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News May 23, 2011 Issue

Performance Fee Rule To Get Inflation-based Adjustments

Advisers may only charge performance fees to "qualified" clients, this has long been the proviso of Rule 205-3. And as long as the rule has been around, the definition of qualified client has rarely changed.

It has changed only once in fact, in 1998, since the rule was adopted in 1985.

All that will soon be a thing of the past, thanks to the Dodd-Frank Act. The DFA has mandated regular inflation-adjusted tune-ups in several areas, and Rule 205-3 under the Advisers Act is one of them.

Rule 205-3 permits advisers to charge performance fees to clients meeting certain net worth and investment criteria. While not dispositive, higher net worth and larger amounts of assets under management have long been associated with a level of financial sophistication Ė or at least an ability to tolerate the risk of loss.

Section 205(e) of the Advisers Act permits the SEC to exempt persons from that sectionís performance fee prohibitions on the basis of such factors as "financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, relationship with a registered investment adviser, and such other factors as the Commission determines are consistent" with the Section 205 protections.

DFA Section 418 requires the SEC to regularly order inflation adjustments to any dollar amount test in the qualified client standard. The first inflation adjustment must be made by July 21, 2011, with subsequent adjustments every five years thereafter. If you saw the January proposal to inflation-adjust the accredited investor standards, the recently proposed amendments to the qualified client standards will look familiar.

If adopted as proposed, the new thresholds for qualified client status would be:

  • $1 million in assets under management (up from $750,000); and
  • $2 million net worth (up from $1.5 million net worth).

There is one big change, however. As in the proposed changes to the accredited investor standards, the net worth calculation would be altered to exclude the value of a clientís primary residence.

"The value of a personís residence may have little relevance to an individualís financial experience and ability to bear the risks of performance fee arrangements, and therefore little relevance to the individualís need for the Actís protections from performance fee arrangements," said the proposing release.

Any debt secured by the residence that does not exceed the propertyís current market value would be similarly excluded. However, any home debt over the propertyís market value would be included as a liability in the net worth calculation. The SEC said it will follow Internal Revenue Code Section 121 guidance regarding what constitutes an individualís "primary residence."

Thereís some good news for advisers in the proposed amendments.

Current client investments would be grandfathered.

A segment of their client base may be shrinking, but advisers will still be in good shape with clients in current investments. "This approach would minimize the disruption of existing contracts that met applicable standards at the time the parties entered into the contract," said the release. Existing clients making new investments, however, would have to meet the new criteria.

Assets under management would include assets a client is contractually obligated to invest but has not yet invested in private funds.

A bona fide contractual commitment must exist, said the release, and the adviser must have a reasonable belief that the investor can meet the commitment. The SEC noted that this is consistent with the SECís approach in its separate proposal to exempt venture capital and other private fund advisers from registration requirements. For the purposes of calculating AUM there, the SEC would require that unfunded capital commitments be included in the calculation of an adviserís AUM.

The SEC may delay compliance with the new standard for 30 days or more after the rule amendments are effective.

"We anticipate that Ö we will allow an appropriate time period before requiring compliance with the new standards," said the SEC. The Administrative Procedure Act generally requires 30 days, and the SEC requested comment on whether the 30-day period will be sufficient, or whether 60-, 90-, or 120-day periods would be appropriate.

And one final note about the inflation standard.

The SEC intends to base current and future inflation adjustments on an inflation-tracking index published by the Department of Commerce. Known for short as the "PCE Index," the staff noted that the Personal Consumption Expenditures Chain-Type Price Index is often used as an indicator of inflation in the personal sector of the U.S. economy.

If you like another index better, or take issue with other elements of the proposal, comments should be submitted to the SEC by July 11.