SEC Issues Notice Regarding Inflation Indexing of Performance Fee Rule

Investment Management Update

Date: May 19, 2011


On May 10, 2011, the Securities and Exchange Commission (SEC) published notice of its intent to issue an order required under Section 418 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act") that would adjust for inflation two dollar amount tests set forth in Rule 205-3 under the Investment Advisers Act of 1940, as amended ("Advisers Act").1 The order would narrow the number of investors that would be eligible to pay a performance fee to registered investment advisers. The SEC also proposes to make amendments to Rule 205-3 that would authorize it to issue an order every five years adjusting for inflation the dollar amount tests set forth in Rule 205-3, exclude the value of a person's primary residence from the net worth calculation in determining whether the person satisfies the "qualified client" definition and add certain transition provisions to Rule 205-3 to address the changes brought about by the order and proposed amendments.

Order Adjusting "Qualified Client" Dollar Amount Tests

Section 205(a)(1) of the Advisers Act generally prohibits a registered investment adviser from entering into, extending, renewing or performing any investment advisory contract that provides for compensation to the adviser based upon the capital gains or capital appreciation of a client's account, including appreciation or gains attributable to an investment in a pooled investment vehicle. However, Rule 205-3 provides an exception that allows advisers to receive compensation based on capital gains or appreciation (generally referred to as "performance fees") from "qualified clients."

As presently defined, a client is deemed to be a qualified client where, among other requirements, 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 management with the adviser immediately after entering into the contract (together, the "Asset Tests"). Section 418 of the Dodd-Frank Act amended Section 205(e) of the Advisers Act to provide that by July 21, 2011, and every five years thereafter, the SEC will adjust the dollar amount tests included in rules issued under Section 205(3), including the Asset Tests set forth in Rule 205-3. Thus, the SEC now intends to increase the net worth requirement from $1.5 million to $2 million and the assets under management requirement from $750,000 to $1 million. The increase in each requirement would reflect changes in the Personal Consumption Expenditures Chain-Type Price Index ("PCE Index") since the Asset Tests were last adjusted in 1998.

An order adjusting the Asset Tests will be issued by the SEC, unless it orders a hearing. Hearing requests should be submitted to the SEC by June 20, 2011.

Proposed Amendment to Rule 205-3 Under the Advisers Act

In addition to implementing the order required under the Dodd-Frank Act, the Notice also proposes certain rule amendments. First, the SEC proposes amending Rule 205-3 by adding new paragraph (e). If adopted, proposed paragraph (e) would authorize the SEC to issue an order every five years adjusting the Asset Tests to account for inflation. As proposed, the PCE Index would be used to account for future inflation adjustments; however, the SEC has requested comments on whether the PCE Index is the most appropriate index for purposes of adjusting the Asset Tests.

Second, the SEC proposes to exclude the value of a natural person's primary residence and the debt secured by such property from the calculation of an individual's financial net worth for purposes of Rule 205-3. To the extent that the amount of a mortgage secured by the person's primary residence exceeds the value of such residence, the "negative equity" would be deducted from a person's net worth under the proposed amendments.

Finally, the SEC proposes various transition rules to replace the current ones set forth in Rule 205-3. Proposed Rules 205-3(c)(1) and (2) are intended to limit the application of the new restrictions on the use of performance fees to new contractual arrangements and to clarify that such restrictions are not intended to apply retroactively to existing contractual arrangements, including private investment funds that are excluded from the definition of an "investment company" under Section 3(c)(1) of the Investment Company Act of 1940, as amended. If, however, a natural person or company that was not a party to the original advisory contract becomes a party, the conditions of Rule 205-3 in effect at the time they become a party would apply to such person or company. Proposed Rule 205-3(c)(2) would also provide that if an investment adviser was previously exempt from registration with the SEC pursuant to Section 203 of the Advisers Act and subsequently registers with the SEC, Section 205(a)(1) of the Advisers Act would not apply to the contractual arrangements the investment adviser entered during the period it was exempt from registration.

Comments on the proposed amendments to Rule 205-3 are due by July 11, 2011.


1 Investment Adviser Performance Compensation, Rel. No. IA-3198 (May 11, 2011) ("Notice"). A copy of the Notice can be found on the SEC's website at