SEC Amends Performance Fee Rule

Investment Management Update

Date: March 09, 2012

Overview

Amendments to the performance fee rule going into effect this spring will change the way such fees are calculated.

On February 15, 2012, the Securities and Exchange Commission (SEC) adopted amendments to Rule 205-3 (Amendments) under the Investment Advisers Act of 1940 (Advisers Act) revising the dollar amount thresholds used to determine whether an individual or company is a "qualified client."1 At the same time, the SEC amended Rule 205-3 to exclude the value of a client's primary residence and certain associated debt from the calculation of the client's net worth. In addition, the Amendments authorize the SEC to issue an order every five years, adjusting the dollar amount thresholds for inflation. The Amendments are effective May 22, 2012.

Rule 205-3

Section 205(a)(1) of the Advisers Act generally restricts an investment adviser from entering into, extending, renewing or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, a client's funds. The SEC in 1985 adopted Rule 205-3 under the Advisers Act to allow an investment adviser to charge performance fees if a client had at least $500,000 under management with the adviser immediately after entering into the advisory contract (AUM Test) or if the adviser reasonably believed the client's net worth was more than $1 million at the time the client entered into the contract (Net Worth Test). In 1998, the SEC amended Rule 205-3 to raise the AUM Test threshold to $750,000 and the Net Worth Test threshold to $1.5 million.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) amended Section 205(a)(1) of the Advisers Act to require that the SEC adjust the AUM Test and Net Worth Test thresholds for inflation, rounded to the nearest $100,000.2 In May 2011, the SEC released a notice of its intent to issue an order revising the thresholds as required.3 The notice also proposed the following amendments to Rule 205 3:

  • The rule would be updated to reflect any inflation adjustments to the thresholds ordered by the SEC.
  • The SEC would issue an order every five years adjusting the thresholds for inflation.
  • The value of a person's primary residence would be excluded from the Net Worth Test.
  • Certain transition provisions of the rule would be modified.

On July 12, 2011, the SEC issued an order raising the AUM Test threshold to $1 million and the Net Worth Test threshold to $2 million.4

Adjustments to the Tests

The SEC is codifying the order it issued on July 12, 2011 to amend paragraph (d) of Rule 205-3 to set the AUM Test threshold at $1 million and the Net Worth Test threshold at $2 million. The release adopting the Amendments states that in determining the amount of assets under management, an investment adviser can include bona fide contractual commitments by a client to invest in private funds managed by the adviser. A bona fide contractual commitment is one that the adviser has a reasonable belief the investor will be able to meet.

Five-Year Inflation Adjustment

The Amendments authorize the SEC to issue an order every five years adjusting for inflation the dollar thresholds for the AUM Test and the Net Worth Test.5 Under new Rule 205-3(e), the SEC will issue an order adjusting the Net Worth Test and the AUM Test on or about May 1, 2016 and approximately every five years thereafter. Future inflation adjustments will be based on the Personal Consumption Expenditures Chain-Type Price Index (PCE Index), which is calculated by the Commerce Department's Bureau of Economic Analysis.6

The adjusted tests will apply to contractual relationships entered into on or after the effective date of the order and will not apply retroactively to contractual relationships already in existence on the date of the order.

Exclusion of Primary Residence From the Net Worth Test

The Amendments revise the test for determining an individual client's net worth by excluding from the calculation the value of the client's primary residence. The SEC based this revision on its determination that the value of an individual's residence generally has little relevance to the individual's financial experience and, because of the generally illiquid nature of residential assets, little relevance to the ability of an investor to bear the risk of loss inherent in performance fee arrangements.

Any debt secured by a person's primary residence, up to the estimated fair market value of the residence at the time the investment advisory contract is entered into, is not treated as a liability under the Net Worth Test, except to the extent the debt exceeds the estimated fair market value of the primary residence. In addition, any increase in the amount of any debt secured by the property in the 60 days before the advisory contract is entered into will be included as a liability, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by the property.

In other words:

  • Net worth is calculated only at the time the advisory contract is entered into.
  • The client's primary residence is excluded from assets.
  • Debt secured by the residence, up to its estimated value, is not included in liabilities unless any incremental debt secured by the primary residence is incurred in the 60 days before the advisory contract is entered into.
Transition Provisions

The SEC adopted transition provisions that will allow investment advisers to maintain existing performance fee arrangements that were permissible when the advisory contract was entered into, even if the performance fees would not be permissible if the contact were entered into under amended Rule 205-3.

If an individual or company not party to the original contact becomes a party, however, the conditions of Rule 205-3 in effect at the time the individual or company becomes a party will apply to that individual or company. In addition, if an investment adviser previously not required to register with the SEC is required to register, Section 205(a)(1) will apply only those individuals or companies that become clients (including equity owners of private investment companies advised by the adviser) after the adviser registers.

Finally, if the owner of an interest in a private investment company transfers an interest by gift or bequest, or pursuant to a legal separation or divorce, the transfer will not cause the transferee to become a party to the contract with the adviser and will not cause Section 205(a)(1) to apply to the transfer.

Conclusion

Complexities inherent in the new Amendments mean that investment advisers would do well to address any business issues these changes could present sooner rather than later.

Footnotes

1"Investment Adviser Performance Compensation," Investment Advisers Act Release No. 3372 (February 15, 2012).

2Separately, the Dodd-Frank Act also required that the SEC adjust the net worth standard for an "accredited investor" in rules under the Securities Act of 1933, such as Regulation D.

3"Investment Adviser Performance Compensation," Investment Advisers Act Release No. 3198 (May 10, 2011).

4"Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 Under the Investment Advisers Act of 1940," Investment Advisers Act Release No. 3236 (July 12, 2011).

5Rule 205-3(e).

6The PCE Index is an indicator of U.S. economic inflation in the personal sector. See http://www.bea.gov.