On July 12, 2011, the Securities and Exchange Commission (the “SEC”) issued an order (the “Order”) pursuant to Section 418 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) 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 (the “Advisers Act”).1
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 contract meets certain criteria, including the assets under management test or the net worth test, thereby making such client a “qualified client”. Effective as of September 19, 2011, the Order raises the dollar amounts of the assets under management test and the net worth test contained in the definition of qualified client to $1 million (from $750,000) and $2 million (from $1.5 million), respectively. Pursuant to Section 205(e) of the Advisers Act, as amended by the Dodd-Frank Act, the SEC will subsequently adjust for inflation the dollar amounts of the assets-under-management test and net worth test every five years.
The SEC continues to consider the amendments it proposed to Rule 205-32, which, if adopted as proposed, would result in the SEC (i) issuing orders pursuant to Rule 205-3 (rather than only Section 205(e)) making future inflation adjustments to the assets under management test and the net worth test every five years and to provide the method for calculating such future adjustments; (ii) excluding the value of a person’s primary residence from the determination of whether a person meets the net worth test contained in the definition of “qualified client”; (iii) grandfathering existing performance compensation arrangements between a SEC-registered investment adviser and its clients that were permissible when the performance compensation arrangements were entered into; and (iv) grandfathering performance compensation arrangements entered into by an investment adviser prior to SEC registration. For more information about the proposed amendments to Rule 205-3, please refer to our memorandum issued on May 13, 2011, entitled “SEC to Change Registered Investment Adviser Performance Compensation Rule and Proposes Transition Rules”.
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Since the raising of the assets under management test and the net worth test are effective as of September 19, 2011, it is recommended that SEC-registered investment advisers who manage funds that rely on Section 3(c)(1) of the Investment Company Act of 1940, as amended, to exclude such funds from registration as investment companies (“3(c)(1) funds”), or unregistered investment advisers to 3(c)(1) funds that otherwise include qualified client representations in their subscription agreements, revise their subscription agreements to reflect this adjustment prior to September 19, 2011.
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 Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3236 (July 12, 2011).
2 See Investment Adviser Performance Compensation, Investment Advisers Act Release No. IA-3198 (May 10, 2011).
