Ia 3198
Ia 3198
RIN 3235-AK71
issue an order that would adjust two dollar amount tests in the rule under the Investment
Advisers Act of 1940 that permits investment advisers to charge performance based
compensation to “qualified clients.” The adjustments would revise the dollar amount tests to
account for the effects of inflation. The Commission is also proposing to amend the rule to:
provide that the Commission will issue an order every five years adjusting for inflation the dollar
amount tests; exclude the value of a person’s primary residence from the test of whether a person
has sufficient net worth to be considered a “qualified client;” and add certain transition
DATES: Comments on the proposed rule should be received on or before July 11, 2011.
Electronic Comments:
(http://www.sec.gov/rules/proposed.shtml); or
subject line; or
2
Paper Comments:
All submissions should refer to File Number S7-17-11. This file number should be included on
the subject line if e-mail is used. To help us process and review your comments more efficiently,
please use only one method. The Commission will post all comments on the Commission’s
website viewing and printing in the Commission’s Public Reference Room, 100 F Street, NE,
Washington, DC 20549, on official business days between the hours of 10:00 am and 3:00 pm.
All comments received will be posted without change; we do not edit personal identifying
information from submissions. You should submit only information that you wish to make
available publicly.
HEARING REQUEST: An order adjusting the dollar amount tests specified in the definition
of “qualified client” will be issued unless the Commission orders a hearing. Interested persons
may request a hearing by writing to the Commission’s Secretary. Hearing requests should be
received by the SEC by 5:30 p.m. on June 20, 2011. Hearing requests should state the nature of
the writer’s interest, the reason for the request, and the issues contested.
Investment Management, Securities and Exchange Commission, 100 F Street, NE, Washington,
DC 20549-8549.
3
proposing for public comment amendments to rule 205-3 [17 CFR 275.205-3], under the
TABLE OF CONTENTS
Determination ........................................................................................... 10
3. Transition Rules ........................................................................................ 14
C. Effective and Compliance Dates ............................................................................17
III. REQUEST FOR COMMENT ................................................................................................... 18
IV. COST BENEFIT ANALYSIS .................................................................................................. 18
V. PAPERWORK REDUCTION ACT ........................................................................................... 26
VI. REGULATORY FLEXIBILITY ACT CERTIFICATION ............................................................... 26
VII. STATUTORY AUTHORITY ................................................................................................... 27
TEXT OF PROPOSED RULES .................................................................................................... 27
I. BACKGROUND
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.2 Congress prohibited these compensation arrangements
clients from arrangements it believed might encourage advisers to take undue risks with client
1
15 U.S.C. 80b. Unless otherwise noted, all references to statutory sections are to the Investment
Advisers Act, and all references to rules under the Investment Advisers Act, including rule 205-3,
are to Title 17, Part 275 of the Code of Federal Regulations [17 CFR 275].
2
15 U.S.C. 80b-5(a)(1).
4
funds to increase advisory fees.3 In 1970, Congress provided an exception from the prohibition
exempt any advisory contract from the performance fee prohibition if the contract is with persons
that the Commission determines do not need the protections of that prohibition.6
The Commission adopted rule 205-3 in 1985 to exempt an investment adviser from the
prohibition against charging a client performance fees in certain circumstances.7 The rule, when
3
H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940). Performance fees were characterized as
“heads I win, tails you lose” arrangements in which the adviser had everything to gain if
successful and little, if anything, to lose if not. S. Rep No. 1775, 76th Cong., 3d Sess. 22 (1940).
4
15 U.S.C. 80b-5(b)(2). Trusts, governmental plans, collective trust funds, and separate accounts
referred to in section 3(c)(11) of the Investment Company Act of 1940 [15 U.S.C. 80a-3(c)(11)]
are not eligible for this exception from the performance fee prohibition under section
205(b)(2)(B) of the Advisers Act.
5
15 U.S.C. 80b-5(b). A fulcrum fee generally involves averaging the adviser’s fee over a specified
period and increasing or decreasing the fee proportionately with the investment performance of
the company or fund in relation to the investment record of an appropriate index of securities
prices. See rule 205-2 under the Advisers Act; Definition of “Specified Period” Over Which
Asset Value of Company or Fund Under Management is Averaged, Investment Advisers Act
Release No. 347 (Nov. 10, 1972) [37 FR 24895 (Nov. 23, 1972)]. In 1980, Congress added
another exception to the prohibition against charging performance fees, for contracts involving
business development companies under certain conditions. See section 205(b)(3) of the Advisers
Act.
6
Section 205(e) of the Advisers Act. In 1996, Congress included in the National Securities
Markets Improvement Act of 1996 (“1996 Act”) two additional statutory exceptions from the
performance fee prohibition and new section 205(e) of the Advisers Act. The 1996 Act added
exceptions for contracts with companies excepted from the definition of “investment company” in
the Investment Company Act of 1940 (“Investment Company Act”) [15 U.S.C. 80a] by section
3(c)(7) of the Investment Company Act [15 U.S.C. 80a-3(c)(7)] and contracts with persons who
are not residents of the United States. See sections 205(b)(4) and (b)(5). Section 205(e) of the
Advisers Act authorizes the Commission to exempt conditionally or unconditionally from the
performance fee prohibition advisory contracts with persons that the Commission determines do
not need its protections. Section 205(e) provides that the Commission may determine that
persons do not need the protections of section 205(a)(1) 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 [section 205].”
7
Exemption To Allow Registered Investment Advisers to Charge Fees Based Upon a Share of
Capital Gains Upon or Capital Appreciation of a Client’s Account, Investment Advisers Act
5
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
Commission 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.8
In 1998, the Commission amended rule 205-3 to, among other things, change the dollar
amounts of the assets-under-management test and net worth test to adjust for the effects of
inflation since 1985.9 The Commission revised the former from $500,000 to $750,000, and the
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform
and Consumer Protection Act (“Dodd-Frank Act”). 11 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 Commission shall adjust for inflation the dollar amount tests included in rules
issued under section 205(e).12 Separately, the Dodd-Frank Act also required that we adjust the
Release No. 996 (Nov. 14, 1985) [50 FR 48556 (Nov. 26, 1985)] (“1985 Adopting Release”).
The exemption applies to the entrance into, performance, renewal, and extension of advisory
contracts. See rule 205-3(a).
8
See 1985 Adopting Release, supra note 7, at Sections I.C and II.B. The rule also imposed other
conditions, including specific disclosure requirements and restrictions on calculation of
performance fees. See id. at Sections II.C – E.
9
See Exemption To Allow Investment Advisers To Charge Fees Based Upon a Share of Capital
Gains Upon or Capital Appreciation of a Client’s Account, Investment Advisers Act Release No.
1731 (July 15, 1998) [63 FR 39022 (July 21, 1998)] (“1998 Adopting Release”).
10
See id. at Section II.B.1.
11
Pub. L. No. 111-203, 124 Stat. 1376 (2010).
12
See section 418 of the Dodd-Frank Act (requiring the Commission to issue an order every five
years revising dollar amount thresholds in a rule that exempts a person or transaction from section
205(a)(1) of the Advisers Act if the dollar amount threshold was a factor in the Commission’s
6
net worth standard for an “accredited investor” in rules under the Securities Act of 1933
II. DISCUSSION
Pursuant to section 418 of the Dodd-Frank Act, today we are providing notice that the
Commission intends to issue an order revising the dollar amount tests of rule 205-3 to account
for the effects of inflation. We also are proposing for public comment amendments to rule 205-3
to provide that the Commission will subsequently issue orders making future inflation
adjustments every five years.15 In addition, we are proposing 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.” Finally, we propose to modify the
transition provisions of the rule to take into account performance fee arrangements that were
permissible when they were entered into, so that new dollar amount thresholds do not require
investment advisers to renegotiate the terms of arrangements that were permissible when the
parties entered into them. These proposals are discussed in more detail below.
test and the net worth test in the definition of “qualified client” in rule 205-3. As discussed
above, the Commission last revised these dollar amount tests in 1998 to take into account the
effects of inflation. At that time, the Commission revised the assets-under-management test
from $500,000 to $750,000 and revised the net worth test from $1 million to $1.5 million.
determination that the persons do not need the protections of that section).
13
15 U.S.C. 77a et seq.
14
See section 413(a) of the Dodd-Frank Act.
15
Rule 205-3 is the only exemptive rule issued under section 205(e) of the Advisers Act that
includes dollar amount tests, which are the assets-under-management and net worth tests.
7
Pursuant to section 418 of the Dodd-Frank Act, which requires that we revise the dollar amount
thresholds of the rule by order not later than July 21, 2011, and every five years thereafter, today
we are providing notice16 that we intend to issue an order to revise the assets-under-management
and net worth tests of rule 205-3 to $1 million17 and $2 million respectively.18
These revised dollar amounts would take into account the effects of inflation by reference
to the historic and current levels of the Personal Consumption Expenditures Chain-Type Price
Index (“PCE Index”),19 which is published by the Department of Commerce.20 The PCE Index
is often used as an indicator of inflation in the personal sector of the U.S. economy.21 The
16
See section 211(c) of the Advisers Act (requiring the Commission to provide appropriate notice
of and opportunity for hearing for orders issued under the Advisers Act).
17
An investment adviser could include in determining the amount of assets under management the
assets that a client is contractually obligated to invest in private funds managed by the adviser.
Only bona fide contractual commitments may be included, i.e., those that the adviser has a
reasonable belief that the investor will be able to meet.
This approach to calculating assets under management conforms with the approach we took in
our recent release proposing to implement certain exemptions from registration with the
Commission under the Advisers Act. In that release, we proposed to include uncalled capital
commitments in the calculation of assets under management used to determine whether an
adviser qualifies for the private fund adviser exemption. See Exemptions for Advisers to Venture
Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under
Management, and Foreign Private Advisers, Investment Advisers Act Release No. 3111 (Nov. 19,
2010) [75 FR 77190 (Dec. 10, 2010)] at nn.192-94 and accompanying text.
18
As discussed further below, we also would revise the definition of “qualified client” in rule
205-3(d) to reflect the updated thresholds.
19
The revised dollar amounts in the tests would reflect inflation as of the end of 2010, and are
rounded to the nearest $100,000 as required by section 418 of the Dodd-Frank Act. The 2010
PCE Index is 111.123, and the 1997 PCE Index was 85.395. Assets-under-management test
calculation to adjust for the effects of inflation: 111.123/85.395 x $750,000 = $975,962;
$975,962 rounded to the nearest multiple of $100,000 = $1 million. Net worth test calculation to
adjust for the effects of inflation: 111.123/85.395 x $1.5 million = $1,951,923; $1,951,923
rounded to the nearest multiple of $100,000 = $2 million.
20
The values of the PCE Index are available from the Bureau of Economic Analysis, a bureau of the
Department of Commerce. See http://www.bea.gov. See also
http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=64&ViewSeries=NO&Java
=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=1997&LastYear
=2010&3Place=N&Update=Update&JavaBox=no#Mid.
21
See Clinton P. McCully, Brian C. Moyer, and Kenneth J. Stewart, “Comparing the Consumer
8
Commission has used the PCE Index in other contexts, including the determination of whether a
person meets a specific net worth minimum in Regulation R under the Securities Exchange Act
We also are proposing to amend rule 205-3 under the Advisers Act. We would add a new
paragraph (e) stating that the Commission will issue an order every five years adjusting for
inflation the dollar amounts of the assets-under-management and net worth tests of the rule, as
required by the Dodd-Frank Act.23 Our proposed amendment would specify that the PCE Index
will be the inflation index used to calculate future inflation adjustments of the dollar amount tests
in the rule.24 We believe the use of the PCE Index is appropriate because, as discussed above, it
Price Index and the Personal Consumption Expenditures Price Index,” Survey of Current
Business (Nov. 2007) at 26 n.1 (PCE Index measures changes in “prices paid for goods and
services by the personal sector in the U.S. national income and product accounts” and is primarily
used for macroeconomic analysis and forecasting). See also FEDERAL RESERVE BOARD,
MONETARY POLICY REPORT TO THE CONGRESS (Feb. 17, 2000) at n.1 (available at
http://www.federalreserve.gov/boarddocs/hh/2000/february/ReportSection1.htm#FN1) (noting
the reasons for using the PCE Index rather than the consumer price index).
22
See Definitions of Terms and Exemptions Relating to the “Broker” Exceptions for Banks,
Securities Exchange Act Release No. 56501 (Sept. 24, 2007) [72 FR 56514 (Oct. 3, 2007)]
(“Regulation R Release”) (adopting periodic inflation adjustments to the fixed-dollar thresholds
for both “institutional customers” and “high net worth customers” under Rule 701 of Regulation
R). See also Amendments to Form ADV, Investment Advisers Act Release No. 3060 (July 28,
2010) [75 FR 49234 (Aug. 12, 2010)] (increasing for inflation the threshold amount for
prepayment of advisory fees that triggers an adviser’s duty to provide clients with an audited
balance sheet and the dollar threshold triggering the exception to the delivery of brochures to
advisory clients receiving only impersonal advice). The Dodd-Frank Act also requires the use of
the PCE Index to calculate inflation adjustments for the cash limit protection of each investor
under the Securities Investor Protection Act of 1970. See section 929H(a) of the Dodd-Frank
Act.
23
Proposed rule 205-3(e) would provide that the Commission will issue an order effective on or
about May 1, 2016 and approximately every five years thereafter adjusting the
assets-under-management and net worth tests for the effects of inflation.
24
Proposed rule 205-3(e) would provide that the assets-under-management and net worth tests will
be adjusted for inflation by (i) dividing the year-end value of the PCE Index for the calendar year
9
is an indicator of inflation in the personal sector of the U.S. economy and is used in other
provisions of the federal securities laws.25 We also intend to revise paragraph (d) of rule 205-3,
which sets forth the assets-under-management and net worth tests, to reflect the revised
thresholds that we establish by the order discussed above.26 Finally, we anticipate that, if we
adopt these proposed amendments to rule 205-3, we would delegate to our staff the authority to
• Is the proposed use of the PCE Index as a measure of inflation appropriate? Is there
• The rule would establish the dollar amount tests we adopted in 1998 as the baseline
for all future adjustments, as a consistent denominator for all future calculations.
Should we instead establish each future adjustment of the dollar amount tests as a
preceding the calendar year in which the order is being issued, by the year-end value of the PCE
Index for the calendar year 1997, (ii) multiplying the threshold amounts adopted in 1998
($750,000 and $1.5 million) by that quotient, and (iii) rounding each product to the nearest
multiple of $100,000. For example, for the order the Commission would issue in 2016, the
Commission would (i) divide the 2015 PCE Index by the 1997 PCE Index, (ii) multiply the
quotient by $750,000 and $1.5 million, and (iii) round each of the two products to the nearest
$100,000.
25
See supra notes 21-22 and accompanying text.
26
As discussed above, we would revise the assets-under-management test to $1 million and the net
worth test to $2 million.
27
To delegate this authority to the staff, we would amend our rules of organization and program
management to delegate to the Director of the Division of Investment Management the authority
to issue notices and orders revising the dollar amount thresholds in rule 205-3(d)(1)(i)
(assets-under-management) and 205-3(d)(1)(ii)(A) (net worth) for the effects of inflation pursuant
to amended section 205(e) of the Advisers Act every five years after 2011. See rule 30-5 of the
Commission’s Rules of Organization and Program Management [17 CFR 200.30-5] (delegating
authority to the Director of the Division of Investment Management). We also anticipate that
future changes to the dollar amount tests that are issued by order, will be reflected in technical
amendments to rule 205-3(d).
10
new baseline for the next calculation of the dollar amount tests? If we were to adopt
that approach, because the Dodd-Frank Act requires that revised thresholds be
rounded to the nearest $100,000, could the establishment of new baselines at the
rounded amounts, each time the thresholds are adjusted, result in the underestimation
We also are proposing to amend the net worth standard in rule 205-3, in the definition of
“qualified client,” to exclude the value of a natural person’s primary residence and debt secured
by the property.28 This change, although not required by the Dodd-Frank Act, is similar to that
Act’s requirement that we exclude the value of a natural person’s primary residence in the
definition of “accredited investor” in rules under the Securities Act.29 The value of a person’s
residence may have little relevance to an individual’s financial experience30 and ability to bear
28
Proposed rule 205-3(d)(1)(ii)(A) (excluding from the assessment of net worth the value of a
natural person’s primary residence “calculated by subtracting from the estimated fair market
value of the property the amount of debt secured by the property, up to the estimated fair market
value of the property”).
29
See section 413(a) of the Dodd-Frank Act (requiring the Commission to adjust any net worth
standard for an “accredited investor” as set forth in Commission rules under the Securities Act of
1933 to exclude the value of a natural person’s primary residence). The Dodd-Frank Act does not
require that the net worth standard for an accredited investor be adjusted periodically for the
effects of inflation, although it does require the Commission at least every four years to
“undertake a review of the definition, in its entirety, of the term ‘accredited investor’ … [as
defined in Commission rules] as such term applies to natural persons, to determine whether the
requirements of the definition should be adjusted or modified for the protection of investors, in
the public interest, and in light of the economy.” See section 413(b)(2)(A) of the Dodd-Frank
Act. In a separate release, we proposed rule amendments to adjust the net worth standards for
accredited investors in our rules under the Securities Act. See Net Worth Standard for Accredited
Investors, Securities Act Release No. 9177 (Jan. 25, 2011) [76 FR 5307 (Jan. 31, 2011)]
(“Accredited Investor Proposing Release”).
30
We stated in 2006, when we proposed a minimum net worth threshold for establishing when an
individual could invest in hedge funds pursuant to the safe harbor of Regulation D, that the value
of an individual’s personal residence may bear little or no relationship to that person’s financial
knowledge and sophistication. See Prohibition of Fraud by Advisers to Certain Pooled
11
the risks of performance fee arrangements, and therefore little relevance to the individual’s need
for the Act’s protections from performance fee arrangements.31 The Commission took a similar
approach when it excluded the value of a person’s primary residence and associated liabilities
from the determination of whether a person is a “high net worth customer” in Regulation R under
the Exchange Act32 and from the determination of whether a natural person has a sufficient level
Our proposed amendment would exclude the value of a natural person’s primary
residence and the amount of debt secured by the property that is no greater than the property’s
current market value.34 Therefore a mortgage on the residence would not be included in the
assessment of a natural person’s net worth, unless the outstanding debt on the mortgage, at the
time that net worth is calculated, exceeds the market value of the residence. If the outstanding
debt exceeds the market value of the residence, the amount of the excess would be considered a
liability in calculating net worth under the proposed amendments to rule 205-3.
Advisers Act Release No. 2576 (Dec. 27, 2006) [72 FR 400 (Jan. 4, 2007)] at Section III.B.3.
31
For example, an individual who meets the net worth test only by including the value of his
primary residence in the calculation is unlikely to be as able to bear the risks of performance fee
arrangements as an individual who meets the test without including the value of her primary
residence.
32
See, e.g., Regulation R Release, supra note 22, at Section II.C.1 (excluding primary residence and
associated liabilities from the fixed-dollar threshold for “high net worth customers” under Rule
701 of Regulation R, which permits a bank to pay an employee certain fees for the referral of a
high net worth customer or institutional customer to a broker-dealer without requiring registration
of the bank as a broker-dealer).
33
A qualified purchaser under section 2(a)(51) of the Investment Company Act [15 U.S.C.
80a-2(a)(51)] includes, among others, any natural person who owns not less than $5 million in
investments, as defined by the Commission. Rule 2a51-1 under the Investment Company Act
includes within the meaning of investments real estate held for investment purposes. 17 CFR
270.2a51-1(b)(2). A personal residence is not considered an investment under rule 2a51-1,
although residential property may be treated as an investment if it is not treated as a residence for
tax purposes. See Privately Offered Investment Companies, Investment Company Act Release
No. 22597 (Apr. 3, 1997) [62 FR 17512 (Apr. 9, 1997)] at text accompanying and following n.48.
34
Proposed rule 205-3(d)(1)(ii)(A).
12
residence from the calculation of a natural person’s net worth under rule 205-3.
• Should we, as proposed, exclude the value of a natural person’s primary residence
from the calculation of net worth? Or should we include the value of a person’s
primary residence? Does such ownership evidence financial experience and the
ability to bear risks associated with performance fee contracts? Should we, as
proposed, also exclude from the net worth standard in rule 205-3 debt secured by a
person’s primary residence, up to the market value of the residence? Does such debt
affect the ability to bear risks associated with performance fee contracts or
• We note that although the Dodd-Frank Act requires the Commission to exclude a
natural person’s primary residence from the net worth standard for an “accredited
investor” in rules under the Securities Act, the Dodd-Frank Act does not require the
Commission to exclude a natural person’s primary residence from the standards for a
“qualified client” in rules under section 205(e) of the Advisers Act. Instead, the
Dodd-Frank Act requires that the dollar amount tests of “qualified client” be adjusted
for inflation every five years. Should our amendment of rule 205-3 accomplish only
what the Dodd-Frank Act mandates (i.e., inflation-adjustment of the dollar amount
tests) and not revise the net worth test by excluding the value of a primary residence?
• Should the rule require, as proposed, that debt secured by the residence in excess of
the market value of the residence at the time the advisory contract is entered into be
included as a liability in the determination of the person’s net worth? Should the rule
instead require that all debt that is secured by the primary residence (regardless of
13
whether it exceeds the fair market value of the residence) be excluded from the
calculation of net worth under rule 205-3? Alternatively, should the rule exclude the
entire market value of the residence from net worth, but require treatment of any
associated debt as a liability? Should the rule require inclusion of debt secured by a
primary residence as a liability if proceeds of the debt are used to enter into an
• Should the rule provide that the calculation of net worth must be made on a specified
date prior to the day the advisory contract is entered into, for example 30, 60, or 90
days? If not, would investors be likely to inflate their net worth by borrowing against
their homes to attain qualified client status? If we were to require that the net worth
advisory contract, would such a requirement make the calculation unduly complex?
substitute the word “equity” for the word “value” when referring to the primary
residence excluded from the calculation of a natural person’s net worth? Should we
define the term “primary residence” for purposes of rule 205-3? If so, should we
address the circumstances of a person who lives in multiple residences for roughly
35
As we stated in the Accredited Investor Proposing Release, supra note 29, at nn.35-36 and
accompanying text, helpful guidance may be found in rules that apply in other contexts. For
example, the IRS Publication 523, Selling Your Home 3-4 (Jan. 5, 2011) lists the following
factors to be used, in addition to the amount of time a person lives in each of several homes, to
determine a person’s “principal residence” under section 121 of the Internal Revenue Code, 26
U.S.C. 121: place of employment; location of family members’ main home; mailing address for
bills and correspondence; address listed on federal and state tax returns, driver’s license, car
registration, and voter registration card; location of banks used and recreational clubs and
14
• As noted above, the Commission proposed in a separate release to adjust the net
worth standards for accredited investors in our rules under the Securities Act, to
exclude the value of a natural person’s primary residence from the assessment of a
natural person’s net worth.36 We request comment on whether the net worth
standards that we consider in connection with rule 205-3 should differ from any
3. T
ransition Rules
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
companies that are excluded from the definition of an “investment company” under the
Investment Company Act by reason of section 3(c)(1)37 of that Act (“private investment
companies”).38 This approach would minimize the disruption of existing contracts that meet
religious organizations.
36
See supra note 29.
37
See rule 205-3(d)(3) (defining “private investment company” for purposes of rule 205-3).
Advisory contracts with companies excepted from the definition of an “investment company” by
reason of section 3(c)(7) of the Investment Company Act are not subject to the Advisers Act
performance fee prohibition. See section 205(b)(4) of the Advisers Act. Therefore these
contractual arrangements do not need, and are not included within, the exemptive relief provided
by rule 205-3.
38
Under rule 205-3(b), the equity owner of a private investment company, or of a registered
investment company or business development company, is considered a client of the adviser for
purposes of rule 205-3(a). We adopted this provision in 1998, and the provision was not affected
15
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.39 If,
however, a natural person or company that was not a party to the contract becomes a party, the
conditions of the rule in effect at the time they become a party would apply to that person or
company. This proposed subsection would mean, for example, that if an individual meets the
$1.5 million net worth test and enters into an advisory contract with a registered investment
adviser, the client could continue to maintain funds (and invest additional funds) with the adviser
under that contract even if the net worth test were subsequently raised and he or she no longer
met the new test. If, however, another person were to become a party to that contract, the current
net worth threshold would apply to the new party when he or she becomes a party to the
contract.40
advisory services under performance fee arrangements that were permitted under the
rule in effect at the time the contract was entered into, if the client does not meet the
by our subsequent rule amendments and related litigation concerning the registration of
investment advisers to private investment companies. See 1998 Adopting Release, supra note 9;
Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006).
39
Proposed rule 205-3(c)(1) would modify the existing transition rule in rule 205-3(c)(1), which
permits advisers and their clients that entered into a contract before August 20, 1998, and
satisfied the eligibility criteria in effect on the date the contract was entered into to maintain their
existing performance fee arrangements.
40
Proposed rule 205-3(c)(1). Similarly, a person who invests in a private investment company
advised by a registered investment adviser must satisfy the rule’s conditions when he or she
becomes an investor in the company. See rule 205-3(b) (equity owner of a private investment
company is considered a client of a registered investment adviser for purposes of rule 205-3(a)).
16
eligibility criteria after an adjustment to the dollar amount tests or for any other
reason (e.g., a decrease in the client’s net worth below the dollar amount test)?
Should the rule in these circumstances permit the management of existing funds
performance fees with respect to funds committed after the effective date of the rule?
If so, how should the rule treat dividends and realized capital gains reinvested by the
adviser?
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 Commission and
subsequently registers with the Commission, 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 Commission.41 This proposed subsection would mean, for example, that if an
investment adviser to a private investment company with 50 individual investors was exempt
from registration with the Commission in 2009, but then subsequently registered with the
Commission because it was no longer exempt from registration or because it chose voluntarily to
register, section 205(a)(1) would not apply to the contractual arrangements the adviser entered
into before it registered, including the accounts of the 50 individual investors with the private
investment company and any additional investments they make in that company. If, however,
any other individuals become new investors in the private investment company after the adviser
41
Section 205(a)(1) would apply, however, to contractual arrangements into which the adviser
enters after it is no longer exempt from registration with the Commission. See proposed rule
205-3(c)(2). The approach of the proposed subsection is similar to the transition subsections we
adopted in 2004, in rules 205-3(c)(2) - (3), when we adopted rules to require the registration of
investment advisers to private funds. See Registration Under the Advisers Act of Certain Hedge
Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2, 2004) [69 FR 72054 (Dec.
10, 2004)]. Those transition provisions were vacated by the U.S. Court of Appeals for the
District of Columbia Circuit when it vacated the Commission’s rulemaking in its entirety. See
Goldstein v. SEC, supra note 38.
17
registers with the Commission, section 205(a)(1) would apply to the adviser’s relationship with
them.
compensated under performance fee arrangements that were permitted when the
adviser was exempt from registration with the Commission? Should the rule in these
performance fee with respect to any additional funds to be managed under previously
existing contracts?
• Should the rule differentiate between the reasons why an adviser was exempt from
registration (e.g., due to a particular subsection of the Advisers Act) but is no longer
exempt? Should the rule include different transition provisions depending upon the
reason why an adviser was exempt from registration but is no longer exempt?
We anticipate that, if we issue the order described above and adopt the rule amendments
we are proposing, we will allow an appropriate time period before requiring compliance with the
new standards. For rule amendments, the Administrative Procedure Act generally requires at
least 30 days prior to the effectiveness of new rules, absent special circumstances.42
• We request comment on the transition period or delayed compliance date that would
be appropriate for any revised thresholds that we issue by order, or for any rule
amendments that we adopt. Should we allow more time than the 30 days required
42
See 5 U.S.C. 553(d).
18
under the Administrative Procedure Act (e.g., 60 days, 90 days, 120 days)?
The Commission requests comment on the rule amendments we propose in this release.
Commenters are requested to provide empirical data to support their views. The Commission
also requests suggestions for additional changes to existing rules or forms, and comments on
other matters that might have an effect on the proposals contained in this release.
The Commission is sensitive to the costs and benefits imposed by its rules. We have
identified certain costs and benefits of the proposed amendments, and we request comment on all
aspects of this cost benefit analysis, including identification and assessment of any costs and
benefits not discussed in this analysis. We seek comment and data on the value of the benefits
identified. We also welcome comments on the accuracy of the cost estimates in this analysis,
and request that commenters provide data that may be relevant to these cost estimates. In
addition, we seek estimates and views regarding these costs and benefits for particular
investment advisers, including small advisers, as well as any other costs or benefits that may
In proposing to amend rule 205-3 to provide that the Commission will issue orders every
five years adjusting for inflation the dollar amount tests of the rule, we are responding to the
Dodd-Frank Act’s amendment of section 205(e) of the Advisers Act requiring the Commission
to issue these orders.43 The proposed amendments to rule 205-3 also would exclude the value of
a natural person’s primary residence and debt secured by the property from the determination of
whether a person has sufficient net worth to be considered a “qualified client,” and would modify
43
Section 418 of the Dodd-Frank Act.
19
the transition provisions of the rule to take into account performance fee arrangements that were
A. Benefits
We expect that adjusting the dollar amount thresholds in rule 205-3 for the effects of
inflation would benefit advisory clients. When the Commission adopted the dollar amount
thresholds in the definition of “qualified client” in rule 205-3 in 1985, it evaluated the most
appropriate dollar amount for both the assets-under-management and net worth tests. The
Commission 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.44
The adjustment of these dollar amount tests every five years would carry forward these
protections at dollar levels that are based on the current price levels in the economy. We believe
that adjusting these eligibility criteria to reflect real dollar equivalents would help to preserve
these protections.
The proposed exclusion of the value of an individual’s primary residence also would
benefit clients. As discussed above, the value of an individual’s primary residence may bear
little or no relationship to that person’s financial experience or ability to bear the risks associated
with performance fee arrangements. Therefore, a client who does not meet the net worth test of
rule 205-3 without including the value of her primary residence would be protected by the
44
See supra note 8 and accompanying text.
45
As discussed above, the proposed amendments to rule 205-3 also would exclude from the net
worth test the amount of debt secured by the primary residence that is no greater than the
property’s current market value. The exclusion of the debt might limit these benefits in some
circumstances. For example, if a client meets the net worth test as a result of the exclusion of
debt secured by the primary residence and the market value of the primary residence were to
decline to the extent that the debt could not be satisfied by the sale of the residence, the client
might be less able to bear the risks related to the performance fee contract and the investments
20
The proposed amendments to the rule’s transition provisions would benefit advisory
clients and investment advisers. The proposed amendments would 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 are designed so that the
restrictions on the charging of performance fees apply to new contractual arrangements and do
investment companies. Otherwise, advisory clients and investment advisers might have to
terminate contractual arrangements into which they previously entered and enter into new
• We request comment on these anticipated benefits, and on whether the proposed rule
advisers.
B. Costs
We do not expect that adjusting the dollar amount tests in rule 205-3 would impose
significant new costs on advisory clients or investment advisers. As discussed above, section
418 of the Dodd-Frank Act requires the Commission to periodically issue orders adjusting for
inflation the assets-under-management and net worth tests in rule 205-3. Raising these eligibility
criteria could mean that certain persons who would have qualified under the current dollar
amount thresholds would no longer qualify under the dollar amount thresholds as adjusted for the
performance fees to new clients to whom it could have charged performance fees if the advisory
contract had been entered into before the adjustment of the dollar amount thresholds. This effect
may result in an investment adviser declining to provide services to potential clients.46 However,
this cost is a consequence of the Dodd-Frank Act, and therefore we do not attribute this cost to
this rulemaking.
Section 418 of the Dodd-Frank Act does not specify how the Commission should
measure inflation. We have proposed to use the PCE Index because it is widely used as a broad
indicator of inflation in the economy and because the Commission has used the PCE Index in
other contexts. It is possible that the use of the PCE Index to measure inflation might result in a
larger or smaller dollar amount for the two thresholds than the use of a different index, although
the rounding required by the Dodd-Frank Act (to the nearest $100,000) would likely negate any
The proposed amendments to the rule’s transition provisions are not likely to impose any
new costs on advisory clients or investment advisers. As discussed above, the proposed
amendments would 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.
The proposed amendments also would exclude the value of a person’s primary residence
and debt secured by the property (if no greater than the current market value of the residence)
from the calculation of a person’s net worth. Based on data from the Federal Reserve Board,
approximately 5.5 million households have a net worth of more than $2 million including the
46
As discussed above, the proposed amendments would 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. See supra Section II.B.3.
22
equity in the primary residence (i.e., value minus debt secured by the property), and
approximately 4.2 million households have a net worth of more than $2 million excluding the
equity in the primary residence.47 Therefore, approximately 1.3 million households currently
would not meet a $2 million net worth test under the proposed revised test, and would therefore
not be considered “qualified clients,” if the value of the primary residence is excluded from the
test. Excluding the value of the primary residence (and debt secured by the property up to the
current market value of the residence) would mean that 1.3 million households that would have
met the net worth threshold if the value of the residence were included, as is currently permitted,
would no longer be “qualified clients” under the proposed revised net worth test and therefore
would be unable to enter into performance fee contracts unless they meet another test of rule
205-3.48
As noted above, the proposed amendments would allow an investment adviser and its
clients to maintain existing performance fee arrangements that were permissible when the
advisory contract was entered into. For purposes of this cost benefit analysis, Commission staff
assumes that 25 percent of the 1.3 million households would have entered into new advisory
contracts that contained performance fee arrangements after the compliance date of the
amendments, and therefore approximately 325,000 clients would not meet the revised net worth
test.49 Commission staff estimates that about 40 percent of those 325,000 potential clients (i.e.,
47
These figures are derived from the 2007 Federal Reserve Board Survey of Consumer Finances.
These figures represent the net worth of households rather than individual persons who might be
clients. More information regarding the survey may be obtained at
http://www.federalreserve.gov/pubs/oss/oss2/scfindex.html.
48
The net worth test includes assets that a natural person holds jointly with his or her spouse. See
rule 205-3(d)(1)(ii)(A).
49
The assumption that 25% of these investors would have entered into new performance fee
arrangements is based on data compiled in a 2008 report sponsored by the Commission. See
ANGELA A. HUNG ET AL., INVESTOR AND INDUSTRY PERSPECTIVES ON INVESTMENT ADVISERS
23
130,000) would separately meet the “qualified client” definition under the
assets-under-management test, and therefore could enter into performance fee arrangements.50
The remaining 60 percent (195,000 households) would have access only to those investment
advisers (directly or through the private investment companies they manage) that charge
advisory fees other than performance fees.51 Commission staff anticipates that the
non-performance fee arrangements into which these clients would enter would contain
management fees that yield advisers approximately the same amount of fees that clients would
have paid under performance fee arrangements. Under these arrangements, if the adviser’s
performance does not reach the level at which it would have accrued performance fees, a client
might end up paying higher overall fees than if he were paying performance fees. For purposes
of this cost benefit analysis, Commission staff assumes that approximately 80 percent of the
195,000 households (i.e.¸ 156,000 households) would enter into these non-performance fee
arrangements, and that the other 20 percent would decide not to invest their assets with an
adviser.52
Commission staff estimates that the remaining 39,000 households that would have
entered into advisory contracts, if the value of the client’s primary residence were not excluded
from the calculation of a person’s net worth, will not enter into advisory contracts. Some of
these households would likely seek other investment opportunities, for example, investing in
mutual funds, closed-end funds, or exchange-traded funds. Other households may forgo
professional investment management altogether because of the higher value they place on the
alignment of advisers’ interests with their own interests associated with the use of performance
fee arrangements.
We recognize that the proposed amendments that would exclude the value of a person’s
primary residence from the calculation of a person’s net worth also might result in a reduction in
the total fees collected by investment advisers. Because advisers would no longer be able to
charge some clients performance fees, it is possible that the overall fees collected by advisers
might be reduced. As discussed above, advisers may adjust their fees in order to obtain the same
revenue from clients who do not meet the definition of “qualified clients.” In addition, advisers
may choose to market their services to a larger number of potential clients and thereby enter into
advisory contracts with others to whom they could charge performance fees.53 As a result,
Commission staff estimates that the proposed amendments are not likely to impose a significant
estimates that less than one percent of registered advisers charge performance fees exclusively.
See supra note 51.
53
Commission staff notes that expanding marketing efforts could result in additional costs that
offset some of the new sources of revenue. As noted above, Commission staff estimates that
39,000 households that would have entered into advisory contracts would not enter into such
contracts as a result of the proposed exclusion of a client’s primary residence from a
determination of a client’s net worth. Based on ADV filings, Commission staff estimates that
3295 registered advisers charge performance fees. Therefore, Commission staff estimates that on
average each adviser would need to offset the loss of approximately 12 households (39,000/3295
= 11.8 households) to avoid a reduction in total fees collected, either by charging those
households comparable fees other than performance fees, or by attracting other clients that meet
the net worth test.
25
net cost on advisers. Because of the ability of investment advisers to attract qualified clients who
satisfy the proposed standards, and the ability of non-qualified clients to invest in other
investment opportunities that do not entail performance fees, we expect that the proposed rule
We request comment on the economic costs of excluding the value of the primary
residence and debt secured by the property from the net worth test for determining whether
• Would most households that no longer meet the net worth standard due to the
exclusion of the value of the primary residence, still receive advisory services?
offset the potential lost performance fees? If not, what would be the amount of lost
The Commission requests comment on all aspects of the cost benefit analysis, including
the accuracy of the potential benefits and costs identified and assessed in this release, as well as
any other benefits or costs that may result from the proposals. We encourage commenters to
identify, discuss, analyze, and supply relevant data regarding these or additional benefits and
costs. For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996,55 the
Commission also requests information regarding the potential annual effect of the proposals on
54
Clients who no longer meet the net worth test as a result of the exclusion of their primary
residence likely would have invested a smaller amount of assets than other clients who continue
to meet the test. Therefore, the revenue loss to investment advisers from the exclusion of these
clients from the performance fee exemption may be mitigated.
55
Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996) (codified in various sections of 5 U.S.C., 15
U.S.C., and as a note to 5 U.S.C. 601).
26
the U.S. economy. Commenters are requested to provide empirical data to support their views.
The proposed amendments to rule 205-3 under the Advisers Act do not contain a
“collection of information” requirement within the meaning of the Paperwork Reduction Act of
Section 3(a) of the Regulatory Flexibility Act of 198057 (“RFA”) requires the
Commission to undertake an initial regulatory flexibility analysis (“IRFA”) of the proposed rule
amendments on small entities unless the Commission certifies that the rule, if adopted, would not
U.S.C. section 605(b), the Commission hereby certifies that the proposed amendments to rule
205-3 under the Advisers Act, would not, if adopted, have a significant economic impact on a
substantial number of small entities. Under Commission rules, for purposes of the Advisers Act
and the RFA, an investment adviser generally is a small entity if it: (i) has assets under
management having a total value of less than $25 million; (ii) did not have total assets of $5
million or more on the last day of its most recent fiscal year; and (iii) does not control, is not
controlled by, and is not under common control with another investment adviser that has assets
under management of $25 million or more, or any person (other than a natural person) that had
total assets of $5 million or more on the last day of its most recent fiscal year .59
56
44 U.S.C. 3501-3521.
57
5 U.S.C. 603(a).
58
5 U.S.C. 605(b).
59
Rule 0-7(a).
27
11,888 investment advisers registered with the Commission are small entities. Only
approximately 20 percent of the 617 registered investment advisers that are small entities (about
122 advisers) charge any of their clients performance fees. In addition, 24 of the 122 advisers
require an initial investment from their clients that would meet the current
grandfathered into the exemption provided by rule 205-3 under the proposed amendments.
Therefore, if these advisers in the future raise those minimum investment levels to the revised
level that we intend to issue by order ($1 million), those advisers could charge their clients
performance fees because the clients would meet the assets-under-management test, even if they
would not meet the proposed net worth test that would exclude the value of the client’s primary
residence. For these reasons, the Commission believes that the proposed amendments to rule
205-3 would not, if adopted, have a significant economic impact on a substantial number of
small entities.
Commission solicits comments as to whether the proposed amendments could have an effect on
small entities that has not been considered. We request that commenters describe the nature of
any impact on small entities and provide empirical data to support the extent of such impact.
The Commission is proposing amendments to rule 205-3 pursuant to the authority set
forth in section 205(e) of the Investment Advisers Act of 1940 [15 U.S.C. 80b-5(e)].
For the reasons set out in the preamble, Title 17, Chapter II of the Code of Federal
28
otherwise noted.
* * * * *
* * * * *
adviser entered into a contract and satisfied the conditions of this section that were in effect when
the contract was entered into, the adviser will be considered to satisfy the conditions of this
section; Provided, however, that if a natural person or company who was not a party to the
contract becomes a party (including an equity owner of a private investment company advised by
the adviser), the conditions of this section in effect at that time will apply with regard to that
person or company.
(2) Registered investment advisers that were previously exempt from registration. If an
investment adviser was exempt from registration with the Commission pursuant to section 203 of
the Act (15 U.S.C. 80b-3), section 205(a)(1) of the Act will not apply to an advisory contract
29
entered into when the adviser was exempt, or to an account of an equity owner of a private
investment company advised by the adviser if the account was established when the adviser was
exempt; Provided, however, that section 205(a)(1) of the Act will apply with regard to a natural
person or company who was not a party to the contract and becomes a party (including an equity
owner of a private investment company advised by the adviser) when the adviser is no longer
exempt.
(i) A natural person who, or a company that, immediately after entering into the contract
(ii) A natural person who, or a company that, the investment adviser entering into the
contract (and any person acting on his behalf) reasonably believes, immediately prior to entering
(A) Has a net worth (together, in the case of a natural person, with assets held jointly
with a spouse) of more than $2,000,000, excluding the value of the primary residence of such
natural person, calculated by subtracting from the estimated fair market value of the property the
amount of debt secured by the property, up to the estimated fair market value of the property; or
Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the time the contract is entered into; or
* * * * *
(e) Inflation adjustments. Pursuant to section 205(e) of the Act, the dollar amounts
specified in paragraphs (d)(1)(i) and (d)(1)(ii)(A) of this section shall be adjusted by order of the
Commission, effective on or about May 1, 2016 and issued approximately every five years
30
thereafter. The adjusted dollar amounts established in such orders shall be computed by:
(1) Dividing the year-end value of the Personal Consumption Expenditures Chain-Type
Price Index (or any successor index thereto), as published by the United States Department of
Commerce, for the calendar year preceding the calendar year in which the order is being issued,
by the year-end value of such index (or successor) for the calendar year 1997;
(2) For the dollar amount in paragraph (d)(1)(i) of this section, multiplying $750,000
times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the
(3) For the dollar amount in paragraph (d)(1)(ii)(A) of this section, multiplying
$1,500,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the
By the Commission.
Elizabeth M. Murphy
Secretary