SEC changes to the performance compensation rule affecting registered investment advisers
An order made by the Securities and Exchange Commission (the "SEC") on July 12, 2011, raises the thresholds that determine whether a registered investment adviser can charge performance fees to its clients. These changes stem from a requirement of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act").
The current rule:
Section 205(a)(1) of the Investment Advisers Act of 1940 (the "Advisers Act") generally prohibits an investment adviser from charging a performance fee to a client. However, Rule 205-3 exempts certain investment advisers from this prohibition and allows a performance fee to be charged to "qualified clients". There are two tests under Rule 205-3 that determine whether a client is a qualified client. The first test is the "assets-under-management test", which requires that the client have at least $750,000 of assets under management with the investment adviser. The second test is the "net worth test" and requires the client to have a net worth of more than $1,500,000. A client would need to meet at least one of these two criteria to be considered a qualified client.
If the investment adviser is managing a pooled investment vehicle that is relying on Section 3(c)(1) of the Advisers Act, then the adviser is required to "look through" the pooled investment vehicle to the underlying investors. Those investors must each meet the qualified client requirements in order to charge a performance fee to the investor.
The revised rule:
The Dodd-Frank Act amended the Advisers Act and required the SEC to raise the thresholds for the dollar amounts set forth in Rule 205-3 of the Advisers Act in order to reflect inflation and subsequently adjust those thresholds every five years. The last time the SEC revised these thresholds for inflation was in 1998. The assets-under-management test will increase to a minimum of $1,000,000 and the net worth test will increase to $2,000,000. These changes will become effective on Sept. 19, 2011.
The proposed rules:
The SEC has also proposed other amendments to Rule 205-3 that are still under consideration including revising the net worth test for qualified clients that would exclude the value of a natural person's primary residence including any debt secured by the property, provided that the mortgage is not greater than the current market value of the property. This requirement would be similar to the requirement contained in the Dodd-Frank Act that changed the Accredited Investor definition (as defined in the Securities Act of 1933) to exclude the value of a person's primary residence.
There are also "transition rules" which have been proposed that would provide some relief to existing clients. An investment adviser's existing clients (including investors in a private investment fund) would be grandfathered in with respect to their current investment. Also, any additional funds invested by existing clients (including investors in a private investment fund) would not be subject to the new thresholds. New clients of the registered investment adviser (including investors in a private investment fund) would be subject to the higher dollar thresholds as described above.
If an adviser is currently exempt from registration and does become registered pursuant to the requirements of the Dodd-Frank Act, the adviser's existing clients (including investors in a private investment fund) would not have to meet the qualified client standards in order to be charged a performance fee. After the adviser becomes registered, all new clients would have to meet the qualified client standards.
The road ahead:
The investment adviser or their administrator will need to be familiar with the new rule to monitor compliance for new investors. In addition, SEC registered investment advisers who manage funds that rely on Section 3(c)(1) of the Investment Company Act of 1940 will need to revise their subscription documents prior to September 19, 2011.
Since investors in 3(c)(1) funds that are managed by registered investment advisers need to be both accredited investors and qualified clients in order to charge a performance-based fee, there may now be a substantially smaller pool of investors that will qualify to join such vehicles.
Todd E. Rosen, CPA, Director, RSM US LLP, 212.372.1715