By Scott H. Moss, Esq., David L. Goret, Esq. and Cole Beaubouef, Esq.
On May 10, 2011, the Securities and Exchange Commission (the “SEC”) released a proposed rule and notice of intent to issue an order relating to a registered investment adviser’s ability to receive performance-based compensation. The SEC’s proposal is part of its rulemaking initiative under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which, among other items, directed the SEC to adjust for inflation certain dollar amount tests used to determine a registered investment adviser’s ability to receive performance-based compensation.
As discussed in more detail below, the SEC’s proposal also (i) excludes the value of a person’s primary residence from the determination of whether a person meets the requisite net worth standards; (ii) allows for certain transition provisions (i.e., a “grandfathering” provision); and (iii) establishes a method for future adjustments to the dollar amount tests it contains.
The Existing Qualified Client Rule
Under current SEC rules, registered investment advisers are generally prohibited from collecting any performance-based compensation or assessing any performance-based fees, except in certain limited circumstances. However, pursuant to Rule 205-3 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), registered investment advisers may charge clients performance-based fees if, among other things, such clients are qualified clients. The definition of qualified client under Rule 205-3 includes (i) a natural person who or a company that has at least $750,000 under the management of an investment adviser immediately after entering into an advisory contract with the investment adviser, and (ii) a natural person who or a company that the investment adviser reasonably believes has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time an advisory contract with the investment adviser is consummated.
For registered investment advisers that advise private investment funds relying upon the Section 3(c)(1) exemption under the Investment Company Act of 1940, as amended (the “Investment Company Act”), the performance-based compensation prohibition applies to the investors in such private investment funds.
Proposed Revisions to the Rules
Noting that the dollar amounts set forth in the assets under management and net worth tests in the qualified client rule were last adjusted for inflation in 1998, the SEC’s proposal would now revise the thresholds set forth in such tests to $1,000,000 with respect to the assets under management test, and to $2,000,000 with respect to the net worth test. In determining eligibility under the assets under management test, the SEC’s proposal states that investment advisers may include committed capital of its clients.
The SEC’s proposal also states that, as directed by the Dodd-Frank Act, the SEC will issue an order every five years adjusting for inflation the dollar amounts referenced in such tests. Such adjustments for inflation would take into account inflationary trends as referenced in the U.S. Department of Commerce’s Personal Consumption Expenditures Chain-Type Price Index, with the dollar amounts adopted in 1998 (i.e., $750,000 and $1,500,000) referenced as the baseline for all future adjustments.
Exclusion of the Value of Primary Residence from Net Worth
Although not required by the Dodd-Frank Act, the SEC’s proposal also would amend the net worth standard in Rule 205-3 to exclude the value of a natural person’s primary residence (and debt secured by such residence). This proposal, which was anticipated by many commentators, is similar to the Dodd-Frank requirement that the value of a personal residence be excluded when determining an investor’s “accredited investor” status.
Transition Rules
In a move that was widely anticipated by many in the investment management industry, the SEC’s proposal provides for transition rules designed to ensure that the revised qualified client standards would apply only to new contractual arrangements and not to existing contractual arrangements that were permissible when entered into. These proposed grandfathering provisions would also allow additional investments by any clients/investors who were parties to such existing contractual arrangements, even if such clients/investors would not meet the revised standards imposed by the SEC’s proposal at the time of the proposed additional investment.
Finally, the SEC’s proposed transition rules would provide that any investment adviser that was previously exempt from registration as an investment adviser with the SEC pursuant to Section 203 of the Advisers Act, and that subsequently registers with the SEC, would not be subject to the revised qualified client standards with respect to contractual arrangements entered into when exempt from registration. This proposal would allow investment advisers that are currently exempt from registration pursuant to the current Section 203(b)(3) of the Advisers Act, and that advise private investment funds relying upon the Section 3(c)(1) exemption under the Investment Company Act, to continue charging performance-based fees to investors in such private investment funds, whether or not such investors are qualified clients, even after registering as an investment adviser with the SEC.
Next Steps
If enacted in its current form, the SEC’s proposal would require registered investment advisers to review and revise accordingly, offering memoranda and subscription documents relating to private investment funds that rely upon the Section 3(c)(1) exemption under the Investment Company Act. Registered investment advisers would also be required to address the revised standards with respect to any future managed account agreements that they enter into. Lowenstein Sandler’s Investment Management Group encourages investment advisers to review their current advisory documentation and to consider what actions may be required in light of the SEC’s proposal.
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The SEC’s notice and proposed rule may be found here. The SEC will issue a final rule relating to the items addressed in this summary following a period of public comment, which will close on July 11, 2011. Those clients wishing to submit comments on the proposed rule may do so here.
Lowenstein Sandler’s Investment Management Group will monitor public comments relating to this proposal and keep you informed of any final rules or additional proposals.
In the interim, please contact any of the attorneys listed, or any other member of Lowenstein Sandler’s Investment Management Group, for further information on the matters discussed in this summary.
