SEC Amends Investment Adviser Performance Compensation Rules

On February 15, 2012, the Securities and Exchange Commission (“SEC”) issued a final rule (the “Final Rule”) which amends provisions of the Investment Advisers Act of 1940 (the “Act”) permitting investment advisers to charge performance based compensation to qualified clients.

History of Investment Adviser Performance Compensation Rules

In 1985 the Securities and Exchange Commission (“SEC”) adopted rule 205-3 of the Investment Advisers Act of 1940 (the “Act”) to permit investment advisers to charge performance based fees to “qualified clients” under certain circumstances.  Under rule 205-3, investment advisers are allowed to charge clients a performance based fee if the client has a certain prescribed minimum amount of assets under management with the adviser (“asset-under-management test”) or if the adviser reasonably believes the client had a prescribed minimum net worth (“net worth test”).  Prior to July 12, 2011, the assets-under-management threshold was a minimum of $750,000 and the net worth minimum was $1.5 million.  Under an order issued by the SEC on July 12, 2011, these thresholds were raised to $1 million for the assets-under-management test and a minimum of $2 million for the net worth test.

Summary of SEC’s Recent Amendments

The Final Rule adds a provision requiring the adjustment of the dollar thresholds every five years to account for the effects of inflation.  The Final Rule also revises the method used to compute the net worth standard for qualified clients by excluding the value of a client’s primary residence and also revises the consideration of certain debt secured by a client’s primary residence. Lastly, the Final Rule contains certain transition provisions which are aimed at minimizing the disruption to existing contractual relationships between investment advisers and their clients.  More information on the Final Rule amended provisions are included below.

The Final Rule will be effective 90 days after its publication in the Federal Register. 

Amendments to the “Assets-Under-Management” and “Net Worth” Tests

The Final Rule requires the SEC to adjust the dollar thresholds for the assets-under-management and net worth tests every five years to give effect to inflation.  The Personal Consumption Expenditures Chain-Type Price Index, which is issued by the Department of Commerce, will be used for indexing purposes.  Any indexation will be rounded to the nearest $100,000.

Changes to the Determination of Net Worth

The Final Rule provides that the value of a person’s primary residence must be excluded for purposes of determining the client’s net worth.  Debt secured by the primary residence generally will not be included as a liability in the net worth calculation except to the extent that it exceeds the estimated value of the primary residence.  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 value of the primary residence exceeds the aggregate amount of debt secured by the primary residence.

Net worth is only required to be calculated at the time the advisory contract is entered into.

Transition Provisions under the Final Rule

The SEC has provided for the following transition provisions under the Final Rule:

1. The restrictions on performance fees only apply to new contractual arrangements and do not apply to new investments by clients who met the definition of a “qualified client” when they initially entered into the advisory contract.  This is true even if the client subsequently does not meet the dollar thresholds of the Final Rule.  The amended “qualified clients” thresholds will apply to new clients who become a party to the contract.
2. If a registered investment adviser was not previously required to register with the SEC and did not register, the Final Rule will not apply to the contractual arrangements entered into prior to the adviser’s registration with the SEC.  In the case of private investment companies, any new investors in a private investment company managed by the adviser after the adviser is required to be registered with the SEC will be subject to the provisions of the Final Rule.  Transfers of interests from one private investment company to another private investment company managed by the same adviser are considered new investments and will be subjected to the provisions of the Final Rule if they occur after the adviser is required to be registered with the SEC.
3. In the case of a transfer of ownership interest in a private investment company by gift or bequest, or pursuant to an agreement relating to a legal separation or divorce, the transferee will not be considered “a party” to the advisory contract and the provisions of the Final Rule will not apply to such transfer.

For additional information regarding the requirements of the SEC’s final rule, please contact your legal counsel or your Arthur Bell client service executive at 410.771.0001 or contactus@arthurbellcpas.com.