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by Kay Gordon and Joshua M. O'Melia
On May 10, 2011, as required by
Section 418 of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(the "Dodd-Frank Act"), the U.S. Securities and Exchange Commission
(the "SEC") proposed to amend Rule 205-3 (the "Rule") of
the U.S. Investment Advisers Act of 1940, as amended (the "Advisers
Act") to increase the dollar thresholds used to determine whether an
investment advisory client is a "qualified client" that can be
subject to a performance fee paid by such client to an investment adviser. The proposed amendments to the Rule (collectively,
the "Proposed Rule Amendments") also (i) provide for a periodic
inflation adjustment to the dollar thresholds used to determine the qualified
client standard, (ii) exclude the value of a person's primary residence from
the calculation of net worth under the Rule and (iii) add a transition
provision to the Rule to allow for the continuation of certain arrangements
(including certain new investments under such arrangements) that were
permissible at the time the adviser and client entered into the advisory
agreement. The SEC has requested that all comments on the Proposed Rule
Amendments be received by the SEC on or before July 11, 2011.
The Advisers Act and the rules thereunder generally do not permit registered
investment advisers to be compensated based on a share of capital gains or
capital appreciation of the funds of a client under such adviser's management
(generally known as a performance fee or performance allocation) unless the
client is a "qualified client," as defined under the Rule. In its
current form, the Rule defines a "qualified client" as (i) a client
with at least $750,000 under the management of the adviser immediately after
entering into the advisory contract (the "AUM Threshold"), or (ii) a
client that the adviser reasonably believes (a) has a net worth (in the case of
a natural person, together with assets owned jointly by his or her spouse) of
more than $1,500,000 at the time the advisory contract is entered into (the
"Net Worth Threshold") or (b) is a "qualified purchaser,"
as defined in Section 2(a)(51)(A) of the U.S. Investment Company Act of 1940,
as amended (the "Company Act").
The Dodd-Frank Act, among other provisions, amended the Advisers Act by
requiring the SEC to adjust for inflation, by July 21, 2011 and every five
years thereafter, the dollar tests used in all rules issued under Section
205(e) of the Advisers Act, including the qualified client test used in the
Rule. Separately, the Dodd-Frank Act required the SEC to adopt a new definition
of "accredited investor" under the U.S. Securities Act of 1933, as amended,
to exclude the value of a person's primary residence. The SEC has proposed that
the definition of "qualified client" under the Advisers Act be
similarly amended. [footnotes omitted]
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Kay Gordon is a partner at K&L Gates LLP. Ms. Gordon practices in the
firm's New York office and concentrates her work in the Investment Management
practice, with a particular emphasis on hedge funds, private equity funds and
compliance-related matters involving registered advisers and broker-dealers. She
also advises clients on a broad range of securities and regulatory matters as
well as a variety of financial instruments and transactions, including managed
accounts, credit facilities, joint ventures and derivative instruments. She also
represents clients in investigations by the SEC and other regulators.Joshua M. O'Melia is an
associate at K&L Gates LLP. Mr. O'Melia concentrates his work in the
investment management practice, with a particular emphasis on hedge funds,
private equity funds and compliance-related matters involving investment
advisers and broker-dealers. He advises clients (including investment advisers,
private domestic and offshore investment funds, broker-dealers and financial
institutions) on structuring, organization, distribution, regulatory and
compliance issues. He also assists clients undergoing investigations and
examinations by the SEC and other regulatory organizations.