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Banking and Finance

Tighter Rules on Advisory Performance Fee Charges

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 officially increased.

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 SEC standards.

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 the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.


For additional commentary on developments in compliance and ethics, visit Compliance Building, a blog hosted by Doug Cornelius.

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