SEC Raises “Qualified Client” Net Worth Threshold

June 24, 2016

Effective as of August 15, 2016, the dollar amount of the “qualified client” net worth test will increase from $2 million to $2.1 million.

In an order dated June 14, 2016, the Securities and Exchange Commission (the “SEC”) adopted its prior proposal to increase the net worth threshold for “qualified clients” under Rule 205-3 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), from $2 million to $2.1 million.1 This adjustment is being made pursuant to a five-year indexing adjustment required by section 205(e) of the Advisers Act and section 419 of the Dodd-Frank Act.2 The effective date of the increase is August 15, 2016. Clients that enter into advisory agreements in reliance on the net worth test prior to the effective date will be “grandfathered” in under the prior net worth threshold.

Rule 205-3 of the Advisers Act permits investment advisers to receive performance-based compensation only when the client is a “qualified client.” Since performance-based compensation includes performance fees and carried interest, the increased threshold will affect managed accounts and private funds that rely on the exception to the definition of an investment company provided in section 3(c)(1) of the Investment Company Act. Under Rule 205-3, each investor in these 3(c)(1) private funds must be a qualified client to the extent the fund pays performance-based compensation.

After giving effect to the increase, a qualified client will be a client that:

(i) has at least $1 million in assets under management with the investment adviser immediately after entering into the advisory contract;3  or 

(ii) has a net worth (together, in the case of a client which is a natural person, with assets held jointly with a spouse) which the investment adviser reasonably believes to be in excess of $2.1 million immediately prior to entering into the advisory contract (“net worth test”).4 

A qualified client also includes both a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), and an investment adviser’s “knowledgeable employees.”

Clients that enter into advisory agreements in reliance on the net worth test prior to the effective date, will be “grandfathered” in under the prior net worth threshold. However, sponsors of section 3(c)(1) funds should update their current offering documents to conform to the new qualified client threshold.5 The updated net worth threshold should be reflected in prospective investor net worth representations in subscription agreements for any section 3(c)(1) funds with closings on or after the effective date and representations in any documents used in effectuating secondary transfers of ownership interests in existing section 3(c)(1) funds following the effective date.

Please do not hesitate to contact us with any questions.

Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Advisers Act Release No. 4421 (June 14, 2016), available at: http://www.sec.gov/rules/other/2016/ia-4421.pdf.

Section 205(e) of the Advisers Act and section 418 of the Dodd-Frank Act require the SEC to issue an order every five years to adjust for inflation the dollar amount thresholds in Rule 205-3’s assets-under-management and net worth tests based on the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index,” published by the United States Department of Commerce), rounded to the nearest $100,000.

The dollar amount of the assets-under-management test will remain $1 million because the amount of the SEC’s inflation adjustment calculation is smaller than the rounding amount specified under Rule 205-3(e) of the Advisers Act.

While a natural person’s primary residence must not be included as an asset, indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time the investment advisory contract is entered into, may be excluded as a liability (subject to limitations in the case of recently acquired debt). Additionally, indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the residence also must be included as a liability.

The transition rules set forth in Rule 205-3(c)(1) provide that, if an investment adviser entered into an advisory agreement prior to the effective date with an investor that satisfied the qualified client status rule in effect at the time the advisory agreement was entered into, the qualified client rule will be considered satisfied; however, if an investor who was not a party to the advisory agreement becomes a party to it on or after August 15, 2016 (including an investor coming into a 3(c)(1) fund on or after August 15, 2016), the new standard would apply (i.e., if the new investor is relying on the net worth test, it would need to meet the new $2.1 million net worth threshold).

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Timothy M. Clark, an O'Melveny partner licensed to practice law in New York, Don Melamed, an O'Melveny partner licensed to practice in California, and Alicja Biskupska-Haas, an O'Melveny counsel, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted. 

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