On Feb. 15, 2012, the Securities and Exchange Commission issued a final rule that amends the definition of qualified client in Rule 205-3 under the Advisers Act. The final rule: (i) codifies the order issued by the SEC on July 12, 2011, that increased the dollar amounts of the asset under management test to $1 million and the net worth test to $2 million in the definition of qualified client; (ii) requires that the value of a natural person’s primary residence and certain debt secured by the residence be excluded for purposes of determining whether a client meets the net worth test; (iii) modifies the transition provisions of the rule to take into account existing client and investor arrangements; and (iv) requires the SEC to issue subsequent orders to adjust the dollar amounts of the net worth test and the asset under management test every five years to account for inflation.
A registered investment adviser is only permitted to enter into an investment advisory contract that provides for incentive-based compensation if the client meets the definition of a qualified client (or another exception is available). Rule 205-3 previously defined a qualified client as including, among other things:
(i) a natural person or company with at least $750,000 under management with the adviser immediately after entering into the contract (the “assets under management test”); and
(ii) a natural person or company that the adviser reasonably believes, immediately prior to entering into the contract: (A) has a net worth (together with his or her spouse) of more than $1.5 million at the time the contract is entered into (the “net worth test”); or (B) is a qualified purchaser (as defined under the Investment Company Act).
Rule 205-3 provides that an adviser can enter into an investment advisory contract that provides for incentive-based compensation with a hedge fund, private equity fund or other fund that relies on the exception from the definition of investment company in Section 3(c)(1) of the Investment Company Act (each, a “3(c)(1) Fund”), a registered investment company or a business development company only if each equity owner of the entity is a qualified client.1
Changes to the Assets Under Management and Net Worth Tests
The final rule codifies the increase in the dollar amount threshold in the assets under management test from $750,000 to $1 million2 and in the net worth test from $1.5 million to $2 million.
Pursuant to the final rule, in calculating a natural person’s net worth:
In a significant change from the proposed rule, indebtedness secured by the primary residence that is incurred in the 60 days prior to the time the advisory contract is entered into will be subtracted as a liability, unless the indebtedness is a result of the acquisition of the primary residence. This provision applies even if the total indebtedness secured by the person’s primary residence is less than the estimated value of the primary residence.
The final rule grandfathers incentive-based compensation arrangements that were permissible under the rule in effect at the time an advisory contract was entered into with the client, including a 3(c)(1) Fund with investors that met the definition of qualified client at the time of their investment in the fund. The transition rules also exempt advisory contracts that were entered into and investments in 3(c)(1) Funds that were made before an adviser was required to register with the SEC.
As a result, an adviser can continue to receive incentive-based compensation with respect to existing clients and 3(c)(1) Funds, even if these clients and the existing investors in the 3(c)(1) Fund do not meet the new qualified client definition. Clients and investors are also permitted to add to their existing investments even if they do not meet the new qualified client definition, as long as the advisory contract was permissible at the time it was entered into. These clients and investors, however, are not permitted to enter into new advisory contracts or invest in other 3(c)(1) Funds unless they meet the revised definition.
In addition, the final rule provides that a person that receives an equity ownership interest in a 3(c)(1) Fund by gift or bequest, or pursuant to an agreement related to a legal separation or divorce, is not required to be a qualified client at the time of transfer (and, thus, can retain the investment). The release is silent on whether such a transferee would be able to make an additional investment without satisfying the qualified client definition; it is our view, however, that such a transferee would not be able to make an additional investment unless the transferee satisfies the qualified client definition at the time the additional investment is made.
The final rule removes the existing transition rules under Rule 205-3 that applied to certain conditions existing during periods prior to August 1998 and February 2005.
Adjustments for Inflation
The final rule requires the SEC to adjust the dollar amounts provided in the assets under management test and the net worth test for inflation starting on or about May 1, 2016, and approximately every five years thereafter. The final rule ties the adjustment to the Personal Consumption Expenditures Chain-Type Price Index, with the baseline for future adjustments to be based on the dollar amounts adopted in 1998 ($750,000 for the assets under management test and $1.5 million for the net worth test).
The dollar amount tests in the definition of “qualified client” have been in effect since July 12, 2011. The remaining amendments will become effective 90 days after the final rule is published in the Federal Register. The SEC has stated that it will not object, however, if advisers rely on the amended transition provisions prior to the effective date of the final rule.
The final rule may be found here.
Investment Management Partners:
Thomas John Holton
1 Note that an adviser can enter into an investment advisory contract that provides for incentive-based compensation with a private fund that relies on the exception from the definition of investment company in Section 3(c)(7) of the Investment Company Act without regard to Rule 205-3.
2 The release provides that an adviser may include amounts the client or investor is contractually obligated to invest in private funds managed by the adviser (i.e., uncalled capital commitments) in the adjusted amount, as long as the adviser has a reasonable belief that the client or investor will be able to meet those commitments.