SEC Tightens Rules on Advisory Performance Fee Charges

February 16, 2012 § 2 Comments

As part of its continuing Dodd-Frank mandated rulemaking, the Securities and Exchange Commission recently issued final rules to raise the net worth requirement for investors who pay performance fees. The tightened standard excludes the value of the investor’s home from the net worth calculation.

SEC Rule 205-3 requires that registered investment advisers can charge performance-based fees only to “qualified clients” who meet either a net worth or assets under management test. Before Dodd-Frank, those tests were either $750,000 under management with the adviser or net worth of at least a $1,500,000.

The rule applies to managed account clients as well as investors in “private investment companies,” i.e., 3(c)(1) funds.

Dodd-Frank gave the SEC one year to adjust the net asset threshold. In July 2011 the Commission ordered changes to the standards increasing the test to  $1,000,000 under management or $2,000,000 in net worth (excluding primary residence). The heightened standard became effective for all advisory relationships as of September 19, 2011. By its recent action, the SEC has formalized the action taken last July and adopted final rules.

Under the final rule qualified clients must have either $1,000,000 under management or net worth of at least $2,000,000. As with the accredited investor standard, the value of the investor’s primary residence is excluded from the net worth calculation. Indebtedness on primary residence is also excluded unless it exceeds the estimated value of the residence. Certain indebtedness on the residence that is incurred within 60 days of the advisory contract may also be included to reduce an investor’s net worth. This is intended to prevent investors from manipulating their net worth shortly before entering into advisory contracts by borrowing against their homes to inflate their cash or other assets that would be included in the net worth calculation.

Under the rule’s transition provisions, advisers will continue to be able to charge performance fees to their clients and investors who met the earlier qualified client standard. The new standard will not apply retroactively. The new rules become effective May 22, 2012. Until that time, the standard adopted in September 2011 will remain in effect and the value of investors’ primary residences may be included in determining qualified client status.

The tightened standard applies to SEC-registered investment advisers as well as many state-registered advisers. Many states–California, for example–expressly refer to the SEC rule in their own performance fee regulations.

Dodd-Frank requires the SEC to revisit the qualified client standard every five years.



Jack G. Martel is the author of Investment Adviser Law Blog which is devoted to providing information and discussion of interest to investment advisers, private fund managers and others in the financial management industry. Jack is a partner in Ragghianti | Freitas LLP. He has over fifteen years experience in general business and securities transactions with a focus on assisting investment advisers, fund sponsors and managers in all manner of legal, regulatory and compliance issues. Jack can be reached at 415.453.9433.

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