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Under the Investment Advisers Act, an adviser can only
charge a performance fee if the client was a "qualified client". The SEC
equates net worth with sophistication, so a "qualified client" had to have a
level assets to prove their financial sophistication. Those levels are now
The original standard was that the client had to have at
least $500,000 under management with the adviser immediately after entering
into the advisory contract ("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 ("net worth test"). Those levels were
increased to $750,000 and $1.5 million in 1985 to adjust for inflation.
The Dodd-Frank Wall Street Reform and Consumer Protection
Act called for Section 205(e) of the Advisers Act to adjust those levels for
inflation and re-adjust the levels every five years. The SEC also decided to
toss out the value of a person's primary residence, just as they did with the
new accredited investor standards.
The rule now requires "qualified clients" to 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 SEC is using the same primary residence calculation
they used in the new accredited investor standard. So, if you owe more on your
mortgage than the value of your house, then you need to treat the overage as a
negative asset. As the SEC did with the accredited investor standard, the SEC
requires certain mortgage refinancings to be counted against net worth. If the
borrowing occurs in the 60 days preceding the purchase of securities in the
exempt offering and is not in connection with the acquisition of the primary
residence, the new increase in debt secured by the primary residence must be
treated as a liability in the net worth calculation. This is intended to
prevent manipulation of the net worth standard, by eliminating the ability of
individuals to artificially inflate net worth under the new definition by
borrowing against home equity shortly before participating in an exempt
securities offering. Once again, owning a house can only be a negative for the
While I used the CPI-I standard as the benchmark for
inflation, the SEC chose to use the Personal
Consumption Expenditures Chain-Type Price Index ("PCE Index"), published by
the Department of Commerce. One of the questions from the SEC in the proposed
rule was whether the PCE index was the appropriate measure of inflation.
They've decided to use this index and continue to benchmark it against the
original test amounts. In five years, you will be able to predict what the new
levels will be.
As for private funds, Rule 205-3(b)
requires a look -through from the fund to the investors in the fund. Each
"equity owner ... will be considered a client for purposes of the"
limitation. If the fund is relying on the 3(c)(7)
exemption from the Investment
Company Act then the fund's investors should be "qualified
purchasers" and you won't need to look much further. If the fund is using
exemption, then it will need to take a closer look at its investors to make
sure that each is a qualified client.
additional commentary on developments in compliance and ethics, visit Compliance Building,
a blog hosted by Doug Cornelius.
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