The Securities and Exchange Commission (the “SEC”) recently adopted final rules that codified a prior SEC order raising the dollar amounts of the “assets-under-management test” and the “net worth test” contained in Rule 205-3 under the Investment Advisers Act of 1940, as amended.1 The final rules also provide that the SEC will adjust the assets-under-management test and the net worth test for inflation every five years. Additionally, the final rules amend Rule 205-3 to exclude the value of a person’s primary residence and certain other indebtedness from the determination of whether a person meets the net worth test. Lastly, the final rules (i) grandfather existing performance compensation arrangements between a SEC-registered investment adviser and its clients (including investors in private investment companies2) that were permissible when the performance compensation arrangements were entered into, (ii) grandfather performance compensation arrangements entered into by an investment adviser prior to SEC registration; and (iii) allow for limited transfers of interests in private investment companies from qualified clients to persons who are not qualified clients. Investment advisers may rely on the grandfathering provisions before May 22, 2012, the effective date of amended Rule 205-3.
Changes to “Assets-Under-Management Test” and “Net Worth Test”
Rule 205-3 exempts a SEC-registered investment adviser from the prohibition against charging a client performance based compensation, provided that the client entering into the agreement is a “qualified client”. A client can satisfy the “qualified client” standard by meeting an assets-under-management test or a net worth test. Rule 205-3, as amended, codifies an SEC order that was effective as of September 19, 2011, raising the dollar amounts of the assets-under-management test and the net worth test to $1 million (from $750,000) and $2 million (from $1.5 million), respectively.
Exclusion of the Value of Primary Residence from the Net Worth Test
The SEC also amended the net worth test contained in the definition of “qualified client” to exclude the value of a natural person’s primary residence and any debt secured by the primary residence, up to the estimated fair market value of the residence.3 This means that a mortgage on a primary residence would not be included as a liability in the determination of a natural person’s net worth, unless the outstanding debt on the mortgage, at the time that net worth is calculated, exceeds the market value of the residence. Where the outstanding debt exceeds the market value of the residence, the amount of the excess is considered a liability in calculating net worth. Notwithstanding the foregoing, any increase in the amount of debt secured by the primary residence in the 60 days before a performance compensation arrangement is entered into (other than as a result of the acquisition of such residence) is to be included as a liability when calculating a client’s net worth. This provision is meant to prevent investors from inflating their net worth by borrowing against their home shortly before entering into a performance compensation arrangement for purposes of satisfying the definition of qualified client.
Future Adjustment of the Assets-Under-Management Test and the Net Worth Test
Rule 205-3, as amended, also provides that the SEC will issue an order every five years to adjust the dollar amounts of the assets-under-management test and the net worth test for inflation.4
Transition Rules
A. Existing Clients of SEC-Registered Investment Advisers
Under amended Rule 205-3, a SEC-registered investment adviser that entered into a performance compensation arrangement with a client (including investors in private investment companies) that satisfied the conditions of Rule 205-3 that were in effect at that time, are deemed to have satisfied the conditions of Rule 205-3 despite future changes to the Rule. This transition rule also allows the investment of additional assets by a client (including investments of additional assets by investors in private investment companies), as long as the conditions of Rule 205-3 that were in effect when the arrangement was entered into were satisfied. If, however, another person or entity becomes a party to the existing performance compensation arrangement, the qualified client standard in effect at such time will apply to such new party.
B. SEC-Registered Investment Advisers That Were Previously Exempt from Registration
The SEC has also adopted a transition rule that grandfathers performance compensation arrangements that predate an investment adviser’s SEC registration. An investment adviser previously exempt from registration, which subsequently registers with the SEC, is permitted to continue performance compensation arrangements entered into prior to SEC registration even if such arrangements are with clients (including investors in a private investment company) who are not qualified clients. Such clients (including investors in a private investment company) are also allowed to invest additional assets without having to satisfy the provisions of Rule 205-3 in effect at the time of the additional investment. Once the investment adviser is registered, however, new clients and new investors in private investment companies (including investors that may have pre-existing performance compensation arrangements with the investment adviser with respect to other private investment companies) are required to meet the “qualified client” standard in effect at that time.
C. Limited Transfers From Qualified Clients to Non-Qualified Clients
As amended, Rule 205-3 now allows an investor in a private investment company to transfer his or her interest(s) in the private investment company by gift, bequest or pursuant to an agreement related to legal separation or divorce to a person that was not a party to the existing performance compensation arrangement and is not a qualified client at the time of the transfer. Such transferee is not considered to have “become a party” to the performance compensation arrangement, thereby allowing the investment adviser to maintain the performance compensation arrangement.
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It is recommended that investment advisers to private investment companies revise the subscription agreements for such private investment companies to reflect the amendments to Rule 205-3.5 If you have any questions with respect to the foregoing, please contact your primary attorney in the Investment Management Group at Seward & Kissel LLP.
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1 Investment Adviser Performance Compensation, Investment Advisers Act Release No. IA-3372 (February 15, 2012) (the “Release”).
2 For purposes of this memorandum, a “private investment company” is a company that is excluded from the definition of “investment company” by reason of Section 3(c)(1) under the Investment Company Act of 1940, as amended.
3 The exclusion of the value of a natural person’s primary residence and any debt secured by the primary residence (up to the estimated fair market value of the residence) from the net worth test is similar to the net worth test contained in the definition of “accredited investor” in Rule 501(a)(5) under the Securities Act of 1933.
4 Amended Rule 205-3 specifies that the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”) will be used to adjust the assets-under-management test and the net worth test for inflation.
5 An investment adviser that is not SEC-registered but is seeking exemption from registration as an investment adviser in certain states by relying on a private fund adviser exemption (if any) in the state or states may need to include additional representations in private fund subscription agreements.
