SEC Proposes To Raise Qualified Client Standard
- The Securities and Exchange Commission has proposed a rule change and given notice of its intent to issue a related order that would narrow the universe of persons who can pay performance fees to registered investment advisers. Release No. IA-3198 (May 10, 2011). The proposal would not affect advisory contracts that were properly entered into before the rule changes took effect or before the adviser was required to register with the SEC.
Registered investment advisers generally are not allowed to share in their clients' capital gains or capital appreciation, but Rule 205-3 allows advisers to receive compensation based on capital gains or appreciation (generally referred to as "performance fees") from "qualified clients." If the client is a hedge fund or other private or registered investment company, then each of its equity owners must be a qualified client. In general, a client is a qualified client if the adviser reasonably believes that the client has a net worth of more than $1.5 million at the time the advisory contract is entered into, or the client has at least $750,000 under the adviser's management immediately after entering into the contract.
Section 418 of the Dodd-Frank Act requires the SEC, by July 21, 2011, to issue an order to adjust the dollar amount tests in Rule 205-3 for inflation. The SEC notice announces that the SEC intends to issue an order to revise the net worth and assets-under-management tests to $2 million and $1 million, respectively. The proposed increase would reflect changes in the Personal Consumption Expenditures Chain-Type Price Index since the dollar amount tests were last adjusted in 1998. The Dodd-Frank Act also requires further adjustments for inflation every five years thereafter, and the SEC proposal would provide an adjustment mechanism in the rule.
The SEC also proposes to amend the net worth standard to exclude the value of a natural person's primary residence and debt secured by the property. The Dodd-Frank Act made a similar change to the "accredited investor" standard. The SEC reasons that the value of a person's residence may have little relevance to an individual's financial experience and ability to bear the risks of performance fee arrangements, and therefore little relevance to the individual's need for the Advisers Act's protections from performance fee arrangements.
The proposed transition rules are likely to get the lion's share of attention. If an adviser entered into a contract and satisfied the conditions of the rule that were in effect when the contract was entered into, then it is proposed that the adviser will be considered to satisfy the conditions of the rule. In addition, if an investment adviser was previously exempt from SEC registration and subsequently registered with the SEC, it is proposed that the performance fee ban would not apply to the contractual arrangements into which the adviser entered when it was exempt from registration. In either case, however, it is proposed that new advisory arrangements (e.g., new investors in a hedge fund) would be subject to the new qualified client standards.
The SEC's press release, with a link to the proposing release/notice, is available online at
John M. Baker <JMB@...>
Stradley Ronon Stevens & Young, LLP http://www.stradley.com
1250 Connecticut Avenue, NW, Suite 500
Washington, DC 20036
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