SEC Amends the "Qualified Client" Standard for Investment Adviser Performance-Based Compensation

SEC Amends the "Qualified Client" Standard for Investment Adviser Performance-Based Compensation


I. Introduction

On February 15, 2012, the U.S. Securities and Exchange Commission (the "SEC") issued a final rule release (the "Adopting Release") amending Rule 205-3 (the "Rule") of the U.S. Investment Advisers Act of 1940, as amended (the "Advisers Act"), pursuant to the requirements of Section 418 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The Rule amendments will become effective on May 22, 2012 (the "Effective Date") and will provide for the following new requirements:

  • Codification of the increase in the dollar thresholds used to determine whether an investment advisory client is a "qualified client" implemented by an SEC order on July 12, 2011;
  • A modified net worth test for "qualified clients," including a provision that excludes the value of a person's primary residence and certain debt secured by the residence from the calculation of net worth under the Rule;
  • Revised transition provisions of 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; and
  • A requirement for the SEC to issue periodic orders to adjust the dollar thresholds used to determine the qualified client standard to account for inflation.

II. Background

The Advisers Act generally does 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. Before the Dodd-Frank Act, the Rule defined 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 believed (a) had 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 was entered into (the "Net Worth Threshold") or (b) was 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 SEC adjusted these thresholds upwards by order on July 12, 2011 in order to implement the requirements of the Dodd-Frank Act, which mandated that the SEC 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 from the "accredited investor" net worth test (although the Dodd-Frank Act did not require a similar amendment to be implemented in respect of the "qualified client" test).

The term "qualified client" is also incorporated in the SEC definition of "investment adviser representative," and thus, the newly adopted Rule amendments also affect whether advisory personnel need to be licensed with applicable states as investment adviser representatives. [footnotes omitted]

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Kay. A. 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.

Ms. Gordon was recently recognized by Legal 500 US in its 2009 Edition as a Leading Lawyer in Investment Fund Formation and Management.

Yusef Alexandrine is an associate in K&L Gates' San Francisco office and a member of the Investment Management practice group. He advises participants in the financial services industry, including investment advisers to hedge funds, private equity funds, and venture capital funds, registered open-end and closed-end funds, exchange traded funds and mutual funds, as well as mutual fund independent directors, investment banks and broker-dealers, on regulatory, transactional and counseling matters involving the securities and commodities laws. He also regularly provides advice with respect to exemptions, no-action letters, and other forms of regulatory relief. In addition, he advises clients on state blue sky issues, particularly California securities law regulatory issues.