On May 10, 2011, the Securities and Exchange Commission (the “SEC”) issued a release providing notice that it intends to issue an 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 (the “Advisers Act”).1 The SEC has also proposed amendments to Rule 205-3 to provide that the SEC will subsequently issue orders 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. Additionally, the SEC has proposed to amend Rule 205-3 to exclude 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”. The proposed amendment also (i) grandfathers existing performance compensation arrangements between a SEC-registered investment adviser and its clients (including investors in private investment companies)2 that were permissible when the performance compensation arrangements were entered into and (ii) grandfathers performance compensation arrangements entered into by an investment adviser prior to SEC registration.
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 contract meets the assets-under-management test or the net worth test and, accordingly, is a “qualified client”. Pursuant to Section 418 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the SEC intends to issue an order to raise 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.
Exclusion of the Value of Primary Residence from the Net Worth Test
The SEC has proposed to amend, and is seeking comment on, the net worth test contained in the definition of “qualified client” to exclude the value of a natural person’s primary residence and debt secured by the property that is no greater than the property’s current market value. This would mean that a mortgage on a primary residence would not be included 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. If the outstanding debt exceeds the market value of the residence, the amount of the excess would be considered a liability in calculating net worth.3
Future Adjustment of the Assets-Under-Management Test and the Net Worth Test
The SEC has also proposed to amend Rule 205-3 to provide that the SEC will subsequently issue orders every five years to adjust the dollar amounts of the assets-under-management test and the net worth test for inflation. The SEC further proposed, and is seeking comment on, the method for calculating future inflation adjustments of the assets-under-management test and the net worth test.4
Transition Rules
A. Existing Clients of SEC-Registered Investment Advisers
The SEC has proposed a transition rule that would allow an SEC-registered investment adviser which 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, to have satisfied the conditions of Rule 205-3 despite future changes to the Rule. The proposed transition rule would also allow the investment of additional funds by a client (including investments of additional funds 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.
B. SEC-Registered Investment Advisers That Were Previously Exempt from Registration
The SEC has also proposed a transition rule that would grandfather performance compensation arrangements that predate SEC registration. Under the proposal, an investment adviser previously exempt from registration, which subsequently registers with the SEC, will be 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. The proposed amendment would also allow such clients (including investors in a private investment company) to invest additional funds. Once the investment adviser is registered, however, new clients and new investors in private investment companies would be required to meet the “qualified client” standard in effect at that time.
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Comments on the proposed amendments should be received by the SEC by July 11, 2011.
If you have any questions about these potential changes, please contact an 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-3198 (May 10, 2011) (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 debt secured by the property from the net worth test, although not required by the Dodd-Frank Act, is similar to the Dodd-Frank Act requirement that the value of a natural person’s primary residence be excluded from the net worth test contained in the definition of “accredited investor” in Rule 501(a)(5) under the Securities Act of 1933.
4 The proposed amendment specifies that the Personal Consumption Expenditures Chain-Type Price Index (the “PCE Index”) would be the inflation index used to calculate future inflation adjustments of the assets-under-management test and the net worth test.
