I.          Increase to the Dollar Amounts of the Qualified Client Assets Under Management and Net Worth Tests.  Section 205(a)(1) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) generally prohibits advisers registered or required to be registered (“SEC Advisers”) with the Securities and Exchange Commission (the “SEC”) from charging their clients “performance fees” or fees based on a share of capital appreciation of the client’s assets under management.  However, pursuant to Advisers Act Rule 205-3, an SEC Adviser may charge a performance fee to a “qualified client¹.”  Among those currently designated by the rule as qualified clients are (a) a natural person or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser (the “AUM Test”) and (b) a natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time the contract is entered into (the “Net Worth Test”).  The current dollar amounts of the AUM Test and the Net Worth Test have been in place since 1998.  However, Section 418 of the Dodd-Frank Wall Street Reform and Consumer Protection Act² (the “Dodd-Frank Act”) requires the SEC to adjust these dollar amount tests for inflation by July 21, 2011 and every five years thereafter.  On July 12, 2011, the SEC, in response to this Dodd-Frank mandate, issued an order³ that increases the dollar amount of the AUM Test to at least $1,000,000 and increases the dollar amount of the Net Worth Test to more than $2,000,000.  These increased dollar amounts become effective on September 19, 2011.

II.        Other Changes to Rule 205-3 Currently Proposed.   In addition to increasing the monetary thresholds for the qualified client AUM Test and Net Worth Test, as described above, the SEC has proposed the following additional amendments to Advisers Act Rule 205-3:

(a)  Dollar Amounts to be Adjusted Every Five Years:    The SEC plans to revise Rule 205-3 to require the SEC to issue an order every five years adjusting the dollar amounts of the rule’s AUM Test and Net Worth Test for inflation based upon the PCE Index (the Personal Consumption Expenditures Chain-Type Price Index).    

(b)  Exclusion of the Value of Primary Residence from Net Worth Determination; Approach Mirrors Revised Accredited Investor Standard:  The SEC is considering whether the value of a natural person’s primary residence and the debt secured by the property should be excluded for purposes of Rule 205-3’s Net Worth Test.  Specifically, revised Advisers Act Rule 205-3, as proposed, would calculate net worth by excluding the value of the primary residence of a natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.  In other words, the individual’s net equity in his/her primary residence would be excluded when calculating the individual’s net worth.   Outstanding debt exceeding the market value of the residence would be considered a liability deduction in the net worth calculation.

This approach mirrors the SEC’s proposed revisions to the “accredited investor” net worth calculation under the rules issued under the Securities Act of 1933.⁴  Section 413(a) of the Dodd-Frank Act required, the accredited investor definition to exclude, effective July 21, 2010, (i.e., the enactment date of the Dodd-Frank Act) the value of an individual’s primary residence for purposes of determining whether the individual qualifies as an accredited investor on the basis of having a net worth of more than $1 million.  In order to define the term “value” and address how mortgage indebtedness should be treated for purposes of the amended accredited investor net worth calculation, the SEC has proposed amending the accredited investor net worth standard to read as follows:

“Any natural person whose individual net worth, or joint net worth with the person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.”⁵  Thus, as has been proposed with respect to the qualified client net worth calculation, the accredited investor net worth calculation would exclude only the individual’s net equity in his/her primary residence.  Indebtedness secured by the residence in excess of its estimated fair market value would be a liability deduction in the net worth calculation.

(c)  Transition Rules / Grandfathering Rules:  The SEC has also proposed to revise Advisers Act Rule 205-3 to permit investment advisers and their clients to continue performance fee arrangements that were permissible at the time the advisory contract was signed, even if such client could not be charged performance fees under the revised rule.  The adviser may also continue to accept additional funds from these clients.  However, if an individual or company that was not a party to the original contract subsequently becomes a party, then the adviser, with respect to the new party, must comply with the conditions of the rule that are in effect at the time the new party joins the contract.  Revised Rule 205-3, as proposed, would also provide that, if an adviser was previously exempt from SEC registration pursuant to Section 203 of the Advisers Act (e.g., certain private fund advisers) and then registers with the SEC, the performance fee prohibition will not apply to contractual arrangements that the adviser entered into when it was exempt from SEC registration.  As a result, investors who entered a private fund while the fund’s adviser was exempt from SEC registration would not be subject to the performance fee prohibition but investors who enter the private fund after the fund’s adviser has registered with the SEC would be subject to the performance fee prohibition of Rule 205-3 and its exceptions.   

If you would like additional information about anything discussed in this memorandum, please contact Geraldine Cunningham (GCunningham@kmollp.com; 212-906-8310).    

Disclaimer

This memorandum may be considered attorney marketing and/or advertising.  The information contained in this memorandum is for informational purposes only and is not intended and should not be considered legal advice on any subject matter.  Recipients of this memorandum should not act or refrain from acting on the basis of any information included in this memorandum without seeking appropriate legal or other professional advice.  This information is presented without any warranty or representation as to its accuracy or completeness, or whether it reflects the most current legal developments.

To ensure compliance with Treasury regulations regarding practice before the IRS, we inform you that, unless expressly stated otherwise, any federal tax advice contained in this communication was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (i) avoiding penalties that may be imposed on the taxpayer under United States federal tax law, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

©2011 Kavanagh Maloney & Osnato LLP, 415 Madison Avenue, New York, NY 10017, 212-207-8400, www.kmollp.com.  All rights reserved.