On May 10, 2011, the Securities and Exchange Commission released a proposed rule, pursuant to Section 418 of the Dodd-Frank Act, that provides notice of the SEC’s intent to issue a proposed order (the “Proposed Order”) that would increase the dollar amounts in the definition of “qualified client” in Rule 205-3 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). In addition, the proposed rule would (i) require the SEC Staff to issue subsequent orders to adjust the dollar amount tests in the definition of “qualified client” every five years to account for inflation, (ii) exclude the value of a person’s primary residence for purposes of determining whether a client meets the “net worth test” in the definition of “qualified client,” and (iii) modify the transition provisions of the rule to take into account existing client arrangements. The proposed rule is discussed in more detail below.
I. Incentive-Based Compensation Arrangements Under the Advisers Act
As background, Section 205(a)(1) of the Advisers Act generally prohibits an investment adviser registered under the Advisers Act or required to be registered under the Advisers Act from “enter[ing] into, extend[ing], or
renew[ing] any investment advisory contract, or in any way perform[ing] any investment advisory contract . . . [that] [p]rovides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of a client.” One exception to this prohibition, contained in Rule 205-3 of the Advisers Act, permits a registered investment adviser to enter into such an investment advisory contract if the client meets the definition of a “qualified client.”1 Currently, Rule 205-3 defines a “qualified client” as including:
(i)a natural person or company with at least $750,000 under management of the investment adviser immediately after entering into the contract (the “assets under management test”);
(ii)a natural person or company that the investment 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 in Section 2(a)(51)(A) of the Investment Company Act of 1940.
A. Adjustments to the “Assets Under Management Test”
The Proposed Order would raise the dollar amount threshold in the “assets under management test” from $750,000 to $1 million, and the proposed rule would permit an investment adviser to include amounts the client 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 will be able to meet those commitments.
B. Adjustments to the “Net Worth Test”
The Proposed Order would also raise the dollar amount threshold in the “net worth test” from $1.5 million to $2 million, and the proposed rule would exclude a person’s primary residence from the calculation of the person’s net worth. In excluding the primary residence from the calculation, the proposed rule would also exclude the amount of debt secured by the property, as long as the amount of debt is no greater than the property’s current market value. If the debt exceeds the current market value of the property, the excess would be considered a liability when calculating a client’s net worth.
C. Adjustments for Inflation
The proposed rule would require the SEC to adjust the threshold 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 proposed rule would tie the adjustment to a consumer price index — the Personal Consumption Expenditures Chain-Type Price Index — and would use the amounts currently in effect, from 1998, as a baseline for all future adjustments. The SEC stated that it anticipates delegating authority to the SEC Staff to issue inflation adjustment orders going forward.
D. Transition Rules
The proposed rule would replace the existing transition rules to “grandfather” incentive-based compensation arrangements that were permissible under the rule in effect at the time the advisory contracts were entered into with the client.2 This would allow advisers to avoid having to renegotiate the terms of arrangements that were permissible when the parties entered into them, for example, when clients can no longer meet the “qualified client” definition after the dollar amounts are adjusted for inflation. The transition rules would also apply to an investment adviser that was previously exempt from registration pursuant to Section 203 of the Advisers Act by exempting from Section 205(a)(1) of the Advisers Act those advisory contracts that were entered into before the adviser was registered.
II. Practical Implications for Advisers That Are Not Yet Registered With the SEC
If an adviser registers with the SEC before the effective date of the proposed rule, the adviser could be faced with the prospect of having to re-evaluate its arrangements with existing clients. This could pose an administrative burden to determine whether a client meets the definition of a “qualified client” and/or to terminate existing advisory contracts with those clients that do not meet the current definition of a “qualified client.” If, however, an adviser waits to register until after the effective date of the proposed rule, the proposed transition rules would apply and the adviser would not have to re-evaluate its existing arrangements with clients (so long as such arrangements were permissible when entered into). This gives unregistered advisers another reason to consider delaying registration. We suggest that advisers consult with their legal advisors to determine the timing of registration that is best for them.
Comment and Effective Dates
Comments on the proposed rule are due on or before July 11, 2011. The new dollar amounts in the definition of “qualified client” would become effective no sooner than 30 days after the Proposed Order is issued.
The proposed rule can be found at http://www.sec.gov/rules/proposed/2011/ia-3198.pdf.
Investment Management Partners:
Thomas John Holton
1Other Exceptions to Section 205(a)(1) of the Advisers Act are contained in Section 205(b) of the Advisers Act and apply in the following cases:
(i) where the contract is with a registered investment company or where the contract relates to the investment of assets in excess of $1 million, if the contract provides for compensation based on the asset value of the fund averaged over a specified period and increasing and decreasing based on an appropriate index (a “fulcrum fee”);
(ii) under certain circumstances where the client is a business development company;
(iii) where the client is a company exempt from registration under Section 3(c)(7) of the Investment Company Act of 1940;
(iv) where the client is not a resident of the United States.
Further exceptions are contained in the transition rules currently in effect under Rule 205-3 under the Advisers Act and include:
(i) contracts entered into by an investment adviser before August 20, 1998, where the investment adviser satisfied the conditions of Section 205(a)(1) in effect on the date the contract was entered into (but not extending to parties added to the contract after August 20, 1998);
(ii) contracts relating to existing accounts of equity owners of private funds where the private fund advisers were exempt from registration under the Advisers Act pursuant to Section 203(b) prior to February 10, 2005, and the equity owner was an equity owner of the company prior to February 10, 2005;
(iii) contracts entered into by investment advisers prior to February 10, 2005, where the investment adviser is an adviser to a private investment company that is a “private fund” as defined in Section 203(b)(3)-1 of the Advisers Act and was exempt from registration under Section 203(b)(3) of the Advisers Act at the time the contract was entered into prior to February 10, 2005 (excluding contracts to which a private investment company is a party, and parties added to the contract after February 10, 2005).
2This provision would prohibit an adviser from adding clients to these arrangements if the arrangement would not have been permissible at the time the party was added.
This article was originally published by Bingham McCutchen LLP.