The Securities and Exchange Commission (“SEC”) announced on February 15, 2012 that it is tightening its rule on investment advisory performance fees by raising the net worth and asset requirements for investors and excluding the value of their homes from the net worth calculation.1
New Dollar Thresholds for Qualified Clients
Under amended Rule 205-3 of the Investment Advisers Act of 1940 (the “Rule”), registered investment advisers may charge a client a performance fee if the client’s net worth or assets under management with the adviser meet certain dollar thresholds. Investors meeting the net worth or asset threshold are deemed by the SEC to be “qualified clients,” as defined under the Rule, and able to bear the risks associated with performance fee arrangements.
The amended Rule will require qualified clients to have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million. The Rule’s dollar thresholds now conform to the levels set by the SEC in a July 12, 2011 order. The increase in the thresholds was required by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).
Exclusion of Primary Residence and Certain Property-Related Debts
Notably, the Rule excludes the value of a client’s primary residence and certain property-related debts from the net worth calculation. According to the SEC, “the value of a person’s residence generally has little relevance to the individual’s financial experience and ability to bear the risks of performance fee arrangements…”2
While this change was not required by the Dodd-Frank Act, it is consistent with changes the SEC approved in December 2011 to net worth calculations for determining who is an “accredited investor” eligible to invest in certain unregistered securities offerings.
Debt secured by a primary residence will generally not be included as a liability in the net worth calculation under the Rule, except to the extent it exceeds the estimated value of the primary residence. Under the Rule, however, any increase in the amount of debt secured by the primary residence in the 60 days
before the advisory contract is entered into generally will be included
as a liability, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by such primary residence.3
The Rule also includes a new “grandfather” provision permitting advisers to continue to charge clients performance fees if the clients were considered “qualified clients” before the Rule changes. Further, the grandfather provision will permit newly registering investment advisers to continue charging performance fees to those clients who were already being charged performance fees.
Under the Rule, the SEC will issue an order every five years making inflation adjustments to the dollar thresholds used to determine whether an individual or company is a qualified client, as required by the Dodd-Frank Act. The Rule also specifies the price index on which future inflation adjustments will be based.4
The Rule amendments will take effect 90 days after publication in the Federal Register. Advisers may, however, rely on the grandfather provision before the effective date.
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1 See Investment Adviser Performance Compensation
, Investment Advisers Act Release No. IA-3372 (February 15, 2012), available at http://www.sec.gov/rules/final/2012/ia-3372.pdf
The fair market value of the primary residence is determined as of the time the advisory contract is entered into, even if the investor has changed his or her primary residence during the 60-day period.
Rule 205-3(e) provides that the assets under management and net worth tests will be adjusted for inflation by (i) dividing the year-end value of the PCE Index for the calendar year preceding the calendar year in which the order is being issued, by the year-end value of the PCE Index for the calendar year 1997, (ii) multiplying the threshold amounts adopted in 1998 ($750,000 and $1.5 million) by that quotient, and (iii) rounding each product to the nearest multiple of $100,000. For example, for the order the SEC would issue in 2016, the SEC would (i) divide the year-end 2015 PCE Index by the year-end 1997 PCE Index, (ii) multiply the quotient by $750,000 and $1.5 million, and (iii) round each of the two products to the nearest $100,000.