Be on Alert: Changes Coming for Advisers Charging Performance Fees

Rule 205-3 of the Advisers Act provides an exemption from the general prohibition on charging performance-based fees and permits SEC-registered investment advisers to charge such fees to “qualified clients.” Currently, a client is a “qualified client” under the dollar amount tests of Rule 205-3 if: (i) the client at least $750,000 under management of the adviser; or (ii) the adviser reasonably believes that the client has a net worth of more than $1.5 million. In a release issued yesterday, the SEC stated that it intends issue an order increasing the dollar amount thresholds for determining whether a client is a “qualified client” eligible to be charged performance-based fees. These adjustments, which are required by the Dodd-Frank Act, accounts for the effects of inflation and will adjust the requirements for assets under management from $750,000 to $1 million and increase worth from $1.5 million to $2 million. This will take effect no later than July 21, 2011 and will be adjusted every five years thereafter.

In addition to the adjustments to the dollar amount tests, the SEC is proposing to amend the net worth standard in the definition of “qualified client” under Rule 205-3 to exclude the value of a person’s primary residence from the determination of whether a person meets the definition of “qualified client” on the basis of his/her net worth. Although not required by the Dodd-Frank Act, this change is intended to correspond to the revised net worth standard for the definition of accredited investor under the Securities Act. However, when combined with the mandatory adjustment to the dollar amount test to account for inflation, this change could potentially bring about a dramatic shift in the number of clients who are eligible to be charged performance fees, and may result in many advisers revising their traditional fee schedules to make up for the potential loss of revenue.

Comments on the proposed revisions are due by July 11, 2011 and may be submitted using the SEC’s Internet comment form, or by sending an email to rule-comments@sec.gov and including File Number S7-17-11 on the subject line. For additional information, please contact Zac Rosenberg, Compliance Consultant by email at zachary.rosenberg@corecls.com or by phone at (619) 278-0020.