SEC Tightens "Qualified Client" Requirements for Registered Investment Advisers to Charge Performance Fees

This note summarizes rule amendments adopted by the Securities and Exchange Commission (the “SEC”) under the Investment Advisers Act of 1940 tightening eligibility requirements for “qualified clients” from which registered investment advisers may collect performance fees.

Under existing Rule 205-3, registered investment advisers may only charge clients performance fees if the client’s (i) net worth, or (ii) assets under management by the adviser meet certain dollar thresholds (“qualified clients”). The SEC believes that such performance fee arrangements may encourage undue risk-taking by advisers, and the rules are intended to limit such arrangements to clients “who are financially experienced and able to bear the risks.”

On February 15, 2012, the SEC adopted rule amendments that tighten the requirements for “qualified clients” in the following manner:

• Clients must now have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million
• The value of a client’s primary residence and certain property-related debts is excluded from the net worth calculation
• Every five years, the Commission will issue an order adjusting the dollar thresholds to account for inflation

Most of these changes were mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. However, a new grandfather provision to the performance fee rule permits registered investment advisers to continue charging performance fees if its clients were “qualified clients” before the rule changes. In addition, formerly exempt investment advisers may continue charging performance fees to its clients upon registration, provided that such clients were already being charged in such a manner.

In its adopting release, the SEC estimates that the exclusion of the value of a client’s home will result in up to 1.3 million households no longer meeting the net worth test, though an estimated 40% of such households will remain “qualified clients” under the assets under management test. The SEC acknowledges that, as a result of the rule changes, some clients will pursue non-performance fee arrangements with advisers or target investment opportunities elsewhere.

The full adopting release can be found here.

If you have any questions, please feel free to contact any of your regular contacts at the firm or any of our partners and counsel listed under ”Private Equity.”