The SEC has issued proposed rules regarding performance fees that can be charged by investment advisers. As a result of changes to the Investment Advisers Act effected by the Dodd-Frank Act, many private equity sponsors and hedge fund advisers will be required to register with the SEC. These fund advisors should breathe a sigh of relief that the proposed rules will grandfather their existing advisory arrangements that would not otherwise be permitted.
Section 205(a)(1) of the Investment Advisers Act generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client. Congress prohibited these compensation arrangements (also known as performance compensation or performance fees) in 1940 to protect advisory clients from arrangements it believed might encourage advisers to take undue risks with client funds to increase advisory fees. In 1970, Congress provided an exception from the prohibition for advisory contracts relating to the investment of assets in excess of $1,000,000, if an appropriate “fulcrum fee” is used. Congress subsequently authorized the SEC to exempt any advisory contract from the performance fee prohibition if the contract is with persons that the SEC determines do not need the protections of that prohibition.
The SEC adopted Rule 205-3 in 1985 to exempt an investment adviser from the prohibition against charging a client performance fees in certain circumstances. The Rule, when adopted, allowed an adviser to charge performance fees if the client had at least $500,000 under management with the adviser immediately after entering into the advisory contract (“assets-under-management test”) or if the adviser reasonably believed the client had a net worth of more than $1 million at the time the contract was entered into (“net worth test”). The SEC stated that these standards would limit the availability of the exemption to clients who are financially experienced and able to bear the risks of performance fee arrangements.
In 1998, the SEC amended Rule 205-3 to change the dollar amounts of the assets-under-management test and net worth test to adjust for the effects of inflation since 1985. The SEC revised the former from $500,000 to $750,000, and the latter from $1 million to $1.5 million.
Indexing for Inflation; Conforming Changes to Accredited Investor Stadard
The Dodd-Frank Act, among other things, amended Section 205(e) of the Advisers Act to state that, by July 21, 2011 and every five years thereafter, the SEC shall adjust for inflation the dollar amount tests included in rules issued under Section 205(e). Pursuant to Section 418 of the Dodd-Frank Act, the SEC has provided notice that it intends to issue an order revising the dollar amount tests of Rule 205-3 to account for the effects of inflation. The SEC also proposed for public comment amendments to Rule 205-3 to provide that the SEC will subsequently issue orders making future inflation adjustments every five years. In addition, the SEC 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 standard required to qualify as a “qualified client.” The latter conforms the net worth calculation to the proposed rules defining the term “accredited investor” for the purposes of Regulation D.
The proposed amendments would replace the current transition rules Section of Rule 205-3 with two new subsections to allow an investment adviser and its clients to maintain existing performance fee arrangements that were permissible when the advisory contract was entered into, even if performance fees would not be permissible under the contract if it were entered into at a later date. These transition provisions, proposed rules 205-3(c)(1) and (2), are both designed so that restrictions on the charging of performance fees apply to new contractual arrangements and do not apply retroactively to existing contractual arrangements. This approach would minimize the disruption of existing contracts that meet applicable standards at the time the parties entered into the contract.
First, proposed Rule 205-3(c)(1) would provide that, if a registered investment adviser entered into a contract and satisfied the conditions of the Rule that were in effect when the contract was entered into, the adviser will be considered to satisfy the conditions of the Rule. Second, proposed Rule 205-3(c)(2) would provide that, if an investment adviser was previously exempt pursuant to Section 203 from registration with the SEC and subsequently registers with the SEC, Section 205(a)(1) of the Act would not apply to the contractual arrangements into which the adviser entered when it was exempt from registration with the SEC.
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