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News July 18, 2011 Issue

Performance Fee Rule Gets Inflation-based Adjustments

The Dodd-Frank Act required it. In May, the SEC announced it. Last week, the SEC ordered it.

On July 12, the SEC issued an order amending Rule 205-3 (a/k/a the performance fee rule) to increase the minimum threshold tests for net worth and assets under management in the rule’s definition of "qualified client." Beginning on the September 19 effective date, qualified clients can be individuals with a minimum net worth of $2 million, or individuals with minimum assets under management of $1 million.

The rule prohibits an adviser from taking a performance fee from anyone other than a qualified client. Greater financial resources have long been viewed under the securities laws as an indicator of greater financial sophistication and a greater ability to tolerate the risk of loss.

The Dodd-Frank Act (DFA) called for inflation-based adjustments to several tests of financial sophistication in the securities laws, including the accredited investor standard and the performance fee rule’s qualified client definition. DFA Section 418 requires the SEC to regularly order inflation-based adjustments to any dollar amount test in the qualified client standard at least every five years. The first such adjustment was due by July 21, and the July 12 order met that mandate.

Standards set, potential calculation changes loom.

On May 10, when the SEC published the notice of its intent to order increases in the qualified client dollar threshold tests, the SEC also proposed other amendments to Rule 205-3. The proposed amendments would alter the calculations of net worth and AUM in the qualified client definition and specifically provide for the grandfathering of existing clients in current investments.

The proposed amendments that remain pending would provide that:

  • the value of a client’s primary residence would be excluded from the calculation of net worth;
  • assets under management would include unfunded capital commitments where a bona fide contractual commitment exists and the adviser reasonably believes the client can meet the commitment(s); and
  • current clients may remain in current investments, but would have to meet any new standard in effect at the time such client makes any new investments.

The July 12 order is effective September 19. Unless and until the proposed amendments to the rule are adopted and become effective, the current calculation standards and guidance for meeting the net worth and assets under management standards remain in place.

Built-in grandfathering.

Grandfathering, although included in the proposed amendments, is built into Rule 205-3. The rule provides under paragraph (a) that an adviser may charge a performance fee to a client "provided, that the client entering into the contract subject to this section is a qualified client." The qualified client definition at paragraph (d)(1) of the rule also states that a qualified client is one who meets the minimum assets under management threshold immediately after entering into the advisory contract, or who meets the net worth threshold at the time the contract is entered into.