SEC Revises Thresholds Allowing Investment Advisers to Charge Performance Fees but Grandfathers Existing Relationships

February 21, 2012


The Securities and Exchange Commission (the “Commission”) adopted revisions to the rules under the Investment Adviser Act of 1940 (the “Advisers Act”) that permit investment advisers to charge performance-based compensation to “qualified clients.” The Commission’s release adopting the revised investment adviser performance fee is available here.

Section 205(a)(1) of the Advisers Act generally restricts 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. In 1985, the Commission adopted Rule 205-3 to exempt an investment adviser from the restrictions against charging a client performance fees in certain circumstances. The rule 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 (the “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 (the “net-worth test”). In 1998, the Commission increased these thresholds to $750,000 and $1.5 million, respectively, to adjust for inflation. The amendments adopted by the Commission this week codify revisions put into effect by a Commission order dated July 12, 2011, revising the threshold of the assets-under-management test to $1 million, and of the net-worth test to $2 million.[1]

The Commission also adopted a new rule that will permit it to make inflation-based adjustments to the dollar amount of the assets-under-management and the net-worth tests by order in lieu of the rule-making process. These future inflation adjustments will be based on the Personal Consumption Expenditures Chain-Type Price Index, or PCE Index, published by the Chamber of Commerce.

In addition, the Commission amended the net-worth test in the Rule 205-3 definition of “qualified client” to exclude the value of a natural person’s primary residence and certain debt secured by the property. Debt secured by a primary residence generally will not be included as a liability in the net-worth calculation under the rule, except to the extent it exceeds the estimated value of the primary residence. However, any increase in the amount of debt secured by the primary residence in the 60 days before the advisory contract is entered into generally will be included as a liability, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by such primary residence. In other words, at the time the advisory contract is entered into, the 60-day look-back provision requires investors to identify any increase in mortgage debt over the 60-day period prior to entering into an advisory contract and count that debt as a liability in calculating net-worth.

To minimize the disruption of existing contractual relationships, restrictions on performance fees apply only to new contractual arrangements and do not apply to new investments by clients (including equity owners of “private investment companies”) who met the definition of “qualified client” when they entered into the advisory contract. Nor will the new rules apply to the contractual arrangements of a registered investment adviser that were entered into before the adviser was required, or voluntarily chose, to register with the Commission. Finally, the rules adopted by the Commission permit limited transfers of interests from a qualified client to a person who was not a party to the contract and is not a qualified client at the time of the transfer — specifically, transfers of an interest by gift or bequest, or pursuant to an agreement related to a legal separation or divorce.

If you have any questions regarding the revisions to the tests for an investment adviser to charge performance fees, including the transition rules, please contact the authors of this Client Alert or your O’Melveny & Myers advisor.

[1] See Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3236 (July 12, 2011).