As discussed in a previous Tonkon Tip, last summer, the Securities and Exchange Commission (the "SEC") issued an order (the "Order") raising the financial thresholds of Rule 205-3 ("Rule 205-3") under the Investment Advisers Act of 1940, which provides that only "qualified clients" may be charged a performance-based fee. The Order was issued pursuant to the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank"), which requires the SEC to periodically adjust the qualified client wealth thresholds of Rule 205-3.
Current Standards. The Order, which was effective September 19, 2011, provides that a qualified client must be:
a natural person or entity with at least $1 million in assets under management with the adviser immediately after entering into the advisory contract;
a natural person with a net worth (together with assets held jointly with a spouse) of more than $2 million at the time of entering into the advisory contract; or
an entity with a net worth of more than $2 million at the time of entering into the advisory contract.
Amended Rule 205-3. Earlier this year, the SEC adopted amendments to Rule 205-3 to codify the new wealth thresholds and clarify certain issues not addressed in the Order. The amendments are effective May 22, 2012 and provide for:
Exclusion of the Primary Residence. To calculate the net worth of a natural person for purposes of Rule 205-3, the value of the person's primary residence must be excluded as an asset in all cases. Any liabilities secured by the primary residence, up to the value of the residence, may be excluded, unless the liabilities were incurred (a) in the 60 days preceding the execution of the advisory contract or securities purchase and (b) for reasons other than to acquire the residence. Any indebtedness secured by the residence that exceeds the fair market value of the residence must be considered a liability when calculating net worth.
Transition Rules. The new thresholds apply only to new contractual arrangements and do not apply to new investments by clients (including investors in private investment funds advised by the adviser) who met the definition of "qualified client" when they entered into the advisory contract (or purchased the fund interest). Thus, for example, if a person met the $1.5 million net worth test in effect before September 19, 2011 (the Order's effective date) and entered into an advisory contract with a registered adviser before that date, the person could continue to maintain assets (and invest additional assets) with the adviser under that contract even though the net worth test was subsequently raised to $2 million and the person no longer met the new test.
Inflation Adjustments. The SEC will adjust the qualified client wealth thresholds for inflation on or about May 1, 2016, and then again every five years thereafter.
Action Items. Registered investment advisers charging performance-based fees should ensure that advisory agreements and subscription agreements used with new clients and investors reflect the revised wealth thresholds of Rule 205-3 and take into account the treatment of the primary home and associated liabilities when determining net worth for purposes of that rule.