.
  2. The restrictions on performance-based compensation will not apply to any contractual arrangements entered into by an investment adviser at a time when the adviser was not required to be registered and was not so registered with the SEC. However, once the adviser registers with the SEC, any new advisory contracts will be subject to the requirements of revised Rule 205-3. For example, where an investment adviser to a private investment company with 50 individual investors that was exempt from registration in 2009, but then subsequently registered with the SEC because such adviser was no longer exempt from registration or because such adviser chose voluntarily to register, the restrictions on performance-based compensation will not apply to the contractual arrangements the adviser entered into before it was registered, including the accounts of the 50 individual investors with the private investment company and any additional investments they make in that company. If, however, any other individuals become new investors in the private investment company, then the new investors would be subject to the new requirements of revised Rule 205-3.
  3. Limited transfers of interest from a qualified client to a non-qualified client as a result of a gift, bequest, or legal separation or divorce are allowed.5 The SEC believes that, when these types of transfers occur, the transferee does not make a separate investment decision to enter into an advisory contract with the adviser, but is the recipient (perhaps involuntarily) of the benefits of the pre-existing contractual relationship. Therefore, the transferee is not of the type that needs the protections of the performance fee restrictions.

Effective Date

The amendments to Rule 205-3 will take effect May 22, 2012, 90 days after publication in the Federal Register.

Footnotes

1. See Investment Adviser Performance Compensation, Investment Advisers Act Release No. IA-3372 (February 15, 2012), available at: http://www.sec.gov/rules/final/2012/ia-3372.pdf.

2. The Net Worth Test will be calculated only once, at the time the advisory contract is entered into.

3. See Net Worth Standard for Accredited Investors, Securities Act of 1933, Release No. 33-9287 (December 21, 2011), available at: http://www.sec.gov/rules/final/2011/33-9287.pdf.

4. The rule provides an exception to the 60-day look-back provision for increases in debt secured by a primary residence, where the debt results from the acquisition of the primary residence. Without this exception, an advisory client who acquires a new primary residence in the 60-day period before a sale of securities may have to include the full amount of the mortgage incurred in connection with the purchase of the primary residence as a liability, while excluding the full value of the primary residence, in a net worth calculation. The 60-day look-back provision is intended to address incremental debt secured against a primary residence that is incurred for the purpose of inflating net worth. It is not intended to address debt secured by a primary residence that is incurred in connection with the acquisition of a primary residence within the 60-day period.

5. The approach the SEC implemented is similar to the approach it adopted in Rule 3c-6 under the Investment Company Act of 1940, which provides that, in the case of a transfer of ownership interest in a private investment company by gift, bequest, or legal separation or divorce, the beneficial owner of the interest will be considered to be the person who transferred the interest.

This article is presented for informational purposes only and is not intended to constitute legal advice.